Sowell_Thomas_-_Basic_Economics_-_5th_Edition_2014

“the poor” can short-circuit this process by making it unnecessary for many peopleto work, and minimum wage laws can make it harder for the young to find work,costing them both current pay and the acquisition of human capital for the future.Similarly, the need to “think things, not words” makes the distinction betweenprivilege and achievement not simply a matter of semantics, but an urgent needfor clarity when making moral decisions. Privileges, which harm others, must bedistinguished from achievements, which benefit others and advance society as awhole.

Chapter 26

THE HISTORY OF ECONOMICS I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas. John Maynard Keynes{981} People have been talking about economic issues, and some writing aboutthem, for thousands of years, so it is not possible to put a specific date on whenthe study of economics began as a separate field. Modern economics is oftendated from 1776, when Adam Smith wrote his classic, The Wealth of Nations, butthere were substantial books devoted to economics at least a century earlier, andthere was a contemporary school of French economists called the Physiocrats,some of whose members Smith met while traveling in France, years before hewrote his own treatise on economics. What was different about The Wealth ofNations was that it became the foundation for a whole school of economists whocontinued and developed its ideas over the next two generations, including suchleading figures as David Ricardo (1772–1823) and John Stuart Mill (1806–1873),and the influence of Adam Smith has to some extent persisted on to the presentday. No such claim could be made for any previous economist, despite manypeople who had written knowledgeably and insightfully on the subject in earliertimes.

More than two thousand years ago, Xenophon, a student of Socrates,analyzed economic policies in ancient Athens.{982} In the Middle Ages, religiousconceptions of a “fair” or “just” price, and a ban on usury, led Thomas Aquinas toanalyze the economic implications of those doctrines and the exceptions thatmight therefore be morally acceptable. For example, Aquinas argued that sellingsomething for more than was paid for it could be done “lawfully” when the sellerhas “improved the thing in some way,” or as compensation for risk, or because ofhaving incurred costs of transportation.{983} Another way of saying the same thingis that much that looks like sheer taking advantage of other people is often in factcompensation for various costs and risks incurred in the process of bringing goodsto consumers or lending money to those who seek to borrow. However far economists have moved beyond the medieval notion of a fairand just price, that concept still lingers in the background of much present-daythinking among people who speak of things being sold for more or less than their“real” value and individuals being paid more or less than they are “really” worth, aswell as in such emotionally powerful but empirically undefined notions as price“gouging.” From more or less isolated individuals writing about economics thereevolved, over time, more or less coherent schools of thought, people writingwithin a common framework of assumptions—the medieval scholastics, of whomThomas Aquinas was a prominent example, the mercantilists, the classicaleconomists, the Keynesians, the “Chicago School,” and others. Individualscoalesced into various schools of thought even before economics became aprofession in the nineteenth century. THE MERCANTILISTS One of the earliest schools of thought on economics consisted of a group of

writers called the mercantilists, who flourished from the sixteenth through theeighteenth centuries. In a motley collection of writings, ranging from popularpamphlets to a multi-volume treatise by Sir James Steuart in 1767, themercantilists argued for policies enabling a nation to export more than it imports,causing a net inflow of gold to pay for the difference. This gold they equated withwealth. From this school of thought have come such present-day practices asreferring to an export surplus as a “favorable” balance of trade and a surplus ofimports as an “unfavorable” balance of trade—even though, as we have seen inearlier chapters, there is nothing inherently more beneficial about one than theother, and everything depends on the surrounding circumstances. The inevitable gropings of pioneers include inevitable ambiguities and errors—and economics was no exception. Some of the errors of the mercantilists, whichhave been largely expunged from the work of modern economists, still live on inpopular beliefs and political rhetoric. However, there is a coherence in the writingsof the mercantilists, if we understand their purposes, as well as their conceptionsof the world. The purposes of the mercantilists were not the same as those of moderneconomists. Mercantilists were concerned with increasing the power of their ownrespective nations relative to that of other nations. Their goal was not theallocation of scarce resources in a way that would maximize the standard of livingof the people at large. Their goal was gaining or maintaining a nationalcompetitive advantage in aggregate wealth and power over other nations, so asto be able to prevail in war, if war occurred, or to deter potential enemies by one’sobvious wealth that could be turned to military purposes. A hoard of gold wasideal for their purposes. In a typical mercantilist writing in 1664, Thomas Mun’s book England’sTreasure by Forraign Trade declared the cardinal rule of economic policy to be“to sell more to strangers yearly than wee consume of theirs in value.” Conversely,the nation must try to produce at home “things which now we fetch fromstrangers to our great impoverishing.”{984} Mercantilists focused on the relative

power of national governments, based on the wealth available to be used by their respective rulers. Mercantilists were by no means focused on the average standard of living of the population as a whole. Thus the repression of wages by imposing government control was considered by them to be a way of lowering the costs of exports, creating a surplus of exports over imports, which would bring in gold. The promotion of imperialism and even slavery was acceptable to some mercantilists for the same reason. The “nation” to them did not mean a country’s whole population. Thus Sir James Steuart could write in 1767 of “a whole nation fed and provided for gratuitously” by means of slavery.{985} Although slaves were obviously part of the population, they were not considered to be part of the nation. CLASSICAL ECONOMICSAdam Smith Within a decade after Sir James Steuart’s multi-volume mercantilist treatise, Adam Smith’s The Wealth of Nations was published and dealt a historic blow against mercantilist theories and the whole mercantilist conception of the world. Smith conceived of the nation as all the people living in it. Thus you could not enrich a nation by keeping wages down in order to export. “No society can surely be flourishing and happy, of which the far greater part of the members are poor and miserable,” Smith said.{986} He also rejected the notion of economic activity as a zero-sum process, in which one nation loses what another nation gains. To him, all nations could advance at the same time in terms of the prosperity of their respective peoples, even though military power—a major concern of the mercantilists—was of course relative and a zero-sum competition. In short, the mercantilists were preoccupied with the transfer of wealth,

whether by export surpluses, imperialism, or slavery—all of which benefit some atthe expense of others. Adam Smith was concerned with the creation of wealth,which is not a zero-sum process. Smith rejected government intervention in theeconomy to help merchants—the source of the name “mercantilism”—andinstead advocated free markets along the lines of the French economists, thePhysiocrats, who had coined the term laissez faire. Smith repeatedly excoriatedspecial-interest legislation to help “merchants and manufacturers,” whom hecharacterized as people whose political activities were designed to deceive andoppress the public.{987} In the context of the times, laissez faire was a doctrine thatopposed government favors to business. The most fundamental difference between Adam Smith and themercantilists was that Smith did not regard gold as being wealth. The very title ofhis book—The Wealth of Nations—raised the fundamental question of whatwealth consisted of. Smith argued that wealth consisted of the goods and serviceswhich determined the standard of living of the people{988}—the whole people,who to Smith constituted the nation. Smith rejected both imperialism and slavery—on economic grounds as well as moral grounds, saying that the “great fleetsand armies” necessary for imperialism “acquire nothing which can compensatethe expence of maintaining them.”{989} The Wealth of Nations closed by urgingBritain to give up dreams of empire.{990} As for slavery, Smith considered iteconomically inefficient, as well as morally repugnant, and dismissed withcontempt the idea that enslaved Africans were inferior to people of Europeanancestry.{991} Although Adam Smith is today often regarded as a “conservative” figure, hein fact attacked many of the dominant ideas and interests of his own times.Moreover, the idea of a spontaneously self-equilibrating system—the marketeconomy—first developed by the Physiocrats and later made part of the traditionof classical economics by Adam Smith, represented a radically new departure, notonly in analysis of social causation but also in seeing a reduced role for political,intellectual, or other elites as guides or controllers of the masses.

For centuries, landmark intellectual figures from Plato onward had discussedwhat policies wise leaders might impose for the benefit of society in various ways.But, in the economy, Smith argued that governments were giving “a mostunnecessary attention”{992} to things that would work out better if left alone to besorted out by individuals interacting with one another and making their ownmutual accommodations. Government intervention in the economy, whichmercantilist Sir James Steuart saw as the role of a wise “statesman,”{993} Smith sawas the notions and actions of “crafty” politicians,{994} who created more problemsthan they solved. While The Wealth of Nations was not the first systematic treatise oneconomics, it became the foundation of a tradition known as classical economics,which built upon Smith’s work over the next century. Not all earlier treatises weremercantilist by any means. Books by Richard Cantillon in the 1730s and byFerdinando Galiani in 1751, for example, presented sophisticated economicanalyses, and François Quesnay’s Tableau Économique in 1758, containedinsights that inspired the transient but significant school of economists called thePhysiocrats. But, as already noted, these earlier pioneers created no enduringschool of leading economists in later generations who based themselves on theirwork, as Adam Smith did. Here and there in history there have been a number of individual economistswho produced work well in advance of their times, but who attracted littleattention and had few followers—and who faded into obscurity until they wererediscovered by later generations of scholars as pioneers in their field. Frenchmathematician Augustin Cournot, for example, produced mathematical analysesof economic principles in 1838 that did not become part of the analytical tools ofeconomists until nearly a century later, when they were developed independentlyby economists of that later era. One of the consequences of Adam Smith’s economic theories, developed inopposition to the theories of the mercantilists, was an emphasis on downplayingthe role of money in the economy. This emphasis persisted throughout the era of

classical economics, which lasted nearly a century. Understandable as this opposition to the mercantilists was, in light of the mercantilists’ over-emphasis on the role of gold, which was money in many economies, the classical economists’ statements that money was only a “veil”—obscuring but not essentially changing the underlying real economic activities—were often misunderstood by those who read them. The leading classical economists understood that contractions in the money supply could create reduced production, and correspondingly increased unemployment, at a given time.{xxxvii} But this was not always clear to their readers, and the classical economists’ own attention was seldom focused in that direction.David Ricardo Among the followers of Adam Smith was the great classical economist David Ricardo, the leading economist of the early nineteenth century who, among other things, developed the theory of comparative advantage in international trade. In addition to his substantive contributions to economic analysis, Ricardo created a new approach and style in writing about economics. Adam Smith’s The Wealth of Nations was full of social commentary and philosophical observations, and closed with a strong suggestion that Britain should not try to hold on to its American colonies that were in rebellion the same year that his treatise was published. By contrast, David Ricardo’s Principles of Political Economy in 1817 was the first of the great classic works in economics to be devoted to analysis of enduring principles of economics, divorced from social, political and philosophical commentary, and emphasizing those principles more so than immediate policy issues. This is not to say that Ricardo had no interest in social or moral issues. Some of his analysis was inspired by the particular economic problems faced by Britain in the wake of the Napoleonic wars but the principles he derived were not confined to those problems or that era, any more than Newton’s law of gravity was confined to falling apples. Contemporary policy issues were simply not what

his Principles of Political Economy was about. What Ricardo brought to economics was a more narrowly focused system of analysis, using more sharply defined terms and more tightly reasoned analysis. David Ricardo was not simply a reasoning machine, however. In his personal actions and private correspondence, Ricardo showed himself to be a man of very high moral standards and social concerns. When he became a member of Parliament, Ricardo wrote to a friend: I wish that I may never think the smiles of the great and powerful a sufficient inducement to turn aside from the straight path of honesty and the convictions of my own mind.{995} As a member of Parliament, Ricardo lived up to his ideals. He voted repeatedlyagainst the interests of wealthy landowners, though he himself was one, and hevoted for election reforms which would have cost him his seat in Parliament.{xxxviii} What we today call “economics” was once called “political economy” up through much of the nineteenth century. When the classical economists referred to “political economy,” they meant the economics of the country as a whole—the polity—as distinguished from the economics of the household, or what might today be called “home economics.” The term “political economy” did not imply an amalgamation of economics and politics, as some have used that term in more recent times. The principles of economics did not spring forth, ready-made, in a flash of inspiration or genius. Instead, profound and conscientious thinkers in successive generations groped toward some kind of understanding of both the real world of economic activity and the intellectual concepts that would make it possible to study such things systematically. The supply and demand analysis that can be taught to today’s beginning students in a week took at least a century to emerge from the controversies among early nineteenth-century thinkers like David Ricardo, Thomas Malthus, and Jean-Baptiste Say. In one of many letters between Ricardo and his friend Malthus, discussing

economic issues over the years, Ricardo said in 1814: “I sometimes suspect that we do not attach the same meaning to the word demand.” He was right; they did not. {xxxix} It would be decades after both men had passed from the scene before the term could be clarified and defined precisely enough to mean what it means to economists today. What may seem like small steps in logic, after the fact, can be a long, time-consuming process of trial and error groping, while creating and refining concepts and definitions to express ideas in clear and unmistakable terms which allow substantive issues to be debated in terms that opposing parties can agree on, so that they can at least disagree on substance, rather than be frustrated by semantics.Say’s Law One of the fundamental concepts of economics, over which controversies raged in the early nineteenth century and were re-ignited by John Maynard Keynes in 1936, was what has been called Say’s Law. Named for French economist Jean-Baptiste Say (1767–1832), though other economists had a role in its development, Say’s Law began as a relatively simple principle whose corollaries and extensions grew ever more complex in the hands of both its advocates and its critics, during the controversies between the two in both the nineteenth and twentieth centuries. At its most basic, Say’s Law was an answer to perennial popular fears that the growing output of an economy could reach the point where it would exceed the ability of the people to buy it, leading to unsold goods and unemployed workers. Such fears were expressed, not only before the time of Jean-Baptiste Say, but also long afterward. As we have seen in Chapter 16, a best-selling writer of the 1960s warned of “a threatened overabundance of the staples and amenities and frills of life” which have become “a major national problem.”{996} What Say’s Law, in its most basic sense, argued was that the production of output, and the generation of real income for those producing that output, were not processes independent of

each other. Therefore, whether a nation’s output was large or small, the incomesgenerated in producing it would be sufficient to buy it. Say’s Law has often beenexpressed as the proposition that “supply creates its own demand.” In otherwords, there is no inherent limit to how much output an economy can produceand purchase. Say himself asked: “Otherwise, how could it be possible that there shouldnow be bought and sold in France five or six times as many commodities, as in themiserable reign of Charles VI?”{997} A similar idea had been expressed even earlierby one of the Physiocrats, that aggregate demand “has no known limits.”{998} This,of course, did not preclude the possibility that, as of any given time, consumers orinvestors might not choose to exercise all the aggregate demand that was in theirpower. What Say’s Law did preclude was the recurrent popular fear that the sheerrapid growth of output, with the rise of modern industry, would reach a pointwhere output would become so great that it would be impossible to buy it all. As often happens in the history of ideas, an initially very straightforwardconcept became extended in so many directions by its advocates, and embroiledin so many controversies by its opponents, that meanings and distortionsproliferated, even when the economists on both sides—which included virtuallyall the leading economists of the early nineteenth century—were earnest andintelligent thinkers who simply talked past each other. That was, in part, becauseeconomics had not yet reached the stage where the terms in which they spoke(“demand,” for example) had rigorous definitions agreed to by all. {xl} Howevertedious the students of a later time might find the process of rigorous definition,the history of economics—and of other fields—makes painfully clear theconfusing consequences of trying to discuss substantive issues without havingclear-cut terms that mean the same thing to all those who use those terms.

MODERN ECONOMICS Today we think of economics as a profession with academic departments,scholarly journals, and professional organizations like the American EconomicAssociation. But these are relatively late developments, as history is measured. It was centuries before economics became a separate subject, even thoughphilosophers from Aristotle to David Hume wrote knowledgeably about economicmatters, as did theologians like Thomas Aquinas and members of the nobility likeSir James Steuart. But, even after some writers began to specialize in economics,they did not immediately begin to earn their livings as economists. Adam Smith,for example, was a professor of philosophy, and achieved renown for his bookTheory of Moral Sentiments nearly twenty years before achieving lasting famefor The Wealth of Nations. David Ricardo was an independently wealthy retiredstockbroker when his writings made him the leading economist of his times.When Thomas R. Malthus was appointed a professor of history and politicaleconomy in 1805, he became the first academic economist in Britain and probablyin the world. Britain at that point produced most of the leading economists in theworld, and would continue to do so for the remainder of the nineteenth century. Aside from Malthus, most of the leading British economists of the first half ofthe nineteenth century did not derive a major part of their income from teachingor writing about economics. Economics was a specialty but not yet a career. Norwas it yet enough of a specialty to have its own professional journals. Mostleading analytical articles on economics during the first half of the nineteenthcentury were published in the intellectual periodicals of that era, such as theEdinburgh Review, the Quarterly Review or the Westminster Review in Britain orthe Revue Encyclopédique or the Annales de Législation et d’ÉconomiePolitique in France. The first scholarly journal devoted exclusively to economicswas the Quarterly Journal of Economics, first published at Harvard in 1886. Manymore such journals were then created in many countries in the twentieth century.

Those who wrote for these journals were overwhelmingly academic economists, with Americans now joining British, Austrian and other economists among the leaders of the profession. The first professor of economics in the United States was appointed by Harvard in 1871 and the first Ph.D. in economics was awarded by the same institution four years later.{999} From the time of Alfred Marshall’s Principles of Economics in 1890 onward, economics began increasingly to be expressed to the profession and taught to students with graphs and equations, though purely verbal presentations have not completely died out even today. It was in the second half of the twentieth century that mathematical analyses in economics began to supersede wholly verbal analyses in the leading academic journals and scholarly books. While predominantly mathematical economic analysis can be found as far back as Augustin Cournot in the 1830s, Cournot was one of those pioneers whose work made no impact on the dominant economists of his time, so that much of what he said had to be rediscovered, generations later, as if Cournot had never existed.The “Marginalist” Revolution One of the watersheds in the development of economic analysis in the nineteenth century was the widespread acceptance among economists of a price theory based on the demands of consumers, rather than just on the costs of producers. It was revolutionary not only as a theory of price but also in introducing new concepts and new methods of analysis that spread into other branches of economics. Classical economics had regarded the amount of labor and other inputs as crucial factors determining the price of the resulting output. Karl Marx had taken this line of thinking to its logical extreme with his theory of the exploitation of labor, which was seen as the ultimate source of wealth, and therefore as the ultimate source of the income and wealth of the non-working classes, such as capitalists and landowners.{xli}

Although the cost-of-production theory of value had prevailed in Englandsince the time of Adam Smith, an entirely different theory had prevailed incontinental Europe, where value was considered to be determined by the utility ofgoods to consumers, which was what would determine their demand. Smith,however, disposed of this theory by saying that water was obviously more usefulthan diamonds, since one could not live without water but many people livedwithout diamonds—and yet diamonds sold for far more than water.{1000} But, inthe 1870s, a new conception emerged from Carl Menger in Austria and W. StanleyJevons in England, both basing prices on the utility of goods to consumers—and,more important, refining and more sharply defining the terms of the debate, whileintroducing new concepts into economics in general. What Adam Smith had been comparing was the total utility of water versusthe total utility of diamonds. In other words, he was asking whether we would beworse off with no water or no diamonds. In that sense, the total utility of waterobviously greatly exceeded the total utility of diamonds, since water was a matterof life and death. But Menger and Jevons conceived of the issue in a new way—away that could be applied to many other analyses in economics besides pricetheory. First of all, Menger and Jevons conceived of utility as entirely subjective.{1001}That is, there was no point in third party observers declaring one thing to be moreuseful than another, because each consumer’s demand was based on what thatparticular consumer considered useful—and consumer demand was whataffected prices. More fundamentally, utility varies, even for the same consumer,depending on how much of particular goods and services that consumer alreadyhas. Carl Menger pointed out that an amount of food necessary to sustain life isenormously valuable to everyone. Beyond the amount of food necessary to avoidstarving to death, there was still value to additional amounts necessary for health,even though not as high a value as to the amount required to avoid death, andthere was still some value to food to be eaten just for the pleasure of eating it. But

eventually “satisfaction of the need for food is so complete that every furtherintake of food contributes neither to the maintenance of life nor to thepreservation of health—nor does it even give pleasure to the consumer.”{1002} Inshort, what mattered to Menger and Jevons was the incremental utility, whatAlfred Marshall would later call the “marginal” utility of additional unitsconsumed. Returning to Adam Smith’s example of water and diamonds, the relativeutilities that mattered were the incremental or marginal utility of having anothergallon of water compared to another carat of diamonds. Given that most peoplewere already amply supplied with water, the marginal utility of another carat ofdiamonds would be greater—and this would account for a carat of diamondsselling for more than a gallon of water. This ended the difference between thecost-of-production theory of value in England and the utility theory of value incontinental Europe, as economists in both places now accepted the marginalutility theory of value, as did economists in other parts of the world. Essentially the same analysis and conclusions that Carl Menger reached inAustria in his 1871 book Principles of Economics appeared at the same time inEngland in W. Stanley Jevons’ book The Theory of Political Economy. WhatJevons also saw, however, was how the concept of incremental utility was readilyexpressed in graphs and differential calculus, making the argument more visiblyapparent and more logically rigorous than in Menger’s purely verbal presentation.This set the stage for the spread of incremental or marginal concepts to otherbranches of economics, such as production theory or international trade theory,where graphs and equations could more compactly and more unambiguouslyconvey such concepts as economies of scale or comparative advantage. This has been aptly called “the marginalist revolution,” which marked a breakwith both the methods and the concepts of the classical economists. Thismarginalist revolution facilitated the increased use of mathematics in economicsto express cost variations, for example, in curves and to analyze rates of change ofcosts with differential calculus. However, mathematics was not necessary for

understanding the new utility theory of value, for Carl Menger did not use a singlegraph or equation in his Principles of Economics. Although Menger and Jevons were the founders of the marginal utilityschool in economics, and pioneers in the introduction of marginal concepts ingeneral, it was Alfred Marshall’s monumental textbook Principles of Economics,published in 1890, which systematized many aspects of economics around thesenew concepts and gave them the basic form in which they have come down topresent-day economics. Jevons had been especially at pains to reject the notionthat value depends on labor, or on cost of production in general, but insisted thatit was utility which was crucial.{1003} Alfred Marshall, however, said: We might as reasonably dispute whether it is the upper or the under blade of a pair of scissors that cuts a piece of paper, as whether value is governed by utility or cost of production.{1004} In other words, it was the combination of supply (dependent on the cost ofproduction) and demand (dependent on marginal utility) which determinedprices. In this and other ways, Marshall reconciled the theories of the classicaleconomists with the later marginalist theories to produce what became known asneo-classical economics. His Principles of Economics became the authoritativetext and remained so on into the first half of the twentieth century, going througheight editions in his lifetime.{xlii} That Alfred Marshall was able to reconcile much of classical economics withthe new marginal utility concepts was not surprising. Marshall was highly trainedin mathematics and first learned economics by reading Mill’s Principles ofPolitical Economy. In 1876, he called it “the book by which most living Englisheconomists have been educated.”{1005} Before that, Alfred Marshall had been astudent of philosophy, and was critical of the economic inequalities in society,until someone told him that he needed to understand economics before makingsuch judgments. After doing so, and seeing circumstances in a very different light,his continuing concern for the poor then led him to change his career and become

an economist. He afterwards said that what social reformers needed were “cool heads” as well as “warm hearts.”{1006} As he was deciding what career to pursue, “the increasing urgency of economic studies as a means towards human well- being grew upon me.”{1007}Equilibrium Theory The increased use of graphs and equations in economics made it easier to illustrate such things as the effects of shortages and surpluses in causing prices to rise or fall. It also facilitated analyses of the conditions in which prices would neither rise nor fall—what have been called “equilibrium” conditions. Moreover, the concept of “equilibrium” applied to many things besides prices. There could be equilibrium in particular firms, whole industries, the national economy or international trade, for example. Many people unfamiliar with economics have regarded these equilibrium conditions as unrealistic in one way or another, because they often seem different from what is usually observed in the real world. But that is not surprising, since the real world is seldom in equilibrium, whether in economics or in other fields. For example, while it is true that “water seeks its own level,” that does not mean that the Atlantic Ocean has a glassy smooth surface. Waves and tides are among the ways in which water seeks its own level, as are waterfalls, and all these things are in motion at all times. Equilibrium theory allows you to analyze what that motion will be like in various disequilibrium situations found in the real world. Similarly, students in medical school study the more or less ideal functioning of various body parts in healthy equilibrium, but not because body parts always function ideally in healthy equilibrium—since, if that were true, there would then be no reason to have medical schools in the first place. In other words, the whole point of studying equilibrium is to understand what happens when things are not in equilibrium, in one particular way or in some other way. In economics, the concept of equilibrium applies not only in analyses of

particular firms, industries or labor markets, but also in the economy as a whole. Inother words, there are not only equilibrium prices or wages but also equilibriumnational income and equilibrium in the balance of trade. The analysis ofequilibrium and disequilibrium conditions in particular markets has becomeknown as “microeconomics,” while analyses of changes in the economy as awhole—such as inflation, unemployment or rises and falls in total output—became known as “macroeconomics.” However, this convenient divisionoverlooks the fact that all these elements of an economy affect one another.Ironically, it was two Soviet economists, living in a country with a non-marketeconomy, who saw a crucial fact about market economies when they said:“Everything is interconnected in the world of prices, so that the smallest change inone element is passed along the chain to millions of others.”{1008} For example, when the Federal Reserve System raises the interest rate onborrowed money, in order to reduce the danger of inflation, that can cause homeprices to fall, savings to rise, and automobile sales to decline, among many otherrepercussions spreading in all directions throughout the economy. Following allthese repercussions in practice is virtually impossible, and even analyzing it intheory is such a challenge that economists have won Nobel Prizes for doing so.The analysis of these complex interdependencies—whether microeconomic ormacroeconomic—is called “general equilibrium” theory. It is what J.A.Schumpeter’s History of Economic Analysis called a recognition of “this all-pervading interdependence” that is the “fundamental fact” of economic life.{1009} The landmark figure in general equilibrium theory was French economistLéon Walras (1834–1910), whose complex simultaneous equations essentiallycreated this branch of economics in the nineteenth century. Back in theeighteenth century, however, another Frenchman, François Quesnay (1694–1774),was groping toward some notion of general equilibrium with a complex tableintersected by lines connecting various economic activities with one another.{1010}Karl Marx, in the second volume of Capital, likewise set forth various equationsshowing how particular parts of a market economy affected numerous other parts

of that economy.{1011} In other words, Walras had predecessors, as most great discoverers do, but he was still the landmark figure in this field. While general equilibrium theory is something that can be left for advanced students of economics, it has some practical implications that can be understood by everyone. These implications are especially important because politicians very often set forth a particular economic “problem” which they are going to “solve,” without the slightest attention to how the repercussions of their “solution” will reverberate throughout the economy, with consequences that may dwarf the effects of their “solution.” For example, laws setting a ceiling on the interest rate that can be charged on particular kinds of loans, or on loans in general, can reduce the amount of loans that are made, and change the mixture of people who can get loans—lower income people being particularly disqualified—as well as affecting the price of corporate bonds and the known reserves of natural resources, {xliii} among other things. Virtually no economic transaction takes place in isolation, however much it may be seen in isolation by those who think in terms of creating particular “solutions” to particular “problems.”Keynesian Economics The most prominent new developments in economics in the twentieth century were in the study of the variations in national output from boom times to depressions. The Great Depression of the 1930s and its tragic social consequences around the world had as one of its major and lasting impacts an emphasis on trying to determine how and why such calamities happened and what could be done about them. {xliv} John Maynard Keynes’ 1936 book, The General Theory of Employment Interest and Money, became the most famous and most influential economics book of the twentieth century. By mid-century, it was the prevailing orthodoxy in the leading economics departments of the world—with the notable exception of the University of Chicago and a few other economics departments in

other universities largely staffed or dominated by former students of MiltonFriedman and others in the “Chicago School” of economists. To the traditional concern of economics with the allocation of scarceresources which have alternative uses, Keynes added as a major concern thoseperiods in which substantial proportions of a nation’s resources—including bothlabor and capital—are not being allocated at all. This was certainly true of thetime when Keynes’ General Theory was written, the Great Depression of the1930s, when many businesses produced well below their normal capacity and asmany as one-fourth of American workers were unemployed. While writing his magnum opus, Keynes said in a letter to George BernardShaw: “I believe myself to be writing a book on economic theory which will largelyrevolutionize—not, I suppose, at once but in the course of the next ten years—the way the world thinks about economic problems.”{1012} Both predictions provedto be accurate. However, the contemporary New Deal policies in the United Stateswere based on ad hoc decisions, rather than on anything as systematic asKeynesian economics. But, within the economics profession, Keynes’ theories notonly triumphed but became the prevailing orthodoxy. Keynesian economics offered not only an economic explanation of changesin aggregate output and employment, but also a rationale for governmentintervention to restore an economy mired in depression. Rather than wait for themarket to adjust and restore full employment on its own, Keynesians argued thatgovernment spending could produce the same result faster and with fewerpainful side-effects. While Keynes and his followers recognized that governmentspending entailed the risk of inflation, especially when “full employment” becamean official policy, it was a risk they found acceptable and manageable, given thealternative of unemployment on the scale seen during the Great Depression. Later, after Keynes’ death in 1946, empirical research emerged suggestingthat policy-makers could in effect choose from a menu of trade-offs between ratesof unemployment and rates of inflation, in what was called the “Phillips Curve,” inhonor of economist A.W. Phillips of the London School of Economics, who had

developed this analysis.Post-Keynesian Economics The Phillips Curve was perhaps the high-water mark of Keynesian economics. However, the Chicago School began chipping away at the Keynesian theories in general and the Phillips Curve in particular, both analytically and with empirical studies. In general, Chicago School economists found the market more rational and more responsive than the Keynesians had assumed—and the government less so, at least in the sense of promoting the national interest, as distinguished from promoting the careers of politicians. By this time, economics had become so professionalized and so mathematical that the work of its leading scholars was no longer something that most people, or even most scholars outside of economics, could follow. What could be followed, however, was the slow erosion of the Keynesian orthodoxy, especially after the simultaneous rise of inflation and unemployment to high levels during the 1970s undermined the notion of the government making a trade-off between the two, as suggested by the Phillips Curve. When Professor Milton Friedman of the University of Chicago won a Nobel Prize in economics in 1976, it marked a growing recognition of non-Keynesian and anti-Keynesian economists, such as those of the Chicago School. By the last decade of the twentieth century, a disproportionate share of the Nobel Prizes in economics were going to economists of the Chicago School, whether located on the University of Chicago campus or at other institutions. The Keynesian contribution did not vanish, however, for many of the concepts and insights of John Maynard Keynes had now become part of the stock in trade of economists in all schools of thought. When John Maynard Keynes’ picture appeared on the cover of the December 31, 1965 issue of Time magazine, it was the first time that someone no longer living was honored in this way. There was also an accompanying story inside the magazine:

Time quoted Milton Friedman, our leading non-Keynesian economist, as saying, “We are all Keynesians now.” What Friedman had actually said was: “We are all Keynesians now and nobody is any longer a Keynesian,” meaning that while everyone had absorbed some substantial part of what Keynes taught no one any longer believed it all.{1013} While it is tempting to think of the history of economics as the history of asuccession of great thinkers who advanced the quantity and quality of analysis inthis field, seldom did these pioneers create perfected analyses. The gaps,murkiness, errors and shortcomings common to pioneers in many fields were alsocommon in economics. Clarifying, repairing and more rigorously systematizingwhat the giants of the profession created required the dedicated work of manyothers, who did not have the genius of the giants, but who saw many individualthings more clearly than did the great pioneers. David Ricardo, for example, was certainly far more of a landmark figure in thehistory of economics than was his obscure contemporary Samuel Bailey, but therewere a number of things that Bailey expressed more clearly in his analysis ofRicardian economics than did Ricardo himself.{1014} Similarly, in the twentiethcentury, Keynesian economics began to be developed and presented withconcepts, definitions, graphs and equations found nowhere in the writings ofJohn Maynard Keynes, as other leading economists extended the analysis ofKeynesian economics to the profession in scholarly writings, and its presentationto students in textbooks, using devices that Keynes himself never used orconceived. THE ROLE OF ECONOMICS Among the questions often raised about the history of economic analysis are:

(1) Is economics scientific or is it just a set of opinions and ideological biases? and (2) Do economic ideas reflect surrounding circumstances and events and change with those circumstances and events?Scientific Analysis There is no question that economists as individuals have their own respective preferences and biases, as do all individuals, including mathematicians and physicists. But the reason mathematics and physics are not considered to be mere subjective opinions and biased notions is that there are accepted procedures for testing and proving beliefs in these disciplines. It is precisely because individual scientists are likely to have biases that scientists in general seek to create and agree upon scientific methods and procedures that are unbiased, so that individual biases may be deterred or exposed. In economics, the preferences of Keynesian economists for government intervention and of University of Chicago economists for relying on markets instead of government, may well have influenced their respective initial reactions to the analysis and data of the Phillips Curve, for example. But the fact that both Keynesian economists and economists of the Chicago School shared a common set of analytical and empirical procedures in their professional work enabled them to reach common conclusions as more data came in over time, undermining the Phillips Curve. Controversies have raged in science, but what makes a particular field scientific is not automatic unanimity on particular issues but a commonly accepted set of procedures for resolving differences about issues when there are sufficient data available. Einstein’s theory of relativity was not initially accepted by most physicists, nor did Einstein want it accepted without some empirical tests. When the behavior of light during an eclipse of the sun provided a test of his theory, the unexpected results convinced other scientists that he was right. A leading historian of science, Thomas Kuhn, has argued that what distinguishes

science from other fields is that mutually contradictory theories cannot co-existindefinitely in science but that one or the other must prevail, and the othersdisappear, when enough of the right data become available.{1015} Thus the phlogiston theory of combustion gave way to the oxygen theory ofcombustion and the Ptolemaic theory of astronomy gave way to the Copernicantheory. The history of ideologies, however, is quite different from the history ofscience. Mutually contradictory ideologies can co-exist for centuries, with noresolution of their differences in sight or perhaps even conceivable.{xlv} What scientists share is not simply agreement on various conclusions but,more fundamentally, agreement about the ways of testing and verifyingconclusions, beginning with a careful and strict definition of the terms being used.The crucial importance of definitions in economics has been demonstrated, forexample, by the fallacies that result when popular discussions of economicpolicies use a loose term like “wages” to refer to such different things as wagerates per unit of time, aggregate earnings of workers, and labor costs per unit ofoutput.{xlvi} As noted in Chapter 21, a prosperous country with higher wage ratesper unit of time may have lower labor costs per unit of output than a Third Worldcountry where workers are not paid nearly as much. Mathematical presentations of arguments, whether in science or economics,not only make these arguments more compact and their complexities easier tofollow than a longer verbal presentation would be, but can also make theirimplications clearer and their flaws harder to hide. For example, when preparing alandmark 1931 scholarly article on economics, one later reprinted for decadesthereafter, Professor Jacob Viner of the University of Chicago instructed adraftsman on how he wanted certain complex cost curves constructed. Thedraftsman replied that one of the set of curves with which Professor Viner wantedto illustrate the analysis in his article was impossible to draw with all thecharacteristics that Viner had specified. As Professor Viner later recognized, he had asked for something that was“technically impossible and economically inappropriate,” because some of the

assumptions in his analysis were incompatible with some of his otherassumptions.{1016} That flaw became apparent in a mathematical presentation ofthe argument, whereas mutually incompatible assumptions may co-existindefinitely in an imprecise verbal presentation. Systematic analysis of carefully defined terms and the systematic testing oftheories against empirical evidence are all part of a scientific study in many fields.Clearly, economics has advanced in this direction in the centuries since itsbeginnings. However, economics is scientific only in the sense of having some ofthe procedures of science. But the inability to conduct controlled experimentsprevents its theories from having the precision and repeatability often associatedwith science. On the other hand, there are other fields with a recognized scientificbasis which also do not permit controlled experiments, astronomy being oneexample and meteorology being another. Moreover, there are different degrees ofprecision among these fields. In astronomy, for example, the time when eclipses will occur can bepredicted to the second, even centuries ahead of time, while meteorologists havea high error rate when forecasting the weather a week ahead. Although no one questions the scientific principles of physics on whichweather forecasting is based, the uncertainty as to how the numerouscombinations of factors will come together at a particular place on a particular daymakes forecasting a particular event that day much more hazardous thanpredicting how those factors will interact if they come together. Presumably, if a meteorologist knew in advance exactly when a warm andmoisture-laden air mass moving up from the Gulf of Mexico would encounter acold and dry air mass moving down from Canada, that meteorologist would beable to predict rain or snow in St. Louis to a certainty, since that would be nothingmore than the application of the principles of physics to these particularcircumstances. It is not those principles which are uncertain but all the variableswhose behavior will determine which of those principles will apply at a particularplace at a particular time.

What is scientifically known is that the collision of cold dry air and warm moist air does not produce sunny and calm days. What is unknown is whether these particular air masses will arrive in St. Louis at the same time or pass over it in succession—or both miss it completely. That is where statistical probabilities are calculated as to whether they will continue moving at their present speeds and without changing direction. In principle, economics is much like meteorology. There is no example in recorded history in which a government increased the money supply ten-fold in one year without prices going up. Nor does anyone expect that there ever will be. The effects of price controls in creating shortages, black markets, product quality decline, and a reduction in auxiliary services, have likewise been remarkably similar, whether in the Roman Empire under Diocletian, in Paris during the French Revolution or in the New York housing market under rent control today. Nor has there been any fundamental difference whether the price being controlled was that of housing, food, or medical care. Controversies among economists make news, but that does not mean that there are no established principles in this field, any more than controversies among scientists mean that there is no such thing as established principles of chemistry or physics. In both cases, these controversies seldom involve predicting what would happen under given circumstances but forecasting what will in fact happen in circumstances where there are too many combinations and permutations of factors for the outcome to be completely foreseen. In short, these controversies usually do not involve disagreement about fundamental principles of the field but about how all the trends and conditions will come together to determine which of those principles will apply or predominate in a particular set of circumstances.Assumptions and Analysis Among the many objections made against economics have been claims that

it is “simplistic,” or that it assumes too much self-interested and materialistic rationality, or that the assumptions behind its analyses and predictions are not a true depiction of the real world. Some of the problems of declaring something “simplistic” have already been dealt with in Chapter 4. Implicit in the term “simplistic” is that a particular explanation is not just simple but too simple. That only raises the question: Too simple for what? If the facts consistently turn out the way the explanation predicts, then it has obviously not been too simple for its purpose—especially if the facts do not turn out the way a more complicated or more plausible-sounding explanation predicts. In short, whether or not any given explanation is too simple is an empirical question that cannot be decided in advance by how plausible, complex, or nuanced an explanation seems on the face of it, but can only be determined after examining hard evidence on how well its predictions turn out. {xlvii} A related attempt to determine the validity of a theory by how plausible it looks, rather than how well it performs when put to the test, is the criticism that economic analysis depicts people as thinking or acting in a way that most people do not think or act. But economics is ultimately about systemic results, not personal intentions or individual acts. Economists on opposite ends of the ideological spectrum have understood this. Karl Marx said that capitalists lower their prices when technological advances lower their costs of production, not because they want to, but because market competition forces them to.{1017} Adam Smith likewise said that the benefits of a competitive market economy are “no part” of capitalists’ intentions.{1018} As already noted in Chapter 4, Marx’s collaborator Engels said, “what each individual wills is obstructed by everyone else, and what emerges is something that no one willed.”{1019} It is “what emerges” that economics tries to predict and its success or failure is measured by that, not by how plausible its analysis looks at the outset.Bias and Analysis