Classical political economy

Pekka SutelaAalto University

05.03.2015b

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The Newton – Smith approach

• ”So divinely is the world organized that every one of us, in our place and time, is in balance with everything else.”

• - Goethe

”Adam Smith had many children but we do not know whom he would have recognised”

• Smith drafted an approach – surely not a paradigm – which prevailed in British economics and more generally until about 1870.– It had its predecessors– It is partial and difficult to be seen as fully consistent, but it did leave

plenty of fruitful questions– This is the beginning of a new science

• What then distinguishes economics from thinking about economic issues?– Aiming at consistency, logical, example-based or (later) mathematical

thinking– Tradition: an inherited theoretical framework – Some way of distinguishing betwen true and false sentences, including

debate (here Political Economy Club)

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• ”I regard the purely abstract investigations of political economy .. as of very minor importance compared with the great practical questions which the progress of democracy and the spread of socialist opinions are pressing on.” – John Stuart Mill

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Thomas Malthus (1766-1834)

• Priest, first British professor in economics 1805-, and a best-selling author

• Population– Population tends to grow (due to ”passion between

sexes”) fast (”geometric series”) while food (”food is necessary”) grows slowly (”arithmetic series”)

– Therefore standard of living tends toward subsistence minimum, and hunger and disease (misery) restrict population accordingly

– This became known as ”the iron law of wages”

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Malthus: continued– Birth control is a sin – other economists tended to disagree on this– Political economy came to be called dismal science– But basically Malthus gave an accurate description for Europe

before 18th century. Modern literature uses the term ”Malthusian state” for this period. Living standard of an English land labourer was in early 19th century hardly better than that of a Roman slave (Clark 2007)

– But did Malthus not notice that times were a-changing? – Smith did not predict the future: he was fighting a battle against old

institutions and trusted the natural cause of things, as established by God

– Malthus at least came very close to saying that things could not change

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Malthus: his conclusions• Supporting the poor would lead to increased births and would thus

be self-defeating. The essential goal was lower fertility. • Britain should not import cheaper foreign grain as that would

endanger food self-sufficiency. – Also, logically at least, the iron law of wages would again push wages to

minimum subsistance • Against Say’s Law

– Economists generally believed in Jean-Baptiste Say (1803): supply in the aggregate always creates its demand

– Precursor of circular flow of income -thinking • Malthus: Aggregate demand could be too low causing unemployment

(compare with Keynes)– Therefore a land-owning class was needed: they did not produce anything

but consumed a lot...

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David Ricardo (1772-1823)

• A wealthy rentier, member of parliament, a ”one book economist” – with three editions though

• Perhaps the first one who – clearly thought within a (even if an informal) model – and used counterfactual arguments to prove the opposite

• Like Malthus did not aim at a general presentation but concentrated on – Value, income distribution and growth– Taxation– Other topics

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Value and income distribution

• The amount of labour used, not its price determines relative prices– But what is the relation between labour value and natural

price when there are other factors of production?– Capital has been produced by labour: it is cristallized labour.

However, capital is formed slowly and there is an impact of time in its price (some 6-7%). Therefore Ricardo has been characterised as holding a ”93% labour theory of value” (George Stigler)

– Land rent is (like in Smith) a residual, not something creating natural price

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Stationary state• As population grows agriculture must go to lands which are more

difficult to utilise (less productive or more distant).• Marginal production costs increase. They determine grain price, and the

share of land rent in costs increases. As wages are down to subsistence minimum profits must decrease. As investment is financed from profits, growth must slow down until the economy reaches zero growth or stationary state.

• Some more dismal science here! • This however is a counterfactual argument. Stationary state can be

prevented by– Allowing imports of cheaper grain– Improving agrarian productivity through technical improvements– <=> Ricardo’s aim was to show that these should to be done to prevent a

dismal future

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With persuasive arguments buying a seat in Parliament came naturally...

• The three-class model with population growth implied very clear key policy conclusions:– Liberalize imports of cheaper foreign grain– Further techical progress in agriculture

• So, Ricardo bought a seat in the Parliament and became prominent in British politics– Buying a seat was both possible and an established tradition

in pre-democratic Britain• In practice, buy a village!• Ricardo could well afford this, as knowing the outcome of the

battle of Waterloo before the others helped to make a fortune by selling his French (!) war debt in London (!) markets

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Ricardo and foreign trade

• Tackling trade theory was the natural next step– Buying cheap foreign grain is good for the country, but what

about specialization in general?• In Smith, free trade promotes division of labour and is

therefore good for efficiency• Smith´s trade theory was rudimentary. He writes about

absolute advantage (country A is more efficient in producing good 1, country B in producing good 2). Therefore country A should specialize in producing good 1 and B good 2. But how about when country A is more efficient in producing both goods?

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Relative advantageLabour hours needed to produce

Cloth Wine Relative price of wine / cloth

England 100 120 1.2

Portugal 90 80 0.89

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• Portugal is more efficient in producing both cloth and wine. It should specialize in wine as the productivity advantage is there relatively bigger.

• Britain should specialize in cloth as its disadvantage is there relatively less.

• But note that like Smith wrote about deer and beaver, Ricardo writes about grain and wine.– Where is the emphasis on industrial revolution

already very evident by the time?

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Economics and foreign trade, continued

• British political economists strongly promoted free trade. Those in other countries tended to disagree.– Germany: Friedrich List

• the infant industry argument

– USA: importance of infrastructure investment, strongly promoted by the state

• Where does relative advantage come from?– Heckscher – Ohlin (Sweden, early 20th century)

• Resource endowments

– Krugman (USA, late 20th century)• Historical coincidence, economies of scale, imperfect competition

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Ricardo on taxes and machinery

• Taxes: Ricardo did not believe in what is now called the Ricardian equivalence – Robert Lucas (1970s): assume state wants to stimulate economy by

increasing public expenditure (trusting in the Keynesian multiplier effect on production). Whether public deficits are covered by higher taxes or increasing public debt does not matter. In both cases citizens understand that they are the final future payers, and adjust current consumption downwards. Thus, no fiscal multiplier exists.

– Ricardo: I understand that also state credits are paid by taxpayers. Ordinary citizens do not understand that and thus do not adjust consumption when public debt increases.

– Covering deficits with higher taxes, whose negative impact on consumption ordinary citizens understand is more honest and distorts behaviour less.

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”On machinery” (1821)• In early writings Ricardo had thought that the technical progress

he promoted would not create unemployment.– Displaced workers would find new jobs, as the economy was expanding

• Now he admits that this may not be so:– ”The opinion entertained by the labouring classes … is conformable to

the correct principles of political economy.”• The historical reference was to so-called Luddism (aka machinery-

breaking)– Luddism was not mad, but a desparate reaction when nothing else had

helped (so have E.P. Thompson and others argued)– The problem is still with us and obviously a complex one. (For a modern

discussion see Mokyr: The enlightened economy: An economic history of Britain 1700-1850, 2009).

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Concluding and renewing orthodoxy: John Stuart Mill (1806-1873)

• Leading intellectual of the time in Britain – Father James Mill (a well-known economist) set upon educating a child-genius

(greek at three, latin at eight..., economics at thirteen, nervous break-down at twenty)

– As a philosopher JS Mill was utilitarian– As an economist JS Mill was generaliser and renewer– He spread the message, also with a textbook: Principles of Political Economy

1848 (which dominated for some forty years)– Radical social activist: in particular promoting birth control and women’s

position in society (Harriet Taylor!)• Classical political economy grew highly complacent: ”Happily, there is

nothing in the laws of Value which remains for the present or any future writer to clear up; the theory of the subject is complete.” Similarly on money (cited above)

• Still JSM was an important bridge between the past and the future

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Why renewal?• JSM was open to developments in other disciplines, especially to the birth

of sociology. Auguste Comte (1789-1857) criticized the Ricardian abstractions of economics– JSM (1848): ”For practical purposes, Political Economy is inseparably intertwined

with many other branches of social philosophy. Except on matters of mere detail, there are perhaps no practical questions, even among those which approach nearest to the character of purely economic questions, which admit of being decided on economic premises only.”

– In this sense JSM reminds of Adam Smith• Regardless of what dismal science claimed the British economy had grown

fast and that was very visible. The price of grain declined already before import liberalization (by the Corn Laws of 1846).– This may the biggest single social reform (quite directly) due to arguments from

political economy. It took quarter of a century!– And remember free trade dominated only British thinking

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What did renewal mean?• Price theory moved from the labour theory of value towards supply and

demand analysis. • The distinction between productive and unproductive labour was watered

down by emphasising the usefulness of labour. • Ambivalent attitude to Say’s Law.

– On one hand JSM regards it as a principle evidently true– On the other he notes that in crises overproduction relative to amount of money (~

aggregate demand) does exist• Surprisingly JSM thought that Britain was just about to enter stationary

state. That would be no catastrophe. In a stationary state people would be freed from ever-present urge for more and they could concentrate on matters like justice and cultural pursuits. – Historically economics is no hymn for greed. The typical economist has been a

scholar with ascetic tendencies. (Keynes was an exception both in theory and in practice.)

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This may sound familiar...

• ”It is only in the backward countries of the world that increased production is still an important object: in those most advanced, what is economically needed is better distribution, of which one indispensable means is a strict restraint on population.”

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JS Mill and laissez faire• Proper role of the state is a practical issue always to be decided

separately. There are no general rules. Starting point is personal freedom and the burden of proof is always on those proposing state activism ( see On Liberty (1859)).– (Mill himself would have given state the authority to ban marriages

without sufficient means to support the family.) • Against Ricardian tradition supported (in 1848) on infant-industry

arguments protective tariffs (this he later came to regret perhaps due to the popularity of the argument in Germany)

• As public intellectual took economically grounded positions on practically all issues in the emerging industrial society. Saw the dividing line no longer between land and capital, but between capital and labour.

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Example: taxation

• Taxation should favour earned income. Preference order of tax bases: – Land ownership income due to ”natural reasons” – Gifts and inheritances– Housing and such– Income tax

• preferably to be used only in cases of national emergency

• Income tax– Flat rate beyond a threshold

• Incentives• Marginal utility of income is not declining

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”Social problem of the future”

• ”how to unite the greatest individual liberty of action with a common ownership of the raw materials of the globe, and an equal participation of all in the benefits of combined labour.”

John Stuart Mill in 1848 on preconditions for accelerated modernization

• …first, a better government: more complete security of property; moderate taxes, and freedom from the arbitrary exaction in the names of taxes… Secondly, improvement of the public intelligence: the decay of usages or superstitions which interfere with the effective employment of industry; and the growth of mental activity, making people alive to new objects of desire. Third, the introduction of foreign arts, which raise the returns derivable from additional capital, … and the importation of foreign capital, … and by installing new ideas and breaking the chain of habit… These considerations apply more or less to all Asiatic populations, and to the less civilized and industrious parts of Europe, as Russia, Spain, and Ireland.”

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Final words on classical political economy as enlightenment thinking

• ”The same age, which produces great philosophers and politicians, renowned generals and poets, usually abounds with skillful weavers and ship carpenters. We cannot reasonably expect, that a piece of woollen cloth will be wrought to perfection in a nation, which is ignorant of astronomy, or where ethics are neglected.” David Hume, 1752.

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• ”At the foundation of economic expansion lies the ability and willingness of society to expand and exploit the useful knowledge at its exposal and experience productivity growth. If it did so better and faster than its trading partners, it would therefore create the comparative advantage that drove Ricardo’s trade model (…). There can be no question that this is precisely what happened in the textile, iron and energy industries during the Industrial Revolution.” Joel Mokyr 2009.