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The History of Economic Ideas:The History of Economic Ideas:

How Did We Get Here from There?How Did We Get Here from There?

Peter FortunePeter FortunePh.D. Harvard UniversityPh.D. Harvard University

www.econseminars.comwww.econseminars.com

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The Primary Reference for this Course Is:The Primary Reference for this Course Is:

Blaug, Mark. Blaug, Mark. Economic Theory in RetrospectEconomic Theory in Retrospect,,Fifth Edition, Cambridge, England, 1997Fifth Edition, Cambridge, England, 1997

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Major Economic Questions

How Will Economic Decisions be Made? • Tradition: Tribes and Villages • Command: National or Regional • Market: The Needs and Wants of Consumers

What Is the Source of “Economic Surplus” (The Wealth of Nations)?

What Determines the Distribution of Wealth and Income? • By Functional Shares (Labor, Capital, Land)

• By Wealth Holder or Income Recipient (Percentile)

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Major Economic Questions

Production, Consumption, Pricing and AllocationProduction, Consumption, Pricing and Allocation •• What will be Produced, How Much, and For Whom?What will be Produced, How Much, and For Whom? •• What Prices will be Attached and Who will Pay Them? What Prices will be Attached and Who will Pay Them? •• How Will Factors of Production be Allocated across FirmsHow Will Factors of Production be Allocated across Firms and Consumers, and at what pricesand Consumers, and at what prices How “Efficient” is the Allocation of Resources and

Production? • Economic Efficiency vs. Engineering Efficiency

• Judging Economic Efficiency

The Nature of Business Cycles (“General Gluts”)? • Why Can General Gluts Occur? • Monetary vs. Real Causes

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Major Economic Philosophies

Mercantilism Jean-Baptiste Colbert, Richard Cantillon, John Lock, David Hume

Physiocracy: Francois Quesnay, Pont de Nemours, Mirabeau

Capitalism I: The Merits of a Market Economy Adam Smith, David Ricardo, John Stuart Mill, F.Y. Edgeworth, Alfred Marshall, F. A. Hayek, Milton Friedman

Capitalism II: The Pitfalls of a Market Economy: Recession and Depression Thomas Malthus, John Maynard Keynes

Socialism Karl Marx, Joseph Schumpeter, The Fabians

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Economic Thinking

Before Adam Smith:

Mercantilism and Physiocracy

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Jean-Claude ColbertJean-Claude Colbert

andand

MercantilismMercantilism

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Jean-Baptise Colbert (1619-1683)

• Finance Minister to Louis XIV (1665-1683) • Louis XIV was extravagant and constantly at war—needed treasure • Colbert believed that the source of national strength is money (specie) • … and that government must encourage specie inflows • … especially to the King’s coffers!

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Colbert’s Policies

• Tariffs on imported goods to discourage imports and generate tax revenue • Internal improvements (bridges, roads, canals) to promote exports • Regulation of French product characteristics to promote brand identity • Tax reform to get the rich to pay their taxes and to lessen the burden on the poor • Subsidies to French agriculture and cloth to encourage exports and discourage imports • Formation of French colonies to create gains from trade

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Critics of MercantilismCritics of Mercantilism

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Richard Cantillon (1680-1734)

• Irishman with Spanish name writing in French--little is known about him • A speculator in John Law’s enterprises • Charged with murder • Wrote “A Treatise on the Nature of General Commerce” – his only known work • The treatise outlined the first general equilibrium model of an economy (two sectors: trade and agriculture) with both prices and quantities determined

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Cantillon’s Ideas

• Influenced the Physiocrats by proposing a “land theory of value”--only land adds to value • Proposed that inflows of money created increases in prices (inflation), not more trade • … and that mercantilist policies to create a trade surplus were self-defeating • laid the foundations for David Hume’s “Price-Specie Flow Mechanism” • … and for the “Quantity Theory of Money”

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David Hume (1711-1776)

• Scottish Philosopher and Friend of Adam Smith • Influenced by English empiricists John Locke and Bishop Berkeley. Hume believed that only concepts which were observable had meaning. • Argued that morals arise from the utility they create—moral rules exist because we all benefit; Influenced Smith’s “Theory of Moral Sentiments (1759) • Died in 1776 -- the year “The Wealth of Nations” was published

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David Hume’s Price-Specie Flow Mechanism

• Proposed that in a specie money system (fixed exchange rates) there is an automatic mechanism in which specie flows between countries create inflation in the long run • When the domestic currency weakens enough so that foreign currency price goes above the “gold export point,” gold is sent abroad and domestic prices fall while foreign prices rise • When the domestic currency strengthens enough so that foreign currency price goes below the “gold import point” gold is sent from abroad and domestic prices rise while foreign prices fall • Thus, policies to induce importation gold ultimately only change prices levels in domestic and foreign currencies— gold flows do not increase real purchasing power

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Hume on Money and Inflation

• Hume formalized the money-price level link as the “Equation of Exchange” (MV=PT) • Is this a tautology? If VPT/M then MV=PT reduces to PT=PT! Gibberish!!, But when supplemented by theories of M, V, P and/or T it is valid. • A common theory of V was: V is not identically equal to PT; It is only so in an economic equilibrium. Velocity is determined by the synchronization between receipts and expenditures • The quantity theory assumes M is a “Medium of Exchange,” not a “Store of Value.” • The Implication is that in a fully employed economy the price level is proportional to the money supply

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Francois QuesneyFrancois Quesney

andand

PhysiocracyPhysiocracy

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Francois Quesnay (1694-1774)

• French Physician ennobled by Louis XV as “his thinker”

• With Jean Gournay formed the French Economistes, called the Physiocrates

• The Physiocrats became the leading economic thinkers of France

• Wrote the Tableau Economique, considered by many the first great economic analysis

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The Tableau Economique (1758)

• Land is the only source of economic surplus (wealth) • Labor and capital only earn what is needed to maintain them so their earnings only replace the value used up in the act of production • Land is a free gift from God and does not need to be maintained. Landlord receipts in excess of payments to labor and capital are the only source national wealth • This was demonstrated by a table of receipts and expenditures for workers, landlords and capitalists (the Economic Table) • Made a distinction between “productive labor”(labor in agriculture, the source of excess value) and “unproductive labor” (labor in industry and trade). Smith would make the same distinction but with different definitions. • The only measure of economic health is the income of landlords

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A Summary of Pre-Smithian Ideas

A theory of the price level had emerged from Cantillon and Hume

Economists had struggled with the Issue of what is the net value of economic activity: The Mercantilists looked to gold and silver, the Physiocrats to agricultural output

The triumvirate of players--land, labor, and capital--had been formed

A subsistence theory of wages had been introduced

A discussion about when income was “necessary” and when it was “value added” had been opened by the distinction between productive and unproductive labor

Economic activity was heavily regulated with the goal of promoting National “Welfare”

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The Advent Of Economic Science

Smith, Ricardo, Malthus and Marx

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Adam SmithAdam Smith

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The Birth of Capitalism: Adam Smith

Adam Smith (1723-1790)

• Scottish moral philosopher, wrote The Theory of Moral Sentiments (1759): Why are we self-interested yet not at each others throats? Answer: the capacity for empathy • Adhered to Hume’s view that morality came from our experience and psychology, not from innate principles or from reason, but rejected Hume’s notion that utility is source of moral sentiments • Published An Enquiry into the Nature and Causes of the Wealth of Nations in 1776. Applied his view of moral sentiments to economic matters: self-interest motivates people to make economic decisions that, as if guided by an “invisible hand,”

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Smith’s Economic Philosophy

• Self Interest (with “moral sentiments”) combined with individual freedom is the source of economic wealth • The mechanism is that self-interested responses to prices and opportunities leads to improved production and consumption decisions • In the long run, free entry and exit leads to zero profits for firms (“economic profits”) while wages stay at the subsistence level • Regulation of economic decisions (as in Mercantilism) reduces the general welfare by thwarting incentives and preventing free choices benefit all. • There is no inherent economic conflict between labor, capital, and land: all benefit from the free choices made by others

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The Dynamics of Capitalism

• The fundamental driving force in capitalist accumulation: The capitalist automatically saves his profits and thus induces economic growth • Economic growth encourages a “division of labor” creating increases in productivity which add to profits and to further capital accumulation (the pin factory example) • In the short run, capitalist accumulation leads to increases in wages and decreases in the profit rate as capitalists compete for markets.Also, increased wages induce population growth which--with a lag of many years--adds to the labor force and reduces wage rates back to original subsistence level • In the long run, free entry and exit into production and trade leads to zero “economic profits” for firms while wages stay at the subsistence level. Wage and profit rates are at their “natural” levels but output and population have grown

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International Trade

• International trade is different from domestic interregional trade because capital and labor are domestically mobile, but internationally fixed • “Absolute advantage” directs trade: Countries produce and trade those goods which they can produce more cheaply than others • Free trade benefits all--world production and domestic welfare are maximized by encouraging purchase of low- priced imports and sale of high priced exports

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Smith’s Theory of “Value”

• “Value in Exchange” (relative price) vs “Value in Use (total utility): The Water-Diamonds Paradox • Long Run Value in Exchange: “Natural Price” is Supply Determined (Constant Costs) • “Natural Price” is set by cost of production: wages+profits (+rent?) • In the Short Run value in exchange is determined by “Demand and Supply” • Resources shift between industries when LR value differs from SR value

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Pri

ce p

er G

allo

n

0

Gallons Consumed

D

S’

SD’

Value in Exchange vs. Value in Use The Example of Free Water

Value in Use

Value in Use = Total That Would Be Paid (“Total Utility”)Value in Exchange = Value That Must Be Paid (“Marginal Utility,” or Price )

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Smith’s Theory of Wages

• The Subsistence Theory of Wages: subsistence is the “natural price” of labor -- the wage at which population is constant • The subsistence wage might increase over time as standards of living improve • Deviations between subsistence wage and actual wage induce population changes • Relative wages (the wage structure) is determined by differences in cost of employment, and the desirability of each job (“compensating differences”) • Distinguishes between “productive labor (employed in adding value, such as factory or farm) and “unproductive labor” employed in the consumption sector (servants, professors)

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Smith’s Theory of the Profit Rate

• The “natural” rate of profit is the interest rate plus a premium for risk • Deviations between the actual profit rate and the natural rate induce resource reallocations • In the long run, free entry and exit into production and trade leads to zero economic profits • There is a secular tendency for the profit rate to decline because of the capitalists’ proclivity to accumulate even in the face of diminishing investment opportunities

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Smith’s Theory of Land Rent

• Land rent arises from differential soil qualities (“differential rent”) not land scarcity (“scarcity rent”) • Land rent is price-determined,, it is not a production cost (anticipates Ricardo, Henry George) • Land rent is a cost of production--Smith contradicted himself on this issue

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Smith on Measuring Economic Welfare

• Smith proposed an “Invariable Measure of Value” as a measure of price level--something whose real value “in use” (utility) does not change over time. The price of that thing is a price index that can be used to “deflate” nominal output • Today we use price indexes--the average price of a representative basket of goods. But no such thing existed in Smith’s time • Smith thought that the the real “pain and suffering” of an hour of work was constant and chose the money wage rate as the price index (the corn wage had been constant)

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Measuring Real National Income

• Smith’s measure of national wealth was “command over labor,” defined as the amount of labor that output can buy [if there is $100 of of gross product (Y) and the wage rate (w) is $5, then there are Y/w = 20 units of labor commanded] • Effectively, this made the employed labor force his measure of national wealth (Y/w=N) • One might argue that the inverse is a better measure--the less labor is employed to produce national output, the greater is productivity and the more output can be produced.

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Monetary Policy: The Real Bills Doctrine

• “Real” bills were bank loans on paper used to trade in newly produced goods. This was “self-liquidating” because the loan would be paid off when the transaction was completed. • Smith proposed the “Real Bills” doctrine of money— banks would not create too much money (leading to inflation) if they discounted “real bills” • The Real Bills doctrine, though fallacious, had a long life and was a tenet of the 1913 Federal Reserve Act

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Fallacies in the Real Bills Doctrine • The fallacies in the Real Bills Doctrine were the subject of Henry Thornton’s classic An Enquiry Into the Nature and Effects of The Paper Credit of Great Britain (1802). • The Fallacies The money created by discounting real bills stayed in circulation during the life of the bill. But if the “velocity of circulation” is normally greater than 1, lending on real bills adds more to total spending than the purchase of the good whose bill was discounted. Banks could not distinguish between bills presented to trade in newly produced goods and those presented to trade in existing goods, so money creation exceeded new production

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Thomas Robert MalthusThomas Robert Malthus

Economics As The Dismal Economics As The Dismal ScenceScence

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Thomas Robert Malthus (1766-1834)

• Son of, and frequent debater with, Daniel Malthus -- a “perfectabilist” who believed that mankind would constantly improve materially, spiritually, and morally • Thomas wrote An Essay on Population (1798) to argue the opposite--mankind’s lot in life is grim, illness-ridden, and plagued by early death-- and that’s the good news! • Thomas corresponded regularly with David Ricardo, with whom he disagreed on almost everything economic

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Malthus’s View of Economic Dynamics

• The subsistence wage is the bare minimum, not just Smith’s “ wage rate at which population remains constant’ • When wages rise above the subsistence wage, population will increass at an exponential rate • Agricultural output (“corn”--the wage good) increases at only an arithmetic rate • The outstripping of food supply by population raises the price of food (“corn”), driving the real wage to below the subsistence, creating starvation, illness and death • This stops when populatio has fallen enough to raise wages to the original subsistence level. level again.

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The Inevitability of the Malthusian Apocalypse

• In later editions of The Essay, Malthus accepted the possibility of several “automatic checks”– preventative factors which weakened the message of inevitability. These included late marriage (fewer births per family) moral restraint (fewer illegitimate births), vice (fewer births per female) a high death rate due to starvation, illness, etc.

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The Law of Diminishing Returns

• Malthus was among the first contributors to the idea that there are diminishing return in agriculture: as more variable factors (labor+capital) are added to an acre, the average product of labor falls. • Diminshing Returns is one of the reasons why population growth necessarily exceeds the growth of food supply • David Ricardo drew on Malthus and others to develop a more complete theory of diminishing returns

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The Possibility of “General Gluts” (Depressions)

• Malthus, in correspondence with Ricardo, argued that there could be “general gluts,” periods of unsold production and high unemployment • Ricardo disagreed, arguing that supply creates its own demand: the act of production generates income (wages, profits, and rent) that was just enough to buy the produced goods. • Ricardo won the argument in the 19th century mind, but Malthus is now vindicatedn the general glut issue • It took until the 1930s for economists to side with him—that was the “Keynesian Revolution”

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Malthus’s Place in the Pantheon

• Malthus ignored evidence to the contrary--agricultural improvements, a growing British population without the Malthusian consequences. He was not a good empiricist • Malthus was unscientific (his theory was not “testable” because it allowed for no circumstances in which it could fail). and his theory had no teeth. He was not a good theorist • Malthus’s contribution to economics is negligible, but his contribution to how economics is seen in the popular mind is extremely powerful

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David RicardoDavid Ricardo

The First Economic TheoristThe First Economic Theorist

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David Ricardo (1772-1823)

• A stockbroker considered the first rigorous economic theorists • Made major contributions building on Smith’s ideas • Best known for theory of land rent and theory of comparative advantage in international trade • Frequent correspondent with Thomas Malthus

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Ricardo’s Theory of Land Rent: The Assumptions

• Land is divided into “Farms” of different soil qualities, ranging from “Best Farm” to “Worst Farm” • Farms produce corn which is used to pay the next season’s workers (the “wages fund”) or to provide seed for planting (“circulating capital”) or to keep as rent • Corn can be sold at national price (farms are price-takers) • Capital and Labor work together in “doses” with fixed proportions; labor receives only a subsistence wage; capital earns a normal rate of profit • On each farm there are diminishing returns to increased doses; the average product (corn per dose) declines, so the marginal product is less than average product and declines even faster • Good farms will be cultivated first, then poorer farms. The worst farm is the last to be cultivated

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Ricardo’s Theory of Land Rent: The Results

• Each farm will add doses until the marginal product of a dose equals the cost of a dose—the “intensive margin” • Rent on each farm is the excess of total product over total cost of doses • The best farm will use the most doses, produce the most corn, and receive the highest rent • The worst farm produces just enough corn to pay for doses used; it will produce the least corn and the landlord will receive no rent—the “extensive margin” • Rent is not a necessary cost of production—it is the residual between output and costs; rent is price-determined, not price determining • Land is required for production, but it is not a”factor of production,” that is, not a required cost of producing

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Ricardo’s Theory of Land Rent: Policy Implications

• Ricardo argued for an end to the Corn Laws (1804-1846), which levied a stiff tariff on imported corn,* because the Corn laws raised the price of corn, benefiting landlords (who would get increased rent) and harming manufacturers (who would have to pay higher real wages and would suffer a fall in profits). • A confiscatory tax on rent could be introduced without affecting corn production—the only effects would be on the distribution of income—landlords would lose and the public would gain via increased revenues. [On this same issue, see Henry George and the Fabian Society]

*Note: In Britain corn was a generic term for cereal grains. What we call corn was called maize.

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David Ricardo's Theory of Differential Rent

Assumptions: Corn price = $10 per bushelDose cost = $900 labor + $100 profitDiminishing returns within farms (intensive margin)Diminishing returns across farms (extensive margin)

The Intensive MarginThe Best Farm The Poor Farm

Doses Total Average Marginal Average Average Marginal Total Average Marginal Average Average Marginal(K+L) Gross Revenue Gross Revenue Gross Revenue wage Profit Cost Gross Revenue Gross Revenue Gross Revenue wage Profit Cost

1 $10,000 $10,000 $10,000 $900 $100 $1,000 $5,000 $5,000 $5,000 $900 $100 $1,0002 $19,000 $9,500 $9,000 $900 $100 $1,000 $9,000 $4,500 $4,000 $900 $100 $1,0003 $27,000 $9,000 $8,000 $900 $100 $1,000 $12,000 $4,000 $3,000 $900 $100 $1,0004 $34,000 $8,500 $7,000 $900 $100 $1,000 $14,000 $3,500 $2,000 $900 $100 $1,0005 $40,000 $8,000 $6,000 $900 $100 $1,000 $15,000 $3,000 $1,000 $900 $100 $1,0006 $45,000 $7,500 $5,000 $900 $100 $1,000 $15,000 $2,500 $0 $900 $100 $1,0007 $49,000 $7,000 $4,000 $900 $100 $1,000 $14,000 $2,000 -$1,000 $900 $100 $1,0008 $52,000 $6,500 $3,000 $900 $100 $1,000 $13,000 $1,625 -$1,000 $900 $100 $1,0009 $54,000 $6,000 $2,000 $900 $100 $1,000 $12,000 $1,333 -$1,000 $900 $100 $1,000

10 $55,000 $5,500 $1,000 $900 $100 $1,000 $11,000 $1,100 -$1,000 $900 $100 $1,00011 $55,000 $5,000 $0 $900 $100 $1,000 $10,000 $909 -$1,000 $900 $100 $1,00012 $54,000 $4,500 -$1,000 $900 $100 $1,000 $9,000 $750 -$1,000 $900 $100 $1,00013 $53,000 $4,077 -$1,000 $900 $100 $1,000 $8,000 $615 -$1,000 $900 $100 $1,00014 $52,000 $3,714 -$1,000 $900 $100 $1,000 $7,000 $500 -$1,000 $900 $100 $1,00015 $51,000 $3,400 -$1,000 $900 $100 $1,000 $8,000 $533 -$1,000 $900 $100 $1,000

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Ricardo's Extensive MarginForty Farms of Different Qualities

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20

40

60

80

100

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39

Farm

Per

cent

of T

otal

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even

ue

Wages + Profits Rent

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Ricardo on the Direction of Int’l Trade

Ricardo’s On International Trade: Comparative Advantage

• Smith proposed that a country would produce and export a good if it was produced at a lower cost than in another country (“Absolute Advantage”) • Ricardo argued that this could only be a temporary condition—suppose a country could produce all goods at least cost. This would mean that the second country would export no goods, paying for imports with specie, driving prices down in the second country and up in the first. • In the long run, imported goods must be paid for by exported goods, so each country must have something to export.

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The Classic Example of Comparative Advantage

• England and France both produce corn and wine. France produces 2 cases of wine for each bushel of corn (so the French corn price of wine is 0.50); England produces 1 case of wine for each bushel of wheat (so the English corn price of wine is 1.0).

• Question: Which Goods Will Each Country Export to the other?

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Comparative Advantage and the Direction of Trade

Answer: England specializes in corn and trades with France for wine to (say) point e France specializes in wine and trades with England for corn to (say) point f Eventually, world corn price of wine settles between 0.5 and 1.0 Trade pattern is determined by comparative advantage

Analysis: If France doesn’t trade it must consume along the line FF’; England will consume along EE’ if it doesn’t trade. Both countries can improve their consumption possibilities by specializing in different products, then trading its surplus: France will specialize in wine and sell it to England at England’s higher price—consuming along F’F’’. England will specialize in corn and sell it to France at France’s higher price. The trade pattern is determined by comparative advantage, not by absolute advantage

Cases of Wine

Bushels of Corn

F

F’ F’’

E’’

E

E’

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General Gluts: Ricardo vs. Malthus

• Malthus argued that an economy could suffer protracted periods of depression—periods with excess capacity, including high unemployment • Ricardo responded with Say;’s Law: Jean-Baptiste Say had argued that general gluts were impossible because “goods trade for goods.” By this he meant that the act of producing $100 worth of goods was simultaneously an act of creating $100 of income (wages and profits) to buy the goods. Thus, “Supply creates its own Demand.” • Ricardo believed that what looked like a general glut was simply a transitional period when resources were shifting from declining industries to growing industries (buggy whips to auto horns).

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Why Might Gluts Occur?

• One proposed source of gluts was excess saving: Instead of spending the income received from producing goods, workers and capitalists could save (abstain from consuming) • Saving (consumers’ abstaining from consumption) could generate offsetting demand only if it led to investing (business capital expenditures). • In the early 19th century almost all saving was by businesses in the form of retained earnings that were intended to buy investment goods. So there was a strong link between saving and investment • The subsequent development of financial institutions weakened the saving-investment link, making general gluts more likely

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Gold Exports and Note Depreciation in the Napoleonic Wars

• England ran large international deficits to buy war goods, borrowing heavily to finance the wars. Poor wheat harvests compounded the deficit by raising imports of foodstuffs. • The demand for foreign exchange increased sharply, leading to a price of gold, at the gold export point. Gold began flowing out of the Exchequer. • To prevent the loss of gold, the Exchequer and the Bank of England suspended convertibility of notes into gold. As a consequence, the price of gold (in notes) rose to a premium above the mint parity; stated in language of the day, “notes depreciated.” • The reason for the note depreciation was hotly debated in “The Bullionist Controversy,” in which Ricardo played an important role.

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The Bullionist Controversy:

• Ricardo argued that the premium on notes was due to the suspension of convertibility; the Bank of England had weakened the currency, thereby inducing inflation in the note price of gold and other goods. This became known as “The Currency School.” • The Bank of England responded that it could not cause inflation because it adhered to the “real bills doctrine,” creating notes by discounting “real bills” (self-liquidating commercial notes created by trade). This became known as “The Banking School.” • Who was right? Ricardo had the upper hand because the real bills doctrine was a fallacy [see Adam Smith]

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Ricardo’s “Invariable Measure of Value” • Ricardo’s Invariable Measure of Value was designed to serve two goals Provide a price index to compute real national output Determine the source of variation in relative prices • Ricardo proposed using the commodity with average capital and labor per unit produced, and with average durability of capital. Its price (average cost of production) would be the average of all prices, against which both relative prices and the price level could be measured • Ricardo arbitrarily chose gold as the average commodity, so the price of gold was his price index— By dividing the value of national product in pounds sterling by the sterling price of gold the real value of national could be calculated If the price of a good is rising (falling) relative to gold, the cost of producing that good is rising (falling) relative to all goods

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Ricardo’s View of the Dynamics of Economic Growth

• As an economy grows its labor and capital both grow • As labor increases, the demand for food (“corn”) rises, the price of corn increases relative to the price of manufactured goods (“cloth”) • As the price of corn rises, less fertile land is brought into production, and total land rent increases • The increasing price of corn relative to cloth raises wage rates relative to the price of cloth and the profit rate declines • In summary, as an economy grows the share of output going to rent increases, the profit rate on capital falls, and the real wage rate rises

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Jean-Baptiste SayJean-Baptiste Say

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Jean-Baptiste Say (1767-1832) • Laissez-faire French economist who built on Smith’s The Wealth of Nations • Published A Treatise on Political Economy in 1803 • Worked as a finance secretary to Napoleon’ government until 1804, when Napoleon told him to rewrite the Treatise to support his war aims. Say left government and went into the textile business • Say taught at French universities after leaving the textile industry in 1812. He had become wealthy and was an active speculator • In 1832 Say was given the first chair in economics at the prestigious College de France

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Say’s Law

• Jean-Baptiste Say was first to argue against the possibility of extended periods of excess capacity (general gluts) • His claim was that “commodities are bought with commodities,” by which he meant that the act of producing generated the income necessary to buy an equal amount of goods • Example: A widget maker produces 100 widgets and sells them at $10 each The $1000 received is paid out to labor ($750), kept as business profit ($150), or used to pay suppliers $100) Workers spend $750 on corn and cloth, the widget factory owner spend $150 on equipment to produce more widgets, and the supplier’s $100 is also distributed as wages (and spent by workers) or kept as profits (and spent on new equipment) Supply ($1000 of goods sold) has created its own demand ($1000 of spending)

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The Problem of Hoarding

• Economists after Say accepted one caveat to Say’s Law—if businesses and individuals use their income to accumulate cash (read: gold or silver) that breaks the link between income received from production and spending on produced goods, creating an excess supply of goods and a busness contraction. • The opposite could also occur—a boom could be created by dishoardin • But hoarding and dishoarding are temporary phenomena. Once the desired money balances are accumulated or decumulated, the hoarding or dishoarding ends • So even if hoarding is a problem, it can not explain a prolonged state of excess capacity and high unemployment

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Ricardian SpinoffsRicardian Spinoffs

Henry George and the FabiansHenry George and the Fabians

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Henry George (1839-1897)

• George was a journalist, author, and speaker on economic matters who was influenced by David Ricardo and John Stuart Mill • Wrote Progress and Poverty (1879), arguing that Economic rents (from monopoly, land ownership, etc) were the source of an unequal distribution of income Taxes affected incentives to produce, consume, invest, work, and save. In modern terms, taxes had an “excess burden,” creating a loss to society, not just a transfer of purchasing power On Ricardian grounds, land rent was an unnecessary payment that could be taxed without altering the allocation of resources The only tax should be a tax on land rents sufficient to generate the required revenue; this was the Single Tax proposal

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Henry George’s Single Tax

• The only tax should be a tax on land rents sufficient to generate the required revenue; this was the Single Tax proposal The Single Tax would be “efficient,” having no excess burden because landowners would not reduce cultivation The Single Tax would also have the advantage of discouraging speculation in land (but is speculation bad?)

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Henry George’s Single Tax

• Critics argued that this was nationalization and that landowners should be fully compensated for the taxes they would pay. George realized that this would gut the idea by requiring government to pay for the future taxes in a lump sum.

• The Single Tax was a very popular idea but had a number of problems. Chief among them: The difficulty in separating the site value of land from the value of improvements The issue of compensation The possibility that if land had alternative uses not all rents were unnecessary payments (e.g. if arable land could be converted to residential uses)

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The Fabian Society

• Formed in 1864; named after Quintus Fabius Maximus, the Roman General whose tactics against the Carthaginians involved delay and attrition—the tactics used by the Fabians in their reform efforts. • The Fabians were the preeminent British intellectual society of the time, with members like Sidney and Beatrice Webb, George Bernard Shaw, John Maynard Keynes, and a host of other leading lights • The Fabians were instrumental in creating the Labour Party • The Webbs and Bernard Shaw started the London School of Economics

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The Fabian Society’s Political Agenda

• Improving the distribution of income

• Encouraging universal public education

• Nationalizing land and essential capital-intensive busineses (utilities, transportation, etc)

• Protectionism in international trade

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The Fabian View of Economic Dynamics

• Land rent was an unnecessary payment to the landowner of about 15% of national income (according to Shaw) • As Britain’s population grew, land rent would grow as a share of national income (according to Shaw) • Public ownership of land would have no effect on agricultural production but rents would go to the national treasury for public uses • BUT the facts were different Land rent was about 5% of national income The land rent share had been declining.

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George Bernard Shaw and Sidney Webb

• Were the leaders of the Fabian Society in the last decades of the 19th century. • Both were economic dilettantes though tutored by Jevons and Wicksteed. • Shaw and Webb believed that the distribution of income in Britain was grossly unfair and public ownership of land (and some capital) was a way of addressing the inequality of income distribution the Marxian argument for socialism (public ownership of capital) was seriously flawed but the Ricardian argument for public ownership of land was solid Webb and Shaw attempted to extend their conclusion to urban rents by trying (unsuccessfully) to treat interest on capital (urban buildings) as equivalent to land rent.

71

Rural Land Rent vs. Urban Ground Rent

• Webb and Shaw attempted to extend their conclusions to urban land • The problem with urban rents is that most of it consists of necessary expenses The owner’s Interest payments or opportunity costs The owner’s management expenses and taxes The owner’s opportunity cost of other uses of the land

72

Karl MarxKarl Marx

The Communist Critique The Communist Critique

Of CapitalismOf Capitalism

73

Karl Marx (1818 - 1883) • Marx’s chief cheerleader was Frederick Engels, with whom he wrote The Communist Manifesto (1848) • Published three-volume Das Kapital (Vol 1, 1867, Vol 2, 1885 ; Vol 3, 1894) – the last two volumes were posthumous, completed by Engels • Viewed his work as the natural result of Smith and Ricardo, but believed that Smith and Ricardo failed to see that capitalism was a transitional system • Marx wanted to demonstrate that capitalism was unsustainable and would morph into socialism • Marx was an adherent of Hegel’s philosophy of “thesis- antithesis-resolution’ • Marx’s philosophy of “dialectical materialism” applied Hegel to the economic (material) system

74

Marx’s View of Production Costs • All production is attributable to either living labor (current workers) or to dead labor (machinery constructed by past labor). Thus, the value of a machine is its embedded labor • Payments to labor per unit of output (“variable capital,” denoted as “v”) are labor hours employed times wage rate required to just maintain the worker • Payments to capital per unit of output (”constant capital,” denoted as “c”) are the value of the “dead” workers’ labor embedded in the equipment. This is equal to the price paid for the machine (that is, the value of the embedded labor) divided by the years the machine lasts; we call this “straight line depreciation” • Thus, the necessary costs of production are c+v, the cost of the dead labor plus the cost of the living labor

75

Marx’s Theory of Surplus Value

• Labor produces a “surplus value” (call it “s”) which goes to the capitalist because of his control over the access to capital. Surplus value is the value of labor employed by the capitalist but not paid out as wages. • Surplus value does not exist because of any necessary returns to capital. It is simply “expropriated labor.” • Surplus value can be thought of as extra hours the worker is required to work beyond those hours necessary to pay his subsistence wage. • Both the rate of profit [(s/(c+v)] and the “rate of surplus value” (s/v) are the same for all capitalists because of competition Machinery (constant capital) will move from lower to higher profit rate industries until the profit rate is equal in all industries Labor (variable capital) will move from higher to lower surplus value rate industries until the profit rate is equal in all industries

76

The Internal Contradictions of Capitalism

• Capitalists save all surplus value, investing the proceeds in labor-saving constant capital • As constant capital increases, labor demand increases, wages rise, population increases, and national product grows • The economy’s capital/labor ratio grows as capital grows more rapidly than labor--firms become more capital intensive, and “big business” emerges • As businesses become more capital intensive the rate of profit falls • To maintain profits, capitalists engage in strategies to increase the rate of surplus value, i.e. they increase the exploitation of labor by lengthening the work day, they substitute equipment for workers in an effort to increase “productivity,” they shift capital to foreign (low wage) regions, they intimidate workers through government repression, and so on.

77

The Final Phase of Capitalism

• Ultimately--and inevitably--exploitation turns into revolution and the exploiters become the exploited; a worker state is formed and the means of production are owned and controlled by a workers’ government • Socialism is the new thesis, and it will have its own internal contradictions which create tensions that eventually lead o yet another economic system, as yet unknown. • And so it goes…

78

Marx’s Labor Theory of Value

• Marx adhered to a labor theory of value--The relative price of any two goods is the relative labor “living labor” content of the goods, that is

(p1/p2) = (v1/v2)

• The Labor Theory of Value is extremely flawed because it contains a great contradiction On the one hand, Marx recognized that capital costs (constant capital) are costs of production that should be recovered in the price of the product But Marx insisted that only living labor affects relative costs

79

Fundamental Problems in Marx’s Economic Analysis

• The Transformation Problem

The Transformation Problem is the problem of how relative labor values can be transformed into relative prices of goods The only resolution is that all goods must be produced with the same c/v, which Marx called the “organic composition of capital,” and we now call the capital-labor ratio. Both Ricardo and Smith had rejected a labor theory of value precisely because goods are produced with different capital-labor ratios. But Marx insisted that the labor theory of value was valid. The transformation problem bothered Marx greatly, and it lead to many years of study before his (incorrect) resolution appeared in Volume 3 of Das Kapital.

80

Fundamental Problems in Marx’s Economic Analysis

• What keeps wages down in Marx’s capitalist system? Marx rejected the Malthusian concept of wage-related population changes; instead, he postulated a “reserve army of the unemployed” as a mechanism keeping wages down--high unemployment was chronic and was created for the benefit of capitalists The reserve army was created as a result of labor-saving bias in new capital goods--workers were displaced by equipment. Three problems with this: - Evidence does not suggest that technical progress is labor-saving - What prevents the unemployed workers from getting jobs by reducing wage demands? - Capitalist economies do not exhibit chronically high unemployment

81

Fundamental Problems in Marx’s Economic Analysis

• Can Surplus Value Exist in a Capitalist System? Marx argued that profits are surplus value--free labor extracted from workers because capitalists control the means of production--and that the rate of surplus value was the same in all industries But if surplus value is costless to the capitalists, why wouldn’t they bid for labor until the workers were paid the whole product and surplus value is zero? Thus,something must prevent this competition for labor— Marx rejected centralized business (monopoly power) in his analysis and had no other answers

82

PREDICTIONPREDICTION TRUETRUE FALSEFALSE

Wage rate constant over long periodsWage rate constant over long periods XX

Rise of Big BusinessRise of Big Business XX

Increasing Capital per WorkerIncreasing Capital per Worker XX

Falling Profit RateFalling Profit Rate XX

Increasing Investment AbroadIncreasing Investment Abroad XX

Rise of SocialismRise of Socialism XX XX

Decline of CapitalismDecline of Capitalism XX

High unemployment (“Reserve Army of the Unemployed”)High unemployment (“Reserve Army of the Unemployed”) XX

Labor-saving bias in technologyLabor-saving bias in technology XX

Fundamental Problems in Marx’s Economic Analysis

Does Marx’s Analysis Fit the Data?

83

Marx’s Place in the Economic Pantheon

• Marx was not a Great Economist Marx’s work is filled with inconsistencies, contradictions, and poorly developed ideas Marx’s worst misses were in the areas that modern economists value most • Marx scores much better as a visionary Foresaw the rise of “Big Business” long before it appeared Predicted the emergence of colonialism driven by economic interests Understood the importance of government as a source of support for economic interests • Marx is best viewed as a powerful sociologist, not an economist

84

Neoclassical Economics

The Integration Of Demand and Supply

And The

Determination of Prices and Quantities

John Stuart Mill and Alfred Marshall

85

John Stuart MillJohn Stuart Mill

86

John Stuart Mill (1806-1873)

• Mill’s father, James Mill, was an eminent economist; his godfather was Jeremy Bentham, the founder of utilitarianism (whose skeleton still stands in a conference room at Cambridge University) • Mill was an important philosopher; among his major contributions were A System of Logic (1843), On Liberty (1859), Considerations on Representative Government (1860), and Utilitaranism (1863) • His The Principles of Political Economy (1848) was the premier economics textbook until the 1920s. Mill considered himself a follower and expositor of Smith and Ricardo-not an innovator • He served as an independent Member of Parliament in 1865- 66, advocating womens’ suffrage, a light hand on Ireland, proportional representation, labor unions, and other liberal causes

87

Mill’s Contributions to “Price Theory” (Demand and Supply)

• Introduced the idea of demand and supply as relationships between price and quantity—the price of a good and its quantity produced (consumed) are simultaneously and jointly determined in a process of market clearing • It was no longer “necessary” to treat prices as determined only by cost-of-production only and quantities as determined only by price-insensitive “demand” • This initiated the development of microeconomics—the study of the role of prices as signals and of the allocation of resources (capital, labor, land) between industries and firms • It also introduced the analysis of prices as incentives, It also introduced the analysis of prices as incentives, an ideaan idea that had been loosely introduced by Smith but had that had been loosely introduced by Smith but had not beennot been an integral part of economic analysisan integral part of economic analysis

88

Price Price

Quantity Quantity

Q* Q*

P* P*D’

D’

D

D

S S’

S’

S

Classical Case 1:Quantity is Demand-DeterminedPrice is Supply-Determined

Note that in both cases, Price and Quantity Changes are independent (uncorrelated):An increase in demand (rightward shift) raises quantity produced, not price; an increase (upward shift) in supply raises price but does not affect quantity

Classical Case 2:Price is Demand-DeterminedQuantity is Supply-Determined

The Smith-Ricardo “Classical” Analysis of Markets

89

The Mill-Marshall “Neo-Classical” Analysis of Markets

Quantity

Q*

P*

D’

DS

S’

Price

Price and Quantity are Jointly Determined. As Alfred Marshall said“price determination requires two blades of the scissors”

A Test for Demand or Supply Shifts:Prices and Quantities are positively correlated when demand shiftsPrices and Quantities are negatively correlated when supply shifts

Note that the analysis involving shifts of only DD or SS assumes that demand and supply shift for different reasons. In neoclassical theory, demand depends on “tastes,” on prices of substitute or complementary goods, and on consumer income. Supplty depends on “technology” and the costs of factors of production

90

Mill on the “Gains from Trade”

• The Physiocrats and the Classical Economists had great trouble explaining why markets create “value added for a society If the cost of producing every unit of a good is the same, the total cost of production is equal to the value to the total value to consumers In this case, markets simply transfer alue from one part to another. The is no net value added. • Mill distinguished between average production costs (total cost per unit) and marginal costs (the cost of producing the last unit • Similarly, he distinguished between the average value of a good to consumers (total value divided by number of units consumed) and the marginal value (value of the last unit) • As a result, he could show that trade in markets created value added for all concerned. This was called the “Gains from Trade.”

91

The Gains from Trade:Measuring an Economy’s “Value Added”

Quantity

Q*

P*

DemandSchedule

S

SupplySchedule

Price

Consumer Surplus

Producer Costs

Economic Profit

P* x Q* = Area + Area =Consumer Spending on Soybeans = Revenue (Sales) of Soybean Producers = Cost of Soybean Production to Society

Area + Area = Consumer Surplus + Economic Profit = Society’s Net Gain from Trade

92

Mill’s View of the Link between Wage Rates and Employment

• Mill adhered to the Wages Fund Doctrine, arguing that because of lags between production of goods and consumption by workers the capitalist had to save previous production in order to pay workers: Saving was an advance of wages, not accumulation of fixed capital • If K is the wages fund to be paid out in this production period, then the wage rate per hour (w) and the number of man-hours employed was related by the simple equation

wN = K or N = K/w Employment (N) is equal to the wages fund (K) divided by the wage rate (w)

93

Implications of the Wages Fund Doctrine

• An increase in wage rate causes an equal proportional reduction in employment • The wage rate and/or employment can increase only when capital grows • Capital is equated to “goods in process,” not fixed capital (plant and equipment) • Productivity increases accrue entirely to the employer in the short run The legacy of the wages fund doctrine • It is a useful style of thinking because it stresses that sometimes current choices are conditioned by past decisions) • The notion of advance economics still exists in the Austrian theory of capital, and cash-in-advance macroeconomic models • But it is no longer a useful concept in labor market analysis

94

Mill on Economic Decisions and Tax Policy

• Mill’s focus on prices paid (and received) as signal to producers and consumers led naturally to the idea that government, through its power to tax and to subsidize, could alter private decisions

• Mill believed that government could levy taxes on “bad” goods and give subsidies to “good” goods, thereby improving the allocation of resources and enhancing the general welfare.

• Mill recognized that any tax creates an “excess burden,” that is, it doesn’t simply transfer income from taxpayers to government, it creates a social cost in lost production (see next figure).

95

Quantity of Soybeans

Q0*

P0*

D

D

S0

Price

S0

S1

Q1*

P1* + t

Unit Tax (t)

The Social Cost (Excess Burden) of an Excise Tax

S1P1*

An excise tax of t per unit of production is levied. Producers must charge T additional dollars for each unit in order to cover their costs so the supply schedule shifts up To S1S1. The price to the consumer rises and fewer units of soybeans are bought. The least efficient producers cut back production or go out of business. In the new equilibrium the price received by producers is P 1* and the price paid by consumers is P1* + T.

Area = Loss of Consumers’ Surplus and Area = Loss of Producers’ SurplusArea + Area = Excess Burden (Cost of Tax to Society)Area = Excise taxes paid by firms, collected from consumers

96

Mill on Money and Inflation

• Mill followed Ricardo’s “Currency School” The Quantity Theory of Money—inflation was a matter of too much money The real bills doctrine was a very poor guide to monetary management A “convertible currency would not cause inflation because the banking system could not create too much money; if it did, specie would be exported and the money supply would return to the original level An inconvertible currency unhooked from specie would allow inflation the test of excess money was an exchange rate above the gold export point

97

Mill’s Theory of the Rate of Interest

• Previous economists had no theory explaining the interest rate—it was a given • Mill proposed the “Loanable Funds Theory of Interest” The quantity of loanable funds supplied is the annual amount of saving in the economy less the amount of annual “hoarding” of money; it is positively related to the rate of interest The quantity of loanable funds demanded is the annual amount of borrowing or stock issue to finance capital expenditures or government spending; it is negatively related to the rate of interest The equilibrium rate of interest is determined by the equality of demand and supply, that is, it is the interest rate at which investment by firms + govt spending is equal to saving by firms and individuals + govt tax receipts.

98

Quantity of Loans

r*

D’

D

S

S’

Interest Rate(% per year)

L*

99

Mill on International Trade

• Recall Ricardo’s theory of Comparative Advantage: Countries produce and export goods in which they have the lowest relative cost of production Each country will specialize in that good—producing only that good (“corn”) and exporting some of it in trade for the other country’s good (“wine”) in which that country specializes The relative prices of the two goods in international markets will be somewhere between the relative production costs in the two countries This indeterminacy of prices in international trade occurs for two reasons: (1) there is no consideration of the role of demand factors; (2) it is assumed that production costs are constant

100

Mill’s on International Trade

• Mill resolved ths indeterminacy of relative prices by bringing demand for traded goods into consideration. The result was that in equilibrium with international trade two things would happen: the relative price of the two goods would be equal for all buyers and sellers in both countries at the equilibrium prices trade accounts would be balanced; that is, the value of wine that France wanted to export would be just the value that England wanted to import, and vice versa. • An increase in (say) England’s demand for wine would have The price of wine would rise as the English shifted from corn to wine the French would shift from wine to corn in response A new equilibrium would emerge with England drinking more wine and France eating more corn

101

Mill on Monetary Management

• Mill was among the first to argue that the “bank rate” was an important consideration in the Hume price-specie flow mechanism • The bank rate was the interest rate that the Bank of England charged on loans to British banks. It is the equivalent of the Federal Reserve System’s discount rate. Thus, the bank rate determined the short-term interest rate. • Hume had argued that when the market-determined foreign exchange rate was above (below) the gold export (import) point, gold would flow out to (in from) other countries and the domestic money supply would fall (increase). The effect would be a fall (rise) in domestic prices and a rise (fall) in foreign prices until the exchange rate moved to within the gold flow points

102

Mill on Monetary Management

• Mill argued that gold flows would also affect interest rates in each country—as gold flowed out and money supply fell, credit would tighten and domestic interest rates would rise while foreign interest rates would fall. • The rise in the relative interest rate in Britain would induce foreigners to make loans to British borrowers. This would increase the demand for UK notes and help to move the pound back within the gold-flow points • Mill went even farther, arguing that the Bank of England could alter the bank rate to affect the exchange rate, hence not waiting for the automatic price-specie flow mechanism to work. • Mill’s insight that the bank rate could be an instrument of monetary policy was a major advance

103

Mill on The Incidence of Taxation • Mill was among the first to discuss the “incidence of taxes”—this is the question of who really bears the tax burden. • Consider the case of an excise tax in which producers pay say) $10 in tax per unit produced. With 1000 units made, the producers write checks totalling $10,000. But is that really the producers tax burden? • Mill argued that the producer would try to pass the tax on to consumers, but consumers would reduce their purchases in response to the higher price. This would mitigate the price increase. In the end less would be produced, and it would be sold to consumers at a higher gross price with producers keeping a lower net Consumers who still bought the good would pay part in a higher price, while producers would get a lower net price for the units produced. The burden of the tax actually paid is shared by buyers and sellers.

104

Mill on The Incidence of Taxation • Thus, there would be a sharing of the burden of the tax Consumers who still bought the good would pay part in a higher price Producers would get a lower net price for the units produced. The burden of the tax actually paid is shared. In addition there is an “excess burden” of the tax. Because less is produced, both consumers and producers lose the value of the lost output (and, of course, government gets no tax revenues fro the output not produced).

105

The Incidence of an Excise Tax

Quantity of Soybeans

Q0*

P0*

D

D

S0

Price

S0

S1

Q1*

P1* + T

Unit Tax (T)

S1P1*

An excise tax of T per unit of production is levied. Producers must charge T additional dollars for each unit in order to cover their costs so the supply schedule shifts up To S1S1. The price to the consumer rises and fewer units of soybeans are bought. The least efficient producers cut back production or go out of business. In the new equilibrium the price received by producers is P 1* and the price paid by consumers is P1* + T.

Amount “paid” by consumers but not collected as taxes (lost consumer surplus)Amount “paid” by producers but not collected as taxes (lost producers surplus)Amount of taxes actually paid by consumers to producers for tax collection Amount of taxes actually paid by producers for tax collection

+ = Tax collections by government (tax check written by producers)

T

106

Mill on Government Deficits and “Crowding Out” • Mill was among the first to raise the possibility that a government deficit might crowd out of private investment Recall the loanable funds theory of interest—as debt- financed government spending increases, the demand for loanable funds rises, increasing the equilibrium rate of interest. As the interest rate increases the economy slides along the fixed supply of loanable funds schedule, creating a reduction in interest-sensitive spending, particularly business investment in plant and equipment In the new equilibrium the interest rate is higher, government debt is greater, and investment is smaller • This “crowding out” means that future generations are saddled with a smaller capital stock and lower productivity (output per man hour). This is the real cost of deficit finance—everything else is a zero-sum transfer

107

Quantity of Loans

r0*

D0’

D0 S

S’

Interest Rate(% per year)

L0*

D1

D1’

r1*

L1*

A Debt-Financed Increase in Government Spending

An increase in government spending shifts the demand for loanable funds up (or out). The economy moves along the original supply curve, reaching a new equilibriumat interest rate r1* and loan volume L1*. As the economy moved along the SSCurve, private saving increases; but the higher interest rate also chokes off someprivate investment. The increased government debt has “crowded” out private investment.

108

But…Enough on Mill!

We could continue much longer, but now we can appreciate why

his 1848 textbook was widely used for fifty years

The next generations up until the Keynesian Revolution in the 1930s were devoted to improving and expanding Mill’s vision

The primary contributor to this work was Alfred Marshall,

a British economist at Cambridge University

109

Alfred MarshallAlfred Marshall

under constructionunder construction

110

The Great Debate Of The The Great Debate Of The

2020thth Century: Century:

Capitalism vs. SocialismCapitalism vs. Socialism

Joseph Schumpeter And Friedrich Von HayekJoseph Schumpeter And Friedrich Von Hayek

111

Joseph A. Schumpeter (1883-1950)

• Shumpeter’s Career

Czech-Born, Moved To Vienna As Teenager Educated At University Of Vienna, Center Of “The Austrian School Of Economics” Taught At Several European Universities, Ending At University Of Vienna Achieved First Notoriety With The Theory Of Capitalist Development (1911) Left University Of Vienna To Become Partner In Major Austrian Bank Served As First Post-WWI Austrian Finance Minister Joined Harvard Faculty In 1932, Staying Till His Death In 1950

112

Schumpeter’s Vision

• Father Of The Field Of “Business Economics” • Integrated History, Sociology, Economics, And Business In An Analysis Of Capitalism’s Nature And Direction • Contributed Much To Modern Business Discourse Role Of “Entrepreneur” Process Of “Creative Destruction” Viewed Capitalism As Unstable And Chaotic But Conducive To Great Material Growth Deep Distrust Of Government Intervention In Economic Affairs Believed That High Taxes Discouraged Entrepreneurial Activity And Innovation • Viewed “Big Business” As The Engine Of Growth Had The Financial Resources And Security To Risk Funding Research Efforts

113

Schumpeter’s Scholarly Contributions

• The Theory Of Economic Development (1911) Emphasized Entrepreneurial Creativity As The Source Of Economic Growth Argued That Big Business Had The Financial Resources To Fund Creative Developments And To Keep The Advantages To Themselves By Inhibiting Competition

• Business Cycles (1939) Emphasized The Chaotic Nature Of Capitalist Development Eschewed The Idea That “Equilibrium” Was A Capitalist Characteristic; Rather, Capitalsm Was Characterized By Disequilibrium

• Capitalism, Socialism, And Democracy (1942) His Best-Known Work; Assesses Karl Marx And Argues That Capitalism Will Decline But For Entirely Different Reasons

114

Schumpeter’s View Of The Business Cycle

• Innovation In Products And Techniques Is The Essential Contribution Of Capitalism • Innovation Creates Dramatic Rises In Some Industries And Declines In Others • The Innovating Industries Enjoy Monopoly Rents In The Short Run, Which Attract High Prices For Their Common Stocks • In The Long-Run The Short Term Rents Are Competed Away By Copy-Cat Firms Entering The Innovating Industry • As Investors Discover They Have Overpaid, The Share Prices Decline, Investment In The New Industry Slows, And The Economy Slows • If The New Industry And Its Investors Have Been Heavy Borrowers, Lenders (Banks) Fail And A Financial Crisis Deepens The Economic Decline • Ultimately A New Set Of Innovations Emerges And The Cycle Recurs

115

Schumpeter’s View Of Capitalism’s Future

• Marx Believed Capitalism Would Die Because Of The Rise Of Big Business The Declining Rate Of Profit As Big Business Rises… Creates Capitalist Defensive Reactions, Such As Labor-Saving Innovation, That Displace Labor… Leading To The “Increasing Immiserization Of Labor” … Class Warfare (Capital vs. Labor) Leads To Increased Tensions… And The Proletariat Revolts--The Expropriators Are Expropriated • Schumpeter Agreed That Capitalism Would Give Way To Socialism, But For Very Different Reasons Capitalism’s Emphasis On Impersonal Markets Cuts The Social Threads That Create Widespread Support Big Business Faces Increasing Government Intervention That Throttles Innovation

116

Friedrich von HayekFriedrich von Hayek

And The And The

“ “Austrian School Of Economics”Austrian School Of Economics”

117

The Austrian School

• Major Figures Carl Menger (1840-1921) Ludwig von Mises (1881-1973) Friedrich von Hayek (1899-1992)

• Major Ideas Libertarian Philosophy Economic Analysis Is Central To Understanding The Human Condition And Human Choices Axiomatic Foundation Of Economic Analysis—Contrast With The Inductive Method Of German Historical School Early Application Of Marginal Utility Analysis Of Product Demand

118

Friedrich von Hayek (1899-1992)

• Hayek’s Career

Educated At University Of Vienna, Center Of “The Austrian School Of Economics” Did Scholarly Work In A Broad Range Of Topics: From Neurology To Political Philosophy To Monetary Theory And Business Cycles Best-Known Book: The Road To Serfdom (1944) Became U.K. Citizen In 1938; Eventualy Took Faculty Position At University Of Chicago Received Nobel Prize In Economcs In 1974 For Work In Monetary Theory

119

The Road To Serfdom

• Centrally Planned (“Collectivist” or “Socialist”) Economies Are Inherently Incompatible With Democracy In Theory A Collectivist Economy Could Allocate Resources As Efficiently As The Market Economy, But In Practice This Is Impossible The “Aggregation Problem” Is At The Heart Of This Failure - The Preferences Of Each Consumer And The Costs Faced By Each Producer Are Reflected In Prices In A Market Economy, Leading To Efficient Allocation - A Centrally Planned Economy Can Never Collect The Necessary Information To Mimic The Resource Allocation Achieved In A Market Economy The Failure Of Central Planners Leads To Ever-Increasing Centralization Of Power To Allow The Central Plan To Be Achieved. This Undermines Democracy

120

The Great Depression

And The

Advent of Macroeconomics

John Maynard Keynes

121

An OverviewAn Overview

of the of the

Great DepressionGreat Depression

122

The Classical View of General Gluts

• As a general rule, economists before the 1930s did not accept the idea of long-lasting economy-wide depression. Both labor and capital tended to be fully utilized in the long run • Malthus had debated this with Ricardo, a debate that Ricardo won on points. Ricardo, appealing to Say’s Law, argued that excess capacity in one industry occurred as part of the process by which resources shifted from declining industries to growing industries. Because declining industries were typically mature and thus affected more people, this gave the impression of a general slump • Marx had taken an intermediate position, believing that capital was fully employed but that there was, by capitalist design, a “reserve army of the unemployed”

123

The Neoclassical View General Gluts

• While Ricardo argued that a general glut could not happen, “neoclassical” economists prior to the 1930s argued that a glut could occur but that it would be short because the economy was “homeostatic,” or self-correcting. • The mechanism ensuring homeostasis was flexibility in wages, prices and interest rates. In a depression or recession: Wages would fall in response to high unemployment, inducing businesses to maintain their labor force The general price level would fall in response to an excess supply of, encouraging a rise in consumption as real wealth increased Interest rates would fall in response to a collapse in investment spending, encuraging businesses to spend more

124

Wage-Price-Interest Rate Flexibility

Aggregate Production (Q)

P0*

D0’

D0

S

S’

Price Level (P)

Q

D1

D1’P1*

Q*0

ab

c

SS’ is the aggregate supply curve at full employment. At full employment all labor is employed and all capital is utilized. Full eployment output is Q*. D0D0‘is the initial aggregate demand schedule. Aggregate demand equals aggregate (full employment) supply at price level P0*. So the economy is initially at point a. Now Consider the following events: ● Capitalists become less optimistic about future profits so the aggregate demand schedule shifts leftward to D1D1‘. At each price level the aggregate output demanded is smaller. If the price is fixed at P0* the economy would move to point b: The entire effect of the decrease in demand is on output, which falls to QQ. There is a general glut, with excess capacity of both capital and labor.

● If, however, interest rates, wages, and prices are downwardly flexible, the glut at point b induces movement down the new demand schedule toward point c. This movement arises from a decline in interest rates, which acts to increase investment from its low level at point b, from a decline in money wages, which tends to reduce the real wage rate and induce firms to rehire labor, and from a decline in the price level, which (a) increases real cash balances, inducing consumers to spend more, and (b) redistributes wealth from creditors to debtors, thereby increasing investmebnt since the majority of debt is issued by businesses

So, in the end, rice flexibility ensures full employment. It was also believed that this process worked quickly (within, say, a year).

125

The 1920s: The International Scene

• German War Reparations and U.S. War Loans Treaty of Versailles imposed punitive payment to Britain and France Germany followed a policy of undervaluing the mark in order to promote exports and discourage imports so that it could earn the foreign exchange to pay the debt; this reduced German production available for domestic investment and consumption Germany printed money hand-over-fist to encourage domestic consumption and investment. But without goods to buy, this generated hyperinflation Britain and France used German reparations payments to pay war loans from the U.S.

126

The 1920s: The International Scene

• In 1925 Britain restored convertibility at the pre-war exchange rate of $4.86 per pound in spite of the high war-time inflation that it had experienced The greatly overvalued pound encouraged British imports and discouraged exports, creating a slump in aggregate demand and a chronic economic recession throughout the 1920s Keynes called this recession “The Economic Consequences of Winston Churchill,” who was Chancellor of the Exchequer at the time • Thus, through the 1920s Britain and much of Europe was having hard times

127

The 1920s: The U.S. Economy

• Severe but short post-WWI depression in 1920-21, initiated by reduced postwar demand and a surge in the civilian labor force. • A burst of new investment was encouraged by high-tech innovations: the spread of electricity requiring construction of generating and transmission facilities, and creating a demand for electrical appliances the the spread of the automobile, requiring construction of plants, roads, and roadside facilities as well as expansion of oil extraction and gasoline refining facilities the advent of commercially-viable radio with consequent construction of transmitting facilities and demand for radios

128

The 1920s: The U.S. Economy

• Consumer demand increased, driven by purchase the new technologies availability of a new form of finance: consumer credit • The prosperity—high investment and consumption, high employment, and stable prices—created optimistic expectations for future corporate profits and led to a stock market boom concentrated in the new industries • The investment boom was excessive, with capacity expanding beyond demand, and it was based on highly levered industries that borrowed heavily from banks. • The stock market boom led to stock purchases financed by bank loans (margin loans) by both regular folk unable to assess the risks as well as by sophisticated investors who expected the train to stay on the tracks.

129

The 1928-29 Turnaround

• In August of 1928 the economy peaked, and in September the stock market peaked • In late 1928 the Federal Reserve System expressed concern about the use of bank credit to buy common stocks banks maling significan margin loans had restricted access to the discount window to heavy lenders the discount rate was increased from 1½% to 3½% • The stock market collapse in 1929 was the initiating cause of the Great Depression, as banks restricted credit in response to loan losses and consumers cut back on spending because of credit costs and declining wealth

130

Index of Macroeconomic VariablesDuring the Great Depression

(1929-100)

0255075

100125150175200225250275300325

1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939 1940

Real Money Stock Real Nat'l Debt Real Stock Prices

Index of Macroeconomic VariablesDuring the Great Depression

(1929-100)

60

70

80

90

100

110

1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939 1940

Real GNP Private Nonag Employment GDP Delator

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Why was the Depression so Long and Deep?

• 1930: The Smoot-Hawley Act imposed high tariffs on imported goods in order to shift demand to domestic products. But the effect was to restrict demand for our exports because foreign countries could not earn dollars to buy U.S. goods Widespread crop failures in the early 1930s (the Dust Bowl) create foreclosures of farms and bank failures in the interior extending to weakness at city correspondent banks • 1931: Federal Reserve Board raised the discount rate from 1½% to 3½% in spite of serious deflation; over 2000 banks collapse; The Federal Reserve Board failed to expand bank reserves enough to offset the credit contraction effects of sizable runs on banks Britain suspended convertibility, ending its overvaluation of the pound, reducing its imports from the U.S., and increasing its exports to the U.S.

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Why was the Depression so Long and Deep?

• 1932: To balance the budget, Hoover signed a bill increasing personal income taxes from 25% to 63% • 1933: FDR suspends convertibility of the dollar, followed in 1934 by prohibition of private ownership of gold and an increase in the price of gold from $20.67 to $35 • 1935: FDR signs Social Security Act that will levy a payroll tax beginning in 1937, hence playing a role in a 1937-38 recession in a depression Not until 1938 did FDR openly accept a federal deficit; prior to that he had attempted to balance the budget by raising taxes, or had grudgingly accepted it

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John Maynard KeynesJohn Maynard Keynes

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John Maynard Keynes (1883-1946)

• Keynes “rhymes with rains” was a major figure in British social, business, and intellectual life a member of the Fabian society and the Bloombergs, both major collections of the British literati married to a world-famous ballerina, Lydia Lopokova a Cambridge Don who was a prolific economist a very successful speculator in commodities and currencies an important advisor to the British government the intellectual father of the Bretton Woods Agreement reshaping international currency relationships after WWII

• Published The General Theory of Employment, Interest and Money in 1936

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The Main Arguments of The General Theory

• Rejected Say’s Law A General Glut could be both serious and prolonged The cause of the Depression was insufficient demand for goods and services, particularly arising from decreases investment in fixed capital Both hoarding and excess saving created the general glut There were no automatic mechanisms ensuring full employment of labor and capital In the absence of sufficient wage-price flexibility, aggregate income (=aggregate production) would decline—a depression would emerge the economy would stay in a high unemployment condition as long as wages and prices failed to adjust sufficiently • Argued that spending by government was a solution to the underemployment equilibrium

136

Reasons for Insufficient Wage-Price Flexibility

• Workers focus on the money wage rate, resisting its decline even when prices are falling. As a result, the real wage rate rises and businesses lay workers off • Interest rates fail to fall as much as they should because of “liquidity preference—as interest rates fall, people choose to hold more money. This creates temporary hoarding

Multiplier-Accelerator Effects • A decline in workers’ income creates a reduction in consumer spending, which is exacerbated by the “consumption multiplier” • The “investment accelerator” further exacerbates the downward adjustment of spending

137

Keynes’s Arguments against Say’s Law

• Say’s economic world was simple: Household saving was almost nonexistent except for the affluent landowners and capitalists—the problem of excessive saving was not due to household behavior businesses were the primary source of saving via retained earnings that were reinvested in the business—businesses did not resort to external finance, neither did they invest saving in financial instruments As a result, saving was quickly transmitted to spending because the savers (businesses) were the spenders

• In a modern economy, saving and investment decisions are separated Households place their savings with financial institutions Businesses engage in external finance by borrowing from financial institutions or investors

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Why Wouldn’t Interest Rate Flexibility be Sufficient

• Interest rate flexibility existed, but was impeded by two monetary factors Induced hoarding: the decision about how much money to hold depends (inversely) on the rate of interest on bonds, which is the opportunity cost of money. As interest rates decline, firms and household want to hold more money.The resulting shift toward money balances was akin to hoarding—it reduced the amount of consumer saving that went into loanable funds A liquidity trap might prevent interest rates from falling enough: At a very low interest rate money would be preferred to bonds, and loanable funds would be drained off into hoarding

139

Why Wouldn’t Wage and Price Flexibility be Sufficient

• Wage flexibility would be restricted by sociological considerations. Workers resist cuts in money wages because: They have “money illusion” and confuse money wage cuts with real wage cuts They are concerned about their position in the wage distribution—”if I accept a cut, others might not and I will be relatively worse off”

• Price flexibility would be restricted because Wage rigidities cited above would reduce the willingness of firms to accept lower prices for their products Businesses do not know if others would follow their price cuts. If not, my shareholders would get less income from sales while competitors would maintain income (unless consumer shifted to lower price firms)

140

Keynes’s Prescription: An Expansionary Monetary Policy

• The Central Bank should reduce interest rates (the bank rate in England, the discount rate in the U.S.) to stimulate business investment • In the U.S. this means expanding bank reserves by open market purchases of securities, or lending to banks through the discount window • This might not be sufficient if: there is a liquidity trap (the interest rate can’t be reduced enough) business investment does not respond sufficiently to interest rate reduction • The evidence suggests that there is no clear affirmation of a liquidity trap. However, business investment is not very sensitive to interest rates (though spending on home construction and on consumer durables is interest sensitive)

141

Keynes’s Prescription: Active Use of Fiscal Policy

• The federal government should increase government spending and cut income taxes This would help to restore aggregate demand through both its direct effects and through its multiplier and accelerator effects the direct effects are increased employment and capital utilization to produce goods for government use.

• The resulting increased federal deficit is not a problem when the economy has excess capacity

142

Why Aren’t We All Keynesians Now?

• Keynesian Analysis is useful only in the “Short Run” It rests on insufficient flexibility of wages and prices. In the long run, wage-price flexibility will work unless government policy intercedes Monetary and fiscal policy are short-run aids in hastening the return to full employment, though experience suggests that fiscal policy is less effective because of long lags in implementation Keynesian analysis assumes backward-looking expectations about future events.

• Keynesian Analysis Only Addresses Business Cycles Due to Shifts in Aggregate Demand—Aggregate Supply is Ignored Recent Cycles Have Been From Supply Shocks “Real business cycle” theories have focused on shocks to aggregate supply

143

Why Aren’t We All Keynesians Now?

• The Keynesian Focus on the Short Run Diverts Attention From Important Long Run Issues An increased government deficit, if not offset later, can create crowding out of business investment by government spending, thereby reducing the production of future consumer goods—this is the real cost of a deficit If the central bank monetizes the government debt in an effort to keep interest rates from rising, the result is an increase in the money supply and subsequent inflation Easy monetary policy might create inflation in the long run

• After the 1970s attention shifted away from short-term stabilization to long term growth

144

Milton FriedmanMilton Friedman

And And

““Monetarism”Monetarism”

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Milton Friedman (1912 – 2006)

• Career

Began His Career Was As A Loyal Keynesian, But Rejected Keynesianism In The 1950s Served As Government Economist During WWII Joined University Of Chicago Faculty In Received The Nobel Prize In Economcs in 1976

• Philosophy

Advocated Libertarian Philosophy With Minimal Intrusion Of Government In Economic Affairs Believed That The Business Cycle Was The Result Of “Monetary Mischief,” Rejecting The Keynesian Emphasis On “Animal Spirits”

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Milton Friedman (1912 – 2006)

• Major Scholarly Contributions

A Permanent Income Theory Of Consumer Spending (1957) Arguing That Consumption (Accounting For About 2/3 Of National Spending) Was Determined By Long-Term Expectations Of Future Income Capitalism And Freedom (1962), Advocating The Use Of Microconomic Analysis In The Analysis Of Public Policy A Monetary History Of The United States (1963), A Detailed Analysis Of Monetary Institutions And The Role Of “Money” In Inflation And Unemployment Published Hundreds Of Articles And Essays On Economic Theory And Policy

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