Quo Bono? . . .

My traditional training in economics involved lots of complex graphical analysis, advancing to differential calculus by grad school, measuring impacts on market equilibrium based on various conditions imposed by government, unions or monopoly, and their effect on firm profit or national wealth. I don’t think I ever saw a student ask a professor what all this graphical and formulaic analysis really meant, they were too busy making sure they understood it. But the only course I loved in high school was physics, so I was attracted to the field of economics, which seemed to consist of the application of calculus to broad social and political problems. The following is a little like eating vegetables for breakfast, or maybe rusty nails, but I think this is a pretty good, plain language explanation of the evolution of the major tenets of economic thought, and discussion of some of its limitations; a careful read should be worth the effort for non-specialists.

“Mercantilism” was a trade-based economic system predominant in Western Europe in the 16th-18th centuries. Mercantilism was based on the belief that the world’s wealth was fixed, so that nations must compete to increase their share of it, gaining wealth at the expense of competing nations’ loss of it; a zero-sum game. The mercantilist system was designed to protect domestic manufacturers that imported raw materials, used them to manufacture finished goods, then sold those products to other countries at a profit, thus increasing their firms’ and the nation’s wealth. The government protected domestic manufacturers by subsidizing manufacture of exports, and limiting competing imports through tariffs. The mercantilist system expanded internationally as imperialism, with colonies established under government control to extract and produce raw materials, which were imported for domestic manufacture of finished goods, and which were then sold back to both the colonies and other countries at a profit. Naval power was developed to defend colonial ports, insure access to foreign markets, and to protect trade routes. The wealth of a nation under the mercantilist system was measured by the monarch’s accumulation of precious metals, primarily silver and gold, in its treasury, and by the observable wealth of its supporting aristocracy, primarily major landowners endowed by the monarch.

“Classical” economics is based on a critique of the mercantilist system published in 1776 as “The Wealth of Nations” by Adam Smith, a British economist. This thesis is considered the philosophical foundation for the free market economic system in the industrialized world. Smith argued that economic inputs of land, labor and capital would be combined more efficiently with free competition and free trade, uncontrolled by government subsidies, tariffs, price controls and regulated manufacturing. Free competition and free markets would increase productivity among competing firms, lower the cost of production, and allow individuals, businesses, and nations to enjoy a greater range of goods, and at lower prices. In addition, while mercantilist countries were almost constantly engaged in warfare, battling over resources, trade routes, ports, and access to markets; nations operating under a free-trade system would prosper by engaging in mutually beneficial trade relations, without the military costs associated with mercantilism. These efficiencies in production costs, and savings in military expenditures, would combine to substantially increase overall national wealth. This was a “liberal” policy in comparison to mercantilism, allowing greater freedom of decision by entrepreneurs, investors and consumers, and would extend the benefits of increased national wealth beyond the monarchy and its supporting aristocracy, to the broader society.

“Marxist” economics is based on the critique of Classical economics presented by Karl Marx in his famous treatise “Das Kapital”, published in 1867, which was centered around the role of labor in the economy. Marx argued that a growing population and immigration would always provide a pool of surplus labor, and the increasing scale and efficiency of industry would lead to specialization of labor, so that a larger portion of the labor force would be relegated to worker status, with lower skill levels, and would be treated as a commodity. This industry would generate profit not by selling superior products at a higher price, but by paying workers less. Therefore, the price of goods in a free market does not account for the true value of labor, thus labor is not properly compensated under a free market system. Marx argued that capitalism consistently benefits the owners of capital, who become richer, concentrating wealth with a capitalist aristocracy, at the expense of depressed wages for labor, which would ultimately be relegated to subsistence levels of compensation. Marx believed that overcoming this condition, and achieving a fairer division of wealth, required political revolution by the working class, with production to be controlled by the state.

“Neo-Classical” economics advanced free market economic theory based largely on Alfred Marshall’s “Principles of Economics” published in 1890, with the argument that consumers, as rational decision makers, maximize the utility of their consumer choices, and therefore it is primarily consumer choice, not the cost of production, that determines the value of a product in the market. Marshall introduced graphical analysis to the study of economics in order to demonstrate new economic concepts, including supply and demand, equilibrium pricing, fixed and variable costs, elasticity, marginal cost and utility, economies of scale, and consumer and producer surplus. Neoclassical economic theory argues that firms are profit maximizers; that consumers are utility maximizers possessing full information; and that forces of supply and demand create market equilibrium pricing. Neo-Classical economic theory built on the Classical economic thesis that free market competition leads to the most efficient allocation of resources within an economy, maximizes national wealth, and provides full employment. 

“Keynesian” economics is based on John Maynard Keynes groundbreaking work “A General Theory of Employment, Interest and Money”, published in 1936. While Classical and Neoclassical economic theory held that natural economic forces would work in combination to recover full employment in normal business down-cycles; the depth, severity and longevity of the Great Depression severely tested this hypothesis. Keynes argued that once an economic downturn sets in, it can become a self-reinforcing downward cycle, engendering pessimism among consumers, businesses and investors, and can lead to a sustained period of depressed economic activity and mass unemployment. In such conditions, Keynes advocated a countercyclical government fiscal policy in which the government should reduce interest rates, reduce taxes, and undertake deficit government spending to make up for the decline in investment, employment and consumer spending in the private sector, thus recovering and stabilizing “aggregate demand”, stimulating the private economy to recovery to full employment. Keynes believed the government was in a better position to recover a depressed economy than private investors and businesses.

“Mainstream” economic theory has been widely accepted in industrialized nations with market based economic systems since 1950. Mainstream economics maintains core principles of Classical and Neo-Classical theory of rational firm and consumer behavior (“microeconomics”), and reconciles this approach with Keynesian approaches (“macroeconomics”) to stabilize business cycles through government fiscal and monetary policy. Mainstream economics has developed sophisticated graphical, mathematical and statistical modeling techniques, beneficial to policymakers, demonstrating basic points of supply, demand and equilibrium pricing under varying market conditions; the impact of government imposed constraints for wages, prices, tariffs, subsidies, etc; market failure such as monopolies and cartels; externalities such as pollution; and the benefit of various regulatory impositions designed to address these problems. .

Looking back, economic theories were not pure abstractions, around which economic systems were then designed. Rather, each stage of economic theory attempted to explain the real world around them, and to advance economic theory based on critique of previous theories; based on gaps between theory and the world around them; and based on social, political or technological changes; all in an effort to better organize human and natural resources. Advancing stages of economic theory were each in turn vetted through extensive public debate by economists, investors and politicians.

So what are the core elements of economic theory? First, theoretical stages of market economics have been organized around the principles of maximizing firm profit and national wealth; only Marx organized his theory around the value of labor. Second, wealth is not static, it is dynamic, new wealth can be created through improvements to application of land, labor and capital in economic processes; competition is the means to accomplish this in market economies. Third, just as regulation constrains economic growth; deregulation spurs economic growth, consistent with the primary goal of free market economics. Fourth, the government’s role in balancing business cycles through fiscal and monetary policy is well accepted in both theory and practice. Fifth, modern mainstream economics has synthesized the tenets of the evolving historic free market economic theories; has provided core graphical modeling to demonstrate those principles; and has developed sophisticated statistical modeling that assists policymakers in addressing various market failures.

Now for some problems. First, economic theory deals with the commercial economy; maximization of firm profit and national wealth; economic theory does not address the multiplicity of other critical dimensions of society; e.g., crime, pollution, labor unrest, health care, education, poverty, care for disabled, etc. Second, treatment of labor as one of three equivalent components (land, labor and capital) of the economic process, with its value determined by unfettered supply and demand, ignores the role of labor in the democratic political process, which can (and does) lead to major constraints on market function imposed by the government on labor’s behalf. Third, the assumption of modern mainstream economics, that consumers have full information in their decision making, may be true enough for theoretical treatment of simple goods, but it is certainly not true for complex goods and services, and puts consumers at a major disadvantage to firms in a market economy; this is a major constraint for all mainstream economic theory. Fourth, the limitations of mathematical and statistical methodology, data limitations, imprecision of measurement, and gaps between theory and observable real world conditions, leave even advanced economic theory trapped in its own methodological constraints, resulting in major debate over some policy implications.

Since Adam Smith’s work is the foundation for all subsequent stages of free market economic theory, it is important to emphasize that Smith was not arguing against a role for government in the economy, but against the mercantilist system then in place, designed for the benefit of the European monarchies, which he believed carried costs and inefficiencies that impaired the objective of enhanced overall national wealth.  Smith’s analysis was focused on the commercial sector of the economy; he did not question the need for government to maintain national defense and civil order; to organize the structure for the economy; to enforce laws and contracts; and to otherwise provide for the “common good”; he just did not address these areas, as they were not the subject of his treatise.

Marx is dismissed by mainstream economists because he does not share their assumptions, presents a different objective, and because his proposed solution requires the elimination of private markets; so the entire approach is wholly inconsistent with market-based economic systems.

The competitive market system in the commercial sector of the economy delivers on its theory, providing consumer choice, product utility and competitive pricing. But what one economics professor at Georgetown University called “the deification of the free market system” has led many to believe that this approach can be applied to the public and nonprofit sectors of the economy to positive result, examples abound in policy debates over health care and education.

The capital markets effectively redeploy capital to finance innovative technologies, shifting consumer preference, and reward improved operational strategies; thus continually enhancing firm productivity and consumer utility, the genesis for wealth creation and improved life quality in the broad economy. The challenge in this sector is to maintain effective regulation to protect the integrity of public information for investors in the capital markets, and preventing excesses that lead to speculative bubbles that can endanger the overall economy, a tendency Keynes called “the inherent instability of the financial markets”. I look at the role of the capital markets as the “locomotive” for the economy, continually moving capital around to new technological and operational innovation and shifting consumer preference, dynamic and healthy. But no one uses a locomotive to run around on its own, it has a purpose – to pull the whole train.

Marx shared the view of John Adams (see “Founders’ Findings”) that increasing scale of industry would depress wages for the working class and concentrate wealth in the capital class, generating a new form of permanent aristocracy, replacing that of the monarchical system that was just overthrown. So looking at our economic history in the late 19th century through the early 21st century, re-organization of mainstream economic theory around labor’s share of societal wealth seems well worth consideration, and I think is underway.