Around 200 something years ago, an Englishman Adam Smith proposed in his book “The Wealth of Nations” (Original title is too long) that humans’ self-interest (a fancy word for greed) acted as “an invincible hand” to drive the free market, and thus the society to grow and prosper. He was revered as “Father of Economics” for his theory.

The working mechanism of Smith’s theory is simple: Assume that all people are rational and profit-maximizing (another fancy word for greed), they would picked the best decision available, which produce maximum amount of products at the lowest cost.  At the end we will have the maximum amount of aggregated utility available in the society. The famous “invisible hand” was widely accepted by the Western World as the only way to bring a society to prosperity.

To ensure the “invisible hand” work its magic to the extreme, all sorts of regulations regarding the market must be removed (e.g. all sorts of government interventions). This is where the term “deregulation” came into play in early 1970s U.S.. The White House tried to lift all or most market restrictions to as to apply Smith’s theory to the real world.

The Wall street went bananas after the deregulation took place. It gave rise to investment banking, derivatives and crazy lending. People want crazy as if there is no tomorrow. As if the market would never collapse. It did in 2000 in form of “IT Bubble Burst”. But people still haven’t learn their lesson. The market strike us again in 2009. This time it is real big. Big enough to crush a government, and major investment banks, something we thought were invincible for the last century.

What happened? Why Smith’s “invisible hand” didn’t work this time? What did the big shots in huge corporations like AIG do? Shouldn’t they chose the best business decision for their company, which was also best for the society?

What we missed in Smith’s theory is that decision-makers made decisions what they thought was best at that moment. It still sounds alright. Except the fact that what the decision-makers thought was best does not necessary turn out to be what they have expected – decision-makers are not always right about what’s best.  They can be wrong. Very wrong. Smith’s theory to some degree assume decision-makers are wise enough to choose what’s best, which is impossible since humans are not perfect in any point of view.

Some people may argue that there is another mechanism in Adam’s theory to recycle bad decision-makers. Bad decision-makers shut their factory/company down after they made a mistake, so only good decision-makers are left in the market, therefore the market will continue to work at optimism condition. What the mechanism did not mention is the damage bad firms done to the economy when they leave the market. If bad firms are small, of course the good firms can easily help in recovering the loss. How if the bad firms are as big as AIG, GM? Can the good firms cover up for them this time?

Are we relying on greed too much?