Working Paper No. 893 The Neoclassicals’ Conundrum: If Adam Smith Is the Father of Economics, It Is a Bastard Child by Oscar Valdes Viera July 2017 * The author would like to thank John F. Henry for his most helpful comments on earlier drafts. All errors, however, are the author’s own. The Levy Economics Institute Working Paper Collection presents research in progress by Levy Institute scholars and conference participants. The purpose of the series is to disseminate ideas to and elicit comments from academics and professionals. Levy Economics Institute of Bard College, founded in 1986, is a nonprofit, nonpartisan, independently funded research organization devoted to public service. Through scholarship and economic research it generates viable, effective public policy responses to important economic problems that profoundly affect the quality of life in the United States and abroad. Levy Economics Institute P.O. Box 5000 Annandale-on-Hudson, NY 12504-5000 http://www.levyinstitute.org Copyright © Levy Economics Institute 2017 All rights reserved ISSN 1547-366X ABSTRACT Neoclassical economists of the current era frequently pay lip service to Adam Smith’s theories to certify the validity of natural-laws-based, laissez-faire policies. However, neoclassical theories are fundamentally disconnected from Adam Smith’s notion of value, his understanding of the economic individual and their interactions in society, his methodology, and the field of study he afforded to political economy. Instead, early neoclassical economists parted ways with the theories of Adam Smith in an effort to construct economic laws that would validate the existing capitalist order as universal, natural, and harmonious. Keywords: Economic Thought; Classical School; Neoclassical Economics; Adam Smith; Economists JEL Classifications: A11; A13; B12; B13; B16; B20; B31 1 “But coherence doesn’t mean ‘equilibrium’,” Alice objected. “When I use mathematics,” Humpty Dumpty said, in a rather scornful tone, “it means what I choose it to mean—neither more nor less.” “The question is,” said Alice, “whether you can make mathematics mean so many different things.” “The question is,” said Humpty Dumpty, “which is to be the master—that’s all.” —A corruption of an exchange in Lewis Carrol’s Through the Looking Glass (Minsky 1985, epigraph) I. INTRODUCTION Modern orthodox economists frequently theorize and propose their models wrapped in algebraic expressions and econometrics symbols that make their theories incomprehensible to anyone without significant training in mathematics. These complicated mathematical models rely on sets of assumptions about human behavior, institutional frameworks, and the way society works as whole, i.e., theoretical underpinnings developed through history. Yet, more frequently than not, their assumptions go to such great lengths that the models turn out to be utterly detached from reality. The mathematical approach was brought to the forefront of economics during the 1870s, in an effort to emulate the success of the natural sciences in explaining the world around us, and so transform political economy into the “exact” science of economics. The new discipline, born with a scientific aura, would provide a legitimate doctrine for rationalizing the existing system and state of affairs as universal, natural, and harmonious. It is frequently claimed that orthodox economic theory is traceable to the theories of Adam Smith and his “invisible hand” metaphor (Henry 2008). However, Adam Smith argued that the scientific method should be an attempt of the imagination to solve observable problems; the scientist could use mathematical tools or models to propose laws, but they should subordinate to observed phenomena (Fleischacker 2004, ch. 2). Smith’s notion falls more along the lines of the ideas proposed by heterodox economists like Hyman Minsky, who argued that any scientific 2 theory disconnected from observations should be rejected, because in “sciences theory is a servant of observations” (Minsky 1985, 1). Nevertheless, the “invisible hand” metaphor seems to be the most pervasive misrepresentation of Adam Smith and is taken literally by high-ranked economists in their understanding of economics. Smith’s hypothesis of how the economy works, as if governed by an “invisible hand,” has been disguised behind scientific-mathematical formulations that tend to reduce our complex world and irrational society to a small, rational scheme, where the profit motive and competition align the self-interests of individuals to produce a collective good. Then, because such process is natural and inevitable, all that is needed to guarantee the proper functioning of the economy is to remove any barriers (i.e., the government and its regulations) and allow the system to work freely. In short, this paper argues that the advent of rigorous mathematical models was the turning point in the transformation of political economy into the science of economics. On the basis of economic laws that would confirm those characteristics, the new science—epitomized by the neoclassical Marginal Revolution—parted ways with the theories of Adam Smith in an effort to validate the existing capitalist order as universal and natural. However, neoclassical economists of the current era still pay lip service to Smith and his theories to certify their laissez-faire policies, representing an incongruence that is at the foundations of orthodox economic theory. II. ON THE POLITICAL ECONOMY AND METHODOLOGY OF ADAM SMITH As put forward above, modern neoclassical economists frequently invoke the spirit of Adam Smith, and his “invisible hand” metaphor, when they claim that the government is an intruder that only interferes with the natural workings of the economy. In short, the “invisible hand” hypothesis would explain how the pressures of competition align the behavior of self-loving, rational individuals—chasing only after their own interest in the marketplace—to produce socially beneficial outcomes. Put in another way, left on their own, market mechanisms 3 operating through the laws of supply and demand would equilibrate prices and generate the socially desired amount of goods. From the above, neoclassicals gathered that the required conditions for the market to gravitate towards an equilibrium are rational, self-interested individuals and unhindered competition. The former is illustrated by the widely quoted passage in The Wealth of Nations: “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our necessities but of their advantages” (Smith [1776] 2007, 16). And the latter can also be exemplified from the same book, as Smith (256–57) says that generally, “if any branch of trade, or any division of labour, be advantageous to the public, the freer and more general the competition, it will always be the more so.” It seems that neoclassical economists considered that these two notions from the political economy of Adam Smith were a sufficient condition for considering their efforts of devising mathematical models that would provide the ultimate laws of economics as descendants of the Classical tradition. However, atomistic competition in the marketplace is not the only concept Smith set out to explain, nor is self-love the only human quality discussed in his writings. Does Smith’s “Invisible Hand” Work in a Vacuum-like Marketplace? Adam Smith did not abstract his theories—and more specifically, his economic individual— from the society he put under examination. The problem was to uncover the complex mechanisms that allow members of society and institutions to interact and keep moving forward through history. In the words of Heilbroner (1992, 53) in his book, The Worldly Philosophers, the question that attracted Smith’s attention was: “How is it possible for a community [emphasis added] in which everyone is busily following his self-interest not to fly apart from sheer centrifugal force?” In other words, how is it that the incipient capitalist system of production of Smith’s time aligns the particular interests of individuals with the collective interest of society? 4 In this alignment of the individual and collective interests, it is important to notice the influence that society exerts over its members. In Smith’s theories, individuals are not considered in a social vacuum in the way that neoclassicals would later assume. Even if neoclassical economists want to use the famous metaphor and its players, the butcher, the brewer, and the baker have to be regarded as social beings, interacting in a collective setting with each other and social institutions. The “invisible hand” would not work without social pressures that alter individuals’ behaviors and judgments, and it is precisely through the interplay between individuals and institutions that these pressures would bring about coherence. A “socialization of the individual,” to borrow Heilbroner’s (1982) term, is needed to amalgamate self-interested actions with other moral traits—namely, empathy and the economic behavior of individuals. Moreover, society not only influences the behavior of individuals, but is the framework that creates the opportunities for them to enjoy the benefits of the division of labor. The “invisible hand” is more a manifestation of social influences than of a divine force or intervention (Fleischacker 2004). In Smith’s ([1776] 2007, 349) famous passage involving the “invisible hand,” he says that “[every individual] intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention.” Readers can choose to take this enunciation literally, but a critical reading can make the case that in this passage Smith is not consistent—or is vague—with the general theme in The Wealth Nations. Take Smith’s (350) description of the division of labor, just two paragraphs later: It is the maxim of every prudent master of a family never to attempt to make at home what it will cost him more to make than to buy.