The Invisible Hand: How Markets Work
Three Warrants for Markets

Maria: It all seems unrealistic. I can't imagine that markets work in this smooth fashion.

McCloskey: real markets work more or less in accordance with the laws of demand and supply and the equilibrating system as described here.

Maria: Even if you're right, I still think that markets are terrible things. They make poor people poorer.

McCloskey: Many people think so. But they are wrong: markets in fact make poor people better off. They have in the past and they will in the future.

Maria: How can you think so?

McCloskey: A very relevant question, Maria. Back in Chapter 1 we noted that an argument in support of a claim is called a "warrant." I want to persuade you that markets are good for society, so I have to give warrants. That's what an argument is. Let me give three. (There are many more warrants I could give, but these are quite important ones.)

1.) Markets are voluntary: so in a market you make a deal you think is OK

McCloskey: Nobody puts a gun to your head to make you give up something you own---a $10 bill, say---in exchange for something else---a pizza, say. You can leave one job and take another or get out of the job market completely. Since you enter a market voluntarily, it must make you better off. If you hadn't gained something, you wouldn't have entered into it.

Maria: But I could be forced to buy something. How about when I desperately need a medicine to save the life of my child? I need to buy it and the pharmacist knows that so he can charge me an outrageous price. That is unfair.

McCloskey: You're extending the word "forced." "Force" refers to physical violence. The principle stands. You gave a lot of money, you saved your child.

In short, you need never enter a market if you don't want to. Before you shake hands or sign a contract, you can walk out the door. If you stay, you are saying in effect that you are willing to enter the deal.

2.) Markets pop up anyway: seems that people think they are OK

Markets pop up when something is scarce. Think what happens in a prisoner-of-war camp when a shipment of chocolate arrives from the Red Cross. Who gets the chocolate? It goes first to those prisoners who have received packages from their loved ones. Then what Adam Smith called "trucking and bartering" sets in ("trucking" is an old word for making deals). Prisoners who like cigarettes more than chocolate will start trading their chocolate with prisoners who like chocolate more than cigarettes. The chocolate changes hands by way of the market.

Is there any alternative? Instead of offering cigarettes for chocolate, the strongest prisoner might "offer" to break your arm for what he wants. Or the prison authorities may decide to confiscate the chocolate and allocate it by status, with the officers getting a lot, the enlisted men little. Or they might allocate according to which prisoners are willing to waste the most time standing in line. In countries that do not allow markets to allocate chocolate, or vodka, or potatoes, the lines are long and the amount of time wasted is staggering.

So any attempt to interfere with supply and demand changes the nature of the competition but does not eliminate it. Scarcity makes competing for things inevitable. The question is not whether we need to have a method to allocate goods among people, but which method is best. In markets people bid up against each other with pieces of paper called "money." In the lines of the former Soviet Union-or nowadays, in the lines of singers hopeful for an audition with American Idol-people who were willing to wait the longest win.

Maria: That sounds fair.

McCloskey: So it's fair that people with the most time on their hands win?

Maria: But they are the poor people.

McCloskey: So poor people should always win? And how about the rich, idle person with plenty of time on her hands? And what about the rich person who hires a poor person to stand in line for her? But wait: the most characteristic argument an economist makes against line-standing is that it wastes a scarce thing to bid for another scarce thing.

Maria: Huh? So what? Money is scarce too, isn't it?

McCloskey: No, not in the sense that time standing in lines is. Time is a real resource. Money is just a paper claim to purchases. A dollar bill costs to make only a few cents of real resources (remember: not only natural resources, but also labor and machines). The economist points out that it's crazy to throw away real resources to compete for goods when there's a price system available that uses almost costless dollar bills.

Maria: I don't get the difference. I have to work hard for my money.

McCloskey: Keep thinking about it. If there is a method for dividing up goods that is reasonably fair and costs very little to administer, isn't it better than a method that is doubtfully fair and costs gigantic amounts to administer?

Maria: Well. . . sure. So?

McCloskey: I'm claiming that the first method, fair and efficient, is called . . . the price system! The others are called violence or superior social status or standing in lines.

For example, what happens when the government decides the price of gasoline is too high and imposes a price ceiling? Consumers who felt the equilibrium price was too high will now begin to buy, and consumers who were already buying step up their purchases. Great! Stick it to the greedy suppliers---who are profiting too much anyway! Help the people! Constrain the landlords, bankers, and oil companies! Right?

Wrong. The result of a price ceiling is a perpetual market imbalance. At the government controlled low price, more gasoline is demanded than is supplied. The excess demand leads to long lines at gasoline stations, back-up of traffic on adjoining roads, angry drivers, and "Sold Out" signs posted at 3:00 p.m. Why? Because there's another group involved, too: the suppliers. The quantity supplied at the controlled price will be low. The result is the waste of a precious resource - namely, the time of all the people who are standing in lines. Or worse: violence, bribery of police, midnight raids on the gasoline station with guns in hand.

Figure 3.9 Price ceilings prevent markets from eliminating shortages

The price ceiling sets the maximum price sellers of gasoline are allowed to charge. In reality queues would form at gasoline stations and consumers would compete with each other by trying to outlast everyone else in line. The wasted resources are just enough to make the full price---money plus wasted time---equal to the high price at which the (too low) supplied amount would be bid for by the demanders.

McCloskey: Markets are like the referee of a competition, deciding who gets how much of a scarce resource.

Ziliak: But what are the "initial conditions" of the market? How have property rights been assigned and by whom, from what did current income and ownership derive, and what are the market rules?

McCloskey: So?

Ziliak: In an athletic event the referee carries out the rules of a game agreed upon in advance by equals, whether one speaks of commissioners or coaches or players. The wealth and race of the Chicago Bulls team, circa 1991-the "initial conditions" of the Bulls-was not supposed to affect the rules of the game. But the wealth of Enron the oil company or Eli Lilly the drug manufacturer certainly does affect the rules and outcomes of the market game.

McCloskey: How's that?

Ziliak: Political influence bought with their wealth.

McCloskey: Well, yes. We Good Old Chicago School economists agree with Adam Smith and with our friends on the left that a big threat to liberty---and the good functioning of markets---is political influence on the rules of the game.

Ziliak: Likewise, poverty and race matter to market exchange and outcomes. This is the philosopher John Rawls' point about "initial conditions" and "justice as fairness" (A Theory of Justice: Harvard University Press, 1971).

McCloskey: But markets erode the advantages of race and riches. It is in a competitive market that a poor man's dollar is just as powerful as a rich man's.

Ziliak: True enough, but not in Congress.

McCloskey: I told you I agreed with that point, and worry about it.

Heterodox Box: Ethics in Economics

When Adam Smith published The Wealth of Nations in 1776, he gave birth, we have said, to modern economics. Surprisingly, Smith had been from 1752 to 1763 a professor of moral philosophy. . . not of economics. Until the late 19th century it was rather common in Europe and the United States for economics courses to be taught in departments of philosophy or theology. Smith himself published in 1759 The Theory of Moral Sentiments, the last of the great treatises on "virtue ethics" until the revival of the approach in departments of philosophy two centuries later. Most economists have never heard of Smith's book on ethics---his first book (his second and last was The Wealth of Nations) and his favorite one.

After Smith economists tried more and more to separate facts from values. It was part of the 19th-century idea of a "science," even a science about such a field as the economy, that it should stick to the facts, and leave ethical assessment to preachers. The wholesale separation of economics from ethics, gathering special force after the 1930s, was probably not such a good idea.

Many heterodox economists agree. The Marxist tradition in some of its recent versions has taken up ethical themes---though on the whole the Marxists have shared with their neoclassical and Samuelsonian colleagues a disdain for questions of good and bad in the economy. Other small groups of heterodox economists---the Catholic economists, for example, espousing what they call "social economics"---advocate bringing the price system and ethics together. The Association for Social Economics, established in the United States 1941, describes itself as "formed to advance scholarly research and writing about the great questions of economics, human dignity, ethics, and philosophy." This is not the sort of language you will find in the modern version of the American Economic Association. Ethics is out. At its founding in 1885, though, the Association foreshadowed American insitutionalism, one of the heterodox schools; and many of its early members, such as its founding secretary and later president Richard T. Ely of Johns Hopkins and the University of Wisconsin, would have agreed on many points---Christian socialism, for example---with the Association for Social Economics. Recently even the heirs of economics, such as Amartya Sen and Robert Frank, have wrestled with ethical issues at a deeper level than the Samuelsonian "more is better."

3. ) Markets promote economic growth and thus reduce poverty in the long run: capitalism is the world's best program against poverty.

The big story in the world economy over the past two centuries is that average annual income per person has increased by a factor of eight even though the population of the world has increased by a factor of six. In other words, the world since 1800 or 1820 has moved from the living standards of today's Bangladesh to those of today's Mexico - from the level of desperation to the level of hope. And these gains are largely attributable to the spread of free markets. Down to 1992 the story. according to the economic historian Angus Maddison, was as in Figure 3.10. Since then Maddison has extended and revised his remarks, to the same effect.

Figure 3.10 Increase in world living standards, 1820-1992
YearAnnual GDP per person (1990$) Comparable country today World population (M)
1820 $651 Bangladesh 1.07
1870 $895 - 1.26
1913 $1539 Pakistan 1.77
1950 $2138 Philippines 2.51
1992 $5145 Mexico 5.44
Source: Angus Maddison, Monitoring the World Economy 1920-1992, OECD, Column 2:228; Column 3: 194-206; Column 4: 226.

The story of the United States is even more remarkable. Using Maddison's 1992 tables we can see that real annual income per head in the United States increased from 1820 to 1992 not by 10 percent or even 100 percent but 1,600 percent. In 1820 the average American, free and slave, earned $1,290 (as measured in 1990 constant dollars: see Chapter 23), about the level of present-day India. Now the average American earns about $35,000. It's pretty much the same story for every now-rich nation from Britain to Japan.

It's not heaven on earth. Rich countries are imperfect. But this 1,600 percent is giving hundreds of millions of people a scope of life denied to their great-great-great-grandparents. It is arguably the most important event in world economic history, and ought to be near the top of any list of "most important events" in human history.

Caption: Modern Tokyo, at dusk. Courtesy:

Just try to imagine how your great-great-great-grandparents lived, all 32 of them. Rural paradise? Happy small town life? Satisfied craftspeople? Hardly: not on the U.S. income of $3200 a year in 1880, and much, much less if they were then living in Sicily or Shanghai. It's hard for us to imagine what it means to have one dress for Sunday, to spend 40 hours a week as a woman on food preparation alone, or to be pleased if you learn to sign your name, though you still can't read much. But that's what it means to live a rural life with few markets and little specialization.

Such riches are spreading to the entire world. Economies that have adopted markets---so-called "Communist" China and so-called "License-Raj" India, for example---have grown recently at astonishing rates. That's the third and perhaps the best warrant for liking markets---the deliver the goods, and massively to the poor.

Caption: 19th Century New York, at dusk. In the late 19th century, the journalist Jacob Riis photo-documented a variety of America's urban poor. As here, circa 1889, in a filthy flophouse in New York City. Courtesy: History Matters Project, George Mason University.

Doubts about the free-market vision

Rodney:I'm still not buying it. You make it seem like markets are always good for the little guy. But big companies have all the power over workers and consumers. I don't think it's a fair system.

Klamer: You make a good point, which we'll talk more about in Chapter 4.

McCloskey: But you're missing the main point. Modern economic growth has done more for the poor workers of the world, that is, the ordinary consumers, than any form of socialism or government intervention. As we speak it's bringing Thai, Indonesian, and Mexican workers into a world economy where they can earn incomes that permit adequate nutrition, smaller families, expanded education, and all the other increases in human scope that modern economic growth has brought to, say, South Korea. I know it may seem unjust that the stockholders of global corporations earn profits in the process. Yet their profits are helping the world to become richer. That's the capitalist deal: Let me make profits and I'll make you rich.

Rodney: That's what they say. But they always give workers as little as possible.

McCloskey: I didn't like capitalism either when I was your age, so I appreciate your worries. But let me suggest that you re-read those numbers we just gave you in Figure 3.10. If you're serious about wanting to help people escape poverty, markets really are the best way - in fact, the only real way - to get it done.

Klamer: I think you're missing Rodney's point. He's suggesting that our free market optimism ignores the darker side of economics, like power differences, conflicts between employers and workers, human interactions. It is for good reasons we do not subject everything we do to the regime of the market. Families, for example, keep the market out, and so do companies in their internal operations.

McCloskey: It's a question of focus. As a free-market economist, I focus on the potential gains to all parties from increased specialization and trade, and above all free invention and innovation, rather than antagonisms of class, nationality, race, caste, and the like. I don't deny their existence. But if we're going to talk seriously about how to alleviate global poverty I think markets are historically, theoretically, and ethically more important.

Ziliak: I too like free markets. But the "free market" as you're using it is misleading to Rodney and other readers. As Arjo pointed out, every nation's economy contains a mixture of market and non-market institutions---family, governments such as the New England town meetings, nonprofit NGOs such as churches, and many others. And the non-market stuff isn't just a barrier or distraction to getting to the market system. In many ways they enable or complement markets, and vice versa.

Klamer: Precisely. I speak of the three spheres, the market, the home, and politics---in their Greek names, the agora, the oikos---remember, the very word from which "economics" comes!---and the polis. It's crucial to bear them in mind, and not collapse the whole economy into the agora, the marketplace.

Ziliak: But even if we agree that a "market economy" is best (we do), there are many ways to do it, depending on the legal, cultural, and political systems in which markets operate. The real question is not markets vs. government or capitalism vs. socialism or Adam Smith vs. Karl Marx. The real question is, what kind of market economy do we want to have?

McCloskey: Fair enough. Just as self-interest is only one part of being human (and not necessarily the best part), markets are only one part of our economy (though an indispensably important one).