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6. CLASSICAL ECONOMICS Classical economics = dominant doctrine from late 18th, starting with Adam Smith, to late 19th century (Anders Chydenius as precursor to Adam Smith?) 1. The labor theory of value 2. Growth and distribution 3. The invisible hand 4. The price-specie flow mechanism 5. The role of the state 1 Classical economists • The Scotsman Adam Smith was professor of moral philosophy at the University of Glasgow. Before ‘The Wealth of Nations’ he had already published an influential philosophical work ‘The Theory of Moral Sentiments’ (1759). The Wealth of Nations is large and wide-ranging, covering theory and history as well as descriptions of social and economic institutions. • David Ricardo made already as a young man a fortune as a stockbroker specializing in government bonds. His main work, characterized by highly abstract analysis, is ‘The Principles of Political Economy and Taxation’ (1817). • Robert Malthus, British priest and demographer, is above all famous for his (pessimistic) ‘An Essay on the Principle of Population’ (1798). • The Scotsman David Hume is mainly known from the history of philosophy but he also wrote on economics, particularly on the monetary system, in his ‘Political Discourses’ (1752). • James Stuart Mill was the son of another economist, James Mill (a close friend of Ricardo), and received an exceptional education already as a child. It is generally considered that John Stuart Mill gave the definitive statement of the classical tradition from Smith to Ricardo. He is also an important contributor to the utilitarian philosophy and to political liberalism. His main economic work is ‘Principles of Political Economy’ (1848). 2 1. The labor theory of value (price theory) • Adam Smith: relative prices of commodities are determined by (equal to) the relative amounts of labor needed for their production (in the long run, on average) - later Smith also took account of rent and profits as costs of production • David Ricardo: - production requires labor but also ’capital’, which he interpreted as embodying ’past’ labor, - found that the labor theory of value will not hold in the sense that relative prices of commodities will deviate from the relative amount of labor in their production (taking account of both ’direct’ and ’past’ labor) if the capital intensity differs between the sectors and if the required rate of return on capital is the same, • Karl Marx: - took over the labor theory of value from Ricardo and faced the same difficulty - exploitation = value created by labor - labor needed for its reproduction (subsistence wage) - the relation between prices and values is ”transformation problem” • In retrospect the labor theory of value is a metaphysical and useless endeavour (Joan Robinson): it is not necessary to explain prices by something more fundamental (values), this is not a precondition for claiming that capitalism is immoral • The ultimate reason for the search for a labor theory of value is probably the popular idea (held by, e.g., John Locke), that labor is the original justification of property (fruits of labor). 3 2. Growth and distribution • Starting with Smith, the classics focussed on the distribution of income between labor, land and capital and the long-term rate of growth (towards an ultimate stationary state) • Thomas Malthus: population grows in a geometric ratio (2, 4, 8…) but food production only in an arithmetic ratio (1,2,3,…) (?), from which he derived his ’iron law of wages’: in the long run wages will unavoidably converge to the subistence level, in spite of poor relief (unless tough birth control can be instigated). • David Ricardo: growth calls for successively less productive land to be brought into cultivation, which raises the rent earned by land of better quality and increases the income share of landowners. With a constant rate of wages (Malthus) , rising rents cause a fall in the rate of profit and in capital accumulation until the stationary state is reached. • The stationary state was a dismal state for Malthus, less so for Smith and J.S.Mill, for whom the stationary state could be compatible with intellectual and moral progress as well as more wight being given to non-material values. 4 3. The invisible hand For posterity the most important messasge of Smith’s ’Wealth of Nations’: the market economy as a self-regulatory system with sopantenous coordination of activity. “Every individual necessarily labours to render the annual revenue of society as great as he can. He generally, indeed, neither intends to promote the publick interest, nor knows how much he is promoting it. … He intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.” “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their own self-interest. We address ourselves not to their humanity but to their self-love, and never talk to them of our own necessities, but of their advantages.” Self-love as virtue? However, Smith was no apostle of egoism! 5 4. The quantity theory of money and the price-specie flow mechanism David Hume is one of the first to set out the important ’quantity theory of money’. Money is a means of exchange and a measure of value but not really a portfolio asset. The quantity theory states that nominal income (PY) equals the stock of money (M) multiplied by its ’velocity of circulation’. This can be read as an identity and a definition of V. However, it becomes a theory if V is assumed to be determined by the payments technology. P MV=PY P1 P0 M0 M1 Assume that flexible wages and prices are maintaining full employment, to which corresponds a certain level of real income Y, and assume the stock of money to be given for the time being, and a given V (payments technology), then the price level is proportional to the stock of money. That is, an increase in the stock of money leads to a equiproportionate increase in the price level, that’s all. Money is ’neutral’. M 6 Assume that money is a stock of gold. Alternatively, part of it can consist of paper currency provided it is convertible at a fixed price into gold (such that paper money is just a convenient surrogate for gold). Assume also sufficient gold backing and free trade. The point of the analysis of Hume is to demonstrate the self-equilibrating character of the gold standard provided by the external balance and its effect on the supply of money. Figure 6.2: The price-specie flow mechanism P MV=PY P1 Current account in deficit P* P* P0 M0 M* M1 The horizontal line P*P* represents the domestic price level at which the trade account of the country is in balance. At a higher domestic price level there is an external deficit and at a lower price level a surplus (assuming sufficiently high price elasticities in exports and imports). If the money stock is originally at level M0, to which corresponds the price level P0, there will a surplus in the trade balance. This means that the stock of money (gold) will increase as less is paid for imports than is earned through exports. M 7 5. The role of the state Smith explained that the wealth of a nation was not to be identified with the treasury of the ruler, as proposed by the mercantilists, but consisted rather of the production (the national income) and consumption of the citizens of the nation. He considered division of labor to be the key to efficiency, and growth of the market as beneficial by allowing further specialization. Smith condemned mercantilist policies because they would distort competitive conditions and reduce economic efficiency. The view that unfettered competition enhances efficiency has since been widely embraced by economists, though exception must be made for various kinds of ‘market failure’. The role of government was for Smith to protect citizens and their property against foreign aggression and against violence or oppression from other citizens. However, he also saw the need for the provision of certain public or collective goods such as “publick works and certain publick institutions which it can never be for the interest of any individual, or small number of individuals, to erect and maintain; because the profit would never repay the expence to any individual or small number of individuals, though it may frequently do much more than repay it to a great society.” 8 Ricardo on free trade Ricardo argued forcefully for free trade and is most famous for setting out the theory of comparative advantage. This theory explains that it makes sense for, say, Portugal and England to trade with each other even if the costs of production of all goods were lower in Portugal than in England. In his original version Ricardo set out the required labor input for production of wine and cloth in Portugal (of some specific amounts) with the following figures: • England Portugal • Wine 120 80 • Cloth 100 90 • As can easily be demonstrated, Portugal is more efficient in both sectors, but Portugal can achieve more production by specializing in wine and importing cloth from England. Conversely, England will produce cloth and exchange part of its output for wine imported from Portugal. Both countries gain by specializing according to their comparative advantage. For Portugal, a unit of cloth costs 90. But by selling one unit of wine to England, getting 120 and exchanging this to cloth, this gives more than one unit of cloth. For England, one unit of wine costs 120. But selling one unit of cloth to Portugal for 90, and exchanging it for wine, it gets more than one unit of wine. However, it was left for J.S.Smith to determine the actual prices and trade volumes. 9 Ricardian equivalence A theoretical proposition according to which fiscal policy does not even affect the rate of interest and the effects are the same indpendent of how fiscal expansion is financed: taxes or borrowing. The preconditions for this ”Ricardian equivalence”, which was rediscovered in recent decades by Robert Barro, are demanding: perfect capital markets and infinitely long planning horizons of households. For Ricardo this was an unlikely theoretical possibility; in recent years it has been taken more seriously (but has little empirical support). 10