Whatever Happened to the Invisible Hand of Capitalism?

in FP: Latest/In Defense of Capitalism by

The article was in the works for over a year. I sat down to write it several times, and every time, until the last time, I walked away with just an incomplete paragraph or two. Just like any article about today’s global economy, it is an open-ended article. When I shared a draft with my father, his response was, “So What?” I answered … see the answer in the P.S. section.

When I was growing up in the Soviet Union, our local grocery store had two types of sugar: The cheap one was priced at 96 kopecks (Russian cents) a kilo and the expensive one at 104 kopecks. I vividly remember these prices because they didn’t change for a decade. The prices were not set by sugar supply and demand but were determined by a well-meaning bureaucrat (who may even have been an economist) a thousand miles away. If all Russian housewives (and househusbands) had decided to go on an apple pie diet and started baking pies for breakfast, lunch and dinner, sugar demand would have increased but the prices still would have been 96 and 104 kopecks. As a result, we would have had a shortage of sugar — a very common occurrence in the Soviet era.

In a capitalist economy, the invisible hand serves a very important but underappreciated role: It is a signaling mechanism that helps balance supply and demand. High demand leads to higher prices, telegraphing suppliers that they’ll make more money if they produce extra goods. Additional supply lowers prices, bringing them to a new equilibrium. I am slightly embarrassed as I write this, because you may confuse me for an economist — I am not one. But this is how prices are set for millions of goods globally on a daily basis in free-market economies.

In the command-and-control economy of the Soviet Union, the prices of goods often had little to do with supply and demand but were instead typically used as a political tool. This in part is why the Soviet economy failed — to make good decisions you need good data, and if price carries no data, it is hard to make good business decisions.

When I left Soviet Russia in 1991, I thought I would never see a command-and-control economy again. I was wrong. Over the past decade our global economy has started to resemble one, as the well-meaning economists running central banks have been setting the price for the most important commodity in the world: money. Interest rates are the price of money, and the daily decisions of billions of people and their corporations and governments should determine them. Like the price of sugar in Soviet Russia, interest rates today have little to do with supply and demand (and thus have zero signaling value).

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P.S. If Martian economists paid a visit to Planet Earth and surveyed our global economy, they’d form a very different view of its true health than most earthlings have. See, Martians wouldn’t be influenced by the positive feedback loop generated a seven-year bull market in stocks. The “low unemployment” numbers spat out by government agencies and touted by presiding politicians would also have little influence on them. They’d look at the percentage of people employed in the US, which is 3.5% below the 2007 high, and understand that true unemployment is probably double the official number.

The Martians would not be swayed by the calmness and confidence exuded by central banks economists. They’d see that the global economy is barely producing modest growth while government debt is on the rise and interest rates are mostly at zero or even less.

After they studied our wild- and not-so-wild life they would conclude that the most superior and resilient living species on Earth is the cockroach, which seems to survive anything. If the Martians were to set themselves the task of constructing a stock portfolio that would perform well under the tumultuous market conditions that pertain on the Earth today, they would of course try to model the portfolio after that incredible insect. This is what I told my father.

Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of Active Value Investing (Wiley) and The Little Book of Sideways Markets (Wiley). His books were translated into eight languages. Forbes Magazine called him "The new Benjamin Graham".