From Smith to Say: A Brief History of Modern Economic Thoughts

(CLAUDIUS) My words fly up, my thoughts remain below. Words without thoughts never to heaven go.

Hamlet, Act III, Scene III

 

The common survey course in the history of economic thought refers to “ideas” as a singular concept. This dominance of ideas is the norm among economists since every epoch calls for a specific set of explanations. That's why it has always been controversial to say “economics” without a modifier. However, any attempt to explain the history of economic thought has always been interpreted as one with tendentious undertones. Why? Because the history is vast and complicated. Two economists can be on the same aisle, but disagree with one another’s best judgments. In what follows, I will explore the history and evolution of economic thoughts, in addition to pointing out what implications such developments have for policymakers.

 

Some Beginnings

 

The overarching concept which we call “economics” is said to have begun with Adam Smith's publication of The Wealth of Nations in 1776. Prior to that, nobody thought of economics or markets as an object of study. It was not that there were no discussions around economic matters; it was simply that there was no systematic method of discussing exchange. These dialogues consisted primarily of off-the-cuff intuitions and policy proposals by a myriad of merchants, government officials, and writers of all sorts.

 

It is common to denote the period before 1776 as “Mercantilism.” It wasn’t a coherent school of thought, but a hodge-podge of varying ideas about improving tax revenues, the value and movement of gold, and how nations competed for international commerce and colonies. In particular, the mercantilists fiercely stated that trade generates wealth, and is stimulated by the accumulation of profits and/or profitable objects, particularly precious metals like gold and silver. The strongest proponents of mercantilist thinking were the protectionists. These thinkers urged their governments to keep all their assets in the basement (so to speak) to accumulate wealth.

 

But that was problematic for the Enlightenment thinkers. In short, there was a new tendency for thinkers to look at applying scientific principles not only to the physical world, but also to the social world. This led to a sudden surge of alternatives in economic thought. On the one hand,  we have physiocrats, who emerged from France advocating for a "natural" outlook. They thought land is the source of all wealth, and that land agriculture is what generates the wealth of nations. As much as this “natural order” is central to physiocrats, the concept of individualism — which eventually paves way for laissez-faire approach — was just as vital. Self-interest is what drives a worker in the physiocratic model of economic behavior. The physiocrats also emphasized the concept of diminishing return – that notion that there is an ultimate limit to productivity. In doing so, they showed that wealth isn't endless. 

 

Along with the physiocrats arose the classical economists. The term "classical” appears a lot in the history of economic thoughts; exemplars of classical economist economic thought include Adam Smith, David Ricardo, Thomas Malthus, John Stuart Mill, and Jean-Baptiste Say. They all asserted that markets function best without government interference.  For Smith, people act out of their self-interests; by extension, if we observe some activities in the markets, we thereby observe people’s voluntary choice to expend their own resources so as to maximize their own gain. For Say — the lesser-known Classical economist — the argument was that in competitive markets, supply created its own demand. In other words, if we lift restrictions on businesses, we can let the suppliers (ie. firms) create demand for the markets, thereby creating equilibrating forces among customers and firms.

 

Those two thoughts are integral to Ricardo’s works in economics. Among many other achievements,  he advanced the labor theory of value and an analysis of the economic concept of rent.  The labour theory of value states that the value of a commodity depends on the relative quantity of labour required for its production. In more concrete terms, a piece of clothing is worth more than a lumber of wood because the former takes time to make by hand. In addition, rent is the payment to some factor of production in addition to the cost needed to bring such factor into production. Labour, and of course, capital, are among the factors of production considered.

 

Ricardo’s ideas gave structure to economic discourse, in large part by giving us an account of the  value of objects. Marx elaborated on the Ricardian theory of value by saying that any commodity has two values: exchange value, which means the quantity of some good A that can be exchanged for good B (given that a trade occurs), and use value, which is the utility or benefit from consuming a good. With those values come preferences for some objects over others: if one prefers more utility from consumption, and less so for the exchange values, then what should we call the type of goods? What if the case is the exact opposite? Why do people behave differently? By extension, all sorts of political discussions can ensue once we define some values for different objects. This is the basic analytic framework of Marxist economics.

 

Approaching Our Time

 

The Marxists were stumped by a problem known as the diamond-water paradox. If having water is more useful than having diamonds (ie. you need water to survive, but can live without diamonds), then why is the former cheaper than the latter? One might argue that water has higher use value than exchange value (and the reverse case is true for diamonds) — which the total value of water can potentially exceed that of diamonds. But that was not good enough.

 

The dilemma instead spurred the onset of marginalism, a branch that studies the discrepancy in the value of goods and services by reference to their marginal utility. This is much easier to work with in multiple different contexts. Alfred Marshall explained the concept of marginalism as that which substitutes marginal physical productivity. If we think about a production process, marginal physical productivity is a cost to production, in the sense that an additional unit of output requires a trade-off between quantity and factors of production utilized.

 

This fundamentally changed the way we think about economics. Before Marshall, three economists almost independently worked on the foundations of what is now known as Marginalist (also called Neoclassical) school of thought: William Stanley Jevons (British), Carl Menger (Austrian), and Léon Walras (French). They discarded Ricardian tenets of Classical economics by introducing the concepts of supply and demand. They changed the understanding of markets and, perhaps more fundamentally, equilibrium.

 

 By the end of the nineteenth century, the mainstream school of thought has been set in stone: we are to understand the world scientifically by understanding general equilibrium, elasticities of demand and income, exchange economies, welfare, and some form of investment theory. This view has even dopted some mathematical tendencies, with the likes of Marshall and Hicks inventing different notations and concepts to make analyses easier.

 

The Fin de siècle has brought some interesting developments in our perception of the world. In the early twentieth century, Joseph Schumpeter came to popularize a concept we now as creative destruction. It relates two different, but equally important concepts—those of innovation and business cycles. With his work, there was a clear analytic demarcation between microeconomics and macroeconomics. During this time, economists started focusing on real changes in people’s preferences, economy’s technologies, and monetary fluctuations over time. These changes in part motivated then-young economists to study how markets fluctuate or grow at the same time. The concepts of (Pareto) efficiency was also formalised. Then, macroeconomics was conceived of as the study of the dynamics of output and employment in the economy as a whole, and not just studying how competitive processes establishes prices and output levels in different (independent) markets. Schumpeter’s interests in relating innovation to the onset of business cycles—that economies constantly undergo a “process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one”—has some kinship to Keynes’ thoughts.

 

And then there was Keynes. What Keynes contributed to the development of macroeconomics was not formalism, but intuitions. Formally, Keynesian macroeconomics focused on the fact that short-run economic output is strongly influenced by aggregate demand. But Keynes himself was never a mathematician, but a writer. He essentially made a living by criticising certain well-established theories. His most famous critique was that of Say’s law. Let us put things in perspective. With monetary exchange, demand of goods does not need to be as high as the supply of money. This is not solely attributed to the onset of credits (as we now know of today), but to the guaranteed existence of a monetary equilibrium when Say’s law is imposed. Because regardless of the price, there are always takers/buyers. Under Say’s law, both exchange and unique equilibrium do not exist because demand is as large as supply is. And there were no appropriate tools to understand macroeconomies: a (Walrasian) general equilibrium framework may work, but it is built to analyze single exchange economies, not for large, multi-market, multi-agent economies.

 

This was why Keynes’ General Theory was a success: he proposed a new theory to explain aggregate phenomena in the economy as a whole, the area Neoclassical theory had been having immense difficulty explaining. It is important to note that Keynes did not propose to displace Neoclassical theory. The theoretical principles of Neoclassicism were still true—but it was, Keynes contended, incomplete. Neoclassicism was still good for explaining “micro-level” things, such as markets, prices, production and distribution of wealth and jobs, but poor at explaining “macro- level” items, such as GDP, inflation, and unemployment rates. Thus a more ”general theory” was needed—one that preserved Neoclassicism at the micro level, but proposed a new set of principles for the macro level. The Keynesian Revolution had an enormous impact not only on economics but also on the real world. The entire idea of the relationship between government and the economy was transformed. Many of these changes had already been underway, but Keynes provided the theoretical basis for them. As some people have put it, “We knew (what the Neoclassical economists were telling us) was bad policy. Now we know it was also bad economics.”

 

Creating History

 

Recent years have seen a surge in what we call Neoliberal tendencies, by which we observe a general movement towards advocating for free markets and analyses of non-economic variables. The Chicago School is still well-known for its outspoken support for both of these types of research. Milton Friedman, a staunch proponent of the efficiency of markets in all areas of economic activity, was the dominant figure of the Chicago School throughout the 20th century, that school being later sustained and fostered by Gary Becker and many other like-minded economists. Together, they outlined and developed the so-called life-cycle approach to analysis, whereby they examine economic outcomes throughout one’s life. Becker, in particular, analyzed marriage as a sort of matching-searching type exchange, and expanded the role of an individual’s personal life in analyzing economic outcomes. Friedman, along with the likes of Edmund Phelps, began to explore another way of understanding the macroeconomy: namely, by saying that there exists a natural rate of unemployment such that, in the long-run, unemployment is not determined by the rate of inflation, but by the frictions and imperfections of the labour market.

 

Now, let us briefly discuss the questions that may concern us as future policymakers. Where does the history of economic thought lead the current generation of policymakers to? What conclusions can economic analyses arrive at? What is eventually the next steps of economics as a discipline? How does the discourse shape our ways of understanding policies? These are not so much big questions as they are deep ones. Consider the example of stagflation. What is interesting is not necessarily the phenomenon itself; what should pique one’s interest are the underlying principles that govern these behaviors. Many still contest that monetary policy cannot have real effects (which implies they are supporters of the neoclassical tradition of money neutrality); moreover, economists mostly still conclude that adverse supply shocks on both prices and output drive the inflation high, unemployment rate high, and growth rate low. Therefore, the Keynesian insight of analyzing aggregate demand has no use during the years of stagflation. But there were no suitable alternatives— nor were there adequate explanations since the years of stagflation. The Monetarist School find themselves unable to provide a coherent explanation for the macroeconomy — because their underlying Neoclassical theory is still quite poor at explaining aggregate phenomena. They are at a loss when they are asked to explain persistent unemployment or sticky prices, and have few or no tools to offer to address it.

 

Since the beginning, economists have focused on how a single market reacts, or what a set of agents will do to optimise their gains from engaging in market activities. Although the language has changed, the underlying principle has not. The central question to the study of economics remains the same: how do individuals allocate resources, given that resources are always scarce? These questions are at the heart of policymakers' jobs. Though, what underpins any policy at the aggregate level is not just how some individuals behave, but how markets interact. Equally importantly, policymaking does not necessarily require explanation, but reaction: the current training in academic economics certainly does not focus on the latter, and most are focused on explaining some phenomena with elaborate stories.

 

Policymaking is not just the job of academic economists. In fact, many are not interested in the policy implications of their work, since most of their works are explanatory and not empirically possible. To truly “make” a complete theory, there has to be some recognition that economics is a social science — that the bulk of modern economics is an outcome of the history of human inventiveness and discovery.

 

Just last month, Richard Thaler was awarded the Nobel Prize in Economics. He said, “Let’s think about the world’s big problems —climate change and health. These are behavioural issues, and until we realize this we won’t make much progress.” Science calls for a constant recognition of human action, and the best way forward is to approach policymaking from the perspective of explaining how and why markets and their participants behave in certain ways. Then, and only then, can we focus on explaining the issue at hand.