The ancient world
Serious thought began in the ancient world – roughly 400 BC – with ideas on how to deal with what we know today as the “economic problem” (scarcity, and how society decides what to produce/consume, how to produce, and who will consume).
The background then was a stage in history when man had progressed from hunting/gathering to agriculture. We can imagine that the economic problem for hunter/gatherers was then mostly that of survival, but agriculture later brought some element of abundance beyond the most basic necessities of food and water.
The Greek philosophers started with Socrates pestering others with his questioning of everything that was thought “obvious.” Plato contributed the idea of an efficient organization of a just society ruled by philosopher-kings. Aristotle was the most prolific and influential, through his ideas on concepts of justice that he applied to the exchange and distribution of goods.
Importantly, Aristotle gave three main arguments in favor of private property. First, we need private property before we can exercise liberality. Second, people take more care of their own property over those of the community or of others. Third, private property leads to peace and order.
Hesiod had the beginnings of the idea of opportunity cost as something that had to do with the choice between leisure and work. Xenophon coined the word “economics,” by which he meant the study of how to manage an agricultural estate. He also wrote about the division of labor.
Other philosophers, the Cynics, Stoics, and Romans were responsible for the idea that we should judge human institutions according to their adherence to “natural law,” which became the foundation for Roman law. Natural law was something to be discovered as “self-evident” by human reasoning (as opposed to knowledge through divine revelation), as later written by William of Auxerre.
The middle ages and the Renaissance
There was little progress in economics per se until about 1700, but ideas about science and knowledge came to the fore in the middle ages and during the Renaissance, and these ideas provided foundations for economic thought.
William of Ockham anticipated the scientific revolution by separating human reason from divine revelation. He also proposed what is now known as Ockham’s Razor, the idea that competing theories can be judged according to their simplicity and explanatory power.
Rene Descartes contributed the concept of deduction, which is the idea that knowledge comes from applying first principles to formulate particular statements. Francis Bacon, on the other hand, thought of induction, which is the idea that one can generalize from particular samples of observations or experiments.
The Scottish enlightenment and other influences on Adam Smith
Backhouse traces the intellectual lineage of Adam Smith back to Aristotle, through the Scottish Enlightenment (a period of intellectual ferment in the 1700s), and the works of Gershom Carmichael (1672-1729) and Samuel Pudendorf (1632-94), a German natural law philosoper who emphasized the role of the state and the law, and the implied social contract behind these institutions. Smith was also influenced by the French (Quesnay, the Physiocrats, and Turgot). These writers were active around 1756-1763.
Quesnay (1694-1774) and the Physiocrats contributed an early form of national income accounting (what we call GDP today) based on the idea that income circulates among different producers and consumers. They believed that only agriculture was productive, and that the other economic sectors were “sterile.” This idea is clearly wrong, but still persists.
Turgot (1727-81) thought of how to define national wealth as the capitalized present value of current and future incomes. He championed free trade on the assumption that every man knows his own interest best, and this formed the basis of the doctrine of laissez faire. He also suggested a subjective theory of value, as well as the idea that competition becomes practical when there are at least 4 traders involving two goods.
Smith wrote two main books, The Theory of Moral Sentiments (published 1759), and the Wealth of Nations (published 1776). The important thing to remember is that Smith’s contribution to economics cannot be understood in its proper context without appreciating the earlier book on moral sentiments. In essence, Smith’s ideas about how markets solve the economic problem require an underpinning of civilization among participants who abide by the law of contracts, and limit the sphere of economic competition to non-violent means. Smith presumed that man was inherently “moral” in this sense of restraint on behavior.
Smith contributed the idea of the market mechanism, also known as the Invisible Hand. It is generally thought that Smith espoused the doctrine of laissez faire, of letting the market decide the solution to economic scarcity. This idea has at times been used to justify the Wall Street motto that “greed is good.” Smith would disagree; he intended the market mechanism as a reasonable and civilized means of settling conflicting views in society about what an economy should produce, all this in the context of “prudence” or enlightened self-interest, but not in the context of a dog-eat-dog world of unbridled competition. Much of Smith’s work was subsequently refined into textbook microeconomics today (also called neoclassical economics).
Smith also supported the idea that certain goods imbued with public interest, which we today call public goods, were best produced and decided by government instead of by the markets.
Thomas Malthus and David Ricardo
Thomas Malthus (1766-1834) is famous for warning that the planet has a fixed amount of usable resources, whereas humans tended to reproduce exponentially. His thesis went awry because technological advances lifted the fixity of the resource constraint.
Ricardo (1772-1823) went beyond the theory of absolute advantage given in Smith’s work by propounding the theory of comparative advantage. This is the basis for a win-win solution whereby producers with different capabilities produce more goods for society if they were to specialize. It doesn’t mean therefore that those without an absolute advantage would lose whatever employment they might aspire to. Like Malthus, Ricardo thought about the effects of population growth. He propounded the Iron Law of Wages, which states that in the long run, when population increases are not checked, wages fall and remain near subsistence levels.
Jean Baptise Say (1767-1832) was a French economist who was a follower of Adam Smith. He is remembered for Say’s Law, the idea that supply creates its own demand. Income earned in the process of production, also lies behind the demand for goods. Under Say’s Law, there could be no unemployment because wages would adjust to clear the labor market. Say’s Law would later be seen by John Maynard Keynes as something that did not obtain in the real world where there was, from time to time, unemployment in the labor markets.
Karl Marx (1818-83) is usually seen as more than just an economist. He founded an ideology that was to rival the capitalist ideas inherent in the laissez faire doctrine. His main complaint was that laborers were paid too low because they had little bargaining power (in this, he continued the line of thought of Ricardo’s Iron Law of Wages). Marx did not see overpopulation as the root cause of workers’ misery; instead he proposed an historical theory that capitalism would eventually give way to socialism and communism, whereby workers would have control of the means of production. His followers would use Marx’s ideas to foment violent revolutions whereby capital in private hands was taken over by the state in socialist or communist countries. In Marx’s view, the aftermath of capitalism would be a society that did not require a market mechanism to solve the economic problem; instead governmental institutions (later called “central planning”) would have such a responsibility.
The Great Depression of the 1930s was a worldwide phenomenon that was generally cited as a failure of the market mechanism and of capitalism (where capitalism may be seen as the idea that market forces should govern the deployment of financial and physical capital in the economy). Adam Smith’s economics, which had become the mainstream view, was called into question. John Maynard Keynes (1883-1946) supplied a competing model of how an economy could operate in an “underemployment” equilibrium. Keynes thought that wage rigidities prevented the market-clearing equilibrium for labor, so that the business cycle could be explained in terms of fluctuating confidence factors (“animal spirits”). His solution was to consider that the markets failed, and government intervention through spending and adjustment of tax policies could smooth out the cycle and prevent the recurrence of the Great Depression.
Hayek and Schumpeter
Friedrich Hayek (1899-1992) apparently lost out in a debate with Keynes on how to fix the business cycle. Hayek believed that the market mechanism and capitalism were the best means of surmounting the problem of how to guess the future, particularly the area of technological advances. Hayek would concede Keynes’ take on the idea that undue optimism/pessimism (animal spirits) drives the modern economy, but he disagreed with the Keynesian solution. Hayek believed that socialist/communist planning suffered from the “fatal conceit” of knowing the unknowable, and therefore was bound to fail. But Hayek had little to offer the politician who, scared of unemployment figures, would attempt to use government spending to reduce the severity of an economic downturn, such as that which occurred in 2008.
Josef Schumpeter (1883-1950) is best remembered for the theory of Creative Destruction. He believed that the business cycle was a natural outcome of both changes in demand (tastes of the consuming public) and advances in technology. The latter result in waves of business failures for those using obsolete technologies, and the ensuing booms of business start-ups who gain from newly-discovered technology. The problem is that Schumpeter’s theory cannot be used to predict the course of the business cycle because the advances and declines in technology cannot be foreseen.
The Neoclassical Synthesis
The followers of Adam Smith had problems with Keynesian economics, initially because Keynes did not lay out a sufficient “microeconomic” explanation of the failure of aggregate demand. Neoclassical synthesis was a research program that dominated macroeconomics for about two decades since the 1950s. The synthesis is between Keynesian economics and neoclassical microeconomics; it was an effort to give microeconomic foundations to Keynesian economics.
In the 1970s, the synthesis failed to explain stagflation. One explanation for its failure was the so-called Lucas Critique whose main argument was that economic agents are sufficiently rational that they would eventually anticipate government interventions, and this would tend over time to make such interventions ineffective. Another explanation is that inflation could arise from imperfect competition (“cost push”), such as that resulting from the OPEC cartel.