Understanding the Invisible Hand Theory and How It Applies to Crypto
Trading Analysis

Understanding the Invisible Hand Theory and How It Applies to Crypto

4 months ago

Ever wondered why markets move the way they do? We aim to address that question by discussing the Invisible Hand Theory, a concept that tries to address the forces behind markets.

Understanding the Invisible Hand Theory and How It Applies to Crypto

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At many points in Bitcoin's history, price has moved around erratically, as if without any discernible reason. In most cases though, these movements can be logically explained, if one knows where to look. In fact, most of Bitcoin's volatility can be explained using the Invisible Hand Theory — an idea proposed by economist Adam Smith, to illustrate why self-interested decisions can turn out to benefit society as a whole. Over time, we have learned that the same theory also has surprising parallels to crypto markets, trading and investing in general.

Let's dive into everything there is to know about the invisible hand theory, its history and how it applies to crypto!

What Is the Invisible Hand Theory?

The invisible hand theory is a concept founded in what is known as rational choice theory, which states that individuals are in control of their decisions, and that they make their decisions based on rational considerations rather than unconscious drives such as traditional or environmental influences.

The theory of the invisible hand is used to metaphorically describe the invisible forces behind a free market economy (an economy with little to no market interference from the government). It describes that if freedom of production and consumption, combined with the nature of people to act in their best interests, then the interests of society will be fulfilled.

For example, if society has a lack of access to bread, self-interested opportunists will start bakeries, as there is clearly demand for freshly baked bread. In this sense, the constant relationship between supply and demand causes even the most self-interested people to serve the needs of society as a whole.

History of the Invisible Hand Theory

The concept of the invisible hand dates back to the year the USA declared independence (1776), when economist Adam Smith published his most famous work: The Wealth of Nations. In his book, Smith explains how all the individual interests in a society come together in a way that benefits society as a whole, and prevents crises from arising.

As an example, while consumers would like to pay as little as possible for a bag of rice, the producers of this rice would love to get as much as they can. When these two interests combine, the invisible hand brings these two together, and a fair market price is established: a price that works for both consumers and producers.

What Smith described as the Invisible Hand is considered to be similar to what modern day professors of economics will describe when they discuss free markets, and the forces that move them. At least, many consider it to be similar, while proponents of (more) market intervention and protectionism suggest the idea is taken out of context.

The Invisible Hand in Crypto Markets

While the theory is centuries old, it can still easily be applied to financial markets, such as stocks, commodities, forex or crypto. Especially in crypto — a market that is known for its lack of government intervention, the theory seemingly makes a lot of sense. After all, market participants seem to have found a way to transact and agree on prices to do so for years.

If you are trading crypto, understanding the concept of free markets — or the invisible hand — is important, as understanding is the first step towards skilful analysis or prediction.

Let's look at some examples of the invisible hand at work, in crypto markets.

The FTX Crash

After the collapse of the then-second largest derivatives exchange in crypto, markets sold off, resulting in a domino effect where the initial sell off triggered a bunch of liquidations and stop losses, resulting in an even deeper sell-off. Eventually, the invisible hand intervenes, in the sense that the cheaper prices attract new buyers, and the sell off eventually finds a bottom.

The same happens when price skyrocketed in a short squeeze, or when options traders get gamma squeezed. When prices skyrocket for these reasons, the increased risk associated with the pumps results in less buying interest, and the market eventually retraces the move, to return to levels deemed appropriate by all market participants.

Memecoin Rallies

Memecoin rallies are another perfect example of the invisible hand at work. Let's take Dogecoin as an example. During the mania stage of the previous bull market, the tokens value skyrocketed to a whopping $0.73 per coin – on pure speculation-driven demand.

The Invisible Hand intervened, as new demand dried up and the market started selling off, back to more reasonable levels. Dogecoin's value has since dropped over 90%, now trading at just over $0.065.

Essentially, when markets start moving irrationally high (or low), you can count on the invisible hand to step in – eventually. We say eventually, because as John Maynard Keynes famously said: "Markets can stay irrational longer than you can remain solvent." With this, he means that an irrational market (such as Dogecoin's rally) can continue to move higher for much longer than you can afford to bet against it.

Critics of the Invisible Hand Theory

There is a lot of disagreement on the invisible hand theory. Not only do people disagree on whether markets should be free in the first place, but they also have more direct concerns about the assumptions made in the theory.

For example, they argue that self-interested actions do not always lead to benefits to society as a whole, citing economic and social inequalities and exploitation of workers as evidence for their critique.

Other critics argue that the theory oversimplifies economics, and that – contrary to what I described earlier – someone will not just go and bake bread, because of the cost of setting such an operation up. This critique becomes especially true when instead of bread, the item in the example becomes, let's say, high precision semiconductors.

Closing Thoughts

Ultimately, Adam Smith's theory is useful to learn more about why markets move the way they do — even if critics believe the theory is flawed. After all, to this day there still is no theory that perfectly explains the financial world as we know it, as it is far too complicated to encapsulate in a single theory.

The Invisible hand theory helps you understand ways that the market regulates itself, and how balance exists, even in a wild western scene full of crypto cowboys.

Writer’s Disclaimer: This article is based on my limited knowledge and experience. It has been written for educational purposes. It should not be construed as advice in any shape or form. Please do your own research.

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