The importance of Adam Smith's 'Invisible Hand'

Commemoration of the birth of Adam Smith, 300 years ago, has prompted new debate on his legacy. He remains much misunderstood on economics, but understanding of his moral views is growing. This makes his work relevant today, when the invisible hand of a mixed economy seems to be failing to deliver what society wants. But might the problem reflect a lack of price signals in an economy that seems more driven by ad hoc intervention? Tempting as it is to see market failure everywhere, prices can do the work of an army of politicians and economists. How can the right balance be achieved?

Targeted and temporary intervention in the economy is sometimes essential. Inflation and the ensuing cost of living crisis has spurred government action to support the worst hit, control prices, and challenge business behaviour. But there is a contradiction at the heart of political initiatives. Economic policy starts from an assumed position of equilibrium - the calculations on economic behaviour depend on this. The further the position is from a stable state the harder it is to work out the impact of any intervention. Unintended consequences abound but become harder to predict. Some of the efficient allocation of resources around the economy starts to unravel. Prices do a lot of unseen work in the background that usually makes good things happen.

There is evidence in recent interventions. Dealing with inflation in particular quickly looks like Whack-a-Mole, as holding down some prices pushes up many others or leads to new costs elsewhere. There are many models internationally for addressing the impact of high energy prices, but the UK approach is unique. Setting an energy price cap causing the failure of suppliers and then effectively nationalising the biggest problem at a cost of billions was a convoluted way of addressing consumer problems. The ceiling on energy prices prevented many suppliers from being able to provide economically the energy that their customers needed. The way in which the cap compromised the price mechanism did not achieve a public saving and meant that the subsidy was less effective in targeting the needy. While oil and gas prices have fallen from last year’s peak levels, it would be worth developing better policy before the next crisis. Price ceilings are not sustainable and inevitably distort markets.

Similar confusion has been at the core of interest-rate policy and its impact on mortgage borrowers. Some years ago policy changed to encourage more use of variable interest rate borrowing and reduce the potential risk to banks from offering long-term fixed rate mortgages. This was seen as allowing the Bank of England to make more impact on consumers when it wished to tighten and cool the economy. Now the effect of rising rates has been so hard on some borrowers that banks are being asked to show forbearance on debts and accept losses. Full circle for unintended consequences.

The mixed economy blends elements of a market economy and state intervention with strong regulatory oversight. It relies a lot on the price mechanism to allocate resources, whether by organisations or individuals. Prices link supply to demand, helping to move goods and services where they are wanted. This can be a catalyst for investment and innovation, with the state intervening where prices do not capture public value and costs. Good examples of intervention are minimum wages and minimum unit pricing for alcohol, which were carefully researched. At the other extreme, UK intervention in the property rental market has encouraged a shortage and hit the availability of student accommodation in particular.

In three centuries, economics has taken self-interest off its pedestal but Smith’s concept of the invisible hand of the market should give us more respect for price information. Replacing that with the bureaucracy of a centrally planned economy would be an expensive alternative. The mix of the UK economy has changed in recent years. Government should focus on correcting the bits that do not signal well.

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