[A-List] Adam Smith's invisible hand is invisible because, at least in part, it is not there

[Sabri Oncu]

The Economic Times


TUESDAY, DECEMBER 17, 2002


Celebrating the irrational


JOSEPH STIGLITZ


Three cheers for the new Nobel laureates in economics: Daniel
Kahneman of Princeton University, and Vernon Smith of George
Mason University in Virginia.

Like many Nobel prizes, these awards recognise not only the
seminal work undertaken by Kahneman and Smith, but also the
schools of thought they help to lead.

Kahneman, a psychologist, has demonstrated how individuals
systematically behave in ways less rational than orthodox
economists believe they do.

His research shows not only that individuals sometimes act
differently than standard economic theories predict, but that
they do so regularly, systematically, and in ways that can be
understood and interpreted through alternative hypotheses,
competing with those utilised by orthodox economists.

To most market participants - and indeed, ordinary observers -
this does not seem like big news. Wall Street brokers who peddled
stocks they knew to be garbage exploited the irrationality that
Kahneman and Smith exposed. Much of the mania that led to the
bubble economy was based on exploiting investor psychology.

In fact, this irrationality is no news to the economics
profession either. John Maynard Keynes long ago described the
stock market as based not on rational individuals struggling to
uncover market fundamentals, but as a beauty contest in which the
winner is the one who guesses best what the judges will say.

This year's Nobel prize celebrates a critique of simplistic
market economics, just as last year's award (of which I was one
of the three winners) did. Last year's laureates emphasised that
different market participants have different (and imperfect)
information, and these asymmetries in information have profound
impact on how an economy functions.

In particular, last year's laureates implied that markets were
not, in general, efficient; that there was an important role for
government to play. Adam Smith's invisible hand - the idea that
free markets lead to efficiency as if by an invisible hand - is
invisible at least in part because it is not there.

This, too, is not news to those who work day after day in the
market (and make their fortunes by taking advantage of and
overcoming asymmetries in information). For more than twenty
years economists were enthralled to so called "rational
expectations" models which assumed that all participants have the
same (if not perfect) information and act perfectly rationally,
that markets are perfectly efficient, that unemployment never
exists (except when caused by greedy unions or government minimum
wages), and where there is never any credit rationing.

That such models prevailed, especially in America's graduate
schools, despite evidence to the contrary bears testimony to a
triumph of ideology over science. Unfortunately, students of
these graduate programmes now act as policymakers in many
countries, and are trying to implement programmes based on the
ideas that have come to be called market fundamentalism.

Let me be clear: the rational expectations models made an
important contribution to economics; the rigor which its
supporters imposed on economic thinking helped expose the
weaknesses many underlying hypotheses. Good science recognises
its limitations, but the prophets of rational expectations have
usually shown no such modesty.

Vernon Smith is a leader in the development of experimental
economics, the idea that one could test many economic
propositions in laboratory settings. One reason that economics is
such a difficult subject, and why there are so many disagreements
among economists, is that economists cannot conduct controlled
experiments. Nature throws up natural experiments, but in most
circumstances, so many things change so rapidly that it is often
difficult to untangle what caused what.

In principle, in a laboratory, we can conduct controlled
experiments, and therefore make more reliable inferences. Critics
of experimental economics worry that subjects bring to
experimental situations modes of thought determined outside of
the experiment, and thus that the experiments are not as clean
and the inferences not as clear cut as in the physical sciences.
Nonetheless, economic experiments provide insights into a number
of important issues, such as the improved design of auctions.
Most importantly, the irrationality of market participants, which
was the focus of Kahneman's work, has been verified repeatedly in
laboratory contexts.

Among the more amusing results that have come out of experimental
economics are those concerning altruism and selfishness. It
appears (at least in experimental situations) that experimental
subjects are not as selfish as economists have hypothesised,
except for one group - the economists themselves.

Is it because economics as a discipline attracts individuals who
are by nature more selfish or is it because economics helps shape
individuals, making them more selfish? The answer, almost
certainly, is a little bit of both. Presumably, future
experimental research will help resolve the question of the
relative importance of these two hypotheses.

The Nobel prize signifies how important it is to study people and
economies as they are, not as we want them to be. Only by
understanding better actual human behaviour can we hope to design
policies that will make our economies work better as well.


(The author is Professor of Economics and Finance at Columbia
University and the winner of the 2001 Nobel prize in Economics)