Saturday, January 21, 2012

Adam Smith and the FDR Framework

Regular readers know that this blog is focused on fixing the financial system and not on choosing sides in the long running debate between schools of economic thought.

However, I was reading a post on ZeroHedge where I found a couple of observations by economists that I thought were both interesting and relevant.

Let me read to you from Adam Smith, the section with the invisible hand explanation. He’s with Mises and Hayek on this humility point, even though the book,An Inquiry into the Nature and Causes of theWealth of Nations, is written as advice to statesmen: 
“What is the species of domestic industry which his capital can employ [ie what he should invest in], and of which the produce is likely to be of the greatest value, every individual, it is evident, can, in his local situation, judge much better than any statesman or lawgiver can do for him. The statesman, who should attempt to direct private people in which manner they ought to employ their capitals, would not only load himself with a most unnecessary attention, but assume an authority which could safely be trusted, not only to no single person, but to no council or senate, and which would nowhere be so dangerous as in the hands of a man who had folly and presumption enough to fancy himself fit to exercise it.” 
In The Theory of Moral Sentiments Smith calls him “the man of system” who is arrogant in his own conceit. Hayek comes back to this in an essay, “Individualism True and False”, and he tries to explain where the system goes. He writes: 
“The main point about which there can be little doubt, is that Smith’s chief concern was not so much about what man can occasionally achieve when he was at his best, but that he should have as little opportunity as possible to do harm when he was at his worst. It would scarcely be too much to claim that the main merit of the individualism which he and his contemporaries advocated is that it is a system under which bad men can do least harm. It is a social system that does not depend for its functioning on our finding good men for running it, or on all men becoming better than they are now, but which makes use of men in all their given variety and complexity, sometimes good and sometimes bad, sometimes intelligent, and more often stupid. Their aim was a system under which it should be possible to grant freedom to all, instead of restricting it, as their French contemporaries wished, to ‘the good and the wise’. 
“The chief concern of the great individualist writers was indeed to find a set of institutions by which man could be induced, by his own choice and from the motives which determined his ordinary conduct, to contribute as much as possible to the need of all others; and their discovery was that the system of private property did provide such inducements to a much greater extent than had yet been understood.”
The FDR Framework is built on two ideas
  • It is the role of governments to be sure that market participants have access to all the useful, relevant information in an appropriate, timely manner; and
  • Under the principle of caveat emptor investors are responsible for all the gains or losses on their investments.
This framework is consistent with Adam Smith's invisible hand explanation and Hayek's interpretation.

Under the framework, governments are not responsible for making the decisions, but rather for ensuring that the buyer has access to all the useful, relevant information.  It is the buyer that makes and lives with the decision.

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