ECO 4119 POLITICAL ECONOMY

Chapter 3

The Classical Liberal Perspective

Introduction• Classical Liberalism envisions society as an aggregation of

autonomous individuals seeking to pursue their private interests.

• All social interaction: voluntary exchanges among persons• Its focus on individual choice as the primary determinant of

social outcomes• The historical development of Classical Liberalism starts with

classical political economy, continues with the Austrian branch of neoclassical economics, and culminating in a variety of current bodies of thought including neo-Austrian economics, public choice theory, new classical economics, law and economics, new institutional economics, constitutional economics, libertarianism, supply-side economics, monetarism, and property-rights theory.

Architects of Classical Liberalism Thomas Hobbes (1588-1679) • English philosopher Thomas Hobbes was one of the first

social theorists to adopt the methods of the newly emerging natural sciences for the analysis of human behavior.

• The world as a mechanical system operating according to precise laws of nature.

• He aimed at uncovering the natural laws governing society by analyzing individual behavior.

• Humans need to satisfy their appetites and desires.• Nonmaterial desires such as the need for social

recognition can matter, but desires were best met by the pursuit of wealth.

Architects of Classical Liberalism • By starting his analysis with the isolated individual in a state of nature,

Hobbes portrayed society and government as secondary and artificial creations.

• The pursuit of private interests is presumed to be the only purpose of human existence, with politics merely a necessary activity to maintain social order.

• Hobbes rejected the earlier Aristotelian notion of political activity as the site of human development gained through participation in public life.

• Despite Hobbes’s strong commitment to individualism, he concluded that government must have absolute authority to establish and enforce laws.

• The title of Hobbes major book Leviathan (1651) has become synonymous with an authoritarian state.

• Thus, although Hobbes was a founder of Classical Liberalism, his conclusions about the scope of government authority have been rejected by subsequent Classical Liberals.

Architects of Classical Liberalism John Locke (1632-1704) • English philosopher and physician• Locke also assumed the self-interested and acquisitive nature

of humans, but he believed that the capacity for reason enabled people to discover “natural laws”.

• Natural laws serve as guides both for restraining the pursuit of self-interest and defining the proper role of government.

• Hobbes relied on government to establish and protect property rights. Locke claimed that property rights existed before government, so government’s authority was limited to protecting those natural rights.

• In “Two Treatises of Government (1689)” Locke believed that property rights were natural and therefore no person or government could legitimately violate them.

Architects of Classical Liberalism • His explanation of the origins of property rights seems to

support unlimited freedom to accumulate property and therefore substantial inequality.

• However, Locke attached two “provisos” to the right to obtain property: property must be used without spoilage or waste, and any claim to property is valid only when “there is enough, and as good left in common for others”.

• He argued that the use of money permits people to accumulate wealth without spoilage and that the “enough and as good” restriction becomes impractical once all valuable land in a country has been claimed.

Architects of Classical Liberalism • At the dawn of the capitalist era, liberal thinkers were confident

that individual rights and freedom would result in substantially more equality than had existed under feudal domination.

• Locke’s defense of freedom to accumulate wealth was not insensitive to those who lacked property.

• He argued that private property benefits all persons in society; poor citizens are better off as wage laborers in a private-property system than if they were living in a society with communal ownership.

• This shift from defending property as a natural right to defending property for its social benefits is the beginning of a split within Classical Liberalism that ultimately gave birth to a new perspective--Modern Liberalism.

Architects of Classical Liberalism

Adam Smith (1723-1790)•Adam Smith, a Scottish professor of moral philosophy, was the first to articulate Classical Liberalism in the form of economic theory rather than the political language of Hobbes and Locke.•In his first major work, The Theory of Moral Sentiments (1759), Smith argued that humans are able, through social interaction, to overcome their narrow self-interest and view situations from the perspective of an “impartial spectator”.•The human capacity for sympathy would restrain aggressive, selfish behavior and create a stable society.

Architects of Classical Liberalism • Motivated by these concerns, Smith turned his attention from

moral philosophy to political economy.• After being introduced to the idea of laissezfaire by a group of

French political economists known as the Physiocrats, he concluded that a market society could not only withstand the effects of acquisitive selfishness, but could actually steer this “vice” into productive and socially beneficial channels.

• Without meaning to do so, self-interested individuals actually promote the good of society by engaging their talents and resources in the most profitable use.

• By the time he published The Wealth of Nations in 1776, Adam Smith had substituted the market for individual conscience as the mechanism for reconciling self-interest with an orderly and prosperous society.

Architects of Classical Liberalism • Although Smith is often portrayed as the champion of

capitalism, he was not completely optimistic about the market.• He found self-interest compatible with the public good only

when competition prevailed, and he warned that businessmen would constantly seek to suppress competition and deceive the public to increase profits.

• Smith also expressed concern about the well-being of workers in a market economy.

• While he recognized the tremendous efficiency gained by dividing production into separate, routine tasks, he worried that the monotony and mindlessness of factory jobs would render workers “as stupid as it is possible for a human being to become”.

Architects of Classical Liberalism • Finally, Smith set the tone for subsequent classical

political economists with his fear that the dynamism and growth of a market society would eventually come to an end as profitable investment opportunities were exhausted.

• Adam Smith’s legacy has been his defense of free markets and nonintervention by government.

• Smith believed that government intervention should be limited to three functions: law enforcement, printing of money, and provision of certain public goods such as harbors and roads.

Architects of Classical Liberalism

Thomas Malthus (1766-1834) • A professor of history and political economy at the East

India College in England• In contrast to Enlightenment thinkers, Malthus believed

that human misery was caused by nature rather than badly organized institutions.

• In his book An Essay on the Principle of Population (1798), Malthus claimed that population grows at a faster rate than do food supplies because of the limited availability of fertile land.

Architects of Classical Liberalism • Malthus had little hope that humans would be capable of

exercising the restraint required to control population growth, so positive checks such as “famines, plagues, and wars” would be the effective controls on overpopulation.

• Moreover, Malthus believed that government should not attempt to interfere with the operation of these positive checks.

• In addition to rejecting efforts to help the poor, Malthus argued that the privileges and wealth of the upper classes benefitted all of society.

Architects of Classical Liberalism • Malthus represents a turning point in Classical Liberalism. • The Enlightenment attack on aristocratic privilege evolved

into a defense of capitalist inequality.• Later in the nineteenth century, Malthus’s ideas would

resurface as “social Darwinism”.• Relying on the evolutionary theory of Charles Darwin,

Herbert Spencer (1820-1903) in England and William Graham Sumner (1840-1910) in America claimed that the human species evolves according to the principle of “survival of the fittest”.

• Any attempts by government to aid the poor would cause deterioration of the human gene pool by allowing unfit members of the human species to survive and reproduce.

Architects of Classical Liberalism Friedrich A. Hayek (1899-1992) • He was born in Austria and spent most of his adult life in

England and America.• He devoted himself to defending laissez-faire capitalism

against the challenges posed by Conservatives, Modern Liberals, and Radicals.

• In The Road to Serfdom (1944), Hayek rejected the notion of a middle ground between capitalism and socialism; the concept of a “mixed economy” is untenable.

• Government intervention disrupts the smooth functioning of a free-market economy, thereby generating the need for additional corrective intervention.

• This vicious circle by which government-induced problems lead to a larger role for government will eventually push society toward socialism.

•

Architects of Classical Liberalism • He defended the market not because he believed in the power

of individual reason, but rather because of his skepticism about the capacity of the human mind to obtain knowledge.

• Since each person can have detailed knowledge of only a small portion of society, humans lack sufficient knowledge to plan or direct the entire economy.

• Hayek praised the market for upholding individual freedom and emphasized its ability to process and transmit vast amounts of information about individual preferences, availability of resources, and technology.

• Prices reflect the conditions underlying supply and demand, so individuals are able to compensate for their personal lack of knowledge by simply comparing prices.

Architects of Classical Liberalism • Hayek’s distrust of human reason led him to oppose virtually all

government activity on the grounds that politicians and bureaucrats cannot know what is best for society.

• Hayek warned that when government is permitted to expand its activities beyond the protection of property rights, it will inevitably become the tool of special interests.

• Hayek rejected the notion that economics can provide a scientific basis for predicting or attempting to control the future of the economy.

• The most that economics can accomplish is to demonstrate the wisdom of free markets and minimal government.

Architects of Classical Liberalism • Hayek also opposed efforts by economists to identify

market failures that might warrant government intervention.

• He claimed that the efficiency of the market in processing information, providing price signals to guide individual choice, and encouraging innovation more than offsets any inefficiency resulting from market failures.

• Government does not possess sufficient knowledge to improve the workings of the market.

• Intervention is likely to cause greater disruption than the market failure.

Architects of Classical Liberalism Robert Nozick (1938-2002) • A recent restatement of Classical Liberalism has been

undertaken by Harvard philosopher Robert Nozick in his book Anarchy, State, and Utopia (1974).

• Nozick argues that the free market will create justice in the distribution of rewards if the following three conditions are met: (1) property must be acquired without theft, fraud, or coercion; (2) transfers of property from one person to another must occur through

free exchanges, inheritance, gifts, or charity; (3) any property holdings failing to meet the first two requirements must

be “rectified” through redistribution.

• While Nozick defends laissez-faire in principle, his commitment to rectify past injustices leads him to acknowledge the legitimacy of redistributive policies.

Architects of Classical Liberalism • Nozick also dismisses any conception of justice linking reward

with individual merit. • Nozick’s definition of justice: “from each as they choose, to

each as they are chosen”.• Each person’s reward should be determined by his or her

choices of what to offer in the market and by other people’s choices to buy the person’s goods or services.

• So long as people are free to choose, markets will tend to generate inequality, but this inequality will be fair.

• Attempts by government to interfere with market distributions are the major cause of injustice.

• Taxation is slavery, it forces citizens to work for the government.

• The only legitimate role of government is as a “nightwatchman” protecting property rights and preserving individual liberty.

Principles of Classical Liberalism • The essential features of Classical Liberalism are

contained in the definitions it gives to some of the most controversial terms in political economy.

• Human Nature. Humans are self-interested and capable of acting autonomously by using their capacity for reason to discover the most efficient means to satisfy their needs and desires.

• Society. Society is an aggregation of individuals and has no goals or purposes of its own. The good society permits individuals to pursue their private interests free from arbitrary constraint.

Principles of Classical Liberalism • Government. Individuals create government for the

purpose of protecting their rights as established by a constitution. Beyond this function, government is best when it governs least.

• Morality. No objective method exists for discerning which values are superior to others; therefore, individuals should be free to determine right and wrong based on their personal preferences. The only valid social values are those that all citizens would support. Since nobody wants their property or civil rights to be violated, such violations are wrong and should be illegal.

Principles of Classical Liberalism • Freedom. Synonymous with autonomy and

independence, freedom is the absence of coercion by government or by other people.

• Authority. Legitimate authority arises only through the consent of individuals to relinquish a degree of their autonomy. For example, authority in the workplace may be consented to by employees in exchange for a wage. Authority by government may be consented to by citizens in exchange for protection of their rights to freedom and property.

• Equality. Equality means that all citizens have the same opportunity to engage in economic activity and the same civil rights as established by the constitution.

Principles of Classical Liberalism • Justice. Justice requires protection of property rights and

civil rights established by the constitution and punishment of those who violate the rights of others.

• Efficiency. Efficiency is a situation in which no person can be made better off without making someone else worse off. In other words, resources are allocated to those persons most willing and able to pay for them.

Classical Liberalism Today • The Great Depression of the 1930s dealt a crushing blow to

Classical Liberalism by persuading large numbers of citizens that the free market could not be trusted to organize economic activities.

• Until the 1970s, Classical Liberals were absent from public discourse. Exception: economics department at the University of Chicago.

• The 1970s, the crisis of the welfare state, high inflation+ high unemployment = resurgence of Classical Liberal thought.

• 1980s + 1990s: Reductions in government spending, taxes, regulations, and public ownership.

• Three of the most prominent schools of thought in contemporary Classical Liberalism: neo-Austrian economics, public choice theory, and new classical economics.

Classical Liberalism Today Neo-Austrian Economics • The conquest of Austria by the German army during

World War II forced many intellectuals in that country to emigrate.

• Ludwig von Mises (1881-1973) and Friedrich A. Hayek were the principle carriers of Austrian economics to England and the United States.

• Although neo-Austrians are committed to free markets and personal liberty, they reject the neoclassical assumption that individuals possess full information.

• If full information prevailed, then planners could conceivably replicate the market, and the defense of private property would be weakened.

Classical Liberalism Today • Shortcomings of the markets: monopolistic elements,

uncertainty, and externalities.• Their defense of the market rests not on its ability to allocate

resources efficiently at any single point in time, but on its role as an engine for discovering and applying knowledge that will raise standards of living.

• Markets provide best information and incentives to innovate. • No planning agency or bureaucracy can match the dynamism

of entrepreneurs in pushing technology forward.• Government intervention will almost always be detrimental

because government caters to special-interest groups rather than promoting the public good.

Classical Liberalism Today • They join with Radicals in rejecting the neoclassical effort

to create a scientific economics analogous to physics.• Neo-Austrians conclude that economics is largely a

completed project.• The aim is to persuade other economists, politicians, and

the public that laissez-faire is the best policy. • The neo-Austrian perspective has influenced mainstream

economics through the development of game theory to illuminate situations in which decisions must be made without full information.

Classical Liberalism Today Public Choice Theory • In recognition of the growing power of government in capitalist

societies, some Classical Liberal theorists have attempted to analyze political decision-making by applying the same principles of rational individual choice used to explain the actions of consumers and firms.

• Rejecting the Modern Liberal view of government as an impartial promoter of the wellbeing of society, public choice theorists claim that voters, bureaucrats, and politicians behave in the same fashion as do private consumers and producers: they pursue their private interests, seeking maximum utility at minimum cost.

• Citizens vote for candidates who will deliver the most benefits and the lowest taxes.

Classical Liberalism Today • Politics is viewed by public choice theorists as simply

economic activity conducted in the public sphere of government instead of the private sphere of the market.

• This approach to political economy is sometimes called the “Virginia school” because its leading proponents taught at the University of Virginia in the 1960s, moved to Virginia Polytechnic Institute in the 1970s, and finally established a permanent base at George Mason University in the 1980s.

• The most prominent public choice theorist is James Buchanan, winner of the Nobel Prize in economics in 1986.

Classical Liberalism Today • Public choice theorists uphold the Classical Liberal faith in

free markets, but they express concern that democratic politics creates an avenue by which individuals and groups can gain economic benefits while spreading costs among all taxpayers.

• Because individuals can be expected to pursue their interests by any means available, ending this abuse of democracy requires strict constitutional limits confining government to its appropriate role as protector of property rights.

Classical Liberalism Today New Classical Economics • When Keynesian policies faltered in the early 1970s, Classical

Liberals were quick to fill the theoretical void.• New classical economics describes the modern revival of

laissez-faire ideas from the nineteenth century.• Some of its leading proponents are Thomas Sargent, Neal

Wallace, Robert Lucas, and Robert Barro. • New classical economists focus on the role of expectations in

affecting individual behavior. • Sargent and Wallace developed the theory of “rational

expectations” to demonstrate the fallacy of Keynesian efforts to lower the rate of unemployment.

• Any deliberate effort by government to increase economic activity will be frustrated by the reactions of citizens seeking to defend their income against anticipated inflation.

Classical Liberalism Today • Closely related to new classical economics are two other theoretical

approaches: monetarism and supply-side economics.• The former, championed by Milton Friedman, seeks to revive the

classical idea that the amount of money in the economy affects prices but not the level of employment or output.

• Monetarists conclude that active monetary policy by the Federal Reserve System can have no positive impact on unemployment and therefore should be abandoned in favor of steady growth of the money supply at a rate sufficient to accommodate increases in real output.

• Supply-side economics is so named because it rejects the Keynesian focus on demand management and instead proposes to stimulate the economy through deregulation, tax cuts, and privatization.

• These policies mesh perfectly with the new classical goal of minimizing the size and role of government.

An Assessment of Classical Liberalism

• By undermining superstition, tradition, and arbitrary power, Classical Liberalism promoted a wider scope for individual expression and cultural diversity.

• Pursuit of self-interest: mainspring of social and economic progress.

• However, the changing nature of Western societies poses several challenges to Classical Liberalism’s commitment to the market as the primary institution for organizing society.

• First, industrialization and urbanization have contributed to a proliferation of “externalities” that cause the market to allocate resources inefficiently.

An Assessment of Classical Liberalism

• Second, the large-scale production required to take advantage of economies of scale associated with modern technology has proven subversive to effective competition.

• Without competition, the market contains no mechanism for guiding self-interest into socially useful channels.

• Third, the same self-interested behavior motivating individuals and firms to compete in the market also drives them to form groups and seek government protection against the competitive pressures and instability of the market.

• The resulting politicization of the economy can be reversed only by a government sufficiently powerful to override the groups benefitting from political activity.

An Assessment of Classical Liberalism

• Classical Liberals face the paradox that a very powerful government may be necessary to minimize the role of government.

• The question of whether such a government could be trusted to exercise its power judiciously remains unanswered.

• Finally, Classical Liberalism fails to adequately recognize the human desire for community and a sense of common purpose.

• Individuals want to pursue their private goals and achieve personal success, but they also exhibit commitments to collective goals and the quality of public life.

• In fact, with rising standards of living in Western societies, “quality of life” issues have become more significant.

• Personal income and wealth cannot secure a high-quality lifestyle when public life is deteriorating.