1. THE ETHICAL BASIS OF ECONOMIC POLICY
Economists are rarely explicit with regard to the values that they embrace and that
may have a bearing on their policy views. They want to think of economics as a valuefree “box of tools” to be used in the analysis of economic behavior and of economic
systems, including also the effects of alternative policies. Yet, values cannot be escaped
if policy recommendations are sought; a policy recommendation is inevitably also a
moral statement. It is presumably in this sense one should understand the statement
of Keynes (in a letter to Lionel Robbins in the 1930s) that “economics is basically a
moral science”. Keynes was, after all, interested in economics mainly because of the
light it could shed on economic policy.
Economists have over the centuries been using different criteria for evaluating ethically
the market economy, institutional structures and alternative policies. The following
subsections will deal with the most common of the criteria used in the economic
literature.
”The political problem of mankind is to combine three things: economic efficiency, social justice
and individual liberty” (John Maynard Keynes, ‘Essays in Persuasion’, 1931)
4.1 Freedom
Classical economics is closely related to natural law theory (cf. section 5), which
stresses individual freedom. Much of the attraction of the market economy for the
classics was precisely the freedom that unregulated markets were associated with. An
added and significant aspect was that freedom would be conducive to economic
efficiency.
This perspective has also been stressed by the intellectual heirs of classical theory, such
as Friedrich Hayek and Milton Friedman. For them the chief contribution of the market
is that it allows decentralized economic activity by using the price mechanism (the
“’invisible hand’) to provide information and to incentivize economic actors as well as
to balance markets.
Hayek was of the view that the alternative to the market economy, central planning,
inevitably results in a totalitarian dictatorship. This is visible already in the title of his
main work ‘The Road to Serfdom’ (1944). The market economy is for him a
precondition of democracy and freedom. A similar argument is put forward by Milton
Friedman, who is the author of ‘Capitalism and Freedom’. Freedom of contracts is
essential for him, economic growth only a bonus that freedom provides.
But what is freedom? Sen (2003) emphasizes that freedom is a matter of both the
process of and the scope for substantial choices. Considerations of process concern
immunity or autonomy of the individual from restrictions imposed by others (‘negative
freedom’), meaning that choices are in our own hands. Freedom from restriction on
individual choice should be as extensive as is compatible with granting the same
freedom to other citizens. As the market economy is based on voluntary transactions, it
scores high with regard to the freedom of the process.
The perspective of substantial possibilities for choice concerns the real possibilities that
an individual has for achieving commodities or states that he appreciates highly
(‘positive freedom’). It must make quite a difference if the choice is to be made
between alternatives that are ‘good’, ‘terrific’ and ‘wonderful’, or between alternatives
that are ‘bad, terrible and disastrous’ (Sen, 2003).
Markets give the freedom to choose – another important book of Friedman (written
together with his wife Rose) has the title ‘Free to Choose’ – and this freedom is of great
importance in principle, but its content may be rather poor in practice. Freedom is of
more importance if the set of choice includes truly valuable alternatives for the
individual. This perspective on the substance of freedom and the actual opportunities
open to individuals has been emphasized by many personalities throughout history –
such as Aristotle, Adam Smith, Karl Marx, Mahatma Gandhi and Franklin Roosevelt (Sen
2003).
4.2 Happiness
It seems quite natural to assume that the proper purpose of the economy and of
policies must be to help the individual and society to achieve ‘happiness’. This idea
goes back at least to the philosopher Epicuros in ancient Greece, and it was an
important theme also for the medieval scholastics. For one of its first protagonists in
modern times, John Stuart Mill (cf. section 5 below), happiness as the objective of
human aspiration is so obvious as not to require any proof. However, it is far from clear
how happiness is to be interpreted or measured.
In economics there are two versions that dominate much of the literature: classical
utilitarianism (described in this section) and the ‘modern’ welfare economics (dealt
with in the next section). It should also be noted that utility maximization has two
different roles in economics. On one hand it is used by neoclassical and later
economists to derive the demand functions of households. This use of utility has no
necessary connection to the use of utility as an ethical criterion.
The starting point in utilitarianism (and modern welfare economics) is the assumption
that the economy consists of households, that are maximizing their utility functions,
and firms, that are maximizing their profits. It is mostly assumed that all markets
function in an ideal manner: perfect competition and rapid adjustment towards a
stable equilibrium. All economic actors have access to relevant information and there
are no externalities. It is further assumed that only the exogenously given preferences
or utility of individuals matter for welfare (rather than other characteristics of society1).
For its initiators, Jeremy Bentham and Mill (both John Stuart Mill and his father James
Mill), utilitarianism is the doctrine that seeks ‘the greatest happiness of the greatest
number’ or that maximizes the sum of happiness of the members of society. This was
the view of the classical economists through much of the 19th century. For them the
role of economics was to ‘calculate pleasure and pain’. Obviously utilitarianism thus
understood is a form of consequentialism, meaning that actions are to be evaluated in
1
Arguably characters of society as a whole could matter. For instance, many individuals might
appreciate national autonomy, the possibility for citizens of a political community to decide their own
future. The assumption of exogenous preferences might be called into question on the grounds that
most preferences are de facto resulting from our upbringing, education or culture.
terms of their consequences (rather than, for instance, their conformity with certain
moral obligations).
John Stuart Mill was both a utilitarian and a liberal; he is the author of ‘On Liberty’
(1859) and ‘Utilitarianism’ (1863). However, the relation between utilitarianism and
liberty or individual freedom has been a source of contention. Some philosophers have
argued that there is an inconsistency in that Mill’s utilitarianism may contradict the
rights and freedoms of the individual. It is conceivable that the suppression of
individual liberty would increase aggregate utility in society. How can such a conflict
between two fundamental principles, both essential to the classical economists, be
reconciled?
The answer appears to be twofold (Machowski). First, upholding the basic rights and
liberties of the individual is arguably in a broader perspective essential for collective
happiness to be achieved. In his ‘Utilitarianism’ Mill states that “justice is a name for
certain moral requirements, which, regarded collectively, stand higher in the scale of
social utility, and are therefore of more paramount obligation, than any others…”. The
direct pursuit of utilitarian happiness must in other words be constrained by the
respect of individual freedom in order to actually promote general happiness of the
larger community. Suppressing individual rights would risk leading to some form of
possibly well-meaning but de facto disastrous totalitarianism.
Second, Mill makes a distinction between fulfilling desires and ‘higher pleasures’ which
are in the end more important for happiness. In ‘Utilitarianism’ he states that “Human
beings have faculties more elevated than the animal appetites, and when once made
conscious of them, do not regard anything as happiness which does not include their
gratification”. Mill’s utilitarianism, different from any simple hedonism, reconciles
utility with freedom because higher pleasures would be inconceivable in a restrained or
illiberal context.
Happiness has in recent years experienced something of a comeback in the economic
literature. The more recent literature on ‘happiness economics’ is not directly related
to classical utilitarianism. However, it has a certain affinity to it in that it thinks that the
success of a society is properly evaluated on the basis of the happiness of its citizens.
Measurements of happiness in various countries are routinely made in the form of
surveys, in which individuals are asked to report the extent to which they are happy or
satisfied with their life. Needless to say, happiness at the level of the individual
depends very much on idiosyncratic circumstances such as health, marriage and
personal relations to other people. Also, it is important to have a meaningful job (to
loose one’s job causes a considerable decline in happiness).
Comparing reported happiness with income levels seems to show a rather clear
positive correlation. This would mean that society becomes happier as its income level
rises, and that rich countries should be happier than poor countries.
However, the correlation between income and happiness has been the subject of
considerable controversy. In the early 1970s Easterlin ( ) claimed to have
demonstrated that higher income improves happiness only up to a certain level. Also,
he argued that happiness is more a function of the increase in income, and that
happiness falls back to the earlier level once the individual gets used to the higher
income level. Furthermore, happiness may be enhanced by an increase in income
relative to others (status). However, happiness based on relative positions does not
enhance overall happiness in society. From these arguments many have drawn the
conclusion that economic growth and the aspiration of ever higher incomes is futile or
counterproductive.
On the other hand, there is recent research that claims to demonstrate that happiness
is, after all, a growing function of income levels without any obvious ceiling. Needless
to say, few would argue that money in itself makes man happy. But it helps people to
afford, for instance, more varied leisure, more healthy food and better housing. Recent
data seems to indicate that citizens in the Nordic countries (notably in Denmark and
Finland) are happy, even more happy than GDP per capita in itself would suggest
(figure).
4.3 Efficiency
The neoclassical economists started to have methodological doubts about the
utilitarian doctrine. In the 20th century and notably in the 1930s, it became common to
argue that utility could not possibly be measurable in the sense of allowing
interpersonal comparisons. This view was argued forcefully by Lionel Robbins in his ‘An
Essay on the Nature and Significance of Economic Science’ (1932) and it was soon
embraced by ‘modern’ welfare economics. The new view argues that the fulfillment of
preferences or the utility of various individuals cannot be compared, and that therefore
the sum of utilities is a meaningless concept.
How is it possible to define the characteristics of a good society if the utilities of its
members cannot be compared? The only safe statement then is that alternative A is
better than alternative B (a so called ‘Pareto-improvement’) if alternative A improves
the situation of one or more individuals without worsening the outcome for anybody. A
‘Pareto-optimum’ is a state of affairs in which no ‘Pareto-improvements’ are possible,
where all ‘win-win’ possibilities have already been exploited.
Pareto-optimum is a very different welfare criterion as compared to the maximization
of the sum of utilities (figure 3). Assume that a certain amount of income is to be
divided between individuals A and B, the income of A being measured as the distance
from point A to the right and the income of B from point B to the left. The marginal
utility of A is given by the line aa and the marginal utility of B by b1b1, these two curves
being identical (except for direction).
Assume that the original distribution of income is given by point H, so that income of A
is represented by the distance AH and income of B by HB. The marginal utility of A is PH
and that of B is ZH. For the utilitarian this means that income should be shifted from A
to B until marginal utilities are equalized at point E, where income is equalized (AC =
CB).
This is not compatible with the Pareto criterion; in fact, no other distribution than the
one at point H is allowed under the Pareto criterion because any redistribution would
imply a loss for either A or B (as this is a pure “sharing the cake”-problem). The Pareto
criterion is extremely conservative in the sense that no redistribution is suggested
however unequal the original distribution of income.
It should be added that the results would be modified if account were taken of how
income is generated and of any negative incentive effects associated with
redistribution. In particular, the utilitarian criterion would suggest somewhat smaller
redistributions if those caused the “cake” to become smaller.
Utility maximization is more egalitarian than the Pareto criterion but can also have
surprising consequences. Assume that individual B for some reason (for instance a
handicap of some sort) has only half the capacity for utility as compared to individual A.
Marginal utility of B is now indicated by the line b2b2 along which marginal utility is
always half as compared to marginal utility on the line b1b1. This has no consequence
for the Pareto-optimum, which remains at point P, but it will shift the utilitarian
optimum from E to G. The person suffering in terms of less capacity for utility is
therefore punished by a shift of income in favor of the (anyway) happier individual A,
which may seem strange.2
Figure 2: Pareto-optimum and utility maximization
MUA
MUB
a
b1
P
E
Z
G
b1
b2
a
b2
O
H
C
D
B
A result of modern welfare economics that has attracted widespread interest is the
‘fundamental theorem’, according to which any competitive market equilibrium is
necessarily also a Pareto-optimum (provided that a number of restrictive assumptions
hold). This result is interesting in principle; it gives a theoretical basis for the claim that
a market economy fulfills certain efficiency conditions. It may be seen as a
sophisticated vindication of Adam Smith’s view on the role of the invisible hand in free
markets.
2
The Rawlsian criterion (maxmin), when abstracting from incentive effects, would also recommend some degree of
egalitarianism and would certainly not agree with the utilitarian solution at point G.
However, the practical significance of this theory is limited, because it has nothing to
say about issues of income distribution. It could be that a small portion of the
population lives in great affluence while the great majority lives in conditions of
extreme poverty; yet the theory could not recommend any redistribution from the rich
to the poor because that would weaken the position of the rich, and this loss cannot be
compared to the gain of the poor (because of the impossibility of interpersonal utility
comparisons)!
In sum, modern welfare economics based on the Pareto-criterion is of no great use
when confronted with the important, difficult and interesting problems of society,
which often concern distribution. It is therefore a poor approach to the ethical
question that society faces. Efficiency is important but it cannot be the only criterion;
some additional guidance is needed. This is probably the reason why welfare
economics in the sense of Pareto has faded into the background in recent decades.
4.4 Equity
Considerations of freedom and happiness certainly suffice to make an ethical case for
the state to assume basic tasks like safeguarding individual rights, including property
rights, and providing certain basic collective goods, such as a (stable) monetary regime,
external defense and law and order. These are the roles of the ‘night-watch’ state
embraced by classical liberalism and classical economics (which are mutually
overlapping, the classical economists also being liberals).
A pure night-watch state would be modest in terms of size; handling of its tasks would
require public expenditure of some 10 per cent of GDP. However, the actual size of the
public sector is in most developed countries nowadays rather something between a
third and a half of GDP (or even higher). This is because the public sector has over time
come to assume many tasks beyond those of the night-watch state. Many of these
tasks relate to presumed ‘market failures’ calling for the state to replace or
complement action by markets (next section). Other actions are justified by the
political desire to reduce income inequality and enhance social equity.
What does equity or social equity mean? Obviously it refers to some sort of equality as
between members of society. One candidate is equality of the right to liberty in the
sense of absence of restrictions on individual action (often referred to as “negative
freedom”). This is indeed the first principle in John Rawls’ famous theory of justice as
fairness (Box).
An alternative or complementary option is that equality may refer to equality of actual
ability to succeed in life and to achieve objectives that individuals themselves
appreciate. Such “positive freedoms” can be enhanced, to some extent, by social
policies (such as housing or child care) and above all by providing free education to all.
The stride for ‘ex ante’ equality (equality of possibilities) is compatible with the
‘capabilities approach’ to policies propagated by Amartya Sen, in which focus is on
what individuals are actually able to do (capability) in terms of functioning and
achieving substantially valuable and desired objectives.
Box: John Rawls’ principles of justice (‘A Theory of Justice’ (1971)).
The first principle of justice states that “each person is to have an equal right to the most
extensive basic liberty compatible with a similar liberty for others”. The basic liberties of citizens
are the political liberty to vote and run for office, freedom of speech and assembly, liberty of
conscience, freedom of personal property and freedom from arbitrary arrest. The first principle is
lexicographically prior to Rawls’ second principle. However, Rawls adds that “liberties not on the
list, for example, the right to own certain kinds of property (e.g. means of production) and
freedom of contract as understood by the doctrine of laissez-faire are not basic; and so they are
not protected by the priority of the first principle.”
The second states that social and economic inequalities are to satisfy two requirements:
a. “They are to be attached to offices and positions open to all under conditions of fair
equality of opportunity”; and
b. “They are to be to the greatest benefit of the least-advantaged members of society (the
difference principle)”.
Part a of the second principle is lexicographically prior to part b. The relation of these principles to
equality is a debated and complicated topic. For instance, equality (in some sense) must not be
enhanced by worsening the position of the least advantaged. Also, inequalities can be just if they
are to the benefit of the least well off.
A third option would be to aim at ‘ex post’ equality in the sense of the outcomes that
are realized. Policies to limit extreme or absolute poverty have a long history. Most
countries have policies in place in the form of social security that take at least some
(even if modest) steps in this direction Also, most citizens and many politicians are in
favor of policies to promote a more equal distribution of income and wealth (though
views on the appropriate means of favoring equality differ considerably).
There is no doubt that ‘equity’ is a highly controversial concept, where views differ
widely as a function of broader ideological positions. The concept of equality as an
object of policy becomes even more difficult if allowance is made for the time
dimension (equality as between generations) and the space dimension (equality in a
global context).
4.5 Market failure – and political failure
As already noted above, governments in most countries pursue activities far beyond
the tasks called for by the concept of the night-watch state. Basically this is because
government in a modern democracy is an institution or set of institutions, which
citizens use for collective action to counter problems and to pursue the ‘public interest’
(however understood). From an economic point of view, these activities may often be
justified as ways to deal with ‘market failures’, of which there are many instances.
First, the market functions satisfactorily only if there is effective competition. This may
call for action to improve conditions for competition by, for instance, creating obstacles
to monopolies or high concentration on the supply side or demand side of the market.
Second, the government may want to counter the effect of distortions in the form of
externalities (positive or negative) by regulation or by specific taxes and/or subsidies.
For instance, governments may want to tax pollution and subsidize activity conducive
to a clean environment.
Third, information problems hamper the effective functioning of some markets,
notably markets for insurance. Asymmetric information causes ‘adverse selection’
and/or ‘moral hazard’, which gives reason for public unemployment insurance as well
as public pension and health care systems. Myopia (lack of foresight) can provide an
additional reason for compulsory and collective pension systems. It is also common for
paternalistic arguments to be used when arguing for public intervention in areas like
health and education.3
To these considerations must be added macroeconomic aspects. John Maynard
Keynes, the father of macroeconomics, argued in the 1930s that the market economy
cannot be assumed to adjust flexibly and rapidly towards an equilibrium characterized
by full employment. Various factors explain why the economy may get stuck into a
situation with excess capacity and large-scale unemployment. Keynes also argued that
the situation in a deep slump can be ameliorated by active stabilization policies geared
towards ensuring a level of demand for output compatible with a high degree of
capacity utilization.
Many of the market failures do not necessarily or in principle raise serious issues of
ethical character. To the extent that market failures create economic distortions, and if
these distortions can be corrected by government intervention, then such intervention
may constitute Pareto-improvements. As observed above, it is difficult to object to
Pareto-improvements whatever values one is embracing.
However, in practice it is extremely difficult to make a clean separation between
considerations of efficiency and equity, and both are often relevant for policies
motivated by market failure. For instance, given market failures of the kind already
referred to above, there may be an efficiency case for social policies in areas such as
education, health or pensions (Barr, ). On the other hand, actions in these areas are
also thought to enhance equality of citizens – and may well do so even if the case for
efficiency were in fact weak.
Fighting unemployment or runaway inflation with appropriate macroeconomic policies
makes sense whatever ethical views one holds – provided only that the economy
functions in the way that protagonists of active policies assume (which is a notorious
source of controversy). However, unemployment is not only an economic waste but
3
Paternalism is the view that individuals may not always understand fully what is best for them – in
combinations with the view, difficult for classical liberals to swallow, that there is somebody else, like
a politician or a bureaucrat, who can deem the proper needs of the citizen better than the individual
himself.
also a serious social problem and cause of inequality. Action to fight unemployment
can consequently be justified both as enhancing efficiency and as furthering equality.
The desirability of such policies will unavoidably be weighed in the light of two kinds of
considerations: the assessed effectiveness of the policies to achieve higher
employment on one hand, and the weight attached to a reduction in unemployment
(and associated poverty) as an objective on the other.
While there are market failures, there are also ‘political failures’. This is the important
message of what is called ‘public choice theory’. This theory employs an economic
perspective on political and other collective decision making; in other words, it refers
to “the use of economic tools to deal with traditional problems of political science”
(Gordon Tullock).
Public choice theory has been used to demonstrate, inter alia, why and how politicians
act to maximize votes (medium voter theory), how bureaucracies may reduce overall
efficiency if focused on a narrow maximization of their own budget, and how effective
lobbying for special interests risk creating distortions. Also, this perspective may
explain the tendency for overall budget expansion and for the deficit bias in public
finances, which arguably reflects the fact that future generations are absent from
current decision making. A main point of public choice theory is that institutions (such
as the constitution) should be designed so as to constrain the scope for politicians to
rely on majority positions in order to exploit minorities; ‘Leviathan” should be chained.
4.6 Other objectives and values
Probably the most common objective referred to in policy discussions by economists
and politicians is the GDP. One may get the impression that the level of output or real
income or the growth rate of GDP is the overriding aim of policies.
One reason for this is the fact that production is the source of income and therefore of
consumption. Economic growth is the means of raising populations out of poverty.
Another consideration is that production and employment go hand in hand, and lower
unemployment is an important objective of policy. Also, higher income makes it easier
to finance action with, for instance, social or environmental purposes.
Policy discussions often refer also to external balance or to the desirability of reducing
the budget deficit (or the ‘sustainability gap’ in public finances). However, these are
obviously not to be seen as objectives in themselves but rather as constraints that need
to be taken into account for policies to be sustainable. The same may to some extent
be said of environmental objectives. On the other hand, some environmental
objectives may also be seen as non-instrumental targets, as ethical values in
themselves (like preserving natural diversity).
Many ‘composite indicators’ have been developed with a view to complementing or
replacing GDP as a measure of how the economy is doing. These indicators include the
Human Development Index (developed by Sen), which is based on life expectancy,
education and income. Another example is the ‘General Progress Index’, based on
private consumption, investment, household work, criminality, traffic accidents and
environmental damages. For an illuminating discussion of such measure in the Finnish
context see Pohjola (2013). He presents calculations of alternative indicators, indicating
that ‘welfare’ in Finland has developed positively (more positively than indicated by the
GDP) in recent decades, when taking account of private consumption, leisure time and
life expectancy (positive effects) and income inequality (negative effect).
One recurrent theme in the philosophical and also the economic literature is that
money is not the key to happiness, though financial resources are useful means to
more important ends. For ancient philosophers, like Aristotle, a key question was how
man should live his life, and economic aspects were not central to his thinking.
John Stuart Mill was convinced that there would in the future emerge a ‘stationary
state’, in which the economy would cease to grow and develop. However, differently
from Malthus he did not regard the stationary state as a dismal prospect (Box). For Mill
the ideal society was not one of economic growth but rather one which laid emphasis
on nonmaterial values.
A century later (in the 1930s), John Maynard Keynes pondered capitalist progress
towards a future (utopian) society. He thought that rapid economic growth would
continue for a century or so, until society would be affluent enough to start giving more
weight to what really matters for the welfare of man (Box). Work would be done only
for a few hours per day or a few days per week; much more time would be given to all
kinds of art and philosophy. Obviously, this utopian vision is still waiting to become
reality.
Capitalism was for Keynes an ethically disgusting system which, however, had a useful
role in solving the economic problem of scarcity. Somewhat similarly, capitalism was
for Marx an inevitable but transient phase in the historical development towards
paradise on earth (communism).
John Stuart Mill wrote that “I am inclined to believe that it would be, on the whole, a very
considerable improvement on our present conditions. I confess I am not charmed with the ideal of
life held out by those who think that the normal state of human beings is that of struggling to get
on; that trampling, crushing, elbowing, and treading on each other’s heels, which form the
existing type of social life, are the most desirable lot of human kin, or anything but the
disagreeable symptoms of one of the phases of industrial progess.” (quoted in AS).
“When the accumulation of wealth is no longer of high social importance, there will be great
changes to the code of morals. We shall be able to rid ourselves of many of the pseudo-moral
principles which have hag-ridden us for two hundred years, by which we have exalted some of the
most distasteful of human qualities into the position of the highest virtues. We shall be able to
afford to dare to assess the money-motive at its true value. The love of money as a possession — as
distinguished from the love of money as a means to the enjoyments and realities of life — will be
recognised for what it is, a somewhat disgusting morbidity, one of those semi-criminal, semipathological propensities which one hands over with a shudder to the specialists in mental disease
… But beware! The time for all this is not yet. For at least another hundred years we must pretend
to ourselves and to everyone that fair is foul and foul is fair; for foul is useful and fair is not.
Avarice and usury and precaution must be our gods for a little longer still. For only they can lead
us out of the tunnel of economic necessity into daylight.” (quoted in ‘Keynes and the Ethics of
Capitalism’ by Robert Skidelsky).
4.7 Social choice theory
The basic question examined in social choice theory is this: Is it possible to derive a
meaningful preference function of the society, or to rank alternative institutional
settings or policies that may be pursued by society, on the basis of the preferences of
the individuals of which the society is composed? This would seem necessary for it to
be possible to speak without ambiguity about, for instance, the ‘public interest’. Is
majority voting or some other procedure appropriate for generating a consistent ‘social
welfare function’? This problem was raised already more than two centuries ago by
Condorcet (see Box on the ‘voting paradox’).
Interest in this problem was stimulated in the 1950s by the so called ‘Arrow’s paradox’.
Arrow assumes that only the preferences of individuals count and that they all have
equal weight. He assumes these preferences to meet certain reasonable requirements
such as to be transitive. Also, he assumes that interpersonal utility comparisons are not
possible.
In Arrow (1951) he demonstrated that even mild conditions of reasonableness
attached to the procedure and the preferences of individuals would make it impossible
to arrive at a result in the form of a ‘reasonable’ social welfare function. The paradox is
that it is not possible to generate a reasonable ranking of social choices from
reasonable rankings of alternatives by the individuals constituting the society. In
particular, Arrow demonstrated that social choice could be violating the requirement of
transitivity (Box). Only a dictatorship would avoid inconsistencies, but then that would
not be a choice by the society.
There is a large literature on how one should interpret the Arrow paradox and how one
could modify the analysis to achieve a well-behaved social welfare function. One option
is to assume some similarity of individual preferences, possibly due to cultural
homogeneity. It is not surprising if it is easier to agree on appropriate objectives if
individuals have common conceptions of what is good and bad. However, the
difficulties of finding agreement are even then great in choices involving distribution.
(The sharing of a cake of a given size is unavoidably associated with distributive
conflict.)
Box: Condorcet’s paradox.
The problem that majority voting may have arbitrary outcomes was noted more than two centuries
ago by the French mathematician and philosopher Marquis de Condorcet. The problem may be
illustrated by the table below, which describes the preferences over alternatives X, Y and A by the
voters A, B and C.
Voter Preferences
A
X > Y > Z
B
Y > Z > X
C
Z > X > Y
Another option is to introduce interpersonal comparison of utilities. This does help to
do away with the paradox and to achieve a consistent ranking of social alternatives.
Nevertheless, the general result is that it is – even at a conceptual level and under
uncontroversial assumptions – difficult to find a way of generating a social welfare
function and a ranking of alternatives for society on the basis of individual preferences.
Arrow’s paradox raises big and still partly unanswered questions for public policy. In
particular, democracy is often understood as relying on (and occasionally even
identified as) majority voting. Arrow’s paradox demonstrates that there is no inherent
optimality attached to this system; its attractiveness relates more obviously to the
procedure than to its results.
5. PRE-CLASSICAL ECONOMICS
Economic issues, including monetary and financial problems, were thought about
already by the ancient Assyrians, Babylonians, Chinese and Indians. Ancient Egypt had a
kind of a planned economy based on the predictable flooding of the Nile River and an
irrigation system of the fertile valley, allowing rich crops and a rather high population
density. The Assyrian and Babylonian theocracies had large military and bureaucratic
establishments and elaborate legal systems (such as the law of Hammurabi about 2000
BC). They developed monetary institutions and knew credit and banking. Ancient China
had a highly developed public administration and dealt comprehensively with issues of
economic policy. Sen (2009) makes reference to a large economic and political
literature in ancient India.
The Bible contains the famous story of Joseph, who interpreted Pharaoh’s dream as a
forecast that seven fat years (in terms of grain harvests) were to be followed by seven
bad years. Authorized by Pharaoh, Joseph then bought grain during the good years and
Egypt therefore had grain to use and to sell during the bad years. Joseph is not in the
Bible characterized as a speculator, but he had a good understanding of the
microeconomics of the grain market. His behavior also conforms to the golden rule of
stabilization policy proposed by the father of macroeconomics, John Maynard Keynes,
according to whom one should accumulate surpluses during the good years and run
deficits in bad years.
Economicum is the name of the building where most academic economists in Helsinki
are located. The word comes from the Greek “oikonomia”, which refers to household
management, something that Xenophon has written a book (“Oeconomicus”).
Athens in particular experienced a long period of economic affluence in the centuries
BC. The economy was based on agriculture, there was some manufacture, but Athens
was also pursuing a lot of foreign trade, and it possessed a rich silver mine. Athens
pursued a liberal trade policy. There was a monetary system and banks, various forms
of finance and insurance as well as some sort of companies (legal entities not too far
from joint stock companies in some cases). There was also speculation and crises
caused by excessive lending already some 600 years BC (during the reign of Solon). The
city state of Athens at times pursued social policies with a view to keeping the price of
bread low, and the authorities also subsidized going to the theatre.
Plato had little to say about economic issues. In his ‘The Republic’ he outlines a famous
collective utopia. His ideal state is governed by wise and responsible rulers
(philosopher kings, “who love the sight of wisdom”), a special caste of guardians or
rulers who were to live together without property or family ties. The role of other
citizens is to be productive (workers) or protective (worriers). The views in the Republic
have some affinity with later communist and other totalitarian ideas.
Why was Plato attracted by a sort of totalitarian ideal? According to Schumpeter, Plato
disliked the chaotic changes of his time. He hated tyranny (then prevalent in Sicily) and
he probably disliked the Athenian democracy. For him, tyranny grew out of democracy
and was its alternative. Democracy, in its turn, was an inevitable reaction to oligarchy,
itself traceable to inequality of wealth arising out of commercial enterprise.
In the Republic Plato also examines carefully the significance, from the point of view of
efficiency, of the division of tasks and of specialization in society, an issue which later
was to be central for Adam Smith. However, the kind of specialization pondered by
Plato was obviously not based on private exchange on markets but was rather a feature
of a society based on central planning and in which all activities (economic or not)
were strictly regulated.
Aristotle considered private ownership to enhance virtue. He had a lot to say about
trade and exchange. He made a distinction between use value and exchange value and
understood voluntary transactions to take place only when benefiting both seller and
buyer. He identified monopoly (much in the way it is done today) and condemned it as
bad. He also pondered what could be the ‘just’ price, and he has been interpreted to
mean that it is the price which in the long run is necessary to cover costs and make
production possible (later called the ‘natural’ price by the scholastics). Aristotle saw the
importance of money as a measure of value and means of exchange. He supported a
metallic standard (a currency based on, e.g., gold or silver), while Plato was in favor of a
paper currency (‘fiat money’).
While Aristotle understood the importance of specialization and exchange for
efficiency, he was nevertheless quite critical of the monetary economy and notably of
trading activities based on the profit motive. He thought that business enterprise and
the pursuit of monetary gains would be corruptive and bad for human virtue. This has
been interpreted as reflecting his status as a privileged man who did not need to work
for his existence, the material preconditions for life being taken care of by slaves and
women. Free men could in such conditions spend time on reflection of virtues and
eternal truths4 (Sihvola).
The views of Aristotle on the monetary economy can be summarized (Sihvola) as the
claim that “money has a tendency to transform itself from being an instrument for the
facilitation of transactions into becoming an end in itself or a means for accumulating
profit. Then it dominates the life of people, it spreads its mechanisms of functioning
over the whole society and causes moral decay”. (This is reminiscent of the views of
Karl Marx but also of more recent views of philosophers like Michael Sandel.) In
4
Schumpeter refers to “ideological preconceptions to be expected in a man who lived in, and wrote
for, a cultivated leisure class, which held work and business pursuits in contempt and, of course, loved
the farmer who fed it and hated the money lender who exploited it”. Anyway, Aristotle thought that
the hard work of workers, merchants, bankers and others took a lot of time and would also affect
negatively the moral character of those working hard, thereby making virtue unachievable.
economics the fundamental counterargument to Aristotle was finally provided by
Adam Smith.
Aristotle condemned interest on loans, considering it unnatural and as constituting
‘usury’. However, it is symptomatic that he never asked the question why interest is
paid, he had no theory of the rate of interest. The justification of interest on loans was
later a subject of extensive debate by the medieval scholastics.
The legacy of Aristotle is not without significance; his critical attitude to market
activities cast a long shadow into the future. In particular, the ethical position of the
Roman Catholic Church was significantly influenced by Aristotle.
The Aristotelian views on the economy were influential throughout the middle ages
and changed only with the writings of Martin Luther and Jean Calvin. The former saw
hard work or diligence as a divinely ordinated mission to improve the material
conditions of life. The latter thought that the purpose of economic activity was to
spread the honor of God and saw economic success a sign of belonging to those chosen
for eternal life. These views later inspired Max Weber to think that Protestantism
constituted a cultural attitude particularly favorable for the capitalist system.
While the contribution of ancient Greece to philosophy and the development of
science in general has been huge, the assessment of Schumpeter on their role in the
area of economics is a different one: “So far as we can tell, rudimentary economic
analysis is a minor element – a very minor one – in the inheritance that has been left to
us by our cultural ancestors, the ancient Greeks.” He also states that “They merged
their pieces of economic reasoning with their general philosophy of state and society
and rarely dealt with an economic topic for its own sake. This accounts, perhaps, for the
fact that their achievement in this field was so modest, especially if compared to their
resplendent achievements in others.”
In the middle ages the Scholastics (mostly priests and teachers at medieval universities)
gave thoughts to the issue of the “just price”. This should be seen against the
background that transactions at the time rarely took place within the framework of
well-organized markets; much exchange took place between individuals operating in
relative isolation. In such cases one cannot count on competition to keep a check on
prices. The scholastics came to the conclusion that the just price would equal the
‘natural’ price, the price that would emerge in the long run or on average in a
competitive market (a price only covering unavoidable costs). The scholastics also
pondered the justice of taxation and the justifications for charging interest on loans,
coming to the conclusion that interest might be justified by credit risks and/or the rate
of return that the creditor might forgo by lending money.
The mercantilists are the first group of economists identified as a school of economic
thought on their own. In fact, this identification was done by Adam Smith, who set out
to criticize the views of the mercantilists. It would seem that mercantilism was more a
political ideology and economic doctrine than a common approach to economic
analysis (Agnar Sandmo p. 19).
The mercantilists identified wealth with the amount of precious metals, gold and silver,
that a particular country had at its disposition. To increase the wealth thus conceived
was the appropriate goal of economic policy, and this could mostly happen through a
surplus in the balance of trade (assuming the country does not have gold or silver
mines of its own). The means for achieving this surplus included promotion of exports,
including by promoting export monopolies and the staple system, as well as the
nurturing of domestic industries competing with foreign companies and restrictions on
imports.
Adam Smith, as well as most economists after him, has considered the priorities of the
mercantilists to be misplaced. However, one should take into account that the
mercantilists were defining policy prescriptions for rulers who mostly wanted to
increase their military power relative to other countries. (Large financial means at the
disposal of the ruler may be quite useful in situations of military conflict.) Also, while
monopolies may create profits at the expense of consumers, in the case of export
monopolies the consumers are foreigners (while the profits accrue to citizens and
partly to the home state of the company). Administrative regulation of foreign
exchange can make sense in situations of crisis and times of conflict (JS s. 341). Some
mercantilist writers argued for their policies on the basis of the infant industry
argument as well as by the argument that an increase in net exports will stimulate the
business process by increasing expenditure geared towards domestic production (cf.
the arguments of Keynes).
The French physiocrats considered agriculture to be the main foundation of economic
wealth; thus, what was good for agriculture would most likely be good for France.
Francois Quesnay, in his Tableau Economique (1759), analyzed the formation of
national income in terms of its circular flows. Quesnay also formulated a number of
“maxims” for economic policy, the most important of which was that the government
should promote free competition and free trade – “laissez faire, laisser passer”. It is
thought that Adam Smith was influenced by the physiocrats (whom he met and
discussed with during his long stay in Paris in the 1760s).
6. CLASSICAL ECONOMICS
The period of ‘classical economics’, the term being first used by Karl Marx, covers the
period from the late 18th century to the mid or late 19th century. Its starting point is the
publication by Adam Smith, often considered to be the ‘founding father’ of economics
as a science, of his ‘An Inquiry into the Nature and Causes of the Wealth of Nations’
(1776). The publication of John Stuart Mill of ‘Principles of Political Economy’ (1848)
consolidated the teaching of the classical school and the book retained an important
position as ‘the’ interpretation of classical or orthodox economics for many decades.
6.1 The labor theory of value
In his theoretical work Smith distinguished between value in use and value in exchange.
The main part of his value theory (that is price theory) consists of a labor theory or
value, according to which the relative price between commodities in the long run is
equal to the relative amounts of labor needed for their production. As all classical
economists, he distinguished the ‘natural’ or long-run price from the ‘market’ or shortrun price, which could fluctuate around its ‘value’ for many reasons. Later Smith
considered also the need to pay rent (to the landlords) and profit (to the capitalists)
and elaborated a more general cost-of-production theory.
Ricardo presented a more sophisticated version of the labor theory of value, in which
also capital was measured in terms of the labor input required to produce it (‘past’
labor). However, it turns out that the relative price of two commodities will (also in the
long run) deviate from the relative amounts of labor needed to produce them if the
relative importance of direct labor and ‘past’ labor differs. With different capital
intensities and assuming that the required rate of return on capital is the same in all
sectors, relative prices will not conform to the values claimed by the labor theory of
value.
The labor theory of value was later taken over by Karl Marx, but neither Ricardo nor
Marx could find a fully satisfactory formulation of the theory. It is not possible to
demonstrate that relative prices correspond to values of commodities with any
reasonable definition of the amount of labor (or ‘abstract’ labor or socially necessary
labor) used in their production. The analysis of the relation between relative prices and
values in terms of labor is in the Marxian literature referred to as the ‘transformation
problem’.
The reason underlying the search for a labor theory of value is probable the idea, held
by many past philosophers (including John Locke) that labor is the original justification
of property. On the other hand, for Marx the labor theory of value was a scientific
explanation of exploitation of labor by capital. For him the key point was that labor
produces more value than the value of the (subsistence) wage needed for the
reproduction of labor, the difference constituting exploitation. In retrospect the effort
to explain prices by something more fundamental in terms of value based on labor
arguably amounts to a metaphysical and useless endeavor (Joan Robinson): whether
capitalism is an immoral system based on exploitation and whether prices are based on
values may be seen as two separate questions that can be answered independently.
6.2 Growth and distribution
As all classics, Smith wanted to understand the forces determining the distribution of
income and the long-term rate of economic growth. At one stage he argued that wages
would in the long run converge towards the subsistence level that was just allowing
reproduction of the working class. Later he held less definite and less pessimistic views
on the future of the working class, the lot of which could be better in a growing
economy and would anyway depend on the ‘general circumstances’ of the economy.
The classics mostly took for granted that full employment would be ensured by flexible
wages, assuming that demand for labor would be high enough (at least) at the
subsistence wage rate.
Thomas Malthus claimed that the population tends to grow in a geometric ratio (which
is easily understood), while the production of the means of subsistence would grow
only in an arithmetic ratio (which is less obvious). From this he derived his ‘iron law of
wages’, according to which wages would in the long run inevitably converge to the
subsistence level. From this comes the characterization of economics as the ‘dismal
science’.
It should be noted that Malthus wrote in the aftermath of the Napoleonic wars which
had raised the price of food grains and led to a fall in real wages. Also, the age of
entrance into the labor force was quite low in Malthus’ day: many textile mills were
manned by children under ten and cole-pits could use children that were only six year
old.
One of the more controversial conclusions of Malthus was that poor relief was
misguided and should be dismantled. For him the only remedy would be policies that
would guide people to have fewer children. In retrospect it is clear that his pessimism
was excessive, notably with regard to technological development and its impact as well
as concerning fertility developments.
The priority for Ricardo was to explain the determination of income between
landowners, capitalists and workers as well as the long-term rate of growth. Ricardo
was of the view that growth would call for successively less productive land to be
brought into cultivation, which would raise the rent earned by land of better quality
and increase the income share of landowners.5 With a constant rate of wages – at the
subsistence level (Malthus) – rising rents would cause a fall in the rate of profit. A
decline in capital accumulation and economic stagnation would therefore be the final
outcome.
The classical economists tended to view landlords as enjoying high incomes without
particular merit, while capitalists were the principal agents that would convert
revenues in the form of profit into growth-supporting accumulation. Smith insisted that
saving would not cause any shortage of demand for current output (the problem
identified later by Keynes): “What is annually saved, is as regularly consumed as what is
annually spent, and nearly in the same time too; but it is consumed by a different set of
people”. Saving would, in other words, be matched more or less automatically and
instantaneously by spending for investment. This view has been labeled after its
original protagonist as ‘Say’s law’ (J.B.Say).
Not all economists were equally confident in Say’s law. Malthus argued that deficient
demand could be a problem for the economy (and had a dispute on this with his friend
Ricardo). John Stuart Mill, unlike most classical economists, was concerned by
economic fluctuations and the unemployment they were associated with. He was not
convinced by Say’s law and pondered the possibility of too much supply of
commodities relative to demand associated with a shortage of money being spent.
The classical economists thought that the economy would ultimately end up in a
stationary state, which for Malthus was a dismal vision (given the iron law of wages).
For Smith, however, the stationary state was not a dismal vision as it in his view be
could be compatible with intellectual and social progress as well as more weight being
given to moral and non-material values.
Mill was (already in 1848!) of the opinion that “I know not why it should be matter of
congratulation that persons who are already richer than anyone needs to be, should
5
It seems to be a historic fact that the incomes of landlords increased dramatically between 1776
and 1816; W.J. Barber p. 76.
have doubled their means of consuming things which give little or no pleasure except as
representatives of wealth… It is only in the backward countries of the world that
increased production is still an important object…”. He was also critical of the belief in
the necessity of growth (cf. section 4).
BOX: Classical economists.
The Scotsman Adam Smith was professor of moral philosophy at the University of Glasgow. Before
‘The Wealth of Nations’ he had already published an influential philosophical work ‘The Theory of
Moral Sentiments’ (1759). The Wealth of Nations is large and wide-ranging, covering theory and
history as well as descriptions of social and economic institutions.
David Ricardo made already as a young man a fortune as a stockbroker specializing in government
bonds. His main work, characterized by highly abstract analysis, is ‘The Principles of Political
Economy and Taxation’ (1817).
Robert Malthus, British priest and demographer, is above all famous for his (pessimistic) ‘An Essay
on the Principle of Population’ (1798).
The Scotsman David Hume is mainly known from the history of philosophy but he also wrote on
economics, particularly on the monetary system, in his ‘Political Discourses’ (1752).
James Stuart Mill was the son of another economist, James Mill (a close friend of Ricardo), and
received an exceptional education already as a child. It is generally considered that John Stuart Mill
gave the definitive statement of the classical tradition from Smith to Ricardo. He is also an
important contributor to the utilitarian philosophy and to political liberalism. His main economic
work is ‘Principles of Political Economy’ (1848).
6.3 The invisible hand
For posterity, the main idea of the ‘Wealth of Nations’ is the invisible hand. Smith did
not (quite) achieve a general equilibrium perspective, but he had the vision of the
market economy as a self-regulatory system with a capacity for spontaneous
coordination of economic activity. Also, this economic mechanism was associated with
some attractive characteristics.
Smith sets this out as follows (Book IV chapter 2): “Every individual necessarily labours
to render the annual revenue of society as great as he can. He generally, indeed, neither
intends to promote the publick interest, nor knows how much he is promoting it. … He
intends only his own gain, and he is in this, as in many other cases, led by an invisible
hand to promote an end which was no part of his intention. Nor is it always the worse
for the society that it was no part of it. By pursuing his own interest he frequently
promotes that of the society more effectually than when he really intends to promote
it.” (quoted by AS p. 43)
Another quotation, probably the most used quotation in the whole literature of
economics, explains the role of economic incentives: “It is not from the benevolence of
the butcher, the brewer, or the baker that we expect our dinner, but from their own
self-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.”
Later economists have interpreted Smith as saying that selfishness is a virtue6, that
what is best for the individual is also best for society. This view has been widely
embraced, partly no doubt because it implies harmony between private and social
interests. As already noted in section 4, modern welfare theory gives some support for
such an interpretation in the sense of Pareto-efficiency.
6.4 The price-specie flow mechanism
David Hume is one of the first exponents of the fundamentally important ‘quantity
theory of money’. This theory views money as having importance as a measure of value
and as a medium of exchange or means of transaction (but not as a portfolio asset).
The stock of money can here be understood as consisting of gold. Alternatively, it can
partly consist of paper currency provided that there is full convertibility at a fixed price
of paper money into gold (so that paper money is just a convenient surrogate for gold).
Also, the central bank needs to maintain sufficient gold backing of its issuance of notes.
6
The view of Smith as an apostle of selfishness is actually quite misleading, as Sen (1987) has pointed
out. What Smith wanted to explain was that exchange would be mutually beneficial even if the parties
were selfish, which was also acceptable in many ordinary matters. However, in his ‘The Theory of
Moral Sentiment’ Smith insists on such moral characteristics as ‘sympathy’ and self-discipline. He
states that “man, according to the Stoics, ought to regard himself, not as something separated and
detached, but as a citizen of the world, a member of the vast commonwealth of nature”, and “to the
interest of this great community, he ought at all times to be willing that his own little interest should
be sacrificed.” Adam Smith was no apologetic for egoism, even stating as his recommendation that
“humanity, justice, generosity, and public spirit, are the qualities most useful to others”.
It is further assumed, as part of the “rules of the game”, that there is complete
freedom in trade (and capital movements, here abstracted from).
The quantity theory of money states that nominal income (PY) equals the stock of
money (M) multiplied by its ‘velocity of circulation’ (V). This can be interpreted as an
identity (defining V), but becomes a theory by assuming V to be a constant given by the
payments technology.
Given the classical assumption that flexible prices and wages would result in full
employment, the outcome of the theory is that the price level would be proportional to
the stock of money (figure 6.1).
Figure 6.1: the quantity theory of money
P
MV=PY
P1
P0
M0
M1
M
Real output Y is the level of production corresponding to full employment, while the
‘velocity of circulation’ V is a constant determined by the existing payment technology.
The ‘Fisher equation’, M V = P Y, therefore determines the price level P as a function of
the stock of money M, the price level in fact being proportional to the stock of money.
Money is ‘neutral’, it does not affect the real economy (except perhaps temporarily), a
change in the stock of money (from M0 to M1) in due time only leading to a
proportional rise in the level of prices (from P0 to P1).
Hume was also one of the firsts to examine the gold standard and explain its relation to
the quantity of money and the price level. His famous exposition of these relations is
referred to as his ‘price-specie flow mechanism’ and it operates as follows (figures 6.2).
Figure 6.2: The price-specie flow mechanism
P
MV=PY
P1
Current account in deficit
P*
P*
P0
M0
M*
M1
M
Figure 6.2 replicates figure 6.1 but adds the horizontal line P*P*, which represents the
domestic price level at which the trade or the current account of the country is in
balance. At a higher domestic price level there is an external deficit and at a lower price
level a surplus (assuming sufficiently high price elasticities in exports and imports). If
the money stock is originally at level M0, to which corresponds the price level P0, there
will a surplus in the trade balance. This means that the stock of money (gold) will
increase as less is paid for imports than is earned through exports. The point of the
analysis of Hume is to demonstrate the self-equilibrating character of the gold standard
provided by the external balance and its effect on the supply of money.
6.5 The role of the state
As noted above (section 5), the French physiocrats coined the term ‘laissez faire’.
Adam Smith was influenced by the physiocrats, including Quesnay, whom he had met
while staying in Paris in the 1760s. Smith was highly critical of the analysis and policy
recommendations of the mercantilists and one of his main objectives was to
demonstrate the faults of their arguments and make the case for free trade and
unregulated markets.
Smith explained that the wealth of a nation was not to be identified with the treasury
of the ruler, as proposed by the mercantilists, but consisted rather of the production
(the national income) and consumption of the citizens of the nation. He considered
division of labor to be the key to efficiency, and growth of the market as beneficial by
allowing further specialization.
Smith condemned mercantilist policies because they would distort competitive
conditions and reduce economic efficiency. The view that unfettered competition
enhances efficiency has since been widely embraced by economists, though exception
must be made for various kinds of ‘market failure’.
The role of government was for Smith to protect citizens and their property against
foreign aggression and against violence or oppression from other citizens. However, he
also saw the need for the provision of certain public or collective goods such as
“publick works and certain publick institutions which it can never be for the interest of
any individual, or small number of individuals, to erect and maintain; because the profit
would never repay the expence to any individual or small number of individuals, though
it may frequently do much more than repay it to a great society.” (AS p. 55) Smith
argued for a role of the government also in health and education. Furthermore, Smith
was in favor of regulation of banking.
Ricardo argued forcefully for free trade and is most famous for setting out the theory
of comparative advantage. This theory explains that it makes sense for, say, Portugal
and England to trade with each other even if the costs of production of all goods were
lower in Portugal than in England. In his original version Ricardo set out the required
labor input for production of wine and cloth in Portugal (of some specific amounts)
with the following figures:
England
Portugal
Wine
120
80
Cloth
100
90
As can easily be demonstrated, Portugal is more efficient in both sectors, but Portugal
can achieve more production by specializing in wine and importing cloth from England.
Conversely, England will produce cloth and exchange part of its output for wine
imported from Portugal. Both countries gain by specializing according to their
comparative advantage.7 Ricardo was strongly opposed to the corn laws of the time,
which severely restricted imports of grain and caused their prices to be high (to the
benefit of landowners).
One of Mill’s contributions was to explain how demand and supply would determine
the actual volume of trade as examined by Ricardo. This was needed as Ricardo had
only explained the direction but not the extent of specialization and had not explained
what would be the relative price of wine and cloth.
Ricardo (as also Smith and Mill) examined taxation from the point of view of their
efficiency and fairness (the classical economists were often in favor of the land tax). He
also set out what has later been referred to as ‘Ricardian equivalence’, according to
which it does not matter whether the government finances its expenditure by
borrowing or by taxation. This view is right in the sense that Ricardo explained that
borrowing and taxation could have, under certain circumstances, equivalent effects on
the economy. However, it seems that he did not believe the required assumptions to
be fulfilled (AS).
7
For Portugal, a unit of cloth costs 90. However, selling one unit of wine to England and exchanging it to cloth gives more
than one unit of cloth. Similarly England can get more wine by selling cloth than producing wine itself.
John Stuart Mill, the liberal and utilitarian, had some sympathy for socialist ideas or at
least social reform. The tasks of government should extend beyond those of protecting
citizens against foreign enemies and creating a safe domestic environment for life and
property. In particular, the government should provide for a number of collective
goods (such as lighthouses, parks and museums) and provide equal access to basic
education for all. His main criticism of socialists was that they had confused and
mistaken views on the real effects of competition.
7. NEOCLASSICAL ECONOMICS
There are considerable differences in the emphasis and analysis as set out by the
classical and the neoclassical economists. At the same time, the differences in their
views on economic policies are rather limited.
The classical economists were concerned with the big questions, with the functioning
of the economic system as a whole, notably from the point of view of the distribution
of income between the three classes (landowners, capitalists and workers) and with
long-term economic growth. With the neoclassical economists the dynamics of the
capitalist system receive much less attention. The same holds for the labor theory of
value, which is relegated to the history of economic thought.
Instead, the neoclassical economists focused their attention on the microeconomic
analysis of the behavior of economic agents, firms and households, assumed to be
maximizing profits and utility respectively. They laid more attention on the demand
side and introduced new concepts such as marginal utility and marginal productivity.
They saw (more clearly than the classical economists) the market economy as a system
of interrelated markets with equilibrium prices determined by demand and supply.
They introduced the mathematical formulation of economic theory.
While classical and neoclassical analysis differs a lot, the same cannot be said about
their policy views. The variety of views by individual economists is, needless to say,
considerable, but it remains the case that neoclassical economists by and large
retained the skepticism of classical economists with regard to an interventionist or
active role for government in economic life.
The limited role for government action proposed by economists is to be seen against
the background of the political environment in the 19th century. These were times
before the franchise had been widened and in which only a privileged elite had serious
political influence. These were not conditions in which government could be expected
to pursue the truly general interest or social welfare of the population as a whole. In
these circumstances unregulated markets would arguably produce better results than
government intervention excessively influenced by interests of a narrow economic and
political elite.
7.1 The marginalist revolution
Ricardo’s theory of rent was based on the assumption of a declining marginal
productivity of land, and there were other precursors to the assumptions of declining
marginal utility and declining marginal productivity. Nevertheless, William Stanley
Jevons and Carl Menger have come to be identified as the key initiators of the so called
marginalist revolution.
Jevons postulated that marginal utility is a declining function of the quantity consumed,
and he noted that the marginal utility of money spent must be the same for alternative
uses for total utility to be maximized. Menger presented an early version of the
marginal productivity theory of the prices of factors of production. Neither of them
formulated a general equilibrium theory covering both goods and factor markets.
Alfred Marshall explained pedagogically the determination of the equilibrium price as
determined by supply and demand in a partial equilibrium framework (roughly as still
presented in economic textbooks, cf. figure 5). Demand was based on the assumption
of a declining marginal utility in consumption, while supply was based on the
assumption of a given stock of capital and a rising marginal cost or a declining marginal
product of labor.
Marshall’s price theory offered a synthesis of the cost-of-production theory of the
classical economists and the view of the marginalist theory. The classical theory held
that the price would be independent of the quantity produced, which could hold in the
long run when all production factors could be treated as variable. However, in the short
run some factors of production (capital) would be fixed, and then it would follow that
the short run supply curve would be upward sloping (due to a falling marginal product
of labor).
Marshall also pointed out that the individual consumers demand curve would
correspond to his marginal utility curve.8 This means that the consumer surplus, the
difference between the maximum price that the consumer would be willing to pay and
the actual price, can be identified as the area which is under the demand curve but
above the price for some given quantity (the area CAF). Similarly, the producer surplus,
the difference between revenue of the supplier and the cost of production, is the area
above the supply curve but below the price (the area BAC).
Figure 5: The consumer and producer surplus
P
F
S
C
B
8
A
D
Marshall notes that this holds only if the marginal utility of income is constant. This assumption is needed because a
decline in the price of the good will reduce (somewhat) the price level of the goods consumed and thereby raise real
income. For a higher real income, the marginal utility of consumption would be (a bit) lower. However, this effect will be
small for items that are not a large fraction of total spending.
X
H
Q
It is easy to see that the equilibrium at point A, the competitive equilibrium in this
market, is the amount of transactions or consumption and production that maximizes
the sum of the consumer and producer surplus (the social surplus). For instance, if the
level of production were as indicated by point X, it would be possible to increase both
the consumer and producer surplus by increasing production to the level indicated by
point H. This optimality feature of the equilibrium could be seen as a (partial)
justification of the benefits achieved with the help of Adam Smith’s invisible hand. In
fact, Marshall notes that “a position of (stable) equilibrium of demand and supply is a
position also of maximum satisfaction”. However, this statement does not cover any
implications that the equilibrium could have for the distribution of income and welfare.
7.2 General equilibrium and welfare
Leon Walras focused on the general equilibrium of the economy as a whole. In some
sense he had the same ambition as the classical economists but his framework of
analysis was entirely different. He specified the structure of the economy in terms of
utility-maximizing consumers (households) and profit-maximizing producers (firms). He
noted that general equilibrium would prevail when households’ demand is equal to
firms’ supply for all consumer goods and when firms’ demand is equal to households’
supply for all factor inputs.
His model basically determines relative prices, but he could transform these into
money prices by introducing an equation representing the quantity theory into his
model. In this model (as in the original formulation by Hume) money is neutral with
regard to the real economy, meaning that the latter is independent of the former.
Walras formulated a mathematical model of the economy that determines all prices as
the result of decentralized decisions about consumption by households and about
production by firms. He thereby demonstrated that individual markets could be fitted
together to an integrated whole or to a general equilibrium.9 Walras (as many of his
9
Actually Walras only demonstrated the possibility of an equilibrium solution to his system of equations, but he did not
prove that a solution fulfilling reasonable requirements (such as positive prices for all commodities) in fact could be found.
This so called “existence problem” has later been the subject of great interest.
followers) gave some weight to the aesthetic appeal of his theory: “The law of supply
and demand regulates all these exchanges of commodities just as the law of universal
gravitation regulates the movements of all celestial bodies. Thus the system of the
economic universe reveals itself, at last, in all its grandeur and complexity: a system at
once vast and simple, which, for sheer beauty, resembles the astronomical universe”
(AS p. 208).
Walras also concerned himself with the question of how equilibrium would be arrived
at. He did so with his famous theory of the so called ‘tatonnement’. He asks the reader
to imagine that price setting on markets is administered by an auctioneer. This
auctioneer starts by crying out some arbitrary set of prices for all goods and services. At
these prices there will be excess supply for some commodities and excess demand for
others. The auctioneer reacts by raising prices for commodities in excess demand and
lowering them for goods in excess supply. This process goes on until all markets are in
equilibrium such that demand equals supply at the set of prices announced by the
auctioneer. Only then are transactions allowed to take place, general equilibrium is
reached. Walras claimed that this mechanism is stable.
There is an obvious problem with the theory set out by Walras: in most markets there
is no auctioneer. Instead, it is mostly the firms that adjust prices according to market
conditions. Yet, the theory of competitive equilibrium assumes that all households and
firms are price takers. Also, transactions obviously take place all the time and often at
prices which cannot be assumed to be at their equilibrium level. This raises the
question as to what happens to the hypothetical equilibrium (and what is its meaning)
when transactions take place at ‘wrong’ (disequilibrium) prices.
The general equilibrium model gave expression to the idea that the market is a
mechanism for the allocation of resources. Already Smith (as well as Marshall and
WaIras) also thought that the market mechanism served the public interest, though
they did not clearly formulate how the public interest should be interpreted.
John Stuart Mill thought that the right measure of public interest or social welfare was
the sum of utilities. This was also the view of Francis Edgeworth; the appropriate
objective of policies was “the greatest happiness for the greatest number”. He
assumed that all members of society have the same utility function and that the
marginal utility of income is decreasing. Neglecting differences in capacity to work and
incentive effects, the appropriate (and radical) solution would then be to aim at a
complete equalization of income (cf. section 4).
Edgeworth thought that it self-evident that utility was measurable and comparable as
between individuals. This was also the view of Artur Pigou, who expressed this view as
follows: “It is evident that any transference of income from a relatively rich man to a
relatively poor man of similar temperament, since it enables more intense wants to be
satisfied at the expense of less intense wants, must increase the aggregate sum of
satisfaction. The old law of “diminishing utility” thus leads securely to the proposition:
Any cause which increases the absolute share of real income in the hands of the poor,
provided that it does not lead to a contraction in the size of the national dividend from
any point of view, will, in general, increase economic welfare.” (AS p. 257)
A different position was taken by Vilfred Pareto, who noted that interpersonal
comparability of utility was not necessary for the derivation of demand curves
(downward-sloping as a function of the price). For this purpose it sufficed to assume
ordinal rather than cardinal utility. This means that is suffices to assume that
consumers on the basis of their preferences can rank the alternatives as better or
worse. However, it is not necessary to assume that they are able to define the distance
between the alternatives (in terms of utility).
Pareto did not see any meaning in interpersonal comparison of utilities and
reformulated the contribution of the competitive equilibrium in a way which created
what has subsequently been denominated the “modern” theory of welfare economics
(though it is a century old by now). Avoiding interpersonal comparisons, Pareto defined
the condition for a social optimum as a situation in which it is impossible to increase
the utility for one individual without decreasing the utility for someone else. He went
on to demonstrate that a competitive equilibrium was necessarily also a Pareto
optimum (assuming, inter alia, perfect competition and complete markets as well as
lack of externalities).
Pareto-optimum is a very different welfare criterion as compared to the maximization
of the sum of utilities. Utilitarianism is nowadays relegated to the history of economic
thought. The modern theory of welfare economics has been based on the Pareto
criterion since the 1930s, when Lionel Robbins famously made the case against
interpersonal utility comparisons in his ‘An Essay on the Nature and Significance of
Economic Science’ (1932).
Needless to say, not all neoclassical economists agreed without reservation to the view
that the allocation of resources produced by free competition would be socially
optimal. Knut Wicksell did not dispute the Pareto criterion as such but insisted that the
desirability of a certain outcome should not be judged in isolation from the distribution
of income and wealth: “As a matter of fact, all argument in favour of free competition
rests on one tacit assumption, which, however, corresponds but little to reality, namely
that from the beginning all men are equal. If that were so, everyone would be equipped
with the same working power, the same education and, above all, the same economic
assets, and much could then be said in favour of free, unhampered competition; each
person would only have himself to blame if he did not succeed.But if all conditions are
basically unequal, if some people have good hands from the beginning and others hold
only low cards, free competition does nothing to stop the former from winning every
trick while the latter pay the table.” (quoted in WJB p.211). This is reminiscent of a later
critic of unfettered competition, John Maynard Keynes (Box).
Somewhat surprisingly, the same Knut Wicksell proposed that taxation and public
spending should be decided on the basis of unanimity of all citizens. This would ensure,
in conformity with the Pareto principle, that taxes would only be raised to finance
expenditure to the benefit of all citizens. Needless to say, this proposal (which
encapsulates the “benefit principle” of taxation) is not easy to implement in practice.
“Capitalism is the astounding belief that the most wickedest of men will do the most wickedest
of things for the greatest good of everyone.” (Keynes, as quoted in Moving Forward:
Programme for a Participatory Economy (2000) by Michael Albert, p. 128)
7.3 Monetary theory
Eugen von Böhm-Bawerk was one of the first economists to answer the question why
the interest rate is (mostly) positive. His answer in three parts was that individuals
mostly expect more resources to be available in the future, that people tend to
underestimate future needs (myopia), and that time-consuming processes would be
more productive (such as trees producing more timber if they are, up to a point,
allowed to grow larger and older). Knut Wicksell similarly demonstrated how the rate
of interest would affect the capital intensity of production.10
The neoclassical economists retained the quantity theory of money as set out by David
Hume. Like most classical and neoclassical economists, Böhm-Bawerk strongly
supported a stable currency linked to the gold standard (and balanced budgets). The
rate of growth of the quantity of money should be sufficiently low to maintain a stable
level of prices. This was also the view of Irving Fisher, though his main focus was on the
real rate of interest (the difference between the nominal rate of interest and the
expected rate of inflation).
The quantity theory of money gives expression to a dichotomy, according to which
relative prices are determined by the general equilibrium theory, while nominal
magnitudes like prices are determined separately by the quantity of money. It has
often been felt that the causal mechanism involved remains unclear. Also, the quantity
theory of money seems to be linked to the dubious assumption of Say’s law (see
section x below).
Wicksell made an original attempt at explaining the causality from monetary factors to
the real economy. He distinguished between the natural rate of interest and the
market rate of interest. The former is determined by the rate of return on capital in
production, while the latter is determined by monetary policy and the banking system.
Wicksell argued that a market rate of interest which is below the natural rate (which
was not easy to identify) would increase the demand for capital and initiate a
cumulative process of inflation, while a market rate above the natural rate would
similarly cause deflation. The important and difficult task of the central bank would be
to try to keep the market rate at the (natural) rate so as to keep the price level stable.
10
Wicksell examined the case where a wine producer is storing the wine in the expectation of its quality to improve and
the price to rise. Assuming that the price of wine, as a function of waiting, first rises more rapidly and later (or ultimately)
more slowly, how long should the producer wait before selling? The answer given by Wicksell is that wine should be
stocked in the cellar until the time when the rate of increase of its price (the return for waiting) equals the rate of interest
(the cost of waiting). The longer the waiting time, the bigger is obviously the stock of capital invested in the wine cellar.
7.4 A benchmark model
As was already noted above, the analysis of classical and neoclassical economists
differs significantly in important respects. In particular, with the arrival of neoclassical
economics the focus shifts from the big questions about growth and distribution to a
more systematic analysis of the behavior of utility-maximizing consumers and profitmaximizing producers as well as the interaction of supply and demand on markets.
Neoclassical analysis makes great progress in its analysis of both partial equilibrium
(Marshall) and general equilibrium (Walras).
While the analytical differences are significant, differences in views on policy matters
are much less so. In fact, John Maynard Keynes, in his ‘General Theory’ (section x),
argued that all mainstream economists before him could be lumped together into one
category that he called the ‘classics’. This he no doubt did to underline the originality of
his own contribution. He also justified the encompassing use of the label ‘classics’ by
pointing to those similarities which led both the classical and neoclassical economists
to, by and large, argue in favor of a laissez faire-approach to policy issues.
Sir John Hicks in 1937 famously formulated a simplified model of the classics (in the
sense of Keynes), which could then be compared to a similar formulation of the theory
of Keynes.11 The formulation of Hicks of the classical/neoclassical model has remained
the formulation typically used when discussing the differences between Keynesian
economics and its predecessors on issues related to macroeconomic policies. (It is also
the origin of the well-known ‘IS-LM model’ of textbooks.)
A simplified version of the Hicksian model of the classics can be set out as follows. First,
the quantity theory of money can be used to determine the price level (figure 7). Given
that the “velocity of circulation” V is taken to be constant (determined by payments
technology), nominal income PY is proportional to the supply of money M. However,
the level of real output can be assumed to be a function of the level of employment; a
certain level of employment would, given the state of technology and other conditions
(the production function) correspond to a certain level of output (figure 8).
11
See Hicks ( ). The formulation of Hicks arguably is more appropriate as a characterization of neoclassical than of classical
economics.
The level of employment in turn would, accepting short run frictions and unavoidable
difficulties of matching, tend towards full employment (figure 9). This would be
ensured by flexible prices and (notably) wages adjusting so as to balance supply and
demand for labor. In addition to the wage rate the former would depend on
preferences of households (disutility of labor and utility of income), while the latter
would reflect the marginal product of labor.
Figure 7: The quantity theory of money
P
Y
P1
MV=PY
Figure 8: The level of output
Y = f(N)
Y*
P0
M0
M1
M
N*
N
Given the velocity of circulation and real income, what remains is for the quantity
theory of money to determine the price level. A change in the quantity of money from
M0 to M1 would therefore (in due time) have no other consequences than to raise the
price level from P0 to P1. It should be noted that this seems to assume that all income is
always spent; if households occasionally decided to keep their money rather than
spend it (‘hoarding’), then this would presumably affect the velocity of circulation
(reducing it). But, of course, most of the classics explicitly endorsed Say’s law to the
effect that all income is spent, ‘supply creates its own demand’.
Differently from the views of Wicksell (cf. above), the rate of interest is in this model
independent from the stock of money. It is determined in the market for loanable
funds so as to create balance between saving and investment. The former is assumed
to be a positive function of the rate of interest, while the latter is a negative function of
the rate of interest. This reflects the view that interest is the reward for saving (waiting)
and that a higher interest rate must be matched by a higher marginal productivity of
capital, which reduces investment.
Figure 9: The labor market
w
Figure 10: The interesr rate
r
NS
w*
I
S
r*
I+ΔG
ND
N*
N
I*(=S*)
I,S
What are the effects of an increase in public spending? Assume first that the increased
public spending ΔG is financed by higher taxes. This would reduce household
disposable income and ‘crowd out’ private consumption (possibly also increase private
saving). Alternatively the increase in public spending could be financed by government
borrowing. In this case it would be reflected as an increase in demand for loanable
funds, which would raise the rate of interest and crowd out private investment (but
would also increase private saving). In neither case would there be a change in overall
output or employment.
Another useful way to look at the classical model is to start from the national income
identity, according to which the following follows by definition of the national accounts:
(1)
Y = C + I + G + X - M,
where Y is real output (or income), C is private consumption, I is private investment, G
is public expenditure (public consumption and investment), X is exports and M imports
(not the money stock!), all expressed in volume or real terms. This in an open economy
model, but it assumes only trade but no private capital movements. Defining saving S
as the difference between disposable income (income less taxes) and private
consumption:
(2)
S = Y - T - C,
allows equation (1) to be rewritten as stating that the sum of the financial surpluses of
the domestic private sector, the public sector and the rest of the world must be zero:
(3)
(I - S) + (X - M) = (T - G).
This equation states the simple fact that an excess of private investment over private
saving must be financed by borrowing from abroad (importing more than exporting) or
by drawing on a financial surplus of the public sector. Another statement, similarly true
by definition, is that a budget deficit (excess of G over T) must have a counterpart
either in an excess of private saving over private investment (used to finance the
government deficit) or a trade deficit (borrowing from abroad).
Assume first that the government budget is in balance. As stated above, there is a
presumption in the classical model that the domestic rate of interest would adjust so as
to equilibrate saving and investment. Also, the classical price-specie flow mechanism
demonstrates that under the gold standard a surplus in the trade balance will lead to
an increase in the supply of money (the stock of gold), which will raise the domestic
price level and thereby reduce the trade balance surplus (vice versa for a deficit). This
process will go on until the trade balance is in equilibrium and the money supply is at
its stationary or equilibrium level. The presumption is therefore that the trade balance
will in the long run be in balance.
This balance between saving and investment and in trade will, however, hold only if the
government budget is in balance. Assume instead that the government increases its
spending and runs a deficit. According to equation (3) this must necessarily be reflected
in an excess of saving over investment and/or in a trade balance deficit.
The excess of saving over investment would be a consequence of the demand of the
government for loanable funds (figure 10). This increase would raise the rate of
interest, which might increase private saving but would also reduce (“crowd out”)
private investment. The classical economists considered such negative effects on
private investment to be undesirable for the overall economy.
In addition to upsetting the balance between private investment and saving, the
government deficit would cause at least a temporary trade balance deficit, which
would induce a decline in the stock of money. Conceivably the government would
choose to borrow from abroad so as not to crowd out domestic private investment. In
this case the negative effect of the trade deficit on money supply (the stock of gold)
could be offset by the financial inflow resulting from government borrowing from
abroad. However, in this case the government debt would go on increasing, as would
the need to ultimately raise taxes to finance interest payments in addition to the
deficit.
In all, discretionary government action in the area of macroeconomic policy has no
beneficial effects. However, this does not really matter as the economy is taking care of
itself by its self-regulatory mechanisms. The remaining and appropriate role for
government is to contribute towards stability of money and ‘sound’ public finances
(next section).
BOX: Neoclassical economists.
William Stanley Jevons (1835-82), one of the first economists with a university education in the
subject, set out his marginalist thinking in his ‘The Theory of Political Economy’ (1871).
Posterity remembers him also for his much ridiculed sunspot theory of the business cycle.
The Austrian Carl Menger (1840-1921), worked out an alternative to the labor theory of value
in his ‘Grundsätze der Volkswirtschaftslehre’ (1871).
Alfred Marshall (1842-1924), professor at Cambridge (UK), wrote a long-standing textbook in
Economics, ‘Principles of Economics’ (1890).
The Frenchman Leon Walras (1834-1910), according to Joseph Schumpeter “the greatest of all
8. THE CLASSICAL/NEOCLASSICAL ECONOMIC POLIC DOCTRINE
It should be emphasized that almost all of the classical economists (following Keynes
and denoting by this term all mainstream economists from the late 18th century to the
early 1930s) were also classical liberals; economics as a science originated as part of
liberalism. This is the case for Adam Smith, David Hume, Thomas Malthus, David
Ricardo, John Stuart Mill as well as many other economists and philosophers. While
some (earlier) economists were holding a labor theory of value and others (later)
applied marginalist thinking, these analytical differences have a limited importance
from the point of view of the doctrine that the classical and neoclassical economists
espoused.
Classical liberalism was based on a world view or ideology underlining individual liberty
and belief in progress. Its thinking was based on the concept of natural law and
utilitarianism. Man was seen as a rational if selfish being (homo economicus), seeking
pleasure and trying to avoid pain. Society was no more than the sum of its members.
Classical liberalism and classical economics advocated limited government under the
rule of law, private property rights, and laissez-faire liberalism in economic policies.
8.1 The self-regulating market economy
The idea that the market has a capacity for automatic adjustment and coordination of
economic activities through the price system and with the help of economic incentives
is fundamental to economics. As stated in a textbook: “Probably the most important
accomplishment of economics is the demonstration that individuals with purely selfish
motives can mutually benefit from exchange” (Mueller 1989). However, it may be
recalled that the mechanism guided by the invisible hand can function satisfactorily
only within a framework of law and order and basic rights upheld by the state.
Ideally a market economy would generate an equilibrium that is Pareto-efficient.
However, this would not only require a government capable of establishing rule of law
and the protection of private property but also assumes the absence of so called
market failures. This means that there are a large number of buyers and seller in all
markets (perfect competition), that there are no externalities (creating divergences
between private and social costs or benefits), that market participants are well
informed and that transaction costs are modest. Also, distributional issues are
abstracted from or not considered.
The classical doctrine is based on the presumption that all wages and prices are
flexible, and that the economy adjusts rapidly towards equilibrium. This capacity for
flexible adjustment also holds for the labor market. Full employment is therefore the
natural state of affairs, towards which the economy automatically tends.
In the short run, however, there might be excess demand or excess supply for specific
categories of labor or for labor in specific sectors. The adjustment process would
therefore be associated with some frictional unemployment. Also, wage rigidity
imposed by unions or government regulation could explain unemployment. In the
absence of such interference, unemployment would be temporary and full
employment was expected to prevail. (Observed non-frictional unemployment had to
be assumed to be voluntary, reflecting unwillingness to work at the prevailing wage
rate.)
Lack of overall demand for goods and services was not a concern to the classical
economists (J.S. Mill and particularly Malthus being notable exceptions). Say’s law,
according to which production generates income which generates spending of equal
size as production, was axiomatically accepted. What income would not be consumed
directly, would be indirectly spent in the form of investment, financial resources being
channeled through the market for loanable funds.
Given full employment, the classics naturally gave a lot of emphasis to the supply side.
Important virtues were therefore “thrift” (a high propensity to save) and “enterprise”
(a high propensity to invest). They were mostly also of the view that diligence of labor
would best be fostered by minimizing poverty relief, reflecting the belief that people
risk having the temptation to claim relief rather than work.
As explained above, the self-adjusting characteristic also covered the stock of money
and the price level, provided the country was on the gold standard. For some of the
classics, like Malthus and Ricardo, the self-regulatory mechanism even covered the
reproduction of the work force.
8.2 The principle of laissez-faire
Consistent with the classical liberalism that they embraced, most classical economists
saw no need for government beyond the so called night-watch state. Also, given the
efficiency of the market economy, it seemed to make sense that the government
sector should be as small as was compatible with its fulfillment of the functions
necessary for the market economy. This would also be in accordance with the weight
given to individual liberty in the sense of “negative” freedom (cf. ).
The utilitarianism embraced by the classical economists was in many areas an
inspiration for reforms. In the economic sphere, however, it became a further
justification for laissez-faire. In fact, laissez-faire was seen as the only reasonable or
responsible or possible approach, and government intervention, with some exceptions,
was seen as useless or harmful. The role of the government was just to uphold the
conditions for free trade and free markets.
Needless to, there were nuances of difference and exceptions. A particularly strong
defender of laissez-faire was the magazine ‘The Economist’, founded in 1843 (and still
giving expression to a liberal credo, though now a sort of ‘social liberalism’). The
Economist considered the ‘lower orders’ to be responsible for their circumstances and
considered regulation of factory hours to be harmful to workers. It was also strongly
opposed to, inter alia, support for education, health or the provision of water. Other
economists (such as Mill) advocated state support for public works and education.
Most economists supported legislation to regulate the number of hours that children
were allowed to work. Some economists (Marshall and Pigou) saw reasons for selective
interventions to deal with positive or negative externalities of economic activities.
While government could define some minimum conditions for protection of workers, it
remains the case that the classical economists advocated minimum government and a
hands-off attitude to the economy. There was no need for government intervention or
activism, given that the economy was a mechanism capable of automatic adjustment
to a state of efficiency and full employment.
8.3 Neutrality of money
The quantity theory of money reigned supreme from the late 19th century and up to
the 1930s. It was almost never put into question (Wicksell being an exception). This
cornerstone of the classical theory had profound implications. Above all, it implied that
money was only a “veil”, which could be abstracted from when analyzing the
determination of relative prices and real magnitudes. The point was not that money
would be without significance; an economy having at its disposal a medium of
exchange is much more effective than one based on barter. However, given the
existence of the monetary system, the actual amount of money in circulation is of little
importance. It will only determine the nominal magnitudes: a doubling of the stock of
money will in the long run imply a doubling of all prices and wages without real
variables being affected.
This dichotomy of the economy as between the real economy and the monetary
sphere has later been the subject of extensive discussion and controversy. A main
reason for this is the importance subsequently attached to monetary policy. The
classical view on this issue was particularly simple and followed directly from the
quantity theory: monetary policy would have no long-run effects on phenomena in the
real economy such as the level of output or employment.
Given that monetary policy could not improve the real economy, the agreed and
sensible line of action was to keep money supply stable with a view to achieving price
stability. Money is an important institution in the economy not only in facilitating
exchange but also because contracts are usually denominated in nominal terms.
Stability of money can therefore be considered important from the point of view of
making sure that contracts are respected in the way that the parties entering into the
contract (presumably) originally intended. Stable money can be seen as a common
good, a bit similar to law and order or the rule of law.
It is because of consideration such as these that classical economists were strongly
attached to ‘sound money’ or price stability. Also, a metallic standard, notably the
international gold standard, was seen as the appropriate institutional device for
realizing price stability. Assuming authorities to follow the ‘rules of the game’ of the
gold standard, this institutional framework would constitute an automatic mechanism
for ensuring monetary discipline and price stability.
8.4 Fiscal prudence and balanced budgets
The classical model leaves no useful role for fiscal policy in the sense in which the term
is nowadays commonly used. The level of output is determined by the supply side, full
employment is ensured by price and wage flexibility. Overall developments of the price
level depend on the quantity of money.
The appropriate task for government was to finance the expenditures needed for the
(small) night-watch state to fulfill its functions. This should be done with those taxes
that minimized harmful effects on the economy. Attempts at pursuing expansionary
fiscal policy do not make sense if unemployment or underutilization of resources is not
a serious problem. Increases in public spending only crowd out private investment,
which is to the detriment of long-term growth of the economy. Tax reductions would
similarly increase private consumption, again crowding out investment (given an
unchanged level of output given by full employment).
There is in these circumstances no reason to deviate from the simple rule that the
government budget should be in balance. Running a deficit would only imply a higher
level of government debt, which subsequently would imply a need for higher tax rates
to finance the larger interest payments.
The balanced-budget doctrine made sense for the classics not only economically but
also politically. It would constrain the temptation for using budget deficits as an
instrument for living beyond the means currently available. One aspect of the classical
doctrine is that deficit spending is a way of increasing current consumption at the
expense of future generations, which is morally dubious.
The classical/neoclassical doctrine (with numerous caveats for complications not dealt
with) is attractive in its simplicity. Government should focus on its role, which is
essential but not extensive, leaving economic activity to regulate itself by market
forces. Laissez-faire should be the guideline, in combination with stable money and
balanced government budgets.