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History of economic thought
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The history of economic thought deals with different thinkers and theories in the field of political economy and economics from the ancient world to the present day. Although British philosopher Adam Smith is cited by many as the father of modern economics, his ideas built upon a considerable body of work from predecessors in the eighteenth century. They in turn were grappling with ideas received from centuries before and attempting to apply them to a modern setting.
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The history of economic thought deals with different thinkers and theories in the field of political economy and economics from the ancient world to the present day. Although British philosopher Adam Smith is cited by many as the father of modern economics, his ideas built upon a considerable body of work from predecessors in the eighteenth century. They in turn were grappling with ideas received from centuries before and attempting to apply them to a modern setting. In this sense, Smith was an interpreter to his day of ages-old information.
Economics was not considered a separate discipline until the nineteenth century. In his works on politics and ethics, the ancient Greek philosopher Aristotle grappled with the "art" of wealth acquisition and the question of whether property is best left in private or public hands. In medieval times, scholars like Thomas Aquinas argued that it was a moral obligation of businesses to sell goods at a just price. Economic thought evolved from feudalism in the Middle Ages to mercantilist theory in the renaissance, when the prevailing wisdom advocated that trade policy be structured in order to further the national interest. The modern political economy of Adam Smith appeared during the industrial revolution, when technological advancement, global exploration, and material opulence that had previously been unimaginable was becoming a reality. Changes in economic thought have always accompanied changes in the economy, just as changes in economic thought can propel change in economic policy.
Following Adam Smith's Wealth of Nations, classical economists such as David Ricardo and John Stuart Mill examined the ways the landed, capitalist and labouring classes produced and distributed national riches. In London, Karl Marx castigated the capitalist system he saw around him which he thought was exploitative and alienating, before neo-classical economics in a new era sought to erect a positive, mathematical and scientifically grounded field above normative politics. After the wars of the early twentieth century, John Maynard Keynes led a reaction against governmental abstention from economic affairs, advocating interventionist fiscal policy to stimulate economic demand, growth and prosperity. But with a world divided between the capitalist first world, the communist second world, and the poor of the third world, the post-war consensus broke down. Men like Milton Friedman and Friedrich von Hayek warned of The Road to Serfdom and socialism, focusing their theory on what could be achieved through better monetary policy and deregulation. As Keynesian policies seemed to falter in the 70's there emerged the so called New Classical school, with prominent theorists such as Robert Lucas and Edward Prescott. Their revival of laissez-faire ideas caught the imagination of some western leaders. However, the policies of governments through the 1980s have been challenged, and development economists like Amartya Sen and information economists like Joseph Stiglitz have brought new ideas to economic thought in the twenty first century.
Early economic thought
The earliest discussions of economics date back to ancient times (e.g. Chanakya's Arthashastra or Xenophon's Oeconomicus). Back then, and until the industrial revolution, economics was not a separate discipline but part of philosophy.Chulavamsa records that Parakramabahu I of Sri Lanka had debased the currency of Ancient Sri Lanka in order to produce monies to support his large scale infrastructure projects. Parakramabahu I also pioneered free trade during his reign, a war was fought with Burma to defend free trade. In Ancient Athens, a slave based society but also one developing an embryonic model of democracy, Plato's book The Republic contained references to specialisation of labour and production. But it was his pupil Aristotle that made some of the most familiar arguments, still in economic discourse today.
Aristotle
Aristotle's Politics (c.a. 350 BC) was mainly concerned to analyse different forms of a state (monarchy, aristocracy, constitutional government; tyranny, oligarchy, democracy) as a critique of Plato's advocacy of a ruling class of "philosopher-kings". In particular for economists, Plato had drawn a blueprint of society on the basis of common ownership of resources. Aristotle viewed this model as an oligarchical anathema. In Politics, Book II, Part V, Aristotle argued,
"Property should be in a certain sense common, but, as a general rule, private; for, when everyone has a distinct interest, men will not complain of one another, and they will make more progress, because every one will be attending to his own business... And further, there is the greatest pleasure in doing a kindness or service to friends or guests or companions, which can only be rendered when a man has private property. These advantages are lost by excessive unification of the state."
Though Aristotle certainly advocated there be many things held in common, he argued that not everything could be, simply because of the "wickedness of human nature". "It is clearly better that property should be private," wrote Aristotle, "but the use of it common; and the special business of the legislator is to create in men this benevolent disposition." In Politics Book I, Aristotle discusses the general nature of households and market exchanges. For him there is a certain "art of acquisition" or "wealth-getting". "Of everything which we possess," writes Aristotle, foreshadowing Karl Marx's theory of use and exchange value, "there are two uses... a shoe is used to wear, and is used for exchange." Money itself has the sole purpose of being a medium of exchange, which means on its own "it is worthless... not useful as a means to any of the necessities of life". Nevertheless, points out Aristotle, because the "instrument" of money is the same many people are obsessed with the simple accumulation of money. "Wealth-getting" for one's household is "necessary and honourable", while exchange on the retail trade for simple accumulation is "justly censured, for it is dishonourable". Aristotle disapproved highly of usury and also cast scorn on making money through monopoly. In Nicomachean Ethics (c.a. 350 BC) Aristotle discusses further the use of money as a medium of exchange, and its reflection of the demand for goods and services.
Middle Ages
Knowledge of western and northern European economic thought in the early middle ages is scarce. The value of money was perceived as metal based, and that supported notions of "just prices" and objective evaluations. The economy itself remained based on a system of feudal land distribution which included the granting of rights to have an income from them (through taxes and duties). The inspiration to develop and discuss more complex theories of economics and money values rose with options to borrow money (on interest rates), with investments in trade (on the speculation of successful trading missions) and with the rise of the modern banking system in northern Italy in the 13th and 14th centuries. Questions Europe had to solve were: Could it be fair to lend money on interest (if the value of money would be the same, when it came to an evaluation of metal in coins). Could it be justified that Jews and a growing banking sector made money simply by trading with money. It remained unclear how a trade of money could work, though it worked practically and to the mutual benefit of all parties, answering needs and yielding profits both to those those who borrowed money and those who offered their services.
Thomas Aquinas (1225-1274) dominated economic thought in medieval Europe, drawing largely on Aristotle's theory. Questions 77 and 78 of the Second Part of his treatise Summa Theologica relate to economic issues, particularly the fairness of a seller dispensing faulty goods and the concept of a just price. Aquinas argued against any form of cheating and recommended compensation always be paid in lieu of good service. Whilst human laws might not impose sanctions for unfair dealing, divine law did. Bearing similarities to the concept of long-run equilibrium, a just price was supposed to be one just sufficient to cover the costs of production, including the maintenance of a worker and his family. He argued it was immoral for sellers to raise their prices simply because buyers were in pressing need for a product.
Duns Scotus (1265-1308), a Scottish born theologian criticised Aquinas in Sententia (1295). Duns Scotus thought it possible to be more precise than Thomas in calculating a just price, emphasising the costs of labour and expenses - though he recognised that the latter might be inflated by exaggeration. Because buyer and seller usually have different ideas of what a just price comprises, he thought an agreed price usually contains a ‘gift' element on either side, an early forerunner to the idea of trade being a "win-win" situation. If people did not benefit from a transaction, in Scotus' view, they would not trade. Scotus defended merchants as performing a necessary and useful social role, transporting goods and making them available to the public.
Mercantilists and nationalism
From the localism of the Middle Ages, the waning feudal lords, new national economic frameworks began to be strengthened. From 1492 and explorations like Christopher Columbus' voyages, new opportunities for trade with the New World and Asia were opening. New powerful monarchies wanted a powerful state in order to boost their status. Mercantilism was a political movement and an economic theory that advocated the use of the state's military power to ensure local markets and supply sources were protected. Mercantilists theoricians considered international trade could not benefit all countries at the same time: money and gold being the only source of riches, there was a limited quantity of resources to be shared between countries. Therefore, tariffs could be used to encourage exports (meaning more money comes into the country) and discourage imports (sending wealth abroad). In other words a positive balance of trade ought to be maintained, with a surplus of exports. The term mercantilism was not in fact coined until the late 1763 by Victor de Riqueti, marquis de Mirabeau and popularised by Adam Smith, who vigorously opposed its ideas.
Thomas Mun
English businessman Thomas Mun (1571-1641) represents early mercantile policy in his book England's Treasure by Foraign Trade . Although it was not published until 1663 it was widely circulated as a manuscript before then. He was a member of the East India Company and also wrote about his experiences there in A Discourse of Trade from England unto the East Indies (1621). According to Mun, trade was the only way to increase England’s treasure (i.e., national wealth) and in pursuit of this end he suggested several courses of action. Important were frugal consumption in order to increase the amount of goods available for export, increased utilisation of land and other domestic natural resources to reduce import requirements, lowering of export duties on goods produced domestically from foreign materials, and the export of goods with inelastic demand because more money could be made from higher prices.
Philipp von Hörnigk
Philipp von Hörnigk (1640-1712, sometimes spelt Hornick or Horneck) was born in Frankfurt am Main and became an Austrian civil servant writing in a time when his country was constantly threatened by Ottoman invasion. In Österreich Über Alles, Wenn Sie Nur Will (1684, Austria Over All, If She Only Will) he laid out one of the clearest statements of mercantile policy. He listed nine principal rules of national economy.
"To inspect the country's soil with the greatest care, and not to leave the agricultural possibilities of a single corner or clod of earth unconsidered... All commodities found in a country, which cannot be used in their natural state, should be worked up within the country... Attention should be given to the population, that it may be as large as the country can support... gold and silver once in the country are under no circumstances to be taken out for any purpose... The inhabitants should make every effort to get along with their domestic products... [Foreign commodities] should be obtained not for gold or silver, but in exchange for other domestic wares... and should be imported in unfinished form, and worked up within the country... Opportunities should be sought night and day for selling the country's superfluous goods to these foreigners in manufactured form... No importation should be allowed under any circumstances of which there is a sufficient supply of suitable quality at home."
Nationalism, self-sufficiency and national power were the basic policies proposed.
Jean Baptiste Colbert
Jean Baptiste Colbert (1619-1683) was Minister of Finance under King Louis XIV of France. He set up national guilds to regulate major industries. Silk, linen, tapestry, furniture manufacture and wine were examples of the crafts in which France specialised, all of which came to require membership of a guild to operate in. These remained until the French revolution. According to Colbert, "It is simply, and solely, the abundance of money within a state [which] makes the difference in its grandeur and power."
British enlightenment
Britain had gone through some of its most troubling times through the 17th century, enduring not only political and religious division in the English Civil War, King Charles I's execution and the Cromwellian dictatorship, but also the plagues and fires. The monarchy was restored under Charles II, who had catholic sympathies, but his successor King James II was swiftly ousted. Invited in his place were Protestant William of Orange and Mary, who assented to the Bill of Rights 1689 ensuring that the Parliament was dominant in what became known as the Glorious revolution. The upheaval had seen a number of huge scientific advances, including Robert Boyle's discovery of the gas pressure constant (1660) and Sir Isaac Newton's publication of Philosophiae Naturalis Principia Mathematica (1687), which described the three laws of motion and his law of universal gravitation. All these factors spurred the advancement of economic thought. For instance, Richard Cantillon (1680-1734) consciously imitated Newton's forces of inertia and gravity in the natural world with human reason and market competition in the economic world. In his Essay on the Nature of Commerce in General, he argued rational self interest in a system of freely adjusting markets would lead to order and mutually compatible prices. Unlike the mercantilist thinkers however, wealth was found not in trade but in human labour. The first person to tie these ideas into a political framework was John Locke.
John Locke
John Locke (1632-1704) was born near Bristol and educated in London and Oxford. He is considered one of the most significant philosophers of his era mainly for his critique of Thomas Hobbes' defence of absolutism and the development of social contract theory in Leviathan (1651). Locke believed that people contracted into society which was bound to protect their rights of property. He defined property broadly to include people's lives and liberties, as well as their wealth. When people combined their labour with their surroundings, then that created property rights. In his words from his Second Treatise on Civil Government (1689),
"God hath given the world to men in common... Yet every man has a property in his own person. The labour of his body and the work of his hands we may say are properly his. Whatsoever, then, he removes out of the state that nature hath provided and left it in, he hath mixed his labour with, and joined to it something that is his own, and thereby makes it his property."
Locke was arguing that not only should the government cease interference with people's property (or their "lives, liberties and estates") but also that it should positively work to ensure their protection. His views on price and money were laid out in a letter to a Member of Parliament in 1691 entitled Some Considerations on the Consequences of the Lowering of Interest and the Raising of the Value of Money (1691). Here Locke argued that the "price of any commodity rises or falls, by the proportion of the number of buyers and sellers," a rule which "holds universally in all things that are to be bought and sold."
Dudley North
Dudley North (1641-1691) was a wealthy merchant and landowner. He worked as an official for the Treasury and was opposed to most mercantile policy. In his Discourses upon trade (1691), which he published anonymously, he argued that the assumption of needing a favourable trade balance was wrong. Trade, he argued, benefits both sides, it promotes specialisation, the division of labour and produces an increase in wealth for everyone. Regulation of trade interfered with these benefits by reducing the flow of wealth.
David Hume
David Hume (1711-1776) agreed with North's philosophy and denounced mercantile assumptions. His contributions were set down in Political Discourses (1752), later consolidated in his Essays, Moral, Political, Literary (1777). Added to the fact that it was undesirable to strive for a favourable balance of trade it is, said Hume, in any case impossible. Hume held that any surplus of exports that might be achieved would be paid for by imports of gold and silver. This would increase the money supply, causing prices to rise. That in turn would cause a decline in exports until the balance with imports is restored.
The circular flow
Similarly disenchanted with regulation on trademarks inspired by mercantilism, a Frenchman name Vincent de Gournay (1712-1759) is reputed to have asked why it was so hard to laissez faire, laissez passer (free trade, free enterprise). He was one of the early physiocrats, a word from Greek meaning "government of nature", who held that agriculture was the source of wealth. As historian David B. Danbom wrote, the Physiocrats "damned cities for their artificiality and praised more natural styles of living. They celebrated farmers." Over the end of the seventeenth and beginning of the eighteenth century big advances in natural science and anatomy were being made, including the discovery of blood circulation through the human body. This concept was mirrored in the physiocrats' economic theory, with the notion of a circular flow of income throughout the economy.
François Quesnay
François Quesnay (1694-1774) was the court physician to King Louis XV of France. He believed that trade and industry were not sources of wealth, and instead in his book, Tableau économique (1758, Economic Table) argued that agricultural surpluses, by flowing through the economy in the form of rent, wages and purchases were the real economic movers. Firstly, said Quesnay, regulation impedes the flow of income throughout all social classes and therefore economic development. Secondly, taxes on the productive classes, such as farmers, should be reduced in favour of rises for unproductive classes, such as landowners, since their luxurious way of life distorts the income flow.
Jacques Turgot
Jacques Turgot (1727-1781) was born in Paris and from an old Norman family. His best known work, Réflexions sur la formation et la distribution des richesses (1766, Reflections on the Formation and Distribution of Wealth) developed Quesnay's theory that land is the only source of wealth. Turgot viewed society in terms of three classes: the productive agricultural class, the salaried artisan class (classe stipendice) and the landowning class (classe disponible). He argued that only the net product of land should be taxed and advocated the complete freedom of commerce and industry. In August 1774, Turgot was appointed to be Minister of Finance and in the space of two years introduced many anti-mercantile and anti-feudal measures supported by the King. A statement of his guiding principles, given to the King were "no bankruptcy, no tax increases, no borrowing." Turgot's ultimate wish was to have a single tax on land and abolish all other indirect taxes, but measures he introduced before that were met with overwhelming opposition from landed interests. Two edicts in particular, one suppressing corvées (charges from farmers to aristocrats) and another renouncing privileges given to guilds inflamed influential opinion. He was forced from office in 1776.
The Wealth of Nations
Adam Smith (1723-1790) is popularly seen as the father of modern political economy. His publication of the An Inquiry Into the Nature and Causes of the Wealth of Nations in 1776 happened to coincide not only with the American Revolution, shortly before the Europe wide upheavals of the French Revolution, but also the dawn of a new industrial revolution that allowed more wealth to be created on a larger scale than ever before. Smith was a Scottish moral philosopher, whose first break was The Theory of Moral Sentiments (1759). He argued in this that people's ethical systems develop through personal relations with other individuals, that right and wrong are sensed through others' reactions to one's behaviour. This gained Smith more popularity than his next work, The Wealth of Nations, which the general public initially ignored. Yet Smith's political economic magnum opus was successful in circles that mattered.
Context
William Pitt, the Tory Prime Minister in the late 1780s based his tax proposals on Smith's ideas and advocated free trade as a devout disciple of The Wealth of Nations. Smith was appointed a commissioner of customs and within twenty years Smith had a following of new generation writers who were intent on building the science of political economy.
Smith expressed an affinity himself to the opinions of Edmund Burke, known widely as a political philosopher, a Member of Parliament.
"Burke is the only man I ever knew who thinks on economic subjects exactly as I do without any previous communication having passed between us".
Burke was an established political economist himself, with his book Thoughts and Details on Scarcity. He was widely critical of liberal politics, and condemned the French Revolution which began in 1789. In Reflections on the Revolution in France (1790) he wrote that the "age of chivalry is dead, that of sophisters, economists and calculators has succeeded, and the glory of Europe is extinguished forever." Smith's contemporary influences included Francois Quesnay and Jacques Turgot who he met on a stay in Paris, and David Hume, his Scottish compatriot. The times produced a common need among thinkers to explain social upheavals of the Industrial revolution taking place, and in the seeming chaos without the feudal and monarchical structures of Europe, show there was order still.
The invisible hand
| "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 self interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages." | | Adam Smith's famous statement on self interest |
Smith argued for a "system of natural liberty" where individual effort was the producer of social good. Smith believed even the selfish within society were kept under restraint and worked for the good of all when acting in a competitive market. Prices are often unrepresentative of the true value of goods and services. Following John Locke Smith thought true value of things derived from the amount of labour invested in them.
"Every man is rich or poor according to the degree in which he can afford to enjoy the necessaries, conveniencies, and amusements of human life. But after the division of labour has once thoroughly taken place, it is but a very small part of these with which a man's own labour can supply him. The far greater part of them he must derive from the labour of other people, and he must be rich or poor according to the quantity of that labour which he can command, or which he can afford to purchase. The value of any commodity, therefore, to the person who possesses it, and who means not to use or consume it himself, but to exchange it for other commodities, is equal to the quantity of labour which it enables him to purchase or command. Labour, therefore, is the real measure of the exchangeable value of all commodities. The real price of every thing, what every thing really costs to the man who wants to acquire it, is the toil and trouble of acquiring it."
When the butchers, the brewers and the bakers acted under the restraint of an open market economy, their pursuit of self interest, thought Smith, paradoxically drives the process to correct real life prices to their just values. His classic statement on competition goes as follows.
"When the quantity of any commodity which is brought to market falls short of the effectual demand, all those who are willing to pay... cannot be supplied with the quantity which they want... Some of them will be willing to give more. A competition will begin among them, and the market price will rise... When the quantity brought to market exceeds the effectual demand, it cannot be all sold to those who are willing to pay the whole value of the rent, wages and profit, which must be paid in order to bring it thither... The market price will sink..."
Smith believed that a market produced what he dubbed the "progress of opulence". This involved a chain of concepts, that the division of labour is the driver of economic efficiency, yet it is limited to the widening process of markets. Both labour division and market widening requires more intensive accumulation of capital by the entrepreneurs and leaders of business and industry. The whole system is underpinned by maintaining the security of property rights.
Limitations
Smith's vision of a free market economy, based on secure property, capital accumulation, widening markets and a division of labour contrasted with the mercantilist tendency to attempt to "regulate all evil human actions." Smith believed there were precisely three legitimate functions of government. The first function was...
"...erecting and maintaining certain public works and certain public institutions, which it can never be for the interest of any individual or small number of individuals, to erect and maintain... Every system which endeavours... to draw towards a particular species of industry a greater share of the capital of the society than what would naturally go to it... retards, instead of accelerating, the progress of the society toward real wealth and greatness."
In addition to the necessity of public leadership in certain sectors Smith argued, secondly, that cartels were bad because of their potential to limit production and quality of goods and services. Thirdly, Smith criticised government support of any kind of monopoly which always charges the highest price "which can be squeezed out of the buyers" However, in both cases, Smith believed it was governments' encouragement of monopolies that needed to end, rather than the need for active intervention to prevent them. The existence of monopoly and the potential for cartels, which would later form the core of competition law policy, could distort the benefits of free markets to the advantage of businesses at the expense of consumer sovereignty.
Classical political economy
The classical economists were referred to as a group for the first time by Karl Marx, who admired their scientific rigor. One unifying part of their theories was the labour theory of value, contrasting to value deriving from a general equilibrium of supply and demand. Theses economists have seen the first economic and social transformation brought by the Industrial Revolution: rural depopulation, precariousness, poverty, apparition of a working class. They wonder about the population growth, because the demographic transition had begun in Great Britain at that time. They also asked many fundamental questions, about the source of value, the causes of economic growth and the role of money in the economy. They supported a free-market economy, arguing it was a natural system based upon freedom and property. However, these economists were divided and did not make up a unified current of thought.
Jeremy Bentham
Jeremy Bentham (1748-1832) was perhaps the most radical thinker of his time, and developed the concept of utilitarianism. Bentham was an atheist, a prison reformer, animal rights activist, believer in universal suffrage, free speech, free trade and health insurance at a time when few dared to argue for any. He was schooled rigorously from an early age, finishing university and being called to the bar at 18. His first book, Fragment of Government (1776) published anonymously was a trenchant critique of William Blackstone's Commentaries of the laws of England. This gained wide success until it was found that the young Bentham, and not a revered Professor had penned it. In The Principles of Morals and Legislation (1791) Bentham set out his theory of utility.
"Nature has placed mankind under the governance of two sovereign masters, pain and pleasure... On the one hand the standard of right and wrong, on the other the chain of causes and effects, are fastened to their throne... In words a man may pretend to abjure their empire: but in reality he will remain subject to it all the while. The principle of utility recognizes this subjection, and assumes it for the foundation of that system, the object of which is to rear the fabric of felicity by the hands of reason and of law."
The aim of legal policy must be to decrease misery and suffering so far as possible while producing the greatest happiness for the greatest number. Bentham even designed a comprehensive methodology for the calculation of aggregate happiness in society that a particular law produced, a felicific calculus. Society, argued Bentham, is nothing more than the total of individuals, so that if one aims to produce net social good then one need only to ensure that more pleasure is experienced across the board than pain, regardless of numbers. For example, a law is proposed to make every bus in the city wheel chair accessible, but slower moving as a result than its predecessors because of the new design. Millions of bus users will therefore experience a small amount of displeasure (or "pain") in increased traffic and journey times, but a minority of people using wheel chairs will experience a huge amount of pleasure at being able to catch public transport, which outweighs the aggregate displeasure of other users. Interpersonal comparisons of utility were allowed by Bentham, the idea that one person's vast pleasure can count more than many others' pain. Much criticism later showed how this could be twisted, for instance, would the felicific calculus allow a vastly happy dictator to outweigh the dredging misery of his exploited populace? Despite Bentham's methodology there were severe obstacles in measuring people's happiness.
Jean-Baptiste Say
Jean-Baptiste Say (1767-1832) was a Frenchman, born in Lyon who helped to popularise Adam Smith's work in France. His book, A Treatise on Political Economy (1803) contained a brief passage, which later became orthodoxy in political economics until the Great Depression and known as Say's Law of markets. Say argued that there could never be a general deficiency of demand or a general glut of commodities in the whole economy. People produce things, said Say, to fulfill their own wants, rather than those of others. Production is therefore not a question of supply, but an indication of producers demanding goods. Say agreed that a part of the income is saved by the households, but in the long term, savings are invested. Investment and consumption are the two elements of demand, so that production is demand, so it is impossible for production to outrun demand, or for there to be a "general glut" of supply. Say also argued that money was neutral, because its sole role is to facilitate exchanges: therefore, people demand money only to buy commodities. Say said that "money is a veil". To sum up these two ideas, Say said "products are exchanged for products". At most, there will be different economic sectors whose demands are not fulfilled. But over time supplies will shift, businesses will retool for different production and the market will correct itself. An example of a "general glut" could be unemployment, in other words, too great a supply of workers, and too few jobs. Say's Law advocates would suggest that this necessarily means there is an excess demand for other products that will correct itself. This remained a foundation of economic theory until the 1930s. Say's Law was first put forward by James Mill (1773-1836) in English, and was advocated by David Ricardo, Henry Thornton and John Stuart Mill. However two political economists, Thomas Malthus and Sismondi, were unconvinced.
Thomas Malthus
Thomas Malthus (1766-1834) was a Tory minister in the United Kingdom Parliament who, contrasting to Bentham, believed in strict government abstention from social ills. Malthus devoted the last chapter of his book Principles of Political Economy (1820) to rebutting Say's law, and argued that the economy could stagnate with a lack of "effectual demand". In other words, wages if less than the total costs of production cannot purchase the total output of industry and that this would cause prices to fall. Price falls cause incentives to invest, and the spiral could continue indefinitely. Malthus is more notorious however for his earlier work, An Essay on the Principle of Population. This argued that intervention was impossible because of two factors. "Food is necessary to the existence of man," wrote Malthus. "The passion between the sexes is necessary and will remain nearly in its present state," he added, meaning that the "power of the population is infinitely greater than the power in the Earth to produce subsistence for man." Nevertheless growth in population is checked by "misery and vice". Any increase in wages for the masses would cause only a temporary growth in population, which given the constraints in the supply of the Earth's produce would lead to misery, vice and a corresponding readjustment to the original population. However more labour could mean more economic growth, either one of which was able to be produced by an accumulation of capital.
David Ricardo
David Ricardo (1772-1823) was born in London. By the age of 26, he had become a wealthy stock market trader and bought himself a constituency seat in Ireland to gain a platform in the British parliament's House of Commons. Ricardo's best known work is his Principles of Political Economy and Taxation, which contains his critique of barriers to international trade and a description of the manner the income is distributed in the population. Ricardo made a distinction between the workers, who received a wage fixed to a level at which they can survive, the landowners, who earn a rent, and capitalists, who own capital and receive a profit, a residual part of the income. If population grows, it becomes necessary to cultivate additional land, whose fertility is lower than that of already cultivated fields, because of the law of decreasing productivity. Therefore, the cost of the production of the wheat increases, as well as the price of the wheat: The rents increase also, the wages, indexed to inflation (because they must allow workers to survive) too. Profits decrease, until the capitalists can no longer invest. the economy, Ricardo concluded, is bound to tend towards a steady state.
To postpone the steady state, Ricardo advocates to promote international trade to import wheat at a low price to fight landowners. The Corn Laws of the UK had been passed in 1815, setting a fluctuating system of tariffs to stabilise the price of wheat in the domestic market. Ricardo argued that raising tariffs, despite being intended to benefit the incomes of farmers, would merely produce a rise in the prices of rents that went into the pockets of landowners. Furthermore, extra labour would be employed leading to an increase in the cost of wages across the board, and therefore reducing exports and profits coming from overseas business. Economics for Ricardo was all about the relationship between the three "factors of production": land, labour and capital. Ricardo demonstrated mathematically that the gains from trade would outweigh the perceived advantages of protectionist policy. The law of comparative advantage suggests that even if one country is inferior at producing all of its goods than another, it may still benefit from opening its borders since the inflow of good produced more cheaply than at home produces a gain for domestic consumers. Say that in one day in England an average worker produces a bushel of wheat and in two days a yard of cloth, while the average French worker can do either in just a day. If England swaps the wheat it produces (one day's production) for French cloth (while English cloth takes two days) then both sides can strike a bargain between the margin that is mutually beneficial. England by selling its wheat can get its cloth in a day, rather than two days, and France can get an extra bushel of wheat for selling its more efficiently produced cloth. This would lead to a shift in prices so that eventually England would be producing goods in which its comparative advantages were the highest.
John Stuart Mill
John Stuart Mill (1806-1873) was the dominant figure of political economic thought of his time, as well as being a Member of Parliament for the seat of Westminster, and a leading political philosopher. Mill was a child prodigy, reading Ancient Greek from the age of 3, and being vigorously schooled by his father James Mill. Jeremy Bentham was a close mentor and family friend, and Mill was heavily influenced by David Ricardo. Mill's textbook, first published in 1848 and titled Principles of Political Economy was essentially a summary of the economic wisdom of the mid nineteenth century. It was used as the standard texts by most universities well into the beginning of the twentieth century. On the question of economic growth Mill tried to find a middle ground between Adam Smith's view of ever expanding opportunities for trade and technological innovation and Thomas Malthus' view of the inherent limits of population. In his fourth book Mill set out a number of possible future outcomes, rather than predicting one in particular. The first followed the Malthusian line that population grew quicker than supplies, leading to falling wages and rising profits. The second, per Smith, said if capital accumulated faster than population grew then real wages would rise. Third, echoing David Ricardo, should capital accumulate and population increase at the same rate, yet technology stay stable, there would be no change in real wages because supply and demand for labour would be the same. However growing populations would require more land use, increasing food production costs and therefore decreasing profits. The fourth alternative was that technology advanced faster than population and capital stock increased. The result would be a prospering economy. Mill felt the third scenario most likely, and he assumed technology advanced would have to end at some point. But on the prospect of continuing economic growth, Mill was more ambivalent.
"I confess I am not charmed with the ideal of life held out by those who think that the normal state of human beings is that of struggling to get on; that the trampling, crushing, elbowing, and treading on each other's heels, which form the existing type of social life, are the most desirable lot of human kind, or anything but the disagreeable symptoms of one of the phases of industrial progress.
Mill is also credited with being the first person to speak of supply and demand as a relationship rather than mere quantities of goods on markets, the concept of opportunity cost and the rejection of the wage fund doctrine.
Marxism
Just as the term "mercantilism" had been coined and popularised by its critics, like Adam Smith, so was the term "capitalism" or Kapitalismus used by its dissidents, primarily Karl Marx. Karl Marx (1818-1883) was, and in many ways still remains the pre-eminent socialist economist. His combination of political theory represented in the Communist Manifesto and the dialectic theory of history inspired by Friedrich Hegel provided a revolutionary critique of capitalism as he saw it in the nineteenth century. The socialist movement that he joined had emerged in response to the conditions of people in the new industrial era and the classical economics which accompanied it. A political exile from his native Germany, Marx himself had lived until 1855 in the inner-London slum of Soho, before his wife Jenny inherited money enough to move to the north London suburb of Kentish Town, then still in development. He wrote his magnum opus Das Kapital at the British Museum's library.
Context
Movement for reform of the conditions in which working class people lived was present long before either Marx or the notion of capitalism. Saint Thomas More as early as 1516 had used his satire name Utopia to criticise the displacement of the peasantry for sheep rearing of the landed gentry. Charles Dickens in the early nineteenth century was becoming popular for books where he had observed and shamed the nineteenth century business ethic in Hard Times, the levels of poverty and crime in Oliver Twist and the institutions of justice in Bleak House. Robert Owen (1771-1858) was one industrialist who determined to improve the conditions of his workers. He bought textile mills in New Lanark, Scotland where he forbade children under ten to work, set the workday from 6 a.m. to 7 p.m. and provided evening schools for children when they finished. Such meagre measures were still substantial improvements and his business remained solvent through higher productivity, though his pay rates were lower than the national average. He published his vision in The New View of Society (1816) during the passage of the Factory Acts, but his attempt from 1824 to begin a new utopian community in New Harmony, Indiana ended in failure. One of Marx's own influences was the French philosopher Pierre Proudhon, who concluded in his book What is Property? (1840) that property is theft. Compared to the classical Mill, who had written that "partial taxation is a mild form of robbery", this strain of thought represented important and radical criticism. Marx had been a friend of Proudhon. But when Proudhon made a political economic attack on the classical "iron law of wages", among other things, in his book The Philosophy of Poverty (1846) Marx replied with a cynically titled article, The Poverty of Philosophy. Legend has it that they never spoke again. That same year the Revolutions of 1848 took place and Marx, along with Friedrich Engels published the Communist Manifesto, calling for the workers of the world to unite and fear the loss of nothing but their chains. Engels himself was a published radical author. He released a book titled The Condition of the Working Class in England in 1844 describing people's positions as "the most unconcealed pinnacle of social misery in our day." Engels himself was heir to a Manchester factory, and though he detested the business, used his profits to help finance Marx's work. After Marx died, it was Engels that completed the second volume of Das Kapital from Marx's notes.
Das Kapital
Karl Marx begins Das Kapital with the concept of commodities. Before capitalist societies, says Marx, the mode of production was based on slavery (e.g. in ancient Rome) before moving to feudal serfdom (e.g. in mediaeval Europe). As society has advanced, economic bondage has become looser, but the current nexus of labour exchange has produced an equally erratic and unstable situation allowing the conditions for revolution. People buy and sell their labour in the same way as people buy and sell goods and services. People themselves are disposable commodities. As he wrote in the Communist Manifesto,
"The history of all hitherto existing society is the history of class struggles. Freeman and slave, patrician and plebeian, lord and serf, guildmaster and journeyman, in a word, oppressor and oppressed, stood in constant opposition to one another... The modern bourgeois society that has sprouted from the ruins of feudal society has not done away with class antagonisms. It has but established new classes, new conditions of oppression, new forms of struggle in place of the old ones."
And furthermore from the first page of Das Kapital,
"The wealth of those societies in which the capitalist mode of production prevails, presents itself as “an immense accumulation of commodities,” its unit being a single commodity. Our investigation must therefore begin with the analysis of a commodity.
Marx's use of the word "commodity" is tied into an extensive metaphysical discussion of the nature of material wealth, how the objects of wealth are perceived and how they can be used. The concept of a commodity contrasts to objects of the natural world. When people mix their labour with an object it becomes a "commodity". In the natural world there are trees, diamonds, iron ore and people. In the economic world they become chairs, rings, factories and workers. However, says Marx, commodities have a dual nature, a dual value. He distinguishes the use value of a thing from its exchange value, which can be entirely different. The use value of a thing derives from the amount of labour used to produce it, says Marx, following the classical economists in the labour theory of value. However, Marx did not believe labour only was the source of use value in things. He believed value can derive too from natural goods and refined his definition of use value to "socially necessary labour time" (the time people need to produce things when they are not lazy or inefficient). Furthermore, people subjectively inflate the value of things, for instance because there's a commodity fetish for glimmering diamonds, and oppressive power relations involved in commodity production. These two factors mean exchange values differ greatly. An oppressive power relation, says Marx applying the use/exchange distinction to labour itself, in work-wage bargains derives from the fact that employers pay their workers less in "exchange value" than the workers produce in "use value". The difference makes up the capitalist's profit, or in Marx's terminology, "surplus value". Therefore, says Marx, capitalism is a system of exploitation.
Marx's work turned the labour theory of value, as the classicists used it, on its head. His dark irony goes deeper by asking what is the socially necessary labour time for the production of labour (i.e. working people) itself. Marx answers that this is the bare minimum for people to subsist and to reproduce with skills necessary in the economy. People are therefore alienated from both the fruits of production and the means to realise their potential, psychologically, by their oppressed position in the labour market. But the tale told alongside exploitation and alienation is one of capital accumulation and economic growth. Employers are constantly under pressure from market competition to drive their workers harder, and at the limits invest in labour displacing technology (e.g. an assembly line packer for a robot). This raises profits and expands growth, but for the sole benefit of those who have private property in these means of production. The working classes meanwhile face progressive immiseration, having had the product of their labour exploited from them, having been alienated from the tools of production. And having been fired from their jobs for machines, they end unemployed. Marx believed that a reserve army of the unemployed would grow and grow, fuelling a downward pressure on wages as desperate people accept work for less. But this would produce a deficit of demand as the people's power to purchase products lagged. There would be a glut in unsold products, production would be cut back, profits decline until capital accumulation halts in an economic depression. When the glut clears, the economy again starts to boom before the next cyclical bust begins. With every boom and bust, with every capitalist crisis, thought Marx, tension and conflict between the increasingly polarised classes of capitalists and workers heightens. Moreover smaller firms are being gobbled by larger ones in every business cycle, as power is concentrated in the hands of the few and away from the many. Ultimately, led by the Communist party, Marx envisaged a revolution and the creation of a classless society. How this may work, Marx never suggested. His primary contribution was not in a blue print for how society would be, but a criticism of what he saw it was.
After Marx
The first volume of Das Kapital was the only one Marx alone published. The second and third volumes were done with the help of Friedrich Engels and Karl Kautsky, who had become a friend of Engels, saw through the publication of volume four. When the World War I and then the Russian Revolution broke out, Kautsky opposed the course of both. He was a member of the Sozialdemokratische Partei Deutschlands and condemned Vladimir Lenin's vision for the Soviet Union. As he wrote in 1934 in Marxism and Bolshevism: Democracy and Dictatorship,
"The Bolsheviks under Lenin’s leadership, however, succeeded in capturing control of the armed forces in Petrograd and later in Moscow and thus laid the foundation for a new dictatorship in place of the old Tsarist dictatorship."
Marx had begun a tradition of economists who concentrated equally on political affairs. Also in Germany, Rosa Luxembourg was a member of the SPD, who later turned towards the Communist Party because of their stance against the First World War. Beatrice Webb in England was a socialist, who helped found both the London School of Economics (LSE) and the Fabian Society. She was married to Sidney Webb, who worked as a minister for Ramsay Macdonald's government. Her political support in Britain was for gradual change through Parliamentary democracy, rather than a Marxian revolution. Yet unlike Kautsky she supported Soviet Russia. Two more English theorists associated with the LSE were John A. Hobson (1858-1940) and Richard H. Tawney (1880-1963). Hobson argued for better social legislation, in terms of wider powers for trade unions, health and safety standards and a more egalitarian distribution of wealth. Tawney was primarily an economic historian, and was critical of the haphazard method of wealth allocation in the modern world. In his book The Acquisitive Society (1920) he wrote, "It is foolish to maintain property rights for which no service is performed... for payment without service is waste." In his later book, Equality (1931) he wrote "the pooling of surplus resources by means of taxation, and the use of the funds thus obtained to make accessible to all, irrespective of their income, occupation or social position, the conditions of civilization".
Marginalism and Neoclassicals
In the 1860s, a revolution took place in economics. The new ideas were that of the Marginalist school. Writing simultaneously and independently, a Frenchman (Leon Walras), an Austrian Carl Menger) and an Englishman (Stanley Jevons)were developing the theory, which had some antecedents. Instead of the price of a good or service reflecting the labor that has produced it, it reflects the marginal usefulness (utility) of the last purchase. This meant that in equilibrium, people's preferences determined prices, including, indirectly the price of labor.
This current of thought was not united, and there were three main schools working independently. The Lausanne school, whose two main representants were Walras and Pareto, developed the theories of general equilibrium and optimality. The main written work of this school was Walras' Elements of Pure Economics. The Cambridge school appeared with Jevons' Theory of Political Economy in 1871. This English school has developed the theories of the partial equilibrium and has insisted on markets' failures. The main representatives were Marshall, Jevonds and Pigou. The Vienna school was made up of Austrian economists Menger, Bohm-Bawerk and Von Wieser. They developed the theory of capital and has tried to explain the presence of economic crisis. It appeared in 1871 with Menger's Principles of Economics.
The marginalist revolution
Carl Menger (1840-1921), an Austrian economist stated the basic principle of marginal utility in Grundsätze der Volkswirtschaftslehre (1871, Principles of Economics). Consumers act rationally by seeking to maximise satisfaction of all their preferences. People allocate their spending so that the last unit of a commodity bought creates no more satisfaction than a last unit bought of something else. Stanley Jevons (1835-1882) was his English counterpart, and worked at University College, London. He emphasized in the Theory of Political Economy (1871) that at the margin, the satisfaction of goods and services decreases.Leon Walras (1834-1910), again working independently, generalized marginal theory across the economy to multiple, independent markets, in Elements of Pure Economics (1874). Walras initially assumed adopted a set of strict assumptions, namely that markets were competitive and that goods were produced under constant returns to scale but future attempts at constructing more general models dispensed with some of these assumptions.
Early attempts to explain away the periodical crises of which Marx had spoken were not initially as successful. After finding a statistical correlation of sunspots and business fluctuations and following the common belief at the time that sunspots had a direct effect on weather and hence agricultural output, Stanley Jevons wrote,
"when we know that there is a cause, the variation of the solar activity, which is just of the nature to affect the produce of agriculture, and which does vary in the same period, it becomes almost certain that the two series of phenomena— credit cycles and solar variations—are connected as effect and cause.
Mathematical analysis
Neoclassical economists had a somewhat different conception of what economics should be than that of classical economists. While classical economists considered economics as a science which accounted for economic phenomena like output, consumption, value of commodities, distribution of income, neoclassical economists defined the economics as the science which additionally could be capable of studying all human rational actions. All humans can be modeled as agents who search for getting the maximal satisfaction from their actions. The marginalist neoclassicals tried to develop general economic laws, imitating the rigorous methods used in physics. Neoclassical economists were above all involved in the development of microeconomics, a science they have founded, even if the idea that all human pursued their self-interest was already mentioned in Smith, Ricardo and Mill's works.
Alfred Marshall (1842-1924) is also credited with an attempt to put economics on a more mathematical footing. He was the first Professor of Economics at the University of Cambridge and his work, Principles of Economics coincided with the transition of the subject from "political economy" to his favoured term, "economics". He viewed mathematics as a way to simplify economic reasoning, though had reservations, revealed in a letter to his student Arthur Cecil Pigou.
"(1) Use mathematics as shorthand language, rather than as an engine of inquiry. (2) Keep to them till you have done. (3) Translate into English. (4) Then illustrate by examples that are important in real life. (5) Burn the mathematics. (6) If you can’t succeed in 4, burn 3. This I do often."
Coming after the marginal revolution, Marshall concentrated on reconciling the classical labour theory of value, which had concentrated on the supply side of the market, with the new marginalist theory that concentrated on the consumer demand side. Marshall's graphical representation is the famous supply and demand graph, the "Marshallian cross". He insisted it is the intersection of both supply and demand that produce an equilibrium of price in a competitive market. Over the long run, argued Marshall, the costs of production and the price of goods and services tend towards the lowest point consistent with continued production.
The use of mathematics and the construction of a rigorous and consistent microeconomics model led to the developpement of two important theories by the economists of the Lausanne School. Léon Walras (1834 - 1910), a French economist, designed the general equilibrium theory, which led then to further analysis. According to this theory, demand and supply can adjust automatically on a competitive market. Vilfredo Pareto (1848-1923), an Italian economist, is known for developing the concept of the circumstance under which nobody need be made worse off, and nobody better off through wealth redistribution. When this situation exists, the economy is said to be "Pareto efficient". Pareto devised mathematical representations for this optimal resource allocation, which when represented on a graph would yield a curve. Different points along the curve represent different allocations, but each would be optimally efficient. Rather than using prosaic persuasion of classical economists like Mill, Pareto used the persuasion of precise mathematical formulae for Pareto efficiency. It was showed that a situation of general equilibrium was Pareto efficient.
Economic policy
As the classical economists, the neoclassical economists supported free-market economy based on private property and individual freedom. While they admitted the perfect competition was an unrealistic model, they argued that the real economy should tend to be as competitive as possible. Therefore, they condemned the intervention of the state within the economy. Like Smith, they wanted the role of the state to be very limited, i.e. focused on assuring the defense and the security of the territory and the citizens, the functioning of justice and the production of common goods. They argued that in a deregulated economy, a lasting crisis was impossible, as Say had explained some decades earlier. However, the English neoclassical economists concentrated on advocating for a moderate economic liberalism. Notably, Arthur Cecil Pigou, in Wealth and Welfare (1920), insisted on the existence of market failures. Markets are inefficient in case of economic externalities, and the State must interfere. However, Pigou retained free-market beliefs, and in 1933, in the face of the economic crisis, he explained in The Theory of Unemployment that the excessive intervention of the sate in the labor market was the real responsible of a massive unemployment, because the governments had established a minimal wage, which prevented the wages from adjusting automatically.
The Austrian school
While the end of the nineteenth century and the beginning of the twentieth were dominated by the mainstream neoclassical theory, the followers of Carl Menger broke from the mainstream, mathematics intensive economic theory and founded the heterodox Austrian School. The third and fourth generations of the Austrian School included notable economists Joseph Schumpeter, who broke with the school early in his career, and Friedrich Hayek, a leading thinker of the School. These two economists are the heirs of the Vienna marginalist school, which worked separately from the math-based Lausanne neoclassical school.
Joseph Schumpeter
Joseph Alois Schumpeter (February 8, 1883 – January 8, 1950) was an economist and political scientist mostly known for his works on business cycles and innovation. He particularly insisted on the role of the entrepreneurs in economy, which had been neglected by previous economists. In Business Cycles: A theoretical, historical and statistical analysis of the Capitalist process, he made a synthesis of the theories already accomplished about business cycles. He suggested that the Kondratiev (54 years), Juglar (9 years) and Kitchin (about 4 years) cycles could encompass and asserted there were relevant to explain the economic situation of his time. He particularly studied the long-term cycles, previously theorised by Kondratieff, and proposed to account for them by innovation. According to Schumpeter, capitalism necessarily goes through long-term cycles, because it is entirely based upon innovations: a scientific invention becomes an innovation when it is marketed by entrepreneurs. These innovations can take two distinct forms: new products or new ways to produce. A phase of expansion is possible thank to these innovations, because they bring productivity gains and encourage entrepreneurs to invest and to develop further innovations, because there is a high demand from the households to buy new products. However, this phase is not everlasting, and when investors have no more opportunities to invest, the economy goes into recession. During this phase, the disemployement develops, several firms collapse, closures and bankruptcy occur. This phase lasts until new innovations bring a creative destruction process, i.e. they destroy old products, reduce the employment, but they allow the economy to start a new phase of growth, based upon new products and new factors of production. Schumpeter argued in Capitalism, Socialism and Democracy that capitalism will foster values hostile to it, especially among intellectuals, that will cause its collapse from within.
Friedrich Hayek
Friedrich von Hayek (1899-1992) was an early follower of Carl Menger. He was awarded the Nobel Prize in 1974. Though a faculty member at the University of Chicago, he mostly worked at the London School of Economics, and he is usually categorized not as a member of the Chicago School, but rather the Austrian School of economics that included Menger, Ludwig von Mises, and Murray Rothbard. In echoes of Smith's "system of natural liberty", Hayek argued that the market is a "spontaneous order" and he actively disparaged the use of terms like "social justice". Hayek was one of the leading academic critics of collectivism in the 20th century. Hayek believed that all forms of collectivism (even those theoretically based on voluntary cooperation) could only be maintained by a central authority of some kind. In his popular book, The Road to Serfdom (1944) and in subsequent works, Hayek claimed that socialism required central economic planning and that such planning in turn had a risk of leading towards totalitarianism, because the central authority would have to be endowed with powers that would have an impact on social life as well, and because the scope of knowledge required for central planning is inherently decentralized. Hayek attributed the birth of civilization to private property in his book The Fatal Conceit (1988). According to him, price signals are the only means of enabling each economic decision maker to communicate tacit knowledge or dispersed knowledge to each other, in order to solve the economic calculation problem.
The Keynesian revolution
Alfred Marshall was still working on his last revisions of his Principles of Economics at the outbreak of the First World War (1914-1918). The new twentieth century's climate of optimism was soon violently dismembered in the trenches of the Western front, as the civilised world tore itself apart. For four years the production of Britain, Germany and France was geared entirely towards the war economy's industry of death. In 1917 Russia crumbled into revolution led by Vladimir Lenin's Bolshevik party. They carried Marxist theory as their saviour, and promised a broken country "peace, bread and land" by collectivising the means of production. Also in 1917, the United States of America entered the war on the side of France and Britain, President Woodrow Wilson carrying the slogan of "making the world safe for democracy". He devised a peace plan of Fourteen Points. In 1918 Germany launched a spring offensive which failed, and as the allies counter-attacked and more millions were slaughtered, Germany slid into revolution, its interim government suing for peace on the basis of Wilson's Fourteen Points. Europe lay in ruins, financially, physically, psychologically, and its future with the arrangements of the Versailles conference in 1919. John Maynard Keynes was the representative of Her Majesty's Treasury at the conference and the most vocal critic of its outcome.
John Maynard Keynes
John Maynard Keynes (1883-1946) was born in Cambridge, educated at Eton and supervised by both A. C. Pigou and Alfred Marshall at Cambridge University. He began his career as a lecturer, before working in the British government during the Great War, and rose to be the British government's financial representative at the Versailles conference. His observations were laid out in his book The Economic Consequences of the Peace (1919) where he documented his outrage at the collapse of the Americans' adherence to the Fourteen Points and the mood of vindictiveness that prevailed towards Germany. Keynes quit from the conference and using extensive economic data provided by the conference records, Keynes argued that if the victors forced reparations to be paid by the defeated Axis, then a world financial crisis would ensue, leading to a second world war. Keynes finished his treatise by advocating, first, a reduction in reparation payments by Germany to a realistically manageable level, increased intra-governmental management of continental coal production and a free trade union through the League of Nations; second, an arrangement to set off debt repayments between the Allied countries; third, complete reform of international currency exchange and an international loan fund; and fourth, a reconciliation of trade relations with Russia and Eastern Europe.
The book was an enormous success, and though it was criticised for false predictions by a number of people, without the changes he advocated, Keynes' dark forecasts matched the world's experience through the Great Depression which ensued in 1929, and the descent into a new outbreak of war in 1939. World War One had been the "war to end all wars", and the absolute failure of the peace settlement generated an even greater determination to not repeat the same mistakes. With the defeat of fascism, the Bretton Woods conference was held to establish a new economic order. Keynes was again to play a leading role.
The General Theory
During the Great Depression, Keynes had published his most important work, The General Theory of Employment, Interest, and Money (1936). The depression had been sparked by the Wall Street Crash of 1929, leading to massive rises in unemployment in the United States, leading to debts being recalled from European borrowers, and an economic domino effect across the world. Orthodox economics called for a tightening of spending, until business confidence and profit levels could be restored. Keynes by contrast, had argued in A Tract on Monetary Reform (1923) that a variety of factors determined economic activity, and that it was not enough to wait for the long run market equilibrium to restore itself. As Keynes famously remarked,
"...this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again."
On top of the supply of money, Keynes identified the propensity to consume, inducement to invest, the marginal efficiency of capital, liquidity preference and the multiplier effect as variables which determine the level of the economy’s output, employment and level of prices. Much of this esoteric terminology was invented by Keynes especially for his General Theory. Keynes argued that if savings were being kept away from investment through financial markets, total spending falls. Falling spending leads to reduced incomes and unemployment, which reduces savings again. This continues until the desire to save becomes equal to the desire to invest, which means a new “equilibrium” is reached and the spending decline halts. This new “equilibrium” is a depression, where people are investing less, have less to save and less to spend.
Keynes argued that employment depends on total spending, which is composed of consumer spending and business investment in the private sector. Consumers only spend “passively”, or according to their income fluctuations. Businesses, on the other hand are induced to invest by the expected rate of return on new investments (the benefit) and the rate of interest paid (the cost). So, said Keynes, if business expectations remained the same, and government reduces interest rates (the costs of borrowing), investment would increase, and would have a multiplied effect on total spending. Interest rates, in turn, depend on the quantity of money and the desire to hold money in bank accounts (as opposed to investing). If not enough money is available to match how much people want to hold, interest rates rise until enough people are put off. So if the quantity of money were increased, while the desire to hold money remained stable, interest rates would fall, leading to increased investment, output and employment. For both these reasons, Keynes therefore advocated low interest rates and easy credit, to combat unemployment.
However, low interest rates are not the prevailing condition to induce investment: if investers' expectations are pessimistic, i.e. if they forecast that effective demand will not grow sufficiently, they will not invest. This is why a lasting situation of unemployment is possible for Keynes. And a situation of recession or deflation can last for a long time, because prices are not flexible: employers prefer to fire employees and reduce their output than reduce prices, because the circulation of the information is unperfect, so that employers cannot know if the price fixed by other investors will also increase. According to Keynes, the only solution to prevent a recssion is the government to interfere in the economy. The state must invest itself, so that investors are more confident in the economic outlooks. Moreover, the investments of the state naturally provoke a growth in the general income in the economy, because the income distributed by the government to the companies are distributed to employees, who will increase their own consuption: this mechanism is called by Keynes the spending multiplier. The intervention of the state makes it possible to quit the situation of unemployment. Keynes advocated that the state spending be financed by a budgetary deficit. In the 1930s, Keynes believed conditions necessitated public sector action. Deficit spending, said Keynes, would kick-start economic activity. This he had advocated in an open letter to President Franklin Delano Roosevelt in the New York Times (1933). The New Deal programme in the US had been well underway by the publication of the General Theory. It provided conceptual reinforcement for policies already pursued.
Keynes also believed in a more egalitarian distribution of income, and taxation on unearned income arguing that high rates of savings are not desirable in a developed economy. Indeed, Keynes argued that the part of income which is saved increases when the income increase, so that richer folk were prone to save too much money. This is why income should be redistributed to the poorest people, whose marginal propensity to consume is the highest. Keynes therefore advocated both monetary management and an active fiscal policy.
Keynesian economics
One year after the publication of Keynes' most important work, John Hicks designed the IS/LM model, which summarized a Keynesian view of macroeconomics. He presented his works in 1937, in an article named Mr Keynes and the Classics: A suggested interpretation, published by Econometrica. The model was to be used by most governments of developed countries after WWII. The model suggests economic policies which governments should follow in order to ensure full-employment and steady economic growth. It advocates a policy mix, i.e. a monetary policy combined with a budgetary policy. When a government increases its spending (spending deficit) to induce investment, interest rates necessarily increase, because there is a higher demand for money to buy the additional production. The government must prevent interest rates from rising (otherwise investment is deterred) by providing additional money (expansive monetary policy).
During the Second World War, Keynes acted as advisor to HM Treasury again, negotiating major loans from the US. He helped formulate the plans for the International Monetary Fund, the World Bank and an International Trade Organization at the Bretton Woods conference, a package designed to stabilize world economy fluctuations that had occurred in the 1920s and create a level trading field across the globe. Keynes passed away little more than a year later, but his ideas had already shaped a new global economic order, and all Western governments followed the Keynesian prescription of deficit spending to avert crises and maintain full employment.
One of Keynes' pupils at Cambridge was Joan Robinson, who contributed to the notion that competition is seldom perfect in a market, an indictment of the theory of markets setting prices. In The Production Function and the Theory of Capital (1953) Robinson tackled what she saw to be some of the circularity in orthodox economics. Neoclassical economists asserted that a competitive market forces producers to minimize the costs of production. Robinson said that costs of production are merely the prices of inputs, like capital. Capital goods get their value from the final products. And if the price of the final products determines the price of capital, then it is, argued Robinson, utterly circular to say that the price of capital determines the price of the final products. Goods cannot be priced until the costs of inputs are determined. This would not matter if everything in the economy happened instantaneously, but in the real world, price setting takes time - goods are priced before they are sold. Since capital cannot be adequately valued in independently measurable units, how can one show that capital earns a return equal to the contribution to production? Piero Sraffa came to England from fascist Italy in the 1920s, and worked with Keynes in Cambridge. In 1960 he published a small book called Production of Commodities by Means of Commodities, which explained how technological relationships are the basis for production of goods and services. Prices result from wage-profit tradeoffs, collective bargaining, labour and management conflict and the intervention of government planning. Like Robinson, Sraffa was showing how the major force for price setting in the economy was not necessarily market adjustments.
The "American Way"
After World War II, the United States had become the pre-eminent global economic power. Europe and the Soviet Union lay in ruins and the British Empire was at its end. Till then, American economists had played a minor role. The institutional economists had been largely critical of the "American Way" of life, especially regarding conspicuous consumption of the Roaring Twenties before the Wall Street Crash of 1929. After the war, however, a more orthodox and conservative body of thought took root, reacting against the lucid debating style of Keynes, and re-matheticising the profession. The orthodox centre was also challenged by a more extremely radical group of scholars based at the University of Chicago. They advocated "liberty" and "freedom", looking back to 19th century style non-interventionist governments.
Institutional criticism
Thorsten Veblen (1857-1929), who came from rural mid-western America and worked at the University of Chicago, is one of the best known early critics of the "American Way". In The Theory of the Leisure Class (1899) he scorned materialistic culture and wealthy people who conspicuously consumed their riches as a way of demonstrating success and in The Theory of Business Enterprise (1904) Veblen distinguished production for people to use things and production for pure profit, arguing that the former is often hindered because businesses pursue the latter. Output and technological advance are restricted by business practices and the creation of monopolies. Businesses protect their existing capital investments and employ excessive credit, leading to depressions and increasing military expenditure and war through business control of political power. These two books, focusing on criticism first of consumerism, and second of profiteering, did not advocate change. However, in 1911, Veblen joined the faculty of the University of Missouri, where he had support from Herbert Davenport, the head of the economics department. Veblen remained at Columbia, Missouri through 1918. In that year, he moved to New York to begin work as an editor of a magazine called The Dial, and then in 1919, along with Charles Beard, James Harvey Robinson and John Dewey, helped found the New School for Social Research (known today as The New School). He was also part of the Technical Alliance, created in 1918-19 by Howard Scott, which would later become Technocracy Incorporated. From 1919 through 1926 Veblen continued to write and to be involved in various activities at The New School. During this period he wrote The Engineers and the Price System (1921).
John R. Commons (1862-1945) also came from mid-Western America. Underlying his ideas, consolidated in Institutional Economics (1934) was the concept that the economy is a web of relationships between people with diverging interests. There are monopolies, large corporations, labour disputes and fluctuating business cycles. They do however have an interest in resolving these disputes. Government, thought Commons, ought to be the mediator between the conflicting groups. Commons himself devoted much of his time to advisory and mediation work on government boards and industrial commissions.
The Great Depression was a time of significant upheaval in the States. One of the most original contributions to understanding what had gone wrong came from a Harvard University lawyer, named Adolf Berle (1895-1971), who like John Maynard Keynes had resigned from his diplomatic job at the Paris Peace Conference, 1919 and was deeply disillusioned by the Versailles Treaty. In his book with Gardiner C. Means, The Modern Corporation and Private Property (1932), he detailed the evolution in the contemporary economy of big business, and argued that those who controlled big firms should be better held to account. Directors of companies are held to account to the shareholders of companies, or not, by the rules found in company law statutes. This might include rights to elect and fire the management, require for regular general meetings, accounting standards, and so on. In 1930s America, the typical company laws (e.g. in Delaware) did not clearly mandate such rights. Berle argued that the unaccountable directors of companies were therefore apt to funnel the fruits of enterprise profits into their own pockets, as well as manage in their own interests. The ability to do this was supported by the fact that the majority of shareholders in big public companies were single individuals, with scant means of communication, in short, divided and conquered. Berle served in President Franklin Delano Roosevelt's administration through the depression, and was a key member of the so called "Brain trust" developing many of the New Deal policies. In 1967, Berle and Means issued a revised edition of their work, in which the preface added a new dimension. It was not only the separation of controllers of companies from the owners as shareholders at stake. They posed the question of what the corporate structure was really meant to achieve.
“Stockholders toil not, neither do they spin, to earn [dividends and share price increases]. They are beneficiaries by position only. Justification for their inheritance... can be founded only upon social grounds... that justification turns on the distribution as well as the existence of wealth. Its force exists only in direct ratio to the number of individuals who hold such wealth. Justification for the stockholder's existence thus depends on increasing distribution within the American population. Ideally the stockholder's position will be impregnable only when every American family has its fragment of that position and of the wealth by which the opportunity to develop individuality becomes fully actualized.”
After the war, John Kenneth Galbraith (1908-2006) became one of the standard bearers for pro-active government and liberal-democrat politics. In The Affluent Society (1958), Galbraith argued voters reaching a certain material wealth begin to vote against the common good. He argued that the "conventional wisdom" of the conservative consensus was not enough to solve the problems of social inequality. In an age of big business, he argued, it is unrealistic to think of markets of the classical kind. They set prices and use advertising to create artificial demand for their own products, distorting people's real preferences. Consumer preferences actually come to reflect those of corporations - a "dependence effect" - and the economy as a whole is geared to irrational goals. In The New Industrial State Galbraith argued that economic decisions are planned by a private-bureaucracy, a technostructure of experts who manipulate marketing and public relations channels. This hierarchy is self serving, profits are no longer the prime motivator, and even managers are not in control. Because they are the new planners, corporations detest risk, require steady economic and stable markets. They recruit governments to serve their interests with fiscal and monetary policy, for instance adhering to monetarist policies which enrich money-lenders in the City through increases in interest rates. While the goals of an affluent society and complicit government serve the irrational technostructure, public space is simultaneously impoverished. Galbraith paints the picture of stepping from penthouse villas onto unpaved streets, from landscaped gardens to unkempt public parks. In Economics and the Public Purpose (1973) Galbraith advocates a "new socialism" as the solution, nationalising military production and public services such as health care, introducing disciplined salary and price controls to reduce inequality.
Post WWII development
After the Second World War, and the death of John Maynard Keynes, a group of mostly American economists worked to combine Keynes' economic theory with statistic method mathematical representations. Introductory university economics courses began with the same approach that pulled the divergent strands of economic thought together and present economic theory as a unified whole. This development of a new orthodoxy is referred to as the neoclassical synthesis. "Positive economics" is the term created to describe certain trends and "laws" of economics that be objectively observed and described in a value free way, separate from "normative economic" evaluations and judgments. Policy solutions based on Keynesian theory were routinely implemented by Western governments.
Paul Samuelson
In the aftermath of the Great Depression leading up to the second world war, Paul Samuelson had been writing his Ph.D. in an attempt to show on how mathematical methods could represent a core of testable economic theory. It was published as Foundations of Economic Analysis in 1947. Samuelson started with two assumptions. First, people and firms will act to maximise their self interested goals. Second, markets tend towards an equilibrium of prices, where demand matches supply. He extended the mathematics to describe equilibrating behaviour of economic systems, including that of the then new macroeconomic theory of John Maynard Keynes. Whilst Richard Cantillon had imitated Isaac Newton's mechanical physics of inertia and gravity in competition and the market, the physiocrats had copied the body's blood system into circular flow of income models, William Jevons had found growth cycles to match the periodicity of sunspots, Samuelson adapted thermodynamics formulae to economic theory. Reasserting economics as a hard science was being done in the United Kingdom also, and one celebrated "discovery", of A. W. Phillips, was of a correlative relationship between inflation and unemployment. The workable policy conclusion that securing full employment could be traded-off against higher inflation. Samuelson incorporated the idea of the Phillips curve into his work. His introductory textbook Economics was influential and widely adopted. It became the most successful economics text ever. Paul Samuelson was awarded the new Bank of Sweden Prize in 1970 for his merging of mathematics and political economy.
Kenneth Arrow
Kenneth Arrow (born 1921) is Paul Samuelson's brother-in-law. Arrow's first major work, forming his doctoral dissertation at Columbia University was Social Choice and Individual Values (1951), which brought economics into contact with political theory. His argument was that individuals can never reach social consensus, when deciding by preferences and presented with over three options. To prove this Arrow sets out five criteria, which he argues are reasonable, that must be fulfilled for lasting social consensus. First, consensus should account for everyone's preferences and not favour one person or group ("non-dictatorship"). Second, consensus must take account of everyone's preferences in unrestricted domain ("universality"). Third, consensus must be based on preferences unaltered by the addition of new options, so that if people choose A over B, if an option C were added, this would not lead people to express greater preference for B over A ("independence of irrelevant alternatives"). Fourth, social preference should have a positive relation with individual preferences, so that if individuals changed preference from A to B, social preference would reflect that and not show any opposite change from B to A ("monotonicity"). And last, any consensus through any combination of individual preferences should be allowed ("citizen sovereignty"). Arrow's impossibility theorem is that if one accepts these five working assumptions (especially the third one), as Arrow argues we should, then any more than three options given to two people or more with different preferences will make agreement impossible. In 1971 Arrow with Frank Hahn co-authored General Competitive Analysis (1971), which reasserted a theory of general equilibrium of prices through the economy. In 1969 the Swedish Central Bank began awarding a prize in economics, as an analogy to the Nobel prizes awarded in Chemistry, Physics, Medicine as well as Literature and Peace (despite Alfred Nobel never having endorsed this in his will). With John Hicks, Arrow won the Bank of Sweden prize in 1972, the youngest ever recipient. The year before, US President Richard Nixon's had declared that "We are all Keynesians now". The irony was, this was the beginning of a new revolution in economic thought.
Monetarism and the Chicago school
The interventionist monetary and fiscal policies that the orthodox post-war economics recommended came under attack in particular by a group of theorists working at the University of Chicago, which came to be known as the Chicago School. This more conservative strand of thought reasserted a "libertarian" view of market activity, that people are best left to themselves, free to choose how to conduct their own affairs. More academics who have worked at the University of Chicago have been awarded the Nobel Memorial Prize in Economic Sciences than those from any other university.
Ronald Coase
Ronald Coase (born 1910) is the most prominent economic analyst of law and the 1991 Nobel Prize winner. His first major article, The Nature of the Firm (1937), argued that the reason for the existence of firms (companies, partnerships, etc.) is the existence of transaction costs. Rational individuals trade through bilateral contracts on open markets until the costs of transactions mean that using corporations to produce things is more cost-effective. His second major article, The Problem of Social Cost (1960), argued that if we lived in a world without transaction costs, people would bargain with one another to create the same allocation of resources, regardless of the way a court might rule in property disputes. Coase used the example of an old legal case about nuisance named Sturges v. Bridgman, where a noisy sweetmaker and a quiet doctor were neighbours and went to court to see who should have to move. Coase said that regardless of whether the judge ruled that the sweetmaker had to stop using his machinery, or that the doctor had to put up with it, they could strike a mutually beneficial bargain about who moves house that reaches the same outcome of resource distribution. Only the existence of transaction costs may prevent this. So the law ought to pre-empt what would happen, and be guided by the most efficient solution. The idea is that law and regulation are not as important or effective at helping people as lawyers and government planners believe. Coase and others like him wanted a change of approach, to put the burden of proof for positive effects on a government that was intervening in the market, by analysing the costs of action.
Milton Friedman
Milton Friedman (1912-2006) stands as one of the most influential economists of the late twentieth century. He won the Nobel Prize in Economics in 1976, among other things, for A Monetary History of the United States (1963). Friedman argued that the Great Depression had been caused by the Federal Reserve's policies through the 1920s, and worsened in the 1930s. Friedman argues laissez-faire government policy is more desirable than government intervention in the economy. Governments should aim for a neutral monetary policy oriented toward long-run economic growth, by gradual expansion of the money supply. He advocates the quantity theory of money, that general prices are determined by money. Therefore active monetary (e.g. easy credit) or fiscal (e.g. tax and spend) policy can have unintended negative effects. In Capitalism and Freedom (1967) Friedman wrote:
"There is likely to be a lag between the need for action and government recognition of the need; a further lag between recognition of the need for action and the taking of action; and a still further lag between the action and its effects.
The slogan that "money matters" has come to be associated with Friedman, but Friedman has also levelled harsh criticism of his ideological opponents. Referring to Thorsten Veblen's assertion that economics unrealistically models people as "lightning calculator[s] of pleasure and pain", Friedman wrote,
"criticism of this type is largely beside the point unless supplemented by evidence that a hypothesis differing in one or another of these respects from the theory being criticized yields better predictions for as wide a range of phenomena."
Friedman was also known for his work on the consumption function, the permanent income hypothesis (1957), which Friedman himself referred to as his best scientific work. This work contended that rational consumers would spend a proportional amount of what they perceived to be their permanent income. Windfall gains would mostly be saved. Tax reductions likewise, as rational consumers would predict that taxes would have to rise later to balance public finances. Other important contributions include his critique of the Phillips curve and the concept of the natural rate of unemployment (1968). This critique associated his name, together with that of Edmumd Phelps, with the insight that a government that brings about higher inflation cannot permanently reduce unemployment by doing so. Unemployment may be temporarily lower, if the inflation is a surprise, but in the long run unemployment will be determined by the frictions and imperfections in the labour market.
Global times
Amartya Sen
Amartya Sen (born 1933) is a leading development and welfare economist and has expressed considerable scepticism on the validity of neo-classical assumptions. He won the Bank of Sweden Prize in Economic Sciences (Nobel Prize for Economics) in 1998.
Joseph E. Stiglitz
Joseph Stiglitz (born 1943) Received the Nobel Prize in 2001 for his work in information economics. He has served as chairman of President Clinton's Council of Economic Advisors and as chief economist for the World Bank. Stiglitz has taught at many universities, including Columbia, Stanford, Oxford, Yale, and MIT. In recent years he has become an outspoken critic of global economic institutions. He is a popular and academic author. In Making Globalization Work (2007), he offers an account of his perspectives on issues of international economics.
"The typical advice of a visiting consultant making a hurried trip to one of the economies making a transition path is to repeatedly emphasize the importance of markets, a lesson seemingly by now well learned (though market advocates would say that it is a lesson that cannot be repeated too often, and as simple as it may seem, the full import of which seems difficult to absorb - even in economies long accustomed to markets). Indeed there seems to be a certain instant attraction between the old ideologues of the left and the ideologues of the right. Both are driven by a religious fervour, not by rational analysis."
"The fundamental problem with the neoclassical model and the corresponding model under market socialism is that they fail to take into account a variety of problems that arise from the absence of perfect information and the costs of acquiring information, as well as the absence or imperfections in certain key risk and capital markets. The absence or imperfection can, in turn, to a large extent be explained by problems of information.
Paul Krugman
Paul Krugman (born 1953) is probably the most widely read contemporary economist. His textbook International Economics (2007) appears on many undergraduate reading lists. Well known as a representative of political liberalism, he writes a weekly column on economics, American economic policy, and American politics more generally in the New York Times. He was awarded the Nobel Prize in Economics in 2008 for his work on New Trade Theory and economic geography.
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