A Brief Introduction to Classical Economics
Backgrounds
In the Western world, the emergence of economics as a comprehensive and serious inquiry happens more or less all at once in the 18th century with the works of Richard Cantillon, Francois Quesnay, Anne Robert Jacques Turgot and far above all, the glorious work of Adam Smith: An Inquiry into the Nature and Causes of the Wealth of Nations. The appearance of what is now called “classical economics” coincides with the rise of the novel (Swift, Hogg, Diderot, Sade, Laclos, Goethe, Kleist), the rise of empirical and enlightenment philosophy (Berkeley, Hume, Kant), Newtonian physics, and the beginnings, principally in America, of a new notion of government which, like Kantian philosophy, takes as its starting point, limits. When I say that the rigorous study of economics happened “all at once” I do mean that its appearance was unprecedented in Western History, and I believe there may be a reason for this to which I shall return shortly. However, in the end, in this talk I am more interested in what happened (than in why) and in what it might mean.
If we look for anything remotely like ‘economic theory’ anywhere up to the 18th century, we find virtually nothing at all. The Old Testament Bible may have a remark here or there about, for example, usury but nowhere is there a systematic attempt to ask about the overall social consequences of the practice, its logic or its means and ends. Plato has nothing to say on the subject of economics; Aristotle, little. There is a book titled Economics under Aristotle’s name but it is not seriously considered authentic. Elsewhere, Aristotle’s remarks about oikonomia (from which we get the word ‘economics’) are concentrated principally in the Book I of the Politics and in Book V of the Nicomachean Ethics. The New Testament of the Bible, like the Old, has a few scattered references to wealth, but these fall within the context of salvation or morality. The Middle Ages of the Roman Catholic Church falls, for the most part, under the sway of St. Paul (I will come back to this shortly). To be sure in the Middle Ages there were market places, travel and trade, but no attention was paid to the details of exchange. Even in the Renaissance with the rise of exploration, mercantilism, monetarism, and the discoveries of gold and silver in the new world, little attention was made even to keep accurate legers. At the end of the 16th century Queen Elizabeth toured her country and exclaimed that while England was rich, “Paupers are everywhere!” (The culprit was wool. Just a bit previously, when England was fighting wars and was in debt, the countryside was filled with working tenant farmers. When, after the wars, the price for wool went up, owners needed more grazing land for sheep, and the farmers had to go.) Indeed, England was becoming rich; the adventures of Sir Francis Drake’s The Golden Hind brought his queen enough gold to retire the national debt; the remainder of which was invested overseas, and (with interest and good fortune) accounted for England’s entire overseas wealth as late as 1930!
To get to the historical point: Why the sudden interest in natural laws (the rate at which apples fall from trees in Newton), or in people who are not legendary heroes (Robinson Crusoe, Sade’s and Laclos’s criminals, the solitary and lovelorn Werther, and so on)? Why the philosophical interest in the mundane empirical (billiard balls clashing and the “fiction” of causality in Hume), and the interest in finitude, in limits to government, to thought, to life (in Jefferson, Hamilton, Madison, and Kant)? In short, why the sudden interest in this world (precisely as this world, as mundane, as banal) and the loss of interest in myth, legend, and the other world? I think that Chu-po gave us the answer two years ago in his highly informative colloquium on Max Weber. Allow me to summarize a portion of his presentation.
Weber wanted to account for modern capitalism and its unprecedented success in subordinating all areas of social production into profit-oriented wage labor and rationalized generation and distribution of wealth. Weber did not believe that this, now global, organization of production came about in any way “naturally” nor as a result of larger-than-life economic “heroes” (in contrast to Schumpeter, whom we will get to later). Weber wished to define the circumstances and relationships to which modern capitalism owes its existence, and in doing so he took a unique theoretical risk because he locates the subject of this development in a small but stubborn religious group. He wanted to understand the dramatic transition from a generally Pauline (from St Paul) way of life to a modern, capitalist one. In the Pauline view:
The systematic seeking after wealth was considered morally damaging (with the exception of the Church itself because of its dual status as both this-worldly and other-worldly).
The pursuit of worldly goals was considered trivial when compared to the search for the salvation of one’s soul; this world and its trappings were “as nothing”.
Spiritual contemplation and prayer were considered more worthy than social activity; social activities (holidays, celebrations, etc.) were carried out as traditions to be respected, and traditions (rather than innovation, calculation, and gain) were generally held to be guides for everyday life.
Weber’s task in The Protestant Ethic and the Spirit of Capitalism was to try to map out how the West became “modern”. He attempted to define a profound transition from a culture dominated by the Church of Rome (Roman Catholicism)—which was always fixated on and oriented toward the Afterworld, the Afterlife—to a culture dominated by a concern with this world and this life. The world where, Weber says (in his essay “Science as a Vocation”), “one can, in principle, master all things by calculation. This means, however, that the world is disenchanted. One need no longer have recourse to magical means in order to master or implore the spirits.”
This was a transition from the religious world to the secular world where the secular world is a process of secularizing—a setting outside of the religious, monastic order—what had been the profane world (the impure, unholy, the polluted, the defiled). Or, although Weber himself does not put it this way, he described a transition from a culture in which death was sacred to one in which life is sacred.
The core of Weber’s analysis was about the unprecedented saturation of Western life with ascetic practices (what is called the ‘work ethic’: the ant as opposed to the grasshopper as in Æsop or La Fontaine) that today have become so normalized as to have become seemingly inevitable and which began from a simple observation he made. He noticed that Protestants were substantially over-represented in various entrepreneurial and technical positions; that, in general, Protestants (and a particular sect of Protestants) were owners of new capital much more widely than Catholics.
In the course of his thinking he finally concluded that the “spirit” of capitalism is neither hedonistic nor utilitarian, is neither fundamentally rational nor irrational, but is instead a modification of the notion of Beruf [‘calling’ or ‘vocation’] from Luther’s translation of the Greek klēsis (from which we get the word ‘ecclesiastical’, meaning ‘the community of those who are called’) which leads to an asceticism that precludes rest, enjoyment or satisfaction. A drive, in short, as in Freud: beyond any pleasure principle. In his analysis he sees that it was not, however, either Luther or Lutheran Protestantism that allowed the seed of the particular notion of “calling” or “vocation” to blossom; instead it was the relatively small, severe, and somber Protestant sect of Calvinists (or, in England and America, “Puritans”) for whom the “calling” they were born into and their success in it became the paramount motivation for this-worldly-life and its organization.
The Calvinist mechanism in a nutshell is this: Human life is predestined by God either to Heaven or to Hell, and nothing can change that, nothing. This doctrine leads the Calvinist to have to concede that the worst, most brutal and unrepentant of murderers—say, somebody from out of the pages of Sade—may very well be ‘elected’ (destined to go to Heavenly reward), while Mother Teresa is destined to suffer forever the torments of Hell. The theology is impeccable if it is accepted: God is God, “wholly other” and no one can ever, not even a little bit, comprehend God. Counter-intuitively, the doctrine of predestination (according to Weber) did not lead to resignation or psychological fatalism. Instead, the good Calvinist is led to a certain conduct in the service of his or her God by methodically and systematically remaking the world in His (God’s) image. The world had to be ‘glorified’, not enjoyed. Worldly success was celebrated as an accumulation of God’s glory. Success was neither hedonistic nor utilitarian, but a calculation and an accumulation of signification because the Calvinist was led to hope that success in this world was a sign of election by God to the next world.
In Calvinist terms, economic theory is a study of glory or glorious signification. Accept that thesis or not (and none of the economists we will look at today do!), clearly the 18th century took a dramatically new interest in everyday life and the everyday people of this world, the “middle rank of men” as Hume calls them. It is an interest (from the novel, to films, to 20th century philosophical interest in ordinary language) of extraordinary extent. There would be no sociology, psychology, or even modern biology without it. Economics was at least a partner with, if not a leader of, this relatively swift historical transition. Consider the following in the introduction to a treatise written by esteemed economist Alfred Marshall (instructor to John Maynard Keynes) in 1925 and which remained a standard textbook throughout the 1930s:
Political Economy or Economics is a study of mankind in the ordinary business of life [my italics and note that the emphasis is on the “ordinary” and on the qualification of life as a “business”]; it examines that part of individual and social action which is most closely connected with the attainment and the use of the material requisites of wellbeing.
Thus it is on the one side a study of wealth; and on the other, and more important side, a part of the study of man [my emphasis]. For man’s character has been molded by his every-day work, and the material resources which he thereby procures, more than any other influence unless it be that of his religious ideals, and the two great forming agencies of the world’s history have been religious and economic. Here and there the ardor of the military or the artistic spirit has been for a while predominant, but religious and economic influences have nowhere been displaced from the front rank even for a time, and they have nearly always been more important than all the others put together. Religious motives are more intense than economic, but their direct action seldom extends over so large a part of life. For the business by which a person earns his living generally fills his thoughts during by far the greater part of those hours in which his mind is at its best; during them his character is being formed by the way in which he uses his faculties at work, by the thoughts and feelings which it suggests, and by his relations to his associates in work, his employers or his employees.
From the time of the ancient Greeks and Hebrews up to the 18th century there is not one serious coherent tract on economics (excepting, perhaps, Mandeville’s Fable of the Bees). Now, in the 20th century, according to the above (and note the august confidence with which it is written!) economics is virtually coextensive with all human life, behavior, and is fundamental to culture! Even more so than religion. Moreover, it has always been this way, according to the passage above. How can the best minds in the West have missed this? Obviously, this calls for speculation, however, clearly from this point of view, Homo sapiens has been transformed into Homo œconomicus. Like it or not, in the West beginning in the 18th century, the economy is (—that is to say, markets are—) the site of freedom, truth and justice; this is where freedom, truth and justice are distributed; this is where the human is par excellence human and this is the reason for the beginnings of, and continuation of, the great and often fierce debates over limited government which we shall examine this semester in our colloquia.
How did it come about? (I will leave the question of why to Weber, Weberians, and many others (like, not the least of which, Engels and Marx).) We can begin with Aristotle and some observations that he did not develop.
Money/Wealth
Within a general discussion of reciprocity and justice Aristotle writes the following:
Let A be a builder, B a shoemaker, C a house, D a shoe. The builder must get from the shoemaker the latter’s work and must himself give him in return his own. If there is a proportionate equality in the first instance then reciprocity follows and the result of which we are speaking [justice] will attain. Otherwise the exchange will not be equal or permanent.
How is this “proportionate equality” attained? We read further:
It follows that such things as are subject of exchange must in some sense be comparable. That is the reason for the invention of money. Money is a sort of medium or mean; for it measures everything and consequently measures among other things excess or defect, e.g. the number of shoes which are equal to a house or a meal […] Money is therefore like a measure that equates things, by making them commensurable; for association would be impossible without exchange and without equality, and equality without commensurability.
Although it is in reality impossible that things which are so widely different should become commensurable, they may become sufficiently so for practical purposes. There must be a single standard then upon which the world agrees […] Let A be a house, B ten minae, C a couch. Now A is half B if the house is worth, or is equal to, five minae. The couch C is a tenth part of B. It is clear then that the number of couches that are equal to a house is five. It is clear too that this was the method of exchange before the invention of money; for it makes no difference whether it is five couches or the value of five couches that we give in exchange for a house. [Bk V, Nicomachean Ethics, 8ff]
We should notice a few things about the above description. The exchange described produces equality of value, not surplus-value (profit); no wealth is created in the exchange process itself. Secondly, money is here merely a “medium”, an agreed upon numerical representation of the value of things that in reality are incommensurable. Money is neutral and it neutralizes a real incommensurability, that is, money neutralizes an aspect of reality; it introduces a certain “agreed upon” unreality into the necessary process of exchange. Money itself disappears into its function as a means to an end (the exchange of goods). But the neutrality of money is highly disputable and the possibility that money itself (and not this or that good) may become an end in itself is not considered by Aristotle. In fact money is a commodity; it is bought and sold and the fluctuation in interest rates indicates a robust market for money itself. Also, why should a house be worth 5 minae? How was that agreement reached? It somehow never dawned on Aristotle that the price of (the worth of) this or that good must itself be just, or natural, or a reflection of intrinsic worth, but how is “intrinsic worth” to be determined? Finally, perhaps most importantly, we note that with the introduction of money buying and selling take place in different times and places. Prior to money two agents—each of whom is buyer and seller—meet in the same place and at the same time to directly exchange goods (shoes for wheat, say) equitably. After the introduction of money, buying and selling are separated; they are distinct activities. Money, like writing for Plato, breaks up the immediacy of the proposed equality of the exchange. That is, money makes possible and also defers the equality (and justice) that Aristotle sees as practical and necessary for any “association” (i.e. any just society).
According to my readings, the status of money has never been clearly defined. Classical economists tend to ‘neutralize’ money or (in Milton Friedman) see the neutralization of money as a necessary goal in a properly functioning market economy. Money is “natural price”. In Mun (whom we shall examine next) and others, money is conflated with gold. But this overlooks a simple structural impossibility: while money may be gold (I can buy gold with money), gold cannot be money (I cannot buy anything with gold, not even more gold; I must first exchange the gold for money or gold itself must take on the form of money, like a gold coin). Thus money is essential for the functioning of any economy yet its value, its status, its own density or being has been more or less brushed aside. Money is at once nothing, neutral, a disappearing numerical mediator and at the same time a stubborn and valuable something without which the capitalist system could never have developed. I am tempted to postulate that money is the source of the formal value of the capitalist system as a whole, and is at the same time a part of that system within which it behaves like any other commodity, like Bertrand Russell’s paradoxical set of all sets that includes itself as a member. The relative neglect of this medium seems to me worth further study. In any case…
Let us leap forward to Thomas Mun (1571-1641), director of the wildly successful East India Company. He was the first to try to conceive of the economy as a whole and as a system that can be analyzed. He was what is called a “mercantilist” who, unlike Aristotle, saw money as an end itself, as “treasure”, and as equal to hordes of gold. For the mercantilists like Mun, one trades goods not for themselves but for a monetary advantage. The purpose of trade is and ought to be the wealth of a nation where wealth is accumulated money (or gold). For example, in an exchange of French wine and British gold, the British mercantilists did not conceptualize the exchange as the buying of wine from France for British gold but instead as the selling of British gold to France in exchange for wine which would then be resold to (perhaps) Scandinavia for even more gold than had been “sold” to the French.
For Mun the overriding concern in economics is the “balance of trade”: a nation should always export more than it imports. The formula seems sensible enough but the mercantilists were plagued by flaws in reasoning. First, they conceived of trade as a zero sum game: England’s positive trade balance always derives from some other nation’s negative trade balance. This is because they conceived of wealth in general as the total amount of gold in the world; an amount that is fixed. The major flaw is that the more successful any one nation the less successful and the more impoverished some other nation. The impoverished nations then become less and less able to trade and thus less able to “contribute” to the wealth of the successful nation. In the end, a single wealthy nation ends up with hordes of useless gold. This dilemma was formally “solved” in 1817 by David Ricardo with the principle of “comparative advantage” by which both sides of trade can profit. Suppose England and France both produce just two exportable goods—cloth and wine—and suppose that France can produce each more efficiently than England. Is it possible that France and England can trade without France eventually bankrupting the economic system for both? Yes! If we suppose that France can produce wine 50% more efficiently than England and cloth 25% more efficiently, then it will become evident that the French should move capital and labor into wine production. Should they do that and should England move its labor and capital into cloth production then the combined production of both nations will be greater than before. New wealth will have been created for each nation.
We should notice a few things. First, Mun is attempting to determine the source of wealth (which he finds in trade), and the value of wealth (which he finds in sheer national accumulation). Second, he devises a simple method: positive balance of trade. Third, and especially when we think about the implicit pressure of “comparative advantage”, we see that economic principles have social consequences and that economic practices have political consequences. For example, what if French lace-makers do not want to become wine-makers? What if an entire traditional way of life is suddenly about to disappear because of the advantages of trade? (This was one of the issues in the Seattle WTO meeting which was successfully shut down in part because of French cheese-makers, Indian farmers, and others who insisted that traditional ways of life were being destroyed.) On the other hand, it is indisputable that trade and the basic principles of comparative advantage do in fact increase overall wealth.
Moving on…In 1755 Richard Cantillon’s Essays on the Nature of Commerce in General was published in France 21 years after its author, often considered the first true economic thinker, had been murdered by his cook. His book begins with the sentence: “The Land is the Source or Matter from whence all wealth is produced”. This was the position of the French Physiocrats (whom I will discuss shortly), but Cantillon was not of their company as he lived in Great Britain and because he factored labor into value as well as land. Chapter X of his book is entitled: “The Price and Intrinsic Value of a Thing in general is the measure of Land and Labour which enter into its Production.” In that chapter he writes: “The price of a pitcher of Seine water is nothing, because there is an immense supply which does not dry up; but in the streets of Paris people give a sou for it—the price of the Labour of the water carrier.” It was Cantillon, in much greater complexity than Mun, who could see the significance of economics and economic principles. For Cantillon society in general is best understood as market-driven rather than tradition-bound. For him, society and markets together constitute a single complex system. Hence, Cantillon was interested in the source of all wealth, yes, but also the details of how prices are set and what is the effect of money supply on prices and how close prices may be to what he defines as “intrinsic value” (Land + Labor). He observed that a doubling of the availability of money in a society did not result in a doubling of the price of all items and wondered why. He was the first to begin to factor into economic thinking rent, and the first to talk of consumption and rates of consumption and their mutual effect on price. In effect, although he did not put it in these terms, he is the first to see wealth as a circulation system among several elements and factors, but not a circulation of wealth so much as wealth as circulation.
Next we must pause briefly and look at the Physiocrats, especially François Quesnay (1694-1774) and Anne Robert Jacques Turgot (1727-1781). We pause only briefly because their greatest insights were captured and then re-systematized by the central figure of the classical economists, Adam Smith who in fact considered Quesnay and Turgot to be extremely important. Quesnay thought that wealth had but one source: Land. The rationale is not without appeal and we need only to look at how many so-called developing nations have (and still do place) agriculture at the center of their initial plans to grow an economy. For, the wealth created by agriculture can then be invested in other industries. The rationale is simple: the gift of nature. Compare a pot maker to a corn farmer. The pot maker takes an existing amount of clay and fashions a useful pot, but the pot does not contain more clay than the lump he or she began with. No new matter has been created. Yet, from a single seed from a single kernel of corn, the farmer grows several ears of corn with several thousand kernels for next season’s planting, for his own use, and for sale to others. More (much more) existed at the end of the process than went into the ground at the beginning. Thus land and land alone is truly productive. This was Quesnay’s insight, and he devised a fascinating “zig-zag” diagram which seemed to show that a properly organized society can and will always acquire wealth from land alone even though land-owners and “sterile” producers (like pot-makers) do not contribute to the growth. Properly organized, he argued, a commercial society cannot but replenish itself and grow in wealth. The flaw in the logic, Marx correctly pointed out, is that growing corn is no more of a gift than is the gravity that drives a water wheel. In every case labor and ingenuity and invention are essential ingredients. Indeed, take away the improved machinery and tools from the “sterile sector” and “Land” will simply sustain itself like the law of gravity.
Interestingly, though, Turgot saw that in addition to agriculture there is another “gift”: the interest gained on money. Just as the farmer can simply observe that his kernels of corn are reproducing themselves exponentially, so the wealthy owner of money can—without working—simply lend money to banks who then lend to capitalists and over a time amass greater wealth than had existed previously—as if by a miracle. Indeed, the whole appeal of capitalism, of market economy, is that it seems that ‘something can be gotten from nothing’, that wealth really can, in effect, grow like corn. Classical economists had to figure out how.
Adam Smith (1723-1790)
(As you can perhaps tell from the advanced reading, with Adam Smith we enter into what I can only call “the mysteries of the banal”.) Born in Scotland and trained in Philosophy, Adam Smith wrote the not insignificant Theory of Moral Sentiments (which I mentioned a few times in last year’s symposium talk on Billy Flesh’s book Comeuppance) before turning his attention to political economics. His Wealth of Nations is the foundational book for modern political economy. The book is both a brilliant economic treatise and also as clear a portrait of everyday life in 1770s England as any novel. It was Smith who first described the English as “a nation of shopkeepers”. An encyclopedic thinker, his book sprawls to well over one thousand pages and thus is very difficult to summarize. (If Smith had a weakness it was an inability to come right to the point and a tendency to become intrigued by details such as the workings of the pin factory in the famous opening pages of his opus. The index alone in the original edition runs on for 66 pages!) I will try to be concise. He is writing at the beginnings of industrialization (before it could be called a “revolution”), and he is witnessing the break up of traditional ways of life as a consequence of economic factors such as comparative advantage. He asked himself: How can such a society hang together when its traditions are eroding and wealth is being created apparently willy-nilly (i.e. no economist had yet devised a comprehensive economic theory) stirring vices, avarice, and greed. Smith defined wealth neither as gold nor as land alone but as a trinity: Land-Labor-Capital. Land would represent a nation’s natural resources; Labor should be understood as society in general, as workers and consumers; and Capital as accumulated labor not immediately consumed. The overall purpose of the production of wealth is consumption. The trinity is unified and hangs together purely and only as a result of market mechanisms and market laws which are basically simple.
The first and chief mechanism is Self-interest which drives even beggars into the market:
It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own 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. Nobody but a beggar chooses to depend chiefly on the benevolence of his fellow-citizens. Even a beggar does not depend on it entirely […] The greater part of his wants are supplied in the same manner as those of other people, by treaty, by barter, and by purchase. [Ch II]
But then how does self interest not drive everyone into the market place in order to achieve the highest possible profits thus driving up prices? Mechanism two: Competition. Every seller in the market will be trying to sell as much as possible and will compete via prices with other similarly self-interested sellers. Suppose one hundred sellers of gloves are competing in London; each will try to undersell the others so that prices will dip toward near zero profit. But suppose all one hundred collude to set prices as in a monopoly? Well, Smith says, then the industrious shoe maker will re-tool his factory, enter the glove market and immediately undersell all one hundred! The market in every case, even monopoly, will correct itself. The market likewise corrects for quantities of goods. Mechanism three: Supply and Demand. If there is a greater demand for gloves than gloves on hand, prices on gloves will rise and consumers will then purchase fewer shoes since their incomes are relatively fixed. Shoe prices will fall, workers will be released. But these released workers will quickly enough find themselves making gloves where business is booming. Shoe production will fall and prices on shoes will gradually rise as stocks dwindle. In the same way wages will be regulated since if the wage at the glove factory is higher than at the shoe factory, glove makers will find more workers and wages will tend to fall. The ability of workers to move from one industry to another is liquefied by Mechanism four: the Division of Labor. No particular aspect in the production of a good like gloves or shoes or pins is especially difficult to master, thus it is very easy for a worker to rationally seek the highest possible wage in whatever industry he or she chooses just as the business owner can rationally decide on what type of good to invest in the manufacture of.
The market as a whole is a marvelously self-creating, self-correcting mechanism. Market pressures create disturbances but the same basic pressures restore the market to harmony. There is no need for any planning. Markets, operating freely and competitively, will always distribute goods to society with (for Smith and many, many others) a self correcting tendency toward what is often called “the natural price” or the “intrinsic worth” of the good bought or sold. Smith had comprehensively described the core principles of what is called “economic freedom”. Smith does not describe a utopia; he does not say that bad things might not happen, only that the market itself will always correct a bad thing like too high prices for necessary goods, or unemployment if the markets remain free to operate according to their own pressures and mechanisms.
It is not difficult to see that the “freedom” in this “free market system” is not so simple. First, there is the Lacanian problem of the “forced choice”. If markets are all there is to a social arrangement then I am compelled to be free, rational, individualistic, competitive, and self-interested. The fundamental experience of freedom (precisely, the decision to be free) is a priori excluded. The market does not merely encourage creativity, rationality, risk-taking, economic self-interest; it demands them. The market itself is the totality of, nowadays, billions of individual decisions freely made by free subjects. Never in human history has so much freedom been available! Indeed, markets require and produce freedom! Yet, the market is experienced as entirely outside anyone’s grasp—indeed the totality of the market must remain elusive, something alien, mysterious, not human, restless and relentless, or, as Smith famously says, guided by “an invisible hand.” The worker thrown out of work, or the consumer who cannot afford a mortgage payment has no appeal anymore than he or she might complain about an earthquake or typhoon. Although entirely human, free, rational and in principle unregulated, free market economy tends to instill a fatalism just as much as it (in a sense, forcibly) liberates creativity, rationality, and the innumerable and incomparable social benefits of these activities which are then in the long run more or less justly distributed according to market laws thus increasing the wealth of the nation as a whole.
To return to basic economics, Smith looked into the problem of accumulation of wealth (of money). Accumulation of money was the most popular driving force in England and elsewhere. Your vocation on earth was to get rich and then to hang on to it. Smith saw that such accumulation could not sustain itself without further investment in the sources of the wealth: farming, industry, others. But with additional factories or farms workers are in demand and wages will tend to rise, thus eating away at profit margins and rationally inhibiting the wealthy industrialist to expand. Smith reasoned however that with rising wages, the number of workers will gradually increase driving wages downward; when wages fall, individuals will be inhibited from having families (can’t afford another mouth to feed!) As Smith so bluntly puts it, “the demand for men, like that of any other commodity, necessarily regulates the production of men.” A law of population would eventually regulate the law of accumulation and vice versa. Remember, Smith felt that the end result of market freedom is the production of wealth to be consumed, not merely accumulated. Smith predicted overall a gradual evolution of increasing national wealth. He did not predict the industrial revolution and exponential growth; nor did he predict the occurrence of overall “business cycles”. Problems of population and accumulation would nevertheless return as we shall see.
All this is clearly the framework for today’s market economy. It is impossible to underestimate the intelligence and influence of Smith’s work, which I have merely skimmed. He died in 1790. His tombstone reads: Here Lies Adam Smith, Author of The Wealth of Nations.
After Smith: Problems, Refinements, More Problems
England had begun to and was continuing to prosper at the time of Smith’s death. Prosperity is good, of course. It means wealth, and wealth means Land, Labor (people), and Capital. However, unlike People and Capital, Land—a, or the source of wealth—does not grow itself. Unlike people, land does not breed, whereas people can breed exponentially. Thus Thomas Malthus wrote his dire predictions concerning overpopulation. His thinking is well-known. It is because of him that Thomas Carlyle called economics “the dismal science”. Less well known is his contemporary, David Ricardo (1772-1823) who would upset the harmonious picture of Smith’s political economy.
There are three classes of “economic units” that interest Ricardo. First, the workers who are “units of energy” addicted to their own survival even though their lives are no more than beer, bread, and bad clothes. Ricardo had little faith in their rational self-interest. They will always tend to overpopulate. Second are the capitalists whose lives (if it can be called life) consist of profit-taking, accumulation, investment, profit-taking, accumulation, investment and so on and so on—all in competition with each other. Finally there are the landowners who compete with no one and gain at everybody else’s expense. Like Smith, Ricardo saw that the economic world tends to expand. As capitalists grow in number they will build new shops and factories requiring land, thus the workers will continue to have labor and will increase in population, requiring more and more housing. As a result land will be taken out of agriculture. Civilization will progressively grow; there will be more mouths to feed and less land to farm, thus increasing landowners’ wealth exponentially. As the price of food goes up, the capitalist is required to increase wages, thus squeezing profits. The worker is condemned to mere subsistence since the increase in his wages will be eaten up by more and more children; the capitalists as a class will grow impoverished because of competition. But even a landowner who leaves his field fallow gains in wealth since the value of the land is accruing (because demand for it is increasing as the supply of it for farming is decreasing). In the end politics, not market self-correction, ended this bottleneck by breaking up the power of the landowners (laws were changed) and encouraging government to promote the mass importation of cheap food from elsewhere in the world until industrialized farming could become widespread in England.
Contemporary with Malthus and Ricardo was the ingenious Jean-Baptiste Say who reasoned out what became know as “Say’s Law”: Supply creates Demand (not the other way around). Say reasoned that the capacity to eat is limited by the size of one’s stomach, but desire for other commodities is incalculably large. No supply could ever exhaust it. To paraphrase a line from an American film: If you make it, somebody will buy it. Everything that is made costs something and every cost is someone’s wage and will be spent. The purpose of the law was to show that fears of general gluts were irrational. What Say failed to reckon on was the possibility of a glut of accumulation in the form of money in the bank (or in the mattress). Keynes would tackle that problem (which does not seem like it should be a problem) later on.
After Ricardo, Malthus, and Say came Utopian Socialists, Karl Marx, the so-called “Marginalists” (who intended that economics should be a branch of mathematics (which to a great degree it now is)), and Utilitarians like Bentham and Mill (who built complex economic models based on a remarkably simple principle: People seek pleasure and avoid pain. For Utilitarians, human being is essentially a pleasure-calculating-machine and numerous sophisticated models were developed from this.)
This takes us up to the 20th century when world economies in the US, Europe and elsewhere began to thrive wildly. Strategic but limited government intervention in markets and massive industrial innovation and expansion all added up to a great explosion in wealth. In the 1920s serious academic economists were actually saying that everybody can be rich. Even somebody making just $15/wk and investing in common stocks would be worth $80,000 in just twenty years. Everyman was assured he would sooner or later become Wealthyman. Then, one day in October 1929…
Keynes and the Crash
In America from 1929 to 1932 the national income shrank from $87 billion to $39 billion. Half the wealth of the US vanished without a trace, 14 million were unemployed, the standard of living was set back 20 years, and the most popular song of the time was “Brother Can You Spare a Dime?” The nation, the world, seemed mired in Depression. Self-correcting mechanisms to extricate it could not be perceived to be working. What was blocking recovery?
In fact, booms and busts—business cycles (which Smith had not predicted)—had been studied by economists. Both England and America could record rough patterns of good and bad years, but no one could figure out why. The economist W. Stanley Jevons placed the cause on sunspots! As a matter of fact, at that time, the periodicity of sunspots was roughly similar to business cycles. It was not so farfetched an idea since sunspots cause weather cycles which cause rainfall cycles which cause crop cycles which effect business cycles in general. But then astronomers more accurately recalibrated and the sunspot theory was abandoned.
John Maynard Keynes (1883 – 1946) focused on a historical change in the very structure of economics. From the time of Smith up through the Victorian era accumulation (of money) and investment (of money in new enterprises) would be handled by a single agent. Only a thrifty, wealthy man could make the rational decision whether or not to build a new factory, look for coal, build a railroad line and so on. But as prosperity broadened, average workers could save money. As businesses grew and became institutionalized new sources of investment were sought from anonymous investors in banks and not just from their wealthy founders and descendents. In the end, in a vast way, accumulation and investment were divorced and carried out by separate groups of people. The introduction of money had separated buying and selling creating two distinct activities each with its own rules, and now the accumulation of money had been separated from investment. This introduced problems. In the 1930s, saving was the problem and it was difficult to accept since saving, thrift, and prudence were all considered cardinal virtues since (at least) the time of the Puritans and Benjamin Franklin. Keynes saw the savings/investment divorce as the culprit blocking recovery. Was there a market law or mechanism that could automatically relate them in a healthy way?
First, how do we measure the prosperity of a nation? It is not gold. Africa is rich in gold, has been for some time, and has been mired in poverty for some time. It is not physical assets like buildings, mines, forests. None of these disappeared from America (or elsewhere) in 1929. It is by incomes: the higher the personal income in general, the more prosperous the nation. Now, every dollar of our income comes from somebody else spending theirs. Money circulates—or it doesn’t. It is sometimes called “taking in each other’s wash”. We all spend money on necessary things and so a reasonable circulation of money is assured because we need food, clothes, housing. But increasingly vast numbers of people had begun to save some of their income. If the money is saved in a mattress then, in effect, I cheat society in general for I do not return to the whole social-economic order what I took out. Fortunately, most people bank their money which is then loaned out to investors whom the bank considers risk-worthy and who return the money to the bank together with a small profit some of which the bank returns to the individual. Result: profit all round and circulation continues. But there is nothing automatic about the circulation. Investment is only needed when a business needs to expand, for, its daily receipts pay for the current business and its upkeep. This is where the problem arises, namely, equilibrium. A modern society always has some savings, but businesses may not want to expand for any number of reasons—war, market “gluts”, inflation, etc. Now, if that happens, then our incomes begin to decline (because the entire building sector of the economy is thrown out of work thus altering the whole economy for the worse); savings are then eaten into, and a spiral begins that threatens to lead to a freezing of circulation.
Keynes had always worried about excessive thrift and excessive caution, that is, the accumulation of money never intended to be spent for anything. When told that gold was in the long run the safest and best way to save, Keynes famously replied that yes but, well, “in the long run we’re all dead”. He wrote:
It has been usual to think of the accumulated wealth of the world as having been painfully built up out of that voluntary abstinence of individuals from the immediate enjoyment of consumption which we call Thrift. But it should be obvious that mere abstinence alone is not enough by itself to build cities or drain fens.
It is Enterprise which builds and improves the world’s possessions […] If Enterprise is afoot, wealth accumulates whatever may be happening to Thrift; and if Enterprise is asleep, wealth decays whatever Thrift may be doing. [from Treatise on Money]
Now, it seems as if when there is a glut of savings there should be a drop in the price of money; that is, money would become cheaper to borrow and thus investors’ risk is reduced thus encouraging investment. But something had gone wrong. Keynes wrote The General Theory of Employment, Interest, and Money because he saw the flaw in his first book. He saw that saving is a luxury; it is only possible in good times. In bad times savings evaporate. In 1929 Americans saved $3.7 billon of its income; by 1933 it was saving nothing. Thus poverty amidst plenty: the factories, the natural resources, and workers were all still there just as they were a decade earlier when things were rosy. As savings evaporate there is no downward pressure on interest rates to encourage investment and growth. Instead, there is an equilibrium of underutilization. What had seemed like a self-correcting see-saw was more like an elevator stuck on the ground floor with no means to move up. There was no one to blame. You could not blame workers for saving up against hard times. When the hard times come the savings are employed to tide them over until good times return, and so are quickly exhausted. You could not blame investors for not investing if they see no reasonable chance to make a profit. The self-interest mechanism had worked. Result: misery all round. Keynes saw the capitalist system as intrinsically vulnerable:
First, an economy in depression could stay there. There was nothing in the economic mechanism to pull it out. One could have equilibrium even […] with massive unemployment.
Second, prosperity depended on investment. If business spending for capital equipment fell, a spiral of contraction would begin […]
And Third, investment was an undependable drive wheel for the economy. Uncertainty, not assurance, lay at the very core of capitalism. Through no fault of the businessman it was constantly threatened with satiety [or, equilibrium], and satiety spelled economic decline. [from The General Theory]
Keynes’s solution was simple and logical and one with which we are all by now familiar: If the problem is business investment and if business is not up to the task, then government must step in and perform its (business’s) function. Government would be the stimulus that would send the economic elevator back up. Keynes himself knew this was not a comprehensive solution, but he said “it’s better than nothing” until normal business enterprise can resume investing.
A lot of things were happening at around this time (the 1930s). For one, banks were bizarrely fearful of inflation and raised interest rates! The Roosevelt programs had some modest success but were misinterpreted by the business community as threatening incursions into the free market which would right itself eventually, but, naturally of course, millions of Americans were in no mood to wait. Then came war and massive debt-inducing spending and investment which eventually righted things again.
Keynes was certainly no opponent of saving tout court. To pay for the war he suggested a program of mandatory deferred savings. Bonds would be issued that would be paid to every citizen at the end of the war, just when they would need money for necessities and re-construction. This was because, with the war effort there was now too much investment and its symptom sooner or later would be inflation. In any case, we are now very close to many of the political-economic issues we read about daily in the newspapers.
I will turn now to one last classical economist of some interest, Joseph Schumpeter (1883-1950) since he both championed, and predicted the general demise of, Adam Smith’s vision.
Schumpeter and the End of Capitalism
During the Great Depression, Joseph Schumpeter strode into his classroom at Harvard where he was lecturer in economics and declared: “Gentlemen! You are worried about the depression. You should not be. For capitalism, a depression is a good cold shower!” Keynesian capitalism is inherently nervous, vulnerable to stagnation, and uncertain, but, with government as an always-ready-to-assist auxiliary motor, it was unquestionably to endure for a long, long time. For Schumpeter capitalism is intrinsically growth oriented, dynamic and buoyant, but it is ultimately doomed to fade into a bureaucratically planned social order resembling some form of Socialism because it will, in the end, have transformed culture, depriving itself of its chief resource, as we shall see.
Schumpeter’s starting point in his Theory of Economic Development is, strangely enough, a description of capitalism as a changeless flow that merely reproduces itself and never expands its wealth, an equilibrium in short. This is so because at any point in its history something that had been a marvelous discovery—like the method of trial and error—eventually becomes mere routine, habit and “as firmly rooted in ourselves as a railway embankment in the earth.” (It is a little bit like William James’s description of how the rivulets of the brain are formed.) Capitalism is the same. Having discovered the mechanisms of self-interest, competition, supply and demand, and division of labor there is seemingly no place for growth of the system as a whole to occur. Competition among employers will force wages and working conditions to become uniform; capitalists (because of competition/imitation) themselves will ultimately receive only salaries for the management of enterprises whose laws have been fully understood. Input and output will equalize. All wealth will be able to be traced to measurable resources, labor time, and initial investment (Land-Labor-Capital).
Schumpeter here is asking a basic question: where does profit—the “magic” of capitalism—come from? There is only one answer: technological or organizational innovations into this static flow. That is, either a newer and cheaper way of making things, or new things. It is from innovation that a flow of wealth is produced that could not previously be accounted for. The innovator is the heroic entrepreneur, and this entrepreneur understands that his innovation and the profits from it are temporary because his innovation will sooner or later be imitated and eventually inundate the whole economy in a period of expansion (just as in William James’ brain; when a new rivulet is created it is then deepened and widened and becomes what we call ‘habit’ altering the brain’s organization altogether). This period is called “Creative Destruction” and during this period an old thing (like the typewriter and the entire typewriter industry) is literally destroyed to make room for the new thing and/or the new way of doing things. (Incidentally, like Smith Schumpeter did not fear monopolies, considering them a perfect expression of creative destruction.) Eventually, because of competition (which Schumpeter interprets as mere imitation), prices are adjusted down, expansion ceases, and we return to plain, stupid habit. It is an ingenious insight. Schumpeter studied the history of innovations and used them to explain the periodicity of business cycles. He determined that there are three categories of cycles depending on types of innovation. He thought that the Great Depression was one in which all three cycles coincided momentarily, and he predicted that the next 30 or so years, after the depression had ended, would be robust.
Importantly, the entrepreneur may not (often does not) reap the profit himself—he may merely have been working for some corporation when he discovered something. But he or she alone is the agent that brings new wealth into the static flow of things. Unfortunately entrepreneurs cannot be produced like MBAs from Harvard, but they are the real “heroes” of capitalism. Without them there would be no “magic” of profits. They come into existence from anywhere, from any class: they are creative and willful, or they simply enjoy exercising their imagination and energy.
Because of the entrepreneur, capitalism seems secure. Surely somebody somewhere will think of something new… But in Capitalism, Socialism, and Democracy Schumpeter predicts the eventual demise of capitalism. “Can Capitalism survive? I think not,” he writes. The very success of capitalism has produced a sort of universal figure: the rational, hedonistic businessman—the very antithesis of the daring innovator. The innovator is an outsider to the culture of this bourgeois capitalist and is outside the purely mechanistic logic of markets, but eventually there will be no outside because innovation itself will be in demand—it will be required—and it will then be performed by relatively weak minded hedonists who are imprisoned within what Schumpeter calls a “capitalist mentality”. Essentially, innovators will be paid to innovate, but they will never be profoundly (that is “destructively”) innovative because they are no longer “outsiders”. Innovation itself will be included within the market system. It will have become as much a commodity as money has become. Like the forgetting of Being in Heidegger and then the forgetting of that forgetting (the pure oblivion of Being), future capitalists will have forgotten how daring and innovative the capitalist system itself ever was in and of itself. “Can Socialism work? Of course it can,” he goes on to say: A Socialism that will be benign, bureaucratic, and part of a planned economy. Capitalism will have ended, according to the flamboyant Harvard professor, in a kind of ennui, a swoon—unknowingly exhausted in the arms of mere habit.
Works consulted
Aristotle, Complete Works Barnes, ed.
Encyclopedia Americana
Encyclopedia Britannica
Foucault, Michel. The Order of Things
Heilbroner, Robert L. The Worldly Philosophers
Keynes, John Maynard. The General Theory of Employment, Interest, and Money
Marshall, Alfred. Principles of Economics
Ricardo, David. Principles of Political Economy and Taxation
Samuelson, Paul, et al. Economics
Schumpeter, Joseph. Theory of Economic Development and Capitalism, Socialism, and Democracy
Smith, Adam. The Theory of Moral Sentiments and The Wealth of Nations
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