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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
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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
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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
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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
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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
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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
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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
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Policy Study
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Public Interest Institute, September 2012