Evolution of Economic Thought
More Notable Economists Before Adam Smith
The Evolution of Economic thought took different paths after Adam Smith. So we need to discuss the ideas prior to Smith -- and why and how the paths took place.
There are, generally speaking, two paths that emerged after Adam Smith. Although there are, of course, off-shoots from these paths. There are three basic differences between the two paths, with the off-shoots having their own differences.
Three differences:
Methodology
Process vs. equilibrium. Once equilibrium – lead to mathematical reasoning.
Value Theory – utility theory vs. labor theory of value
Macro vs. Micro split – staying with the individual to explain all economic phenomena vs. aggregating
Here is how I see the paths:
We certainly need to look at some of the ideas of Cantillon and Turgot -- because they had great insights that Smith didn't include in An Inquiry Into the Nature and Causes of the Wealth of Nations. In fact they had "systems" within their ideas.
One really strange, yet interesting thing about Smith - is that his lectures (unpublished at the time of the publication of An Inquiry Into the Nature and Causes of the Wealth of Nations) were very different than what he put in his book. For example, he had a utility theory of value in his lectures (and to some degree solved the diamond/water paradox). This was all left out of the book. He also left out Hume's specie flow -- even though they were good friends. There were other things as well. Were there political pressures? Was the labor theory of value more politically appealing? Hard to tell? More on this later.
But before looking at Cantillon and Turgot - really the leaders of the Laissez Faire French tradition - let's look (very briefly) at Petty. To some degree he influenced both paths. But mostly he belongs to the "Smith" path.
Sir
William Petty (1623-1687)
Petty was given the task of determining the riches of Ireland after the British had invaded the country (and determine how to divide up the riches). He is known for being the first "econometrician." He was also a scientist, entrepreneur, inventor.
Petty's work on Ireland is found in his 1672 Political Anatomy of the country. A pupil of Hobbes, Petty was a Mercantilist in his policies, but there's also a hint of the labor theory of value in his works. He was particularly influential upon John Locke (some see Locke's theory of property as a kind of labor theory of value - others very much disagree - more on this later).
Major Works of Sir William Petty
His
Treatise of Taxes and Contributions (1662).
Devoted
to the analysis of public finances and the sources of public revenues.
He
dealt with matters of practical policy – taxation, determination of wealth,
population, coinage, etc.
A
physician by training – he also used analogies of the human body with social
communities.
Let’s Measure Everything:
His studies marked the beginning of a new period in economic reasoning – they initiated the formation of economic problems in terms of relations among measurable magnitudes (so a take-off of the Physiocrats as well).
NOW we see Methodology becoming important.
Petty
regarded observable magnitudes as the most appropriate objects of social
analysis – so he wanted to use the aid of “numbers, weights and measures.”
In
his Political Arithmetic
*(which is what he called his method) – written between 1671-1676 – he
wanted to express by figures the wealth of England – according to the value of
the country’s capital assets and population.
Hence
he has been called the Father of English Administration Statistics.
This
emphasis on empirics and objectivism became important to the British Classical
tradition in economics.
In
other words, Petty was a positivist (supposedly devoid of opinion) before
that principle became the main research method of the natural sciences.
Petty also attempted to separate morals from science.
Normative vs. Positive:
Science
does not exist to handle moral problems – it is simply a means to an end.
Moral problems involve the selection of ends.
However,
Petty was not always a “positivist” -
Petty
was very “systematic” – each economic problem confronted in the real world
must be treated as an integral part of a larger whole – not as an independent
phenomenon.
On
Money:
Velocity:
Petty’s chief contribution to monetary theory was his use of the velocity
– of circulation concept to determine the optimum Q of money…an
important predecessor of Locke and Cantillon.
He
related the velocity to institutional factors – such as length of pay periods.
Money
was a means to an end – not an end itself.
The accumulation of money was not as important as employment and economic
activity.
“That
Labour is the Father and active principle of Wealth, as lands are the Mother”
(Economic Writing, Vol. 1, p. 63).
Little
analysis …no theory of value.
But
Petty did a lot of work trying to determine some “natural par” between land
and labor.
Amount
of land req. = days food for an adult man
Value
of this output = value of a day’s
labor.
Trying
to find an absolute standard of value … “productive power” – the
land-labor standard of value.
But
his was not so much a labor theory of value as a land theory of
value.
*Petty’s
main contribution (to mainstream modern day economics) still remains his method … “econometrics.”
Cantillon and Turgot – the beginnings of the French and Austrian path!
Richard Cantillon (1680-1734)
Richard Cantillon is sometimes called the first real theorist in economics. William Stanley Jevons, one of the cofounders of the marginalist revolution (who we will talk about later), and the economist who is generally credited with rediscovering Cantillon (after his work was ignored for many years), called Cantillon's most famous work (and basically his only surviving one),
" a systematic and connected treatise, going over in a concise manner nearly the whole field of economics. . . . It is thus the first treatise on economics."
In fact many feel that Cantillon, not Smith, should be considered the "father of economics."
He was referring to the Essai Sur la Nature du Commerce en Général was written in French circa 1732 and published anonymously in England some twenty years after his death (1755).
The man: Not a lot known about his life except - he was an Irishman (a banker and accountant) with a Spanish name who lived in France. Supposedly, he died in a fire in his London home - allegedly set by his discharged cook (was therefore murdered). But this has also been disputed – a Irish historian of the Cantillon family claims that it was a set up and he took off and lived for many years elsewhere!
From 1721 to 1734 he was involved in legal disputes and was imprisoned twice. It was during this time that he wrote his Essai and there is good reason to suspect that Cantillon developed economic theory as part of his legal defense against charges of usury (he was also charged with murder at one point).
Rothbard points out that as a banker – he saw what fluctuations in the money supply could do to the economy and made money off of understanding the monetary business cycle. But then he would leave town when the bubble burst!!
His followers: His work was well-known to the Physiocrats and the Austrian economists consider him an important influence on the development of Austrian economics. Smith referenced him (which was unusual for Smith) but some say he misrepresented Cantillon's ideas.
As I stated before, the French economists Turgot and Say are more along the lines of Cantillon – followed by the Austrian economists, Menger, etc.
He thought of the economy as a rationally functioning system made up of various parts. His method was remarkably modern - he engaged in theoretical comparative systems analysis.
So the economy was constantly adjusting to changes in productivity, tastes, etc., in accordance with the self-interested pursuit of profit.
The Market System:
Cantillon saw the economy as an organized system with interconnected markets that operate in such a fashion as to achieve a kind of equilibrium. But he was more concerned with the process of the market than with some end state.
Mutual dependence and evolution depending upon “need and necessity.”
Entrepreneurs who conduct “all the exchange and circulation of the state” keep the system in adjustment.
Information and market adjustment:
Also explained adjustment in the labor market: If the price of a good decreased due to drop in demand, then wages will fall in that industry and workers will move elsewhere.
So he understood the concept of derived demand:
Competition and Entrepreneurship
Competition was a rivalrous process – not an end-state (pre-Hayek and other Austrian economists),
He saw the economy in terms of classes of individuals, each class defined by a major economic function:
“We may conclude that, with the exception of the Prince and the Proprietors of Lands, all the Inhabitants of a State are dependent; that they may be divided into two classes, namely, Entrepreneurs and Wage-earners; and that the Entrepreneurs work for uncertain wages, so to speak, and all others for certain wages until they have them, although their functions and their rank are very disproportionate. The General who has a salary, the Courtier who has a pension, and the Domestic who has wages, are in the latter class. All the others are Entrepreneurs, whether they establish themselves with a capital to carry on their enterprise, or are Entrepreneurs of their own work without any capital, and they may be considered as living subject to uncertainty; even Beggars and Robbers are Entrepreneurs of this class.”
Bearing uncertainly is the essence of entrepreneurial activity.
He also recognized the interconnection between product markets and resource markets (as above with labor adjustment).
“All these Entrepreneurs become consumers and Customers of each other; the Draper, of the Wine Merchant; the latter of the Draper. They adjust their numbers in the State to their Customers or to their market. If there are too many Hatters in the City or in a street for the number of persons who buy hats there, those having the fewest customers will have to become bankrupt; if there are too few, it will be a profitable enterprise, which will encourage some new Hatters to open shop there, and it is thus that Entrepreneurs of all kinds, at their own risk, adjust their numbers
in a State.”
Entrepreneurial activity seemed to be the essence of competition and vice versa.
The Effect of Money on Prices and Production
This was the beginning of the Austrian business cycle theory. An explanation of how an increase in the money supply will lead to “bubbles” in some industries – distorting prices and resource allocation (and production). Eventually the bubble will burst – and resources must move to where they are really of value. This is a painful period. Note the resemblance to today!!
Money is not "neutral":
He originated the income approach to monetary theory: the analysis of the causal chain that connects changes in the money stock to changes in expenditures, income, employment and prices.
Cantillon then made an estimate of the stock of money required to make the economy work smoothly:
“It usually happens in state where money is scarcer that there is more barter than in those where money is plentiful, and circulation is more prompt and less sluggish than in those where money is not so scarce. Thus it is always necessary in estimating the amount of money in circulation to take into account the rapidity of its circulation.”
Citing the “quantity theory” of John Locke, Cantillon said:
“Everybody agrees that the abundance of money or its increase in exchange raises the price of everything. The quantity of money brought from America to Europe for the last two centuries justifies this truth by experience…the great difficulty…however, consists of knowing in what way and in what proportion the increase of money raises prices”
Cantillon Effects (ignored in much of modern monetary theory):
Cantillon talked about how money entering an economy could change both interest rates and prices. So there are two market signals that are distorted or changed by the influx of money -- and both distortions lead to changes in resource allocation.
To the degree that new money is spent in the economy (and not saved), there will be relative price changes.
Relative Price Changes :
Modern day -- injection effects (from Cantillon) – The process of inflation vs.
helicopter effects – The quantity theory of money (end state of overall price increases) from an increase in the money supply:
So as relative prices change -- resources will move into those markets that are experiencing a higher demand. Thus, enters the entrepreneurs - who will adjust resource movement to this new spending.
The Interest Rate:
The effect of monetary changes on the interest rate depends on where new money enters the economy and into whose hands it passes first: Spenders vs. Savers
“If the abundance of money in a State comes into the hands of money-lenders it will doubtless bring down the current rate of interest by increasing the number of money-lenders; but if it comes into the hands of those who spend it will have quite the opposite effect and will raise the rate of interest by increasing the number of entrepreneurs who will find activity by this increased spending and who will need to borrow in order to extend their enterprise to every class of customers.”
Graphs:
Therefore his interest rate theory was a loanable-funds theory (Supply and demand of loanable funds as we have seen before).
Therefore an influx of precious metals can act in two ways:
If they are lent – lower the r
or spent – stimulate production directly, increase the demand for loans, increase the interest rate.
This change in interest rates then have resource allocation effects:
More resources moving into where the money is spent.
However, these changes are temporary. While the new money is entering the economy -- there appears to be "boom" going on. But this boom won't last as the money injections end. Entrepreneurs find themselves with investments that are no longer profitable. And the "bust" takes place. Resources must move elsewhere (including people).
Pretty big insight for his time (or any time)!!
Anne Robert Jacques Turgot (1727-1781)
A.R.J. Turgot was born in Paris to a distinguished family which had long served as important royal officials. He died rather young, and the time and energy he devoted to economics was comparatively little – which makes his contributions even more amazing.
His most famous work, "Reflections on the Formation and Distribution of Wealth" (1766), is only fifty-three pages long.
Another good work was the "Elegy to Gournay" (1759), a tribute to his mentor and friend Jacques Claude Marie Vincent, Marquis de Gournay (1712-1759) – who probably taught him most of his economics!
He was magistrate, master of requests, intendant, and, finally, did a short-lived and controversial minister of finance (or "controller-general"). This is where he tried to sweep away government restrictions on the market economy in a virtual revolution from above! (This was the method of the Physiocrats in getting ideas or theories put into action – have the king or his gang implement them. This is why Turgot is sometimes called a Physiocrat (as well as his laissez faire ideas).
Why aren't Turgot's ideas more popular today (really weren't passed down)?
Turgot's finance revolution failed. In spite of his political and economic liberalism, he ended up implementing his reforms too hastily and too harshly, which evoked cries of dissent from the aristocracy. He was advised to implement his reforms more slowly and carefully, but a sense of impending doom for both the regime and his own life — “In our family we die at fifty,” he had said-had spurred him on to reckless, and in some cases despotic, policy-making. Turgot was dismissed by the king in 1776. Hence – he became somewhat discredited.
This is Rothbard’s theory as to why his ideas were not passed on through Smith, etc. Who knows?
LAISSEZ FAIRE AND FREE TRADE
To Turgot mercantilist regulation of industry was not simply intellectual error, but was “coerced cartelization and special privilege conferred by the State.”
For Turgot, freedom of domestic and foreign trade followed equally from the enormous mutual benefits of free exchange. All the restrictions "forget that no commercial transactions can be anything other than reciprocal," and that it is absurd to try to sell everything to foreigners while buying nothing from them in return.
Knowledge – A forerunner to F. A. von Hayek:
Hayek’s knowledge argument:
“Individual knowledge of time and circumstances”
Therefore, central planning of resources would be impossible.
Let’s see how Turgot basically had similar points – but did not go as far as Hayek did.
In his "Elegy," he talks about the uses of indispensable particular knowledge by individual actors and entrepreneurs in the free market. These committed, on-the-spot participants in the market process know far more about their situations than do intellectuals who are not involved in the situation.
Hayek’s Spontaneous Order in Turgot:
Gournay's entire laissez-faire doctrine, Turgot points out, "is grounded on the continuous inspection of a multitude of transactions which by their immensity alone could not be fully known, and which, moreover, are continually dependent on a multitude of ever changing circumstances which cannot be managed or even foreseen."
The Market Process and It's Outcomes
Self-interest is the prime mover of the market process, and that individual interest in the free market must always coincide with the general interest (pre- Smith - who is famous for saying that people acting in their own self interest will benefit society as a whole without meaning to do so - with the right rules in place).
The buyer will select the seller who will give him the lowest price for the most suitable product, and the seller will sell his best merchandise at the highest competitive price.
Governmental restrictions and special privileges, on the other hand, compel consumers to buy poorer products at higher prices.
Turgot concludes that "the general freedom of buying and selling is therefore . . . the only means of assuring, on the one hand, the seller of a price sufficient to encourage production, and, on the other hand, the consumer of the best merchandise at the lowest price."
Turgot concluded that government should be strictly limited to protecting individuals against "great injustice" and the nation against invasion. "The government should always protect the natural liberty of the buyer to buy, and the seller to sell."
The market will ensure quality and decrease fraud:
It is possible, Turgot conceded, that, on the free market, there will sometimes be "a cheating merchant and a duped consumer." But then, the market will supply its own remedies: "the cheated consumer will learn by experience and will cease to frequent the cheating merchant, who will fall into discredit and thus will be punished for his fraudulence." Turgot, in fact, ridiculed attempts by government to insure against fraud or harm to consumers.
Government's attempt then to assure quality, etc. will just lead to higher costs:
Turgot added that all such regulations and inspections "always involve expenses, and that these expenses are always a tax on the merchandise, and as a result overcharge the domestic consumer and discourage the foreign buyer."
Turgot concludes, "To suppose all consumers to be dupes, and all merchants and manufacturers to be cheats, has the effect of authorizing them to be so, and of degrading all the working members of the community."
VALUE, EXCHANGE AND PRICE
Value
One of the most remarkable contributions by Turgot was an unpublished and unfinished paper, "Value and Money," written around 1769.
Turgot developed an Austrian-type theory first of Crusoe economics, then of an isolated two-person exchange, which he later expanded to four persons, and then to a complete market. By concentrating first on the economics of an isolated Crusoe figure, Turgot was able to work out economic laws that transcend exchange and apply to all individual actions.
Subjective Utility:
Diminishing: Like other French writers before him, Turgot sees that the subjective utility of a good diminishes as its supply to a person increases; and like them, he lacks only the concept of the marginal unit to complete the theory.
But he went far beyond his predecessors in the precision and clarity of his analysis. He also sees that the subjective values of goods will change rapidly on the market, and there is at least a hint in his discussion that he realized that this subjective value is strictly ordinal and not subject to measure.
Turgot saw that a "comparison of value, this evaluation of different objects, changes continually with the need of the person."
Turgot proceeds not only to diminishing utility, but to a strong anticipation of diminishing marginal utility, since he concentrates on the unit of the particular goods: "When the savage is hungry, he values a piece of game more than the best bearskin; but let his appetite be satisfied and let him be cold, and it will be the bearskin that becomes valuable to him."
This provides the basis for Carl Menger's analysis of why people consume -- to satisfy ENDS. And the first end satisfied is the highest valued, then we move down our individual end scale. So if a bear is killed --
End1
End2
Etc.
He really solved the so-called “diamond-water or value paradox” - although he never really refined the concept of the "marginal" unit (otherwise he had it)!!
“Water, in spite of its necessity and the multitude of pleasures which it provides for man, is not regarded as a precious thing in a well-watered country; man does not seek to gain its possession since the abundance of this element allows him to find it all around him.”
Opportunity Cost
Although Turgot called the cost of a product its "fundamental value," he comes down generally to a rudimentary version of the later Austrian view that all costs are really "opportunity costs," sacrifices foregoing a certain amount of resources that would have been produced elsewhere.
Thus, Turgot's actor (in this case an isolated one) appraises and evaluates objects on the basis of their significance to himself:
The significance, or utility, is the importance of his "time and toil" expended, but then he treats this concept as equivalent to productive opportunity foregone (although a little sketchy):
as "the portion of his resources which he can use to acquire an evaluated object without thereby sacrificing the quest for other objects of equal or greater importance."
He did point out that the capitalist will tend to earn his imputed wages and the opportunity that the capitalist sacrificed by not investing his money elsewhere.
In short, the capitalist's accounting profits will tend to a long-run equilibrium plus the imputed wages of his own labor and skill.
In other words, today’s idea that the market tends to zero economic profit (which means a positive accounting profit).
Trade
Typical of many economists before the 1870s, Turgot then goes off the subjective value track by adding, unnecessarily, that the terms of exchange arrived at through this bargaining process will have "equal exchange value," since otherwise the person cooler to the exchange "would force the other to come closer to his price by a better offer."
It is unclear here what Turgot means by saying that "each gives equal value to receive equal value"; there is perhaps a notion here that the price arrived at through bargaining will be half-way between the value-scales of each.
He is, however, perfectly correct in pointing out that the exchange increases the wealth of both parties.
THE THEORY OF CAPITAL, ENTREPRENEURSHIP, SAVINGS, AND INTEREST
According to Rothbard, in the roster of Turgot's outstanding contributions to economic theory, the most remarkable was his theory of capital and interest, which, in contrast to such fields as utility, sprang up virtually full-blown unrelated to preceding contributions.
Not only that, but Turgot worked out almost completely the Austrian theory of capital and interest a century before it was set forth in definitive form by Eugen von Böhm-Bawerk.
Savings leads to capital investment.
The "capitalist-entrepreneur" must first accumulate saved capital in order to "advance" their payment to laborers while the product is being worked on. In agriculture, the capitalist-entrepreneur must save funds to pay workers, buy cattle, pay for buildings and equipment, etc., until the harvest is reaped and sold and he can recoup his advances. And so it is in every field of production.
Some of this was picked up by Adam Smith and the later British classicists, but they failed to absorb two vital points:
1. 1. Turgot's capitalist was a capitalist-entrepreneur. He not only advanced savings to workers and other factors of production, he also, as Cantillon had first pointed out, bore the "risks of uncertainty" of the market.
Cantillon's theory of the entrepreneur as facing uncertainty, thereby equilibrating market conditions, had lacked one key element: an analysis of capital and the realization that the major driving force of the market economy is not just any entrepreneur but the capitalist-entrepreneur, the man who combines both functions.
Yet Turgot's memorable achievement in developing the theory of the capitalist-entrepreneur, was, as Professor Hoselitz pointed out, "completely ignored" until the twentieth century.
2. 2. If the British classicists totally neglected the entrepreneur, they also failed to absorb Turgot's emphasis on the crucial role of time in production, and the fact that industries may require many stages of production and sale - and all of this takes time.
Interest
It is not capital assets that allows the capitalist/entrepreneur to borrow – but it his industry and integrity. In other words – his ability to pay back the loan through productivity.
The king on the other hand, will not be productive – therefore, has to obtain the interest from others in the community.
This is a precursor to James Buchanan’s criticism that government debt is the same as private debt.
There are major differences – this is just one of them.
Again, note the Time element:
Note too then that interest has a time element to it. It will be paid back due to the productivity through time.
Time Preferences: And since the lender has to forgo the money during the time lent – he bears a cost. Therefore, needs to be compensated for that cost. We see this as a basis for the Austrian theory of interest.
Usury laws:
Pressing on to an analysis of the nature and use of lending at interest, Turgot engaged in an incisive and hard-hitting critique of usury laws, which the Physiocrats were still trying to defend.
A loan, Turgot pointed out, "is a reciprocal contract, free between the two parties, which they make only because it is advantageous to them." Turgot moved in for the clincher: "Now on what principle can a crime be discovered in a contract advantageous to two parties, with which both parties are satisfied, and which certainly does no injury to anyone else?"
There is no exploitation in charging interest just as there is none in the sale of any commodity. To attack a lender for "taking advantage" of the borrowers need for money by demanding interest "is as absurd as an argument as saying that a baker who demands money for bread he sells, takes advantage of the buyers need for bread."
Capitalization and Interest:
In addition to developing the Austrian theory of time preference, Turgot was the first person, in his "Reflections," to point to the corollary concept of capitalization, that is, the present capital value of land or other capital good on the market tends to equal the sum of its expected annual future rents, or returns, discounted by the market rate of time preference, or rate of interest.
THEORY OF MONEY
While Turgot did not devote a great deal of attention to the theory of money, he had some important contributions to make. In addition to continuing the Hume model and integrating it with his analysis of interest, Turgot was emphatic in his opposition to the now dominant idea that money is purely a conventional token.
Turgot declared, "it is not at all by virtue of a convention that money is exchanged for all the other values: it is itself an object of commerce, a form of wealth, because it has value, and because of value exchanges in trade for an equal value."
There are two kinds of money, Turgot notes:
1. real money--coins, pieces of metal marked by inscriptions—and
2. fictitious money, serving as units of account or numeraires.
When real money units are defined in terms of the units of account, the various units are then linked to each other and to specific weights of gold or silver.
This also comes before Menger’s theory of the origin of money. Very similar! Real money, for Turgot, is something that is an exchangeable commodity. Menger adds the story of how it all comes about.
Problems arise, Turgot shows, because the real moneys in the world are not just one metal but two--gold and silver. The relative values of gold and silver on the market will then vary in accordance with the relative scarcity of gold and silver in the various nations.
With “fictitious” money – or paper money with no backing – he asks what are the bounds (of the king printing more money) and how will they be determined?
Good question!!
He says – because the king prints more money in one period to pay for the kingdom’s expenses – this causes prices to increase. Therefore, the king will have to print even more money next period to pay for the same expenses. Etc., etc. There is no bound to what the king will do with paper money!
Inflation as Taxation
And he understands that basically, the king increasing the money supply for his own use is a way of taxing the people (indirectly). So it saves the time and worry of actually paying taxes -- but it is a tax, nonetheless.
