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History of Economic ThoughtIntroduction

Pekka SutelaAalto University

26 February 2015pekka.sutela@kolumbus.fi

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Approximate contentsDate Contents

26.02. Introduction: the path to Smith

05.03. Smith and classical political economy

12.03. The marginalist revolution and after

19.03. Critics and alternatives

26.03. Macro: Fisher, Keynes and Hayek

02.04. Examination

TBD Re-examination

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Why study history of economics?

• Well, most economists do not, at least beyond the (possible) obligatory minimum– And few in natural sciences do: the progress of science is there

undoubted– Undergraduate science students know more physics than Newton

did!• Accumulation of knowledge!

– Few believe in strict versions of Thomas Kuhn’s (1962) paradigms, but as a metaphor it may be useful• A paradigm is a generally accepted, authorative theory or mental framework• Substituted by another in a scientific revolution• New paradigm (usually) includes the old one as a special case

– Thus even if paradigms change knowledge does accumulate!

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You probably know more economics than Adam Smith did, but...

• Economics and physics do differ– The laws of physics do not change, they become better known– Some ”laws” of economics seem universal (supply and demand –

but how many others?) but issues and institutions vary– Thus little that most of us are interested in does not change– Economics can change reality

• But the channel may be complicated

• Most probably Smith was more clever than (most of ) us are– How does one recognize an issue?– How does one formulate a question?– How does one know what others have succeeded or failed in

doing?

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A difficult balance

• Are we ”standing on the shoulders of past giants” (Marx) or ”prisoners of long-dead economists” (Keynes)?

• Economics does progress over time– Modelling into formalization adds clarity and consistence– Measuring sorts out important from less significant matters and

makes comparing theories and facts possible– Experience helps to understand what works and what does not

• Example: monetary policy in Great Depression (1928-) and Great Recession (2007-)

• Still, it is no guarantee against policy failure!

• History of economics is great fun!– ...which remains to be proven

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What you should also know? (and not only of the past)

• What are the issues of the day?– As seen at the time!

• Before proper statistics economists in fact did not know the economy; it took a keen eye to detect what was going on (cases: Adam Smith, Karl Marx; Irving Fisher)

• What are the institutions of the day?– Money is not money is not money

• What is happening elsewhere?– Sciences: physics (Newton -> Smith), mathematics (optimization), biology (a

two-way relation with economics!)– Neighboring social studies; literature (eg Austen / Dickens on industrial

revolution, Wolfe on Wall Street, Pamuk on Turkey...)• How is the sociology of economics?

– Not only polite words for gossiping (cases: decline of Cambridge UK; Samuelson at Harvard, Zingales 2012 on economists’ capture)

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Which past masters are an easy read?

• At least– Adam Smith: Theory of Moral Sentiments (1759), less so

Wealth of Nations (1776)– John Stuart Mill: Principles of Political Economy (1848)– Karl Marx: Das Kapital, I (1867)– Joseph Schumpeter (anything)

• Find your own favourites!– Much is available in paperbacks (Penguin!) and other cheap

editions– Wishing to find the influential sentiments of the time, read

secondary authors (Bastiat, not JS Mill; Wahlroos, not Hayek)

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The great histories

• Joseph Schumpeter: History of Economic Analysis (1954)• Mark Blaug: Economic Theory in Retrospect (1962; 5th ed.

1997)• Lionel Robbins: A History of Economic Thought (1998)

• We read: Agnar Sandmo: Economics Evolving (2006, 2010)– Not a great history, but an excellent textbook

• Short (just 489 pages!), excellent coverage, hugely readable, great teacher

– Approach:• AS is a first class microeconomist (public, environmental economics)• The Blaug approach of teaching modern economics• As a Norwegian tends to find ”a social democrat” in every economist

– Not totally misplaced: in fact most great economists actually were reformers!

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• Highly recommended additional reading:– Sylvia Nasar: Grand Pursuit: The Story of Economic

Genius. Fourth Estate, London 2011• Economics through some of the masters from early

19th century (Dickens and poverty) to current days• Some controversy over selection of personnel• From professor of journalism at Columbia U, author of

Beautiful Mind, story of John Nash (made into a somewhat beautified film by Hollywood)

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• Also recommended:• White, Lawrence H: The Clash of Economic

Ideas. Cambridge University Press, Cambridge 2010.

• The grand debates of the role of the state in the economy– Told from an Austrian, ie an ”anti-state”

perspective

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Consumer protection announcements

• All jokes told by teacher are bad, but not intended as insulting

• Of many issues discussed the teacher knows less than many of the students

• The approach here differs from that of Sandmo– Not teaching modern economics, as you probably know

the economics that is in Sandmo• If not it is explained there better than in most textbooks

– Emphasis on the two-way connection between economic thought and economic development

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Motto could be

• ”... The causes of the wealth and poverty of nations – the grand object of all enquiries in Political Economy.”– Malthus in a letter to Ricardo 26.1.1817• Exemplary: Malthus and Ricardo were at the opposite

ends of a debate with the greatest political importance – and remained the best of friends

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Primacy of persuation?• For as long as we know, people have naturally thought of economic issues• And used economic ideas to further policies

– Economics as a tool of persuation!• John Maynard Keynes: persuation primary, being consistent secondary• Blogs are a new tool, columns and pamphlets are not• Which way does it go:

– How easily are economists captured by vested interests?

• Do the internal controls of the profession work?

• Transferred their thoughts (”taught”) to others– Enlightenment I: Keynesian thinking brought into the White House of Kennedy,

Johnson (and Nixon!) by Gardner Ackley, Otto Eckstein, Seymour Harris, Walter Heller, Arthur Okun, Paul Samuelson, and James Tobin.

– Enlightenment II: The Washington Consensus– But they also fail: Jeffrey Sachs (Russia and the UN), Joseph Stiglitz (World Bank,

White House)– Should we really be activists?

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A modest example• In about 1996-1997 Sweden and Finland had to decide whether to join the

Economic and Modetary Union (ie to adopt the euro or not)– Two very similar countries– But different policy decisions!

• Two commissions were established– The Calmfors commission

• Politically free hands• Strongly based on Optimum Currency Area thinking

– The Pekkarinen commission• Politically tied hands• Strongly based on efficiency of exchange thinking

• In the end the decision was a political one– Sweden was wary of changing its geopolitical position, Finland wished to do that– It seems all then key advisors to Finnish government now think the euro was a

mistake, but path dependence exists: one cannot step out of history

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So, what distinguishes thinking on the economy from economics? Example from the ancient Egyptians:

Genesis 41• Joseph, the Jew, interpreted Pharaoh’s dream as telling of seven fat years to

be followed by seven lean ones. Therefore Joseph as state agent ”acquired” grain during the fat years and built reserves to be sold during the lean years.

• ”And he gathered up all the food of the seven years which were in the land of Egypt, and laid up the food in the cities; the food of the field, which was round about every city, he laid up in the same. And famine was over all the face of the earth; and Joseph opened all the storehouses and sold unto the Egyptians. And the famine waxed sore in the land of Egypt.”

• Was Joseph a benevolent Pharaoh’s servant for common good by stabilizing food supply and thus prices; or was he a successful speculator?

• This was a no-growth economy• Did Pharaoh use Joseph, or Joseph the Pharaoh?• Later Joseph took advantage of famine to nationalize previously private

lands and thus established slavery in Egypt

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Chosroes, Ruler of Persia (531-579)

• ”With justice and moderation the people will produce more, tax revenues will increase, and the state will grow rich and powerful. Justice is the foundation of a powerful state.”

• See for this and the reaya citation below Francis Fukuyama: The Origins of Political Order. Profile Books, London 2011.

• Justice here means generally acceptable level of taxation• An early version of the Laffer Curve?• Where is the much discussed Oriental Despotism here ?

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Adam Smith, 1755

• ”Little else is required to carry a state to the highest degree of opulence from the lowest barbarism but peace, easy taxes, and a tolerable administration of justice: all the rest being brought about by the natural course of things.”

• But as seen later, when Smith got seriously involved in economic matters, his view grew much more complex…

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The Ottoman circle of equity

• There can be no royal authority without the military.• There can be no military without wealth.• The reaya (i.e. the people) produce the wealth.• The sultan keeps the reaya by making justice reign• Justice requires harmony in the world.• The world is a garden, its walls are the state.• The state’s prop is the religious law.• There is no support for the religious law without

royal authority.

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The interest rate• Preconceived ideas are usually changed when progress demands it• Thus, all three Middle Eastern monotheist religions banned the taking of

interest– Was seen as unjust income– Mohammed also banned price controls!

• The Islamist ban still exists– Therefore the profit-sharing arrangements of Islamic banking

• Jews were the first to accept taking interest– Perhaps out of need: what were the geographically mobile occupations?

• While the Christians used the doctrine of “just price” to circumvent the ban– Fundamentally: if people are ready to pay an interest rate, there must be a

reason for that – thus it is just– But read Martin Luther’s sermons against interest taking / against Jewry

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Why was economics as a science born in Europe, not in China?

• Chinese economic performance– Richest country per capita in 14th century– Still the biggest industrial power in 1830 over Europe and USA (Maddison 2007)– But no increase in income level ca 1500-1950

• Technologies were developed– Paper, printing, bank notes, gunpowder, compass...– But these are early ones: what are the Chinese innovations after 1500?

• What went wrong? • Hypothesis 1: Stationary bandit (Olson 1982)

– Maximizes surplus appropriation and thus prevents investment– A stationary bandit would not need economics, rather gunpowder and

astronomy (just look at the Mayas!) – This story is less than convincing. In fact agriculture was hugely productive (4x

European?) and little taxed, but recipient of much investment (Great Canal !).

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Further on lack of ancient Chinese economics

• Hypothesis 2: splendid isolation– In early 15th century Zheng Ho sailed the China and India Seas, perhaps

even Africa etc. Emperor called him home and had the great ship destroyed (?)

– Foreigners were (often rightly) seen as robbers, not as exchange partners (compare Seabright: The Company of Strangers. Princeton UP 2010)• Why did the ”first” exchange act in history take place?

• Hypothesis 3: bureaucracy– Isolation together with centralized bureaucracy implied excessive control

and lack of initiative. New ideas not welcome. Is this still a problem?– Compare Europe with political-military competition combined with

cultural similarity (case: Galileo)– Problem: strength of Chinese bureaucracy is often exaggerated

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• Hypothesis 4: ideology– Peculiarities of Confucian and Legalist thinking– Tradition bound; good society in the past; modesty, slow life; respect for

elders etc– If true, would hold for Japan and Korea as well

• Were post WW-II success stories due to occupation?• Would (some) poor countries be better off if colonialism had continued? (Paul

Collier)

• Hypothesis 5: no demand for useful knowledge– With high agrarian productivity little need for technical innovation– With emperor as God little possibility for ideological/social innovation– With little contact with the outside little assimilation of knowledge– China was a unitary state, though with (non-frequent) external enemies,

who could be assimilated. Western Europe, in contrast, was a peculiar combination of military-political conflict and cultural homogeneity.

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Why European exceptionalism?

• The hockey stick models of economic growth– In China no income growth 1500-1950. Then unstable and

finally extremely fast growth.– In Europe no income growth 0-1500. Then first very slow

and since early 19th century high growth starting in Britain (”high” in Britain was about 1-1.5 per cent per year per capita!!)

– Some major variation due to climate and diseases• The biggest question in economic history: Why was

Europe exceptional?– Too big an issue for here, but...

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Feudal economics: scholasticism

• After the collapse of the Roman empire, some of the Creek and Roman philosophy was maintained in monasteries– Rich philosophy and ethics, much notes on economic issues

• Feudalism– A hierachic social contract: the master provided protection, as

enemies abounded, the subjects provided manpower and surplus

– Highly fragmented markets• ”Just price” as the key concept

– Beyond religeous ethics: price is just if it covers cost, maintains the social contract and at least in this sense reflects needs

– Easy to put in religeous terms

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Somehow capitalism and economics do go together

• Capitalism ~ markets, private ownership and accumulation– Community of interests in feudalism is based on

the need for protection; what are the interests in market exchange, where does needed trust come from; what to do with monopolies and privileges?

– Class divisions (peasants, landowners, entrepreneurs, workers): role of ownership distribution, justification for land rent, profits, interest rate; again: hierarchies or market exchange

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• State formation– Britain and France are the only old European centralized

states– Many states took long to form (Germany, Italy) others have

vanished (see Davies: Vanished Kingdoms. Allen Lane 2011)– New issues

• Foreign trade, taxation, ”role of the state”

• Technological change– Where is the key: in institutions or in technical change?– Technical change only entered economics in 1820s

(Ricardo); has remained a difficult topic

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Religious or secular thinking?• From the beginning capitalism went together with quest for useful

knowledge: not only to understand the world, but also to create new technologies, institutions and policies.

• But if / as God had created the world, why could humans meddle with it?

• Isaac Newton provided the answer: God had created the world and the rules by which it functions: the celestial mechanics of universal gravitation.– Forces of attraction and repulsion– Learned through observation, experimentation, measurement and calculation– Described by differential calculus

• Acting in the frame of these laws of clock-like mechanism humans were actually fulfilling divine will.

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Modern growth

• Was not only driven by new technologies, but also by the quest for useful knowledge then embodied in technologies, but also in commodities, institutions and policies.

• This was made accessible to society by large through social networks comprising universities, publishers, professional sciences, media and so on.

• So economics was present at this pre-history of the information society (see Mokyr: The Gifts of Athena. Princeton UP 2002).

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Newton, Smith and further• So modern science was in no contradiction with religion• For Smith then the invisible hand was not that of God. It was that of supply and

demand, which had been created by God like the rest of the rules of the universe.• Idea that society can be improved is one of the greatest human inventions

– Technocracy, social engineering– Revolutionism – Conservative and liberal critics

• Smithian economics are in this sense the Newtonian mechanics applied to society.– ”the greatest discovery that ever was made by man” – Smith on Newton

• 100 years later Smithian economics was then fed into biology by Darwin’s theory of evolution (with an explicit bow to Malthus).– Newtonian mechanism no longer a la mode in astrology and physics; but largely in

economics and elsewhere– Evolutionary biology and economics continue to feed into one another (optimizing

models)– In spite of repeated starts evolutionary economics has not been an overwhelming success