The Workings of the “Invisible Hand”
As far as the purely economic analysis is concerned, it is sufficient to our present purpose to be reminded that in the WN the theory of price and allocation was developed in terms of a model which made due allowance to distinct factors of production (land, labor, capital) and for the appropriate forms of return (rent, wages, profit). This point, now so obvious, struck Smith as novel and permitted him to develop an analysis of the allocative mechanism that ran in terms of inter-related adjustments in both factor and commodity markets. The resulting version of general interdependence also allowed Smith to move from the discussion of “micro” to that of “macro” economic issues, and to develop a model of the “circular flow” which relies heavily on a distinction between fixed and circulating capital.
But these terms, which were applied to the activities of individual undertakers, were transformed in their meaning by their application to society at large. Working in terms of period analysis where all magnitudes are dated, Smith in effect represented the working of the economic process as a series of activities and transactions which linked the main socio-economic groups (proprietors, capitalists and wage-labor) and productive sectors. In Smith’s terms, current purchases in effect withdrew consumption and investment goods from the circulating capital of society; goods which were in turn replaced and income re-generated by virtue of productive activity in a given time period over a series of such periods.
We should note in this context that Smith was greatly influenced by a specific model of the economy which he came across during a visit to Paris in 1766. The model was designed to explain the operation of an economic system treated as an organic system. It was first produced by Francois Quesnay, a medical doctor, and later developed by A.R.J. Turgot, Minister of Finance under Louis XVI (Meek 1962, 1973). The significance of the analogy of the circulation of the blood would not be lost on Smith-and not would the link with William Harvey, a distinguished member of the medical school of Padua.
Looked at from one point of view, the analysis taken as a whole provides one of the most dramatic examples of the doctrine of “unintended social outcomes” or the working of the “invisible hand”. The individual undertaker (entrepreneur), seeking the most efficient allocation of resources, contributes to overall economic efficiency; the merchant’s reaction to price signals helps to ensure that the allocation of resources accurately reflects the structure of consumer preferences; and the drive to better our condition contributes to economic growth. Looked at from another perspective, the work can be seen to have resulted in a great conceptual system linking together logically separate, yet inter-related, problems such as price, allocation, distribution, macro-statistics and macro-dynamics.
If such a theory enabled Smith to isolate the causes of economic growth, with the emphasis now on the supply side, it was also informed throughout by what Terence Hutchison has described as the “powerfully fascinating idea and assumption of beneficent self-adjustment and self-equilibration” (Hutchinson 1988, p. 268).
The argument is also buttressed by a series of judgements as to probable patterns of behaviour and actual trends of events. It was Smith’s firm opinion, for example, that in situation where there was tolerable security, “the sole use of money is to circulate consumable goods. By means of it, provisions, materials, and finished work are bought and sold, and distributed to their proper consumer” (WN, 11. iii.23). In the same way he contended that savings generated during any (annual) period would always be matched by investment (WN, 11. iii.18); a key assumption of the classical system which was to follow. In the case of Great Britain, Smith also pointed out that real wages had progressively increased during the eighteenth century, and that high real wages were to be approved of as a contribution to productivity (WN, 1. vii.44). The tone is buoyant with regard to economic growth and this was duly reflected in the policy stance which Smith was to adopt.
Smith’s prescription with regard to economic policy followed the direction of analysis just considered. He called on governments to minimize their “impertinent” obstructions to the pursuit of individuals. In particular, he recommended that the statutes of apprenticeship and the privileges of corporations should be repealed on the grounds that they adversely affect the working of the allocative mechanism. In the same chapter Smith pointed to the Settlement (cf. WN, I. x. c; IV.ii42). But there is also a moral dimension to the argument in the sense that all of the regulations so far reviewed constitute violations of natural liberty.
Smith objected to positions of privilege, such as monopoly powers, which he regarded as creatures of the civil law. The institution was again represented as impolitic and unjust; unjust in that a position of monopoly is a position of unfair advantage, and impolitic in that the prices of the goods so controlled are “upon every occasion the highest which can be got” (WN, 1. vii.27).
In this context we may usefully distinguish Smith’s objection to monopoly in general from his criticism of one manifestation of it namely, the mercantile system, described as the “modern system” of policy, best understood, “in our own country and in our own times” (WN, IV.2). The system is represented as a coherent whole; as a set of policies based on regulation and therefore liable to that “general objection which may be made to all the different expedients of the mercantile system; the objection of forcing some part of the industry of the country into a channel less advantageous that that in which it would run of its own accord” (WN, V.v.a.24).
Professor Winch summarized Smith’s advice to the Legislator (cf. Haakonssen 1981) in these terms: