Mon, Mar 31, 2014 - Page 9 News List

The invisible hand of democracy

The complexity of modern economic systems has rendered Adam Smith’s precept obsolete. However the power of the democratic system has replaced the market as the most effective means of selecting outcomes

By Ricardo Hausmann

Illustration: Yusha

When Adam Smith was 22, he famously proclaimed: “Little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism, but peace, easy taxes, and a tolerable administration of justice: all the rest being brought about by the natural course of things.”

Today, almost 260 years later, we know that nothing could be further from the truth.

The disappearance of Malaysia Airlines flight 370 shows how wrong Smith was, for it highlights the intricate interaction between modern production and the state. To make air travel feasible and safe, states ensure that pilots know how to fly and that aircraft pass stringent tests. They build airports and provide radar and satellites that can track planes, air traffic controllers to keep them apart and security services to keep terrorists on the ground. And, when something goes wrong, it is not peace, easy taxes and justice that are called in to assist; it is professional, well-resourced government agencies.

All advanced economies today seem to need much more than the young Smith assumed. And their governments are not only large and complex, comprising thousands of agencies that administer millions of pages of rules and regulations; they are also democratic — and not just because they hold elections every so often. Why?

By the time he published The Wealth of Nations, at age 43, Smith had become the first complexity scientist. He understood that the economy was a complex system that needed to coordinate the work of thousands of people just to make things as simple as a meal or a suit.

However, Smith also understood that while the economy was too intricate to be organized by anybody, it has the capacity to self-organize. It possesses an “invisible hand,” which operates through market prices to provide an information system that can be used to calculate whether using resources for a given purpose is worthwhile — that is, profitable.

Profit is an incentive system that leads firms and individuals to respond to the information provided by prices. And capital markets are a resource-mobilization system that provides money to those companies and projects that are expected to be profitable — that is, the ones that respond adequately to market prices.

However, modern production requires many inputs that markets do not provide. In the case of airlines, these inputs — rules, standards, certifications, infrastructure, schools and training centers, scientific labs, security services, among others — are deeply complementary to the ones that can be procured in markets. They interact in the most intricate ways with the activities that markets organize.

So here is the question: Who controls the provision of the publicly provided inputs? The prime minister? The legislature? Which country’s top judges have read the millions of pages of legislation or considered how they complement or contradict each other, much less applied them to the myriad different activities that comprise the economy? Even a presidential executive cannot be fully aware of the things that are done or not done by the thousands of government agencies and how they affect each part of society.

This is an information-rich problem, and, like the social-coordination challenge that the market addresses, it does not allow for centralized control. What is needed is something like the invisible hand of the market: a mechanism for self-organization. Elections clearly are not enough, because they typically occur at two or four-year intervals and collect very little information per voter.

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