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September 2012 A Short History of Economic POLICY Theory STUDY No. 12-9 by Adam Wachholz Public Interest Institute Mount Pleasant, IA A Short History of Economic Theory Policy Study September 2012 No. 12-9 Public Interest Institute Dr. Don Racheter, President POLICY STUDIES are published as needed. They are longer, analytical articles on important public issues. POLICY STUDIES are published by Public Interest Institute at Iowa Wesleyan College, a nonpartisan, nonprofit, research and educational institute whose activities are supported by contributions from private individuals, corporations, companies, and foundations. The Institute does not accept government grants. Contributions are tax-deductible under sections 501(c)(3) and 170 of the Internal Revenue Code. Permission to reprint or copy in whole or part is granted, provided a version of this credit line is used: “Reprinted by permission from POLICY STUDY, a publication of Public Interest Institute.” The views expressed in this publication are those of the authors and not necessarily those of Public Interest Institute. If you have an article you believe is worth sharing, please send it to us. All or a portion of your article may be used. This publication is brought to you in the interest of a better-informed citizenry, because IDEAS DO MATTER. We invite you to: CALL us at 319-385-3462 FAX to 319-385-3799 E-MAIL to Public.Interest.Institute @LimitedGovernment.org VISIT our Website at www.LimitedGovernment.org WRITE us at our address on the back cover Contents Executive Summary 3 Adam Smith: Laissez-Faire and the Beginning of Economic Thought 5 Classical Economic Theory: From Adam Smith to Jean-Baptiste Say 8 Karl Marx: The Rise of Collectivism 14 John Maynard Keynes: the Triumph of Government Interventionism 17 Milton Friedman: Rebirth of Liberty 20 The Gold Standard: Medium, Measure, Standard, and Store 24 War of Ideas: Economic Growth and Stabilization Policy 26 Endnotes 28 Copyright 2012 Policy Study Public Interest Institute, September 2012 Executive Summary Economic theories have dominated the last three centuries of world history, and it is imperative that we understand their development and implications for the future. Starting in 1776 with Adam Smith and his seminal work The Wealth of Nations, early economic theory championed the free market and individual liberty. Smith identified the division of labor, money, and the invisible hand as crucial components to a functioning economy, formalizing many basic economic tenets. At the core of Smith’s ideas was a belief in the power of individuals to make correct choices about production and consumption, rather than an ubiquitous central authority. The principles of limited government espoused by Smith were a sharp contrast to the view of monarchy that persisted throughout the 18th century. In the infant United States, Smith’s theory found purchase, driving a century of rapid industrialization and expansion. For all of Smith’s genius, he lacked understanding when it came to a vital part of dynamic economies: entrepreneurism. Into this gap stepped Jean-Baptiste Say, the foremost political economist of the early 1800s. In the chaotic world of the Napoleonic Wars, Say became a quintessential entrepreneur, starting a successful textile business in France before developing his famous Law of Markets. Say’s experience as a doer in the free market allowed him to see the importance of innovative entrepreneurs who make the economy function. By adding the entrepreneur into Smith’s theory, Say brought the capitalistic model to completion. The collectivist answer to Smith and Say’s free market came from Karl Marx in his 1867 work Das Capital. Marx viewed the laissez-faire free market as an exploitative function of business owners’ greed, ignoring the Industrial Revolution’s beneficial impact on all levels of society. Taking a stand in staunch opposition to profits, Marx argued that the real value of a product was determined by the amount of labor expended in its production, ergo, anything paid for the product above the laborer’s wages was tantamount to theft. Das Capital radically altered the framing of economic debates, moving to a “dialectic materialism” model based on class warfare. Although his stated goal was to free the common man from the oppression of capitalism, Marx’s introduction of communism into economic theory established some of the most oppressive regimes in history. While the war between supporters of centralized economic control and free markets raged, John Maynard Keynes shaped modern macroeconomic theory in Policy Study Executive Summary “Starting in 1776 with Adam Smith and his seminal work The Wealth of Nations, early economic theory championed the free market and individual liberty. Smith identified the division of labor, money, and the invisible hand as crucial components to a functioning economy.” Public Interest Institute, September 2012 A Short History of Economic Theory “In response to Keynes’s dismissive attitude towards Smith and Say’s theories, Milton Friedman led an explosive rebirth of economic liberty in his 1964 book Capitalism and Freedom.” his 1936 book The General Theory of Employment, Interest, and Money. Adopting a distanced tone from the early concepts of capitalism, Keynes worked to establish the government as an arbiter of the economy, utilizing fiscal policy to “smooth” the business cycle. Keynes believed that government spending had tremendous simulative effects and advocated an interventionist mindset based on his theories about the marginal propensity to consume and the multiplier effect. His writings had broad policy implications, such as President Franklin D. Roosevelt’s New Deal, which shaped much of the 20th century’s understanding of the relationship between government and the economy. At best, Keynes’ work represented a misguided attempt to fuse the best of Marx and Smith together, and at the worst provided justification for highly restrictive government control over an economy in crisis. In response to Keynes’s dismissive attitude towards Smith and Say’s theories, Milton Friedman led an explosive rebirth of economic liberty in his 1964 book Capitalism and Freedom. This concise work clearly articulated the values of small government and economic freedom, while critiquing Keynes’s fiscal policy suggestions. In addition, Friedman introduced the concept of monetary policy and its connection to Policy Study economic growth, founding the Monetarist school of thought. He also examined the effects of government welfare on society, contrasting it with the benefits of an unbridled free market and detailing the consequences of redistributionist policies. Friedman successfully rebutted the forces of economic collectivism and centralized power, epitomized by Marx and Keynes, and revitalized the faltering forces of advocates for liberty. Without a doubt, one of the most controversial aspects of applied economic theory is the value of a gold standard. Smith and Friedman both acknowledged the benefits of a gold standard; Smith for its use as a currency, and Friedman for its ability to protect against an intrusive government. However, the supply of gold expands much more slowly than the economy, leading to constant deflation when a currency is tied to gold. Additionally, gold has high resource costs and can consume a significant portion of the economy simply to provide a currency. Ultimately, Friedman advocated a fiat currency administered automatically, which would prevent abuses of federal power and avoid the disadvantages of a pure gold standard. Using economic stabilization policy to promote growth has divided economists into three warring camps: the Keynesians, the Monetarists, and the Neoclassicists. The Public Interest Institute, September 2012 Keynesians believe that business cycles should be stabilized by government intervention, raising taxes and cutting spending during an expansion, while doing the opposite during a recession. Monetarists hold that fluctuations in the money supply lead to booms and busts, calling for an end to the discretionary policy of the Federal Reserve and the implementation of an automatic system to give the economy a reliable currency. Followers of Smith, the Neoclassicists seek renewed laissez-faire policies that allow business cycles to “work themselves out” and believe that the economy is naturally selfcorrecting without government interference. Adam Smith: LaissezFaire and the Beginning of Economic Thought As Benjamin Franklin said, “All mankind is divided into three classes: those that are immovable, those that are movable, and those that move.”1 Among those that history remembers as “those that move,” one of its greatest is the Scottish moral philosopher Adam Smith. Through his magnum opus, An Inquiry into the Origin and Causes of the Wealth of Nations, Smith imparted the principles of laissez-faire capitalism to generations of producers, economists, and governments. Eventually, the publishing of The Wealth of Nations led to an avalanche of prosperity that engulfed the entire world. In The Wealth of Nations, Adam Smith brilliantly shaped the principles of the division of labor, nature of money, “invisible hand,” political economy, and taxation, but ignored the fundamental role that entrepreneurship plays in the creation of wealth. Understanding the division of labor is critical to Smith’s free-market model, since it embodies the ideas of production, exchange, and self-interest. At the foundation of the division of labor theory is the idea that the production of goods and services is most efficient if each worker specializes in some specific task, rather than an entire manufacturing process. Rather than have each citizen be a “jack of all trades,” a town might have a baker, a tanner, a brewer, a carpenter, etc., each of whom specializes in a certain product. Since each producer can generate far more than is necessary for his private consumption, the division of labor naturally leads to exchange among the various producers for items that they require but cannot produce.2 The self-interest of each producer to acquire material necessities can be fulfilled through a simple barter economy where all citizens exchange their excess produce for the excess produce of others. Smith readily admits Policy Study A Short History of Economic Theory “At the foundation of the division of labor theory is the idea that the production of goods and services is most efficient if each worker specializes in some specific task, rather than an entire manufacturing process.” Public Interest Institute, September 2012 A Short History of Economic Theory “At its core, the ‘invisible hand’ is a liberty-based philosophy that advocates minimum interference in the personal lives of producers and consumers.” to the limits of the division of labor, acknowledging that some trades and manufactories can only exist inside of towns and cities, due to the low population of the countryside.3 The ability to specialize in certain skills and exchange the products of labor with others would be impossible without the use of money as a medium of exchange. Although many regard the acquisition of money as wealth, Smith debunks this notion with an explanation of money as nothing more than a tool of exchange or measurement of value. Prior to the advent of capitalism, the predominant economic theory was mercantilism, which held that wealth was measured in precious metals, and a nation could only become wealthy by stockpiling gold and silver. Smith demonstrated that money, whether gold, silver, or paper, is merely a medium of exchange between producers, not an actual form of wealth. Money is immensely preferable to barter, since it allows large products (like cattle) to be broken into numerous pieces (money), and be used to purchase a small quantity of another product (such as salt or flour).4 According the Smith, true wealth merely equates to the purchasing power possessed by an individual, not the amount of currency that that individual owns.5 Additionally, money provides a convenient way to measure the value of labor, and brings Policy Study about the conclusion that wealth is really a measure of the power to purchase labor.6 By firmly establishing that the creation and exchange of wealth is most efficient under a system utilizing money and the division of labor, Smith demonstrates how the free market will distribute goods and services. In his defining thesis, Smith explained that as individuals sought their own self-interest, they would benefit society through an efficient distribution of resources. The key to understanding the “invisible hand” is Smith’s underlying worldview that individuals, not statesmen, know best how to spend the proceeds of their labor. He argued that as citizens sought their own self-interest through production and exchange, they would inevitably benefit society as a whole by efficiently distributing goods and services throughout the economy. At its core, the “invisible hand” is a liberty-based philosophy that advocates minimum interference in the personal lives of producers and consumers. Smith claimed that any interference in free trade harms all involved, from the most distant consumers or producers to those that the interference was designed to help.7 Smith applies this concept to the international level with his arguments against mercantilism and in favor of free trade. Adhering to his Public Interest Institute, September 2012 principle of division of labor, Smith expounds on the dangers of tariffs to productivity and exchange, as well as the economic principles behind colonial empires. Tariffs, or a tax on imports, would always harm the economy of the nation imposing them, Smith stated, because it promoted economic inefficiency and forced consumers to pay higher prices.8 Tying this idea to Britain’s enormous empire, Smith defined colonies as attempts to form monopolies over resources and consumers in North America.9 Colonies were economically inefficient, according to Smith, because of the fact that they constituted a vast tariff, doomed to fail because of the nature of the “invisible hand.” He lamented the fact that this principle was not understood by the Empire’s leaders and would lead to war with the colonies (already rebelling against unjust taxation) in an attempt to dominate North America.10 Following his arguments on the political economy, Smith examined the role that a sovereign nation should play in the taxation of its citizens. While readily admitting certain necessary expenses that an independent nation must incur, Smith warns against a large public debt that diverts valuable labor away from production. He acknowledged the necessity of a defensive military force to protect citizens against an aggressive enemy, as well as courts to maintain the domestic peace.11 Of utmost importance to Smith were public institutions, from bridges and harbors to roads and libraries, whose costs were exorbitantly high and would deter private investors.12 Because the division of labor rarely provides opportunities for the worker to challenge his mental faculties, Smith trumpeted the value of a universal, basic education funded by the government.13 Finally, Smith conceded certain “ceremonial costs” that governments must bear to maintain the “dignity of the sovereign.”14 After listing justified uses of tax revenue, a stern warning is issued against large public debts, since they draw wealth away from the productive economy, in direct opposition to the “invisible hand.”15 Although Smith brilliantly explained the principles of production, he ignored entrepreneurship, a vital component of the free market. Entrepreneurship leads to dynamic growth, a factor that Smith did not consider when describing the production and exchange of goods. Although Smith briefly mentioned it during his description of the “components of price,” entrepreneurship allows risks to be taken for a profit to be made, sparking investment into new industries. Last, entrepreneurship moves resources from unproductive areas into highly productive ones, as explained by the Policy Study A Short History of Economic Theory “Tariffs, or a tax on imports, would always harm the economy of the nation imposing them, Smith stated, because it promoted economic inefficiency and forced consumers to pay higher prices.” Public Interest Institute, September 2012 A Short History of Economic Theory French economist Say, himself a pioneer of cotton manufacturing.16 In spite of Smith’s disregard for entrepreneurship, The Wealth of Nations laid the groundwork for centuries of free markets and prosperity. Although it ignored the role of entrepreneurship, Adam Smith’s The Wealth of Nations is a vividly conceived explanation of taxation, political economy, the “invisible hand,” money, and the division of labor. Without a doubt, Smith was one of the great “movers” of history, and gave a foundation to all future economists. The Wealth of Nations, published in 1776, helped disseminate the ideas of freedom to the world, prepare it for the onset of the Industrial Revolution, and ultimately contribute to the founding of the United States. Classical Economic Theory: From Adam Smith to JeanBaptiste Say “It lay with Jean-Baptiste Say to complete what Smith had started and perfect the ideal of a capitalistic system of economics.” The publishing of An Inquiry into the Origin and Causes of the Wealth of Nations by Adam Smith in 1776 was an event destined to change the world. By offering a powerful argument in favor of free markets, Smith helped to usher in an era of prosperity and to defeat the faulty premises of the mercantilists. However, the classical theory was not complete when Smith put pen to paper. It lay with Jean- Policy Study Baptiste Say to complete what Smith had started and perfect the ideal of a capitalistic system of economics. Adam Smith laid the groundwork of classical economic theory through The Wealth of Nations, but because it lacked certain elements, Jean-Baptiste Say improved the theory with his entrepreneurial perspectives. Adam Smith codified the tenets of capitalism in his magnum opus, outlining the principles of the division of labor, the nature of money, and the invisible hand, but neglected the value of entrepreneurs in an economy. The changes brought about by the Industrial Revolution were truly remarkable; it began a long period of unparalleled economic growth for the world. In The Making of Modern Economics, Mark Skousen pointed out that during the pre-Revolution era, a true compendium of economic thought had never been published. 1776 heralded the start of the modern economic saga. Before this watershed date, six millennia had passed without any comprehensive work being written on the topic that dictated every minute of nearly every human’s day: earning a source of revenue. The true per capita salary went practically unchanged for centuries. During the 1700s, when the typical adult did not live past the age of 40, the famous Enlightenment philosopher Thomas Hobbes asserted that life was “Solitary, Public Interest Institute, September 2012 poor, nasty, brutish, and short.”17 At the dawn of the Industrial Revolution, during the 18th century, although great events were about to transpire, there was no concrete economic theory to explain it. Adam Smith stepped forward to rectify this situation. Skousen writes that Smith saw the leading economic philosophy, mercantilism, as harmful and sought to swing the debate decisively towards free-market capitalism. Following more than a decade of writing The Wealth of Nations, its author was certain that he had found the correct type of economic theory to usher in worldwide prosperity. Smith believed this system to be one of “natural liberty.” It is now known as the classical model. Borrowing techniques from another Enlightenment scholar, Sir Isaac Newton, Smith advocated a similar system of universal laws governing economics. His greatest challenge was persuading others of the validity of the classical model, particularly the ruling elite of the 1700s. His goal was to detail the theory and convince his audience of its worth. By writing The Wealth of Nations, Smith issued a challenge to the mercantilists and the political authority, since he wanted to dismantle their erroneous view of wealth and move the world towards a great improvement in living standards, real wages, and life expectancy.18 This challenge ultimately led to the downfall of mercantilism’s measure of wealth, which was simply “gold and silver,” and replaced it with Smith’s definition of labor and productivity as standards of value. To explain how such wealth could be amassed, Smith outlined the division of labor and its ability to enhance productivity. While explaining the nearly automatic process of the division of labor in The Wealth of Nations, Smith foreshadowed his coming argument about the invisible hand. The great benefits stemming from the division of labor are not caused by any human intelligence that can foresee the general prosperity that will be brought about. Rather, it is an obligatory conclusion brought about little by little due to a uniquely human inclination to negotiate, bargain, and exchange the products of labor… Paradoxically, it is not caused by any formal agreement, but is simply the coincidental event of multiple desires for the same object at the same time.19 Simply put, the division of labor allows greater productivity using free exchange between individuals. By defining the division of labor as an extension of the process of exchange, Smith took aim at the mercantilists and their definition of wealth. The mercantilists viewed money itself as wealth, but Smith identified the use of money as a substitute for actual economic value. Following Policy Study A Short History of Economic Theory “Smith issued a challenge to the mercantilists and the political authority, since he wanted to dismantle their erroneous view of wealth and move the world towards a great improvement in living standards, real wages, and life expectancy.” Public Interest Institute, September 2012 A Short History of Economic Theory “The idea that society could function through free exchange was radically new and overturned longheld assumptions about centralized authority.” the initial division of labor, it is impossible for a man to supply all of his desires through the pure production of his labor. Rather, he supplies the vast majority of his wants by trading the surplus of his labor, in excess of his own consumption requirements, for the surplus of others’ labor, as he requires. In the course of time, everybody survives by the mechanism of free exchange, becoming of necessity a trader to some degree or another, and a nation will mature into a fully commercial society.20 The idea that society could function through free exchange was radically new and overturned long-held assumptions about centralized authority. The tendency for free markets to allocate resources through exchange became Smith’s centerpiece argument. He called it the invisible hand. Above all, Smith realized that the invisible hand did not function well with taxation and regulations, as Lisa Smith points out in her article Adam Smith: The Father of Economics. Policies such as minimizing taxation and government interference are central to a “hands-off” economic approach and are presented by Adam Smith along with his idea of an invisible hand that directs the laws of supply and demand. These concepts embody the principle that benevolent selfinterests, i.e. everyone looking out for themselves, will lead to the best possible outcome for Policy Study 10 the community as a whole―by using their resources to create products consumers desire, the goal of producers is to increase their own wealth. Those that successfully satisfy their customers’ requirements are compensated with money. In a self-centered quest to make money, businesses provide products that people want. Smith argued that in such an economic marketplace, with an entire nation of productive laborers working for their own self-interest, a country’s wealth would rapidly rise, mirroring that of its citizens. Likewise, he noted that investment functions along similar lines: wealth will only be invested in companies that the investor sees as being able to produce a healthy return.21 According to the theory of the invisible hand, production and investment can operate along the lines of benign self-interest. The invisible hand theory has a direct consequence in the modern understanding of economics. In his textbook Public Finance, Harvey Rosen traces the development of the First Fundamental Theorem of Welfare Economics to Smith’s ideas in The Wealth of Nations. Using these standards, the First Fundamental Theorem of Welfare Economics comes into play, and a Pareto efficient distribution of goods and services occurs. Essentially, this shocking outcome means that a competitive economic system will mechanically Public Interest Institute, September 2012 distribute scarce resources efficiently, without the need for a central “command-andcontrol” authority…In effect, this economic law simply gives formal structure to the long-held intuition that a free market economy will be unbelievably productive when providing goods and services.22 This idea, that resources can be managed productively and efficiently with a free-market system, was the foundation of the entire classical school of economic thought. Despite its visionary nature, Smith’s initial thesis had a flaw―he did not acknowledge the value of entrepreneurs in an economy. Skousen points out this omission in The Making of Modern Economics, noting that Smith’s background probably played a role in this error. The precise translation of “entrepreneur” is “undertaker,” but due to the ambiguous nature of the word, it has been interpreted as “adventurer.” The mental picture of an entrepreneur is a venture capitalist or business start-up owner, who uses labor, intelligence, and capital to produce goods and services while turning a profit for the company. The author of The Wealth of Nations was a scholar, not a businessman. Since he had never experienced the role of a commercial “adventurer,” the subject of entrepreneurship was minimized in Smith’s book.23 Although the classical model was a masterpiece, it was incomplete. The lack of dynamic growth in Smith’s model led Jean-Baptiste Say to refine and improve it. Jean-Baptiste Say has been largely overshadowed by Smith in economic history, but his contributions completed the classical theory and provided it with a mechanism for expansion. In his Life and Works of Jean-Baptiste Say, David Hart examines the early life of Say, which influenced him to become an economist. Born on January 5, 1767, Jean-Baptiste Say lived for 65 years until his death on November 15, 1832. Say eventually became the primary political economist of his day, active during the beginning of the 1800s. Before his final career as a political economist, Say had experienced a wide variety of professions, including an apprenticeship at a business office, a journalist, a life insurance worker, a writer, a soldier, and a cottonmanufacturing entrepreneur. These sudden occupational shifts were caused by the tumultuous world events in the early 19th century, such as the French Revolution, Revolutionary Wars, the Napoleonic Wars, and the restoration of the Bourbon monarchy in France. Following this chaotic 25 years, Say became a teacher of political economy in Paris in 1815, which he continued to do until his death, 17 years later.24 Say’s varied lines of work started him on a path of discovery that Policy Study 11 A Short History of Economic Theory “The mental picture of an entrepreneur is a venture capitalist or business startup owner, who uses labor, intelligence, and capital to produce goods and services while turning a profit for the company.” Public Interest Institute, September 2012 A Short History of Economic Theory “Say’s Law: Consumers can only exist after producers have created a product.” ultimately led to his career as a political economist and his improvements to Smith’s initial theory. The experience that he gained from starting and running a large manufacturing interest allowed Say to develop his refinements to the classical theory. Hart points out the connection between Say’s experience as an entrepreneur and his disdain for French economic practices, which were based on mercantilism. Following his dismissal from the French government for opposing the economic policies of Napoleon, Say moved his family to Auchy, where he built a cotton-spinning factory and equipped it with imported British machinery. After eight years of success in his factory, which employed between four and five hundred workers, Say came back to Paris in 1813. He was more certain than ever that Napoleon’s economic regulation was leading to a depression: the “Continental System” which prohibited cheap British products, to the government licenses required to set up a business, to the prohibitively high tariffs on raw cotton, to the general wartime problems―all contributed to a stagnant French economy.25 The Napoleonic government of France attempted to defeat England through economic warfare based on the faulty mercantilist ideas of high tariffs and wealth measured in gold, which backfired and caused economic calamity Policy Study 12 on the Continent. From this maelstrom, Say developed his first improvement to the classical theory, his famous Law of Markets. Larry Sechrest pointed out in his Biography of JeanBaptiste Say: Neglected Champion of Laissez-Faire that although Keynesians corrupted Say’s Law of Markets into a simplistic “supply creates its own demand” paradigm, it is still true that suppliers are a precondition of consumers, rather than vice versa. Say pointed out that the stabilizing process functioned in two ways. First, he asserted that although a certain part of income (which itself comes from production) is saved, if those savings are then invested in “productive employment,” there is not a decrease in the total or “aggregate” production, income, or consumption. This cycle of investment is started by the different profits entrepreneurs can earn. Scarce goods will have a higher price, which will attract investment, while plentiful goods, with a lower price, dishearten potential investors. Even in the extreme case of someone hoarding money, it is still intended to purchase something, so it will not harm demand as long as true economic value is being produced. Consumers can only exist after producers have created a product.26 Say’s Law is actually quite simple and ties to Smith’s idea of free exchange and production: a supply of goods, not just Public Interest Institute, September 2012 “money,” will create consumer spending. In line with this philosophy, Say argued that money was merely a means of exchange and not an actual source of wealth. Sechrest continued his analysis of Say’s theories with a look at the requirements for a “good” currency. Say identified consistency, high purchasing power, divisibility, portability, and longevity as the model properties of a medium of exchange. Using this standard, Say concluded that precious metals such as gold and silver are the best option for a reliable currency unit. In a free market, he asserted, most individuals will choose commodity money with intrinsic value. However, Say was not permanently attached to gold and silver as the ideal currency and acknowledged the possibility that the discovery of a new precious substance could lead to an equally acceptably monetary standard. In other words, although he supported specie as a unit of exchange, he did not believe that “money” automatically meant “gold and silver.”27 While acknowledging the value of “hard” currencies, Say absolutely rejected the notion that they were intrinsically “wealth,” as the mercantilists claimed. Say linked his arguments about wealth to the concept of value, a hotly debated issue among early economists. Skousen outlines another of Say’s major contributions to economic thought, his utility theory of value. Say found himself in opposition to David Ricardo, who led the British followers of Adam Smith, on the labor theory of value. Ricardo believed that a constant standard for the value of a product could be found in the labor required to produce it. However, Say saw it to be foolishness, and ridiculed the notion that an invariable measure of value was possible. In its place, Say wanted a subjective theory of value, which he called “utility.” The value of a product, wrote Say, was determined by the amount of utility it gave to consumers. Producers taking inputs and manufacturing outputs at a price covering the cost of production resulted in the creation of value.28 Again, the influence of Say’s entrepreneurial background is clear, and he placed a high priority on profit and providing a useful service for consumers. Unifying the themes of his work, Say attacked taxation and the idea that a nation can “tax itself into prosperity.” Sechrest points out that Say’s final improvement to Smith’s work was to differentiate between direct and indirect taxation and point out the harms inherent in each. Say looked at taxes as separated into two groups. Income and wealth taxes are “direct taxes.” “Indirect taxes” remove wealth through secondary means, like tariffs and sales taxes. No matter which system was Policy Study 13 A Short History of Economic Theory “The value of a product, wrote Say, was determined by the amount of utility it gave to consumers.” Public Interest Institute, September 2012 A Short History of Economic Theory “Say argued that taxation was always harmful to the economy, regardless of the form that it took.” used, Say believed that taxation removes productive capital from an economy and therefore harms production. He accused other economists of obfuscating this fact by claiming that taxation can increase a nation’s wealth while simultaneously removing a portion of it.29 Preempting the coming Keynesians, Say argued that taxation was always harmful to the economy, regardless of the form that it took. Jean-Baptiste Say used his entrepreneurial insights to add crucial features to Adam Smith’s foundation of classical theory, which he had presented earlier in The Wealth of Nations. The consequences of Smith and Say’s work were enormous. Together, they created the classical school of economic thought and gave the infant United States sound principles of freemarket economics. The rapid industrialization and prosperity that took place in the Western World during the 19th century can be directly attributed to the work of these two men and the economic theory they created. Even today, their influence is still felt. As their 20th century disciple, Milton Friedman, said, “To judge from the climate of opinion, we have won the war of ideas. Everyone, left or right, talks about the virtues of markets, private property, competition, and limited government.”30 Policy Study 14 Karl Marx: The Rise of Collectivism Following the collapse of the Soviet Union in 1991, Marxism and its ideological offspring, communism, seemed a thing of the past. Today, Marxism has reentered the public arena with a vengeance, and discussions about socialism hover over public-policy debates. Now more than ever, it is critical to understand the economic policies shaped by Marx for his “classless society.”31 In Das Capital, Karl Marx explained his theory of commodities and money, surplus value, the exploitative model of capitalism, and dialectic materialism, but had no grasp of the fundamental realities of a free-market economy. Marx held that commodities and money were interchangeable and that the production of value within an economic system was a zero-sum game.32 All items, claimed Marx, had a certain amount of “use-value,” an early precursor to the theory of utility.33 Putting forth the equation “C-M-C,” Das Capital argued that commodities (C) could be exchanged for other commodities through the medium of money (M).34 He continued that capitalists lose sight of this, and instead seek “M-C-M,” treating money as the final goal, rather than goods and services. Marx then proposed his infamous “labor theory of value,” holding Public Interest Institute, September 2012 that absolute value could be measured by the amount of labor that goes into making a product.35 The labor theory of value gave Marxist economic thought a solid framework on which to base the rest of his attacks on capitalism. His labor theory of value made Marx’s transition to the idea of surplus value quite natural. Since he held that a product is only worth the amount of labor put into it, Marx concluded that profits and interest came from the laborers being deprived of their rightful wage. Marx constructed an equation to represent exploitation, “p = s/r,” with “p,” “s,” and “r” representing profit, surplus value, and the value of the finished product, respectively.36 Extrapolating, Marx wrote that two types of capital existed, constant and variable. Hence, “p = s/[v + c]” represented the rate of exploitation of workers by capitalists.37 As evidence, Marx railed against the “working day,” citing numerous examples of laborers pushed to the limit of their endurance by their employers.38 Marx loathed the system of division of labor, contending that it represented brutal exploitation of laborers.39 Finally, Marx voluminously described the industrial machinery in use during the Industrial Revolution, alluding to it as another “weapon” of capitalists to keep the poor enslaved.40 It was easy for Marx to move from the labor theory of value and surplus value to an exploitative model of capitalism. Marx was convinced that the capitalist class was forcing laborers to work for less than their rightful wages, since firms made a profit beyond the wages paid to workers. Surplus value, in his opinion, was the same thing as slavery, since it denied laborers their “fair share” of the product.41 The capitalists, Marx claimed, robbed workers of their labor power, unfairly accumulating wealth that rightfully belonged to “the masses.”42 Surplus value “squeezed” profits from the wages of the workers, since in Marx’s view wages were the only place that excess profit could be made.43 Having thoroughly explained the perceived injustices suffered by workers at the hands of capitalists, Marx put forth a theory on the ultimate demise of capitalism and the rise of communism. Dialectic materialism, a theory Marx borrowed from Hegel, predicted that capitalism would eventually be merged with socialism and produce pure communism. Marx described a “crisis of capitalism,” with boom and bust cycles, unemployment, falling profits, and overproduction all contributing to a disillusioned mass of proletariats.44 Believing that history was a continuous process of an idea arising (thesis), followed by its opposite (antithesis), Marx saw socialism as the antithesis Policy Study 15 A Short History of Economic Theory “Believing that history was a continuous process of an idea arising (thesis), followed by its opposite (antithesis), Marx saw socialism as the antithesis of capitalism.” Public Interest Institute, September 2012 A Short History of Economic Theory “However, Marxism had numerous flaws that its creator did not recognize, leading to the breakdown of the theory.” of capitalism. Dialectic materialism holds that when the thesis combines with the antithesis, a synthesis is formed which becomes the new thesis, starting the process again.45 In the case of capitalism and socialism, Marx held that they would merge into the final phase of history, communism. Revolutionary socialism, claimed Marx, would unite with capitalism and, probably through violence, lead to a utopia of communism in a classless world.46 However, Marxism had numerous flaws that its creator did not recognize, leading to the breakdown of the theory. Marx’s central hypothesis was that absolute value is measured by the amount of labor it takes to create a product. The Austrian school of economics, led by Carl Menger, challenged the assumption on which the entire Marxist theory rests. Rather than accept the labor theory of value, they put forth the “consumer origin of value,” claiming that true value was only decided by the consumer, who could choose whether or not to buy a product. The Austrians also introduced the concepts of marginal utility and cost, further weakening the arguments of Das Capital. However, their greatest achievement was introducing subjective value, the concept that there is no absolute value for a product, only what consumers are willing to pay for it.47 If surplus value is Policy Study 16 wrong, then the entire Marxist framework of exploitative capitalism falls apart under its own weight. In addition to his labor theory of value being completely erroneous, Marx’s economic theory was damaged by his misunderstanding of the “boom and bust” cycle of capitalism. Marx predicted the demise of capitalism and rise of communism as the predominant economic force in the world, but his prognostication was severely flawed. Over the last two hundred years, profit has not continuously declined, as Marx thought, despite the massive accumulation of capital in the world. Real wages are rising, not falling, and workers today enjoy more affluence than their 19th century counterparts. There has been no increased concentration of industries, as Marx believed inevitable; rather, industries have become extremely diverse. Socialist societies and revolutions have not overtaken capitalism, becoming the exception, rather than the rule. Capitalism today is even stronger than when Marx wrote Das Capital, and his projected utopias have failed to materialize.48 Another of Marx’s underlying assumptions, that capitalism would inevitably fall to his dialectic materialism, has been incontrovertibly invalidated by history. Despite its obvious failings, Marxism has taken root in several countries, Public Interest Institute, September 2012 primarily agrarian, over the past century, with even fewer surviving at the dawn of the 21st century. Cuba, under the rule of Fidel and Raul Castro, remains one of the most pernicious communist states in the world. Under the leadership of Mao Zedong, China, following millions of deaths during the Great Lead Forward, remains nominally communist, with a hybridized model of capitalism making inroads into their economy. North Korea, under Kim Il-Sung and his son Kim Jong-Il, has remained communist since the cessation of hostilities in 1953, maintaining a close relationship with China. Marxism today is nothing that Marx would have envisioned―instead of violent revolution followed by a peaceful utopia, communism has been one of the most viciously oppressive forms of government in the world. Despite his lack of comprehension concerning the free market, Marx’s Das Capital clearly communicated the theories of dialectic materialism, the exploitative model of capitalism, surplus value, and the circulation of commodities and money. Few have had the influence that Marx possessed, albeit after his death. There can be no doubt that through his work, Marx gave rise to a new school of economic thought, and was indirectly responsible for the rise and fall of entire nations. John Maynard Keynes: The Triumph of Government Interventionism John Maynard Keynes was the founder of a school of economic thought that has dominated a century of history.49 In The General Theory, Keynes introduced the ideas of marginal propensity to consume, the inducement to invest, money-wages and price, the business cycle, and the policy implications of his work, but rejected the principles of Adam Smith and Jean-Baptiste Say while supporting an active fiscal policy.50 In his flagship argument, Keynes proposed the radically new idea of a “marginal propensity to consume” that was behind the demand side of an economy and laid the groundwork for his entire theory.51 The marginal propensity to consume was defined by Keynes as the increase in consumption that results from one additional unit of currency spent.52 It linked directly to his concept of the multiplier effect, which measures the amount that investment and savings move in response to additional consumption.53 According to Keynes, marginal propensity to consume was directly connected to the multiplier, since it demonstrated how investment could lead to full employment.54 Keynes’s equations led him to conclude that the marginal propensity to consume fluctuates directly Policy Study 17 A Short History of Economic Theory “In The General Theory, Keynes introduced the ideas of marginal propensity to consume, the inducement to invest, money-wages and price, the business cycle, and the policy implications of his work.” Public Interest Institute, September 2012 A Short History of Economic Theory “As defined by classical economists, the business cycle was a natural progression of economic activity caused by a failure in the structure of supply and demand, while Keynes argued for a breakdown in the quantity demanded.” with total output, i.e., more output and consumption equals more employment.55 Keynes decided that the marginal propensity to consume would lead to economic stability.56 Moving from the marginal propensity to consume, Keynes explained how investment tied his entire theory together, from the business cycle to moneywages.57 According to Keynes, investment was superior to saving as a means of stimulating the economy.58 The amount of investment in an economy was linked to cyclical fluctuations that persist temporarily and ultimately reverse direction.59 Keynes also connected investment to the marginal propensity to consume, as they both varied in proportion to the economic climate, whether in a boom or a bust.60 The “Trade Cycle” described by Keynes was caused by over- and underinvestments in the economy, creating alternating bull and bear markets.61 Keynes held that economic busts must be ended by remaining in a perpetual state of “quasi-boom” through the application of his theory.62 To describe the national economy, Keynes put forth the equation Y = C + I + G, where the GDP is equal to consumer spending plus investments and government expenditures.63 For Keynes, investment was essential to the rest of his theory, particularly money-wages and price.64 Money-wages and price Policy Study 18 were the linchpins of Keynes’s theory on employment and connected to his argument on the business cycle.65 The wage-unit is an amalgam of the money-wage and the laborunit: simply put, the amount paid for a single unit of labor to perform for a given amount of time.66 As part of his stability principles, Keynes asserted that moderate changes in employment would not result in a noticeable change in the money-wages.67 Attempts to fix money-wages to stem unemployment were futile in liberal democracies, stated Keynes, but could be workable under authoritarian regimes.68 Keynes asserted that prices were connected to the business or “trade” oscillations because of the regular, cyclical nature of the market.69 Keynes felt that investment and wage-units were inextricably combined, because the public tends to invest only when real wages are rising.70 From this standpoint on investment, Keynes transitioned to his theory on the business cycle and recessions.71 The boom-and-bust nature of a free market was Keynes’s greatest challenge, and he sought to prevent future recessions by increased government intervention.72 As defined by classical economists, the business cycle was a natural progression of economic activity caused by a failure in the structure of supply and demand, while Keynes argued for a breakdown in the quantity demanded.73 Public Interest Institute, September 2012 The business cycle was tied to saving, which Keynes despised as “hoarding” and an unproductive waste of money, when compared to investment.74 From this, Keynes derived the idea that consumption, or spending, neutralizes recessions by moving in a countercyclical manner.75 The multiplier effect stabilizes the economy at a state of “quasi-boom,” smoothing out the troughs and crests of the business cycle and moving the economy slowly upward.76 The business cycle, then, was able to be defeated using increased spending and higher consumption, permanently erasing booms and busts.77 Concluding his thoughts on the regulation of the business cycle, Keynes turned to the broader policy implications of his work.78 Keynes looked beyond the economic aspects of theory and outlined the wider sociopolitical impact of his ideas.79 In keeping with his countercyclical fiscal policy, Keynes advocated large public works to bolster consumption during recessions, which was widely implemented by President Franklin Roosevelt.80 Bigger government was also necessary if the aforementioned public works were to take place, and Keynes emphasized a paternalistic welfare state.81 Public and private deficit spending was arguably the most important part of Keynes’s fiscal policy, since he held that deficits were irrelevant in the face of a recession.82 Government intervention in the economy joined several of these threads together, and Keynes wholeheartedly supported an ubiquitous central authority.83 Railing against the gold standard, Keynes advocated its replacement with fiat money instead, which would allow greater elasticity and response to business needs.84 The political ideas put forth by Keynes were nurtured by his concepts of supply and demand, which lie at the heart of his theory.85 One of the chief factors influencing Keynes’s General Theory was his perception of aggregate supply and aggregate demand.86 Keynes reversed Say’s Law and pronounced that “Demand creates its own supply,” cementing his emphasis on “demand-side” economics. Consumption is more important than production because it encourages investment, according to Keynes, and continuous investment would produce the desired countercyclical activity in the market.87 His reversal of Say’s Law actually misquoted the original, and Keynes portrayed it as though Say believed that everything produced was automatically bought, clearly not the Law’s original intention.88 In reality, Say’s Law explains recessions as a problem with business calculations leading to overproduction and unsold goods.89 Aggregate demand is the most important part of the economy, Keynes opined, and Policy Study 19 A Short History of Economic Theory “Keynes reversed Say’s Law and pronounced that ‘Demand creates its own supply,’ cementing his emphasis on ‘demand-side’ economics.” Public Interest Institute, September 2012 A Short History of Economic Theory “‘Underlying most arguments against the free market is a lack of belief in freedom itself.’” should be encouraged by every means possible.90 With his vision of economic equilibrium, Keynes led the way for a century of economic policies in the western world.91 Armed with Keynesian economics, the governments of Western Europe and America fought the Great Depression using fiscal policy.92 Fiscal policy emphasized deficit spending and lower tax rates during a recession, with budget cutting and higher taxes during a surplus.93 Keynes backed fiscal policy as a solution to the business cycle of boomand-bust, stabilizing the economy.94 Keynes derided monetary policy’s concern with long-term inflation, famously quipping that, “In the long run, we are all dead,” proving his deep concern for short-term unemployment and recessions.95 As the inspiration for the New Deal, Keynesian economics promoted massive public works to stimulate the economy out of a recession.96 Bigger government with more intervention was the hallmark of Keynes’s economic theory, but he admitted that it would work best in totalitarian countries such as Italy, Germany, or the Soviet Union, not democracies.97 Clearly, Keynes has irreversibly influenced the course of political economics through his work on fiscal policy.98 While supporting an active fiscal policy and rejecting the principles of Jean-Baptiste Say and Adam Policy Study 20 Smith, John Maynard Keynes’s The General Theory explained the sociopolitical aspects of his work, the business cycle, price and money-wages, the inducement to invest, and the marginal propensity to consume.99 Regardless of a person’s stance on Keynesian economics, there can be no doubt that he represented a watershed in the history of economic thought.100 It is fitting that Keynes wrote the best testament to his own theory, “Ideas shape the course of history.”101 Milton Friedman: Rebirth of Liberty “Underlying most arguments against the free market is a lack of belief in freedom itself.”102 Milton Friedman, founder of the monetarist school of economics, was undoubtedly one of the greatest advocates of liberty in the Postwar Era.103 Underlying his entire philosophy of government was a simple premise in the vein of Adam Smith: benevolent self-interest leads to positive economic consequences.104 In Capitalism and Freedom, Milton Friedman explained the connection between economic and political freedom, described the role of government in a free society, developed monetary economics, critiqued fiscal policy, defined the role that capitalism played in developing society, examined monopolies, Public Interest Institute, September 2012 and analyzed the effects of social welfare.105 Friedman began his work by inextricably linking economic freedom to political freedom, binding them together in his societal model.106 Friedman rejected the modern definition of a progressive “liberal” and identified himself as a classic, 18th and 19th century liberal.107 Economic freedom was an end to itself, Friedman believed, and did not require any other justification.108 Freedom leaves the classical liberal to solve ethical problems, which are not the concern of the State, but are in the jurisdiction of the individual.109 According to Friedman, mutually beneficial exchange was the key to a successful freemarket economic system.110 However, he still believed that government must determine the “rules of the game” and then enforce them.111 In the larger scheme of national power, economic freedom checked political ambition, similar to the way that the three branches of federal government balance each other to prevent unconstitutional actions.112 Having defined the connection between economic freedom and political freedom, Friedman moved on to the role of government in society.113 Opposed to a collectivist community, Friedman sought limited government that maximized individual freedom.114 Imposing conformity is not possible without conflict, so Friedman asserted that the free market eases the problem by promoting self-interest, rather than forced change.115 Absolute freedom is impossible because of human nature, so the government needs to set and enforce the rules of the market.116 Paternalistic government, however, was unjustified in Friedman’s view, since it created a sense of dependency rather than selfworth.117 General education for citizenship was required to maintain a free, productive, and efficient society that was grounded in certain values.118 Friedman backed the view that competitive choice efficiently meets consumer demand for education, no differently than any other part of the free market.119 Registration, certification, and licensure, most of which are unwarranted, represent increasing loss of freedom for producers in an economy.120 According to Friedman, very few licensure processes are justified at all, since they represented barriers to entry in a free market.121 Based on the same classically liberal ideology, Friedman advocated a government monetary policy to affect the economy.122 Friedman, the father of monetary policy, emphasized the quantity of money in the economic system, seeking to end inflation and promote growth.123 Friedman identified the gold standard and fractional reserve system in banking as Policy Study 21 A Short History of Economic Theory “Friedman, the father of monetary policy, emphasized the quantity of money in the economic system, seeking to end inflation and promote growth.” Public Interest Institute, September 2012 A Short History of Economic Theory “According to Friedman, the Great Depression did not signal problems in the free market, as Keynes had thought, but was actually a symptom of governmental problems.” the chief roots of economic ills.124 According to Friedman, the Great Depression did not signal problems in the free market, as Keynes had thought, but was actually a symptom of governmental problems.125 Above all, Friedman stressed the need for rules instead of authorities in the economic system.126 Friedman advocated floating exchange rates rather than a fixed gold standard, which he felt would make the implementation of changes in the quantity of money far easier.127 Elimination of trade restrictions was another key point of Friedman’s, since it encouraged competition and efficient allocation of resources.128 Friedman’s development of monetary economics was a direct confrontation to Keynesian fiscal policy.129 Fiscal policy was, in Friedman’s eyes, a tool to expand government, which he opposed as a classical liberal.130 President Franklin Roosevelt’s New Deal justified intervention on the grounds of full employment, a policy inspired by Keynes.131 However, Friedman argued that rather than helping to stabilize the economy, the federal budget has been a source of instability.132 The balancedwheel theory was defective and counter-productive, according to Friedman.133 Friedman even attacked the sanctum sanctorum of fiscal policy, when he claimed that the multiplier effect of federal spending was Policy Study 22 deeply flawed.134 Friedman’s attack on Keynesian economics led to his belief in capitalism as a force for good in the world.135 Continuing some of the main historical themes in Capitalism and Freedoms, Friedman examined the role of capitalism in reducing discrimination.136 Friedman wrote about how the market had opened up opportunities for discriminated-against minorities from the Middle Ages to the post-Civil War South.137 Capitalism encouraged cooperation and circumvented political attempts to block freedom.138 Friedman believed that fair employment practices harm the economy, since they force uneconomic decisions to be made.139 Rightto-work laws are no different from fair employment laws, according to Friedman, and if businesses are allowed to hire as they wish, employees should be allowed to unionize if they wish.140 From the perspective of 1962, Friedman saw individual choice as the answer to solve segregationist practices.141 Dovetailing from his arguments in favor of maximum choice, Friedman derided monopolies as generally damaging to the economy.142 Friedman went to great lengths to oppose monopolies, which he saw as limiting free choice and competition.143 The issue of social responsibility, according to Friedman, was only raised when a monopoly controlled a large portion of the market, but in free competition, Public Interest Institute, September 2012 the individual bore little responsibility other than to live by the law of the land.144 Industrial monopolies were unimportant and manufacturing was overemphasized, stated Friedman, but the misstatement occurs because of societal image of these firms.145 Friedman saw that labor monopolies in unions harmed the public at large as well as workers by distorting the value of labor away from its true, market worth.146 Governmentally supported monopolies arbitrarily limited free choice, and Friedman opposed them since they represented a governmentbacked cartel.147 Friedman believed that the only social responsibility of business is to increase profits within the “rules of the game.”148 Friedman’s views on monopoly power connected to his aversion to governmental social welfare programs.149 Redistributionist social welfare was the antithesis of the free market according to Friedman, who emphasized free choice and competitiveness.150 Friedman cited public housing, minimum wage laws, and farm price supports as causing the opposite of the intended effect.151 Social Security redistributes income on an illegitimately paternalistic basis that “the government knows best,” asserted Friedman, ever the antagonist of “big government.”152 Attacking the foundation of government redistribution, Friedman declared that any earned income redistribution is fundamentally unfair.153 Looking at the Soviet Union during the mid1960s, Friedman saw that capitalism produced less income inequality than communism did.154 Friedman believed that the poor should be helped because they are poor, not because of their particular occupation.155 In his denouement, Friedman explained the difference between equality of rights and opportunity and equality of outcome.156 Friedman saw the free market as the ultimate source of wealth and increases in material well-being.157 Milton Friedman’s Capitalism and Freedom studied the effects of social welfare, inspected monopolies, explained the role that capitalism played in developing society, evaluated Keynesian economics, developed monetary policy, ascertained the role of government in a free society, and showed the connection between economic and political freedom.158 His short, simple work revived the long-crippled classical economic theory.159 His powerful debate style brought down the Keynesian colossus.160 Milton Friedman has certainly secured his place in the history of economic thought. Policy Study 23 A Short History of Economic Theory “Friedman saw that labor monopolies in unions harmed the public at large as well as workers by distorting the value of labor away from its true, market worth.” Public Interest Institute, September 2012 The Gold Standard: Medium, Measure, Standard, and Store A Short History of Economic Theory “While Smith focused on the physical advantages of a gold standard, Milton Friedman looked to the intangible ability of gold to protect liberty.” Gold. Wars have been fought, alliances betrayed, and empires forged over this malleable metal. Over the millennia, gold has been a source of fascination for mankind and central to the economics profession ever since Adam Smith wrote The Wealth of Nations. The question of whether a gold standard is beneficial has been debated since the mercantilists first proposed that gold equals wealth. The gold standard offers the advantages of a good currency, resistance to central control, and a predictable expansion rate, but can hobble an economy and impose high resource costs. As the old rhyme goes, “Money is a matter of functions four: medium, measure, standard, and store.” In The Wealth of Nations, Adam Smith looks at how gold meets these requirements for a “good” currency. As a medium of exchange, gold is highly useful because it allows different producers to trade their goods and services in small, manageable pieces.161 In a market where thousands of goods and services are worth different amounts, it is natural to settle on a precious metal as a measure of value.162 Obviously, gold is an excellent standard for producers to use when exchanging the product of their labor for the product Policy Study 24 of another.163 Finally, because gold is highly durable and portable, it is an excellent way to store value over time.164 While Smith focused on the physical advantages of a gold standard, Milton Friedman looked to the intangible ability of gold to protect liberty. Friedman, long a proponent of 18th century classical liberalism, initially supported the gold standard in Capitalism and Freedom as a means to curtail centralized authority. In their study of the abandonment of the gold standard by the U.S., Halwood, MacDonald, and Marsh noted that the Great Depression might have been caused by the Federal Reserve’s mismanagement of monetary policy.165 Friedman certainly agreed with this position, and believed that the poor monetary policy of highly leveraged debt fueled the stock crash of 1929.166 Above all, Friedman had a fundamental fear of concentrated governmental power, especially over the economy.167 Although a commodity standard is natural, Friedman asserted that it would automatically bring fiduciary money with it.168 Since fiduciary money entails government control, Friedman was in favor of standard money, such as gold.169 The advantage of limited central control over gold was coupled with a predictable expansion rate in its supply. Stability, one of the most important parts of a Public Interest Institute, September 2012 successful economy, was seen by many to reside in the gold standard. Because of gold’s relative scarcity, the supply tends to rise at a rate of 1-3 percent per year.170 This means that the extremes of high deflation or inflation are not likely under a pure gold standard.171 Even the “supply shocks” brought about by gold rushes are shortlived, returning the market to equilibrium in short order.172 An automatic gold standard is therefore highly predictable and lends stability to an economy.173 Having examined the advantages of the gold standard, it is now necessary to look at the shortcomings of such a system. The relatively slow growth rate of the gold supply means that a pure, 100 percent gold standard results in deflation. Although the steady expansion of the supply of gold seems to provide stability, it has an unexpected side effect.174 A healthy economy grows at a faster rate than the slow, 1-3 percent expansion in the gold supply, and the difference between the growth of a purely gold monetary supply and the economy would lead to deflation. Although Friedman saw the advantages of a gold standard, he realized that it would not be technically feasible, so he advocated a fiat currency tied to gold.175 However, he did not want the Federal Reserve to control the supply, and instead preferred an automatic, targeted rate of 3-5 percent, to keep up with economic growth.176 This compromise avoided centralized control of monetary policy and the naturally slow growth of the gold supply.177 In addition to the slow growth in the supply of gold, it suffers from high resource costs for mining, transport, and minting. Gold requires immense resources to bring to market as a currency, consuming large, productive parts of the economy. Even the indefatigable Friedman saw the folly of expending resources to dig up gold and then interring it at Fort Knox.178 The resources consumed in producing gold leads to an attempt to have the product (money) without the work, i.e., a fiat currency.179 It was estimated that a theoretical maximum of 4 percent of GDP would be required to bring a gold currency to market.180 However, it has also been posited that this may be an unavoidable cost, regardless of whether or not a gold standard is in place.181 Ultimately, Friedman rejected the gold standard due to its deflationary effects, not its resource costs.182 Because of its high resource costs and low expansion rate, the gold standard’s advantages of predictability, resistance to central control, and status as a good currency are not as solid as they appear. When the question of a “pure” gold standard was raised, the father of monetary policy, Milton Friedman, admitted that it Policy Study 25 A Short History of Economic Theory “A healthy economy grows at a faster rate than the slow, 1-3 percent expansion in the gold supply, and the difference between the growth of a purely gold monetary supply and the economy would lead to deflation.” Public Interest Institute, September 2012 A Short History of Economic Theory was neither practical nor desirable. He correctly saw the problem presented by the gold standard. In Capitalism and Freedom, he wrote that, “Our task…is to steer a course between two views, neither of which is acceptable though both have their attractions. The Scylla is the belief that a purely automatic gold standard is both feasible and desirable…The Charybdis is the belief that the need to adapt to unforeseen circumstances requires the assignment of wide discretionary powers to a group of technicians…Neither has proved a satisfactory solution in the past; and neither is likely to in the future.”183 War of Ideas: Economic Growth and Stabilization Policy “Various solutions to promote economic growth and stability can be found in Keynesian, Monetarist, and Neoclassical theories.” After the financial crash of 2007, all of the old debates about the role of government were resurrected. Should large financial institutions be “bailed out” by the government? Should it spend its way out of the recession? Can it afford to do nothing? There can be no question that the recent downturn has rekindled a smoldering war between various economic theories. As should be obvious to all the actors on the great stage of the American economy, we are still suffering from a severe recession, and as the crisis grinds on, the voices on every side grow louder. All Policy Study 26 parties claim to have the key to our economic salvation, if only we follow their policies to the letter. Various solutions to promote economic growth and stability can be found in Keynesian, Monetarist, and Neoclassical theories. Advocated by John Maynard Keynes, Keynesian stimulus theory calls for government intervention to counteract business cycles. According to Keynes, there are three ways to neutralize a recession: an unexpected increase in business confidence, sticky wage adjustment, and governmental stimulus.184 The last of these three options, governmental stimulation of the economy through deficit spending and low taxes, is the main Keynesian solution for an economy that is mired in a recession.185 In the Rational Expectations model, repeated use of such spending to move out of a recession will cease to have any effect, epitomizing the idea of policy irrelevance, because the public will understand that deficit spending today must be financed by a tax tomorrow, and adjust their consumption habits accordingly.186 The Real Business Cycle theory posits that Keynesian demand-side stimulus will do nothing to solve business cycles, since they are a product of drops in aggregate supply, not aggregate demand.187 While Keynesian theory focuses on fiscal stimulus, Monetarists decry this position and support stabilizing Public Interest Institute, September 2012 the economy through the central bank. As their name would suggest, Monetarists seek to use monetary policy, rather than fiscal, for countercyclical activities. Monetarism is closely linked to Classicism, from which Monetarism’s founder, Milton Friedman, drew his inspiration.188 The central principles of Monetarism are adaptive expectations, the short-run effects of shocks to aggregate demand, and the idea that variations in the money supply are responsible for demand fluctuation.189 Due to their belief that a vacillating money supply is responsible for business cycles, Monetarists seek to break the power of recessions by removing discretionary power from central banks and tying the growth of the money supply to the rate of economic growth, about 5 percent.190 This model fits quite well within the Rational Expectations system, since it gives producers and consumers an absolutely reliable medium of exchange, stabilizing demand and supply.191 Monetarism does not mesh well with Real Business Cycles, since they espouse different views of the source of business cycles: shocks to aggregate supply and shocks to the money supply, respectively.192 While Monetarists sought a partial revival of Adam Smith’s ideas, Neoclassical theorists took Friedman’s work one step farther. In a resurrection of the Classical laissez-faire model, Neoclassicists argue for a “hands off” economic system which embraces business cycles. Although it is a renewal of Classicism at the core, Neoclassical models expound the principles of free enterprise with analysis of microeconomics and the business cycle.193 With its roots in The Wealth of Nations, Neoclassical stabilization policy is mainly concerned with preventing the government from intervening in the economy and crowding out the private sector; recoveries from recessions are driven by entrepreneurship and the profit motive.194 Rational Expectations maintains the viewpoint that because producers and consumers understand the economy, they will not be fooled by government attempts at fiscal stimulus into consuming more; instead, they will merely save money for the inevitable taxation.195 The Real Business Cycles theory holds that fluctuations in economic output, i.e. business cycles, are driven by “productivity shocks” which can come from changes in the cost of inputs, technology, and government taxation.196 The defining feature of Neoclassical theory is that it views business cycles as efficient responses to changes in the “natural rate of output,” not the villains that Keynesian and Monetarist economists Policy Study 27 A Short History of Economic Theory “The Real Business Cycles theory holds that fluctuations in economic output, i.e. business cycles, are driven by ‘productivity shocks’ which can come from changes in the cost of inputs, technology, and government taxation.” Public Interest Institute, September 2012 A Short History of Economic Theory cast them as.197 Neoclassical economic models work on the principle of a gyroscope-like economy that is self-correcting. Neoclassical, Monetarist, and Keynesian theories offer different solutions to achieve economic stability and expansion. The debate is still unfinished. Will Keynes’s interventionist instincts, Friedman’s monetary focus, or Smith’s free-market principles win the day? As the war of ideas is waged from the political stage to the kitchen table, only one thing is clear: it’s going to be quite a fight. Endnotes “Neoclassical economic models work on the principle of a gyroscope-like economy that is self-correcting.” 1. Benjamin Franklin, “Benjamin Franklin Quotes,” Goodreads, 2012, 1 Aug. 2012 <http://www.goodreads.com/ quotes/37937-all-mankind-isdivided-into-three-classes-thosethat-are>. 2. Adam Smith, Robert L. Heilbroner, and Laurence J. Malone, The Essential Adam Smith (New York: W.W. Norton, 1986), p. 170. 3. Ibid, p. 171. 4. Ibid, p. 173. 5. Ibid, p. 176. 6. Ibid, p. 177. 7. Ibid, p. 265. 8. Ibid, p. 266. 9. Ibid, p. 281. 10. Ibid, p. 282. 11. Ibid, p. 290 and p. 293. 12. Ibid, p. 298. 13. Ibid, p. 302. 14. Ibid, p. 311. 15. Ibid, p. 315. 16. Mark Skousen, The Making of Modern Economics: The Lives and Ideas of the Great Policy Study 28 Thinkers (Armonk, NY: M.E. Sharpe, 2001), pp. 52-53. 17. Ibid, p. 13. 18. Ibid, p. 17. 19. Smith, p.168. 20. Ibid, p. 172. 21. Lisa Smith, “Adam Smith: The Father Of Economics,” Investopedia.com, 9 Oct. 2008, 8 Nov. 2011 <http://www. investopedia.com/articles/ economics/08/adam-smitheconomics.asp#axzz1d8XiC5n7>. 22. Harvey S. Rosen and Ted Gayer, Public Finance, 9th ed. (Singapore: McGraw Hill/Higher Education, 2010), p. 41. 23. Skousen, p. 52. 24. David M. Hart, “Life and Works of Jean-Baptiste Say,” Library of Economics and Liberty, 2 Jan. 2001, 10 Nov. 2011 <http:// www.econlib.org/library/Say/ SayBio.html>. 25. Ibid. 26. Larry J. Sechrest, “Biography of Jean-Baptiste Say: Neglected Champion of LaissezFaire,” Ludwig Von Mises Institute, 9 Nov. 2011 <http:// mises.org/about/3242>. 27. Ibid. 28. Skousen, p. 52. 29. Sechrest, “Biography of Jean-Baptiste Say.” 30. Skousen, p. 431. 31. Ibid, p. 152. 32. Ibid, pp. 162-163. 33. Mortimer Adler, ed., Great Books of the Western World, vol. 50, Marx (Chicago: W. Benton, 1952), p. 13. 34. Ibid, pp. 48-54. 35. Skousen, p. 149. 36. Ibid. 37. Ibid, p. 150. 38. Adler, pp. 111-146. 39. Ibid, pp. 164-180. 40. Ibid, pp. 180-256. 41. Ibid, p. 113. 42. Skousen, p. 149. 43. Ibid. Public Interest Institute, September 2012 44. Ibid, p. 151. 45. Ibid, p. 152 46. Ibid, pp. 152-155. 47. Ibid, p. 173. 48. Ibid, p. 155. 49. Ibid, p. 321. 50. John Maynard Keynes, The General Theory of Employment, Interest, and Money (Amherst, New York: Prometheus Books, 1997), pp. 1-384. 51. Skousen, p. 322. 52. Keynes, p. 90. 53. Keynes, p. 115. 54. Skousen, p. 346. 55. Keynes, p. 250. 56. Ibid, p. 248. 57. Skousen, p. 343. 58. Ibid. 59. Keynes, p. 314. 60. Ibid. 61. Ibid, p. 322. 62. Ibid. 63. Skousen, p. 345. 64. Keynes, p. 117. 65. Skousen, p. 341. 66. Keynes, p. 41. 67. Ibid, p. 251. 68. Ibid, p. 269. 69. Ibid, p. 250. 70. Ibid, p. 117. 71. Skousen, p. 328. 72. Keynes, p. 164. 73. Skousen, p. 344. 74. Ibid, p. 341. 75. Ibid. 76. Keynes, p. 251. 77. Ibid, p. 254. 78. Ibid, p. 372. 79. Ibid, pp. 372-384. 80. Skousen, p. 346. 81. Ibid, p. 322. 82. Ibid, p. 336. 83. Ibid. 84. Ibid. 85. Ibid, p. 337. 86. Ibid, p. 338. 87. Ibid, p. 336. 88. Ibid, pp. 343-344. 89. Ibid, p. 344. 90. Ibid. 91. Ibid, p. 347. 92. Keynes, p. 345. 93. Skousen, p. 345. 94. Ibid, p. 345. 95. Ibid, p. 348. 96. Ibid, p. 346. 97. Ibid, p. 347. 98. Ibid. 99. Keynes, pp. 1-384. 100. Skousen, p. 347. 101. John Maynard Keynes, “John Maynard Keynes Quotes,” Goodreads, 2012, 1 Aug. 2012 <http://www.goodreads.com/ quotes/50359-ideas-shape-thecourse-of-history>. 102. Milton Friedman, “Milton Friedman Quotes,” Goodreads, 2012, 1 Aug. 2012 <29898underlying-most-argumentsagainst-the-free-market-is-a-lack>. 103. Skousen, p. 390. 104. Ibid, p. 380. 105. Milton Friedman, Capitalism and Freedom, (Chicago: University of Chicago, 2002), pp. 1-202. 106. Ibid, pp. 7-21. 107. Ibid, p. 5. 108. Ibid, p. 8. 109. Ibid, p. 12. 110. Ibid, p. 13. 111. Ibid, p. 15. 112. Ibid, p. 16. 113. Ibid, pp. 22-36. 114. Ibid, pp. 85-107. 115. Ibid, p. 24. 116. Ibid, pp. 25-26. 117. Ibid, pp. 33-34. 118. Ibid, p. 86. 119. Ibid, p. 91. 120. Ibid, p. 144. 121. Ibid, p. 147. 122. Ibid, pp. 37-74. 123. Skousen, p. 401. 124. Friedman, pp. 40-41. 125. Ibid, p. 50. 126. Ibid, p. 51. 127. Ibid, p. 67. 128. Ibid, p. 71. 129. Ibid, pp. 75-84. 130. Skousen, p. 390. 131. Friedman, p. 55. Policy Study 29 A Short History of Economic Theory Public Interest Institute, September 2012 A Short History of Economic Theory 132. Ibid, p. 77. 133. Ibid, pp. 77-78. 134. Skousen, p. 403. 135. Friedman, pp. 108-118. 136. Ibid, p. 108. 137. Ibid, pp. 108-109. 138. Ibid, p. 110. 139. Ibid, pp. 111-115. 140. Ibid, p. 115. 141. Ibid, pp. 115-117. 142. Ibid, pp. 119-136. 143. Ibid, p. 120. 144. Ibid. 145. Ibid, pp. 121-123. 146. Ibid, p. 124. 147. Ibid, p. 125. 148. Ibid, p. 133. 149. Ibid, pp. 177-189. 150. Ibid, p. 176. 151. Ibid, pp. 179-182. 152. Ibid, pp. 183-184. 153. Ibid, pp. 162-165. 154. Ibid, p. 186. 155. Ibid, p. 191. 156. Ibid, p. 195. 157. Ibid, p. 202. 158. Ibid, pp. 1-202. 159. Skousen, p. 380. 160. Ibid, pp. 390-391. 161. Smith, p. 54. 162. Ibid, p. 54. 163. Ibid, p. 55. 164. Ibid. 165. P. Hallwood, et al., “An Assessment of the Causes of the Abandonment of the Gold Standard by the U.S. in 1933,” Southern Economic Journal 67:2 (July 2000), p. 448. 166. K. Cundiff, “MonetaryPolicy Disasters of the Twentieth Century,” Freeman 57:1 (January 2007), p. 29. 167. Friedman, p. 39. 168. Ibid, p. 40. 169. Ibid, p. 41. 170. Skousen, p. 406. 171. Ibid, p. 406. 172. Ibid. 173. Ibid, p. 407. 174. Ibid, p. 406. 175. Friedman, p. 54. Policy Study 30 176. Ibid, p. 54. 177. Ibid. 178. Ibid, p. 40. 179. Ibid. 180. Skousen, p. 407. 181. Ibid. 182. Ibid. 183. Friedman, pp. 38-39. 184. Todd Knoop, Modern Financial Macroeconomics: Panics, Crashes, and Crises (Oxford, UK: Blackwell Publishing, 2008), pp. 80-81. 185. Ibid, p. 81. 186. Ibid, p. 93 187. Ibid, pp. 93-94. 188. Ibid, p. 86. 189. Ibid, pp. 86-87. 190. Ibid, p. 89. 191. Ibid, p. 91. 192. Ibid, p. 95. 193. Ibid, p. 91. 194. Ibid, p. 93. 195. Ibid, p. 92. 196. Ibid, pp. 93-94. 197. Ibid, p. 95. Public Interest Institute, September 2012 Public Interest Institute at Iowa Wesleyan College 600 North Jackson Street Mount Pleasant, IA 52641-1328 nonprofit organization u.s. postage paid mailed from zip code permit no. 338 52761 This policy study is brought to you in the interest of a better-informed citizenry, because IDEAS DO MATTER. You can write Public Interest Institute at: Public Interest Institute 600 North Jackson Street Mount Pleasant, IA 52641-1328 [email protected] www.LimitedGovernment.org Policy Study 31 Public Interest Institute, September 2012