Critics of laissez faire—from Cambridge economic historian Emma Rothschild to British Labor Party leader Gordon Brown—have recently attempted to wrestle Adam Smith out of the hands of the free-market camp and into the camp of the social democrats. According to Iain McLean, professor of politics at Oxford University, and Samuel Fleschaker, professor of philosophy at the University of Illinois at Chicago, the Scottish philosopher was a “radical egalitarian” who, while endorsing economic liberalism, had a lively appreciation of market failure and ultimately rejected “ruthless laissez-faire capitalism” in favor of “human equality” and “distributive justice.”

These critics are quick to claim that Smith was no friend of rent-seeking landlords, monopolistic merchants, and conspiring businessmen, and that he advocated an active State authority in support of free education, large-scale public works, usury laws, progressive taxation, and even limits on free trade.

What about the metaphor of the “invisible hand,” the famous Smithian idea that “by pursuing his own self-interest, [every individual] frequently promotes that of the society”? Free-market economists from Ludwig von Mises to Milton Friedman have regarded it as a powerful symbol of unfettered market forces, what Adam Smith called his “system of natural liberty.” In rebuttal the new critics belittle Smith’s metaphor as a “passing, satirical” reference and suggest that he favored more of a “helping hand.” They emphasize that Smith used the phrase “invisible hand” only once in each of his two major works, The Theory of Moral Sentiments (1759) and The Wealth of Nations (1776). The references are so sparse that commentators seldom mentioned the expression by name in the nineteenth century. No notice was made of it during the celebrations of the centenary of The Wealth of Nations in 1876. Until well into the twentieth century, no subject index listed “invisible hand” as a separate entry. It was finally added to the index in 1937 by Max Lerner for the Modern Library edition. Clearly, it wasn’t until the twentieth century that the invisible hand became a popular symbol of laissez faire.

Could the detractors be correct in their assessment of Adam Smith’s sentiments? Is the metaphor central or marginal to his “system of natural liberty”?

Friedman refers to Adam Smith’s symbol as a “key insight” into the cooperative, self-regulating “power of the market to produce our food, our clothing, our housing . . . without central direction.” Economist George Stigler calls it the “crown jewel” of The Wealth of Nations and “the most important substantive proposition in all of economics.”

On the other hand, economist Gavin Kennedy contended in earlier writings that the invisible hand is nothing more than an afterthought, a “casual metaphor” with limited value. Rothschild, the Harvard University economic historian, even goes so far as to declare, “What I will suggest is that Smith did not especially esteem the invisible hand. . . . It is un-Smithian and unimportant to his theory” and was nothing more than a “mildly ironic joke.”

Who’s right?

A fascinating discovery by Daniel Klein, professor of economics at George Mason University, may shed light on this debate. Based on a brief remark by Peter Minowitz, the Santa Clara University political philosopher, that the “invisible hand” phrase lies roughly in the middle of both of Smith’s books, Klein made preliminary investigations. He next recruited Brandon Lucas, then a doctoral student at Mason, to investigate further. Klein and Lucas reported in Economic Affairs (March 2011) that they found considerable evidence that Smith “deliberately placed ‘led by an invisible hand’ at the centre of his tomes” and that the concept “holds special and positive significance in Smith’s thought.”

Klein and Lucas base their conjecture on two major points. First, the physical location of the metaphor: The single expression “led by an invisible hand” occurs almost dead center in the first and second editions of The Wealth of Nations. (It moves slightly away from the middle after an index and other material were added to later editions.)

Moreover, it appears again “well-nigh dead centre” in the final edition of The Theory of Moral Sentiments. Klein and Lucas admit that it was not in the middle of the first edition in 1759, speculating that “physical centrality was not initially a part of his intentions . . . [but that] by 1776, Smith had become intent on centrality.” Indeed, Smith moved the phrase “invisible hand” closer to the center of the book, first by appending an important essay on the origin of language and finally by making substantial revisions in the final edition.

Second, they note that as a historian and moral philosopher, Adam Smith commented frequently on the importance of middleness in architecture, literature, science, and philosophy. For example:

• Smith wrote sympathetically about the Aristotelian golden mean, the idea that virtue exists “between two opposite vices.” For instance, between the two extremes of cowardice and recklessness lies the central virtue of courage.
• In his essays on astronomy and ancient physics, he was captivated by Newtonian central forces and periodical revolutions.
• Klein discovered that in his lectures on rhetoric, Smith admired the poetry of the Greek poet Thucydides, who “often expresses all that he labours so much in a word or two, sometimes placed in the middle of the narration.”

In sum, according to Klein and Lucas, the invisible hand represents the centrality of Smith’s “system of natural liberty” and is appropriately found in the middle of his works. By this discovery, if true, one goes from one extreme to the other—from seeing the invisible hand as a marginal concept to accepting it as the touchstone of his philosophy.

Klein and Lucas’s list of evidence is what a lawyer might call circumstantial, or “impressionistic,” to use their own adjective. Taken as a whole, the documentation is either an ingenious breakthrough or a “remarkable coincidence,” to quote Kennedy.

A few Smithian experts have warmed up to Klein and Lucas’s claim. Kennedy, who previously considered the invisible hand a “casual” metaphor, now sees a “high probability” in their thesis of deliberate centrality. Others are more skeptical. “We have no direct evidence for the conjecture,” states Craig Smith, an expert on Adam Smith at the University of St. Andrews. The idea that Smith deliberately hid his favorite symbol of his philosophy “strikes me . . . as very un-Smithian,” he states, and runs contrary to his policy of expressing thoughts in a “neat, plain and clever manner.” Placing the shorthand phrase “invisible hand” in the middle of his works may not be plain, but is it not neat and clever?

We may never know the truth, since we have no record of Smith’s confession on the matter. Fortunately, one does not need to depend on the physical centrality of the “invisible hand” to recognize the doctrinal centrality of his philosophy.

There are many passages from The Wealth of Nations and The Theory of Moral Sentiments that elucidate the “invisible hand” theme, the idea that individuals acting in their own self-interest unwittingly benefit the public weal, or that eliminating restrictions on individuals’ behaviors “better[s] their own condition” and makes society better off. Smith repeatedly advocated removal of trade barriers, State-granted privileges, and employment regulations so that individuals could flourish.

In The Theory of Moral Sentiments, Smith writes:

The man of system . . . seems to imagine that he can arrange the different members of a great society with as much ease as the hand arranges the different pieces upon a chess-board. He does not consider that the pieces upon the chess-board have no other principle of motion besides that which the hand impresses upon them; but that, in the great chess-board of human society, every single piece has a principle of motion of its own, altogether different from that which the legislature might chuse to impress upon it. If those two principles coincide and act in the same direction, the game of human society will go on easily and harmoniously, and is very likely to be happy and successful. If they are opposite or different, the game will go on miserably, and the society must be at all times in the highest degree of disorder.

Smith’s argument is comparative. To quote Klein: “Hewing to the liberty principle generally works out better than not doing so—in this respect, [Kenneth] Arrow, Joseph Stiglitz, and Frank Hahn do disfigure Smith when they identify the invisible hand with some rarified perfection. We need not rehearse Smith on the ignorance, folly, and presumption of political power, on the corruption and pathology of political ecology. . . . Smith sees the liberty principle as a moral, cultural, and political focal point, a worthy and workable principle in the otherwise dreadful fog of interventionism.”

To think that Adam Smith, the renowned absent-minded professor, hid a little “invisible” secret in his tomes is indeed the ultimate irony. As Klein concludes, “That the phrase appears close to the center, and but once, in TMS and in WN might be taken as evidence that Smith did intend for us to take up the phrase.”

I find Professor Klein’s story compelling and have enjoyed showing copies of Smith’s works with a bookmark in the key pages to students, faculty, and interested friends.

Adam Smith had one overwhelmingly important triumph:  he put into the center of economics the systematic analysis of the behavior of individuals pursuing their self-interest under conditions of competition. — George Stigler (emphasis added)

Critics of laissez faire — from Cambridge economic historian Emma Rothschild to British Labor Party leader Gordon Brown — have recently attempted to wrestle Adam Smith out of the hands of the free-market camp and into the camp of the social democrats.  According to Iain McLean, professor of politics at Oxford University, and Samuel Fleschaker, professor of philosophy at the University of Illinois at Chicago, the Scottish philosopher was a “radical egalitarian” who, while endorsing economic liberalism, had a lively appreciation of market failure and ultimately rejected “ruthless laissez-faire capitalism” in favor of “human equality” and “distributive justice.”

These critics are quick to claim that Smith was no friend of rent-seeking landlords, monopolistic merchants, and conspiring businessmen, and that he advocated an active State authority in support of free education, large-scale public works, usury laws, progressive taxation, and even limits on free trade.

Powerful Symbol

What about the metaphor of the “invisible hand,” the famous Smithian idea that “by pursuing his own self interest, [every individual] frequently promotes that of the society”?  Free-market economists from Ludwig von Mises to Milton Friedman have regarded it as a powerful symbol of unfettered market forces, what Adam Smith called his “system of natural liberty.”  In rebuttal, the new critics belittle Smith’s metaphor as a “passing, satirical” reference and suggest that he favored more of a “helping hand.” They emphasize that Smith used the phrase “invisible hand” only once in each of his two major works, The Theory of Moral Sentiments (1759) and The Wealth of Nations (1776).   The references are so sparse that commentators seldom mentioned the expression by name in the nineteenth century.  No notice was made of it during the celebrations of the centenary of The Wealth of Nations in 1876.  In the eighteenth, nineteenth centuries, and early twentieth centuries, no subject index, including that of the well-known edition edited by Edwin Cannan (1904), listed “invisible hand” as a separate entry.  It was finally added to the index in 1937 by Max Lerner for the Modern Library edition.  Clearly, it wasn’t until the later twentieth century that the invisible hand became a popular symbol of laissez faire.

Could the detractors be correct in their assessment of Adam Smith’s sentiments?  Is the invisible-hand metaphor central or marginal to his “system of natural liberty”?

Milton Friedman refers to Adam Smith’s symbol as a “key insight” into the cooperative, self-regulating “power of the market to produce our food, our clothing, our housing . . . without central direction.” Economist George Stigler calls it the “crown jewel” of The Wealth of Nations and “the most important substantive proposition in all of economics.”

On the other hand, economist Gavin Kennedy contended in earlier writings that the invisible hand is nothing more than an after-thought, a “casual metaphor” with limited value.  Rothschild, the Harvard University economic historian, even goes so far as to declare, “What I will suggest is that Smith did not especially esteem the invisible hand. . . .  It is un-Smithian and unimportant to his theory” and was nothing more than a “mildly ironic joke.”

Who’s right?

The Discovery

A fascinating discovery uncovered by Daniel Klein, professor of economics at George Mason University, may shed light on this debate.  Based on a brief remark by Peter Minowitz, the Santa Clara University political philosopher, that the “invisible hand” phrase lies roughly in the middle of both of Smith’s books, Klein made preliminary investigations.  He next recruited Brandon Lucas, then a doctoral student at Mason, to investigate further.  Klein and Lucas report in Economic Affairs (March 2011) that they found considerable evidence that Smith “deliberately placed ‘led by an invisible hand’ at the centre of his tomes” and that the concept “holds special and positive significance in Smith’s thought.”

Klein and Lucas base their conjecture on two major points.  First, the physical location of the metaphor:  The single expression “led by an invisible hand” occurs almost dead center in the first and second editions of the Wealth of Nations.  (It moves slightly away from the middle after an index and other material were added to later editions.)

Moreover, it appears “well-nigh dead centre” in the final edition of The Theory of Moral Sentiments.  Klein and Lucas admit that it was not in the middle of the first edition in 1759, speculating that “physical centrality was not initially a part of his intentions . . . [but that] by 1776, Smith had become intent on centrality.”  Indeed, Smith moved the phrase “invisible hand” closer to the center of the book, first by appending an important essay on the origin of language and finally by making substantial revisions in the final edition.

Second, they note that as a historian and moral philosopher, Adam Smith commented frequently on the importance of middleness in architecture, literature, science, and philosophy.  For example:

• Smith wrote sympathetically about the Aristotelian golden mean, the idea that virtue exists “between two opposite vices.”  For instance, between the two extremes of cowardice and recklessness lies the central virtue of courage.
• In his  essays on astronomy and ancient physics, he was captivated by Newtonian central forces and periodical revolutions.
• Klein discovered that in his lectures on rhetoric Smith admired the poetry of Thucydides, who “often expresses all that he labours so much in a word or two, sometimes placed in the middle of the narration.”

Midpoint analysis and centralized themes existed long before Smith’s time.  For example, the Talmud offers considerable commentary about midpoints in the Torah, especially in a poetic form called chiasmus.

In sum, according to Klein and Lucas, the invisible hand represents the centrality of Smith’s “system of natural liberty” and is appropriately found in the middle of his works.  By this discovery, if true, one goes from one extreme to the other — from seeing the invisible hand as a marginal concept to accepting it as the touchstone of his philosophy.

“Impressionistic” Evidence

Klein and Lucas’s list of evidence is what a lawyer might call circumstantial, or “impressionistic,” to use their own adjective.  Taken as a whole, the documentation is either an ingenious breakthrough or a “remarkable coincidence,” to quote Kennedy.

A few Smithian experts have warmed up to Klein and Lucas’s claim.  Kennedy, who previously considered the invisible hand a “casual” metaphor, now sees a “high probability” in their thesis of deliberate centrality.  Others are more skeptical.  “We have no direct evidence for the conjecture,” says Craig Smith, an expert on Adam Smith at the University of St. Andrews.  The idea that Adam Smith deliberately hid his favorite symbol of his philosophy “strikes me . . .  as very un-Smithian” and runs contrary to his policy of expressing thoughts in a “neat, plain and clever manner.”

Placing the shorthand phrase “invisible hand” in the middle of his works may not be plain, but is it not neat and clever?

We may never know the truth, since we have no record of Smith’s confession on the matter.  Fortunately, one does not need to depend on the physical centrality of the “invisible hand” to recognize the doctrinal centrality of his philosophy.  As Craig Smith states, “I’m not convinced that Smith deliberately placed the invisible hand at the centre of his books, but I am certain that it lies at the heart of his thinking.”

There are many passages from The Wealth of Nations and The Theory of Moral Sentiments that elucidate the “invisible hand” theme, the idea that individuals acting in their own self-interest unwittingly benefit the public weal, or that eliminating restrictions on individuals’ behaviors “better[s] their own condition” and makes society better off.  Smith repeatedly advocated removal of trade barriers, State-granted privileges, and employment regulations so that individuals can flourish.

In The Theory of Moral Sentiments, Smith writes:

The man of system … seems to imagine that he can arrange the different members of a great society with as much ease as the hand arranges the different pieces upon a chess-board. He does not consider that the pieces upon the chess-board have no other principle of motion besides that which the hand impresses upon them; but that, in the great chess-board of human society, every single piece has a principle of motion of its own, altogether different from that which the legislature might chuse to impress upon it. If those two principles coincide and act in the same direction, the game of human society will go on easily and harmoniously, and is very likely to be happy and successful. If they are opposite or different, the game will go on miserably, and the society must be at all times in the highest degree of disorder.

Smith’s argument is comparative.  To quote Klein:  “Hewing to the liberty principle generally works out better than not doing so—in this respect, [Kenneth] Arrow, Joseph Stiglitz, and Frank Hahn do disfigure Smith when they identify the invisible hand with some rarified perfection. We need not rehearse Smith on the ignorance, folly, and presumption of political power, on the corruption and pathology of political ecology…. Smith sees the liberty principle as a moral, cultural, and political focal point, a worthy and workable principle in the otherwise dreadful fog of interventionism.”

To think that Adam Smith, the renowned absent-minded professor, hid a little “invisible” secret in his tomes is indeed the ultimate irony.  As Klein concludes, “That the phrase appears close to the center, and but once, in TMS and in WN might be taken as evidence that Smith did intend for us to take up the phrase.”

I find Professor Klein’s story compelling and have enjoyed showing copies of Smith’s works with a bookmark in the key pages to students, faculty, and interested friends.  It has, in the words of philosopher Robert Nozick, “a certain lovely quality.”

—“Consumers Give Boost to Economy,”

New York Times, May 1

Every quarter, when the government releases its latest GDP figures, we hear the familiar refrain:

“What the consumer does is vital for economic growth.”

“If the consumer starts saving and stops spending, we’re in big trouble.”

“Consumer spending accounts for 70 percent of the economy.”

The latter “fact” crops up regularly in the news reports from the Associated Press, the Wall Street Journal, and the New York Times.

The truth is that consumer spending is not the mainstay of the U. S. economy. Investment is. Business spending on capital goods, new technology, entrepreneurship, and productivity is more significant than consumer spending in sustaining the economy and a higher standard of living. In the business cycle, production and investment lead the economy into and out of a recession; retail demand is the most stable component of economic activity.

Granted, personal consumption expenditures represent 70 percent of gross domestic product, but journalists should know from Econ 101 that GDP only measures the value of final output. It deliberately leaves out a big chunk of the economy—intermediate production or goods-in-process at the commodity, manufacturing, and wholesale stages—to avoid double counting. I calculated total spending (sales or receipts) in the economy at all stages to be more than double GDP (using gross business receipts compiled annually by the IRS). By this measure—which I have dubbed gross domestic expenditures, or GDE—consumption represents only about 30 percent of the economy, while business investment (including intermediate output) represents over 50 percent.

Thus the truth is just the opposite: Consumer spending is the effect, not the cause, of a productive healthy economy.

This truth prevails in the marketplace: It’s supply—not demand—that drives the economy. Savings, productivity, and technological advances are the keys to economic growth. This principle was discovered and developed by the brilliant French economist Jean-Baptiste Say in the early nineteenth century and is known as Say’s Law. In fact, he invented the word “entrepreneur” to describe the primary catalyst of economic performance.

Is retail sales a leading economic indicator? Each month the Conference Board releases its Leading Economic Indicators for the United States and nine other countries. The ten U.S. leading indicators are:

• manufacturers’ new orders
• building permits
• unemployment claims
• average weekly manufacturing hours
• real money supply
• stock prices
• the yield curve
• new orders for nondefense capital goods
• vendor performance
• index of consumer expectations

As you can see, almost all the indicators are linked to the early stages of production and business activity.

What about the Consumer Confidence Index that the media highlights every month? It turns out that the title is misleading. The questions asked consumers are more about business conditions than spending attitudes. Here are the questions consumers are asked to determine their “expectations”:

1. Are current business conditions good, bad, or normal?
2. Do you expect business conditions to be good, bad, or normal over the next six months?
3. Are jobs currently plentiful, not so plentiful, or hard to get?
4. Do you expect jobs to be more plentiful, not so plentiful, or hard to get over the next six months?
5. Do you plan to buy a new/used automobile/home/major appliance [note: these are all durable consumer goods, not unlike durable capital goods] within the next sixmonths?
6. Are you planning a U.S. or foreign vacation within the next six months?

In other words, the much-touted “consumer” confidence index is more a forecast by consumers for business, employment, and durable goods than “retail sales” and consumer spending. It does not ask any questions about food, clothing, entertainment, and other short-term buying, because these expenditures seldom change from month to month.

The reality is that business and investment spending are the true leading indicators of the economy and the stock market. If you want to know where the stock market is headed, forget about consumer spending and retail sales figures. Look to manufacturing, capital expenditures, corporate profits, and productivity gains.

We hear so much about the consumer because the media and political pundits still live under the spell of Keynesian economics, which teaches that demand creates supply. Keynes’s law is just the opposite of Say’s law (supply creates demand). According to Keynesians, consumer spending drives the economy and saving is bad when the economy is in a short-term contraction.

In reality, increased savings can actually stimulate the economy, even if consumer spending is anemic. A recent study by the St. Louis Fed concluded that in the short run, “a higher saving rate in the current quarter is associated with faster (not slower) economic growth in the current and next few quarters” (Daniel L. Thornton, “Personal Saving and Economic Growth,” Economic Synopses, St. Louis Fed, December 17, 2009).

How is this possible? When people save more, interest rates fall and businesses can afford to replace their old equipment with new tools, spend more on research and development, or develop new production processes. So while consumer spending may stay low, business spending can pick up the slack. Remember, in a dynamic economy the decision by businesses to spend more investment funds and hire more workers is a function of both current consumer demand and future consumer demand. And don’t forget, during a recession corporate profits often recover first, without an increase in customer demand, because companies can boost profits by cutting costs and downsizing.

In the long run new business strategies and spending patterns increase productivity and lower prices to consumers, which in turn means the consumers’ purchasing power increases. As the St. Louis Fed concludes, “A higher saving rate does mean less consumption [in the short run], but it could also result in more capital investment and, ultimately, a higher rate of economic growth. . . . [T]he growth rate of real GDP has been higher on average when the personal saving rate is rising than when it is falling.”

Granted, the ultimate function of business activity and entrepreneurship is to fulfill the needs of consumers, and the most successful firms are those that satisfy their customers. But more important, who discovers the new, improved products that consumers desire? Who is the catalyst that determines the quantity, quality, and variety of goods and services? Did the consumer come up with the idea of personal computers, SUVs, fax machines, cell phones, the Internet, and the iPhone? No, these technological breakthroughs came from the genius of creative entrepreneurs and the savers/capitalists who funded their inventions.

–“Consumers Give Boost to Economy,”  New York Times, May 1

Every quarter, when the government releases its latest GDP figures, we hear the familiar refrain:

“What the consumer does is vital for economic growth.”

“If the consumer starts saving and stops spending, we’re in big trouble.”

“Consumer spending accounts for 70 percent of the economy.”

The latter “fact” is repeated regularly in the news reports from the Associated Press, the Wall Street Journal, and the New York Times.

The truth is that consumer spending does not account for 70 percent of economic activity and is not the mainstay of the U. S. economy.   Investment is!   Business spending on capital goods, new technology, entrepreneurship, and productivity are more significant than consumer spending in sustaining the  economy and a higher standard of living.  In the business cycle, production and investment lead the economy into and out of a recession; retail demand is the most stable component of economic activity.

Granted, personal consumption expenditures represent 70 percent of gross domestic product, but journalists should know from Econ 101 that GDP only measures the value of final output.  It deliberately leaves out a big chunk of the economy — intermediate production or goods-in-process at the commodity, manufacturing, and wholesale stages — to avoid double counting.  I calculated total spending (sales or receipts) in the economy at all stages to be more than double GDP (using gross business receipts compiled annually by the IRS).  By this measure — which I have dubbed gross domestic expenditures, or GDE — consumption represents only about 30 percent of the economy, while business investment (including intermediate output) represents over 50 percent.

Thus the truth is just the opposite:  Consumer spending is the effect, not the cause, of a productive healthy economy.

The Importance of Say’s Law

This truth prevails in the marketplace:  It’s supply — not demand — that drives the economy.  Savings, productivity, and technological advances are the keys to economic growth.  This principle was discovered and developed by the brilliant French economist Jean-Baptiste Say in the early nineteenth century and is known as Say’s law.  In fact, he invented the word “entrepreneur” to describe the primary catalyst of economic performance.

Is retail sales a leading economic indicator?  Each month the Conference Board releases its Leading Economic Indicators for the United States and nine other countries.  The ten U.S. leading indicators are:

• manufacturers’ new orders
• building permits
• unemployment claims
• average weekly manufacturing hours
• real money supply
• stock prices
• the yield curve
• new orders for nondefense capital goods
• vender performance
• index of consumer expectations

As you can see, almost all of the indicators are linked to the early stages of production and business activity.

Misleading Consumer Confidence Index

What about the Consumer Confidence Index that the media highlights every month?  It turns out that the title is misleading.  The questions asked consumers are more about business conditions than spending attitudes.  Here are the questions consumers are asked to determine their “expectations”:

1. Are current business conditions good, bad, or normal?
2. Do you expect business conditions to be good, bad, or normal over the next six months?
3. Are jobs currently plentiful, not so plentiful, or hard to get?
4. Do you expect jobs to be more plentiful, not so plentiful, or hard to get over the next six months?
5. Do you plan to buy a new/used automobile/home/major appliance [note: these are all durable consumer goods, not unlike durable capital goods] within the next six months?
6. Are you planning a U.S. or foreign vacation within the next six months?

In other words, the much-touted “consumer” confidence index is more a forecast by consumers for business, employment, and durable goods than “retail sales” and consumer spending.  It does not ask any questions about food, clothing, entertainment, and other short-term buying, because these expenditures seldom change from month to month.

The reality is that business and investment spending are the true leading indicators of the economy and the stock market.  If you want to know where the stock market is headed, forget about consumer spending and retail sales figures.  Look to manufacturing, capital expenditures, corporate profits, and productivity gains.

Beware of Keynes’s Law

The reason we hear so much about the consumer is because the media and political pundits still live under the spell of Keynesian economics, which teaches that demand creates supply.  Keynes’s law is just the opposite of Say’s law (supply creates demand).  According to Keynesians, consumer spending drives the economy and saving is bad when the economy is in a short-term contraction.

In reality, increased savings can actually stimulate the economy, even if consumer spending is anemic.  A recent study by the St. Louis Fed concluded that in the short run, “a higher saving rate in the current quarter is associated with faster (not slower) economic growth in the current and next few quarters” (Daniel L. Thornton, “Personal Saving and Economic Growth,” Economic Synopses, St. Louis Fed, December 17, 2009).

How is this possible?  When people save more, interest rates fall and business can afford to replace their old equipment with new tools, spend more on research and development, or develop new production processes.  So while consumer spending may stay low, business spending can pick up the slack.  Remember, in a dynamic economy the decision by businesses to spend more investment funds and hire more workers is a function of both current consumer demand and future consumer demand.  And don’t forget, during a recession corporate profits often recover first, without an increase in customer demand, because companies can boost profits by cutting costs and downsizing.

In the long run new business strategies and spending patterns increase productivity and lower prices to consumers, which in turns means the consumers’ purchasing power increases.  As the St. Louis Fed concludes, “A higher saving rate does mean less consumption [in the short run], but it could also result in more capital investment and, ultimately, a higher rate of economic growth….  [T]he growth rate of real GDP has been higher on average when the personal saving rate is rising than when it is falling.”

Granted, the ultimate function of business activity and entrepreneurship is to fulfill the needs of consumers, and the most successful firms are those that satisfy their customers.  But more important, who discovers the new, improved products that consumers desire?  Who is the catalyst that determines the quantity, quality, and variety of goods and services?  Did the consumer come up with the idea of personal computers, SUVs, fax machines, cell phones, the Internet, and the iPhone?  No, these technological breakthroughs came from the genius of creative entrepreneurs and the savers/capitalists who funded their inventions.

-WORLDWATCH INSTITUTE, 2000¹

“We know that the environment is not in good shape. . . . My claim is that things are improving.”

-BJØRN LOMBORG²

Bjørn Lomborg is a Danish professor of statistics who was an environmental activist and member of Greenpeace for years. He accepted at face value the Malthusian views, expressed by Paul Ehrlich, Lester Brown, and groups such as the Worldwatch Institute, Greenpeace, and the Sierra Club, that the world was running out of renewable resources, clean water, and forestland, and that the earth was becoming more polluted and that population growth was exploding.

Along came Julian Simon, an American economist from the University of Maryland, who challenged Lomborg’s thinking. Simon had published several books and papers filled with data supporting his view that life was actually getting better, that air in the developed world was becoming less polluted, that fewer people were starving, and that the population growth was slowing.

Simon made two devastating arguments against the pessimists: First, natural resources are virtually unlimited in the long run because higher prices, reflecting scarcity, encourage the discovery of additional reserves and the use of substitutes. In addition, entrepreneurs and inventors are developing new technologies and cost-cutting techniques allowing more resources to be discovered and developed. Second, a large and growing population leads to a higher standard of living because it increases the stock of useful knowledge and trained workers.

Lomborg decided to test Simon’s statistics. In the fall of 1997, he and a group of students examined Simon’s data. Their conclusion: Simon was right! Lomborg reversed course and, in publishing his findings in The Skeptical Environmentalist, has created a furor within the environmentalist community.

Lomborg joins Simon in refuting most of the claims of the perma-bear environmentalists: global forests have increased since World War II; the world’s population growth rate peaked in 1964 and has since declined; only 0.7 percent of species have disappeared in the past 50 years; fewer people in the world are denied access to water; incidence of infectious disease is still on the decline worldwide; the number of extremely poor/starving people is also declining; air pollution is falling in many parts of the world.

But what about global warming, the overriding concern that our capitalistic lifestyle is changing the climate and could do permanent damage to our ecosystem? The evidence is clear that temperatures have been rising in the past century, but the questions remain: how much of the temperature increase is due to global carbon-dioxide emissions and what is the best course of action? Economic analysis shows it will be far more expensive to cut CO2 emissions radically than to pay the costs of adapting to global warming.³

Economists have also debunked the popular myth that economic development is responsible for environmental degradation. The truth is largely the opposite. As Lomborg states, “environmental development often stems from economic development–only when we get sufficiently rich can we afford the relative luxury of caring about the environment.”⁴

The Polluted Stat

Economists have also publicized “government failure” in the debate about the environment. Recent studies have revealed how less-developed countries, including the former Soviet Union, have more pollution, lower health standards, and more environmental hazards than industrialized nations. Economists Terry Anderson and Donald Leal point to several examples of government mismanagement: National parks such as Yellowstone are in major disrepair, the U.S. Park Service is notoriously wasteful (it built a $330,000 outhouse), the Canadian government destroyed the cod industry, and Brazil and Indonesia forced migrants to burn once-pristine rain forests to plant crops.⁵

Economics has provided real solutions to pollution and environmental degradation. One problem is what is known as the “tragedy of the commons.” In a 1968 issue of Science, Garrett Hardin, emeritus professor of biological sciences at the University of California at Santa Barbara, wrote a seminal article arguing that a resource tends to be overexploited when owned by the public and not private individuals. If no one owns a piece of grazing land, each herdsman has an incentive to add another animal to the herd until the land is overgrazed. As a result, “Freedom in a common brings ruin to all.”⁶

Hence, the lack of property rights and market prices creates a “tragedy of the commons”–unnecessary pollution, extinction of animals, destruction of forests, strip mining, and more. At first government favored regulation as a solution, but economists have encouraged the establishment of clearly specified property rights and accompanying price signals in water, fishing, and forestland, so that owners can preserve these resources in a balanced way.

In sum, free-market environmentalism has come a long way in showing how to replace the regulatory fist of command with a greener invisible hand. Many free-market think tanks, such as PERC and the Competitive Enterprise Institute, have challenged the supremacy of the Sierra Club and Greenpeace.⁷

Earth Day will never be the same.

Notes

1. . Worldwatch Institute, The State of the World 2002 (New York: Norton, 2002), p. xvii.
2. . Bjørn Lomborg, The Skeptical Environmentalist: Measuring the Real State of the World (Cambridge: Cambridge University Press, 2001), pp. 30, 32.
3. . Ibid., p. 318.
4. . Ibid., p. 33.
5. . Terry L. Anderson and Donald R. Leal, Free-Market Environmentalism, revised ed. (New York: Palgrave, 2001), pp. 47-58.
6. . Garrett Hardin, “The Tragedy of the Commons,” reprinted in Garrett Hardin and John Baden, ed., Managing the Commons (San Francisco: W.H. Freeman, 1977), p. 20.
7. . Two additional sources written from a free-market perspective are Michael Sanera and Jane S. Shaw, Facts, Not Fear: A Parent’s Guide to Teaching Children About the Environment (Washington, D.C.: Regnery, 1996) and Ronald Bailey, ed., Earth Report 2000 (New York: McGraw Hill, 2000).

“I’m tired of Love: I’m still more tired of Rhyme.
But Money gives me pleasure all the time.”
-Hilaire Belloc

I came across a very interesting book the other day called Happiness and Economics: How the Economy and Institutions Affect Human Well-Being by Bruno S. Frey and Alois Stutzer. It’s a technical book, with lots of graphs and mathematical regressions, but the conclusions are pretty clear: “The general result seems to be that happiness and income are indeed positively related.”¹ In other words, money can provide many benefits–more opportunities, higher status in society, and the ability to travel and enjoy better food, housing, health care, and entertainment. Several studies indicate that wealthier people live longer. In short, money fulfills highly desirable wants.

I remember the day that I discovered that I would be financially independent. It was a summer day in the late 1970s when I came home and presented my wife with over a dozen checks from a mail-order business I had started. Within a year, we had bought our first home, with 20 percent down, and by 1984, we had become successful enough that we could move our entire family (with four children) to the Bahamas to “retire.” The experience of becoming financially secure gave Jo Ann and me an incredible feeling of satisfaction. Of course, we didn’t really retire. We used our free time to read and write, go sailing, spend time with our children, and become involved in the local theater, a private school, and church work.²

Why Most Poor People Are Unhappy

The graph on the next page shows the relationship between income and happiness across nations. In general, people in poor countries are less satisfied than people in rich countries. One reason is that poor nations are often more subject to violence and uncertainty. As Frey and Stutzer state, “Countries with higher per capita incomes tend to have more stable democracies than poor countries have. . . . The higher the income, then the more secure human rights are, the better average health is, and the more equal the distribution of income is. Thus, human rights, health, and distributional equality may seemingly make happiness rise with income.”³

But the graph also indicates that money causes diminishing returns in happiness. Subjective well-being rises with income, but once beyond a certain threshold, income has little or no effect on happiness. Many wealthy people have experienced this law of diminishing returns and are not any more happy than middle-class people. In fact, some wealthy people are downright unhappy. Frey and Stutzer conclude, “Higher happiness with material things wears off.”⁴

Four Elements of Happiness

Years ago I read a sermon by a church leader on the “Four Sources of Happiness.” He spoke of work, recreation, love, and worship. I think he’s right.

First, you have to find rewarding and honest employment to be happy. Hard work and entrepreneurship offer the opportunity to create surplus wealth. Money in the bank gives you a real sense of security as well as freedom to do what you want to do. Moreover, studies show that unemployed people, believing they are not contributing to society or themselves, are generally unhappy.

Second, recreation is essential to your well-being. It helps to take a break from work from time to time. Relaxation and avocations are essential elements of a happy life. People who spend too much time at the office and can’t relax with their family or friends at home need to learn the joy of recreation with a hobby, sports, travel, or other avocation. Some of my most memorable times have been playing softball or basketball with friends, traveling with _family members on the weekend, or visiting a bookstore.

Third, love and friendship are also key elements of happiness. Everyone needs someone to confide in, to spend time with, to learn from, to reminisce with, to love and to be loved by. For most people, love and friendship take time and effort. You have to work at developing friendships, but the rewards are never-ending.

Finally, worship. Developing one’s spiritual side is essential to happiness. Some of my friends say they don’t need religion, but they are missing out on one of the joys of life–listening to a great sermon, singing hymns, meditating on the word of God, and praying for God’s help in solving business or family problems.

Let me conclude this essay with a delightful stanza by the Norwegian playwright Henrik Ibsen, who put the role of money in the proper perspective:

Money may be the husk of many things, but not the kernel.
It brings you food, but not appetite;
Medicine, but not health;
Acquaintances, but not friends;
Servants, but not faithfulness;
Days of pleasure, but not peace or happiness.

Notes

1. Bruno S. Frey and Alois Stutzer, Happiness and Economics (Princeton, N.J.: Princeton University Press, 2002), p. 81.
2. See my article “Easy Living-My Two Years in the Bahamas” at www.mskousen.com.
3. Frey and Stutzer, p. 75.
4. Ibid., p. 78. In fact, Frey and Stutzer publish a graph showing that “Per capita income in the United States has risen sharply in recent decades, but the proportion of persons considering themselves to be ‘very happy’ has fallen over the same period” (p. 77).

—LIN YUTANG¹

“Behavioral” finance is the hot new field in the rapidly growing “imperial” science of economics. Consider the titles of recent books on the subject: Irrational Exuberance by Robert Shiller of Yale University, who correctly warned investors that the bull market on Wall Street in 2000 was not sustainable, and Why Smart People Make Big Money Mistakes by Gary Belsky and Thomas Gilovich.

Essentially, these writers take issue with a fundamental principle of economics—the concept of “rational” predictable behavior. They argue that investors, consumers, and business people don’t always act according to the “rational economic man” standard, but instead suffer from overconfidence, overreaction, fear, greed, herding instincts, and other “animal spirits,” to use John Maynard Keynes’s term.²

Their basic thesis is that people make mistakes all the time. Too many individuals overspend and get into trouble with credit; they don’t save enough for retirement; they buy stocks at the top and sell at the bottom; they fail to prepare a will. Economic failure, stupidity, and incompetence are common to human nature. As Ludwig von Mises notes, “To make mistakes in pursuing one’s ends is a widespread human weakness.”³

Fortunately, the market has a built-in mechanism to minimize mistakes and entrepreneurial error. The market penalizes mistakes and rewards correct behavior (witness how well business responded to the Y2K threat in the late 1990s). As Israel Kirzner states, “Pure profit opportunities exist whenever error occurs.”⁴

But the new behavioral economists go beyond the standard market approach. They argue that new institutional measures can be introduced to minimize error and misjudgments, without involving the government.

At the American Economic Association meetings in Atlanta in January 2002, Richard Thaler of the University of Chicago presented a paper on his “SMART” savings plan, which is being tested by five corporations in the Chicago area. Thaler, author of The Winner’s Curse and a pioneer in behavioral economics, has developed a new institutional method to increase workers’ savings rates. Thaler noted that the average workers’ savings rates are painfully low. I blame the low rate on high withholding taxes, but Thaler suggested that part of the problem is the way retirement programs are administered. He convinced these corporations to adopt his plan to have their employees enroll in an “automatic” investment 401(k) plan. Most corporations treat 401(k) plans as a voluntary program and, as a result, only half choose to sign up. In Thaler’s plan, employees are automatically invested in 401(k) plans unless they choose to opt out.

Result? Instead of 49 percent signing up (as they do in a typical corporate investment plan), 86 percent participate.

Raises Invested

In addition, Thaler has participating employees automatically invest most of any pay increase in higher contributions to their 401(k) plans, so they never see their paychecks decline, even though their 401(k) plans are increasing. Consequently, employees under this SMART plan have seen their average savings rate increase from 3 to 11 percent.

Robert Shiller was a discussant at the session and rightly called Thaler’s plan “brilliant.” I agree. Having authored several investment books advocating “automatic investing” and dollar-cost-averaging plans,⁵ I applaud Professor Thaler for taking the concept of automatic investing to a new level. If companies everywhere adopt his plan, it could indeed revolutionize the world and lead not only to a much more secure retirement for workers but to a higher saving and investment rate. The result could be a higher economic growth and standard of living throughout the world.

Most important, Thaler’s plan is a private-sector initiative and does not require government intervention. In short, through innovative management techniques and education, individuals can solve their own financial and business problems without the help of the state.

Notes

1. Lin Yutang, The Importance of Living (New York: John Day Company, 1937), p. 57.
2. References to “animal spirits” and “waves of irrational psychology” can be found in John Maynard Keynes, The General Theory of Employment, Interest and Money (New York: Macmillan, 1973 [1936]), pp. 161–62.
3. Ludwig von Mises, Theory and History (New Haven: Yale University Press, 1957), p. 268. However, Mises refuses to call bad decisions “irrational.” He states, “Error, inefficiency, and failure must not be confused with irrationality. He who shoots wants, as a rule, to hit the mark. If he misses it, he is not ‘irrational’ he is a poor marksman.”
4. Israel M. Kirzner, “Economics and Error” in Perception, Opportunity, and Profit (Chicago: University of Chicago Press, 1979), p. 135.
5. 5. Mark and Jo Ann Skousen, High Finance on a Low Budget (Chicago: Dearborn, 1993) and Mark Skousen’s 30-Day Plan for Financial Independence (Washington, D.C.: Regnery, 1995).

“The makers of the Constitution conferred the most comprehensive of rights and the right most valued by all civilized men—the right to be let alone.”

-Justice Louis D. Brandeis

According to Thomas Jefferson and the Declaration of Independence, one of the “repeated injuries and usurpations” committed against the American people by the King of England was the erecting of “a multitude of New Offices, and . . . swarms of Officers to harass our people, and eat out their substance.”

Today, following the tragic events of September 11, 2001, the American people face another troublesome threat—swarms of security agents harassing us at airports, borders, buildings, and highways. Like many of you who travel frequently, my wife, Jo Ann, and I have been subjected to these often overzealous security guards who ask inane questions; force us to remove our shoes, jackets, and belt buckles; and meticulously go through our carry-on bags. I’ve had my fingernail clippers confiscated twice. Jo Ann was frisked three times in one day. Others have fared far worse. My friend and IOL fellow columnist Walter Williams was almost arrested in Jacksonville, Florida, after he refused to be patted down. A congressman was required to disrobe. After these security encounters, I always feel my privacy, indeed my dignity, has been violated.

President George W. Bush has urged citizens to return to normal life, but business and domestic affairs are never the same when a war is on, and this war on terrorism is no exception.¹ Bush’s proposed federal budget jumped 9 percent from last year, pushing the United States into a deficit again. Private enterprise has been forced to spend billions on security measures, a real burden on a recessionary economy. (Imagine, intelligent employees spending the rest of their lives trying to catch some nut out there, representing 1/1000 of 1 percent of travelers.) Airport security has now become federalized. And we have become, in the words of Sheldon Richman, “tethered citizens.”

In revolutionary times, colonists were so incensed by the invasions of privacy and other personal abuses by British officers that Congress’s first act was to pass a Bill of Rights, including Amendment III, “No Soldier shall, in time of peace be quartered in any house, without the consent of the Owner, nor in time of war, but in a manner to be prescribed by law,” and Amendment IV, “The right of the people to be secure in their persons, houses, papers, and effects, against unreasonable searches and seizures, shall not be violated, and no Warrants shall issue, but upon probable cause, supported by Oath or affirmation, and particularly describing the place to be searched, and the persons or things to be seized.”

The Fourth Amendment forms the basis of a “right to privacy,” the right to be left alone, as Justice Louis Brandeis put it. The enjoyment of financial and personal privacy is fundamental to a free and civil society. True liberty is to be able to walk down the street, cash a check, buy goods, talk on the telephone, or take a trip without being hassled, hounded, followed, or interrogated by government agents. People should be able to get away from the madding crowds without being followed or asked stupid questions. When I travel abroad, there is no better feeling than walking through the green customs door marked “Nothing to Declare.” When I return home and close the door, there is a feeling of security, knowing that the police aren’t going to break it down in the middle of the night for a “warrantless” search. It happened in Soviet Russia and Nazi Germany, but surely not in America!

Privacy Eroding

Yet the right to privacy so cherished by Americans of generations past is gradually eroding. New airport-security laws require all travelers to carry a “government-issued” ID, usually a driver’s license or passport. Thus we have come dangerously close to creating a national identity card for all Americans. The war on drugs has made it virtually impossible to deal legally in large amounts of cash, the most anonymous form of doing business. Some banks are requiring thumbprints for identification. Mandatory drug-testing of students and employees is becoming commonplace without any reference to the constitutional principle of “probable cause.” Since September 11, police routinely check automobiles and trucks coming into New York City without a warrant. Tampa and other big cities are videotaping citizens in “crime-prone” areas around the clock. California and other states are capturing all drivers on film and issuing tickets for alleged speeders.

I wrote the first book on financial privacy in the early 1980s.² It was a huge underground hit, selling over 400,000 copies. Clearly, vulnerable Americans felt the need for protection against potential lawsuits, government surveillance, prying relatives, aggressive salesmen, and professional thieves. From time to time, I am asked to do an updated edition, but I have refused. Why? Because the law has changed and become so complex that it takes a full-time professional to stay up on all the dos and don’ts. However, I can recommend an excellent newsletter that focuses on privacy issues: The Financial Privacy Report, published and written by Michael Ketcher (to subscribe, call 1-866-429-6681; P.O. Box 1277, Burnsville, MN 55337).

Despite the recent intrusions into individual personal affairs, you can still maintain a certain degree of privacy. You can take a car, bus, or train, and go to most destinations without being noticed or tracked. In small transactions, you can still pay with cash instead of using credit cards or checks. You can buy a large number of gold and silver coins with cash and avoid reporting requirements. You can refuse to give your Social Security number to schools, hospitals, dentist and doctor offices, insurance companies, and most private organizations (but not banks, brokers, or the IRS). You can open a foreign bank account with less than $10,000 and not have to report it. You can use a post office box to keep direct mail promoters from contacting you. You can demand a search warrant before allowing the police to come into your house or business, or to search your automobile.

In short, by maintaining a low profile, you can usually avoid the scrutiny of overzeal-
ous bureaucrats, nosy neighbors, or jealous relatives.

Notes

1. Historian Robert Higgs makes this very clear in his excellent article, “How War Makes Government Bigger,” Ideas on Liberty, December 2001.
2. Mark Skousen, The Complete Guide to Financial Privacy (Alexandria House Books, 1979; New York: Simon & Schuster, 1983).

“Economics is a very dangerous science”

-JOHN MAYNARD KEYNES¹

“Economics is haunted by more fallacies than any other study known to man.”

-HENRY HAZLITT²

There is no better example of today’s heated debate over macroeconomics than Japan. What policy should this nation–economically the second largest in the world–adopt to start growing again after a decade of sluggish performance?

It seems that Japan has tried all the traditional remedies since it collapsed into recession in the early 1990s and lost out as a world economic model. The Bank of Japan lowered short-term interest rates to zero. Tokyo raised taxes, ran huge deficits, and spent billions on public-works projects. But neither an easy-money policy nor an aggressive fiscal policy has done the trick. Japan is still mired in recession and rising unemployment, and now faces the largest debt burden among industrial nations.

In the late 1980s, Japan was considered the model of prosperity. Economists predicted that it would surpass the U.S. economy in 2000; the next century belonged to this Asian giant. Its lifetime-employment and bonus system was considered a superior business-labor management strategy. But the weaknesses of the Japanese economy became apparent in the 1990s–its model was too static and homogeneous for the dynamic global new economy. In 1990 the Fraser Institute’s economic freedom report ranked Japan ninth in the world. Now it is ranked only 20th primarily due to the growth of government and the mismanagement of the banking system.³

I witnessed firsthand this endless story of economic frustration when my wife and I spent a few days in Tokyo last June. The government has spent several trillion yen building a massive underwater highway called Aqualine. Now Tokyo residents have a fast alternate route outside the city. But the government charges $50 one way to go five miles under water and, as a result, even the Japanese are reluctant to use Aqualine.

Classical economists long taught that the government should produce only viable public works, where the benefits clearly outweigh the costs. But John Maynard Keynes turned the world upside down when he proclaimed that in a downturn, “To dig holes in the ground, paid out of savings, will increase, not only employment, but the real national dividend of useful goods and services.”⁴ Apparently several Japanese prime ministers have fallen under the Keynesian spell, but to no avail.

New Medicine: Print More Yen!

Several prominent economists have urged the charismatic new prime minister, Junichiro Koizumi, to adopt a more radical proposal–flood the country with yen. “Japan needs to spur demand,” argue Jeffrey Sachs of Harvard and Paul Krugman of Princeton. Even Milton Friedman, the celebrated free-market economist (famous for his refrain, “There’s no such thing as a free lunch”), has joined forces with top Keynesians to promote aggressive easy money as a way to jump-start a weak economy and counter deflation. Friedman has supported a rapid increase in the money supply in Japan since late 1997.⁵

At the Mont Pelerin Society meetings in September 1999, I confronted Friedman on this issue. He and his wife had organized the program under the topic “Can Creeping Socialism Be Stopped?” In one of the breakout sessions I asked him about his easy-money solution to Japan’s economic problems. I held up his article in the Wall Street Journal and noted how it made no reference to cutting taxes, deregulation, or opening up the Japanese economy; only inflation was proposed as a solution. “Isn’t printing more money another example of creeping socialism?” I asked. He was not amused. Friedman said that historically increasing the money supply stimulates economic growth, and fast monetary growth was necessary given Japan’s fragile condition. “Then there is a free lunch?” I asked. “A free disaster!” responded Friedman. Afterwards, Professor Jim Gwartney came up to me and said, “You attacked God today!” Indeed. Yet even free-market icons can make mistakes.

Fortunately, Prime Minister Koizumi has rejected this artificial stimulus and favors a supply-side agenda. He supports a regimen of capping government spending, requiring banks to write off and restructure their mammoth $1.2 trillion in bad loans, and privatizing the massive postal saving system, which funded much of the misconceived public works of the 1990s. Tax cuts would also be highly beneficial. Koizumi would be wise to follow the lead of the Obuchi administration (1998-99), which pushed through moderate tax cuts in personal and corporate income taxes. But he has postponed this vital supply-side ingredient until the crushing government-debt burden can be reduced.

Structural reform, as opposed to easy money and public spending, can work wonders in getting the Japanese economy back on track. For example, in 1994, when Japan deregulated the cell-phone industry, prices dropped and sales skyrocketed, and this year cellular-related revenues are expected to exceed $72 billion, nearly 2 percent of economic output.

The lesson is clear: Free the economy and prosperity will follow.

1. John Maynard Keynes, Essays in Biography (New York: Norton, 1951), p. 107.
2. Henry Hazlitt, Economics in One Lesson, 3rd ed. (New York: Arlington House, 1979), p. 15.
3. James Gwartney et al., Economic Freedom of the World Annual Report 2001 (Vancouver, B.C.: Fraser Institute, 2001), p. 182.
4. John Maynard Keynes, The General Theory of Employment, Interest and Money (London: Macmillan, 1936), p. 220.
5. Milton Friedman, “Rx for Japan,” Wall Street Journal, December 17, 1997.