Tuesday, 28 March 2017

Barnier and the Tantalus game

The EU has laid out its negotiating strategy for Brexit. Well, not officially yet, of course - the letter triggering Article 50 won't be delivered until tomorrow, 29th March. But as is its wont, it has made its intentions clear in the press.

In an op-ed in the FT, Michel Barnier, the EU's chief negotiator, has stated in no uncertain terms how he expects the negotiations to proceed. He identifies three crucial issues that must be resolved before there can be any discussion of future trading arrangements between the EU and UK:

  • the rights of EU citizens living and working in the UK
  • continuing funding for current beneficiaries of EU programmes
  • the border between the Republic of Ireland and Northern Ireland. 

The first of these responds to Theresa May's continued refusal to guarantee the rights of EU citizens currently living in the UK. Tellingly, Barnier makes no mention of UK citizens living in the EU. If May won't guarantee EU citizens' rights, he implies, the EU won't protect the thousands of UK pensioners living in Spain, France, Portugal and other sunny South European countries. It will be up to the governments of those countries to decide what happens to them. Nice.

The second is code for "we want our money". This is the contentious 60bn Euros the European Commission says the UK must pay when it leaves the EU. According to the FT, the bill is for "unpaid budget commitments, pension liabilities, loan guarantees and spending on UK-based projects". Unsurprisingly, hardline Brexiters object to this: UKIP's Suzanne Evans told a BBC Question Time audience that Britain "should not pay a penny" when it leaves the EU, and prominent Tory Leaver Iain Duncan Smith outlined a UK claim to a share of EU assets that he suggested would be more than enough to eliminate any UK liability.

It seems likely that the eventual bill will be significantly less than 60bn Euros, but well above zero. This is something of a problem for Brexiteers, who have already had to row back on their promise of an extra £350m per week for the NHS and are now faced with the likelihood that leaving the EU will actually cost the UK money. I'm not sure how they will explain this to the British people, but they will no doubt find someone to blame. Probably Theresa May.

The first two negotiating conditions set by Barnier should come as no surprise. But the third is new. The UK government has so far treated the question of the Northern Ireland border and the Good Friday Agreement as entirely a domestic matter. Barnier, it seems, disagrees. And he has a point. After all, it is the EU's border too, and reneging on the Good Friday Agreement would threaten the security of one of its remaining member states. If the UK can demand control of its borders, so can the EU.

Barnier makes it clear that trade is simply not on the table until the EU's priority issues are resolved:
If we cannot resolve these three significant uncertainties at an early stage, we run the risk of failure. Putting things in the right order maximises the chances of reaching an agreement. This means agreeing on the orderly withdrawal of the UK before negotiating any future trade deal. 
Note that although Barnier has specifically cited three issues, he has not limited the conditions to these three alone. The "orderly withdrawal of the UK" can mean whatever the EU wants it to mean.

Keeping trade off the table until everything else is agreed puts the UK into the same negotiating position as Greece. Before it can have the debt relief it so desperately needs, Greece must comply with all the conditions set by its creditors. And every time Greece seems to be getting close to meeting conditions for debt relief, the creditors set more conditions, or find reasons to claim conditions have not been met. Similarly, we can expect that every time the UK gets close to agreeing terms that would enable trade negotiations to start, further issues will be raised. This is the Tantalus game - and the EU is an expert player.

But why is the EU planning to play the Tantalus game? Well, it is all because of the attitude of the Brexit camp in the UK government. From the start, they have emphasised trade over everything else. They could hardly have made it clearer that for the UK, a new trade agreement is paramount. But the EU has much less need for a new trade agreement than the UK does.

The Brexiteers have repeatedly claimed that the EU will be so desperate for a trade deal that it will give the UK special terms amounting to single market benefits without the costs. "Just think about all those German cars!" they cry. But the evidence is that the UK has far more to lose from departure without a trade agreement than the EU does. And the EU's negotiating stance, as laid out in Barnier's op-ed, confirms that view.

There are overwhelming political reasons for the EU to be extremely unwilling to cut such a deal anyway. Giving a non-EU state the same access to EU markets as EU member states would strike a mortal blow to the EU political project. The Brexiteers cheerfully assume that for the EU, the economics of Brexit would trump the politics, even though their own Leave campaign was successful precisely because in the UK, politics trumped economics. But events in the last few years have demonstrated beyond any possible doubt that maintaining the EU project will be far more important for the EU negotiators than any amount of economic pain for the member states. Politically, allowing the UK to leave the EU with no trade deal is a much better outcome for the EU than giving the UK trade terms similar to those it enjoys now.

By overemphasising trade, discounting political imperatives and overstating the UK's position, the Brexiteers have played right into Barnier's hands. Hello, Tantalus.

Unfortunately, the UK cannot afford to play Tantalus.There was no end to his misery: but for the UK, there will be an end, and it is all too soon. Article 50's hard deadline means that the UK is negotiating with a gun to its head. It is more Tosca than Tantalus. Barnier (perhaps we should call him Scarpia?) spells this out:
The sooner we agree on these principles, the more time we will have to discuss our future partnership.
You only have two years, Theresa. If you wish to save the UK from the trade firing squad, just agree to our terms on everything else.

But the firing squad might proceed with the execution anyway. Even if the EU could agree the terms of a new trade agreement within two years - which is doubtful, since getting EU member states to agree is like herding cats - enacting it on the UK's exit may be impossible for legal reasons. The EU is hoist by its own Treaties.

Article 50 has not even been triggered yet, but the Brexit team has already managed to compromise the UK's negotiating position with its toxic combination of ignorance, arrogance and foolishness. This is a very bad start, Theresa.

Related reading:

Game theory in Brexitland

Saturday, 18 March 2017

Of cars and tariffs, and Brexit fantasies

"The Germans won't want tariffs on their car exports to the UK", said my father the other day.

I have to agree. No-one likes tariffs, especially when they are used to having none. But it was his next comment that made me pause. My father's idea is that the EU will allow the UK to have tariff-free access to the EU's markets after Brexit in order to placate the powerful German car manufacturing lobby. He's not alone in this view: it has been repeatedly stated by Brexit promoters, both during the Leave campaign and since the vote last June.

The obvious rejoinder is that the EU (ex-UK) is 27 countries, not one, and although Germany is powerful it does not call the shots with regard to trade. Although a qualified majority vote is sufficient to allow the UK to leave the EU, a new free trade deal between the UK and the EU post Brexit would require the agreement of all 27 members, and in some cases sub-sovereign agreement too. The recent trade deal between the EU and Canada was nearly derailed by Wallonia, a sub-sovereign of Belgium.

Nor could there be a deal specifically between Germany and the UK regarding car exports. The UK is leaving the EU, but Germany is not. And members of the EU are not allowed to negotiate their own third-country trade deals. If it tried to enter into a separate agreement with the UK, Germany would be breaking EU treaties. However powerful its car manufacturing lobby is, undermining the EU is not in Germany's interests. The car manufacturers know this. To my knowledge, they have never suggested that Germany should negotiate directly with the UK, nor are they ever likely to do so. That is a Brexiteer fantasy.

Of course, Germany does sell a lot of cars to the UK. But the UK certainly isn't the destination for "most of" its car exports, as some Brexiteers have asserted. Full Fact, debunking Louise Mensch, gives us the figures:
Germany sells about 14% of all the passenger cars it makes domestically to the UK, a little over one in seven. (That makes up about 18% of the passenger cars it exports, a little under one in five.)
So - assuming the UK did impose a tariff of some amount on car imports from the EU - 18% of German car exports would suddenly become more expensive (unless German manufacturers absorbed the tariff as a hit to profits). UK consumers might not like this price increase. But just look at German cars sold in the UK. Mercedes, Audi, BMW.....they are luxury cars. Even the Volkswagen Golf is a status symbol. If British people want cheap runarounds, they don't buy German. They buy Japanese or American cars manufactured in the UK. German cars already command higher prices than these: it is hard to see that British purchasers of German cars are suddenly going to exhibit extreme price sensitivity because of an import tariff. Top-of-the-range luxury marques might even benefit from a price rise, since they are Veblen goods. And some German cars are manufactured in the UK - Minis and Rolls Royces, for example: these would not incur the UK's tariff at all if sold in the UK, though they would incur EU tariffs if exported to the EU.

But where do the rest of Germany's car exports go? Well, a lot of them go to the rest of the EU. In general, the rest of the EU is a much bigger destination for German exports than the UK. And the rest are exported to the rest of the world. According to Eurostat, in 2015 exports of new and used cars made up 11% of the EU's total exports. Of those, over half came from Germany.  Interestingly, the UK is the EU's second largest exporter of cars, at 12% of total car exports. This contribution to EU exports will of course be lost post-Brexit. The EU's trade surplus in cars versus the rest of the world (exports exceed imports by a considerable amount) will therefore fall somewhat. But Germany's trade surplus in cars versus the rest of the world will actually increase, since it is a sizeable net exporter to the UK. The chances of its UK car exports collapsing sufficiently to eliminate this effect is vanishingly small.

The largest export market for EU car exports is the USA, which in 2015 took 26% of EU cars. The US imports more German cars than the UK does. The EU has no free trade agreement with the USA, so sales of these cars incur the US's WTO "most favoured nation" tariffs, which are about 2.5%. The second most important export market for EU-manufactured cars is China, which also has no free trade agreement with the EU. Clearly, not having a free trade agreement is not a great obstacle for German car exporters. There is no particular reason to suppose that the UK imposing tariffs on imports of German cars - or Italian, French and Swedish cars, for that matter - would be a major obstacle either. Admittedly, grandfathering EU WTO tariffs, which is how the UK is likely to do tariffs in the short term, will cause some pain, since the EU's tariffs are rather high. But given the relative price inelasticity of German cars in the UK market, the pain is likely to be limited and short-lived. So Germany is not likely to take fright at the prospect of UK import tariffs. German manufacturers may moan, but the response from the German government is likely to be along the lines of "if you can cope with tariffs elsewhere, you can cope with UK tariffs".

Some have suggested that threatening the EU with a trade war - "if you impose tariffs on our Nissan exports we will impose bigger ones on your Volkswagen exports" - might secure tariff-free access. This is foolish in the extreme. The UK has far, far too much to lose.

When it leaves the EU, the UK will face the EU's WTO "most favoured nation" tariff of 10% on its entire car exports to the EU. In 2015, that was 57% of its total car exports. And British car exports, with few exceptions, do not carry the "luxury" premium of many German marques. It is British car manufacturers, not German ones, who have the most to lose from Brexit. It is British car manufacturers who have lobbied most heavily for UK trade with EU to continue to be tariff-free. And in any trade war over car exports, it is the UK that would suffer most. Ratcheting up tariffs on EU car imports could reasonably be seen by the EU as unfair competition and met with retaliatory action. In a trade war, those that have the greatest exposure suffer the most.

Sterling weakness, if it continues, would also raise the UK price of imported German cars. If the combination of depreciation effects with new import tariffs raised the price enough, German exports to the UK would fall. But just as Brexiteers like to assume that the UK can readily substitute cheaper rest-of-world destinations for the expensive EU after Brexit, so too can Germany. Germany's engineering is respected worldwide. If the UK made exports difficult, Germany would simply seek markets elsewhere. It can well afford the short-term hit to its net exports: it has already weathered worse in the Eurozone crisis. In contrast, even with the assistance of a debauched currency, UK exporters to the EU might find it difficult to find new markets. 57% of total car exports is an awful lot to relocate to lower-tariff destinations.

It doesn't take much fact checking and common sense to debunk most Brexiteer fantasies. This is simply the latest in a long line of myths, legends and outright lies that crumble when exposed to the harsh light of reality. Sadly, though, in this age of fake news and the dominance of opinion, facts and sense are massively devalued goods. The Brexiteers will discover in due course the folly of their ideas. But by then, it will be too late.

Related reading:

Game theory in Brexitland

Image from www.car-brand-names.com

Sunday, 12 March 2017

Game theory in Brexitland

"No deal for Britain is better than a bad deal", says Theresa May. Her Brexit sidekick David Davis appeals to MPs not to "tie her hands". And that master of flannel, trade secretary Liam Fox, says that leaving without a deal would be "not just bad for the UK, it's bad for Europe as a whole".

These three statements sum up the hopes of the Brexiteers. The idea seems to be that if the UK adopts a really strong stance in its forthcoming negotiations with the EU, the Europeans will be so horrified at the prospect of the UK leaving without any agreement that they will cave in and give the UK what it wants. Welcome to the Brexit game of chicken.

On the face of it, the UK government's negotiating principles appear sound: set out your red lines, make it clear that you won't tamely agree to everything the other side wants and that you will walk away rather than give ground on things that really matter. But if you are going to play brinkmanship, you really have to understand your opponent. The EU is well versed in this game - and it knows how to win.

So, how credible is May's threat to walk away from negotiations? Davis's intervention is clearly intended to make it credible. If Parliament can overturn her decision and send her back to the negotiating table, then her position is much weaker. On this occasion, therefore, perhaps they are right. Parliament cannot be allowed to veto a "no deal" exit. To do so would indeed tie Theresa May's hands. She must have the freedom to end negotiations without a deal.

But Parliament is the least of her problems. Theresa May's real difficulty is that she is dealing with a hardened opponent that is not afraid to take pain in order to get what it wants. And to make matters worse, she has a hard deadline. The UK will leave the EU two years after Article 50 is triggered. The deadline can be extended, but it would require agreement from all 27 EU countries. There is no guarantee that in the event of no deal, they would agree to extend the deadline. In fact, there would be a strong incentive for them not to do so. If negotiations ran to the wire, the EU would need to concede virtually nothing. All it would need to do is put its terms on the table and say "take it or leave it".

And if you think the EU would not do this, you have learned nothing from the last few years. In 2015, Greece thought it could negotiate a new deal with the EU. So it set out its red lines, made it clear it would not accept the EU's terms, and threatened to walk away from negotiations - and indeed, from the Euro - if it didn't get what it wanted. For a while, it looked as if it might follow through on its threat: the resounding "NO" to the EU's terms in the Greek referendum should have led to exit from the Euro. But when the European Council explicitly faced Greek prime minister Alexis Tsipras with a choice between accepting their terms or leaving the Euro, he balked. And at that moment, he lost the game. The Greek government's threat to jump over the cliff was exposed as a bluff.

From that moment on, the end was inevitable. In a bruising overnight negotiation, Tsipras conceded almost everything that his government had previously rejected. And since then, further concessions have been made. The "red lines" have been repeatedly crossed. The Greek government is tamely accepting everything the EU demands - because the only alternative is jumping over the cliff edge that they stepped back from in July 2015.

The lesson is clear. If you are going to play the cliff edge game, you must be prepared for the possibility that the other side will push you over. Especially if your opponent is the EU.

Of course, the UK has already decided to jump over the cliff. Indeed, that is what the negotiation is about. It wants to negotiate a soft landing. Clearly, therefore, a European Council "accept our terms or leave" confrontation is not going to happen in this case. But that doesn't mean that the UK has a strong position. It doesn't.

To understand this, we have to consider the nature of the beast. In theory, the negotiations could be limited to the terms of the "divorce" - the status of EU nationals in the UK and UK nationals in the EU, the division of assets, the dismantling of common agreements, the final bill for ongoing responsibilities such as pensions. Leaving the EU without agreement on these would be horrible for everyone.

The UK's attempts to use security, intelligence and the status of EU nationals in the UK as bargaining chips have already been criticised. In all of these, it is hard to see that the "cliff edge" game is remotely credible: unilaterally ending cooperation over security, policing and intelligence would be utter folly, while the humanitarian cost of deporting EU nationals would be appalling. I think it is unlikely that the EU will play brinkmanship over security and intelligence: the EU has as much to lose as the UK, so agreement seems likely early in the negotiation. And the easy way of defusing the "hostages" problem is for the EU to offer UK nationals right-to-remain unilaterally, and then dare the UK to deport EU nationals. The UK government is already facing strong criticism at home for its attitude to EU nationals: international opprobrium as well might be a bridge too far. Nor is the EU likely to go into an exit with no agreement about the 60bn Euros it says it wants from the UK. Once the UK was no longer a member of the EU or under the jurisdiction of the ECJ, the EU would have no power to force it to pay up. No, there will be a deal on all these matters.

But trade is an entirely different matter. The EU and the UK appear to be poles apart. The EU negotiators seem to be intent on keeping the negotiations narrowly focused on the terms of the "divorce" and kicking trade discussions into the long grass. In contrast, the UK government has said it intends to forge a "new customs arrangement" with the EU, though it has not as yet defined what it means by that. And it lays claim to tariff-free trade:
We do not seek to adopt a model already enjoyed by other countries. The UK already has zero tariffs on goods and a common regulatory framework with the EU Single Market. This position is unprecedented in previous trade negotiations. Unlike other trade negotiations, this is not about bringing two divergent systems together. It is about finding the best way for the benefit of the common systems and frameworks, that currently enable UK and EU businesses to trade with and operate in each others’ markets, to continue when we leave the EU through a new comprehensive, bold and ambitious free trade agreement.
Eh, what? The UK government thinks the UK can have the benefits of Single Market membership without actually being a member of it? This is not remotely credible. Zero tariffs on trade and a common regulatory framework are not a side effect of the Single Market, they are its very nature. It would not be in the EU's interests for a non-EU member to have the same benefits as EU members. When the UK leaves the Single Market, therefore, there will no longer be zero tariffs and a common regulatory framework. The costs of doing business with the EU will go up.

How much they will go up depends on what deal the UK government manages to do with the EU. I confess I am not hopeful. The EU drives a very hard bargain. So, what happens if May ends up saying "no deal"?

Leaving the EU with no trade deal would mean that the UK would immediately revert to "most favoured nation" (MFN) status under the World Trade Organisation's rules as far as the EU was concerned. Much nonsense is talked about this, mostly by people who don't know what they are talking about. The "Clean Brexit" economists at the Policy Exchange, for example, blithely say this:
“WTO rules” is often presented as “deeply damaging” and “the hardest of hard Brexits”. We disagree. Tariffs under WTO rules are relatively low and falling. We already conduct around half of all our trade under WTO rules - beyond the Single Market or other formal free trade agreements (FTAs) - with the rest of the world. Both the US and China trade heavily with the EU, under WTO rules and we can do the same. Already, our WTO-rules trade is not only the biggest part - it is also fast-growing and records a surplus.
Aarrggh. There is a world of difference between trading with countries under existing trade tariffs which have been reducing in recent years, and introducing new trade tariffs where currently there are none.

The potential impact on the UK's trade with the EU from introducing new tariffs is considerable. I've reproduced here the WTO's table showing the current EU MFN tariffs:

Remember that the UK currently faces no tariffs on trade with EU countries. Chemicals are one of the UK's principal exports to the EU: after a "no-deal" Brexit, their export price would rise by 4.5%. This might be offset by a further fall in the value of sterling, but that creates problems on the import side. Few manufacturers are immune from import price rises, these days.

These are, of course, goods tariffs. The picture for services is much less clear. The WTO framework for services is at best a work in progress: flawed though it is, the EU's single market in services is far more developed. The "common regulatory framework" mentioned by the UK government is one of the principal benefits of the single market in services. Immediately on exit, this would be unlikely to change much, though the UK government's plans to impose restrictions on the free movement of people will negatively impact services trade right from the start. But over time, as EU and UK law and regulation diverged, services trade would become more and more difficult. The UK is also a major exporter of services to the rest of the world: the US is its largest trade partner in services. Much of this is because it is used as a gateway to the EU by service industries, particularly financial services. Once the UK can no longer perform that function, those service industries might disappear for good. So reverting to WTO rules could cause not only services trade with the EU to decline, but also services trade with the rest of the world.

The EU's MFN tariffs are also currently applied by the UK on its trade with non-EU countries with which the EU has no separate free trade agreement. The UK enjoys WTO membership by virtue of its EU membership, so as part of the Brexit process it will have to negotiate separate membership of the WTO, including setting up its own tariff schedules. Although there are calls for the UK to unilaterally abandon import tariffs, it seems much more likely that the EU's current WTO tariff schedule will form the basis for the UK's own tariff schedule post-Brexit.

After a no-deal Brexit, the UK would have to impose on imports from the EU the same MFN tariffs as it imposes on imports from non-EU countries. If the UK's new WTO schedules were based on the existing EU ones, then the impact on some agricultural imports, in particular, could be rather high, according to a study produced for the National Farmers' Union in April 2016:
.....a tariff of 30-40% would be applied on wine and cheese - two items for which the UK runs a significant deficit with the EU (net-imports of about 2,200 million and 1,250 million euro respectively, see Figure 3.1). In addition, imports of several meat product items would become subject to tariffs that could exceed 30% and might be even close to 70% or 90%, depending on the type of meat. All in all, the UK consumer will face higher prices for many items that are imported, which will only alter, if the UK government negotiates preferential access with the EU when leaving the Union. 
Goodbye to cheap Prosecco, then. And that's without considering the impact of the UK's exclusion from the EU's "tariff-reduced quotas" - see the top RH corner of the table above for the likely excluded rate on agricultural products
There would also be WTO tariffs on trade with countries such as South Korea with which the EU has free trade agreements, since it is highly unlikely that these countries would allow grandfathering of EU free trade agreements. 

None of this is good news for the UK. They are not great for the EU either, but EU countries could be forgiven for thinking that the loss of one country from the trading bloc would not make a great deal of difference - after all, there are still 27 of them and they can all trade freely with each other, as well as with the rest of the world under existing tariff arrangements. The UK, however, would be facing new tariffs on at least 45% of its exports, and it also would be obliged to impose MFN tariffs on over 50% of its imports.

The truth is that May's threat to leave the EU on WTO rules is no more credible than Alexis Tsipras's threat to leave the Euro. Leading the UK over the cliff edge onto a pile of jagged rocks is not delivering the best outcome for the UK. She would pay the price for that folly at the ballot box in 2020, or earlier if she lost the support of her (already restive) back-bench MPs. She has no choice but to try to negotiate some kind of soft landing. So the attempt to stifle Parliament is, once again, wrong. She must be chained to the negotiating table, even if it takes a Parliamentary veto to do it.

But the EU can walk away. After all, if it does nothing, the UK leaves on WTO rules that are a lot more damaging for the UK than they are for the EU. So the EU holds the upper hand. And the EU likes to play brinkmanship, especially when invited to do so by a foolhardy government. So my guess is that there will be a transitional deal. It will be hashed out in a brutal all-nighter just before the Article 50 notice expires. And in that meeting, May will agree to every single one of the EU's terms - because although they will fall a long way short of the benefits the UK currently enjoys, they will be better than the alternative.

The game will play out for the UK just as it did for Greece and Cyprus. And if any other governments are thinking of playing chicken with the EU - be warned. You will end up as roadkill.

Related reading:

Greece: The Game Is On Again - Forbes
Greece, the EU and the IMF are dancing with death - Forbes
Tsipras in the crucible
Sowing the wind
UK Perspectives 2016: Trade with the EU and beyond - ONS

Image by Gerald Scarfe. 

Friday, 3 March 2017

Adam Smith's Destructive Hand

Adam Smith's "invisible hand" is perhaps one of the most misunderstood concepts in economics. It is usually interpreted to mean that when individuals all operate according to their own self-interest, their actions somehow combine to create a well-ordered, well-functioning society "as if guided by an invisible hand".

To be fair, this statement about the "invisible hand" (from the Theory of Moral Sentiments) does seem to mean exactly that:
[The rich] consume little more than the poor, and in spite of their natural selfishness and rapacity…they divide with the poor the produce of all their improvements. They are led by an invisible hand to make nearly the same distribution of the necessaries of life, which would have been made, had the earth been divided into equal portions among all its inhabitants, and thus without intending it, without knowing it, advance the interest of the society, and afford means to the multiplication of the species.
This should have been challenged long ago on the lack of counterfactual evidence. It is an assertion, not a fact. Nonetheless, despite the glaring inequalities in our world today, it could be true. The history of the command economies of the 20th century is not a happy one: attempts to equalise the distribution of resources created poverty for (nearly) all, and the natural human desire to seize resources for oneself at the expense of others was inevitably strongest among those tasked by the rest with ensuring equitable distribution. No socialist revolution in history has succeeded in raising the living standards of all by killing off the rich: but the last 20 years, in which "communist" states have adopted capitalist practices and the number of billionaires in developing countries has risen to an all-time high, has seen the greatest rise in living standards for the world's population in recorded history.

The problem with Smith's statement is that it gives the impression that equitable distribution is not only possible, it is inevitable. The "invisible hand" guides the human species ever closer to complete equality of distribution. Marx would have been proud of him. But I don't think this is what Smith meant. I think he meant that the best distribution of resources we can have as a species is achieved when each individual pursues their own self interest. Unequal distribution of resources is inevitable, but because it is not possible for the rich to hoard everything they have - since ultimately, hoarding is death - the poor benefit from the selfishness of the rich. That is the implication of this paragraph from Smith's better-known work, The Wealth of Nations:
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 interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our necessities but of their advantages.
The poor are fed not in spite of, but because of the selfishness and greed of the rich.

But that is only half the story. This, also from The Wealth of Nations, is the other half:
Every individual... neither intends to promote the public interest, nor knows how much he is promoting it... 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.
For Smith, self-interest is inevitably benevolent in effect, whatever the intention. He does not consider the possibility that self-interest could have malevolent effects. Nor does he consider the possibility that short-sightedness and stupidity may have unexpected consequences. And this is because he is thinking in aggregates. Smith's "invisible hand" applies not to the individual, but to the group. The individual does whatever he wants: but the collective actions of thousands or millions of individuals together bring about a better society.

Here is Adam Smith's "invisible hand" at work:

(YouTube link for this video is here)

Beautiful, isn't it? Millions of individuals all looking for dinner. They are all pursuing their own gain, but they look as if they are organised and directed to create wonderful patterns. They fly as if guided by an "invisible hand". Note that we can see those patterns, but they, individually, cannot.

For Smith, people are like starlings. People pursuing their own self-interest fly as if directed by an "invisible hand", and together, unknowingly, make beautiful patterns. Individually, we cannot see the pattern of which we are part: but when we look back through history, we can see how patterns form and shape themselves from the actions of our forbears. Smith's observation is positive, optimistic, and for a swarming species like humans, accurate. So long as the majority of people are peacefully pursuing their own gain, the outcome for society must be beneficial.

But this is also the "invisible hand" at work:

(YouTube link for this video is here)

Millions of individuals, all looking for dinner - but this time, they make not a benign, beautiful pattern, but a terrifying, destructive one. Locusts are not the only species that can ruin an entire economy when they swarm. Some birds do, too. A small bird known as the "quelea" is feared all over Africa because it arrives without warning in huge flocks and eats everything in sight. The now-extinct "passenger pigeon" was a swarming bird that was feared by farmers in the American Mid-West for the same reason.

This is the part of the story that Smith omits. Humans are a swarming species. Swarms can be benign - or they can be destructive. And importantly, people do not know when they are swarming. Even if they are part of a very large movement of people that is feared by those in its path, they are still pursuing what they perceive to be their own self-interest. It's worth remembering, too, that when people swarm, an individual's own self-interest is to stay with - or join - the crowd. It is a brave person indeed who defies a crowd. And when people are caught up in a swarm, they behave in uncharacteristic and sometimes destructive ways. The "madness of crowds" drives berserker behaviour.

Malign swarms are deliberately whipped up by powerful individuals in pursuit of their own self-interest: the most destructive form of malign swarm is imperialist expansion (think of the Golden Horde, for example). But some swarms are destructive without being malign. The transatlantic credit bubble was a case in point: it was not deliberately whipped up to bring down the financial system, but it very nearly did so anyway. Everyone was pursuing their own interest, but collectively, their own interest, far from being benign as Smith assumes, was highly destructive. We do not see the patterns of which we are part.....

We do not yet know what triggers human swarming behaviour, though research is continuing in this area. But whether a human swarm is benign or destructive is a matter of perception. We don't see the starling swarm as destructive, because we are not being eaten. But the insects that the starlings are eating might (correctly) see the murmuration as a terrifying destructive force that aims to wipe them out. Similarly, people in China don't fear their annual migration home for New Year, which is the largest movement of people on the planet: but people in the West fear the influx of migrants from war-torn Middle Eastern countries.

The swarms we fear are those we believe could destroy our means of survival or wipe us out. And we have reason for our fear. Humans are a swarming species, and swarms can be destructive. Even though individually we may only be looking for a better life, the "invisible hand" is capable of guiding us to destruction.

Related reading:

Here is why economics is built on a monumental mistake - Evonomics
The Invisible Hand is dead! - Evonomics
The Wealth of Nations - Adam Smith
The Theory of Moral Sentiments - Adam Smith
Twitter storms and the madness of crowds - FT

Thanks to Matt and AFP for the videos, and Evonomics for the header image. 

I have corrected the mistaken attribution of the quotations in an earlier version of this post.