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6. Income and Wealth Inequality
One of the primary concerns in our economies in recent times has been with the growing wealth and income inequality. Indeed, the popular success of Thomas Piketty’s (*1971) recent book Capital in the Twenty First Century (2014) suggests that there is a growing resentment at the concentration of wealth in so few hands. Initially, even Adam Smith argued that the invisible hand would tend to equalise incomes and wealth. Yet nothing in the theoretical literature since then has suggested what automatic mechanisms would achieve this. To avoid the difficulties with interpersonal comparisons of utility, Pareto produced the idea of a ranking which only ranks a state of the economy above another if in the preferred state nobody is worse off and somebody is better off. This, of course, has nothing to say about the distribution of wealth or income in the two states. Economists have come to accept Pareto’s criterion which simply does not involve the distribution of income or wealth. But why would people object to a distribution that results from the self-organising of the economy? The answer is that for most people there is a threshold above which inequality becomes socially unacceptable.
This is reflected in the number of protests associated with the Occupy Wall Street movement in the U. S. and similar movements in European countries. The evolution of real wages for individuals in different parts of the income distribution has destroyed much of the faith in the argument that the path to wealth was one which was open to all. The idea that the economy self-organises to enrich not only those at the top of the income distribution but all those below has little support today.
7. Incentives
The last feature of the invisible hand I want to mention is that of incentives. It has long been argued that laissez faire, the very basis of economic liberalism, provides the right incentives for people to do what turns out to be in the common interest. Yet, a little reflection leads one to doubt this simple assertion. The classic example is the Tragedy of the Commons, in which each individual has an incentive to overgraze the land, but collectively this leads to disaster.
Economists observe that this is a problem of ‘externalities’. One person’s action has a direct and, in this case, detrimental effect on the welfare of others. This is considered to be the cause of a ‘market failure’, but in our increasingly interdependent world it is worth reflecting on the fact that such externalities are omnipresent and central to the functioning of the economy. They are not just inconvenient frictions.
Modelling the Economy as a Complex Interactive System: Unintended Consequences
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Furthermore, in the sort of system where people react to or anticipate the actions of others, taking a course of action may produce unforeseen consequences. A well-known and rather simple example is that which has been termed the ‘Cobra Effect’. The British administration in India was concerned about the number of venomous cobras in Delhi. A bounty was therefore offered for every dead cobra. Initially, this was a successful strategy as large numbers of snakes were killed for the reward. However, enterprising people began to breed cobras for the income. When the government found out about this, it cancelled the bounty and the cobra breeders set the now-worthless snakes free. As a result, the wild cobra population actually increased. The measure had exactly the opposite of the intended effect.
Most people remember the paradox of blood donation. As soon as a fee is paid by the authorities to encourage more giving of blood, the amount diminishes. People do not want to be seen as involved in doing something for a monetary reward. Another example is that of the Haifa creche or kindergarten. When fines are imposed for being late, people come even later.
The problem changed from being an ethical or moral one to a calculation as to whether the new price was worth paying.
This is directly relevant to the financial sector since very large fines have been imposed on banks which have violated various rules. The most recent examples are the manipulation of the forex markets and the LIBOR declarations together with banks taking positions against their own clients. The banks, in some cases, openly admitted that they had simply factored into their calculations potential fines for wrongdoing.
We have moved far from markets which were based on trust and integrity to ones in which manipulation of the rules is predominant. New and more complicated regulations, though they may be needed now, are not enough to solve this problem.
The lesson from all of this is that individuals will adapt to whatever rules are put in place and new norms, whether bad or good, will emerge. History is full of examples of taxes that have produced perverse results. It is very difficult to predict what the effect of a policy will be in a system as complex as the economy, but within the standard modelling framework there is no place for unexpected consequences.
8. Conclusion
I have dealt at some length with the nature of, and reasons for, the failure of the Invisible hand to deliver the expected results which would justify laissez faire or economic liberalism. I have also suggested that we need to radically rethink our vision of the economy and to recognise that it is a complex adaptive system which we cannot fully control, and in which we can, at best, see patterns in the evolution of the system and react to them. This will mean being much more modest, but perhaps more realistic in our attempts to implement policy measures and not spend our time arguing that simply liberalising markets will solve all our economic problems. I will conclude by citing Mervyn A. King (*1948), the ex-Governor of the Bank of England, when discussing the work of Friedrich August von Hayek (1899 –1992): “The message from Hayek is that we should avoid the hubris of thinking that we understand how the economy works, just as we should avoid the hubris of thinking that leaving markets to their own devices will lead to nirvana”.4
4 Mervyn A. King, April 2013.
Alan Kirman
References
Kirman, A.: Complex Economics: Individual and Collective Rationality. The Graz Schumpeter Lectures. London:
Routledge 2011
Piketty, T.: Capital in the Twenty First Century. Cambridge (MA): Belknap Press of Harvard University Press 2014 Wilson, D. S., and Kirman, A. P.: Complexity and Evolution: Toward a New Synthesis for Economics. Strüngmann
Forum Reports. Cambridge, MA: MIT Press 2016
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