[This is a second essay from an earlier semester. Unlike the first essay that was reproduced on Ignore This, this essay maintains both its bibliography and in-text citations. I think this is for the best given that I cite mostly books here, hyperlinks for which are difficult to obtain and which, in any event, would doubtless be confusing for readers because I know of no way to link directly to the relevant passages. Like the previous essay, though, the following has been only lightly edited.]
The purpose of this essay is to provide a brief overview of the progression of economic thought. Beginning with Adam Smith and David Ricardo, some of the more important formative economic concepts are discussed. Thereafter, challenges to these classical economists are presented in the ideas of Karl Marx, Thorstein Veblen, and John Maynard Keynes. Joseph Schumpeter’s contributions are also considered in light of Marx, Keynes, and the Great Depression. Finally, we briefly discuss the ideas of Friedrich Hayek, Milton Friedman, and supply-side economists, which arose as a counterpoint to the challenges posed by Marx, Veblen, and Keynes. The paper concludes with a few words on Friedrich Hayek’s 1945 essay, “The Use of Knowledge in Society,” and the economist Leonard Read’s classic, “I, Pencil.”
A Brief Survey of the History of Economic Thought
There is potentially a great deal of insight to be gained from studying the history of economic thought. Contrary to those who might insist that only the best, most correct economic ideas are perpetuated, such an assertion isn’t obvious. Humans, as fallible creatures, both lack perfect knowledge of events as they transpire and are prone to exerting undue influence upon one another depending on their institutional arrangements. Though we, of the present, also lack perfect knowledge of the relationship of each factor to each other factor in the unfolding of historical events such as the Great Depression, we are able to approach them with the benefit of hindsight, which provides a great deal of added insight not available to economic thinkers of the past. In surveying the development of economics, we see a trend that emerges through time: as a pendulum swings back and forth in a clock, so the concentration of economic ideas sways away from economic freedom toward state intervention, and vice versa.
Adam Smith, born 1723 in Kirkcaldy, Scotland is widely considered the father of economics (Heilbroner 1999, p. 46). With the publication of his second, more famous work, An Inquiry into the Nature and Causes of the Wealth of Nations (or simply The Wealth of Nations), Smith made what is still today a cogent and compelling argument, that an exchange must benefit both parties, or else the trade will not take place. Furthermore, the division of labor, Smith argued, is a powerful means of increasing economic output and, therefore, growth. As individuals, firms, and nations begin to engage in smaller portions of labor—that is, as they specialize—and exchange their specialized output with others, the productive capacity of the economy increases. Thus, specialization and trade lead to prosperity. Moreover, nations, as well as individuals, that attempt to be utterly self-reliant in the creation of every conceivable good will be the poorer for it, and attempts to curtail exchange between nations through tariffs and quotas hinder economic growth. Indeed, wrote Smith, “[i]f a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry employed in a way in which have we have advantage” (qtd. in White 2012, p. 213).
Adam Smith’s perception of trade was partly in error, however. Whereas Smith perceived trade between nations as occurring when each nation has an absolute advantage in some good that the other does not, David Ricardo recognized that trade would still be beneficial even if one nation had an absolute advantage in any two given trade goods. The essential piece Smith was missing in his analysis of trade, Ricardo discovered, was opportunity cost (White 2012, p. 368). To use a modern example, if a large, prosperous nation like the United States had an absolute advantage in the production of both potatoes and gasoline engines over, say, India, then determining what trade policy between the two nations for those particular goods would maximize output involves finding out which product they each produce at a lower opportunity cost.
Imagine that a farmer in the United States can harvest five bushels of potatoes in one hour, while his Indian counterpart can only harvest three. In that same hour, one Indian mechanic can assemble one gasoline engine and one American mechanic can assemble five gasoline engines. Before trade, one hour’s total output between the two nations would be eight bushels of potatoes and six gasoline engines. If the United States were to cease the growing and harvesting of potatoes altogether, re-employing their potato farmer to make gasoline engines, then the country could produce ten gasoline engines per hour. If, conversely, the American mechanic were employed harvesting potatoes, the United States could produce ten bushels of potatoes per hour. By the same token, if India only harvested potatoes, it could harvest six bushels per hour, or, producing only gasoline engines, it could assemble two engines per hour. Thus, the opportunity cost of producing one gasoline engine in India is three bushels of potatoes. By contrast, in the United States, the opportunity cost of producing one gasoline engine is only one bushel of potatoes. India thus harvests more potatoes per gasoline engine than does the United States, and the nations would be better off specializing in potatoes and gasoline engines, respectively, and then trading. However, with trade under conditions of total specialization, total output of gasoline engines increases nearly twofold, but total potato output declines by a quarter. For output of both potatoes and gasoline engines to increase the United States would need only employ one gasoline mechanic to split his work-hour between potatoes and gasoline engines, bringing total output to eight-and-one-half bushels of potatoes and seven-and-one-half gasoline engines.
An Increasing Role for the State
Critical of these and other “classical” economists, Karl Marx nevertheless adopted their view of the value of goods—that which is today referred to as the “labor theory of value,” which defines the value of a good by the amount of labor that was required to produce it. Though this concept would later be overturned by the “marginalist revolution,” instigated simultaneously (though quite independently) by the so-called “neoclassical” economists Carl Menger of Austria, Leon Walras of France, and William Stanley Jevons of England in 1871, the idea that labor defined value was crucial to Marx’s critique of capitalism (White 2012, p. 45). Following the logic that a good’s value resided in its constituent labor, Marx argued that the value of one worker was precisely the number of labor hours required for that worker to earn enough to feed, clothe, and house himself. Beyond that number of hours, the worker was being “exploited” by his employer, to whom the “excess value” produced by the laborer redounds. Because employers—Marx’s much maligned capitalists, the owners of capital—owned the means of production, Marx believed they also had total control over the workers they exploited. Thus, capitalists needed to be overthrown, the means of production seized, and laborers put into power in order to create an equitable society (Heilbroner 1999, pp.157-158). Moreover, in Marx’s view such an outcome was inevitable. Indeed, capitalism would ultimately eat itself as a result of an endless series of economic depressions, ultimately inciting the increasingly fed up working class to revolution. The means of production seized and the workers in power, the Marxian society would grow out of the ashes of its predecessor (Heilbroner 1999, p. 147).
An American economist, Thorstein Veblen, disagreed with Marx’s foretelling of events. Looking at the previous decades from his perspective in 1899, the year he published his book Theory of the Leisure Class, Veblen noted that, far from becoming fed up with a series of economic collapses, the working class instead tended to mimic the upper class in terms of lifestyle and consumption (Heilbroner 1999, pp. 233-234).
This “conspicuous consumption,” in Veblen’s vernacular, not only undermined Marx’s vision of what the fall of capitalism and the rise of socialism would entail, but also poked holes in the neoclassical framework of utility-maximizing individuals. Argued Veblen, since individuals derive their demand for goods on the basis of what they observe others consuming, it does not follow that consumers are in any sense “sovereign,” but are rather subject to the whims of firms looking to sell goods by manufacturing demand artificially. It therefore does not follow that resources are pooled toward their most valued uses, and, in fact, a great deal of social value would result from state intervention (Breit 1998, pp. 38-39).
Thorstein Veblen’s fellow Briton John Maynard Keynes likewise saw tremendous merit in the role of government to correct the failings of an imperfect market. Whereas the neoclassical economists before him denied any possibility of persistent unemployment due to the mechanism of Say’s Law (which, in short, asserts that “supply creates its own demand”), Keynes saw a “stickiness” in the wages of laborers that prevented those wages from falling in response to economic downturn, which made it impossible for markets to adjust appropriately. Because of this inability for markets to equilibrate, Keynes argued, it is necessary for government to increase its spending during periods of economic crisis to ensure that total demand is sufficient to maintain full employment (White 2012, pp. 129-130). Disciples of Keynes in the future, most notably the American economist Alvin Hansen, would extend this reasoning to justify incessant government spending in the interest of economic stabilization (Breit 1998, p. 98).
In contrast to Keynes and his disciples, the Austrian economist Friedrich Hayek viewed state incursions into the economy as being the cause of, rather than the cure to, economic downturns. To take the most obvious historical example—an example of significant currency in Hayek’s career—the Great Depression was, in Hayek’s estimation, the result of an artificial bubble that was created by the Federal Reserve’s policy of cheap credit, which resulted in a lower-than-market interest rate. Hayek saw this cheap credit policy as unduly inducing investors to enter into borrowing agreements that they would have otherwise avoided due to higher interest rates. When the Federal Reserve allowed interest rates to climb toward their market levels, the loans taken out by investors began to be too expensive. Because the lower-than-market interest rate had also induced investment rates beyond what private savings would have financed, this created an impetus for further intervention on the part of the Federal Reserve, which ultimately worsened the Depression (White 2012, pp. 85, 131-132).
The economist Joseph Schumpeter perceived the underlying causes of the Great Depression differently: the severity of the Depression itself was due, in Schumpeter’s view, to the convergence of three varieties of business cycles—one short and frequently occurring, one long and happening only approximately once every fifty years, and one of more modest recurrence at a frequency of between seven and eleven years—along with exogenous influences of the era such as the Russian Revolution (Heilbroner 1999, p. 299).
A resurgence in neoclassical economic thought produced an approach to the macro-economy that contrasted the approaches of Keynes, Hayek, and Schumpeter, namely monetarism. Perhaps its greatest exponent was Milton Friedman, whose research augmented the earlier neoclassical quantity theory of money with the addition of empiricism, examination of the money stock’s relationship to the level of prices in the economy, and a formal, testable approach to the idea that markets are self-correcting, which sought to explain the apparent cyclicity of levels of employment and real income on the basis of shocks to the money supply and subsequent normalization (White 2012, p. 321). Another powerful insight that came out of the era of monetarism was that of rational expectations, which asserts that individual economic actors adjust their economic behavior as a response to actions they expect governments to undertake. This insight, captured in a statement uttered a century earlier by Abraham Lincoln that, “[y]ou can’t fool all of the people all of the time,” provided strength to Friedman’s long-held policy recommendation that governments, rather than attempting to micromanage things in the economy, should provide a scheme of stable, predictable market rules to foster economic growth (Breit 1998, pp. 247-248).
Milton Friedman’s influence on economic thought was reflected in the rise of what became known as supply-side economics. Supply-side economists argue, with Adam Smith and the classical economists, that individual self-interest is crucial to economic growth. As economic actors seek to do what is best for themselves, their activities coincide to hold down both inflation and unemployment in the long-run. Arthur Laffer is one such supply-side economist, and his model—known as the Laffer Curve—gives graphical insight into the supply-side contention that tax rates influence the economic behavior of individuals: as tax rates increase, individuals become increasingly induced to engage in non-economic activities over economic activities for which they will be taxed. This relationship continues upward until some point at which the revenues garnered from taxation are no longer increasing, but instead begin to fall. This relationship suggests that, depending upon the point along the Laffer Curve where present taxation resides, it is possible to increase total tax revenue with a decrease in tax rates (Breit 1998, pp. 249-250).
Friedrich Hayek: The Use of Knowledge in Society
Published in 1945 in the American Economic Review, Friedrich Hayek’s essay, “The Use of Knowledge in Society,” was written as a rejoinder to market socialist Oskar Lange, with whom Hayek had been debating the issue of central planning.
Hayek begins his essay with an inquiry into the nature of the economic problem. He asserts that if we assume that all necessary information—from preferences to productive means—is readily available to us, then the question is merely one of best distribution, which can be approached from mathematical models. However, Hayek argues, this is not the point at which we find ourselves precisely because the necessary knowledge is not “‘given’ to a single mind.” Instead, knowledge is widely contained (though incompletely and sometimes contradictorily) in the minds of the millions of economic actors in an economy. Planning, therefore, is only appropriate insofar as it is conducted locally, that is, by each economic actor himself, because central planning is effectively impossible.
The reality of the economic problem, says Hayek, is that of how to address change as it happens, and the more centralized is the control, the less responsive markets are to change. This is where the importance of the price system comes about. As resources are competed for in a free market, they tend to flow toward their most valued uses. The individual consumer does not need to know the particulars of why, say, corn is less expensive than wheat, or that the differences in price indicate that wheat has higher value elsewhere, in order to know that corn would be a more economical choice by comparison. In thus tending toward maximal utility by responding to differences in price, the economic problem is most effectively addressed at the level of the individual economic actor.
Leonard E. Read: I, Pencil
Published in 1958 in the Foundation for Economic Education’s now-defunct periodical The Freeman, Leonard E. Read’s classic essay, “I, Pencil: My Family Tree as Told by Leonard E. Read,” (or just “I, Pencil”) describes the mechanism by which order spontaneously (that is, without a guiding mind) emerges in a free market from the perspective of a pencil.
The essay begins with the pencil describing its constituent parts with the statement that “not a single person on the face of this earth knows how to make me,” in spite of its ostensible simplicity. Among its “antecedents” is cedar wood, which was harvested by loggers using tools made from metal whose ore had to be taken from the ground by still other tools; using rope crafted from hemp; laborers nourishing themselves with food that took the time and effort of other laborers growing it, harvesting it, and processing it; and maintaining mental alertness with coffee which “untold thousands had a hand in” bringing to their worksite. The graphite contained within the pencil, mined in Sri Lanka, was shipped in paper, tied in string, carried on boats which were led safely to harbor by lighthouses, all of these steps having their own long series of production, the totality of which no single person could grasp, much less organize. Such attention is given to the pencil’s lacquer, the tiny metal piece that holds the eraser, the eraser itself, and the label.
The pencil then states, “millions of human beings have had a hand in my creation, no one of whom even knows more than a very few of the others.” As such, there is no central authority that has all of the knowledge required to effect the pencil’s creation, much less the creation of all of its “antecedents.” And yet, time and again governments have taken over charge of the economy in order to plan for the production of such things. Once such power accumulation occurs, the pencil laments, using the delivery of mail as an example, “most individuals will believe that the mails could not be efficiently delivered by men acting freely.”
This is the intent to which the pencil relates its tale: to warn men away from the hubris that leads to state intervention into the economy. The economy is far too complex for any governing individual or quorum to direct. Rather, it is driven along by the individual interactions of free people seeking their own self-interest. Given these truths, it is best that men retain a sense of perspective and humility when they first conceive of any notion of solving centrally a problem that is better dealt with organically.
The history of economic thought, from Adam Smith to supply-side economics, has been as a great pendulum, swinging here toward state intervention, there back toward freedom. In studying the insights of the economists mentioned in the body of this essay, along with the works of those many left unmentioned, we have a lens through which we can measure the general direction we desire the pendulum to swing. While it may not ever be possible to discover exactly what balance to strike between state involvement in economic matters and utter economic freedom, we can at least obtain a sense of direction with which we can orient ourselves.
Breit, W. (1998). The academic scribblers (3rd ed.). Princeton University Press.
Heilbroner, R. L. (1999). The worldly philosophers: The lives, times, and ideas of the great economic thinkers (7th ed.). New York, NY: Touchstone.
White, L. H. (2012). The Clash of economic ideas: The great policy debates and experiments of the last hundred years. Cambridge: Cambridge University Press.
Hayek, Friedrich A. “The Use of Knowledge in Society.” 1945. Library of Economics and Liberty. Retrieved 23 April 2018 from the World Wide Web: http://www.econlib.org/library/Essays/hykKnw1.html.
Read, Leonard E., “I, Pencil: My Family Tree as told to Leonard E. Read.” 1999. Library of Economics and Liberty. Retrieved 23 April 2018 from the World Wide Web: http://www.econlib.org/library/Essays/rdPncl1.html.