Chapter 26

THE HISTORY OF ECONOMICS

I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas.

John Maynard Keynes{981}

People have been talking about economic issues, and some writing about them, for thousands of years, so it is not possible to put a specific date on when the study of economics began as a separate field. Modern economics is often dated from 1776, when Adam Smith wrote his classic, The Wealth of Nations, but there were substantial books devoted to economics at least a century earlier, and there was a contemporary school of French economists called the Physiocrats, some of whose members Smith met while traveling in France, years before he wrote his own treatise on economics. What was different about The Wealth of Nations was that it became the foundation for a whole school of economists who continued and developed its ideas over the next two generations, including such leading figures as David Ricardo (1772–1823) and John Stuart Mill (1806–1873), and the influence of Adam Smith has to some extent persisted on to the present day. No such claim could be made for any previous economist, despite many people who had written knowledgeably and insightfully on the subject in earlier times.

More than two thousand years ago, Xenophon, a student of Socrates, analyzed economic policies in ancient Athens.{982} In the Middle Ages, religious conceptions of a “fair” or “just” price, and a ban on usury, led Thomas Aquinas to analyze the economic implications of those doctrines and the exceptions that might therefore be morally acceptable. For example, Aquinas argued that selling something for more than was paid for it could be done “lawfully” when the seller has “improved the thing in some way,” or as compensation for risk, or because of having incurred costs of transportation.{983} Another way of saying the same thing is that much that looks like sheer taking advantage of other people is often in fact compensation for various costs and risks incurred in the process of bringing goods to consumers or lending money to those who seek to borrow.

However far economists have moved beyond the medieval notion of a fair and just price, that concept still lingers in the background of much present-day thinking among people who speak of things being sold for more or less than their “real” value and individuals being paid more or less than they are “really” worth, as well as in such emotionally powerful but empirically undefined notions as price “gouging.”

From more or less isolated individuals writing about economics there evolved, over time, more or less coherent schools of thought, people writing within a common framework of assumptions—the medieval scholastics, of whom Thomas Aquinas was a prominent example, the mercantilists, the classical economists, the Keynesians, the “Chicago School,” and others. Individuals coalesced into various schools of thought even before economics became a profession in the nineteenth century.

THE MERCANTILISTS

One of the earliest schools of thought on economics consisted of a group of writers called the mercantilists, who flourished from the sixteenth through the eighteenth centuries. In a motley collection of writings, ranging from popular pamphlets to a multi-volume treatise by Sir James Steuart in 1767, the mercantilists argued for policies enabling a nation to export more than it imports, causing a net inflow of gold to pay for the difference. This gold they equated with wealth. From this school of thought have come such present-day practices as referring to an export surplus as a “favorable” balance of trade and a surplus of imports as an “unfavorable” balance of trade—even though, as we have seen in earlier chapters, there is nothing inherently more beneficial about one than the other, and everything depends on the surrounding circumstances.

The inevitable gropings of pioneers include inevitable ambiguities and errors—and economics was no exception. Some of the errors of the mercantilists, which have been largely expunged from the work of modern economists, still live on in popular beliefs and political rhetoric. However, there is a coherence in the writings of the mercantilists, if we understand their purposes, as well as their conceptions of the world.

The purposes of the mercantilists were not the same as those of modern economists. Mercantilists were concerned with increasing the power of their own respective nations relative to that of other nations. Their goal was not the allocation of scarce resources in a way that would maximize the standard of living of the people at large. Their goal was gaining or maintaining a national competitive advantage in aggregate wealth and power over other nations, so as to be able to prevail in war, if war occurred, or to deter potential enemies by one’s obvious wealth that could be turned to military purposes. A hoard of gold was ideal for their purposes.

In a typical mercantilist writing in 1664, Thomas Mun’s book England’s Treasure by Forraign Trade declared the cardinal rule of economic policy to be “to sell more to strangers yearly than wee consume of theirs in value.” Conversely, the nation must try to produce at home “things which now we fetch from strangers to our great impoverishing.”{984} Mercantilists focused on the relative power of national governments, based on the wealth available to be used by their respective rulers.

Mercantilists were by no means focused on the average standard of living of the population as a whole. Thus the repression of wages by imposing government control was considered by them to be a way of lowering the costs of exports, creating a surplus of exports over imports, which would bring in gold. The promotion of imperialism and even slavery was acceptable to some mercantilists for the same reason. The “nation” to them did not mean a country’s whole population. Thus Sir James Steuart could write in 1767 of “a whole nation fed and provided for gratuitously” by means of slavery.{985} Although slaves were obviously part of the population, they were not considered to be part of the nation.

CLASSICAL ECONOMICS

Adam Smith

Within a decade after Sir James Steuart’s multi-volume mercantilist treatise, Adam Smith’s The Wealth of Nations was published and dealt a historic blow against mercantilist theories and the whole mercantilist conception of the world. Smith conceived of the nation as all the people living in it. Thus you could not enrich a nation by keeping wages down in order to export. “No society can surely be flourishing and happy, of which the far greater part of the members are poor and miserable,” Smith said.{986} He also rejected the notion of economic activity as a zero-sum process, in which one nation loses what another nation gains. To him, all nations could advance at the same time in terms of the prosperity of their respective peoples, even though military power—a major concern of the mercantilists—was of course relative and a zero-sum competition.

In short, the mercantilists were preoccupied with the transfer of wealth, whether by export surpluses, imperialism, or slavery—all of which benefit some at the expense of others. Adam Smith was concerned with the creation of wealth, which is not a zero-sum process. Smith rejected government intervention in the economy to help merchants—the source of the name “mercantilism”—and instead advocated free markets along the lines of the French economists, the Physiocrats, who had coined the term laissez faire. Smith repeatedly excoriated special-interest legislation to help “merchants and manufacturers,” whom he characterized as people whose political activities were designed to deceive and oppress the public.{987} In the context of the times, laissez faire was a doctrine that opposed government favors to business.

The most fundamental difference between Adam Smith and the mercantilists was that Smith did not regard gold as being wealth. The very title of his book—The Wealth of Nations—raised the fundamental question of what wealth consisted of. Smith argued that wealth consisted of the goods and services which determined the standard of living of the people{988}—the whole people, who to Smith constituted the nation. Smith rejected both imperialism and slavery—on economic grounds as well as moral grounds, saying that the “great fleets and armies” necessary for imperialism “acquire nothing which can compensate the expence of maintaining them.”{989} The Wealth of Nations closed by urging Britain to give up dreams of empire.{990} As for slavery, Smith considered it economically inefficient, as well as morally repugnant, and dismissed with contempt the idea that enslaved Africans were inferior to people of European ancestry.{991}

Although Adam Smith is today often regarded as a “conservative” figure, he in fact attacked many of the dominant ideas and interests of his own times. Moreover, the idea of a spontaneously self-equilibrating system—the market economy—first developed by the Physiocrats and later made part of the tradition of classical economics by Adam Smith, represented a radically new departure, not only in analysis of social causation but also in seeing a reduced role for political, intellectual, or other elites as guides or controllers of the masses.

For centuries, landmark intellectual figures from Plato onward had discussed what policies wise leaders might impose for the benefit of society in various ways. But, in the economy, Smith argued that governments were giving “a most unnecessary attention”{992} to things that would work out better if left alone to be sorted out by individuals interacting with one another and making their own mutual accommodations. Government intervention in the economy, which mercantilist Sir James Steuart saw as the role of a wise “statesman,”{993} Smith saw as the notions and actions of “crafty” politicians,{994} who created more problems than they solved.

While The Wealth of Nations was not the first systematic treatise on economics, it became the foundation of a tradition known as classical economics, which built upon Smith’s work over the next century. Not all earlier treatises were mercantilist by any means. Books by Richard Cantillon in the 1730s and by Ferdinando Galiani in 1751, for example, presented sophisticated economic analyses, and François Quesnay’s Tableau Économique in 1758, contained insights that inspired the transient but significant school of economists called the Physiocrats. But, as already noted, these earlier pioneers created no enduring school of leading economists in later generations who based themselves on their work, as Adam Smith did.

Here and there in history there have been a number of individual economists who produced work well in advance of their times, but who attracted little attention and had few followers—and who faded into obscurity until they were rediscovered by later generations of scholars as pioneers in their field. French mathematician Augustin Cournot, for example, produced mathematical analyses of economic principles in 1838 that did not become part of the analytical tools of economists until nearly a century later, when they were developed independently by economists of that later era.

One of the consequences of Adam Smith’s economic theories, developed in opposition to the theories of the mercantilists, was an emphasis on downplaying the role of money in the economy. This emphasis persisted throughout the era of classical economics, which lasted nearly a century. Understandable as this opposition to the mercantilists was, in light of the mercantilists’ over-emphasis on the role of gold, which was money in many economies, the classical economists’ statements that money was only a “veil”—obscuring but not essentially changing the underlying real economic activities—were often misunderstood by those who read them. The leading classical economists understood that contractions in the money supply could create reduced production, and correspondingly increased unemployment, at a given time.{xxxvii} But this was not always clear to their readers, and the classical economists’ own attention was seldom focused in that direction.

David Ricardo

Among the followers of Adam Smith was the great classical economist David Ricardo, the leading economist of the early nineteenth century who, among other things, developed the theory of comparative advantage in international trade. In addition to his substantive contributions to economic analysis, Ricardo created a new approach and style in writing about economics. Adam Smith’s The Wealth of Nations was full of social commentary and philosophical observations, and closed with a strong suggestion that Britain should not try to hold on to its American colonies that were in rebellion the same year that his treatise was published. By contrast, David Ricardo’s Principles of Political Economy in 1817 was the first of the great classic works in economics to be devoted to analysis of enduring principles of economics, divorced from social, political and philosophical commentary, and emphasizing those principles more so than immediate policy issues.

This is not to say that Ricardo had no interest in social or moral issues. Some of his analysis was inspired by the particular economic problems faced by Britain in the wake of the Napoleonic wars but the principles he derived were not confined to those problems or that era, any more than Newton’s law of gravity was confined to falling apples. Contemporary policy issues were simply not what his Principles of Political Economy was about. What Ricardo brought to economics was a more narrowly focused system of analysis, using more sharply defined terms and more tightly reasoned analysis.

David Ricardo was not simply a reasoning machine, however. In his personal actions and private correspondence, Ricardo showed himself to be a man of very high moral standards and social concerns. When he became a member of Parliament, Ricardo wrote to a friend:

 

I wish that I may never think the smiles of the great and powerful a sufficient inducement to turn aside from the straight path of honesty and the convictions of my own mind.{995}

 

As a member of Parliament, Ricardo lived up to his ideals. He voted repeatedly against the interests of wealthy landowners, though he himself was one, and he voted for election reforms which would have cost him his seat in Parliament.{xxxviii}

What we today call “economics” was once called “political economy” up through much of the nineteenth century. When the classical economists referred to “political economy,” they meant the economics of the country as a whole—the polity—as distinguished from the economics of the household, or what might today be called “home economics.” The term “political economy” did not imply an amalgamation of economics and politics, as some have used that term in more recent times.

The principles of economics did not spring forth, ready-made, in a flash of inspiration or genius. Instead, profound and conscientious thinkers in successive generations groped toward some kind of understanding of both the real world of economic activity and the intellectual concepts that would make it possible to study such things systematically. The supply and demand analysis that can be taught to today’s beginning students in a week took at least a century to emerge from the controversies among early nineteenth-century thinkers like David Ricardo, Thomas Malthus, and Jean-Baptiste Say.

In one of many letters between Ricardo and his friend Malthus, discussing economic issues over the years, Ricardo said in 1814: “I sometimes suspect that we do not attach the same meaning to the word demand.” He was right; they did not. {xxxix} It would be decades after both men had passed from the scene before the term could be clarified and defined precisely enough to mean what it means to economists today. What may seem like small steps in logic, after the fact, can be a long, time-consuming process of trial and error groping, while creating and refining concepts and definitions to express ideas in clear and unmistakable terms which allow substantive issues to be debated in terms that opposing parties can agree on, so that they can at least disagree on substance, rather than be frustrated by semantics.

Say’s Law

One of the fundamental concepts of economics, over which controversies raged in the early nineteenth century and were re-ignited by John Maynard Keynes in 1936, was what has been called Say’s Law. Named for French economist Jean-Baptiste Say (1767–1832), though other economists had a role in its development, Say’s Law began as a relatively simple principle whose corollaries and extensions grew ever more complex in the hands of both its advocates and its critics, during the controversies between the two in both the nineteenth and twentieth centuries.

At its most basic, Say’s Law was an answer to perennial popular fears that the growing output of an economy could reach the point where it would exceed the ability of the people to buy it, leading to unsold goods and unemployed workers. Such fears were expressed, not only before the time of Jean-Baptiste Say, but also long afterward. As we have seen in Chapter 16, a best-selling writer of the 1960s warned of “a threatened overabundance of the staples and amenities and frills of life” which have become “a major national problem.”{996} What Say’s Law, in its most basic sense, argued was that the production of output, and the generation of real income for those producing that output, were not processes independent of each other. Therefore, whether a nation’s output was large or small, the incomes generated in producing it would be sufficient to buy it. Say’s Law has often been expressed as the proposition that “supply creates its own demand.” In other words, there is no inherent limit to how much output an economy can produce and purchase.

Say himself asked: “Otherwise, how could it be possible that there should now be bought and sold in France five or six times as many commodities, as in the miserable reign of Charles VI?”{997} A similar idea had been expressed even earlier by one of the Physiocrats, that aggregate demand “has no known limits.”{998} This, of course, did not preclude the possibility that, as of any given time, consumers or investors might not choose to exercise all the aggregate demand that was in their power. What Say’s Law did preclude was the recurrent popular fear that the sheer rapid growth of output, with the rise of modern industry, would reach a point where output would become so great that it would be impossible to buy it all.

As often happens in the history of ideas, an initially very straightforward concept became extended in so many directions by its advocates, and embroiled in so many controversies by its opponents, that meanings and distortions proliferated, even when the economists on both sides—which included virtually all the leading economists of the early nineteenth century—were earnest and intelligent thinkers who simply talked past each other. That was, in part, because economics had not yet reached the stage where the terms in which they spoke (“demand,” for example) had rigorous definitions agreed to by all. {xl} However tedious the students of a later time might find the process of rigorous definition, the history of economics—and of other fields—makes painfully clear the confusing consequences of trying to discuss substantive issues without having clear-cut terms that mean the same thing to all those who use those terms.

MODERN  ECONOMICS

Today we think of economics as a profession with academic departments, scholarly journals, and professional organizations like the American Economic Association. But these are relatively late developments, as history is measured.

It was centuries before economics became a separate subject, even though philosophers from Aristotle to David Hume wrote knowledgeably about economic matters, as did theologians like Thomas Aquinas and members of the nobility like Sir James Steuart. But, even after some writers began to specialize in economics, they did not immediately begin to earn their livings as economists. Adam Smith, for example, was a professor of philosophy, and achieved renown for his book Theory of Moral Sentiments nearly twenty years before achieving lasting fame for The Wealth of Nations. David Ricardo was an independently wealthy retired stockbroker when his writings made him the leading economist of his times. When Thomas R. Malthus was appointed a professor of history and political economy in 1805, he became the first academic economist in Britain and probably in the world. Britain at that point produced most of the leading economists in the world, and would continue to do so for the remainder of the nineteenth century.

Aside from Malthus, most of the leading British economists of the first half of the nineteenth century did not derive a major part of their income from teaching or writing about economics. Economics was a specialty but not yet a career. Nor was it yet enough of a specialty to have its own professional journals. Most leading analytical articles on economics during the first half of the nineteenth century were published in the intellectual periodicals of that era, such as the Edinburgh Review, the Quarterly Review or the Westminster Review in Britain or the Revue Encyclopédique or the Annales de Législation et d’Économie Politique in France. The first scholarly journal devoted exclusively to economics was the Quarterly Journal of Economics, first published at Harvard in 1886. Many more such journals were then created in many countries in the twentieth century. Those who wrote for these journals were overwhelmingly academic economists, with Americans now joining British, Austrian and other economists among the leaders of the profession. The first professor of economics in the United States was appointed by Harvard in 1871 and the first Ph.D. in economics was awarded by the same institution four years later.{999}

From the time of Alfred Marshall’s Principles of Economics in 1890 onward, economics began increasingly to be expressed to the profession and taught to students with graphs and equations, though purely verbal presentations have not completely died out even today. It was in the second half of the twentieth century that mathematical analyses in economics began to supersede wholly verbal analyses in the leading academic journals and scholarly books. While predominantly mathematical economic analysis can be found as far back as Augustin Cournot in the 1830s, Cournot was one of those pioneers whose work made no impact on the dominant economists of his time, so that much of what he said had to be rediscovered, generations later, as if Cournot had never existed.

The “Marginalist” Revolution

One of the watersheds in the development of economic analysis in the nineteenth century was the widespread acceptance among economists of a price theory based on the demands of consumers, rather than just on the costs of producers. It was revolutionary not only as a theory of price but also in introducing new concepts and new methods of analysis that spread into other branches of economics.

Classical economics had regarded the amount of labor and other inputs as crucial factors determining the price of the resulting output. Karl Marx had taken this line of thinking to its logical extreme with his theory of the exploitation of labor, which was seen as the ultimate source of wealth, and therefore as the ultimate source of the income and wealth of the non-working classes, such as capitalists and landowners.{xli}

Although the cost-of-production theory of value had prevailed in England since the time of Adam Smith, an entirely different theory had prevailed in continental Europe, where value was considered to be determined by the utility of goods to consumers, which was what would determine their demand. Smith, however, disposed of this theory by saying that water was obviously more useful than diamonds, since one could not live without water but many people lived without diamonds—and yet diamonds sold for far more than water.{1000} But, in the 1870s, a new conception emerged from Carl Menger in Austria and W. Stanley Jevons in England, both basing prices on the utility of goods to consumers—and, more important, refining and more sharply defining the terms of the debate, while introducing new concepts into economics in general.

What Adam Smith had been comparing was the total utility of water versus the total utility of diamonds. In other words, he was asking whether we would be worse off with no water or no diamonds. In that sense, the total utility of water obviously greatly exceeded the total utility of diamonds, since water was a matter of life and death. But Menger and Jevons conceived of the issue in a new way—a way that could be applied to many other analyses in economics besides price theory.

First of all, Menger and Jevons conceived of utility as entirely subjective.{1001} That is, there was no point in third party observers declaring one thing to be more useful than another, because each consumer’s demand was based on what that particular consumer considered useful—and consumer demand was what affected prices. More fundamentally, utility varies, even for the same consumer, depending on how much of particular goods and services that consumer already has.

Carl Menger pointed out that an amount of food necessary to sustain life is enormously valuable to everyone. Beyond the amount of food necessary to avoid starving to death, there was still value to additional amounts necessary for health, even though not as high a value as to the amount required to avoid death, and there was still some value to food to be eaten just for the pleasure of eating it. But eventually “satisfaction of the need for food is so complete that every further intake of food contributes neither to the maintenance of life nor to the preservation of health—nor does it even give pleasure to the consumer.”{1002} In short, what mattered to Menger and Jevons was the incremental utility, what Alfred Marshall would later call the “marginal” utility of additional units consumed.

Returning to Adam Smith’s example of water and diamonds, the relative utilities that mattered were the incremental or marginal utility of having another gallon of water compared to another carat of diamonds. Given that most people were already amply supplied with water, the marginal utility of another carat of diamonds would be greater—and this would account for a carat of diamonds selling for more than a gallon of water. This ended the difference between the cost-of-production theory of value in England and the utility theory of value in continental Europe, as economists in both places now accepted the marginal utility theory of value, as did economists in other parts of the world.

Essentially the same analysis and conclusions that Carl Menger reached in Austria in his 1871 book Principles of Economics appeared at the same time in England in W. Stanley Jevons’ book The Theory of Political Economy. What Jevons also saw, however, was how the concept of incremental utility was readily expressed in graphs and differential calculus, making the argument more visibly apparent and more logically rigorous than in Menger’s purely verbal presentation. This set the stage for the spread of incremental or marginal concepts to other branches of economics, such as production theory or international trade theory, where graphs and equations could more compactly and more unambiguously convey such concepts as economies of scale or comparative advantage.

This has been aptly called “the marginalist revolution,” which marked a break with both the methods and the concepts of the classical economists. This marginalist revolution facilitated the increased use of mathematics in economics to express cost variations, for example, in curves and to analyze rates of change of costs with differential calculus. However, mathematics was not necessary for understanding the new utility theory of value, for Carl Menger did not use a single graph or equation in his Principles of Economics.

Although Menger and Jevons were the founders of the marginal utility school in economics, and pioneers in the introduction of marginal concepts in general, it was Alfred Marshall’s monumental textbook Principles of Economics, published in 1890, which systematized many aspects of economics around these new concepts and gave them the basic form in which they have come down to present-day economics. Jevons had been especially at pains to reject the notion that value depends on labor, or on cost of production in general, but insisted that it was utility which was crucial.{1003} Alfred Marshall, however, said:

 

We might as reasonably dispute whether it is the upper or the under blade of a pair of scissors that cuts a piece of paper, as whether value is governed by utility or cost of production.{1004}

 

In other words, it was the combination of supply (dependent on the cost of production) and demand (dependent on marginal utility) which determined prices. In this and other ways, Marshall reconciled the theories of the classical economists with the later marginalist theories to produce what became known as neo-classical economics. His Principles of Economics became the authoritative text and remained so on into the first half of the twentieth century, going through eight editions in his lifetime.{xlii}

That Alfred Marshall was able to reconcile much of classical economics with the new marginal utility concepts was not surprising. Marshall was highly trained in mathematics and first learned economics by reading Mill’s Principles of Political Economy. In 1876, he called it “the book by which most living English economists have been educated.”{1005} Before that, Alfred Marshall had been a student of philosophy, and was critical of the economic inequalities in society, until someone told him that he needed to understand economics before making such judgments. After doing so, and seeing circumstances in a very different light, his continuing concern for the poor then led him to change his career and become an economist. He afterwards said that what social reformers needed were “cool heads” as well as “warm hearts.”{1006} As he was deciding what career to pursue, “the increasing urgency of economic studies as a means towards human well-being grew upon me.”{1007}

Equilibrium Theory

The increased use of graphs and equations in economics made it easier to illustrate such things as the effects of shortages and surpluses in causing prices to rise or fall. It also facilitated analyses of the conditions in which prices would neither rise nor fall—what have been called “equilibrium” conditions. Moreover, the concept of “equilibrium” applied to many things besides prices. There could be equilibrium in particular firms, whole industries, the national economy or international trade, for example.

Many people unfamiliar with economics have regarded these equilibrium conditions as unrealistic in one way or another, because they often seem different from what is usually observed in the real world. But that is not surprising, since the real world is seldom in equilibrium, whether in economics or in other fields. For example, while it is true that “water seeks its own level,” that does not mean that the Atlantic Ocean has a glassy smooth surface. Waves and tides are among the ways in which water seeks its own level, as are waterfalls, and all these things are in motion at all times. Equilibrium theory allows you to analyze what that motion will be like in various disequilibrium situations found in the real world. 

Similarly, students in medical school study the more or less ideal functioning of various body parts in healthy equilibrium, but not because body parts always function ideally in healthy equilibrium—since, if that were true, there would then be no reason to have medical schools in the first place. In other words, the whole point of studying equilibrium is to understand what happens when things are not in equilibrium, in one particular way or in some other way.

In economics, the concept of equilibrium applies not only in analyses of particular firms, industries or labor markets, but also in the economy as a whole. In other words, there are not only equilibrium prices or wages but also equilibrium national income and equilibrium in the balance of trade. The analysis of equilibrium and disequilibrium conditions in particular markets has become known as “microeconomics,” while analyses of changes in the economy as a whole—such as inflation, unemployment or rises and falls in total output—became known as “macroeconomics.” However, this convenient division overlooks the fact that all these elements of an economy affect one another. Ironically, it was two Soviet economists, living in a country with a non-market economy, who saw a crucial fact about market economies when they said: “Everything is interconnected in the world of prices, so that the smallest change in one element is passed along the chain to millions of others.”{1008}

For example, when the Federal Reserve System raises the interest rate on borrowed money, in order to reduce the danger of inflation, that can cause home prices to fall, savings to rise, and automobile sales to decline, among many other repercussions spreading in all directions throughout the economy. Following all these repercussions in practice is virtually impossible, and even analyzing it in theory is such a challenge that economists have won Nobel Prizes for doing so. The analysis of these complex interdependencies—whether microeconomic or macroeconomic—is called “general equilibrium” theory. It is what J.A. Schumpeter’s History  of Economic Analysis called a recognition of “this all-pervading interdependence” that is the “fundamental fact” of economic life.{1009}

The landmark figure in general equilibrium theory was French economist Léon Walras (1834–1910), whose complex simultaneous equations essentially created this branch of economics in the nineteenth century. Back in the eighteenth century, however, another Frenchman, François Quesnay (1694–1774), was groping toward some notion of general equilibrium with a complex table intersected by lines connecting various economic activities with one another.{1010} Karl Marx, in the second volume of Capital, likewise set forth various equations showing how particular parts of a market economy affected numerous other parts of that economy.{1011} In other words, Walras had predecessors, as most great discoverers do, but he was still the landmark figure in this field.

While general equilibrium theory is something that can be left for advanced students of economics, it has some practical implications that can be understood by everyone. These implications are especially important because politicians very often set forth a particular economic “problem” which they are going to “solve,” without the slightest attention to how the repercussions of their “solution” will reverberate throughout the economy, with consequences that may dwarf the effects of their “solution.”

For example, laws setting a ceiling on the interest rate that can be charged on particular kinds of loans, or on loans in general, can reduce the amount of loans that are made, and change the mixture of people who can get loans—lower income people being particularly disqualified—as well as affecting the price of corporate bonds and the known reserves of natural resources, {xliii} among other things. Virtually no economic transaction takes place in isolation, however much it may be seen in isolation by those who think in terms of creating particular “solutions” to particular “problems.”

Keynesian Economics

The most prominent new developments in economics in the twentieth century were in the study of the variations in national output from boom times to depressions. The Great Depression of the 1930s and its tragic social consequences around the world had as one of its major and lasting impacts an emphasis on trying to determine how and why such calamities happened and what could be done about them. {xliv} John Maynard Keynes’ 1936 book, The General Theory of Employment Interest and Money, became the most famous and most influential economics book of the twentieth century. By mid-century, it was the prevailing orthodoxy in the leading economics departments of the world—with the notable exception of the University of Chicago and a few other economics departments in other universities largely staffed or dominated by former students of Milton Friedman and others in the “Chicago School” of economists.

To the traditional concern of economics with the allocation of scarce resources which have alternative uses, Keynes added as a major concern those periods in which substantial proportions of a nation’s resources—including both labor and capital—are not being allocated at all. This was certainly true of the time when Keynes’ General Theory was written, the Great Depression of the 1930s, when many businesses produced well below their normal capacity and as many as one-fourth of American workers were unemployed.

While writing his magnum opus, Keynes said in a letter to George Bernard Shaw: “I believe myself to be writing a book on economic theory which will largely revolutionize—not, I suppose, at once but in the course of the next ten years—the way the world thinks about economic problems.”{1012} Both predictions proved to be accurate. However, the contemporary New Deal policies in the United States were based on ad hoc decisions, rather than on anything as systematic as Keynesian economics. But, within the economics profession, Keynes’ theories not only triumphed but became the prevailing orthodoxy.

Keynesian economics offered not only an economic explanation of changes in aggregate output and employment, but also a rationale for government intervention to restore an economy mired in depression. Rather than wait for the market to adjust and restore full employment on its own, Keynesians argued that government spending could produce the same result faster and with fewer painful side-effects. While Keynes and his followers recognized that government spending entailed the risk of inflation, especially when “full employment” became an official policy, it was a risk they found acceptable and manageable, given the alternative of unemployment on the scale seen during the Great Depression.

Later, after Keynes’ death in 1946, empirical research emerged suggesting that policy-makers could in effect choose from a menu of trade-offs between rates of unemployment and rates of inflation, in what was called the “Phillips Curve,” in honor of economist A.W. Phillips of the London School of Economics, who had developed this analysis.

Post-Keynesian Economics

The Phillips Curve was perhaps the high-water mark of Keynesian economics. However, the Chicago School began chipping away at the Keynesian theories in general and the Phillips Curve in particular, both analytically and with empirical studies. In general, Chicago School economists found the market more rational and more responsive than the Keynesians had assumed—and the government less so, at least in the sense of promoting the national interest, as distinguished from promoting the careers of politicians. By this time, economics had become so professionalized and so mathematical that the work of its leading scholars was no longer something that most people, or even most scholars outside of economics, could follow. What could be followed, however, was the slow erosion of the Keynesian orthodoxy, especially after the simultaneous rise of inflation and unemployment to high levels during the 1970s undermined the notion of the government making a trade-off between the two, as suggested by the Phillips Curve.

When Professor Milton Friedman of the University of Chicago won a Nobel Prize in economics in 1976, it marked a growing recognition of non-Keynesian and anti-Keynesian economists, such as those of the Chicago School. By the last decade of the twentieth century, a disproportionate share of the Nobel Prizes in economics were going to economists of the Chicago School, whether located on the University of Chicago campus or at other institutions. The Keynesian contribution did not vanish, however, for many of the concepts and insights of John Maynard Keynes had now become part of the stock in trade of economists in all schools of thought. When John Maynard Keynes’ picture appeared on the cover of the December 31, 1965 issue of Time magazine, it was the first time that someone no longer living was honored in this way. There was also an accompanying story inside the magazine:

 

Time quoted Milton Friedman, our leading non-Keynesian economist, as saying, “We are all Keynesians now.” What Friedman had actually said was: “We are all Keynesians now and nobody is any longer a Keynesian,” meaning that while everyone had absorbed some substantial part of what Keynes taught no one any longer believed it all.{1013}

 

While it is tempting to think of the history of economics as the history of a succession of great thinkers who advanced the quantity and quality of analysis in this field, seldom did these pioneers create perfected analyses. The gaps, murkiness, errors and shortcomings common to pioneers in many fields were also common in economics. Clarifying, repairing and more rigorously systematizing what the giants of the profession created required the dedicated work of many others, who did not have the genius of the giants, but who saw many individual things more clearly than did the great pioneers.

David Ricardo, for example, was certainly far more of a landmark figure in the history of economics than was his obscure contemporary Samuel Bailey, but there were a number of things that Bailey expressed more clearly in his analysis of Ricardian economics than did Ricardo himself.{1014} Similarly, in the twentieth century, Keynesian economics began to be developed and presented with concepts, definitions, graphs and equations found nowhere in the writings of John Maynard Keynes, as other leading economists extended the analysis of Keynesian economics to the profession in scholarly writings, and its presentation to students in textbooks, using devices that Keynes himself never used or conceived.

THE ROLE OF ECONOMICS

Among the questions often raised about the history of economic analysis are: (1) Is economics scientific or is it just a set of opinions and ideological biases? and (2) Do economic ideas reflect surrounding circumstances and events and change with those circumstances and events?

Scientific Analysis

There is no question that economists as individuals have their own respective preferences and biases, as do all individuals, including mathematicians and physicists. But the reason mathematics and physics are not considered to be mere subjective opinions and biased notions is that there are accepted procedures for testing and proving beliefs in these disciplines. It is precisely because individual scientists are likely to have biases that scientists in general seek to create and agree upon scientific methods and procedures that are unbiased, so that individual biases may be deterred or exposed.

In economics, the preferences of Keynesian economists for government intervention and of University of Chicago economists for relying on markets instead of government, may well have influenced their respective initial reactions to the analysis and data of the Phillips Curve, for example. But the fact that both Keynesian economists and economists of the Chicago School shared a common set of analytical and empirical procedures in their professional work enabled them to reach common conclusions as more data came in over time, undermining the Phillips Curve.

Controversies have raged in science, but what makes a particular field scientific is not automatic unanimity on particular issues but a commonly accepted set of procedures for resolving differences about issues when there are sufficient data available. Einstein’s theory of relativity was not initially accepted by most physicists, nor did Einstein want it accepted without some empirical tests. When the behavior of light during an eclipse of the sun provided a test of his theory, the unexpected results convinced other scientists that he was right. A leading historian of science, Thomas Kuhn, has argued that what distinguishes science from other fields is that mutually contradictory theories cannot co-exist indefinitely in science but that one or the other must prevail, and the others disappear, when enough of the right data become available.{1015}

Thus the phlogiston theory of combustion gave way to the oxygen theory of combustion and the Ptolemaic theory of astronomy gave way to the Copernican theory. The history of ideologies, however, is quite different from the history of science. Mutually contradictory ideologies can co-exist for centuries, with no resolution of their differences in sight or perhaps even conceivable.{xlv}

What scientists share is not simply agreement on various conclusions but, more fundamentally, agreement about the ways of testing and verifying conclusions, beginning with a careful and strict definition of the terms being used. The crucial importance of definitions in economics has been demonstrated, for example, by the fallacies that result when popular discussions of economic policies use a loose term like “wages” to refer to such different things as wage rates per unit of time, aggregate earnings of workers, and labor costs per unit of output.{xlvi} As noted in Chapter 21, a prosperous country with higher wage rates per unit of time may have lower labor costs per unit of output than a Third World country where workers are not paid nearly as much.

Mathematical presentations of arguments, whether in science or economics, not only make these arguments more compact and their complexities easier to follow than a longer verbal presentation would be, but can also make their implications clearer and their flaws harder to hide. For example, when preparing a landmark 1931 scholarly article on economics, one later reprinted for decades thereafter, Professor Jacob Viner of the University of Chicago instructed a draftsman on how he wanted certain complex cost curves constructed. The draftsman replied that one of the set of curves with which Professor Viner wanted to illustrate the analysis in his article was impossible to draw with all the characteristics that Viner had specified.

As Professor Viner later recognized, he had asked for something that was “technically impossible and economically inappropriate,” because some of the assumptions in his analysis were incompatible with some of his other assumptions.{1016} That flaw became apparent in a mathematical presentation of the argument, whereas mutually incompatible assumptions may co-exist indefinitely in an imprecise verbal presentation.

Systematic analysis of carefully defined terms and the systematic testing of theories against empirical evidence are all part of a scientific study in many fields. Clearly, economics has advanced in this direction in the centuries since its beginnings. However, economics is scientific only in the sense of having some of the procedures of science. But the inability to conduct controlled experiments prevents its theories from having the precision and repeatability often associated with science. On the other hand, there are other fields with a recognized scientific basis which also do not permit controlled experiments, astronomy being one example and meteorology being another. Moreover, there are different degrees of precision among these fields.

In astronomy, for example, the time when eclipses will occur can be predicted to the second, even centuries ahead of time, while meteorologists have a high error rate when forecasting the weather a week ahead.

Although no one questions the scientific principles of physics on which weather forecasting is based, the uncertainty as to how the numerous combinations of factors will come together at a particular place on a particular day makes forecasting a particular event that day much more hazardous than predicting how those factors will interact if they come together.

Presumably, if a meteorologist knew in advance exactly when a warm and moisture-laden air mass moving up from the Gulf of Mexico would encounter a cold and dry air mass moving down from Canada, that meteorologist would be able to predict rain or snow in St. Louis to a certainty, since that would be nothing more than the application of the principles of physics to these particular circumstances. It is not those principles which are uncertain but all the variables whose behavior will determine which of those principles will apply at a particular place at a particular time.

What is scientifically known is that the collision of cold dry air and warm moist air does not produce sunny and calm days. What is unknown is whether these particular air masses will arrive in St. Louis at the same time or pass over it in succession—or both miss it completely. That is where statistical probabilities are calculated as to whether they will continue moving at their present speeds and without changing direction.

In principle, economics is much like meteorology. There is no example in recorded history in which a government increased the money supply ten-fold in one year without prices going up. Nor does anyone expect that there ever will be. The effects of price controls in creating shortages, black markets, product quality decline, and a reduction in auxiliary services, have likewise been remarkably similar, whether in the Roman Empire under Diocletian, in Paris during the French Revolution or in the New York housing market under rent control today. Nor has there been any fundamental difference whether the price being controlled was that of housing, food, or medical care.

Controversies among economists make news, but that does not mean that there are no established principles in this field, any more than controversies among scientists mean that there is no such thing as established principles of chemistry or physics. In both cases, these controversies seldom involve predicting what would happen under given circumstances but forecasting what will in fact happen in circumstances where there are too many combinations and permutations of factors for the outcome to be completely foreseen. In short, these controversies usually do not involve disagreement about fundamental principles of the field but about how all the trends and conditions will come together to determine which of those principles will apply or predominate in a particular set of circumstances.

Assumptions and Analysis

Among the many objections made against economics have been claims that it is “simplistic,” or that it assumes too much self-interested and materialistic rationality, or that the assumptions behind its analyses and predictions are not a true depiction of the real world.

Some of the problems of declaring something “simplistic” have already been dealt with in Chapter 4. Implicit in the term “simplistic” is that a particular explanation is not just simple but too simple. That only raises the question: Too simple for what? If the facts consistently turn out the way the explanation predicts, then it has obviously not been too simple for its purpose—especially if the facts do not turn out the way a more complicated or more plausible-sounding explanation predicts. In short, whether or not any given explanation is too simple is an empirical question that cannot be decided in advance by how plausible, complex, or nuanced an explanation seems on the face of it, but can only be determined after examining hard evidence on how well its predictions turn out.{xlvii}

A related attempt to determine the validity of a theory by how plausible it looks, rather than how well it performs when put to the test, is the criticism that economic analysis depicts people as thinking or acting in a way that most people do not think or act. But economics is ultimately about systemic results, not personal intentions or individual acts.

Economists on opposite ends of the ideological spectrum have understood this. Karl Marx said that capitalists lower their prices when technological advances lower their costs of production, not because they want to, but because market competition forces them to.{1017} Adam Smith likewise said that the benefits of a competitive market economy are “no part” of capitalists’ intentions.{1018} As already noted in Chapter 4, Marx’s collaborator Engels said, “what each individual wills is obstructed by everyone else, and what emerges is something that no one willed.”{1019} It is “what emerges” that economics tries to predict and its success or failure is measured by that, not by how plausible its analysis looks at the outset.

Bias and Analysis

Personal bias is another fundamental question that has long been raised about economics and its claim to scientific status. J.A. Schumpeter, whose massive History of Economic Analysis remains unequalled for its combination of breadth and depth, dealt with the much-discussed question of the effect of personal bias on economic analysis. He found ideological bias common among economists, ranging from Adam Smith to Karl Marx—but what he also concluded was how little effect these biases had on these economists’ analytical work, which can be separated out from their ideological comments or advocacies.

In a scholarly journal as well, Schumpeter singled out Adam Smith in particular: “In Adam Smith’s case the interesting thing is not indeed the absence but the harmlessness of ideological bias.”{1020}

Smith’s unrelievedly negative picture of businessmen was, to Schumpeter, an ideological bias deriving from Smith’s background in a family which “did not belong to the business class” and his intellectual immersion in the work of “similarly conditioned” intellectuals. But “all this ideology, however strongly held, really did not much harm to his scientific achievement” in producing “sound factual and analytic teaching.”{1021} Similarly with Karl Marx, whose ideological vision of social processes was formed before he began to study economics, but “as his analytic work matured, Marx not only elaborated many pieces of scientific analysis that were neutral to that vision but also some that did not agree with it well,” even though Marx continued to use “vituperative phraseology that does not affect the scientific elements in an argument.”{1022} Ironically, Marx’s view of businessmen was not quite as totally negative as that of Adam Smith. {xlviii}

According to Schumpeter, “in itself scientific performance does not require us to divest ourselves of our value judgments or to renounce the calling of an advocate of some particular interest.” More bluntly, he said, “advocacy does not imply lying,”{1023} though sometimes ideologies “crystallize” into “creeds” that are “impervious to argument.”{1024} But among the hallmarks of a scientific field are “rules of procedure” which can “crush out ideologically conditioned error” from an analysis.{1025} Moreover, having “something to formulate, to defend, to attack” provides an impetus for factual and analytical work, even if ideology sometimes interferes with it. Therefore “though we proceed slowly because of our ideologies, we might not proceed at all without them.”{1026}

Events and Ideas

Does economics influence events and do events influence economics? The short answer to both questions is “yes” but the only meaningful question is—to what extent and in what particular ways? John Maynard Keynes’ answer to the first question was this:

 

. . .the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas.{1027}

 

In other words, it was not by direct influence over those who hold power at a particular point in time that economists influence the course of events, according to Keynes. It was by generating certain general beliefs and attitudes which provide the context within which opinion-makers think and politicians act. In that sense, the mercantilists are still an influence on beliefs and attitudes in the world today, centuries after they were refuted decisively within the economics profession by Adam Smith.

The question whether economics is shaped by events is more controversial. At one time, it was widely believed that ideas are shaped by surrounding circumstances and events, and that economic ideas were no exception. No doubt something in the real world starts people thinking about economic ideas, as is no doubt true of ideas in other fields, including science and mathematics. Trigonometry was given an impetus, in ancient times, by the need to re-survey land in Egypt after recurring floods along the Nile wiped out boundaries between different people’s properties.

That is one kind of influence. A more immediate and direct influence has been assumed by those who believed that the Great Depression of the 1930s spawned Keynesian economics. But even if the Great Depression inspired Keynes’ thinking and the widespread acceptance of that thinking among economists around the world, how typical was that of the way that economics has evolved historically, much less how ideas in other fields have evolved historically?

Were more things falling down, or was their falling creating more social problems, when Newton developed his theory of gravity? Certainly there were not more free markets when Adam Smith wrote The Wealth of Nations, which advocated freer markets precisely because of his dissatisfaction with the effects of various kinds of government intervention that were pervasive at the time. {xlix} The great shift within nineteenth century economics from a theory of price determined by production costs to a theory of price determined by consumer demand was not in response to changes in either production costs or consumer demand. It was simply the unpredictable emergence of a new intellectual insight as a way of resolving ambiguities and inconsistencies in existing economic theory. As for depressions, there had been depressions before the 1930s without producing a Keynes.

Nobel Prize-winning economist George Stigler pointed out that momentous events in the real world may have no intellectual consequences: “A war may ravage a continent or destroy a generation without posing new theoretical questions,” he said.{1028} The tragic reality is that wars have spread ruination and devastation across continents many times over the centuries, so that there need be no new issue to confront intellectually, even in the midst of an overwhelming catastrophe.

Whatever its origins or its ability to influence or be influenced by external events, economics is ultimately a study of an enduring part of the human condition. Its value depends on its contribution to our understanding of a particular set of conditions involving the allocation of scarce resources which have alternative uses. Unfortunately, little of the knowledge and understanding within the economics profession has reached the average citizen and voter, leaving politicians free to do things that would never be tolerated if most people understood economics as well as Alfred Marshall understood it a century ago or David Ricardo two centuries ago.

As for what economists today can offer, there have been some very different assessments within the profession. Economics had long been christened “the dismal science” by those unhappy with all the promising-sounding social theories and policy proposals that economists punctured as counterproductive. However, in the wake of John Maynard Keynes’ economic theories, which proposed useful roles for government intervention, there was in many quarters a sense that economists could do much more than provide insights on particular problems or issue warnings against more ambitious but unsound policies. By the 1960s, there were Keynesian economists who spoke of their ability to “fine-tune” the economy. One of these was Walter Heller, Chairman of the Council of Economic Advisors under President John F. Kennedy:

 

Economics has come of age in the 1960’s. . . . the Federal government has an overarching responsibility for the nation’s economic stability and growth. And we have at last unleashed fiscal and monetary policy for the aggressive pursuit of those objectives. . . .Interwoven with the growing Presidential reliance on economists has been a growing political and popular belief that modern economics can, after all, deliver the goods.{1029}

 

The simultaneous rise of unemployment and inflation during the 1970s dealt a blow to Keynesian economics in general and to the idea that the government could fine-tune the economy in particular. Milton Friedman expressed a view that was the direct opposite of that expressed earlier by Walter Heller:

 

A major problem of our time is that people have come to expect policies to produce results that they are incapable of producing. . . . we economists in recent years have done vast harm—to society at large and to our profession in particular—by claiming more than we can deliver. We have thereby encouraged politicians to make extravagant promises, inculcate unrealistic expectations in the public at large, and promote discontent with reasonably satisfactory results because they fall short of the economists’ promised land.{1030}