Updated: Oct 31, 2022
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In his book “An Inquiry into the Nature and Causes of the Wealth of Nations” published in 1776, the classical Economist Adam Smith came up with the metaphor of 'Invisible Hand' which claimed that markets work best if they are allowed to be free from any government intervention. He claimed that if the private markets were allowed to function on their own without any intervention, the forces of market demand and supply would lead the economy to equilibrium and do a better job at allocating resources than the government.
This concept of the 'Invisible Hand' on which the concepts of market economies and capitalism rely, may not be entirely relevant in today’s scenario. The question whether or not the concept of 'Invisible Hand' is relevant is essentially a question of whether markets should be allowed to operate completely freely without any government intervention or if government intervention can actually improve the outcomes in the economy.
The 'Invisible Hand' cannot always lead the market to equilibrium on its own, and leaving the economy to the forces of market demand and supply may not always lead to the best outcome in the economy. The Great Depression showcased the importance of government intervention when the renowned British economist John Maynard Keynes argued, contrary to the belief of classical economists, the economy would not return to equilibrium on its own due to the 'Invisible Hand'. During the Great Depression, there was a severe reduction in output, a rise in unemployment, and an acute case of deflation. Economists who believed in the classical school of thought argued that the market economy should be left on its own to reach back to a point of stability. Keynes, however, suggested increasing government spending, cutting taxes, and adopting an expansionary monetary policy to tackle the depression.
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This concept of Keynes, which is a part of Keynesian economics, talks about the importance of government intervention in achieving equilibrium and continues to be used by governments all over the world to intervene and stabilize the economy and prevent or moderate recessions.
In 2008, the financial crisis is also believed to be a consequence of the Federal Reserve Bank’s belief in the 'Invisible Hand', which failed to see the crisis coming. Jonathan Schlefer, the author of the book The Assumptions Economists Make, suggested that the principal models that the Federal Bank used assumed that the markets were always in an instantaneous equilibrium, so they did not believe that a crisis could ever occur. However, after the crisis occurred, the Federal Bank dropped its high-tech 'Invisible Hand' models and responded with full support to the economy. This is just yet another of the many examples that show that the 'Invisible Hand' is not relevant in the modern economy.
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It is important to also understand that centrally planned economies are not the correct alternative to the free market economies governed by the 'Invisible Hand'. As highlighted by the case of the Soviet Union, centrally planned economies also have their shortcomings. In the 1960s, the Soviet Union, which was a centrally planned economy, reported that its gross national product (GNP) grew at a much higher rate than that of the United States, a market economy. Several authorities, including the Central Intelligence Agency, estimated that the GNP of the Soviet Union would exceed that of the US. This led to many economists doubting the relevance of the 'Invisible Hand' and the notion that market economies produce higher growth rates. However, G. Warren Nutter argued that the CIA’s estimates were far too high as he believed that centrally planned economies could not achieve higher living standards than market economies because the government could not superintend the industry of private people as that required too much information and was too difficult to structure. Nutter’s argument turned out to be meritorious as the Soviet Union was falling behind the US and by the 1990s, it was disintegrated.
I feel that the key to the question of “Is the 'Invisible Hand' still relevant in the modern economy?” lies in changing the question to “to what extent can the economy be allowed to operate freely in the modern world?”. The financial reforms since 2008 have been focused on increasing the government’s involvement in placing checks on destructive market practices, the absence of which led to the crisis in the first place. Hence, an appropriate balance between reliance on market economies and government intervention is the way forward. So, while the ‘Invisible Hand’ is not relevant in its entirety in the modern economy, it is still believed that markets should be allowed to operate freely while addressing the specific problems in the financial system and the economy through occasional government intervention.
BY PRANAV ANAND