David Hirshleifer

David Hirshleifer Ph.D.

What Lies Beneath

The realm in which fantasy rules

Where the biases we can't see hurt us MOST

Posted Jul 17, 2009

To Dan Ariely, the invisible hand—the market force that gets people to help others, even when that is no part of their intention—is a pleasant fantasy. The most elegant statement of the idea he's whacking comes from Adam Smith himself:

It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own self-interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.

Unfortunately, Dan argues, the recent financial market crisis shows that the self-interest of financial managers led to cataclysm. Dan, a distinguished scholar at the Sloan School of Management at MIT, blames this on "our unblinking faith in the invisible hand," and goes so far as to state that "Adam Smith's version of invisible hand does not exist,"

According to Dan, the real invisible hand is human irrationality, "pushing and prodding us along a path can lead to destruction." So we need to "identify the ways in which irrationality plays tricks on us and make the invisible hand visible!"

Does it even exist?

I won't dwell on Dan's claim (perhaps made in the heat of enthusiasm) that the invisible hand—Smith's version—doesn't exist at all. The butcher and the baker don't love me, but yes, they do feed me.  Nowadays few deny at least some role for markets in channeling selfishness in beneficial ways. Even the Soviet Union and China eventually adopted the invisible hand as an economic organizing principle. The alternative, state-directed socialism, didn't work.

What you don't know hurts you

Let me instead focus on a valid and important part of Dan's comments. The problem isn't the things we're irrational about, it's the things we think we're rational about but aren't. If I know I'm prone to the latest investment fad, I can find ways to tie my hands to control temptation. I can put my money in a savings account with withdrawal penalty, or a back-end-loaded mutual fund (which charges a fee when I cash out). Or, I can ask my wife to manage the family finances. But if I think I'm a trading genius, then I'm in real trouble. As Brad Barber and Terrance Odean have shown, on average the more individual investors trade, the more they lose.

Like Smith's invisible hand, Ariely's invisible hand of irrationality coordinates the behaviors of many people, but usually with pernicious results. Ideas and moods are contagious, and can cause mass mania of various sorts—financial market bubbles, religious frenzies, and extremist political movements. Vicious political mania have often ridden upon the frenzied embrace of collectivist ideologies such as Nazism and communism. So the most consequential error caused by the invisible hand of irrationality is a faith that a utopia can be created by punishing villains and running the economy from the top down.

Blind faith

Dan decries faith in Smith's invisible hand, but the real puzzle is the ready faith in the regulation that would displace it. For regulation to work well, legislators and regulators need to be benevolent and rational. Benevolent, because there's little reason to expect a selfish politician pursuing his own ends to help society. (I'm fed by a selfish baker, not a selfish Blagojevich). Rational, since high hopes and good intentions aren't enough.

So Ariely's invisible hand of irrationality raises a red flag for regulation—why should politicians be immune to the biases that infect the rest of us? Might those who have ascended to the commanding heights sometimes become a tad overconfident? Why should we as voters be immune to the biases that infect our personal decisions? Don't we chase fantasies more in our politics than in our practical personal economic choices?

As Bryan Caplan of EconLog and others point out, we have much more incentive to become aware of our biases and control them when making personal plans than when we're voting—which means making plans for others. It's markets, not politics, that help achieve Dan's goal of making people more aware of their irrationality!

Not perfectly, of course. But pointing to an episode where markets blundered is no argument for regulation, since irrationality often rules political processes too. Furthermore, bad financial regulation can feed back into markets, reinforcing bubbles and other investor errors. It can even be argued that psychological bias is a basic driver of the forms of economic and financial regulation that we see around the world and through history—a topic for another day.