As an economist (University of Chicago no less), I find myself pondering the status of Adam Smith and his iconic metaphor of the free market economy as an Invisible Hand, leading people collectively to wise decisions without requiring anything other than their own selfish interests as a guidepost. Meaning that a free people left to their own devices will manage to deploy national resources in an optimal manner, without need of any supposedly wise benevolent government or Godfather to step in. A tenet, after all, central to the national self-image of America.
But today, with the U.S. finding itself in the midst of a crisis caused at root by what may turn out to be the worst mismanagement of scarce resources ever – even surpassing the disasters of Soviet central planning – can we still put faith in the Invisible Hand? Is private greed still good public policy?
How have we ended up with $700,000 McMansions studding the farmlands of Tracy, Stockton, Bakersfield when we needed middle income multi-family housing and good low-income rental stocks? And our largest financial institutions including the firms such as ratings agencies and insurers whose business is risk, failed so miserably to assess and control risk?
So we have the combined loss of trillions of dollars in our banks and insurance houses piled onto a disastrously costly war in Iraq; public infrastructure crumbling so badly that bridges collapse and kill dozens; crucial air traffic control struggling because it hasn’t been upgraded since the 1970s; and CEOs and corporate directors looting shareholder value at a rate so vast it hasn’t yet been completely comprehended.
Adam Smith’s Invisible Hand relies on individuals, and companies, having adequate information on dealings in order to make good decisions. Has our economy so developed in the past half-century that our private decisions are no longer adequately connected to outcomes?
Certainly the rise of mathematically modeled derivatives created a situation where humans had to rely on the accuracy of the models and the assumptions of the models. And the rise of the derivatives created the market that allowed individuals without real means to borrow substantial sums of money. At the same time, forces developed allowing corporate governance to disconnect from real outcomes – think Tyco, Citi and many others. With executive compensation being linked to short-term or transient, and in many cases non-existent, share price increases via the magic of repriceable options, said execs had incentive to use more and more leverage and take on more and more risk. The risk being borne by the shareholders while short-term gains were able to be hijacked by the people supposedly in charge of governance. And the final losses now being borne collectively by the public in the form of the necessary bailouts.
So the question is how far and how well will the next administration go to figuring out the causes of the current debacle and addressing them? Will we still be able to even talk about a wise Invisible Hand in three or five years? We already know central planning is not an option. So what next?