There is No Invisible Hand

This year’s [2002] Nobel Prize celebrates a critique of simplistic market economics, just as last year’s award (of which I was one of the three winners) did. Last year’s laureates emphasised that different market participants have different (and imperfect) information, and these asymmetries in information have a profound impact on how an economy functions.

In particular, last year’s laureates implied that markets were not, in general, efficient; that there was an important role for government to play. Adam Smith’s invisible hand – the idea that free markets lead to efficiency as if guided by unseen forces – is invisible, at least in part, because it is not there.
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That such models prevailed, especially in America’s graduate schools, despite evidence to the contrary, bears testimony to a triumph of ideology over science. Unfortunately, students of these graduate programmes now act as policymakers in many countries, and are trying to implement programmes based on the ideas that have come to be called market fundamentalism.

Let me be clear: the rational expectations models made an important contribution to economics; the rigour which its supporters imposed on economic thinking helped expose the weaknesses underlying many hypotheses. Good science recognises its limitations, but the prophets of rational expectations have usually shown no such modesty.