Yet Another Note on Adam Smith's "Invisible Hand": What It Is and What It Is Not

Adam Smith's "invisible hand" argument: the sole occurrence of the phrase "invisible hand" in the Wealth of Nations:

An Inquiry Into the Nature and Causes of The Wealth Of Nations: Every individual['s]... study of his own advantage naturally, or rather necessarily, leads him to prefer that employment which is most advantageous to the society.

First, every individual endeavours to employ his capital as near home as he can, and consequently as much as he can in the support of domestic industry, provided always that he can thereby obtain the ordinary, or not a great deal less than the ordinary profits.... In the home trade, his capital is never so long out of his sight as it frequently is in the foreign trade of consumption. He can know better the character and situation of the persons whom he trusts; and if he should happen to be deceived, he knows better the laws of the country from which he must seek redress.... The capital which an Amsterdam merchant employs in carrying corn from Koningsberg to Lisbon.... The uneasiness, however, which he feels at being separated so far from his capital, generally determines him to bring part both of the Koningsberg goods which he destines for the market of Lisbon, and of the Lisbon goods which he destines for that of Koningsberg, to Amsterdam; and though this necessarily subjects him to a double charge of loading and unloading as well as to the payment of some duties and customs, yet, for the sake of having some part of his capital always under his own view and command, he willingly submits to this extraordinary charge; and it is in this manner that every country which has any considerable share of the carrying trade, becomes always the emporium, or general market, for the goods of all the different countries whose trade it carries on....

[A] capital employed in the home trade, it has already been shown, necessarily puts into motion a greater quantity of domestic industry, and gives revenue and employment to a greater number of the inhabitants of the country, than an equal capital employed in the foreign trade.... Upon equal, or only nearly equal profits, therefore, every individual naturally inclines to employ his capital in the manner in which it is likely to afford the greatest support to domestic industry, and to give revenue and employment to the greatest number of people of his own country.

Secondly, every individual who employs his capital in the support of domestic industry, necessarily endeavours so to direct that industry, that its produce may be of the greatest possible value.... As every individual, therefore, endeavours as much as he can, both to employ his capital in the support of domestic industry, and so to direct that industry that its produce maybe of the greatest value; every individual necessarily labours to render the annual revenue of the society as great as he can. He... neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain; and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest, he frequently promotes that of the society more effectually than when he really intends to promote it...

Note that Adam Smith's "invisible hand" argument is not the argument economists make today. Adam Smith argues that there are:

• political failures--uncertainty about how to access and indeed the prevalence of the rule of law in other countries.
• psychological failures--people are so anxious to have some of their wealth around them where they can touch it that they pay longshoremen to unload and reload goods at Amsterdam rather than drop-shipping them straight from Konigsburg to Lisbon.

And he argues that, as a result, merchants are good patriots--that they deploy their capital to "render the annual revenue of the [national] society as great as he can."

Adam Smith's purpose here in Book IV, Chapter II is to argue against mercantilism, against the idea that you can make your country wealthier by imposing tariffs and other restrictions on imports. The problem with his argument is that mercantilism is correct (unless you are a very small country), at least in the absence of retailiation.

So Smith, ingeniously, argues that the biases toward home production that mercantilist goals would suggest should be incorporated into economic decision-making are already present in the market because of what modern economists would call political failures and psychological failures. Smith does not argue that the market maximizes wealth because there are no external benefits to home production and merchants are rational. Instead, Smith argues that the market maximizes national wealth because merchants' psychological propensities plus the inability of foreign governments to commit to the rule of law together match the external benefits to others in the national community of merchants' committing their capital at home.