Tuesday, December 7, 2010

I, Pencil

Here's something at the other end of the spectrum from yesterday's post on Capital Market Dysfunctionality.

Over 50 years ago Leonard Read's classic essay, I, Pencil, was first published.

Here's a link to that essay.

In the TV show (and book) "Free to Choose", Milton Friedman references Read's essay and had the following to say:

"None of the thousands of persons involved in producing the pencil performed his task because he wanted a pencil. Some among them never saw a pencil and would not know what it is for. Each saw his work as a way to get the goods and services he wanted—goods and services we produced in order to get the pencil we wanted. Every time we go to the store and buy a pencil, we are exchanging a little bit of our services for the infinitesimal amount of services that each of the thousands contributed toward producing the pencil.

"It is even more astounding that the pencil was ever produced. No one sitting in a central office gave orders to these thousands of people. No military police enforced the orders that were not given. These people live in many lands, speak different languages, practice different religions, may even hate one another—yet none of these differences prevented them from cooperating to produce a pencil. How did it happen? Adam Smith gave us the answer two hundred years ago."

Earlier this year, Matt Ridley wrote an essay in the Wall Street Journal that also references Leonard Read and had this to say:

...the sophistication of the modern world lies not in individual intelligence or imagination. It is a collective enterprise. Nobody—literally nobody—knows how to make the pencil on my desk (as the economist Leonard Read once pointed out), let alone the computer on which I am writing. The knowledge of how to design, mine, fell, extract, synthesize, combine, manufacture and market these things is fragmented among thousands, sometimes millions of heads. Once human progress started, it was no longer limited by the size of human brains. Intelligence became collective and cumulative.

The previous post on market dysfunction and its gross inefficiencies seems to contradict this thinking. I'd say they coexist just fine. So, yes, I generally agree with yesterday's post and think things like efficient market hypothesis (EMH) and most of its relatives are deeply flawed. Taken to the extreme these ideas did a lot of damage and have caused a lot of dysfunction.

In the real world participants swing from euphoria to fear, don't always act sensibly, and from time to time are rather susceptible to the deadly sins. In other words, the theory of rational expectations makes little sense in reality. Players are not always cold, calculated, and rational.

Yet, the failure of EMH and its relatives takes nothing away from the value of Leonard Read's (and others like Hayek, Friedman etc.) insights. The tricky part is developing a system that enables powerful free markets to work while recognizing the limits imposed by human nature.

Adam

Video: Friedman on the Pencil

Leonard Read's Essay: I, Pencil

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