Introduction

The history of economic thought deals with different thinkers and theories in the field of political economy and economics from the ancient world of Mesopotamia to the present day. British philosopher Adam Smith is often cited as the father of modern economics,^1,2 his ideas built upon a considerable body of work from predecessors in the eighteenth century particularly the Physiocrats. They in turn were applying ideas received from millennia before and attempting to integrate them to their time and place. In this sense, Smith was an interpreter of his day, of ages-old information.

In his works on politics and ethics, the Greek philosopher Aristotle examined ideas about 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 at the very beginning of industrial revolution, when technological advancement, global exploration, and material opulence that had previously been unimaginable became a reality.

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 described as exploitative and alienating. In the 19th century, neo-classical economics 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. Others 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.

Rapidly advancing technologies provide the means to achieve a transition of economies in the 21st century using Environmental economics and Ecological economics.³ Concepts using sustainable practices of methods of systems ecology and industrial ecology are now employed to an economic conception of Sustainable development.^4,5 We will look at the history through economic thought as follows:

1. Early Economic Thought
2. Mercantilism
3. Physiocrats
4. Classical Political Economy
5. Critique of Capitalism and Marxism
6. Neoclassical Thought
7. Keynesian Revolution
8. Chicago School of Economics and Monetarism
9. Austrian School of Economics

Early Economic Thought

The first recorded monetary economies were the ancient city states of Sumer. They developed a trade based market economy, using the commodity money of the shekel, which was a certain weight measure of barley. The Babylonians and their city state neighbours before them, developed the earliest system of economic regulations using a metric of various commodities, that was fixed in a legal code.⁶ The early law codes from Sumer could be considered the first (written) economic formula, and had many attributes still in use in the current price system today, such as codified amounts of money for business transactions (interest rates), fines in money for 'wrong doing', inheritance rules, and laws concerning how private property was to be taxed or divided.⁷ For a summary of the laws, see Babylonian law.

Interest-bearing debts were introduced to the Mediterranean lands from the Near East, most likely by Phoenician merchants in the 8th century BC along with their better known innovations such as alphabetic writing. It appears such debts, and for that matter, commercial and agrarian debts even without interest charges, are by no means a spontaneous and universal innovation. No indications of commercial or agrarian debts have been found in Early Bronze Age Egypt, the Indus valley, or even in Ebla, or in Mycenaean Greece.

These types of debts then are first documented in a particular part of the world, Sumer, in the third millennium, and can be traced diffusing from southern Mesopotamia upward along the Euphrates and westward into the Levant as part of the Sumerian commercial expansion. Originally much of the ancient concept of a debt structure is documented as being owed to temple and palace collectors.⁸From all appearances, 'debt cancellation' as a concept, (amargi) law by Enmetena, ruler of the Sumerian city-state of Lagash, c. 2400 BC, may have been the first known (written) legal proclamation of an economic nature. The idea of debt cancellation did not translate itself to Greek and Italian city state economies, as those economies adopted debt structures as regular features and interest-bearing debts became increasingly privatized, as they became westernized.⁹

Later economic discussion such as Chanakya's Arthashastra or Xenophon's Oeconomicus) all have their roots in the Middle east. In Ancient Athens, economically a slave based society, the embryonic model of democracy developed,¹⁰ Plato's book The Republic contained references to specialisation of labour and production. Aristotle made familiar arguments, still in economic discourse today.

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."¹¹

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".¹² "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."¹³ 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".¹⁴ 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".¹⁵ Aristotle disapproved highly of usury and also cast scorn on making money through monopoly.¹⁶ 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.¹⁷

During the Middle Ages, economic thought was primarily through the Scholastic school. Scholasticism was a method of learning taught by the academics (or school people) of medieval universities circa 1100–1500. Scholasticism originally started to reconcile the philosophy of the ancient classical philosophers with medieval Christian theology. Scholasticism is not a philosophy or theology in itself but a tool and method for learning which places emphasis on dialectical reasoning. The primary purpose of scholasticism is to find the answer to a question or to resolve a contradiction. It is most well-known for its application in medieval theology, but was eventually applied to classical philosophy and many other fields of study.

Scholasticism gets its start with late ancient figures like (early church fathers) St.Ambrose and St. Augustine who attempt to use Philosophy and Philosophical reason to help explain the doctrine and mystery's of the church. Ambrose and Augustine were among the first Church fathers to marry Christian sensabilities to Greek philosophy. The synthesis of Greek Philosophy and Christian Doctrine is the heart of scholasticism. (see also Christian Apologetics).

The main figures of scholasticism were Peter Abelard, Albertus Magnus, Duns Scotus, William of Ockham, Bonaventure and, above all, Thomas Aquinas, whose Summa Theologiae is an ambitious synthesis of Greek philosophy and Christian doctrine. Echoing the increasing influence of Aristotle above Plato in the 13th century, the deductive and a priori aspects of scholastic reasoning were to some extent displaced by the inductive reasoning of modern science.

Thomas Aquinas (1225-1274) was an Italian theologian and one of the earliest writers on the topic of economic issues. He taught in both Cologne and Paris was part of a group of Catholic scholars known as the Schoolmen who first moved their enquiries beyond theology to philosophical and scientific debates. In his treatise Summa Theologica Aquinas dealt with the concept of a just price, which was one necessary for the reproduction of the social order. Bearing many similarities with the modern 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.

"If someone would be greatly helped by something belonging to someone else, and the seller not similarly harmed by losing it, the seller must not sell for a higher price: because the usefulness that goes to the buyer comes not from the seller, but from the buyer's needy condition: no one ought to sell something that doesn't belong to him."¹⁸

Aquinas discusses a number of topics in the format of questions and replies, substantial tracts dealing with Aristotle's theory. Questions 77 and 78 concerned economic issues, mainly relate to what a just price is, and the fairness of a seller dispensing faulty goods. 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. One of Aquinas' main critics¹⁹ was Duns Scotus (1265-1308) in his work Sententiae (1295). Originally from Duns, Scotland he taught in Oxford, Cologne and Paris. 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. For more information on Scholasticism, see Scholasticism

Mercantilism

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. Mercantile theorists thought international trade could not benefit all countries at the same time. Because money and gold were 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.

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 (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.²⁰ Scholars are divided on why mercantilism was the dominant economic ideology for two and a half centuries. One group, represented by Jacob Viner, argues that mercantilism was simply a straightforward, common-sense system whose logical fallacies could not be discovered by the people of the time, as they simply lacked the required analytical tools. The second school, supported by scholars such as Robert B. Ekelund, contends that mercantilism was not a mistake, but rather the best possible system for those who developed it. This school argues that mercantilist policies were developed and enforced by rent-seeking merchants and governments. Merchants benefited greatly from the enforced monopolies, bans on foreign competition, and poverty of the workers. Governments benefited from the high tariffs and payments from the merchants. Whereas later economic ideas were often developed by academics and philosophers, almost all mercantilist writers were merchants or government officials.

A third explanation for mercantilism is monetary. European trade exported bullion to pay for goods from Asia, thus reducing the money supply and putting downward pressure on prices and economic activity. The evidence for this hypothesis is the lack of inflation in the English economy until the Revolutionary and Napoleonic wars when paper money was extensively used.

Mercantilism developed at a time when the European economy was in transition. Isolated feudal estates were being replaced by centralized nation-states as the focus of power. Technological changes in shipping and the growth of urban centers led to a rapid increase in international trade. Mercantilism focused on how this trade could best aid the states. Another important change was the introduction of double-entry bookkeeping and modern accounting. This accounting made extremely clear the inflow and outflow of trade, contributing to the close scrutiny given to the balance of trade. Of course, the impact of the discovery of America cannot be ignored. New markets and new mines propelled foreign trade to previously inconceivable heights. The latter led to “the great upward movement in prices” and an increase in “the volume of merchant activity itself.”

Prior to mercantilism, the most important economic work done in Europe was by the medieval scholastic theorists. The goal of these thinkers was to find an economic system that was compatible with Christian doctrines of piety and justice. They focused mainly on microeconomics and local exchanges between individuals. Mercantilism was closely aligned with the other theories and ideas that were replacing the medieval worldview. This period saw the adoption of the very Machiavellian realpolitik and the primacy of the raison d'état in international relations. The mercantilist idea that all trade was a zero sum game, in which each side was trying to best the other in a ruthless competition, was integrated into the works of Thomas Hobbes. The dark view of human nature also fit well with the Puritan view of the world, and some of the most stridently mercantilist legislation, such as the Navigation Acts, were enacted by the government of Oliver Cromwell. To learn more about mercantilism, read here.

Physiocrats

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.²¹ 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.

Locke believed that people contracted into society which was bound to protect their rights of property.²² 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."²³

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."²⁴

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."²⁵ 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 (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 (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. For more about the Physiocrats, see Physiocrats

Classical Political Economy

Classical economics is widely regarded as the first modern school of economic thought. It is the idea that free markets can regulate themselves. Its major developers include Adam Smith, David Ricardo, Thomas Malthus and John Stuart Mill. Sometimes the definition of classical economics is expanded to include William Petty, Johann Heinrich von Thünen. Adam Smith's The Wealth of Nations in 1776 is usually considered to mark the beginning of classical economics. The school was active into the mid 19th century and was followed by neoclassical economics in Britain beginning around 1870.

They produced their "magnificent dynamics" during a period in which capitalism was emerging from a past feudal society and in which the industrial revolution was leading to vast changes in society. These changes also raised the question of how a society could be organized around a system in which every individual sought his or her own (monetary) gain. Classical economists reoriented economics away from an analysis of the ruler's personal interests to a class-based interest. Physiocrat Francois Quesnay and Adam Smith, for example, identified the wealth of a nation with the yearly national income, instead of the king's treasury. Smith saw this income as produced by labor applied to land and capital equipment. Once land and capital equipment are appropriated by individuals, the national income is divided up between laborers, landlords, and capitalists in the form of wages, rent, and interest.

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).

Smith argued for a "system of natural liberty"³¹ 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."³²

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..."³³

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.

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."³⁴ 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.³⁵ Thirdly, Smith criticised government support of any kind of monopoly which always charges the highest price "which can be squeezed out of the buyers"³⁶ 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.

Jeremy Bentham (1748-1832) was perhaps the most radical thinker of his time, and developed the concept of utilitarianism. 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."³⁸

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.³⁹ Bentham even designed a comprehensive methodology for the calculation of aggregate happiness in society that a particular law produced, a felicific calculus.⁴⁰ Society, argued Bentham, is nothing more than the total of individuals,⁴¹ 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 populus? Despite Bentham's methodology there were severe obstacles in measuring people's happiness.

Jean-Baptiste Say (1767-1832) was a Frenchman, born in Lyon who helped to popularise Adam Smith's work in France.⁴² 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 Thornton⁴³ and John Stuart Mill. However two political economists, Thomas Malthus and Sismondi, were unconvinced.

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.⁴⁴ 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".⁴⁵ 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."⁴⁶ 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.⁴⁷ However more labour could mean more economic growth, either one of which was able to be produced by an accumulation of capital.

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.⁴⁸ 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.⁴⁹ 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.⁵⁰ 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.⁵¹ Suppose 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 (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. 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.⁵³ 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.⁵⁴ 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.⁵⁵ 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.⁵⁶ 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.⁵⁷

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,⁵⁸ the concept of opportunity cost and the rejection of the wage fund doctrine.⁵⁹ To learn more about classical economic theory, read here

Critique of Capitalism

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.

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.⁶⁰ 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.⁶¹ 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",⁶² 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)⁶³ Marx replied with a cynically titled article, The Poverty of Philosophy.⁶⁴ 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 1844⁶⁶ 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,⁶⁷ 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.

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,⁶⁸ 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.⁶⁹ 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).⁷⁰ Furthermore, people subjectively inflate the value of things, for instance because there's a commodity fetish for glimmering diamonds,⁷¹ 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".⁷² Therefore, says Marx, capitalism is a system of exploitation.

Marx explained the booms and busts, like the Panic of 1873, as part of an inherent instability in capitalist economies. 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.⁷³ 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.

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 advocated "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".

For more on the socialism, see socialism, Marxism, communism, and historicism.

Neoclassical Thought

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.

Carl Menger (1840-1921), an Austrian economist stated the basic principle of marginal utility in Grundsätze der Volkswirtschaftslehre⁷⁵ (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 than a last unit bought of something else. Stanley Jevons (1835-1882) was his English counterpart, and worked at University College, London. He emphasised in the Theory of Political Economy (1871) that at the margin, the satisfaction of goods and services decreases. An example of the theory of diminishing returns is that for every orange one eats, the less pleasure one gets from the last orange (until one stops eating). Then Leon Walras (1934-1910), again working independently, generalised marginal theory across the economy in Elements of Pure Economics (1874). Small changes in people's preferences, for instance shifting from beef to mushrooms, would lead to a mushroom price rise, and beef price fall. This stimulates producers to shift production, increasing mushrooming investment, which would increase market supply leading to a new lower mushroom price and a new price equilibrium between the products. For many products across the economy the same would go, if one assumes markets are competitive, people choose on self interest and no cost in shifting production.

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 commenting on Mill's assertion of crisis being "the destruction of belief and hope in the minds of merchants and bankers", 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.⁷⁶

To learn more about the marginalist revolution, you can listen to the following lecture

Concurrently with the Marginalist revolution there was a revolution in mathematical economics. Mathematical economics refers to the application of mathematical methods to represent economic theories and analyze problems posed in economics. It allows formulation and derivation of key relationships in a theory with clarity, generality, rigor, and simplicity. Mathematics allows economists to form meaningful, testable propositions about wide-ranging and complex subjects which could not be adequately expressed informally. This rapid systematizing of economics alarmed critics of the discipline as well as some esteemed economists.

The use of mathematics in the service of social and economic analysis dates back to the 17th century. Then, mainly in German universities, a style of instruction emerged which dealt specifically with detailed presentation of data as it related to public administration. Gottfried Achenwall lectured in this fashion, coining the term statistics. At the same time, a small group of professors in England established a method of "reasoning by figures upon things relating to government" and referred to this practice as Political Arithmetick.[3] Sir William Petty wrote at length on issues that would later concern economists, such as taxation, Velocity of money and national income, but while his analysis was numerical, he rejected abstract mathematical methodology. Petty's use of detailed numerical data (along with John Graunt) would influence statisticians and economists for some time, even though Petty's works were largely ignored by English scholars.

The mathematization of economics began in earnest in the 19th century. Most of the economic analysis of the time was classical economics. Subjects were discussed and dispensed with through algebraic means, but calculus was not used. More importantly, until Johann Heinrich von Thünen's The Isolated State in 1826, economists did not develop explicit and abstract models for behavior in order to apply the tools of mathematics. Thünen's model of farmland use represents the first example of marginal analysis. Thünen's work was largely theoretical, but he also mined empirical data in order to attempt to support his generalizations. In comparison to his contemporaries, Thünen built economic models and tools, rather than apply previous tools to new problems.

As the physical sciences became more systematized, economists pushed for a more formal methodology in economics. W.S. Jevons wrote the General Mathematical Theory of Political Economy in 1862, providing a rough outline for use of the theory of marginal utility in political economy. In 1874, he published The Principles of Science, declaring that "our science must be mathematical simply because it deals with quantities". Jevons expected the practice of statistics would become sufficiently sophisticated as to permit analysis of all decisions under the marginal utility framework.

To learn more about neoclassical economics, see neoclassical thought

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 (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 ⁷⁹ (1919) where he documented his outrage at the collapse of the Americans' adherence to the Fourteen Points ⁸⁰ and the mood of vindictiveness that prevailed towards Germany.⁸¹ 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.⁸² 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;⁸³ second, an arrangement to set off debt repayments between the Allied countries;⁸⁴ third, complete reform of international currency exchange and an international loan fund;⁸⁵ and fourth, a reconciliation of trade relations with Russia and Eastern Europe.⁸⁶

The book was an enormous success, and though it was criticised for false predictions by a number of people,⁸⁷ 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.

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."⁸⁸

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, Keynes also argued that low interest rates were not the only necessary condition to restore economic activity. If investors' expectations are pessimistic (they forecast that effective demand will not grow) they will not invest. So lasting unemployment was entirely possible, and there would be no automatic self correction without external intervention by government. Keynes advocated that state spending be financed by a budgetary deficit. In the desparate circumstances of 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.

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 Organisation ⁸⁹ at the Bretton Woods conference, a package designed to stabilise world economy fluctuations that had occurred in the 1920s and create a level trading field across the globe. Keynes died 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 year after the publication of Keynes' most important work, John Hicks designed the IS/LM model, which summarised 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).

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 minimise 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.

To learn more about Keynesian economics, see Keynesian Economics and New Keynesian Economics

Chicago School of Economics and Monetarism

The interventionist monetary and fiscal policies that the orthodox post-war economics recommended came under attack in particular by a group of theorists. Growing around the same time a more conservative strand of thought began to reassert a "libertarian" view of market activity, that people are best left to themselves, free to choose how to conduct their own affairs. Many worked at the University of Chicago, and more were awarded the Nobel Memorial Prize in Economic Sciences than from any other university. Just after Richard Nixon's declaration of conversion to Keynsianism, he took America out of the Bretton Woods system of international currency controls and the gold standard. From 1971, currencies could float. Internationally this adversely affected oil producing countries, who were paid in dollars. Combined with indignation at America and Europe's support for Israel in the Yom Kippur War of 1973, the Organisation of the Petroleum Exporting Countries imposed an oil embargo, and thereafter maintained higher prices with lower output. Consequently, the West was forced into a period of stagflation, which libertarian economists argued was inexplicable and insoluble through Keynesian prescriptions. In 1980, Ronald Reagan was elected in the United States and followed a tax cutting policy to stimulate the economy, known as supply-side economics. Reforms to privatise industry, deregulate markets and shrink government became the new orthodoxy.

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.¹⁰²

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."¹⁰³

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.¹⁰⁴ 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.

To learn more about the scholars from the Chicago school, see Chicago School of Economics. To learn more about monetarism, see Monetarism

Austrian School of Economics

The Austrian School (also known as the “Vienna School” or the “Psychological School”) is a heterodox school of economics that emphasizes the spontaneous organizing power of the price mechanism. It holds that the complexity of subjective human choices makes mathematical modelling of the evolving market extremely difficult (or impossible) and advocates a laissez faire approach to the economy. Austrian School economists advocate the enforcement of voluntary contractual agreements between economic agents, but otherwise the smallest imposition of coercive force (especially government-imposed) on commercial transactions.

Although often controversial, the Austrian School was once influential dating back to the early 20th century, but currently contributes relatively little to mainstream economic thought. The Austrian School derives its name from its predominantly Austrian founders and early supporters, including Carl Menger, Eugen von Böhm-Bawerk and Ludwig von Mises. Despite this name, supporters and proponents of the Austrian School can come from any part of the world, and there are now few Austrian School economists of Austrian nationality. Prominent Austrian School economists of the 20th century include Joseph Schumpeter, Henry Hazlitt, Murray Rothbard, and Nobel Laureate Friedrich Hayek.

Austrian School economists advocate strict adherence to methodological individualism – analyzing human action from the perspective of individual agents. Austrian School economists argue that the only means of arriving at a valid economic theory is to derive it logically from basic principles of human action, a method called praxeology. Proponents of this method hold that it allows for the discovery of fundamental economic laws valid for all human action. Alongside praxeology, the school has traditionally advocated an interpretive approach to history to address specific historical events. Critics of the method contend that it lacks scientific precision, as it eschews formal mathematical models and uses verbal logic instead. Mainstream economists believe that this makes Austrian theories too imprecisely defined to be clearly used to explain or predict real world events.

The school originated in Vienna, in the Austrian Empire. However, later adherents of the school such as Murray Rothbard have derived the roots of the thought of the Austrian School from the Spanish Scholastics teaching at the University of Salamanca of the 15th century and the French Physiocrats of the 18th century. The School owes its name to members of the German Historical School of economics, who argued against the Austrians during the Methodenstreit ("methodology struggle"), in which the Austrians defended the reliance that classical economists placed upon deductive logic. Their Prussian opponents derisively named them the “Austrian School” to emphasize a departure from mainstream German thought and to suggest a provincial, Aristotelian approach. The name “Psychological School” derived from the effort to found marginalism upon prior considerations, largely psychological. The school was no longer centered in Austria after Hitler came to power, and is now based almost entirely in the United States.

Carl Menger was closely followed by Eugen von Böhm-Bawerk and Friedrich von Wieser, in what is known as the "first wave" of the School. Austrian economists developed a sense of themselves as a school distinct from neoclassical economics during the economic calculation debate with socialist economists. Ludwig von Mises and his student Friedrich A. Hayek represented the Austrian position in contending that without monetary prices and private property, meaningful economic calculation is impossible. The Austrian economist Böhm-Bawerk wrote extensive critiques of Marx in the 1880s and 1890s, as was part of the Austrian economists' participation in the late 19th Century Methodenstreit, during which they attacked the Hegelian doctrines of the Historical School.

Austrian economics after 1920 can be broken into two general trends. One, exemplified by Friedrich A. Hayek and Joseph Schumpeter, while distrusting many neoclassical concepts (like most of the corpus of Keynesian macroeconomics), generally accepts a large part of the neoclassical methodology; the other, exemplified by Ludwig von Mises, seeks a different formalism for economics. The main area of contention between the mainstream and the Austrian school is on their view of the market system as a process, not only to be studied using equilibrium models, but to be viewed as an incessant process that only tends toward a constantly changing equilibrium, this difference is the root of the Austrian business cycle theory, the economic calculation debate, and their different views of monopoly and competition. The second primary area of contention between neoclassical theory and the Austrian school is over the possibility of consumer indifference – neoclassical theory says it is possible, whereas Mises rejected it as being “impossible to observe in practice.” This is a more philosophical problem, than one directly relevant to the understanding of the operation of the market. The third major dispute arose when Mises and his students argued, building on Czech economist Franz Cuhel, that utility functions are ordinal, and not cardinal; that is, the Austrians contend that one can only rank preferences and cannot measure their intensity, in direct opposition to the neoclassical view at the time. However, mainstream theorists since then have shown that their results hold for all monotonic transformations of utility, and so also hold for ordinal preferences. Finally there are a host of questions about uncertainty raised by Mises and other Austrians, who argue for a different means of risk assessment. These questions are directly linked to the market process approach to economic theory, since the world of probabilistic uncertainty is the equilibrium world. Only immersed in a world of genuine uncertainty the market process theory is relevant.

Austrian economics was ill-thought of by most economists after World War II because it rejected mathematical and statistical methods. Its reputation rose somewhat in the late 20th century with the work of Israel Kirzner and Ludwig Lachmann, as well as a renewed interest in Hayek after he won the Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel (a.k.a. the Nobel Prize in Economics). Following Hayek, one of Ludwig von Mises's students, Murray Rothbard, become prominent in both Austrian applied theory and Libertarian philosophical thought. However, it remains a distinctly minority position, even in such areas as capital value. Currently, universities with a significant Austrian presence are George Mason University and Loyola University New Orleans in the United States, and Universidad Francisco Marroquín in Guatemala. The library of Universidad Francisco Marroquín is named after Ludwig von Mises, and the university also provides seminars and lectures through a program named for Austrian School proponent Henry Hazlitt. Austrian economic ideas are also promoted heavily by bodies such as the Mises Institute and the Foundation for Economic Education.

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