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Is the “invisible hand” still relevant?

Adam Smith first talked about the invisible hand in the Wealth of Nations, expressing the view that by and large, competitive markets that are relatively free of government guidance do a better job of allocating resources than occurs when governments play a dominant role.

Stephen LeRoy, professor at the University of California, opens with this well-known economic premise in his Economic Letter which has just been published by the Federal Reserve Bank of San Francisco.

He notes that Smith’s view held a lot of credence as seen in the deregulation of financial and non-financial markets in the 1980s and subsequent decades. However, the current credit crisis has led many to revisit this question. Financial markets in recent years have appeared dysfunctional to an extent never previously imagined, raising the question as to whether Adam Smith got it wrong about private markets.

LeRoy then takes us on a tour that starts with Smith and follows through to Pareto, Arrow and Hayek, and notes that Pareto efficiency often does not survive in settings that allow for asymmetric information. So the balance between reliance on markets and government intervention is very much at the forefront of current debate.

He notes that: “Those who believe that unregulated markets generally work well express the view that misconceived interference by the government was the major cause of the crisis. In contrast, those who take a more critical view about the functioning of private markets believe that the crisis stemmed mainly from the destructive consequences of factors such as information asymmetries in financial markets and distortions to incentives that encouraged excessive risk-taking.”

He concludes that opting for either of these extremes will not guarantee improvement in the performance of financial markets and prevent another crisis recurring. He says that “the problems are complex, and sweeping changes in the regulatory structure could do more harm than good. A better strategy may be to identify specific problems in the financial system and introduce regulatory changes that address these clearly defined weaknesses, such as executive compensation practices that encourage excessive risk-taking.”

This is an interesting short article taking the reader through the development of economic thought concerning competitive markets. To access the full article click here.

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Posted in market failure, Microeconomics

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