History of economic thought

Modern economic thought is generally considered to have originated in the late eighteenth century with the work of David Hume and Adam Smith, and Adam Smith has come to be regarded as the founder of classical economics. (Earlier approaches are described in the article on the History of pre-classical economic thought.) The nineteenth and twentieth centuries saw major developments in the methodology and scope of economic theory, and the process of development continues.

Nineteenth- and early twentieth - century economists applied deductive reasoning to axioms considered to be self-evident, and to simplifying assumptions which were thought to capture the essential features of economic activity. That methodology yielded concepts such as elasticity and utility, tools such as marginal analysis, and theorems such as the law of comparative costs. An extension of the relationships governing transactions between consumers and producers was considered to provide all that was necessary to understand the behaviour of the national economy.

The development, in the later 20th century, of systems of economic statistics enabled economists to use inductive reasoning to test theoretical findings against observed economic behaviour, and to develop new theories. By that time the concept had emerged of the national economy as a closed interactive system, and such a system was found to behave in ways that could not be derived by aggregating the behaviour of its components. Analysis of that concept provided explanations of recessions, unemployment and inflation that were not previously available. The application of empirical data and inductive reasoning enabled those theories to be refined, and led to the development of forecasting models that could be used as tools of economic management.

The late 20th and early 21st centuries have seen further theoretical and empirical refinements and significant advances in the techniques of economic management.

Overview: categories of economic thought

Historians categorise economic thought into “periods” and “schools”, and tend to attribute each innovation to one individual. That is helpful for the purpose of exposition, although the reality has been a story of interwoven intellectual threads, crossing some categories and often persisting through all of them; and in which advances attributed to particular individuals have often been prompted by the work of others. For example, the quantity theory of money, that achieved prominence in the twentieth century and is associated with the name of Milton Friedman, was first formulated at least three centuries earlier. Many of those threads - such as the concept of value and the nature of economic growth - that have permeated the categories referred to as "Classical economics" and "Neoclassical economics", had an earlier origin in "Pre-classical economics", which is the subject of a separate article. (The prefix "classical" is used to denote the adoption in the late eighteenth century of an approach which was inspired by the enlightenment and the methodology of the physical sciences, and which abandoned previous tendencies to examine the subject in the context of ethics, religion and politics.) Preoccupation with those threads was overshadowed in the twentieth century by the responses of "Keynesianism" and "monetarism" to the problems of unemployment and inflation, but the development of neoclassical economics started before that time and has continued thereafter. (The boundary between the "classical" and "neoclassical" categories is marked mainly by the rejuvenation of the value thread by the concept of "utility" and the associated explanation of price in terms of "supply and demand".) The introduction - thereby and subsequently - of new tools of exploration has since led to the vigorous development of that and other threads, and an expansion in the scope of economics into many new directions.

Classical Economics

The contribution of David Hume

The Scottish philosopher, David Hume was an early exponent of what was later known as monetary economics, and an opponent of "Mercantilism". (That was the term subsequently applied to the then current policy, which was founded upon the belief that a nation's wealth consisted mainly of its gold and silver. Governments accordingly subsidised exports so as to promote inflows of gold and silver, and restricted imports in order to discourage outflows.) He contested the mercantilist thesis, partly on the grounds that an inflow of money would cause inflation , but also on the grounds that nations would benefit from the international specialisation that would result from the introduction of free trade. More generally, he argued that all government intervention in commerce tended to obstruct economic progress.

The Wealth of Nations

A major advance in the development of economics occurred with the publication in 1776 of Adam Smith's An Inquiry into the Nature and Causes of The Wealth of Nations . It was a comprehensive treatment of the subject, using deductive logic in a similar way to its use in the physical sciences. Its main purpose was to recommend changes of economic policy in the interests of economic growth. Adam Smith argued that the division of labour was the main cause of economic growth, and that government intervention in commerce was its main impediment. He advocated government spending upon what are now termed public goods such as defence, law enforcement and the infrastructure, and upon the education of the children of people who could not afford it – and, by implication, upon nothing else. He identified what he considered to be the economic drawbacks of all forms of taxation (except the taxation of land values) and of the deficit financing of public expenditure. He examined the relation of price to value and concluded that the “natural price” of a product was the same as its cost of production, and that divergences from it would eventually be bargained away. Adam Smith is thought to have got many of his ideas from his friend David Hume and from conversations with the French economist, Francois Quesnay (and his fellow "Physiocrats"), but he had a far greater influence upon economic thought.

Jean-Baptiste Say

Jean-Baptiste Say was an influential advocate of Adam Smith's teaching in French government circles, but his best-known contribution was what came to be known as "Say's Law of Markets". Later paraphrased as "supply creates its own demand", it stated that, although there could be an imbalance between the supply and the demand for particular products, no such imbalance could exist for the economy as a whole. Say's Law remained part of mainstream classical economics until it was challenged by John Maynard Keynes. It embodied the (unstated) postulate that all payments for goods are immediately spent on other goods. That postulate reflected the belief that money plays no part in the functioning of the economy (beyond its role as a medium of exchange) because it would be irrational to acquire money savings and so forfeit benefits in terms of consumption or investment.

Malthus

In his influential Essay on the Principle of Population Thomas Malthus postulated that the population would grow at a geometric rate (2, 4, 8, 16...) while food production could only increase arithmetically (1, 2, 3, 4 ....) and concluded that the food supply would eventually be insufficient to support the population. That conclusion led him to oppose the introduction of the Poor Law and to advocate the protection of agriculture. In other respects he followed Adam Smith in opposing government intervention in commerce. Evidence in support of his postulates was lacking at the time and they have since been found to be mistaken.

David Ricardo

With minor reservations, David Ricardo accepted and extended Adam Smith’s teaching. In his major work,The Principles of Political Economy and Taxation he accepted the concept of a value-determined “natural price”, although he considered value to be determined by labour content rather than cost. Following Adam Smith’s lead, he also developed the “wage-fund” concept that the amount available for the payment of wages is fixed at any particular level of capital investment, so that an increase in the supply of labour would lead to a reduction in wage rates. He pioneered a definition of rent as the difference between the produce of a unit of labour on the land in question and its produce on the least productive land in use, and in a further extension to Adam Smith’s work, he explored the incidence of taxation on wages, profits, houses and rent, identifying in each case (but with the exception of rent) its harm to the economy. Probably his most influential contribution, however, was his development of his Law of Comparative Advantage which challenged the intuitive belief that the trading of a product is possible only with those with a lesser ability to produce it. Ricardo produced a logical demonstration that there can be mutually beneficial trade between two countries, one of which is better able than the other to produce all of the commodities that are traded.

Marxist economics

Karl Marx adapted Ricardo's concept of labour value and put it to an entirely different use. In his analysis, as in Ricardo's, labour consumption determines value - which Marx termed exchange value. But Marx regarded each labourer as a product whose exchange value is determined by the labour inputs required to feed, clothe and train him. In return, as Marx saw it, the capitalist receives a labourer's use value, which is determined by the utility of his products. Marx noted that a labourer's use value normally exceeds his exchange value, and he termed the difference surplus value. Like Adam Smith and his "classical" predecessors, he was preoccupied with the subject of economic growth but, unlike them, he saw technical progress as a major contributor, in addition to as the accumulation of physical capital. If technical progress were to slow down, however, he considered that the only way to maintain growth would be to invest more and more in machinery and buildings, as a result of which the rate of profit on new investment would fall leading to a further reduction in growth. Also, Marx was probably the first economist to make a systematic attempt to explain the fluctuations in economic activity known as the business cycle. In his view, any departure from the conditions necessary for steady growth would lead to the accumulation of unwanted stocks, producing a downturn in economic activity until price-cutting to get rid of them put the process into reverse.

In his major work, Das Kapital Marx puts his findings in an historical, concludes that economic conditions shape history, and forecasts a breakdown of the capitalist system and its replacement by socialism.

Other contributions

Among the many lesser contributors to classical economic theory, the best-known was John Stuart Mill. His Principles of Political Economy, although intended by the author merely to bring together the works of others, offered some fresh insights into increasing returns to scale and their consequences for the development of monopolies, and anticipated (though not in those terms) the neoclassical concepts of elasticity and the determination of price by the interaction of supply and demand.

Writing during the classical period but without recognition at the time was the French economist and mathematician Antoine Augustin Cournot, who set out the mathematical basis for the Theory of the Firm and used differential calculus to demonstrate the profit-maximising requirement of equality between marginal cost and marginal revenue, thus anticipating some of the more important developments of neoclassical economics.

Neoclassical Economics

The neoclassical approach

The term "neoclassical" is commonly applied to all of the continuing developments in economic thinking that followed the replacement of value-based concepts by a systematic consideration of the behaviour of markets that are governed by the interaction of supply and demand. In that sense the term denotes a period rather than a consistent approach, although it is a period that overlaps the competing approaches of Keynesianism and monetarism. It is nevertheless a period in which most economists have deduced their findings from the same hypothetical postulates - including the assumption of competitive markets in which consumers maximise utility and producers maximise profits, and which interact so as to constitute the stable, coherent and predictable system that is now known as the "neoclassical model". Within that framework of postulates, neoclassical economists have explored a variety of aspects of economic activity in a variety of different ways.

Marginal analysis

The neoclassical period is also marked by an expansion in the number of people applying their minds to the problems of economics, as a result of which there have frequently been similar contributions from a number of different thinkers. That was true of the innovative concepts of marginal analysis, that are attributable to the contributions of William Stanley Jevons , Carl Menger and Léon Walras . Their contributions have been brought together by Alfred Marshall in his Principles of Economics , which provides the reader with an accessible and readable (and non-mathematical) account of those and other contributions. The - now familiar - concept of utility, that had been mentioned by the classical economists, was given more prominence, and it was demonstrated logically (and mathematically) that a rational consumer would continue to buy additional units of a product until its marginal utility (the increase in utility obtainable from one additional unit of the product) became level with to its price, and that a rational supplier would continue to offer additional units of a product until its marginal cost became level with the marginal revenue that he would get from selling it. The American Economist John Bates Clark subsequently applied the concept to a market in which a rational employer would continue to hire labour until its marginal product became level with the prevailing wage rate.

Equilibrium and the Price Mechanism

The concept of market equilibrium is central to the neoclassical model. Leon Walras thought of it as the achievement of an imaginary auctioneer who adjusts a notional opening price in response to a succession of bids by buyers and sellers, and permits transactions to take place only when a price is reached at which buyers are willing to buy all that is offered for sale. That is the process of price determination by supply and demand which marks the abandonment of the concept of value-determined price, and which is examined in detail in Marshall's Economics and in Milton Friedman's Price Theory. Walras, and subsequently the Italian economist Vilfredo Pareto , later developed the concept of a general equilibrium in which supply is equal to demand in every market in a closed economy. The normal assumption of neoclassical economics is that of a stable equilibrium to which the economy will automatically return after a disturbance. In particular, unemployment cannot persist because any excess in the supply of labour, relative to its demand, is corrected by a reduction in wages.

Welfare and Efficiency

The most politically influential of the contributions of the neoclassical economists was probably their development of the concept of welfare. In accordance with the precepts of representative government, they assumed the criterion for the success of an economic system to be the welfare of the individual, and they introduced the concept of economic efficiency as a measure of that success. Vilfredo Pareto took the lead in defining efficiency as a state in which no-one could be made better off without making someone worse off. The three types of efficiency were identified as productive efficiency (the production of good at minimum cost), allocative efficiency (the provision of the mix of goods that consumers want) and distributive efficiency (the distribution of the goods in such a way as to maximise individual welfare). That work laid the foundations for the subsequent development of the theory of welfare economics by Sir John Hicks and others. (The subject of economic welfare is discussed extensively in Arthur Pigou's Economics of Welfare , and the theorems of welfare economics are summarised in William Baumol's Economic Theory and Operations Analysis )

Competition

The theorems of welfare economics establish a presumption that allocative effciency will be achieved - that is to say that resources will be optimally allocated as between the production of alternative products - under the hypothetical conditions of perfect competition. (Those conditions include the requirement that for each product there is no supplier large enough to influence prices, that all producers supply identical products, and that all consumers are well informed and behave rationally.) Despite the unreasonableness of those requirements, most economists advocate a presumption that restrictions upon competition will result in a reduction in efficiency - a presumption that is open to rebuttal, however, if economies of scale yield gains in productive efficiency that outweigh the loss of allocative efficiency. Those theoretical developments were the foundation for antitrust and other forms of competition policy, the economics and politics of which have been developed by George Stigler and other members of the Chicago School of Economics.

The theory of the firm

The tools of welfare economics were also used to develop theory concerning the behaviour of firms by Nicholas Kaldor of the London School of Economics in his Equilibrium of the Firm and Ronald Coase in his The Nature of the Firm . (Those theoretical developments have been summarised in William Baumol's Economic Theory and Operations Analysis . An empirical study of the way firms actually behave is provided by Cyert and March's Behavioral Theory of the Firm )

Keynesian macroeconomics

The contribution of John Maynard Keynes

The most important contribution to economic thought by John Maynard Keynes was his examination of the factors determining the levels of national income and employment, and the causes of economic fluctuations. His major (and hard to read) work, the General Theory of Employment, Interest and Money, contains a sustained attack on much of the thinking of classical economics - mainly on the grounds that their postulates were unrealistic. His first target was Say's law of markets with its denial of the possibility of a general deficiency of demand. He challenged its implicit assumption that money is no more than a medium of exchange by drawing attention to the speculative demand for money. Secondly, he attacked the classical economists' contention that it was the interest rate that reconciled savings plans with investment plans, claiming that the level of savings was largely determined by the level of national income. Thirdly, he rejected the classical economists' assumption that any tendency for unemployment to rise would be corrected by a reduction in the general level of wages, substituting the contention that "wages are sticky downward". Having substituted his assumptions for those of his predecessors, he advanced the thesis that a deficiency of demand could occur if there was an excess of planned savings over planned investment, because such an excess could be removed only by a reduction in national income. The implication of that thesis was that the economy could settle down into a condition of high unemployment, lacking the self-righting mechanism envisaged by the classical economists.

Neo-Keynesianism

Shortly after the publication of Keynes' General Theory, John Hicks published an article entitled "Mr Keynes and the Classics" in which he produced a synthesis between the Keynesian and neoclassical models. Its main feature is the IS/LM diagram with its intersecting curves, one of which (Investment/Savings) relates the demand for savings to the interest rate, and the other (Liquidity/Money Supply) relates the demand for money to the interest rate - and in which the point of intersection of the two curves represents an equilibrium level of demand. (The IS/LM diagram subsequently came to be known as the Hicks-Hansen diagram in recognition of prior work by the American economist Alvin Hansen ). The important feature of the synthesised model is that it can be made to depict behaviour in accordance with either the Keynesian model or the neclassical model, depending upon what is assumed concerning the slopes of the two curves. In doing so it introduced a fundamental departure in the methodology of economics - a change from an exclusive reliance upon logical deduction from a priori postulates to the increasing use of the inductive process of testing hyptheses against empirical evidence, that was made possible at the time by the comparatively recent practice of systematically collecting economic statistics. The work of a large body of economists was subsequently devoted to testing such hypotheses using the mathematical technique known as "econometrics". That work does not appear to have resolved the controversy concerning the usefulness of the two models (except that some economists now acknowledge that one or the other seems to have worked better from time to time and in some countries' economies)

Policy Implications

A Keynesian consensus dominated the economic policies of the developed countries for two or three decades following the second world war. Keynesian stabilisation policy required governments to counter downturns in demand by cutting taxes or increasing public expenditure. Since it takes some years for such actions to take effect, their timing had to be based upon forecasts using computerised economic models, but forecasting errors and misguided attempts to stimulate growth often had destabilising consequences. Measures that unwittingly stimulated demand at a time when an economy was operating at its full capacity, frequently gave rise to rising inflation - for which the only remedy appeared to be wage restraint - and the situation was sometimes exacerbated by the operation of foreign exchange policies. Opposition to those policy actions came from economists of the Austrian School , whose thinking is dealt with in a separate article, and from economists of the Chicago School whose thinking is described below.

Monetarism and the Chicago School

The Chicago School

The University of Chicago School of Economics has enjoyed a reputation for economic excellence since its foundation in 1892 . However, the term Chicago School is usually taken to refer to the outlook and methodology of its economists during the period that started in the 1960s - including Milton Friedman , George Stigler, Ronald Coase, Robert Lucas, Cary Becker, Harry Johnson and Merton Miller, and to some like-minded economists in other universities. It is best known for its advocacy of monetarism but its economists have also made contributions on a wide range of other topics, including international trade, rational expectations and institutional economics. Their methodology embodies an approach, which philosophers term instrumentalist, that gives the predictive value of a theory priority over the representativeness of its assumptions

Monetarism

The quantity theory of money , which is often attributed to the American economist Irving Fisher, but which undoubtedly had earlier origins, equated the volume of money in circulation multiplied by a notional velocity of circulation to the volume of physical output multiplied by its unit price (usually written as MV = PT). If the velocity of circulation were roughly constant, that would imply an association between inflation and growth in the money supply. Milton Friedman found that to have been the case during various periods in United States history , and that periods of monetary expansion had been followed by periods of inflation, although with long and variable time-lags. That led him to argue that Keynesian demand management would be ineffective in the long run because it would be accompanied by a damaging rise in the money supply, and that stability of demand and prices could better be achieved by control of the money supply. The controversy that followed was mainly concerned with the nature of the transmission mechanism (the question whether an excess of money would bid up the prices of goods, or whether it would be invested in interest-bearing bonds without affecting the prices of goods).

A theory connecting the money supply and the balance of payments had previously been put forward by Harry Johnson when he was a professor of economics at Manchester University. The conventional view had been that the exchange rate is determined by the balance between the supply and demand of exports and imports, but Harry Johnson treated it as the relative price of the moneys in circulation in the two countries . One of the implications of his theory is that if the exchange rate is fixed, the money supply cannot be controlled - which was a consideration that influenced the Chicago School's campaign to put an end to the system of fixed exchange rates then in operation. Another is that if the money supply is held constant, the balance of payments is self-correcting.

Expectations

Milton Friedman also attacked the thinking behind the Phillips curve (which had reflected the observation that inflation tended to fall when there was a rise in unemployment) on the grounds that it failed to take account of expectations. He proposed its replacement by the expectations-augmented Phillips curve , and used that construction to counter fears that a reduction in growth of the money supply would lead to a sustained increase in unemployment. To do so, he introduced the concept of the non-accelerating inflation rate of unemployment (NAIRU), which is usually referred to as its natural rate, and which is the unemployment rate at which the expected inflation rate is the same as its actual rate. He argued that if a reduction in money supply growth caused unemployment to rise above its natural rate, the expected inflation rate would fall, setting in motion a sequence of events that would cause unemployment to revert to its natural rate. Conversely, a reduction in unemployment accompanying an increase in the money supply would cause an increase in expected inflation, prompting wage demands which would lead to an increase in actual inflation - a process which could continue indefinitely.

Applying the concept of rational expectations formulated by his former colleague, John Muth, to the operation of economic policy, Robert Lucas of the Chicago School put forward what has become known as the Lucas Critique . He argued that policy actions tend to change people's expectations so that the same policy action could have future consequences that differ from the consequences that it had in the past. That possibility has fundamental implications for the construction of forecasting models, and the Lucas critique also raises the possibility that public reactions could frustrate the achievement of policy objectives.

Policy implications and outcomes

The Chicago School's prescription for stabilisation problem was confined to the control the money supply, and its prescription for the reduction of unemployment was to take measures to improve wage - and price-flexibility. Concern for rising inflation, and the failure of attempts to control it by wage restraint, led to the widespread adoption of the first of those prescriptions in the late 1970s. In the United States, the Congress passed The Full Employment and Balanced Growth Act (known as the Humphrey-Hawkins Act) which required the Federal Reserve Bank to set one-year target ranges for money supply growth twice a year and to report the targets to Congress. In the United Kingdom, the Callaghan administration adopted a specific money supply objective: a practice that was enthusiastically adopted by its successor Thatcher administration. In both countries, attempts to keep the growth of the money supply within pre-set limits were generally unsuccessful (and in the United Kingdom, money supply growth actually increased ) and were eventually abandoned. Some central bankers have said that they take account of long-term money supply trends, but none consider control of the money supply to be a practicable instrument of stabilisation policy. Consensus monetary policy since the late 1980s uses interest rates as a means of stabilising both prices and output, and the median inflation rate in 13 industrialised countries has fallen from around 15 per cent in the mid 1970s and early 1980s to around 2 per cent in 2005.

Institutional Economics

The Institutionalist School

The term Institutionalist refers to economists who argue that economic activity cannot properly be understood except in the context of the public and social structure in which it takes place. That approach to the can be traced back to the German Historical Schhool, which included Max Weber, who is best known for his The Protestant Ethic and the Spirit of Capitalism. But the term is more commonly applied to the views of a pre-war group of American economists whose leading member was Thorstein Veblen - the man who coined the term conspicuous consumption - and whose lasting contributions were the collection of economic statistics and the study of business cycles.

Modern institutional economics

A major contributor to the theory of institutional economics has been Ronald Coase , who summarised his approach in his 1991 Nobel Prize lecture . Early in his career as an economist he had formulated what came to be known as the Coase Theorem which was the proposition that economic efficiency will be achieved provided that property rights are fully allocated and can freely be traded; a proposition which he developed futher in his 1960 paper The Problem of Social Cost . The development of institutional economics by economists at the University of Chicago has taken them across the conventional borders of economics into the disciplines of law, sociology and politics. (An extreme example has been the publication of the best-selling Freakonomics that was jointly authored by the Chicago economist Steven Levitt annd the New York journalist Stephen Dubner, and which applies economic thinking tosuch questions as cheating, drug dealing and the connection between crime and abortion.)

Mechanism design theory

A recent extension to institutional economics is concerned with how well different institutions and allocation mechanisms achieve goals such as welfare and private profit. Contributions to that subject by Leonid Hurwicz of the University of Minnesota, Eric Maskin of Princeton and Roger Myerson of Chicago earned them the 2007 Nobel Prize in Economics, and the Nobel Prize Committee have published a summary of their work

Public choice theory

A different approach to the same questions had previously been put forward under the heading of public choice theory, the principle contribution to which had been James Buchanan and Gordon Tullock's major treatise, The Calculus of Choice . However, Buchanan and Tullock are best known for their analysis of the behaviour of politicians, civil servants and voters on the assumption that they are mainly motivated by personal gain, rather than a desire to serve the public interest.

International economics

The gains from trade

David Ricardo's law of comparative advantage - and its implication that trade restrictions are damaging to the interests of the country that imposes them - has remained the basis of economic orthodoxy to the present day. The only theoretical developments have been those resulting from attempts to create mathematical models of inter-country trade. The best-known of those was the Heckscher-Ohlin Trade Theory , that a country will export those commodities that are intensive in the factor of production in which it is most well-endowed a theory, which was extended by Paul Samuelson to conclude that trading between two countries tends to equalise wages and capital costs in those countries. However, doubt was cast upon the relevance of the Heckscher-Ohlin theory by Wassily Leontief's discovery that the United States, which is the world's most capital intensive country, had been exporting labour-intensive commodities and importing capital-intensive commodities. The general conclusion has been that international trade is mainly driven by factors other than labour-intensity and capital-intensity.

Infant industries

Ha-Joon Chang's Kicking Away the Ladder

The balance of payments

Friedman flexible exchange rates