PENGUIN BOOKS

The Penguin History of Economics

Roger E. Backhouse was born in Suffolk in 1951and educated at the universities of Bristol (B.Sc. inEconomics and Economic History) and Birmingham(Ph.D. in Economics). Since 1996 he has beenProfessor of the History and Philosophy ofEconomics at the University of Birmingham, wherehe has taught since 1980. Previously he taughtEconomics at University College London (1975–7)and the University of Keele (1977–9). From 1998to 2000 he held a British Academy ResearchReadership. He has also taught courses in thehistory of economics at the universities of Bristol,Buckingham and Oporto. He is Associate Editor ofthe Journal of the History of Economic Thought andEditor of the Journal of Economic Methodology. Aswell as contributing articles on economics tonumerous journals, he is the author and editor ofmany books, including A History of ModernEconomic Analysis (1985), Economists and theEconomy (1988; second edition, 1994), Keynes:Contemporary Responses to the General Theory(1999), Exemplary Economists (co-editor with Roger

Middleton, 2000) and Toward a History of AppliedEconomics (co-editor with Jeff Biddle, 2000).

The Penguin History of Economics

Roger E. Backhouse

PENGUIN BOOKS

PENGUIN BOOKS

Published by the Penguin GroupPenguin Books Ltd, 80 Strand, London WC2R 0RL, EnglandPenguin Group (USA) Inc., 375 Hudson Street, New York, NewYork 10014, USAPenguin Books Australia Ltd, Ringwood, Victoria, AustraliaPenguin Books Canada Ltd, 10 Alcorn Avenue, Toronto, Ontario,Canada M4V 3B2Penguin Books India (P) Ltd, 11 Community Centre, PanchsheelPark, New Delhi – 110 017, IndiaPenguin Books (NZ) Ltd, Cnr Rosedale and Airborne Roads, Albany,Auckland, New ZealandPenguin Books (South Africa) (Pty) Ltd, 24 Sturdee Avenue,Rosebank 2196, South Africa

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First published 20029

Copyright © Roger E. Backhouse, 2002All rights reserved

The moral right of the author has been asserted

Except in the United States of America, this book is sold subject tothe condition that it shall not, by way of trade or otherwise, belent, re-sold, hired out, or otherwise circulated without thepublisher's prior consent in any form of binding or cover other thanthat in which it is published and without a similar conditionincluding this condition being imposed on the subsequent purchaser

ISBN: 978-0-14-193743-4

Contents

Acknowledgements

PrologueThe History of EconomicsWhat is Economics?Viewing the Past through the Lens of the

PresentThe Story Told Here

1 The Ancient WorldHomer and HesiodEstate Management – Xenophon's

OikonomikosPlato's Ideal StateAristotle on Justice and ExchangeAristotle and the Acquisition of WealthRomeConclusions

2 The Middle AgesThe Decline of RomeJudaism

Early ChristianityIslamFrom Charles Martel to the Black DeathThe Twelfth-Century Renaissance and

Economics in the UniversitiesNicole Oresme and the Theory of MoneyConclusions

3 The Emergence of the Modern WorldView – the Sixteenth CenturyThe Renaissance and the Emergence of

Modern ScienceThe ReformationThe Rise of the European Nation StateMercantilismMachiavelliThe School of Salamanca and American

TreasureEngland under the TudorsEconomics in the Sixteenth Century

4 Science, Politics and Trade inSeventeenth-Century EnglandBackground

Science and the Scientists of the RoyalSociety

Political FermentEconomic Problems – Dutch Commercial

Power and the Crisis of the 1620sThe Balance-of-Trade DoctrineThe Rate of Interest and the Case for Free

TradeThe Recoinage Crisis of the 1690sEconomics in Seventeenth-Century

England

5 Absolutism and Enlightenment inEighteenth-Century FranceProblems of the Absolute StateEarly-Eighteenth-Century Critics of

MercantilismCantillon on the Nature of Commerce in

GeneralThe EnlightenmentPhysiocracyTurgotEconomic Thought under the Ancien

Régime

6 The Scottish Enlightenment of theEighteenth CenturyBackgroundHutchesonHumeSir James SteuartAdam SmithDivision of Labour and the MarketCapital AccumulationSmith and Laissez-FaireEconomic Thought at the End of the

Eighteenth Century

7 Classical Political Economy, 1790–1870Utilitarianism and the Philosophic

RadicalsRicardian EconomicsFrom Moral Philosophy to Political

EconomyAlternatives to Ricardian EconomicsGovernment Policy and the Role of the

StateMoneyJohn Stuart Mill

Karl MarxConclusions

8 The Split between History and Theoryin Europe, 1870–1914The Professionalization of EconomicsJevons, Walras and Mathematical

EconomicsEconomics in Germany and AustriaHistorical Economics and the Marshallian

School in BritainEuropean Economic Theory, 1900–1914

9 The Rise of American Economics, 1870–1939US Economics in the Late Nineteenth

CenturyJohn Bates ClarkMathematical EconomicsThorstein VeblenJohn R. CommonsInter-War PluralismInter-War Studies of CompetitionThe Migration of European Academics

US Economics in the Mid TwentiethCentury

10 Money and the Business Cycle, 1898–1939Wicksell's Cumulative ProcessThe Changed Economic EnvironmentAustrian and Swedish Theories of the

Business CycleBritain: From Marshall to KeynesThe American TraditionKeynes's General TheoryThe Keynesian RevolutionThe Transition from Inter-War to Post-

Second World War Macroeconomics

11 Econometrics and MathematicalEconomics, 1930 to the PresentThe Mathematization of EconomicsThe Revolution in National-Income

AccountingThe Econometric Society and the Origins

of Modern EconometricsFrisch, Tinbergen and the Cowles

Commission

The Second World WarGeneral-Equilibrium TheoryGame TheoryThe Mathematization of Economics

(Again)

12 Welfare Economics and Socialism,1870 to the PresentSocialism and MarginalismThe State and Social WelfareThe Lausanne SchoolThe Socialist-Calculation DebateWelfare Economics, 1930–1960Market Failure and Government FailureConclusions

13 Economists and Policy, 1939 to thePresentThe Expanding Role of the Economics

ProfessionKeynesian Economics and

Macroeconomic PlanningInflation and MonetarismThe New Classical Macroeconomics

Development EconomicsConclusions

14 Expanding the Discipline, 1960 to thePresentApplied EconomicsEconomic ImperialismHeterodox EconomicsNew Concepts and New TechniquesEconomics in the Twentieth Century

Epilogue: Economists and TheirHistory

A Note on the Literature

References

Acknowledgements

Most of this book was written during my tenure ofa British Academy Research Readership from 1998to 2000. I am grateful to the British Academy forits support, and to several colleagues who readvarious drafts of the manuscript and whosedetailed comments have helped me remove manyerrors and improve the argument. These are MarkBlaug, Anthony Brewer, Bob Coats, Mary Morgan,Denis O'Brien, Mark Perlman, Geert Reuten andRobert Swanson. I also wish to thank thosesubscribers to the History of Economics Society'semail list who answered my requests for bits ofinformation (usually dates) that I could not findmyself (Bob Dimand proved a mine ofinformation). I am also very grateful to FatimaBrandão and Antonio Amoldovar for inviting me toteach a course at the University of Oporto, whichhelped me to sort out my ideas on how to organizethe material in the second half of the book. StefanMcGrath, at Penguin Books, encouraged me toembark on this project, and was patient when Iovershot the initial deadline by a long time. He alsoprovided helpful suggestions, as did BobDavenport, whose editing of the final draft was

exemplary and saved me from many mistakes.None of these people, of course, bearsresponsibility for any errors that may remain. Last,but definitely not least, I would like to thank myfamily: Alison, Robert and Ann.

Prologue

The History of Economics

This book is about the history of attempts tounderstand economic phenomena. It is about whathas variously been described as the history ofeconomic thought, the history of economic ideas,the history of economic analysis, and the history ofeconomic doctrines. It is not, except incidentally,concerned with the economic phenomenathemselves, but with how people have tried tomake sense of them. Like the history of philosophyor the history of science, this is a branch ofintellectual history. To illustrate the point, thesubject of the book is not the IndustrialRevolution, the rise of big business or the GreatDepression – it is how people such as Adam Smith,Karl Marx, John Maynard Keynes and many lesser-known figures have perceived and analysed theeconomic world.

Writing the history of economic ideas involvesweaving together many different stories. It is

clearly necessary to tell the story of the people whowere doing the thinking – the economiststhemselves. It is also necessary to cover economichistory. Natural scientists can assume, for example,that the structure of the atom and the molecularstructure of DNA are the same now as in the timeof Aristotle. Economists cannot make comparableassumptions. The world confronting economistshas changed radically, even over the past century.(Maybe there is a sense in which ‘human nature'has always been the same, but the precise meaningand significance of this are not clear.) Politicalhistory matters too, for political and economicevents are inextricably linked, and economistshave, as often as not, been involved in politics,either directly or indirectly. They have sought toinfluence policy, and political concerns haveinfluenced them. Finally, it is necessary to considerchanges in related disciplines and in the underlyingintellectual climate. Economists' preconceptionsand ways of thinking are inevitably formed by theculture in which they are writing. The history ofeconomics has therefore to touch on the historiesof religion, theology, philosophy, mathematics andscience, as well as economics and politics.

What makes the problem difficult is that the

relationships between these various histories arenot simple. There is no justification for claiming,for example, that connections run solely fromeconomic or political history to economic ideas.Economic ideas feed into politics and influencewhat happens in the economy (not necessarily inthe way that their inventors intended); the threetypes of history are interdependent. The same istrue of the relationship between the history ofeconomics and intellectual history more generally.Economists have sought to apply to their owndiscipline lessons learned from science whether thescience of Aristotle, Newton or Darwin. They areinfluenced by philosophical movements such asthose of the Enlightenment, positivism orpostmodernism, as well as by influences of whichwe are completely unconscious. However, linksalso run the other way. Darwin's theory of naturalselection, for example, was strongly influenced bythe economic ideas of Malthus. In short, economicideas are an integral component of culture.

One factor that contributes to theinterdependence of economics and otherdisciplines and intellectual life in general is that, atleast until recently, economics was not an activitycarried out by a group of specialists called

‘economists’. Modern disciplinary boundariessimply did not exist; also, the role of universities insociety has changed almost beyond recognition.The people responsible for developing economicideas included theologians, lawyers, philosophers,businessmen and government officials. Some ofthese held academic positions, but many did not.For example, Adam Smith was a moral philosopher,and his economic ideas formed part of a muchbroader system of social science, rooted in moralphilosophy. Furthermore, the people who wrotethe conventional canon of economic literatureoccupied various positions in the societies in whichthey lived, which means that comparisons acrosstime have to be made with great care. When thethirteenth-century writer Thomas of Chobhamwrote about trade and finance, he was offeringguidance for priests taking confession. Perhaps thepresent-day counterpart to his work should besought not in modern academic economics, but inpapal encyclicals. Gerard Malynes and ThomasMun, both of whom wrote in seventeenth-centuryEngland and are considered to have contributed toour understanding of foreign trade and exchangerates, were respectively a government official and amerchant. Perhaps they should be considered the

forerunners of people like Jacques Polak at theInternational Monetary Fund, or the financierJames Goldsmith.

When writing history of economics that coversover any period longer than about the last century,we have no choice but to select from a greatvariety of literature, written by different people fordifferent purposes under different circumstances.Indeed, one of the most interesting things aboutthe history is to see what has happened to ideas asthey have been taken up by different writers andused for different purposes. This means that wehave to be careful not to treat past writers asthough they were modern academic economists.

What is Economics?

The discussion so far has rested on the assumptionthat we know what economics and economicphenomena are. But economics is notoriouslydifficult to define. Perhaps the most widely useddefinition of the subject is the one offered byLionel Robbins: ‘Economics is the science which

studies human behaviour as a relationship betweenends and scarce means which have alternativeuses.’1 The phenomena we associate witheconomics (prices, money, production, markets,bargaining) can be viewed either as consequencesof scarcity or as ways in which people try toovercome the problem of scarcity. Robbins'sdefinition goes a long way towards capturing thefeatures common to all economic problems, but itrepresents a very specific, limited view of thenature of such problems. Why, for example, shouldthe operations of multinational corporations indeveloping countries, or the design of policy toreduce mass unemployment, be seen as involvingchoices about how to use scarce resources? It isperhaps ironic that Robbins's definition dates from1932, during the depths of the Great Depression,when the world's major economic problem wasthat vast resources of capital and labour were lyingidle.

A more natural definition is that of the greatVictorian economist Alfred Marshall, who definedeconomics as the study of mankind in the ordinarybusiness of life.2 We know what he means by this,and it is hard to disagree, though his definition isvery imprecise. It could be made more precise by

saying that economics deals with the production,distribution and consumption of wealth or, evenmore precisely, is about how production isorganized in order to satisfy human wants. Otherdefinitions include ones that define economics asthe logic of choice or as the study of markets.

Perhaps as important as what these definitionssay is what they do not say. The subject matter ofeconomics is not defined as the buying and sellingof goods, markets, the organization of firms, thestock exchange or even money. These are alleconomic phenomena, but there are societies inwhich they do not occur. It is possible, forexample, to have societies in which money doesnot exist (or performs only a ceremonial function),in which production is not undertaken by firms, orin which transactions are undertaken withoutmarkets. Such societies face economic problems –how to produce goods, how to distribute them, andso on – even though the phenomena we normallyassociate with economic life are missing.Phenomena such as firms, the stock exchange,money and so on are better seen as institutionsthat have arisen to solve more fundamentaleconomic problems, common to all societies. It isbetter, therefore, to define economics in relation to

these more fundamental problems, rather than inrelation to institutions that exist in some societiesbut not in others.

Anyone writing a systematic ‘principles ofeconomics' has to decide on a specific definition ofthe subject and work within it. The historian,however, does not have to do this. It is possible,instead, to start with those ideas that make upcontemporary economics – ideas that are found ineconomics teaching and are being developed bypeople recognized as economists. These, however,do not provide a precise definition, for theboundaries of the discipline are indistinct.Academics, journalists, civil servants, politiciansand other writers (even novelists) all develop andwork with economic ideas. The boundaries of whatconstitutes economics are further blurred by thefact that economic issues are analysed not only by‘economists' but also by historians, geographers,ecologists, management scientists, and engineers.(Such writing may not be what professionaleconomists would consider ‘good' or ‘serious'economics, and it may be ridden with fallaciousarguments, but that is a different matter – it is stilleconomics.) Approaching the subject in this verypragmatic way might seem less desirable than

defining economics in terms of its subject matter.In practice, however, it is a workable approach andprobably corresponds with what most historiansactually do, even if they profess to work within atight analytical definition of the subject.

Having decided on what constitutescontemporary economics, it is possible to workbackwards, tracing the roots of the ideas that arefound there, as far as it is decided to go. Some ofthese roots will clearly lead outside the subject (forexample, to Newtonian mechanics or theReformation), and the historian of economics willnot pursue these further. Others will lead to ideasthat the historian decides still count as economics,even though their presentation and content may bevery different from those of modern economics,and these will be included in the history. The resultof such a choice is that, the further we go back intohistory, the more debatable it becomes whether ornot certain ideas are ‘economic’. When peopleargue, as they have, that a particular individual orgroup is the ‘founder' of economics, they areclaiming that earlier writers should not beconsidered to be economists.

This raises two major questions about writing thehistory of economics. Where should it begin? And

is our perspective on the past distorted throughbeing obtained through the lens provided bypresent-day economics?

Some historians have argued that propereconomics does not begin until we enter themodern world (say the fifteenth or sixteenthcentury), or even till the eighteenth century, whenAdam Smith systematized so much of the work ofhis predecessors. Economics, the argument runs, isabout analysing human behaviour and the waypeople interact through markets and respond tochanges in their economic environment. Earlywriters, it is claimed, had quite different concerns,such as moral and theological issues about thejustice of market exchange or lending at interest,and their work should not be classified aseconomics.

There is, however, a big problem with thisargument: it is simply not possible to draw a cleardividing line between what constitutes economicanalysis and what does not, or between whatconstitutes ‘proper' or ‘real' economics and whatdoes not. For example, the moral and theologicalarguments of medieval theologians about thejustice of commercial activities presuppose anunderstanding of how the economy operates. The

economic content of such writing may be half-hidden or obscure, but it is there. The viewunderlying this book is that economic ideas werepresent even in antiquity, and that those ancientideas are relevant in trying to locate the origins ofmodern economics. Furthermore, even in thepresent century, economics deals with normativequestions (questions about what ought to bedone), some of which parallel those tackled by theancients. Economists are forever arguing that thispolicy or that will improve the welfare of society. Itmay be unfashionable to think of this as involvingethics, or morality; nonetheless, ethicalpresuppositions underlie modern economics just asmuch as they underlay Aristotle's thinking aboutthe market. The Old Testament contains manyeconomic ideas, as does the poetry of Homer. In ageneral history of economics, it may not benecessary to dwell long on these texts, but they arepart of the story.

My argument can be summed up by saying thateconomics does not have a beginning or a‘founder’; people have always thought aboutquestions that we now consider part of economics.In this book I start with ancient Greece and theworld of the Old Testament, for it is necessary to

start somewhere, but these do not represent thebeginning of economic thought.

Viewing the Past through the Lens of thePresent

The approach outlined above, focusing on what hasbeen termed ‘the filiation of economic ideas’, isnow unfashionable. In a postmodern world, thefashion is to stress the historical relativity of ideasand to decry any attempt to view past ideas fromthe perspective of the present. However, anyonewho writes a history of economic thoughtnecessarily views the past, to some extent, from theperspective of the present. Simply to focus on‘economic' ideas is to select past ideas according toa modern category. However much we try to do so,we can never completely escape from ourpreconceptions attached to the questions we aretrying to answer. It is better to state thesepreconceptions as explicitly as possible rather thanto pretend that they do not exist. The objective ofthis book is to explain how economics got where it

is today, at the beginning of the twenty-firstcentury.

A common approach is to write a history thatcovers the accepted canon of ‘important' writingson economics. However, to do this is simply to relyon judgements that others have made in the past. Itdoes not avoid the problem of one's choice ofmaterial being influenced by one's interests. Whatusually happens is that historians start with aconventional canon – a list of the works, figures ormovements that are considered to represent theeconomics of the past. They then modify this,increasing the emphasis in some places, reducing itin others in response to the questions that interestthem and the evidence they find. As economics haschanged, so too have views about what constitutesthe appropriate canon.

To approach the past from the perspective of thepresent can, however, result in stories that makevery unconvincing histories. When the story told isone of progress from crude beginnings to the ‘truth'reached by the historian's friends, contemporariesor other heroes, the result is what has come to becalled ‘Whig history’, after the nineteenth-centuryWhigs who told the story of Britain in this way, andreaders are right to be sceptical. Nevertheless, the

Whigs' attitude is shared by many economists,some of whom write histories of economics. Theyfind it hard to accept that their own generation'stheories and techniques (to which they maythemselves have contributed) may not be superiorto those of earlier generations. Critics of such workare right when they argue that this approach missesthe important historical questions and frequentlyresults in a caricature of what actually happened.

However, to examine the past in order tounderstand the present need not mean telling thestory as one of progress. The reasons why ideasevolved as they did will include historicalaccidents, vested interests, prejudices,misunderstandings, mistakes and all sorts of thingsthat do not fit into accounts of progress. The storymay involve certain lines of inquiry dying out, ormoving away from what is currently consideredeconomics. We may discover, when we look back,that earlier generations were asking differentquestions – perhaps even questions we find it hardto understand – with the result that the notion ofprogress becomes problematic.

The Story Told Here

The story told in this book clearly reflects certainconventional views about what constituteseconomics – certain topics are included because itis ‘obvious' that they should be there. The publisher(not to mention many readers) would have beenunhappy if it said nothing about Adam Smith,David Ricardo, Karl Marx or John Maynard Keynes.It is recognizably a history of economics, as theterm is commonly understood. However, it departsfrom the conventional canon both in the relativeimportance attached to different figures and inmany of the topics that are included. It also tries toplace people in an appropriate historical context –one that they might have recognized.

The book is not organized around the ‘greatfigures' of the past, as was once common. Chapterstypically start with a discussion of the historicalcontext, and proceed from there to the economicideas that emerged. The emphasis on economic,political and intellectual history varies throughoutthe book, and is generally less prominent as thestory unfolds. The most important reason for this isthat when we are discussing periods wheneconomics was less clearly distinguished from

other disciplines it is more important to discussideas outside economics. As economics developed,during the nineteenth century, into an academicsubject, the problems economists tackled wereincreasingly ones that arose within the discipline.Also, throughout the book, there is an emphasis onthe communities and circumstances out of whicheconomic ideas emerged, rather than simply onindividuals: on what could loosely be called thesociology of the economics profession. Theposition of economists (or, more accurately, theposition of people reflecting on economic matters)in society has changed, and this has influenced theway in which ideas have developed. Chaptersdealing with early material therefore contain muchgeneral history. However, as the story develops,economic ideas become much more prominent andgeneral history plays a smaller part. By thetwentieth century, when economics had become apredominantly academic discipline, economic ideaswere changing for reasons that were substantiallyinternal to the discipline.

The book does cover the conventional canon, butthis is challenged in many ways. The Islamic worldenters the medieval story. Political philosophy andthe Hobbesian challenge are an important element

in the chapter on seventeenth-century England.Smith is viewed as a moral philosopher and is set inthe context of the Scottish Enlightenment. Malthusis portrayed not just as a pure economist, ordemographer, but as someone who contributed tocontemporary political debates. Theoreticalcontributions of early-nineteenth-century Frenchand German writers are placed alongside those oftheir English counterparts. Chamberlin is discussedin the context of US industrial economics, not thatof the British cost controversy. The list could becontinued. The most significant change, however,is that the twentieth century is a major part of thestory (almost half the book). In covering it, I haveattempted to give as broad a picture of the subjectas possible. Given that my main aim is to explainhow the discipline reached its present state,developments within its theoretical ‘core' areclearly prominent. However, they are not the wholestory.

In telling this story, I have inevitably drawn onaccounts written by specialists in the variousperiods the book covers. The ‘innovations'mentioned in the previous paragraph are all takenfrom such works. The number of places where Ihave been able to depart from the conventional

story reflects, at least in part, the range of recentwork on the history of economic thought – and thisis particularly true of the twentieth century. Mymain debts are acknowledged in the suggestions forfurther reading at the end of the book.

1

The Ancient World

Homer and Hesiod

Plato suggested that Homer educated Greece, hisepic poems providing the values by which lifeshould be lived. In the literary papyri found inEgypt, Homeric scrolls outnumber those by allother authors put together. Even today, stories ofHector, Achilles, Troy and the journeys of Odysseusform part of Western culture. It is not clearwhether the Iliad and the Odyssey should beregarded as the work of a single individual or ascompilations of the work of many poets, but ineither case they represent the writing down,somewhere around 750–725 BC, of a long oraltradition. The Homeric epics, together with thepoems of Hesiod (c. 700 BC), are as far back as thewritten record takes us in Europe.

The society described in the Iliad and the Odysseyprobably reflects, in part, the Mycenaean (BronzeAge) world of Troy around 1400–1100 BC, and inpart Homer's own time. It was ordered and

hierarchical, based not on market relationships, buton the distribution of wealth through gifts, theft,prizes for winning competitions, plunder receivedin war, and tribute paid by defeated cities to theirconquerors. Troy might have fallen earlier, it hasbeen suggested, if the Greek army had not been sointent on pillaging. Trade was viewed by Homer asa secondary, and inferior, way of acquiring wealth.Heroes were aristocratic warriors, rewarded strictlyaccording to their rank. Gifts were governed by astrict code of reciprocity, in which it was importantthat, when gifts were exchanged, those involvedshould hold the same rank after the exchange asbefore. Hosts were obliged to provide hospitalityand gifts for their guests, who in turn had anobligation to provide gifts, perhaps to the hosts'families, at a later date in return.

The basis for this economy was the household,understood as the landowner, his family and all theslaves working on an estate. Owners and slaveswould work alongside each other. Prosperity wasseen by Homer as the result of being in a well-ordered, rich household. On the other hand, therewas suspicion of excessive wealth – householdsshould be rich, but not too rich. There were, ofcourse, traders and craftsmen (we read of Greek

soldiers exchanging their plunder for provisions,and craftsmen were brought in to do certain taskson landed estates), but they were less importantthan landed estates. Even if he gained his freedom,a slave who lost his place on a landed estate mightlose his security. The acquisition of wealth throughtrade was regarded as distinctly inferior toobtaining it through agriculture or military exploits.

Of the two poems attributed to Hesiod, the onethat is seen as having the most substantialeconomic content is Works and Days. He starts withtwo creation stories. One is the well-known story ofPandora's box. The other, undoubtedly influencedby Mesopotamian creation stories, tells of adescent from the golden age of the immortals,‘remote from ills, without harsh toil’,1 to a race ofiron, for whom toil and misery are everydayrealities. Hesiod offers his readers much adviceabout coping with life under these conditions.Works and Days is a poem within the tradition oforiental wisdom literature, moving seamlesslybetween advice that would nowadays be seen asritualistic or astrological and practical advice onagriculture and on when to set sail in order toavoid being lost at sea. Though they fall within thesame tradition, however, when compared with the

Babylonian and Hebrew creation stories, Hesiod'sstories (like those of Homer) are comparativelysecular. It is Zeus who provides prosperity, andHesiod regards morality and pleasing Zeus as themain challenges that men have to deal with, butthe stories are the product of the author's owncuriosity, not the work of priests.

Hesiod can be read as having realized that thebasic economic problem is one of scarce resources.The reason men have to work is that ‘the gods keepmen's food concealed: otherwise you would easilywork even in a day enough to provide you for thewhole year without working’.2 Choices have to bemade between work (which leads to wealth) andleisure. Hesiod even suggests that competition canstimulate production, for it will cause craftsmen toemulate each other. However, though these ideasare clearly present in Works and Days, they are notexpressed in anything like such abstract terms.Hesiod describes himself as a farmer, and says thathis father was forced to emigrate owing to poverty.The virtues he sees as leading to prosperity are thus– not surprisingly – hard work, honesty and peace.His ideal is agricultural self-sufficiency, withoutwar to destroy the farmer's produce. This is farfrom the aristocratic disparagement of work and

support for martial virtues that can be found inHomer, but the two poets share the idea thatsecurity is bound up with land.

Hesiod's poetry provides a good illustration ofthe earliest writings on economic questions.Economic insights are there, but nothing isdeveloped very far and it is difficult to know howmuch significance to attach to them.

Estate Management – Xenophon's Oikonomikos

The period from the seventh to the fourth centuriesBC saw great literary, scientific and philosophicalachievements. Thales (c. 624–c. 546 BC) proposedthe idea that water was the primal substanceunderlying all forms of life, and the notion that theearth was a disk floating on water. Anaximander (c.610–c. 546 BC) drew the first map of the knownworld and composed what is believed to be thefirst treatise written in prose. We know little oftheir reasoning, for very little of what they wrotehas survived, but the important point is that theywere trying to reason about the nature of the

world, liberating themselves from mythology.Towards the end of the sixth century Pythagoras (c.570–c. 490 BC) used theory and contemplation asmeans of purifying the soul. Though he wasengaged in what we would now see as a form ofnumber mysticism, in which numbers and ratioshave mystical properties, he and his followersmade enduring contributions to philosophy andmathematics. The fifth century saw the emergenceof playwrights, Aeschylus (c. 525–456 BC),Sophocles (c. 495–406 BC) and Euripides (c. 480–406 BC), and historians such as Herodotus (c.485–c. 425 BC) and Thucydides (c. 460–c. 400 BC).

These developments form the background to theworld of Xenophon (c. 430–354 BC) and Plato (c.429–347 BC). For this period there is virtually noeconomic data. Our knowledge of it thereforecomes solely from political history. But we doknow that the economy of this period was, like thatof Homer's day, still based on agriculture, withlanded estates as the main source of wealth. Therehad, however, been enormous political andeconomic changes in the intervening centuries.Among the most important of these were thereforms introduced in Athens by Solon, appointed

archon, or civilian head of state, in 594 BC. Thesecurtailed the power of the aristocracy, and laid thebasis for democratic rule based on the election, bythe property-owning classes, of a council of 400members. Land was redistributed, laws werecodified, and a silver currency was established. TheAthenian merchant fleet was enlarged, and therewas an expansion of trade. Specialized agriculturedeveloped as Athens exported goods – notablyolive oil – in return for grain. The old ideal of self-sufficiency began to break down.

Though intended to bring stability, Solon'sreforms resulted in class divisions and politicalupheaval. Athens and the other Greek cities alsobecame involved in a series of wars with thePersians. In 480 BC Athens itself fell to thePersians, but the Persian fleet was defeated atSalamis. The following year the Persian army wasdefeated by the Spartans at Plataea and hostilitiescame to an end. The legacy of the Greek navalvictory was that Athens became the leader of amaritime alliance of Greek states, exacting tributefrom them. In effect, Athens was the centre of anempire, her great rival being Sparta. The strengthsof Athens were trade and sea power; Sparta'sposition was based on agriculture and its army.

War eventually broke out between the two states in431 BC – the start of the Peloponnesian War thatended with the defeat of Athens, in 404 BC, andthe dissolution of the naval league.

For the fifty years from the end of the PersianWars till the start of the Peloponnesian War,Athens was essentially at peace. The result was aperiod of great prosperity known as the PericleanAge, after Pericles, who led the more democraticparty from 461 to 430 BC. Piracy was removed fromthe eastern Mediterranean, trade flourished, andcommercial agriculture and manufacturingdeveloped, along with many of the activities nowassociated with a commercial society: banking,credit, money-changing, commodity speculationand monopoly trading. One historian has written ofAthens being ‘a commercial centre with a complexof economic activities that was to remainunsurpassed until post-Renaissance Europe’.3 Theresulting prosperity was the basis for great buildingprojects, such as the Parthenon.

Athenian democracy was direct, involving all thecitizens – i.e. adult males of Athenian parentage.Even juries could involve hundreds of citizens, andthe fondness of Athenians for litigation – in whichplaintiffs and defendants had to speak for

themselves – meant that it was important forpeople to be able to defend their own interests,and argue their case. There was thus a demand fortraining in rhetoric, which was provided by theSophists. The Sophists were itinerant, travellingfrom one city to another, and, though the mainrequirement was for skills in public speaking, manyof them believed that their pupils needed to knowthe latest discoveries in all fields. The Sophistswere thus the first professional intellectuals inGreece – professors before there were universities.4The first and greatest of the Sophists wasProtagoras (c. 490–420 BC), who taughtsuccessfully for forty years before being banishedfor his scepticism about the gods.

Socrates (469–399 BC) emerged against thisbackground of ‘professional intellectuals’. Becausethey travelled, they could stand back from the lawsand customs of individual cities. They engaged inabstract thought, and, though many paid respect tothe gods, they looked for non-religiousexplanations of the phenomena they saw aroundthem. What stands out about Socrates is hismethod: relentlessly asking questions. It was thisthat attracted to him pupils as able as Plato andXenophon. He was, however, the butt of

Aristophanes' satire in The Clouds, in which hisquestioning of the gods' responsibility for rain andthunder is ridiculed. As he wrote nothing himself,our knowledge of Socrates stems only fromAristophanes and, above all, from the dialogues ofPlato and Xenophon. We can be confident aboutmuch in their accounts; however, it is often hard toknow precisely which ideas should be attributed toSocrates himself and which come from Xenophonor Plato using him as a mouthpiece.

Xenophon came from the Athenian upper classesand, like all Socrates' pupils, was well off. For somereason (maybe linked to his association withSocrates, who was tried and executed in 399 Bc) heleft Athens, and in 401 Bc he joined a militaryexpedition to Persia, in an attempt to help Cyrusthe Younger take the throne from his brother. Theattempt failed, and Xenophon, if we are to believehis account of the event, was responsible forleading the troops back to Greece. From 399 to394 Bc he fought for Sparta, after which he lived,under Spartan protection, on a country estate, tillhe returned to Athens in 365 Bc. Most of hiswriting was done in this more settled period of hislife.

Oikonomikos, the title of Xenophon's work, is the

origin of the words ‘economist' and ‘economics’. Itis, however, better translated as The Estate Manageror Estate Management. Taken literally it meansHousehold Management, ‘oikos' being the Greek wordfor ‘household’, but by extension the word wasused to refer to an estate, and Xenophon'sOikonomikos is in fact a treatise on managing anagricultural estate. Familiar Socratic themes suchas an emphasis on self-discipline and trainingpeople to wield authority are found in the book,but its main theme is efficient organization. Giventhe Greeks' emphasis on the human element inproduction (perhaps a feature of a slave society),efficient management translated into effectiveleadership.

The prime requirement of an effective leader wasto be knowledgeable in the relevant field, whetherthis was warfare or agriculture. Men would followthe man they saw as the superior leader, Xenophonclaimed, and willing obedience was worth far morethan forced obedience. Though he illustrated thiswith examples taken from war, Xenophon saw thesame principles as applying in any activity. Theother requirement for efficiency was order.Xenophon used the example of a Phoeniciantrireme (a ship propelled by three banks of oars) in

which everything was so well stowed that the manin charge knew where everything was, even whenhe was not present. This was how an efficientestate should be run – with stores efficientlyorganized and accounted for. It was commonlybelieved that good organization could doubleproductivity.

Seen from this perspective, Xenophon's emphasison efficiency seems simply an exercise inmanagement, applied to an agricultural estaterather than to a modern firm. His conception of the‘administrative art’,5 however, was much broaderthan this, extending to the allocation of resourcesin the state as a whole. He makes this clear whenhe discusses the way in which Cyrus the Greatorganized his empire, with one official in charge ofprotecting the population from attack and anotherin charge of improving the land. If either failed todo his job efficiently, the other would notice, forneither could perform his task properly if the otherwas not doing so. Without defence the fruits ofagriculture would be lost; and without enoughagricultural output the country could not bedefended. Though officials were given the rightincentives, it was still necessary that the ruler tookan interest in all the affairs of the state –

agriculture as well as defence. Administrativeauthority, not the market mechanism, was themethod by which resources would be efficientlyallocated and productivity maximized.

Because it is something to which subsequenteconomists and historians have paid greatattention, it is necessary also to mentionXenophon's account of the division of labour. Heobserves that in a small town the same workmanmay have to make chairs, doors, ploughs andtables, but he cannot be skilled in all theseactivities. In large cities, however, demand is solarge that men can specialize in each of these tasks,becoming more efficient. Turning back to theestate, Xenophon argues that division of labour canbe practised in the kitchen, anything prepared insuch a kitchen being superior to food prepared in asmaller kitchen where one person has to performall tasks.

Xenophon's model is of men interacting withnature – not with each other through markets.Productive efficiency involves managing the use ofnatural resources so as to get the most from them.His is a static world in which it is taken for grantedthat nature is known and understood. Trade andmarkets are peripheral. Given the development of

trade and commerce in Athens by this time, it isperhaps surprising that agricultural estates are ascentral to Xenophon's view of economic activity asthey were for Homer's. This can be explained by hisposition as a soldier and, for thirty years, alandowner under Spartan protection. For some ofhis contemporaries, such explanations are harder todefend.

Plato's Ideal State

The background to Plato's Republic, which attemptsto provide a blueprint for the ideal state, is thepolitical turmoil that engulfed Athens and the otherGreek city states in the fifth and fourth centuriesBC. Experience had taught Plato that neitherdemocracy nor tyranny could provide a stablesociety. Leaders in a democracy would not do whatwas just, but would use their office to gainsupport. Tyrants, on the other hand, would usetheir power to further their own interests, notthose of the state as a whole. But without anyleadership there would be chaos. Plato's solution to

this dilemma was to create a class of philosopher-kings – the ‘guardians' – who would rule the state inthe interests of the whole society. These would beself-appointed, for they would be the only onescapable of understanding how society should beorganized. In the ideal state their whole upbringingand way of life would be designed to train them fortheir role and to ensure that they fulfilled itproperly. To ensure that the guardians would notbecome corrupt, pursuing their own interests, theywould be forbidden to own property or even tohandle gold and silver. They would receive whatthey needed to live as a wage from the rest of thecommunity. Unlike tyrants, they would have to putthe interests of the state first.

Plato's vision was concerned with the efficientorganization of society – with a just societyorganized on rational principles. Like other Greekwriters, he saw efficiency as involving the humanelement in production. Men should specialize inthose activities for which they were naturallysuited, and should be trained accordingly. Indeed,the origins of cities (states) lay in specializationand the dependence of people on one another. Hetook the physical endowment of resources andtechnology for granted. His was a static world, in

which everyone had a fixed place, maintained byefficient administration undertaken bydisinterested rulers. Though he saw a role for trade,the role for markets in his ideal state was verylimited. Consumer goods might be bought andsold, but property was to be allocatedappropriately (on mathematical principles)between citizens. There would be no profits orpayment of interest.

This view of the state presumed that cities wouldremain small. In a later work, Plato argued that theoptimum number of households in a city was 5040.The reason for this number was that it was divisibleby the first ten integers, and so allowed divisioninto an optimal number of administrative units.The idea that cities should remain small wasconsistent with the experience of Greek cities,constrained by the availability of agricultural landand resources. When populations rose, a city wouldorganize an expedition to found a colony. Thiscolony would become a new city in which theGreek way of life would be maintained. Suchcolonies, which often became independent of thecities from which they stemmed, were to be foundthroughout the Mediterranean, notably in southernItaly, Sicily and North Africa.

Plato was an aristocrat, involved in Athenianpublic affairs, who fought several militarycampaigns. In his early life he had travelled widely,visiting the Pythagorean communities in Italy, fromwhich he probably acquired his interest inmathematics. While in Sicily, he became involvedwith the ruler of Syracuse, unsuccessfully trying totrain Dionysius II for leadership after the death ofhis father, Dionysius I, in 367 BC. In around 375BC he founded his Academy (in the grove sacred tothe hero Academus just outside Athens) in order totrain statesmen to become philosophers. Unlike theschool founded a few years earlier by Isocrates,which emphasized the teaching of rhetoric, Platobelieved that it was more important to teachprinciples of good government. Several of hisstudents became rulers (tyrants), and Plato saw thetask of his Academy as offering advice to suchpeople. In at least one case, a tyrant is believed tohave moderated his rule in response to Plato'steaching.

Aristotle on Justice and Exchange

Aristotle (384–322 BC) was a son of a physicianand a student of Plato. He joined the Academy atthe age of seventeen, and remained there till Plato'sdeath twenty years later.

The influence of Aristotle on subsequentgenerations was such that, for many, he was simply‘the philosopher’. His writing encompassedphilosophy, politics, ethics, natural science,medicine and virtually all other fields of inquiry,and it dominated thinking in these areas for nearly2,000 years. His contributions to what are nowthought of as economic issues are found in twoplaces: Book V of the Nichomachean Ethics and BookI of the Politics. In the former he analysed theconcept of justice, and in the latter he wasconcerned with the nature of the household andthe state.

In the Athenian legal system, men who were indispute with each other had to go first to anarbitrator, who would try to reach a fair orequitable settlement. Only if the arbitrator'sdecision was unacceptable to one of the partieswould the dispute go to court, in which case thecourt would have to decide on a settlement inbetween the limits set by the two parties' claims, orin between that set by the arbitrator and that

claimed by the aggrieved party. In Book V of theNichomachean Ethics Aristotle was considering theprinciples of justice that ought to apply in suchdisputes. This perspective is important, because itimmediately establishes that he was thinking ofprinciples that should apply in judicial decisions,and that he was dealing with cases of isolatedexchange (in which individual buyers and sellersnegotiate with each other about specific goods). Hewas not dealing with exchange in organized,competitive markets. Indeed, it is likely that,though trade was well developed in Athens by thefourth century BC, competitive markets were fewand far between. There is much evidence thatprices of standard commodities were regulated(even the price of singers was regulated – ifdemand for the services of particular singers wastoo high, they would be allocated by a ballot), andthe quality of manufactured goods was probablysufficiently variable that the price of each itemwould have had to be negotiated individually, as inisolated exchange.

When dealing with exchange and the distributionof goods, Aristotle distinguished between threetypes of justice. The first is distributive justice. Thisrequires that goods (or honours, or whatever is

being distributed) are distributed to people inproportion to their merit. This was a commonproblem in Aristotle's day, for much wasdistributed by the state – booty from war, silverfrom the mines at Laurium, and many other goods.Aristotle's concept of distributive justice was a veryelastic notion, for merit can be defined in differentways in different settings. After a battle, meritmight be measured by the contribution of soldiersto the victory. Within a partnership, justice wouldrequire that goods be distributed in proportion tothe capital that each person had invested.Furthermore, different criteria may be used toassess merit: in a democracy it might be assumedthat all citizens should receive an equal share,whereas in an oligarchy the oligarchs would bethought to merit larger shares than other citizens.The second type of justice is rectificatory justice –putting right previous injustices by compensatingthose who had lost out. Rectificatory justicerestores equality. Finally comes reciprocal (orcommutative) justice, or justice in exchange.

If two people exchange goods, how do we assesswhether the transaction is just? One way,commonly understood in ancient Greece, is toargue that if exchange is voluntary it must be just.

Xenophon cited the example of two boys – one talland with a short tunic, the other short and with along tunic – who exchanged tunics. Theconventional view was that this was a justexchange, for both boys gained from it. Aristotlerecognized, however, that in such exchanges justicedoes not determine a unique price, but merely arange of possible prices in between the lowestprice the seller is prepared to accept and thehighest price the buyer is prepared to pay. There istherefore still scope for a rule to determine the justprice within this range. His answer was theharmonic mean of the two extreme prices. Theharmonic mean has the property that if the justprice is, say, 40 per cent above the lowest price theseller will accept, it is also 40 per cent below thehighest price the buyer is prepared to pay. Justiceinvolves finding a mean between extremes, neitherof which is just.

The principle that justice involves finding asuitable mean also applies to the two other formsof justice. Distributive justice involvesproportionality, or geometric proportion, and isassociated with the geometric mean. (Thegeometric mean of two quantities is found bymultiplying them together and taking the square

root of the result.) Rectificatory justice involvesarithmetic proportion (compensation should equalwhat has been lost). We thus find that Aristotle hasrelated the three types of justice to the three typesof mean that were known to him: the geometric,arithmetic and harmonic means. This was far fromaccidental. Aristotle, like Plato, was stronglyinfluenced by the Pythagoreans, who worked outthe mathematical relationship between musicalnotes. It was believed that similar harmonies andratios could explain other phenomena, and it istherefore not surprising that there were closeparallels between Aristotle's theory of justice andthe mathematics of ratios and harmonies.

The influence of Pythagorean mathematics onAristotle's account of exchange extends evenfurther. By Aristotle's time it was widely acceptedthat all things were built up from common units(atomism). Geometry was based on points,arithmetic on the number ‘1’, and so on to thephysical world. It was believed that this meant thatdifferent phenomena were commensurable in thesense that they could similarly be expressed asratios of whole numbers. This was why it had beena great blow to the Pythagoreans to discover thatthere were irrational numbers like 11 or 2 that

could not be expressed as ratios. Exchange of onegood for another was important because it madethe goods commensurable – shoes could bemeasured in terms of wheat. But if the shoemakerdid not want wheat, or the farmer did not wantshoes, exchange would not take place, making itimpossible to compare the two goods. How wasthis problem to be resolved? Aristotle's answer wasmoney. The shoemaker and the farmer might notwant each other's produce, but they would bothsell it for money, which meant that shoes andwheat could be compared through taking the ratioof their money prices. It is demand that makesgoods commensurable, and money acts as arepresentative of demand.

Aristotle and the Acquisition of Wealth

However, although money was fundamental toAristotle's thinking, he believed that there wereclear limits to the legitimate role of commercialactivity. His argument was based on a distinctionbetween two types of wealth-getting. The first was

a part of estate management. A man should knowthings such as which type of livestock would bemost profitable, or whether to engage in plantingwheat or bee-keeping. These were natural ways inwhich to acquire wealth. In contrast, the secondtype – getting wealth through exchange – wasunnatural, for this involved making a gain atsomeone else's expense. Unnatural ways to acquirewealth included commerce and usury (lendingmoney at interest). Somewhere in between cameactivities such as mining.

The Socratic philosophers, including Xenophon,Plato and Aristotle, held that citizens should aim ata good life. This was the life of the polis, orindependent city state in which citizens played anactive part in civic life. To do this they neededmaterial resources, provided by their estate.Natural ways of acquiring wealth were ones thatincreased the stock of goods needed to live thegood life. Though estate management wasfundamental, trading to obtain goods that couldnot be produced at home and exchanging one'ssurplus produce for something of which one hadgreater need were perfectly natural. But animportant part of such a life was that wants werelimited, and that once a man had enough wealth to

live in the right manner he would have no need forfurther accumulation of wealth. High levels ofconsumption were not part of the good life. Therewas therefore a limit to the natural acquisition ofwealth.

What disturbed Aristotle about commerce wasthat it offered the prospect of an unlimitedaccumulation of wealth. This was something ofwhich Athenians were well aware, for, although theself-sufficient city state was the ideal, there hadbeen several crises when the city had been forcedto raise money from traders. Typically, merchantswere not citizens, so raising money in this waymeant going outside the polis. The puzzle was that,even though they did not do anything useful,traders and speculators managed to create so muchwealth that they could help out cities in times ofcrisis. How was this possible? Aristotle's answerwas that goods can be either used or exchanged. Ofthese, the former is a proper, natural procedure, asis exchange between people who need goodsdifferent from what they currently possess. On theother hand, exchange simply for the purposes ofmaking money is unnatural, for goods are not beingused for their proper purpose. The unnaturalness ofsuch activities is revealed in that creating wealth by

exchange suggests that wealth could beaccumulated without limit something Aristotlebelieved to be impossible. Men might be rich incoin, he argued, yet starve through lack of food.

The view that there are limits to the properacquisition of wealth and the use of exchangesimply in order to make money fits in withAristotle's theory of justice. The essence of naturalacquisition of property is that it enables men tolive a good life in the polis. It has a clear objective,and is not being pursued for its own sake. Similarly,when he turned to the question of justice in theNichomachean Ethics, Aristotle was dealing with theinjustice that arises ‘not from any particular kind ofwickedness, such as self-indulgence, cowardice,anger, bad temper or meanness, but simply fromactivities for which the motive is the pleasure thatarises from gain’6. In making this distinction, onecan see Aristotle separating out one sphere of life –one that it is tempting to describe as ‘economic' –money-making. What is significant, however, is thatAristotle did not see this sphere as covering eventhe major part of those activities that we now thinkof as economic, for production and the mostimportant types of trade were excluded. Even moresignificant, he did not see markets and money-

making activities as providing a mechanism thatcould regulate society. Order was produced notthrough individuals pursuing their own ends, butthrough efficient administration.

Like Plato, Aristotle was a teacher. In 342 BC hewas appointed tutor to Alexander the Great, and in335 BC he returned to Athens to found his ownschool, the Lyceum. It was Alexander who finallydestroyed the independence of the Greek citystates, so weakened by the Peloponnesian War, ashe expanded his Macedonian Empire to include notonly the rest of Greece, but also Egypt and much ofthe Persian Empire, right across to India. ThoughAlexander's empire was relatively short-lived,disintegrating after his death in 323 BC, its majoreffect was to spread Greek culture throughout theancient world. The age of independent city stateswas over, and the Empire's administration was runalong lines taken over from the Persian andEgyptian empires that preceded it. Greek becamethe official language, and was widely spoken in thetowns (though not in the countryside), and Greekmathematics, science, medicine and philosophyflourished in cities such as Alexandria in Egypt. Thewritings of the Greek philosophers, though rooted

in the Greek city state, reached a far wideraudience.

Rome

At the time of Alexander's death, the Romanrepublic controlled no more than a small area onthe west coast of the Italian peninsula. During thefollowing three centuries this grew into an empirethat covered most of Europe and North Africa. Onthe death of Augustus (AD 14) the Roman Empirestretched from Spain to Syria, and from theRhineland to Egypt. It reached its greatest extent inthe reign of Trajan (98–117), and, though it lostterritories, notably to the Frankish tribes in thenorth, it retained much the same boundaries till theend of the fourth century. Roads, cities and othermajor public works were built on an unprecedentedscale. Rome was without any doubt the greatestcivilization the Western world had seen.

Rome produced armies that conquered theworld, and architecture that produced a sense ofawe in those who later looked upon its ruins. Latin

became the language of the educated classes inEurope. Yet the centre of the Empire was always inthe East. Rome relied on Egypt for its supplies ofgrain. The Empire's largest cities and much of itspopulation were in the eastern provinces in AsiaMinor. In contrast, the Western Empire remainedlargely rural. The cultural centre of the Empire wasalso in the Eastern Empire – in Hellenized citiessuch as Antioch and Alexandria, in which Greekscontinued to make advances in science andphilosophy. Roman writers readily acknowledgedtheir debts to the Greeks, with the result that theRomans themselves are widely believed to havecontributed little to economics. They are said tohave been doers rather than thinkers – engineersrather than scientists. However, while there maynot have been contributions comparable with thoseof Plato or Aristotle, this view is far from justified.Roman writers made a different type ofcontribution, the explanation for which is to befound in the structure of Roman society.

The Roman constitution linked political power tothe ownership of land and to military service. Warand conquest were a major source of wealth, andsoldiers were rewarded with grants of land,associated with political power. Romans were

expected to be willing to endure the hardships andrisks of war in order to preserve their wealth. Itfollowed that the rich, who had more wealth topreserve, should face the greatest risks. The poorman gained little from war and should thereforeneither pay taxes nor be required to fight. Tradeoffered a route to wealth, but this wealth had to beconverted into land if it were to bring politicalpower. Land, therefore, was the pre-eminent formof wealth.

The philosophies that gained most adherents inRome, especially among the upper classes, bothoriginated in Greece: Cynicism, founded byDiogenes of Sinope (c. 410–c. 320 BC), and itsoffshoot, Stoicism, founded by Zeno of Citium (c.335–263 BC). The last great exponent of Stoicismwas Marcus Aurelius, Roman emperor from AD 161to 180. Cynicism, like the later teaching ofEpicurus (c. 341–270 BC) emphasized the here andnow. Freedom from want was to be achievedthrough reducing one's needs to the barestminimum, living in what ordinary men wouldconsider poverty. The Stoics believed thathappiness resulted not from material possessions,but from virtue. Moral virtue was the only good,

which meant that a man who had done the best hecould had nothing to regret. For both the Cynicsand Stoics, virtue involved following nature. Theywere thus responsible for the idea of natural law,by which human laws and institutions could bejudged.

The concept of natural laws, applying to thewhole of humanity, provided the foundation forthe field where the Romans made perhaps theirgreatest contribution to social thought –jurisprudence. Roman law has exerted a majorinfluence over subsequent legal systems. Moreimportant, many significant economic ideas werearticulated in Roman commercial law. The Romanshad great respect for property, and the lawcontained many provisions to safeguard ownership.The idea of the corporation, having an existenceindependent of the individuals involved in it, goesback to Roman law. The law on contractspermitted trade, and guaranteed property andallowed it to be transferred. However, though tradewas allowed, wealth acquired from trade remainedmore controversial than wealth from landedestates. There was always a sense that wealth fromtrade, which appeared almost to arise out ofnowhere, was tainted in a way that wealth derived

from the land was not. Stoic ideas were the originof the concept of reasonableness as it appeared inmuch commercial law.

Of particular importance was the idea, goingback to Aristotle, that if all parties had agreed to acontract voluntarily, that contract must be just. Fora contract to be valid, all that was necessary wasthat the parties had consented to it, not that aparticular ritual or formula had been followed. Thisfocused attention on the circumstances underwhich an action was voluntary – on the point atwhich coercion rendered an action involuntary. Ifsomeone could show that he had entered into acontract under threat, he might be able to get itannulled on the grounds that he had not enteredinto it voluntarily. In general, however, a threatwas held to invalidate a contract only if it weresufficient to scare a vir constans: a man of firmcharacter. It would normally, if not always, havehad to involve a threat of physical violence. Theneed for consent was the reason why wilful fraudrendered a contract invalid. For example, someonedid not truly consent to a contract if he was misledabout the quality of good being offered. Normalbargaining over a contract, however, was allowed.

Conclusions

The world of ancient Greece and even Rome canseem very remote. However, the ideas developedthere are more important than their remotenessmight suggest. Greek philosophy has exerted aprofound influence on Western thought, and theeconomic thought discussed in this book formspart of that broader tradition. Our way of reasoninggoes back to Plato and Aristotle. Plato argued forthe existence of universal – ideal, pure forms thatcould be understood only through abstractreasoning. Aristotle, in contrast, saw concrete factsas fundamental, and general principles had to bederived from these through a process of induction.These two different attitudes still beset moderneconomics. Roman law has been similarlyinfluential. In addition, the Classics formed animportant part of many economists' education, atleast until the twentieth century, with the resultthat many of the writers discussed in the followingchapters will have been directly influenced bythem.

The ancient world was dominated by self-sufficiency and isolated exchange. As the terms ofsuch exchanges were clearly something over which

men had control, it was natural that great attentionshould be paid to whether they were just. However,although there was no market economy in themodern sense, commercial activity was sufficientlydeveloped and sufficiently prominent to provide asignificant challenge. On the whole, the thinkerswhose views are known to us (we have lessevidence of how merchants themselves viewedthings) were suspicious of commerce. These twothemes – justice and the morality of commerce –dominated discussions of economic issues right upto the seventeenth century, by which time theexistence of a market economy and a commercialmentality had come to be accepted.

2

The Middle Ages

The Decline of Rome

The ancient world is conventionally thought tohave ended with the fall of Rome and the RomanEmpire. This was a long-drawn-out process, with itsend commonly dated to the fall of the WesternEmpire in 476, though the Empire continued in theEast, based on Constantinople (Byzantium), foralmost another 1,000 years. The modern world isthought to have begun in the fifteenth century.This was the century of the Renaissance, whenEurope rediscovered classical humanism andPortuguese explorers discovered the New Worldand sea routes to the Far East. An importantsymbolic date was that of the fall ofConstantinople to the Turks, in 1453. In betweenwe have the so-called Middle Ages.

Dated in this way, the Middle Ages span nearly amillennium of European history during whichprofound economic, social and political changesoccurred. The way in which men made sense of

these changes cannot be understood separatelyfrom religion. The key event here was the adoptionof Christianity as the religion of the Roman Empire.The emperor Constantine (c. 272/3–337) wasconverted to Christianity in 312, and underTheodosius (c. 346–95) Christianity became theofficial religion, with non-Christians and hereticsbeing persecuted. Religion and politics remainedentangled for centuries, for outsiders to the rulingelite typically favoured non-orthodox versions ofChristianity. For example, Arian Christianity(heretical in relation to the official religion of theEmpire) was widespread in the countryside. AfterRome fell and Islam had come into being, theconflict between Christianity and Islamovershadowed the many disputes withinChristianity.

Economic problems played an important role inthe fall of the Roman Empire, even though attacksby waves of barbarian invaders provide the popularexplanation of what happened. A critical period forthe Empire was the third century. Population fellby a third, partly due to plague brought in byeastern invaders. The supply of gold fell, possiblybecause there were no longer new imperialconquests, a major source of gold in the past.

Alternatively, the reason may simply be thatcommerce was failing. With the fall in the supplyof gold, trade to the East collapsed. Furthermore,given that the Empire was held together only by thearmy and that there were many people in the citieswho needed to be pacified with distributions offood, taxation rose. At times the authorities had torequisition food directly to feed the army and thepoor. Some of the money needed was raised bydebasing the coinage. In the time of Augustus coinswere pure silver, but by 250 the silver content hadfallen to 40 per cent, and by 270 to 4 per cent.Despite attempts at financial reform by a series ofemperors, culminating in Diocletian's famous edictof 301 in which he sought to fix prices and wages,inflation continued.

An important economic and social change duringthe last years of the Empire that became even moremarked during the Middle Ages was the decline ofthe towns. Cities in the Western Empire wereessentially colonial towns, whereas those in theEastern Empire were larger and generated muchwealth. As trade declined, so did the position oftowns in the Western Empire. There was a generalretreat from them, symbolized by the fact that forChristian aescetics such as St Jerome (c. 347-420)

abandoning worldly possessions meant retreatinginto the desert.

To understand the economic thought of theMiddle Ages, it is necessary to understand notsimply the Greek and Roman ideas discussed in theprevious chapter but also two other strands ofthought: Judaism and early Christianity. Thisinvolves going back to the time of the OldTestament.

Judaism

The economic thinking of the early ChristianChurch owed much to Judaism. In the OldTestament tradition it was thought that restrictingone's wants was an important way to cope with theproblem of scarcity. As in ancient Greece, therewas also great suspicion of trade, and hostility tolending money at interest. There were, however,some distinctive features in the biblical teaching oneconomics. Man was seen as a steward, with aresponsibility to make the best possible use ofwhat God had entrusted to him. Work was seen as

good – a part of the divine plan for mankind. Adamwas told to multiply and fill the earth, and even inthe Garden of Eden he was to work the soil and tolook after it.1 Abraham was amply rewarded for hisfaith. These texts can be read as favouringeconomic growth – those who follow the Lordaccumulate wealth.

The Old Testament also contains many laws thatregulated economic activity. Charging interest onloans to fellow Israelites was forbidden. Afterworking for six years, slaves were to be set free andgiven enough capital to make a new start. Evenmore radical, all debts were to be cancelled everyseventh year (the sabbatical), and in every fiftiethyear (the jubilee) ownership of all land was torevert to its original owner. There is no evidencethat the jubilee was ever enforced, and certainly bythe time of the monarchy (c. 1000–900 BC) therewas considerable inequality. This was partly due tothe king's imposition of taxes, requisitioning ofgoods, and forced labour. (The state of the poorwas a major theme in the writings of the prophets.)The provisions of the law nonetheless helped keepalive the view that men were only stewards, notoutright owners, of their lands.

Though wealth was the reward given to the

righteous man, the pursuit of individual wealth wascriticized as leading people away from God. ForMoses, worship of the Golden Calf wasincompatible with the worship of God. Similarly,when Isaiah wrote of Israel being crowded withforeigners and traders, and (presumably as a result)being filled with gold and silver, he observed thatthe land was also filled with idols and that peoplebowed down in front of the work of their ownhands.2 Throughout the Old Testament, seeking toincrease one's own wealth is associated withdishonest business practices and the exploitationof the poor. This attitude was clearly expressed bythe prophet Amos (eighth century BC):Listen to this, you who grind the destitute and plunder the humble,you who say, ‘When will the new moon be past so that we may sellour corn? When will the sabbath be past so that we may open ourwheat again, giving short measure in the bushel and takingoverweight in the silver, tilting the scales fraudulently, and sellingthe dust of the wheat; that we may buy the poor for silver and thedestitute for a pair of shoes?’3

In the same way, moneylenders were seen, alongwith traders and retailers, as behaving unjustly –exacting interest in advance and depriving peopleof essentials such as the cloak under which theyneed to sleep.4

There was thus a clear distinction between thepursuit of wealth, which was castigated, and thewealth that arose through following God'scommands. As obeying God's commands involvedworking and acting as a responsible steward, thiswas far from a condemnation of all economicactivity. The objection was to bad practices, not tothe acquisition of wealth itself. Pursuing wealthwas wrong because it encouraged such practices.Thus, so long as they looked after their own peopleand behaved justly, the Israelites were encouragedin their business activity. The book of Ecclesiasteseven encourages people to engage in foreign tradeand gives advice on taking (and hedging) risks:‘Send your grain across the seas, and in time youwill get a return. Divide your merchandise amongseven ventures, eight maybe, since you do notknow what disasters may occur on earth.’5 The OldTestament is not about withdrawing from theworld. Money corrupts only when it becomespeople's sole motive.

Early Christianity

In the New Testament the emphasis is different.Jesus was steeped in the Old Testament, and muchof his teaching followed the laws of Judaism veryclosely. In the parable of the talents, he spoke ofstewardship and risk-taking, and he taught that therighteous would be rewarded. But he was a workingman, many of whose followers came from thepoorest parts of Jewish society and had no hope ofbringing about major economic, social or politicalchange. Thus he required his followers to give uptheir possessions, warned that the rich might find itimpossible to obtain salvation, and taught thatrewards for righteousness would be found inheaven rather than on earth.

For the earliest Christians, notably St Paul, whowas responsible for transforming Christianity froma Jewish heresy into a religion open to all races,Christ's second coming, and with it the end of thepresent world, was imminent. This meant that theidea of economic progress found in the OldTestament was pushed aside. Even the importanceof good stewardship of resources was played down.Paul wrote that those who have wealth should notcount on keeping it, or even on having time to useit to the full. His advice was that people shouldcarry on as they were, the imminence of the end of

the world meaning that there was no point instarting anything new. This was an environment inwhich economic thought was clearly not going todevelop. However, when it became apparent thatthe end of the world would not happen within thelifetime of the original Apostles (Peter is believedto have died in Nero's persecutions in AD 65), theChurch began to think again about economicdevelopment. There are some hints of this in thelater books of the New Testament, notably theRevelation of St John.

The early Fathers of the Church were thereforeconfronted with a tension between the views of theOld and New Testaments. On the whole they optedfor retreating from the world, possibly influencedby their Cynic and Stoic contemporaries. Povertyand detachment from worldly possessions wereencouraged, and we have the examples of hermitsand saints who gave up everything, retreating to alife of poverty. The Old Testament injunction towork was explained away by arguing that theproblem had been that idleness would lead tocorruption. Work was desirable because itprevented people from being idle, but if one couldresist temptation this was even better.

The outstanding figure of this period was St

Augustine, Bishop of Hippo, in North Africa (354–430). His City of God was written to rebut thecharge that the fall of Rome to Alaric and theGoths in 410 was retribution for the Empire'shaving adopted Christianity. The book is significantbecause it looks forward to the possibility ofcreating a new society, rather than simply lookingback to preserve, or re-create, the past. UnlikePlato, Augustine did not seek to establish ablueprint for a new society, for it is impossible tocreate a perfect society on earth. Instead he sawprogress as trying to get closer and closer to aperfect society.

Wealth, Augustine argued, was a gift from God;but, though it was good, it was not the highestgood. It should be regarded as a means, not an end.Though he considered it best not to own propertyat all, he recognized that not everyone could dothis. Private property was, for Augustine, entirelylegitimate, but it was important for people toabstain from the love of property (which wouldcause it to be misused). In the same way Augustinedistinguished between the trader and his trade:there was nothing wrong with trade in itself, for itmight benefit people through making goodsavailable to those who otherwise would not have

them, but it was open to misuse. Sin was in thetrader, not in trade. There was, however, anunresolved conflict between this teaching aboutthe legitimacy of private property and the natural-law doctrine of communal property. Privateproperty was the creation of the state, whichtherefore had the right to take it away.

Augustine took many ideas from Greek thought,but his horizons were incomparably broader.Whereas Xenophon and even Aristotle wereconcerned with the polis or city state, Augustinedealt with a people defined not by birth or locality,but by agreement on a common interest.Depending on the nature of this shared interest, thecommunity might progress or regress. Hebroadened out the Old Testament notion ofdevelopment to make it relevant to Christendom,not simply Israel, and provided a perspective onhistory that proved influential in the emergingsocieties of western Europe.

Islam

The Western Empire ceased to exist in 476. Thoughthis event was of great symbolic importance, littlechanged. The barbarian kingdoms that emerged inwestern Europe sought not to overthrow theRoman Empire, but to become part of it. They stilllooked up to the Roman emperor, even though thatemperor was now in Constantinople, not Rome.The significant event marking the end of theancient world was not the fall of Rome, but the riseof Islam and the Muslim conquest of Arabia, thePersian Empire, North Africa and much of Spain.The Muslim advance across Europe was stoppedonly in 732, by Charles Martel at Poitiers. It was atthis time that European society was cut off fromthe Mediterranean and had to reorganize itself. Itwas now, for example, not with the fall of theWestern Empire, that Syrian traders disappearedfrom western Europe. In contrast, in the Muslimlands trade flourished and a great civilization wasestablished, absorbing Persian culture in additionto the Hellenistic culture brought by Alexander.Centres of learning were established in cities suchas Baghdad, Alexandria and Cordoba, and there thelegacy of Greece was preserved at a time when itwas lost in the rest of Europe. Plato and Aristotlefirst entered the Latin West through translations

from Syriac and Arabic.The Islamic economic literature of this period

falls into two categories: the literature of the‘golden age' of Islamic dominance (750 to 1250)and that of the crisis years which followed (1250to 1500), by the end of which the Moors had beendriven out of Spain and the European nations wereembarking on voyages of discovery. Thebackground to this literature was the Koran. Likethe Old and New Testaments, this contained nosystematic exploration of economics, but it diddiscuss isolated, practical economic issues. It saidthat income and property should be taxed in orderto support the poor. The taking of interest on loanswas prohibited. Inheritance was regulated, so thatestates had to be broken up instead of being passedon to a single beneficiary. Beyond this there waslittle. While these rules presented a challenge,given the highly developed urban civilization thatIslam had taken over, Islamic society was verytraditional, and the role for economics was ratherlimited.

In the Islamic golden age, two main types ofliterature can be found. One is the so-called ‘mirrorfor princes' literature. The mirror books were openletters, usually written by scholars and viziers,

which presented rulers with an image of efficientand just government and advised on howcommerce and public administration might best beorganized. One of the most economicallydeveloped examples was by al-Dimashqi (in theninth century), who explained how the merchantcould contribute to the good of the community bylinking parties who have surpluses or shortages ofparticular products. He argued, however, that forthe merchant to benefit society he must refrainfrom speculation and the desire to accumulatewealth. He might take a normal profit, but nomore. Another type of writing concerned theorganization of either the city or the household. Itwas written by lawyers and civil servants –sometimes by the sheriffs responsible for ensuringthat markets functioned in an orderly manner. Theyanalysed the conflict between free markets(supported in the Koran) and the desire foradministrative control of markets and prices –something for which there was great pressure whenshortages threatened to make goods too expensivefor the urban poor to survive. Such writingfrequently discusses economic problems such aspricing, factors influencing consumption, and thesupply of goods.

The potential conflict between the Greekheritage and Islamic thought is illustrated byAverroes (Ibn Rushd, 1126–98), writing near theend of the golden age, the last in a line ofoutstanding Muslim philosophers. His father andgrandfather had held the position of chief judge inCordoba, and in 1169 he was appointed to thesame position in Seville. Part of his life was spentin Marrakesh, including a spell late in life as chiefphysician to the Emir. His commentaries onAristotle were probably written in Cordoba in the1170s, and are particularly important because itwas through these, translated from Arabic intoLatin, that Aristotle came to be known in theChristian West.

Though he had sympathies with Plato's ideal of astrong ruler, Averroes followed Aristotle in seekingto establish ethical principles through reasonedargument. This brought him into conflict withreligious traditionalists, who were not happy withthe way in which he sought to reconcile ethicsbased on reason with the revealed ethics of theKoran. At one point the Emir banished him fromMarrakesh, and his many books on Greekphilosophy were burned.

Perhaps the point where Averroes departed

furthest from Aristotle was in his treatment ofmoney. Aristotle had recognized three functions ofmoney: means of exchange, measure of value, anda store of value for future transactions. To these,Averroes added that of being a reserve ofpurchasing power: unlike other goods that couldalso serve as a store of value, money could bespent at any time without having first to be sold.He also took a different view from Aristotle on thequestion of whether money is a commodity likeany other. Writing in the twelfth century, Averroestook monetary transactions for granted in a waythat Aristotle did not: the economy could notfunction without it. Money was thus unique.Furthermore, the value of money had to beunchangeable, for two reasons. One was thatmoney is used to measure all things. Like Allah,also the measure of all things, it must beunchangeable. The other was that, if money is usedas a store of value, changes in its value are unfair.The money a ruler makes by reducing the amountof precious metal contained in coins is pure profitthat he has done nothing to earn, similar to intereston a loan, and is as such unjustifiable. Averroesthus broke with Aristotle's view that the value ofmoney is a convention that the ruler might alter at

will.In the thirteenth century the situation changed.

Following the Mongol advance into Europe, muchof Persia and Asia Minor fell to the Seljuk Turks.The Catholic princes of Aragon, Castile, Navarreand Asturias managed to reclaim much of Spainfrom the Moors. This was the background to thewritings of Ibn Khaldun (1332–1406), who camefrom a Moorish-Andalusian family but whomigrated to North Africa after the fall of Seville tothe Catholics. He pursued a varied career as a civilservant, jurist and historian – at one point heaccompanied the Sultan of Egypt to negotiate apeace treaty with the Mongol conqueror,Tamerlane. He was well educated in the scienceand philosophy of his day. But though he was amember of the ruling class, with close connectionsto emirs and sultans, his Spanish upbringing gavehim the attitude of an outsider to North Africancivilization.

Ibn Khaldun's major work is a history ofcivilization in which he wove together economic,political and social changes. It was a work in socialscience, or the science of culture, in which his aimwas not to derive moral precepts, but to explainthe organization of society. He was familiar with

Greek philosophy, but became sceptical about veryabstract theorizing, on the grounds that it couldlead to speculation and a failure to learn lessonsfrom past experience. Inquiries had to beexhaustive if their results were not to bemisleading.

Civilization, according to Ibn Khaldun, wentthrough a series of cycles. His theory has beensummarized by one historian as follows:A new dynasty comes into being and as it acquires strength, itextends the area within which order prevails and urban settlementand civilization can flourish. Crafts increase in number and there isgreater division of labor, in part because aggregate income rises,swelled by increase in population and in output per worker, andprovides an expanding market, a very important segment of whichis that supported by governmental expenditure. Growth is nothalted by a dearth of effort or by a shortage of demand; for tasteschange and demand rises as income grows, with the result thatdemand keeps pace with supply. Luxurious consumption and easyliving serve, however, to soften both dynasty and population andto dissipate hardier qualities and virtues. Growth is halted by theinevitable weakening and collapse of the ruling dynasty, usuallyafter three or four generations, a process that is accompanied bydeterioration of economic conditions, decline of the economy incomplexity, and the return of more primitive conditions.6

Though this might be seen as a political theory,explaining the rise and decline of dynasties, andthough sociological factors (such as the contrast

between the values acquired in Bedouin ‘desert' lifeand ‘sedentary' city life) are in the forefront of thestory, economic factors are nonetheless equallyimportant. Though not discussed separately,concepts such as the effect of division of labour onproductivity, the influence of tastes on demand,the choice between consumption and capitalaccumulation, and the impact of profits (and hencetaxation) on production are all analysed as part ofthe story.

Ibn Khaldun's account of the process ofeconomic development is a remarkableachievement. When taken together with the otherMuslim literature of this period, it shows how greatan understanding of economic phenomena existedamong certain circles of Islamic society in thefourteenth century. Trade and science bothflourished in the Islamic world, and men such asIbn Khaldun, involved in the legal andadministrative systems, were able to use their ownexperience and the traditions handed down tothem to amass a large stock of economicknowledge. Ibn Khaldun's work had little lastinginfluence in the Islamic world, however. It was inwestern Europe, not North Africa, that the nextmajor developments in economic thought were to

arise.

From Charles Martel to the Black Death

The golden age of Islam was the dark age ofChristian Europe. In the south, Muslims controlledmost of Spain and were at the gates ofConstantinople, while in the ninth century Vikingsdominated the north. Flows of gold into much ofEurope ceased, and there was a lapse into ruralself-sufficiency. Yet Christian Europe survived,primarily through the development of twoinstitutions. One was the monastic cell, in whichChristianity was kept alive. By 700, Benedictinemonasteries in the rest of Europe had fallen toinvaders, but Christian learning, includingknowledge of Latin and Greek classics, was keptalive in monasteries in Ireland andNorthumberland. By the time these were sacked bythe Vikings, Christianity had spread back to Franceand Germany.

The second vital institution was the system,sometimes referred to as ‘feudalism’, by which

grants of land were linked to military service.(‘Feudalism' is a term invented many years later,and meant different things in different parts ofEurope, so has to be used with care.) The invadersthreatening Europe were horsemen. To defeat themit was necessary to follow the Persian andByzantine example and use heavily armoured menon great horses, specially bred for their strength.The problem of how to support such horsemen,which had imposed a serious economic drain onthe Persian and Byzantine empires, was solved byCharles Martel (ruler of the Franks in 719–41), whoused lands confiscated from the Church to endow anew class of warriors. These received rights overland in return for an obligation to put a knight (or acertain number of knights) into the field whencalled upon to do so by the king. Around this grewup an entire social and economic system based onrelationships between land-holding and militaryservice. At the same time Charles Martel broughtmonks from England and Ireland to reorganize theFrankish church. Monasteries were established,along more puritan lines than the old Benedictinefoundations. An alliance at all levels of society wasformed between State and Church, the mostnotable sign of which was the concordat between

the ruler and the Pope, and the coronation ofCharlemagne (742–814) as Emperor in Rome.

The combination of military power and highlydisciplined religious orders provided the basis for aperiod of European expansion. Norman knightsconquered England (1066) and southern Italy(1057–85) and were, together with the monks ofCluny (in Burgundy), instrumental in organizing the‘reconquest' of Spain from the Moors (1085–1340).Between 1096 and 1291 the crusades (inspired bythe Church, but undertaken by Frankish knightsand their followers) established Christian states inPalestine. The twelfth and thirteenth centuries sawthe colonization of the plains of northern Europe.This involved both knights (the Teutonic Knights –the order of St Mary's Hospital in Jerusalem) andreligious orders. The Cistercians were particularlyactive: monasteries set up colonies, usually furthereast, bringing wasteland under cultivation. In thesame way, towns set up new towns further east.Other towns were established by kings. Long-distance trade was revived by the crusades, Veniceand other Italian trading cities providing much ofthe finance and transport, and gold began to becoined again in Europe. Expansion of trade withthe Far East was made possible by the Mongol

conquests in Asia, which established a unified,tolerant and peaceful empire stretching fromeastern Europe to China.

In the fourteenth century, however, thisexpansion halted. Jerusalem and the otherconquests in Palestine were lost by the West,advance in the East was halted, and the Moorsmanaged to halt the reconquest of Spain for twocenturies. The eastern Mediterranean was ruled notby knights organized on the Frankish model but byItalian trading cities. Archers (including those ofthe English at Créy) began to defeat armouredknights. Trade began to fall, bringing about thecollapse of many of the great banking houses ofEurope. Then in 1347–51 the Black Death spreadthroughout Europe. Population fell by a third, andin some areas by a half. Labour became scarce, andconflicts between labourers and landlords becameendemic, with peasant rebellions, legislation tocontrol labour, and attempts by the Church torecover lands it had lost. Feudal society, once themeans of expansion, became conservative andinflexible.

The Twelfth-Century Renaissance andEconomics in the Universities

But before this, in the midst of the process ofexpansion, there took place what has been calledthe twelfth-century renaissance. Perhaps linked torising prosperity, conflicts between emergingpowers (notably Church and State), the looseningof the feudal system, and the emergence of anurban middle class, there arose a demand forlearning. Peripatetic teachers, not unlike theSophists of ancient Greece, emerged. In the firsthalf of the twelfth century, Peter Abelard (1079–1142) argued for the use of reason and againstcensorship. Conquests of parts of Europepreviously controlled by the Moors made Arabiclearning available, and via this route Europeansrediscovered the Greek classics. The commentariesof Averroes were enthusiastically taken up, andthrough them Western scholars were introduced toAristotle. This ferment led to the establishment of anew institution, the university: Bologna, Paris andOxford were the first, and by 1400 there were afurther fifty-three.

It was from these universities that the period's

economic writing emerged. The scholars involvedformed a mobile, international community centredon one university: Paris. The economics theyproduced – usually referred to as ‘scholastic'economics – was concerned primarily with ethics.Ethical questions, however, inevitably requiredpeople to think about the way in which economicactivities actually worked.

The earliest scholastic writings on economics arefound in manuals for confessors – books on howpriests should advise people who came to them forconfession. Economics figured prominentlybecause many priests were unfamiliar with thebusiness practices on which people sought spiritualguidance. An example of such a manual is theSumma Confessorum, by Thomas of Chobham (c.1163–1235), written around 1215 – the year inwhich it became compulsory for all adults to go toconfession at least annually. Economics comes intothe book when Thomas reviews the moral hazardsof various professions, including that of themerchant. His list of capital sins includes bothusury and avarice. However, he provides a strongdefence of commerce, missing from many earlierwritings:Commerce is to buy something cheaper for the purpose of selling it

dearer. And this is all right for laymen to do, even if they do notadd any improvement of the goods which they bought earlier andlater sell. For otherwise there would have been great need in manyregions, since merchants carry that which is plentiful in one placeto another place where the same thing is scarce. Thereforemerchants may well charge the value of their labour and transportand expenses in addition to the capital laid out in purchasing thegoods. And also if they have added some improvement to themerchandise they may charge the value of this.7

He goes on to place merchants alongside craftsmen(a favoured occupation, since Joseph was acarpenter). Thomas warned, however, that it wassinful to deceive the buyer or to charge more thanthe just price.

Thomas brought several arguments to bear onthe question of usury. (1) When money is lent,ownership of the money passes from lender toborrower, so usury involves the lender profitingfrom property which belongs to someone else. (2)The usurer sells time, which belongs to God. (3)Lending for a share of profits is sinful unless thelender also shares expenses and losses in the sameproportion. Thomas did not allow interest to bepaid as compensation for opportunities lost by thelender during the period of the loan, but it wasacceptable to seek compensation for lossesincurred through a borrower's failure to repay a

loan on time.A significant advance in such thinking was made

by William of Auxerre (c. 1140–1231) – thetheologian who, in 1230, is thought to have playeda part in persuading Pope Gregory IX not to banAristotle's work. William based ethics on naturallaw, in the sense of ‘that which natural reasondictates to be done either without any deliberationor without much deliberation’.8 A modern scholarhas written:The importance to social philosophy of a concept like this is hardto overestimate. It provides a set of more or less self-evidentrational postulates on which further arguments are based. Theconclusions reached via such arguments (provided they arelogically correct) are rationally valid, but they are also normativesince they are based on law.9

William paid much attention to private property,concluding that it was a necessary evil – subject tothe qualification that, in times of need, those withproperty were obliged to share it with those whohad none. In a similar vein, he argued that the useof coercion, including the bargaining power thatmight result from a borrower needing a loan,rendered a contract invalid. It could not be arguedthat payment of interest was morally acceptablebecause the borrower had entered into the contract

voluntarily.The major figures in scholastic economics,

however, are usually considered to be Albert theGreat (Albertus Magnus, c. 1200–1280) andThomas Aquinas (c. 1225–74), both Dominicanfriars. By the time of their work, economic thoughtwas found not just in confessional manuals butalso in commentaries on Peter Lombard's Sentencesand on Aristotle, both of which were very commonliterary forms.

Aristotle (Nicomachean Ethics, V.5) argued thatjustice was served if the ratio of shoes to foodequalled that of shoemaker to farmer, or if the ratioof houses to shoes was that of builder toshoemaker. This passage has provoked enormouscontroversy, because the meaning of ‘shoemaker tofarmer' and ‘builder to shoemaker' is far from clear.Albert, in his commentaries on this passage,suggested that it should be read as meaning thatthe value of one good in terms of another shouldbe in proportion both to the relative need for thetwo goods and to the labour involved:As the farmer is to the shoemaker in labour and expenses, thus theproduct of the shoemaker is to the farmer's product… [It is] withregard to communal toil and trouble, they are sufficientlymeasured.

Exchange is to be made… according to a proportion between thevalue of one thing and the value of the other thing, this proportionbeing taken with regard to need, which is the cause of exchange.10

In the first of these sentences, Albert is sayingthat the values of shoes and food should beproportional to the labour and expenses of theshoemaker and the farmer. In the second he bringsin need as what should determine relative values.When taken together, these passages can be read asexplaining why labour should be rewarded: if thebed-maker does not receive enough to cover hisexpenses, no more beds will be produced. Valuesshould thus be related both to the need for goodsand to the costs of producing them. Albert startswith an ethical question, and on the basis of anobscure passage from Aristotle he reaches aconclusion about what prices must obtain ifsociety is to be supplied with the goods it requires.

Thomas Aquinas was a pupil of Albert the Great,and in much of his work he sought to simplify andclarify his teacher's writings. Like Albert, hebrought together ideas from Aristotle and theChurch Fathers, such as Augustine. This is wellillustrated by his teaching on property. Thiscontains all the major arguments used by thescholastics, many of which originated in Aristotle.

These include the need for private property ifpeople are to be in a position to exercise liberality,the argument that people will take more care overtheir own property than over the property ofothers, and the argument that private propertyleads to order. But it is in the argument from peacethat Aquinas's skill in bringing together patristicand Aristotelian ideas is perhaps best illustrated.The argument is Aristotelian, but AquinasChristianizes it by arguing that private property isnecessary for peace only because of the corruptstate of man following the Fall. However, thoughAquinas recognizes that property must of necessitybe private, the fruits of that property are commonand must be shared, either through giving one'ssurplus goods to those in need or through buyingand selling.

To understand their attitudes towards propertyand wealth, it is important to remember that manyof the scholastic writers were mendicant friars whowere committed to a life of poverty. They did notconsider wealth to raise the quality of life, let aloneto be an end in itself. On the other hand, theyrecognized that most poor people had not chosento live in poverty. They also recognized that ifeveryone were poor there would be no one who

could support them. This explains why Aquinas, forexample, warned against an excess both of povertyand of wealth. Wealth was beneficial only if usedin a way that was consistent with the demands ofjustice and charity.

One demand of justice was that, where goodswere used for exchange, buying and selling musttake place at the just price – that there must becommutative justice, or justice in exchange. Herethe scholastics took over from Roman law the ideathat something is worth as much as it can be soldfor without fraud. They were, however, unwillingto draw from this the conclusion that it was just tosell a good for the highest price that could beobtained for it. It was agreed that wilfulmisrepresentation of a good or its quality wasunjust. However, this argument from Roman lawpresumed that both parties consented to the termson which the goods were being exchanged, whichraised the question of how much informationabout a good the seller had to provide. Aquinasallowed that a seller could hide some information.If there were an obvious defect, it was enough tocharge a suitable price, and the seller did not haveto tell everyone about the defect (which mightresult in the good selling for less than the just

price). It was accepted that haggling took place –that buyers and sellers would always try to outwiteach other. There was also no requirement for aseller to tell a buyer about factors that might lowerthe price in future. For example, the owner of aship full of grain did not have to tell buyers aboutother ships that would shortly be arriving. The justprice was the price that was appropriate in thepresent, not the one that would prevail in future.

The main idea underlying scholastic discussionof the just price was that the market offeredprotection against economic compulsion. If thevalue of a good to its seller were more than itsnormal value, it could be sold for this higher value,otherwise the seller would experience a loss.However, it was unjust for a seller to takeadvantage of circumstances affecting the buyer.(Indeed, there was a long tradition in natural lawthat said that in cases of severe need, such asfamine, taking what one needed did not constitutetheft – that property became communal.)Competition between sellers, as occurs in publicmarkets, was recognized as protecting buyers.

What the scholastic writers were doing in theirdiscussions of issues such as property and the justprice was providing arguments based on natural

law to support and interpret (or qualify) theteaching of the Church on economic matters. Theirfocus was continually on injustice arising frompeople being under compulsion, and the need forthe victims of compulsion to be compensated. Indiscussing these problems, they developed andclarified many economic concepts. Nowhere is thismore obvious than in their teaching on usury. Theinjunction in the Sermon on the Mount to ‘Lendwithout expecting any return' was widely cited,11 aswas St Ambrose's claim that ‘If someone receivesusury, he commits robbery’,12 but they also tried tofind rational arguments to support their case.

The fundamental idea underlying all discussionsof usury was that money is sterile. Making moneyfrom money is unnatural. Thus, if a borrowermakes a profit using money he or she hasborrowed, this is because of his or her efforts, notbecause the money itself is productive. This idea ofthe sterility of money was reinforced by the legalconcept of a loan. In law, most loans took the formof a mutuum, in which ownership of the thing lentpasses to the borrower, who subsequently repays inkind. The original goods are not returned to thelender. This can apply only to fungible goods, suchas gold, silver, wine, oil or grain, that are

interchangeable with each other and can bemeasured or counted. Because ownership passed tothe borrower, it followed that any profit madeusing the goods belonged to the borrower, and thatthe lender was not entitled to a share.

The main qualification to the prohibition of anypayment by the borrower was that the lender couldseek compensation if he or she suffered a lossbecause the borrower failed to repay on time.Thomas of Chobham, for instance, gave theexample of a lender who needed the money totrade at the fair, to pay his rent, or to provide hisdaughter with a dowry. Compensation for an actualloss was widely accepted. Controversy began whenthe idea was extended to cover an expected losscaused by default (damnum emergens), or to coverthe loss incurred by the lender within the period ofthe loan (lucrum cessans). Aquinas, for example,rejected the argument for lucrum cessans on thegrounds that, as ownership passed to the borrower,the lender who took money was effectively sellingsomething that was not his to sell. One problemwith these qualifications was that, if they wereallowed, they could be used systematically to getround the prohibition on usury. A penalty clausecould be included in a loan contract on the

understanding that the borrower would default andthat the penalty would be paid.

Nicole Oresme and the Theory of Money

The scholastic economic tradition was an evolvingone, and, though Thomas Aquinas provided whatwas in many ways its definitive statement, itcontinued to evolve in the centuries that followed.The framework laid down by the Church Fathersand, from the twelfth century, by Aristotle was all-pervasive, but it still left room for change and theexploration of new lines of inquiry. Nowhere is thismore evident than in fourteenth- and fifteenth-century writings on money. Aristotelian ideasprovided the analytical framework, but new ideaswere developed in response to new problems.

The fourteenth century was a time of economic,political and social upheaval. For example, feudalinstitutions such as the links between militaryservice and rights over land were declining, andcommerce was expanding. New forms of credit and

banking were being developed. In the middle of thecentury the Black Death produced a chronicshortage of labour, substantially changing therelations between the different classes of society.Kings found themselves short of income and madeincreasing resort to measures such as debasement(reducing the gold and silver content of thecoinage) to increase their revenues. Questions ofmoney and its role in the economy thereforebecame much more prominent.

The way in which the Aristotelian tradition couldbe developed to deal with these new problems iswell illustrated by Nicole Oresme's Treatise on theOrigin, Nature, Law and Alterations of Money. Thiswas written in Latin in the mid fourteenth centuryby a Frenchman, born around 1320, who studied inParis, served as adviser to Charles V of France, anddied as Bishop of Lisieux in 1382. It was unusual inbeing written as a short tract on the evils ofaltering the currency, but it drew heavily onAristotle and probably reflects ideas that, by thistime, were widely accepted by scholastic writers.In the Treatise, Oresme puts forward theAristotelian arguments about the origin of money(in exchange) and condemns ‘unnatural' uses of

money. There are, however, emphases not found acentury earlier. Debasement is condemned asundermining trust in the currency (Oresme regardsit as worse than usury, which in turn is worse thanmaking money through exchange). Clipping ofcoins (in order to melt down and sell the metalclipped off) is also harmful, because the clippedcoins circulate as if they are of full weight. In bothcases, Oresme's argument is that the action leads toconfusion about the value of the currency, and thatthis is harmful. He cites Aristotle's contention thatthe thing that should be most stable in character ismoney.

Another issue to which Oresme pays attention isthe ratio of gold to silver in the currency. This, heargues, should reflect the natural scarcity of thetwo metals – because gold is scarcer, it should bevalued more highly than silver. Implicit in this isthe idea that scarce commodities are more valuablethan those that are more abundant. When therelative scarcity of metals changes, the ratio of goldto silver in the coinage will have to change too.However, such changes, Oresme believes, are rare,and most attempts by rulers to change the currencyare arbitrary and designed solely to raise revenue.He likens attempts to raise the value of a scarce

metal to a monopolist's charging a high price forhis product, and condemns it accordingly.

Oresme's main argument, however, is that moneyis intended for the community, to be used at aprice set by the ruler. In the same way that peoplemay own property but the community has a rightto the fruits of that property, the ruler has the rightto coin money, and to set its price, but is requiredto exercise this right in the interests of thecommunity. Thus, although it is wrong for a rulerto alter the value of money for his own ends, it islegitimate for him to do so on behalf of thecommunity:Since money belongs to the community… it would seem that thecommunity may control it as it wills… And if the community hasgreat need of a large sum of money for a war or for the ransom ofits prince from captivity, or for some other emergency, then itmight raise it by altering the money, and this would not becontrary to nature or usurious, since it would not be the act of theprince alone, but of the community to whom the money belongs.13

The significance of this passage is explained by anevent that happened in 1356. The King of France,Jean le Bon, was captured by the English atPoitiers, and the Dauphin was faced with a demandfor 4 million crowns as his ransom. This sum wasso large that to pay it threatened the stability of the

French currency. The Dauphin (who becameCharles V) turned to Oresme for economic advice.

There is, in Oresme's work, a tension betweendifferent ways of thinking about economic activity.The first idea is that it is the prerogative of theruler to determine the value of money. This impliesthat people should accept clipped coins at fullvalue and not value them according to theirintrinsic value (as natural riches). Against this,Oresme recognizes that men do what they findprofitable: they ignore the price set by the ruler andsell money ‘as if it were natural riches’. Thispractice leads to precious metal being transportedabroad, when it is lost to its proper purpose – tofinance trade in the country where it was minted.Oresme thus glimpses the power of the market, forhe sees that undervalued money will be exported,causing economic difficulties at home. He also seesthat it is important for a ruler to retain the public'strust in a currency, for by this time money hadceased to depend solely on the value of the silver itcontained. In other words, money had becomemore than a piece of precious metal marked with astamp to save people the trouble of weighing andtesting it. However, when Oresme challenges theway in which rulers alter the value of money, his

objection is the moral/political one that theinterests of the community must be placed abovethose of the ruler himself. It is thus moral orpolitical constraints, not economic forces, thatconstrain what the ruler should do. Although thecontext is much more modern, the underlyingargument is thoroughly Aristotelian.

Conclusions

The idea that the Middle Ages produced nosignificant economic thought is far from the truth.The underlying framework remained an ethical one,informed by theology and law. However, thescholastic writers tried to find rational argumentsfor their moral judgements – to develop ideasbased on natural law. To do this, they had todevelop and analyse economic concepts. They wereled into exploring what determined the value of acommodity and the role of competition inregulating prices. They also explored the nature ofmoney, and paid attention to the development ofnew commercial institutions. They used the

concepts of expected profit or loss and ofopportunity cost, though not everyone acceptedthat these could justify the payment of interest.Thus, although the scholastics' focus was onmorality, they could and did analyse the way inwhich the economy worked.

3

The Emergence of the Modern World View – theSixteenth Century

The Renaissance and the Emergence of ModernScience

Medieval society did not suddenly disappear. Inparts of Europe, feudal institutions continued intothe eighteenth and nineteenth centuries. Serfdom,for example, was not abolished in Russia until1861. Medieval views of the world, in whichreligion, science and mysticism exist alongside oneanother, have lasted even longer. In many respects,however, the fifteenth century marks the beginningof the modern world. This is symbolized by the fallof Constantinople to the Turks in 1453, whichmarked the end of the Roman Empire in the East.In the second half of the century the Portugueseexplored the African coastline, and reached India in1498. The West Indies were reached in 1492, andwithin a few years the continents of North andSouth America had been discovered. The world

could no longer be seen as centred on theMediterranean.

Dramatic as the new discoveries were, however,they were only a part of an even more extensivetransformation of European society that took placebetween the fifteenth and seventeenth centuries.Central to this process was the artistic, literary andcultural flowering, centred on Italy, known as theRenaissance. This would never have been possiblewithout the rediscovery of the Greek and Latinclassics. In the fourteenth century Petrarch (1304–74) had looked back on the preceding thousandyears as a ‘dark age' in comparison with the highlydeveloped cultures of Greece and Rome and hadstarted the process of rediscovering ancientliterature. The scholastics of the Middle Ages had,of course, rediscovered much ancient writing, but,whereas they had been interested primarily inphilosophy, and above all in Aristotle, Petrarchsought to learn from the entire corpus of classicalwriting – poetry, history and biography as well asphilosophy and science. Classical scholarship(literae humaniores) provided an alternative sourceof moral inspiration to that provided by theChurch.

Even in artistic works commissioned by the

Church – which were extensive (work on St Peter'sBasilica in Rome was started in 1506) – there wasan increased interest in humanity. Less and less didmajor works of art have a religious theme, and,when such themes were treated, the impact of therediscovery of the classics and the new humanismwas clear. To illustrate this, it is enough to cite thenames of Leonardo da Vinci (1452–1519),Michelangelo (1475–1564) and Raphael (1483–1520). The same was true of music. Art and musicwere no longer being used solely in support ofreligion.

As people rediscovered classical literature, theydiscovered new perspectives on science, manyderiving from Plato rather than Aristotle. It was aview of the world where science, astrology andpagan gods all had a place. A significant part of thiswas the Neoplatonic association of the sun withdivinity, from which it was a short step towardsseeing the world as going round the sun rather thanvice versa.

The man who took this step, Copernicus (1473–1543), was driven by a Pythagorean search for asimple, mathematical formula that would explainthe motion of the planets. What he objected to inthe geocentric cosmology he inherited from

Aristotle and Ptolemy was its inelegance as muchas its inaccuracy – though deriving a more accuratesystem was of crucial importance because of theurgent, practical problem of reforming thecalendar. (Because the calendar year was notexactly the same length as the solar year, theseasons were moving away from their traditionalplaces in the calendar.) Copernicus turned toclassical writers other than Aristotle and Ptolemy,and found there the idea of a sun-centred universewhose implications he worked out. Though thepredictions of such a system were still far fromsatisfactory, Copernicus was nonetheless able toproduce results that were superior to those derivedfrom the old system. However, although displacingthe earth from its position at the centre of theuniverse involved a radical break with tradition, therest of his cosmology was medieval. Heavenlybodies still travelled in circles, at constant speed,moved by crystalline spheres. Postulating a movingearth was anomalous in that Copernicus could notanswer obvious objections, such as why, if theearth was moving, objects on its surface did notfall off.

Further movement away from the medievalworld view towards that of modern science

occurred during the following two centuries. Kepler(1571–1630), working with the more accurateastronomical observations provided by Tycho Brahe(1546–1601), discovered that elliptical orbits, withthe sun at one of the foci, fitted the data far better.He too was inspired by the Neoplatonic search forharmony and pattern in the universe. However, hestill did not answer the main objections to the ideaof a moving earth, nor provide any theoreticalexplanation of why the earth should move. It wasleft to Galileo (1564–1642) to develop newmethods of inquiry (such as turning a telescope onthe stars) and to postulate a uniformity betweenthe motion of bodies on the earth and in theheavens. Descartes (1596–1650), again developingideas from classical writers, took the step of seeingheavenly bodies as particles moving freely in aninfinite space. Taking his lead from Galileo, heprovided the first statement of the law of inertia.The system was then completed by Isaac Newton(1642–1727), who added the law of gravity.Newton was able to use his laws of motion toexplain not only the movement of the planets butalso that of bodies on the earth's surface. For thefirst time, there was a coherent and completealternative to medieval cosmology. The universe

was seen no longer as being kept in motion by Godbut as governed by mechanical laws. God mightplay a role in setting it in motion (a divine clock-maker), but thereafter his role was at an end.

Such a brief account of the rise of modernscience is necessarily oversimplified, but it isenough to make several important points. TheScientific Revolution involved a profoundtransformation in how the world was viewed, withimplications not only for the way in which naturalphenomena were thought of but also for thinkingabout religion and society. A change of thismagnitude was a long-drawn-out process. At itsbeginning, anticipations of the ScientificRevolution can be found in the via moderna(modern way) stemming from the work of Williamof Ockham (c. 1285–c. 1349), with its separation ofthe spheres of human reason and divine revelation.Towards the end of the transformation, evenNewton retained a belief in astrology that cannotbe separated from his astronomy.

The Reformation

The sixteenth century was also the time of theReformation, when the Protestant Churchesseparated from the Roman Catholic Church. Thisevent, or series of events, had profound politicaland social consequences. Although this has beendisputed, it may even have been an importantfactor underlying the economic growth in Englandand the Netherlands, two Protestant countries,during the seventeenth and eighteenth centuries.However, it did not involve any significant breakwith traditional economic thinking, for it wasessentially a conservative movement – areaffirmation of Judaeo-Christian morality andtheology against the humanistic-pagan influencesof the Renaissance. The event that provokedLuther's publication of his ninety-five theses in1517 was the arrival of a friar selling indulgencesto pay for the building of St Peter's Basilica.

One of the factors that made Luther's standagainst the Church hierarchy more far-reachingthan the many similar protests that had been madein earlier centuries was the invention of printing.The Gutenberg Bible was printed in 1455, and bythe end of the fifteenth century the number ofbooks printed probably exceeded the numberwritten by scribes in the previous thousand years.

Printing meant that Protestant ideas could spreadrapidly within Europe. Luther's protest thus becamemuch more than a single monk's quarrel with theChurch. The other factor underlying the success ofthe Reformation was the emerging nationalismwithin Europe. In the German states, Luther foundprotectors against both the papacy and theHabsburg Empire. Religious differences could beused as weapons in political battles.

The major figures in the Reformation – MartinLuther (1483–1546), Jean Calvin (1509–64) andUlrich Zwingli (1484–1531) – were conservative oneconomic questions. Luther strictly upheld theprohibition of usury and the doctrine of the justprice, even rejecting some of the exceptions thathad come to be accepted. As money was sterile, forexample, it was wrong to demand a premium forlate payment. He endorsed the idea of ahierarchically ordered society, in keeping withmedieval thinking. In general, however, Luther hadlittle interest in economic questions and certainlyno curiosity about economic matters. Similarly,although Calvin relaxed the teaching on usury, hetoo held strongly to the idea of the just price.Businessmen were expected to make only moderateprofits, and were not to seek all they could get.

Even on usury, however, his thinking was inpractice close to scholastic doctrine. While heaccepted that the payment of interest waslegitimate, he hedged it with qualifications: peopleshould not be professional moneylenders, theyshould not take advantage of the poor, and theyshould obey legal restrictions on interest rates.Such doctrines were all firmly in the scholastictradition.

The Reformation had a very direct impact onpolitical thought. In the medieval world view, goodlaws were judged by their conformity with God'slaw. Sovereignty derived from God. Thus it was onthe authority of the Pope, Christ's vicar on earth,that Charlemagne was crowned Holy RomanEmperor in 800. Though there were continualdisputes between secular and ecclesiasticalauthorities, neither side sought to dispensecompletely with the other. Conflict between thetwo jurisdictions was a defining feature ofmedieval politics, not something that could beeliminated. On the other hand, given the need toresolve such conflicts, a large literature grew up onthe claims that secular and ecclesiasticalauthorities might rightly make. Radicals entertainedthe notion that sovereignty might come from the

people, though at the same time seeking toreconcile this with the idea that God was sovereignover all.

This situation was transformed with theReformation. There was no longer any singleecclesiastical authority to which everyone owedallegiance. If a ruler became Protestant, there was aproblem for those of his subjects who remainedloyal to the Catholic Church. Individual Protestantsliving under a Catholic ruler were in a similarsituation. It was possible to conceive how subjectsmight find themselves in a situation in whichreligious scruple called for disobedience to theirruler. In short, there was now a problem ofpolitical obligation. A new basis for politicalstructures was required. One way to obtain thiswas to appeal to the idea of natural law. Thoughstemming from Stoic and Roman thought, anddeveloped by the scholastics, the idea of naturallaw was taken up by Protestant lawyers andphilosophers. This had implications for economicthought, though it was not until the seventeenthcentury (with the work of Grotius, Pufendorf,Hobbes and Locke – see pp. 74–5, 80–82 and 108)that these were explored. In the sixteenth century,novel economic thinking arose from a different

quarter.

The Rise of the European Nation State

Alongside these cultural and religious changes wasa fundamental change in the way in which societywas organized. Medieval society was one where avariety of powers competed with each other forsupremacy. This was most clearly represented inthe long struggle between the emperors (first theRoman emperor, later the Holy Roman Emperor)and the papacy. Alongside these, numerous localprinces also claimed allegiance. There had, ofcourse, been monarchies for centuries, but theyrarely ruled over lands that had any strong nationalidentity, and their power was frequently limited bythe power of nobles living within their realms:kings had no monopoly over military force.However, from the fifteenth century, this began tochange. There emerged several powerful nationstates, each of which comprised a definedgeographical area in which the inhabitants shared acommon national identity and were ruled by a king

who held a monopoly of military power and hencepolitical power. The power of the nobility becamesubject to that of the monarch. This process wasmost advanced in England, which had a definednational boundary and was secure from foreigninvasion, but France and Spain – much larger andthen more powerful – were not far behind.

These emerging nation states had extremelymeagre resources available to them. They had toraise armies and maintain navies, but theiradministrative apparatus and tax powers were verylimited. Maintaining a permanent national armywas beyond the economic capacity of anygovernment, and rulers had to resort to suchexpedients as employing foreign mercenaries.Kings, even of the most prosperous parts ofEurope, were chronically short of money. Thus notonly did people increasingly think in nationalterms, they also started to consider ways in whichthe economic power of nations could be increased.There were changes in the economic environmenttoo. The geographic discoveries made by thePortuguese and Spanish changed trade patterns.The opening of long-distance maritime trade routeshad an enormous effect and arguably marked aturning point in western-European economic

history. Spanish conquests in America broughtlarge quantities of gold and silver to Europe. Prices,which had fallen steadily through the fourteenthand fifteenth centuries, began to rise in thesixteenth. The changing role of the Church insociety meant that the state had to take on newresponsibilities. The Poor Law, introduced byElizabeth I of England in 1597–1601, to providesupport for the destitute, was something that hadnot been needed a century earlier.

These changes were associated with twosignificant shifts in the economic balance ofEurope. The first was the decline of independentcity states. The cities that grew most rapidly duringthe sixteenth century were capital cities. Forexample, the population of London rose from lessthan 50,000 in 1500 to around 575,000 in 1700.Other cities did not grow to the same extent.Venice, for example, declined in importancerelative to London, Paris and Amsterdam. Thesecond shift was the increased prosperity of thecountries bordering on the North Sea and thedecline of the Mediterranean. It has been arguedthat by the end of the seventeenth centuryconditions were such that it is inconceivable thatthe Industrial Revolution could have occurred

anywhere other than in England or the LowCountries. It would be difficult to come to thisconclusion looking at the situation two centuriesearlier.

Mercantilism

The rise of the European nation state is oftenassociated with ‘mercantilism’. This term has beenused to describe the economic thought of theentire period from the end of the Middle Ages tothe Age of Enlightenment – from the fifteenthcentury to the eighteenth – but the word‘mercantilism' (along with its synonym ‘themercantile system’) was not used until the secondhalf of the eighteenth century. Its inventor was theMarquis de Mirabeau (see p. 100), in 1763, but theperson who popularized it was Adam Smith, whoused it in his Wealth of Nations in 1776 (see p.121). Smith used it as a label for a set of policieshe was criticizing. It was then taken up byeconomists and historians, who used it to refer todifferent things. As often happens when terms

develop in this way, Smith grossly oversimplifiedhis predecessors' thinking, and many of theseoversimplifications were carried over into theensuing literature. However, although somehistorians have argued that it would be better toavoid using the term, it can be used to describecertain broad sets of ideas and policies.

Mercantilist policies include the use of statepower to build up industry, to obtain and toincrease the surplus of exports over imports, and toaccumulate stocks of precious metals. These stocksof precious metals, which could readily be turnedinto money, were believed to be important fornational power. They might bring economicadvantages (for example, a larger supply of moneymight stimulate production and employment), andthey were needed to pay armies.

Mercantilist economics, unlike ancient ormedieval economics, was centred on the nationstate, which was viewed as being in a competitivestruggle with other nations. However, the so-called‘mercantilist' era spanned three or possibly fourcenturies during which major economic and socialchanges took place. It covered countries rangingfrom the prosperous, growing economies ofEngland and the Netherlands to much more

backward regions such as those in eastern Europe.There were also great differences in social andpolitical institutions within Europe. To see whythese matter, consider some of the goals that havebeen proposed to explain mercantilist policies.These include (1) unification of the state through asystem of national protective tariffs and internalfree trade; (2) provision of sufficient revenue forthe state through developing the economy; (3) highemployment, through encouraging trade andincreases in the money supply; and (4)accumulation of treasure and wealth through tradepolicy. The problem is that different aims appliedin different countries and at different times.Unification through customs policies wasunnecessary in England, and was not achieved inGermany till the late nineteenth century. Provisionof state revenue through economic developmentcharacterizes the policy of Colbert under Louis XIVin France (see pp. 89–90), but does not fit thepolicies pursued in other countries. Notsurprisingly, therefore, it can be argued thatpolicies have to be explained in terms of responsesto particular problems rather than as the result ofgovernments seeking to achieve some larger aim.

There is also the problem that the term

‘mercantilism' is used to denote both the economicpolicies pursued and the economic ideas that wereused to analyse those policies. It refers both to theactions and ideas of statesmen such as Colbert andto the people who developed ideas about how theeconomy worked – the so-called ‘mercantilist'writers. Like mercantilist policy-makers,mercantilist writers were generally responding toimmediate practical problems. Their thinking wasstrongly influenced by the context in which theseproblems arose, and by the perspectives fromwhich they tackled them. Contributors to themercantilist literature include academics workingin the scholastic tradition (natural-lawphilosophers), lawyers, government officials or‘consultant administrators’, merchants, speculatorsand adventurers. It is therefore not surprising thatthere was no uniform mercantilist doctrine. It is forthis reason that the term ‘mercantilism' will be usedvery sparingly in this and following chapters.Though many of the writers discussed could belabelled ‘mercantilist’, in most cases it is preferableto focus on other aspects of their work and torefrain from categorizing them in this way.Sometimes, however, it is hard to avoid using theterm.

Machiavelli

The best-known political thinker of the sixteenthcentury and of the Renaissance was NiccolòMachiavelli (1469–1527) author of The Prince(written in 1513). Although Machiavelli's approachhas much in common with the approaches ofseventeenth-century writers, his book was aresponse neither to the problems of emergingnation states nor to the Reformation's underminingof medieval conceptions of sovereignty.Machiavelli – writing before the Reformation – wasresponding to the situation facing certain Italiancity states.

His book broke with the past in many ways. Theinterests of the state were clearly separated fromreligion, and the science of politics was seen asseparate from morality. Machiavelli offered ananalysis of how rulers could most efficientlyachieve their objectives – typically to increase statepower. Though subsequent commentators haveoften focused on his precepts concerning theruthless use of power by rulers, it is arguably theway in which he approached the problem that wasmore important. His methods involved bothobservation – drawing conclusions from the results

of policies pursued by rulers in the past – anddeduction from general assumptions about humannature. He based his advice on the assumption thatpeople would behave unscrupulously, in a self-interested way – not because he believed that menhad no moral principles, but because this was thesafest and most reliable assumption to make. Menmight behave morally or altruistically, but it wasfoolish for rulers to rely on this.

The School of Salamanca and AmericanTreasure

Scholastic thought continued through the sixteenthand seventeenth centuries, though its contentchanged in response to new circumstances. Oneplace where it remained strong was Spain, wherethe pre-eminent school was at Salamanca. Here,theologians and jurists continued to write in thetraditional scholastic style – full of questions,objections, distinctions, solutions and conclusions,quoting extensively from Aristotle and Aquinas.Their economic analysis began with Aristotle, but,

despite this, they were responsive to the newproblems posed by the growth of commerce andthe influx of vast quantities of treasure from theNew World into what was a backward part ofEurope. The main problems facing the School ofSalamanca were usury, prices and money, where itwas necessary to bring Thomistic doctrines intoline with contemporary business practices, and toexplain the dramatic changes that Americantreasure was having.

An important figure in the line of Salamancanwriters was Martin de Azpilcueta Navarro, orNavarrus (d. 1586), a Dominican who had taughtlaw at Toulouse and Cahors before moving toSpain. Navarrus's account of the value of money iscontained in ‘Comentario resolutorio de usuras’, anappendix to a theological manual published in1556. He began from Aristotle's observation thatthe purpose of money is to facilitate trade.However, where earlier writers had condemnedother uses of money as unnatural, Navarrus arguedthat changing it for profit was an importantsecondary use of money. In the same way that itwas just for merchants to make moderate profitsfrom buying and selling goods, money-changingwas lawful if done to obtain a moderate living. He

also took a more relaxed view of usury, allowing agreater range of compensation for loss.

However, how could someone make a profit atthe same time as always dealing in money at itsjust price? Navarrus's answer was that the value ofmoney was not constant, determined simply by itstale (the stamp on it) or the quantity of preciousmetal it contained. The value also depended onmoney's scarcity and the need for it, as well as onfactors such as uncertainty about whether it wouldbe raised or lowered in value, or even repudiated.Though it was wrong for money-changers to createartificial shortages in order to make a large profit, itwas legitimate to take advantage of normalvariations in the value of money, buying monieswhere or when they were cheap, and selling whereor when they were dear.

These moral assertions rested on a supply-and-demand theory that was applied to money as wellas to other commodities: thatall merchandise becomes dearer when it is in great demand andshort supply, and that money, in so far as it may be sold, bartered,or exchanged by some other form of contract, is merchandise andtherefore becomes dearer when it is in great demand and shortsupply.1

This, Navarrus contended, was why prices rose‘after the discovery of the Indies, which floodedthe country with gold and silver’.2 Though it mightlook as though all other goods had become moreexpensive, this was because money had fallen invalue. He went on to explain changes in the relativeprice of gold and silver in a similar way.

One of the problems faced by Spain was that,though it received vast quantities of treasure fromAmerica, little of it remained in the country. Moneyflowed out to the rest of Europe: it was mostabundant in cities such as Genoa, Rome, Antwerpand Venice. One response to this was to imposelaws forbidding its export. Thomas de Mercado (d.1585), another member of the School ofSalamanca, used exactly the same arguments asNavarrus to claim that such laws would fail to keepmoney in. If money was being exported it wasbecause it was more highly valued abroad than athome – in Antwerp rather than Seville, say – and sothe only way to stop it leaving the country was toincrease its domestic value relative to othercommodities. Like Navarrus, Mercado argued thatthese natural variations in the value of money indifferent places justified making profit throughengaging in foreign-exchange transactions.

The idea that scarcity makes goods dear andplenty makes them cheap has a history going backto ancient times, so it is not surprising that theSalamancans were not alone in seeing a linkbetween American treasure and rising prices.Another to do so was Jean Bodin (1530–96), alawyer and official in the French government.Bodin noted that prices of all goods and also theprice of land had risen. He claimed that theprincipal reason for this was not scarcity ormonopoly (two reasons often given for highprices), but the abundance of gold and silver. Bodincited historical examples, from biblical and ancienttimes, to support this claim. One way in which hisResponse to the Paradoxes of Males-troit Concerningthe Rising Prices of All Things and the Means toRemedy the Situation (1568) stands out from theSalamancan works is in its detailed factualdiscussion of monetary conditions in differentparts of Europe, which enabled him to discuss withsome authority how trade caused money to flowfrom one country to another.

England under the Tudors

The end of the Middle Ages in England is usuallydated to the accession to the throne of HenryTudor, in 1485. Though the Tudor monarchyconfronted many of the problems facing otherEuropean rulers of the period, such as inflation anda chronic shortage of revenue, defining nationalboundaries was not one of them. The mostinteresting economic work from the Tudor period isA Discourse of the Common Weal of This Realm ofEngland, probably written by Sir Thomas Smith(1513–77), a Cambridge don, lawyer andgovernment official, in 1549 and revised in 1581.3It takes the form of a conversation between adoctor (the leading figure), a knight, a merchant, acraftsman and a husbandman (farmer), in whichmany of the social and economic problems of theday are discussed – the major ones being inflationand the enclosure of common land so that it can beused for grazing sheep.

Inflation was, as in the rest of Europe, a seriousproblem in sixteenth-century England. In earliercenturies prices had fluctuated, but there had beenno long-term tendency for prices to rise, whereasby the end of the sixteenth century wheat prices

were between four and five times higher than theywere at its beginning. The author of the Discourseclearly sees the difference between real and moneyincomes, for he points out that rising prices harmonly those people on fixed incomes: landlordswhose rents are fixed by pre-existing contracts, andworkers who work for fixed wages. Those who buyand sell gain from rising prices. He also points outthat it does not make sense to complain aboutforeign goods being more expensive if the goodsthat are exported to buy them have also risen inprice.

People were very familiar with the idea thatscarcity, or ‘dearth’, could cause high prices, butthe problem now was that prices were rising evenwhen goods were plentiful. The explanation offeredby Smith was debasement of the currency – hardlysurprising, given that the first version of theDiscourse was written in the middle of the so-called‘Great Debasement' of 1542–51, during which thesilver content of the shilling was reduced to a sixthof its previous amount. Such changes in the valueof the currency were roundly condemned. In 1581,perhaps because Smith had by now read Bodin, anew explanation of inflation was introduced: anincrease in the quantity of money caused by

imports of gold and silver from the Indies andother countries.

Enclosure of common land was associated withthe expansion of sheep farming, to satisfy thegrowing demand for wool caused by rising exportsof English cloth. Wealthy landlords were seen to befencing off common land to graze sheep, causing adearth of food and depriving poor people of theirlivelihoods. Not surprisingly, enclosure was bitterlycontroversial and was the major issue discussed inthe Discourse. Smith's explanation was thatenclosure was the result of the price of wool beinghigh relative to the price of grain. He argued thatmen would not engage in difficult or dangerouswork unless they received an appropriate reward.Take these rewards from them… [and] what man will plow or digthe ground or exercise any manual art wherein there is any pain?…[I]f all these rewards were taken from them all these faculties mustdecay, so if part of the reward be diminished the use of thosefaculties shall diminish… and so they shall be the less occupied, theless they be rewarded and esteemed.4

Smith argued that it was necessary for ‘the profit ofthe plow to be as good, rate for rate, as the profitof the grazier and sheepmaster’, otherwise ‘pastureshall ever encroach on tillage for all the laws thatever can be made to the contrary’.5 The way to stop

the expansion of sheep farming, therefore, was notto legislate against it, but to make it less profitable.The way to do this was to remove the tariffs thatmade it so profitable to export wool.

Smith saw the importance of the balance of trade,and frowned upon importing unnecessary luxuries,or goods manufactured from English raw materials.He encouraged the introduction of new industriesthat would create work and bring treasure into thecountry. These are all policies that can be labelled‘mercantilist’. However, he showed a keenawareness of the price mechanism, assuming thatmen were motivated by self-interest. In this, hiswork marks a major break with scholasticeconomics.

Economics in the Sixteenth Century

The rise of the European nation state had anenormous impact on economic thinking. Economicstrength was vital to national power, and muchthought was given to designing policies that would

achieve this. There was a change in the focus ofeconomic thinking. It was also important to tacklethe new problems thrown up by the Spanishconquests in America and the expansion ofcommerce and finance. In the longer term, theRenaissance and the Scientific Revolution were tohave a major impact on economic thinking, but inthe sixteenth century their influence was muchless. The movement away from earlier ways ofthinking was gradual – there was no suddenrevolution in economic thought.

The School of Salamanca ended up with anattitude towards commercial activities that wasvery different from that of Aristotle or Aquinas, butits methods lay squarely within the scholastictradition. Men of affairs, such as Jean Bodin and SirThomas Smith – both lawyers cum governmentofficials – moved even further from the medievalview. To a still greater extent, moral questions werepushed aside in favour of analysing what wasactually going on in the world and what could bedone. Instead of disputing the morality of profit,such writers were beginning to take profit-seekingbehaviour for granted and attempted to work outits implications, in much the same way thatMachiavelli had worked out the implications for

statecraft of people taking those actions that werein their own interests.

4

Science, Politics and Trade in Seventeenth-Century England

Background

Seventeenth-century England produced anexplosion of pamphlets dealing with economicquestions. In most of them, merchants andbusinessmen sought to defend their own interestsand to argue for policies that were to their ownadvantage. Trade was organized through tradingcompanies (such as the Merchant Adventurers andthe East India Company) which regulated trade toparts of the world in which they were givenmonopoly privileges. Each of these companies hadits own interests, as did outsiders who wereopposed to the companies' privileges. The resultwas a proliferation of new economic ideas.However, the fact that most writers were motivatedby self-interest did not preclude careful and subtleanalysis, with the result that great progress wasmade. The rise of this literature can be related to

the economic problems facing the country and to apolitical system that gave people the incentive toprovide rational arguments for the policies theywanted to see adopted. Underlying it was anincreasingly secular outlook, reflected in newattitudes to both science and politics which hadprofound effects on the way in which peoplethought about economic questions.

Science and the Scientists of the Royal Society

Two figures dominated seventeenth-centurythinking on science. The first was Francis Bacon(1561–1626), whose Novum Organum (1620)provided a manifesto for experimental, empirical,science. He called for a reconstruction ofknowledge on the basis of two principles: naturalhistory (the detailed, systematic collection of factsabout nature) and induction (deriving laws ofnature from these facts). Scientists were to beservants and interpreters of nature. Bacon wascritical of Aristotle and other ancient authoritiesfor creating elaborate arguments based on

premisses that were not based on carefulobservation and that were frequently contrary tonature. He was far from being the first to makethese complaints, but his views were widelydiscussed.

The second dominant figure was René Descartes(see p. 53). Like Bacon, Descartes challengedscholastic philosophy and sought to establish firmfoundations on which knowledge could rest. He ismost famous for his phrase ‘Cogito ergo sum' (‘Ithink, therefore I am’) – the only thing that cannotbe doubted is that I am doubting. However, in thescientific context, the most significant aspect of histhought is the importance he attached to reason.Whereas Bacon sought to base knowledge onexperimental science, Descartes sought, in themanner of mathematics, to base it on a set ofsimple, self-evident truths. Using deductive logic,more complex truths could then be derived fromthese. The result would be a body of knowledgethat was certain and free of internal contradictions.

Bacon and Descartes both challenged traditionalauthority and offered methods that they believedwould provide secure foundations for knowledge.The methods they offered were radically different,in that Bacon emphasized induction and Descartes

deduction. However, there were similarities.Descartes argued that the simplest, mostcomprehensible view of the world was to see it notas a single organism but as made up of variousparts. It was to be understood in terms of the waythose parts moved and interacted – as a mechanicalsystem. The scientist should rely not on subjectivejudgements about the world but on qualities thatcould be measured. Despite their differences,which were substantial, Descartes's belief inmeasurement paralleled Bacon's belief inexperimental science. They were united in rejectingauthority as the basis for knowledge.

Bacon's programme was taken up by the RoyalSociety, which received its charter in 1662 andincluded most of the leading scientists of theperiod, such as Robert Boyle (1627–91 – theleading figure), Isaac Newton, Robert Hooke(1635–1703), John Locke and Samuel Pepys(1633–1703). Its motto, ‘Nullius in verba' (‘On noman's word’), echoed Bacon's rejection ofarguments from authority, and the Society laiddown procedures about how experiments were tobe conducted and reported if their results were tobe accepted. There were serious difficulties withthe inductive part of the programme (even the

concept of induction was ambiguous). TheSociety's critics (such as Thomas Hobbes (1588–1679)) raised justifiable questions about itsexperimental procedures; some of the fact-gathering was pointless, and some of theexperiments performed by the ‘virtuosi' merited thescorn poured on them by writers such as JonathanSwift (1667–1745). However, despite theseproblems, the Royal Society was undoubtedlyextremely successful. The achievements of Boyleand Newton alone are enough to establish that.

From the start, economic questions formed partof the Society's programme. Bacon had called fornatural histories of different trades – of ‘naturealtered or wrought’. The major figure here wasWilliam Petty (1623–87). Petty studied medicine inHolland and France, served for a short time as anassistant to Hobbes (who himself may at one timehave been an assistant to Bacon), and thenreturned, in 1646, to Oxford. There he met Boyleand became involved in the circle from which theRoyal Society developed. However, having becomeestablished as Professor of Anatomy at Oxford, andProfessor of Music at Gresham College in London,he took leave of absence in order to go to Irelandas physician to Cromwell's army. Cromwell was

faced with the task of dividing Irish lands to rewardhis soldiers and financiers. In 1655–8 Pettyundertook the task of surveying, and producedsome of the best maps of any country at the time.Through buying land from soldiers who wanted tosell the land they had been given, he establishedhimself as a major landowner, though he had tospend much time defending his titles.

Petty's thoroughly Baconian approach toeconomics is stated clearly in the Preface to hisPolitical Arithmetick, written in the 1670s thoughnot published until 1690, after his death: ‘Insteadof using only comparative and superlative words,and intellectual arguments, I have taken thecourse… to express my self in terms of number,weight or measure; to use only arguments of sense,and to consider only such causes, as have visiblefoundations in nature.’1 His objective in writing thebook was to show that, contrary to much popularbelief, England was richer than ever before. Hetried to achieve this by providing arguments basedon numbers and arithmetic calculations.

Central to Petty's claim about England's wealthwas an argument about the value of labour. Wealthcomprised people as well as land (of which Franceclearly had more than England) and capital.

Starting from the observation that people eachspent £7 per annum and assuming a population of6 million, he calculated that national income mustbe £42 million. Deducting £8 million for rents anda further £8 million for profits on ‘personal estate'(housing, ships, cattle, coins and stocks of goods),this left £26 million which had to be produced bylabour. This gave the following national accounts:

Expenditure Income

Personalspending £42 million Wages £26 million

Profits £8 million

Rents £8 million

Total £42 million Total £42 millionPetty went on to compute the value of the

population itself. He made the assumption that therate of return for labour was the same as that forland. He further assumed that its value was 20times the annual revenue that could be derived

from it (implying a rate of interest of 5 per cent perannum), and deduced that, if labour contributed£26 million a year, its value must be 20 times that– namely £520 million. Dividing by the population,this gave him a value for the population of £80 perhead. This could then be used to calculate suchthings as the value of the population lost in theGreat Plague.

In his other works, Petty produced more detailednational accounts. In Verbum Sapienti (1665) hederived his figures for average annual spendingfrom assumptions about the distribution ofspending (that one-sixth of the population spent2d. per day, another sixth spent 4d. per day, and soon), the number of days worked in a year (287),and the proportion of the population that worked(50 per cent). He also derived his figure for rents byassuming that England had 24 million acres of landyielding rents of 6s. 8d. per acre. Even moredetailed accounts were prepared in The PoliticalAnatomy of Ireland (1672), in which he analysed thedistribution of landholdings, house sizes andoccupations.

Simple as these national accounts were, theyinvolved major conceptual advances. Expressingthese in modern terminology, these included the

following ideas. (1) National expenditure (oroutput) and national income are equivalent. (2)National income is the sum of payments receivedby all factors of production (land, labour andcapital). (3) The values of all assets are linked by acommon discount rate to the incomes received (i.e.the ratio of rent to the value of land is the same asthe ratio of profits to the value of capital). This wasclearly a major achievement. However, theaccuracy of the numbers involved in thesecalculations was, to say the least, highly dubious.Petty estimated population from bills of mortality(parish records of deaths from different causes)without discussing the assumptions he had to makein order to do his calculations or the reliability ofthe underlying data. Even worse, many of hisfigures were pure guesswork. He admitted as muchin the preface to Political Arithmetick, where hewrote that many of his observations were ‘eithertrue, or not apparently false… and if they are false,not so false as to destroy the argument they arebrought for; but at worst are suppositions to shewthe way to that knowledge I aim at’.2 In short, bymodern standards he was cavalier about his figures.The reason for this may have been that he was notinterested in completely precise figures. His aim

was just to establish magnitudes sufficientlyprecisely to make the points he wished to make.

Petty's economics was mercantilist in the sensethat he believed that a nation benefited fromaccumulating treasure, and that taxes on importsmight help to achieve this. However, he did notsimply confuse treasure and wealth. He recognizedthat foodstuffs were riches too, and he had atheory about why money was particularlyimportant. What was different about silver, goldand jewels was that they were not perishable andthus were wealth ‘at all times and all places’.Furthermore, money was needed to drive trade.This is why it might benefit a country for plate tobe melted down and coined. The amount of moneythat was needed depended on how quickly itcirculated. Here again Petty turned to a numericalexample. If 6 million people spend £7 per annumeach, their total spending amounts to some£800,000 per week. If ‘every man did pay hisexpence weekly’, money would circulate within theweek and £1 million would be enough. On top ofthis, however, rents of land (amounting to £4million) are paid half-yearly, requiring a further £4million, and the rent of housing (another £4 milliona year) is paid quarterly, which requires a further

£1 million. In total, therefore, £6 million isrequired by the nation. Petty also argued thatincreases in the quantity of money led to falls inthe rate of interest. Over the previous forty years,he claimed, the interest rate had fallen from 10 percent to 6 per cent per annum, this being ‘the effectof the increase of mony’.3

It is easy to look at Petty's data and concludethat he failed to match the achievements of hiscontemporaries in the Royal Society, such as Boyleand Hooke. His arguments were mercilesslysatirized by Jonathan Swift in A Modest Proposal, forPreventing the Children of Poor People in Ireland frombeing a Burden to their Parents or Country; and forMaking them Beneficial to the Publick (1729). It ispossible to argue that Petty failed to live up to hisBaconian methodology – that his deductions werenot about causes that had ‘visible foundations innature’, that they were no less speculative thanthose of his predecessors, and that his use ofarithmetic was no more than a rhetorical device.This, however, is to miss the point that hismethodology did lead him to ask new questions.Merely to ask about the size of labour'scontribution to national wealth, the amount ofmoney needed to drive trade, or the effects of

different taxes was to view economic phenomenain a new way. In asking these questions Petty wasindeed being faithful to the methods of Bacon andthe Royal Society. His involvement in surveyingIreland provided him with some data andstimulated much of his work. However, given theextreme paucity of information available to himand the complexity of the problems he was tryingto tackle, it was inevitable that his statistics wereunreliable.

Though historians of economics associate theterm ‘Political Arithmetick' with Petty, he was notalone in applying such methods. John Graunt(1620–74), a close friend of Petty, was elected afellow of the Royal Society in 1662 on the basis ofhis book Natural and Political Observations… madeupon the Bills of Mortality (1662). He studied dataon births and deaths to estimate the population ofLondon and to construct the first survival table(showing how many people lived to various ages).Towards the end of the century, his work andPetty's were followed up by Gregory King (1648–1712). Having more data available, King producedimproved estimates of population and much moredetailed national accounts than Petty had beenable to construct. He calculated national savings,

dividing the population into those classes thatsaved and those with expenses in excess of theirincomes. He also produced comparative accountsof income, population and income per head forEngland, France and Holland, for 1688 and 1695.These and several of his other calculations weremotivated by his interest in understanding thepotential of these countries to continue in theirthen state of war. For the case of England heestimated the sources of war finance, calculatingthe amounts met from increased production,reduced consumption and disinvestment. Hecalculated, in 1695, that war could not besustained beyond 1698. (Peace was negotiated inthe summer of 1697.) Finally, mention should bemade of Charles Davenant (1656–1714), whostudied the distribution of taxes across differentregions and was responsible for publishing King'swork after the latter's death.

The twentieth-century creators of national-income accounts saw Graunt, Petty, Davenant andKing as pioneers. However, interest in their workfluctuated greatly. Adam Smith, like manyeighteenth- and nineteenth-century economists,was sceptical about the value of ‘PoliticalArithmetick’, with the result that it had little

influence on the discipline. It was only when theresources of the modern twentieth-century statewere applied to the task that it became possible toconstruct systematic, reasonably reliable nationalaccounts.

Political Ferment

England was in a state of political turmoil for muchof the seventeenth century. The early Stuart kings,James I (r. 1603–25) and Charles I (r. 1625–49),were obliged to turn to Parliament when theyneeded more funds than they could raise from theroyal estates and from established forms oftaxation such as customs duties. For a time (the‘eleven years' tyranny’, 1629–40) Charles tried torule without Parliament altogether. The countrythen experienced a period of civil war (1642–9),which was eventually followed by the Protectorateunder Oliver Cromwell. The Stuarts were restoredin 1660 and, though it was now clear that theycould not revert to the absolutism of theirforebears, constitutional conflict persisted. This

came to a head when Charles II (r. 1660–85) wassucceeded by James II (r. 1685–8), a Catholic.James was forced to flee England in 1688 afterWilliam of Orange (r. 1689–1702) landed atTorbay. William took the crown as a strictlyconstitutional monarch. All this political turmoilraised fundamental questions about the basis onwhich society was organized.

Lying behind such questioning was a deeperchange in men's attitudes towards what were, atthe time, known as the passions: greed, envy, lustand so on. By the seventeenth century it hadbecome accepted that such destructive passionscould not be contained by religious or moralteaching, and that it was necessary to look for analternative explanation of how society might beheld together. One possibility was that one passionmight be used to keep others under control. Baconhad argued that, just as a hunter uses one animal tocatch another, or rulers use one faction to controlanother, so one ‘affection' could be used to masteranother. (This approach can clearly be traced backto Machiavelli.) Hobbes believed that thedestructive passions (the desire for riches, gloryand domination) could be checked bycountervailing passions (the fear of death, the

desire to live comfortably, and the hope ofachieving this through work). These countervailingpassions came to be known as ‘interests’.

However, at the same time as people startedthinking that society was held together by interest,there was a profound shift in the way in which theterm was understood. In the late sixteenth century‘interest' was synonymous with ‘reasons of state’,and was seen as lying in between passion andrationality. In England, during the Civil War, theconcept of interest began to be applied not simplyto the national interest but to individuals andgroups within the nation. At this time, the termcovered all human aspirations (glory, security andhonour as well as material comfort) and implied anelement of reflection and calculation about howthese were to be achieved. By the end of theseventeenth century, however, interest had begunto take on a more narrowly economicinterpretation. The same changes happened inFrance. Thus in 1661 Cardinal Richelieu's secretarycould write, ‘the name of interest has remainedattached exclusively, I do not know how, to theinterest of wealth’.4 Thus by the eighteenth centurywe find writers regularly assuming that people aremotivated by, as it was put by David Hume (see pp.

114–6), ‘avidity of acquiring goods and possessions'or, more simply, the ‘love of gain’.5

One of the most widely debated contributions tothis process was that of Thomas Hobbes inLeviathan (1651). This was influential not becausepeople agreed with it but because, although hisconclusions were intensely disliked, Hobbes'sarguments seemed so compelling that they couldnot be ignored. Leviathan offended all sides. Itoffended royalists by arguing against the divineright of kings. At the same time the book alienatedthe opponents of monarchy in arguing thatsovereignty must of necessity be absolute.

Hobbes's argument was that civil society ispossible only if there is a government to make andenforce laws. Without government, society wouldrevert to a state of nature in which every man hadto look after himself. Hobbes went so far as todescribe such a state of nature as a state of war.Every man would be free to do as he liked, therebeing no government to stop him. Furthermore,every man would be aggressive towards hisneighbours, in order to defend himself. Humanbehaviour would be unpredictable, and the resultwould be universal fear and insecurity. Propertywould be insecure, contracts would be

unenforceable, and economic life would beimpossible. Hobbes worked on Leviathan during adecade (1641–51) spent in France after fleeingEngland to avoid the Civil War. While England'sdescent into civil war after Parliament hadchallenged the King's sovereignty may haveinfluenced his views, it seems likely that Hobbeswas influenced as much by what happened inGermany. During the Thirty Years War (1618-48)Germany descended into economic as well aspolitical chaos as competing rulers fought eachother while seeking to establish their own claims tosovereignty.

The way out of such a situation, Hobbes argued,was for men to choose a sovereign (either one manor a body of men) who would become bothlawgiver and law-enforcer. If they did this, civilsociety would become possible. In itself, this is astandard social-contract theory of sovereignty.What distinguishes Hobbes's theory from othersocial-contract theories is his argument thatsovereignty must be absolute – that it cannot bedivided or limited. To impose limitations onsovereignty, Hobbes argued, would create conflict,ultimately resolvable only by war. The sovereigntherefore must have the right to administer justice,

to appoint and reward his servants (for it isphysically impossible for one man to rule alone),and to censor political and religious opinions. Thelast of these was inevitable given that religiousdivisions were one of the major sources of conflictboth in the Thirty Years War and in seventeenth-century England.

Hobbes's argument about sovereignty isimportant in the history of economic thoughtbecause in Leviathan he was tackling thefundamental question of what it is that holdssociety together. Though he saw this as a politicalquestion, many of those who responded to himbegan to see it as an economic one. Almost asimportant is Hobbes's method. His conclusion thatcivil society requires an absolute sovereign is basednot on theological arguments but on rationaldeductions from assumptions about human nature– that, in the absence of restraints, people will beaggressive towards their neighbours in pursuingtheir own security. This is a resolutely secularoutlook on society. It resembles Machiavelli'sapproach to politics, but it goes a step further.Whereas Machiavelli argued that it was prudent forrulers to base their actions on the assumption thatmen might behave in this way, Hobbes works out

his whole theory of sovereignty on the assumptionthat they will do so.

Economic Problems – Dutch Commercial Powerand the Crisis of the 1620s

In the fifteenth and sixteenth centuries theeconomic heart of Europe was northern Italy. Thecity state of Venice dominated trade in theMediterranean, and was a thriving manufacturingcentre. Trade across the Atlantic was dominated bySeville. In the seventeenth century, however,economic power shifted decisively from theMediterranean to north-west Europe. During theseventeenth century the population of northernand western Europe (Britain, Ireland, the LowCountries and Scandinavia) rose by a third, whilethat of the Mediterranean countries (Italy, Spainand Portugal) fell by 4 per cent. After 1600 Veniceentered a period of decline. The Dutch acquired thespice trade, the Counter-Reformation createddifficulties for book publishing, and the ThirtyYears War in Germany took away important

markets. Currency debasement in Turkey raised thecost of cotton and silk, two vital raw materials forthe textile industry. In Spain, the inflow ofAmerican silver declined and the government ofCastile faced a series of financial crises. Theprevious century's prosperity had not beenaccompanied by any sustainable industrial growth.In contrast, though they experienced severeeconomic crises, notably in the early 1620s, theeconomies of northern and western Europe didexperience a period of growth, the most successfuleconomy being that of the Netherlands. Thefluitschip, first launched in 1595, with its long flathull and simplified rigging, which was muchcheaper to build and run than comparable shipsfrom other countries, was perhaps the main symbolof this success.

Like the Netherlands, England was verydependent on overseas trade, and the Dutch wereseen as clear rivals to the English. Naval wars, inwhich trade was the main bone of contention, werefought in 1652–4, 1665–7, 1672–4 and 1680–84.People sought to understand why the Dutch wereso prosperous. In particular, were the low interestrates on loans in Amsterdam the cause or the resultof Dutch prosperity? If they were the cause, then

this could be used to support measures to lowerinterest rates (such as usury laws); but if they werethe result, then such measures might be harmful.

From 1620 to 1624 England experienced anacute commercial crisis, the immediate cause ofwhich was a decline in sales of cloth to Europe.The number of cloths exported from London byEnglish merchants fell from 102,300 in 1618 to85,700 in 1620. Two years later sales had fallen to75,600, and it was not until 1628 that theyreturned to their 1618 level. Unemployment waswidespread. Though the underlying long-term causeof the crisis was the growth of foreign competition,the short-term cause was a sudden loss of markets– first in Germany and the Baltic, and later in theNetherlands.

The crisis provoked a large number of pamphletsarguing about its causes and proposing remedies,with different groups seeking to defend their owninterests and to blame people other thanthemselves. Some located the cause of the crisiswithin the cloth industry itself – the growth offoreign competition and a fall in the quality ofEnglish cloth. Others blamed merchants, criticizingthe monopoly privileges of the Society of MerchantAdventurers, which accounted for over half of

England's cloth exports. The most significantdiscussions, however, were to do with money.There was a widespread view that ‘shortage ofmoney' was a major problem, and that this wasrelated to instability in the foreign exchanges.Currency upheavals in Germany, linked to theoutbreak of the Thirty Years War, could plausiblybe seen as the reason why exports fell so rapidlyfrom 1618 to 1620.

The Balance-of-Trade Doctrine

The traditional explanation of the crisis was putforward by Gerard Malynes (fl. 1586–1641), amerchant and government official. He claimed thatsilver had left England because the English coinwas undervalued. Foreign-exchange dealers couldforce the value of English coin below its par value,the value set by the Mint. If the par value reflectedthe world price of gold and silver, this would causeEnglish coin to be exported, for it would be worthmore as precious metal than as coin. This wouldaccount for the shortage of money in England. The

low exchange rate explained both why Englishgoods were sold cheaply and why imports weredear. The remedy, he argued, was to restore theRoyal Exchange and to regulate foreign-exchangetransactions in order to restore the exchange rateto its proper level.

Against this were ranged the arguments of the so-called balance-of-trade theorists, notably EdwardMisselden (fl. 1608–54, a member of the MerchantAdventurers) and Thomas Mun (1571–1641, amember of the East India Company). They arguedthat it was flows of goods that governed theexchange rate and flows of bullion, not the otherway round. To stem the outflow of treasure it wasnecessary to increase the balance of trade – toreduce imports, especially of unnecessary items,and to increase exports. This required a lowexchange rate, not a high one. More significantly, itwas the ‘balance of trade' that determined flows ofmoney, not the other way round.

It can be shown that if exports and imports donot respond at all to prices Malynes was right inwanting a higher exchange rate, but that if exportsand imports are very responsive to prices Misseldenand Mun were right. However, their differencesinvolved more than different assumptions about

the responsiveness of trade flows to prices. Theyagreed that money was the ‘soul' of commerce andthat England's losses of money abroad had to bestopped, but behind this agreement lay twodifferent views as to how the economy worked. InMalynes's world view, coins had an intrinsic value,dependent on their gold or silver content, which itwas the sovereign's prerogative to establish. TheRoyal Exchange was thus necessary to providemerchants with information on the true value ofthe coinage, so that exchange transactions couldreflect this value. In contrast, for Misselden andMun the buying and selling of goods wasfundamental: supply and demand, not thesovereign, determined values, including the valueof the currency.

The work of the balance-of-trade theorists wasimportant for establishing a link between moneyand economic activity. They viewed money not aswealth to be accumulated but as working capital.For Mun, the clearest exponent of this view, moneywas needed to drive trade. The way to accumulatetreasure was to allow it to be used in trade. In hisposthumously published England's Treasure byForraign Trade (1664), in a chapter entitled ‘TheExportation of our Moneys in Trade of Merchandize

is a means to encrease our Treasure’, Mun arguedthat the purpose of exporting money isto enlarge our trade by enabling us to bring in more forraign wares,which being sent out again will in due time much encrease ourTreasure. For although in this manner wee do yearly multiply ourimportations to the maintenance of more Shipping and Mariners,improvment of His Majesties Customs and other benefits: yet ourconsumption of those forraign wares is no more than it was before;so that all the said encrease of commodities… doth in the endbecome an exportation unto us of a far greater value.6

Mun's theory of the balance of trade wasimportant for several reasons. It was a theory ofgrowth centred on foreign trade: as such, itembodied a particular conception of economicactivity, increasingly challenged in the seventeenthcentury, in which production was fundamental. Inthe passage just quoted, Mun states explicitly thatconsumption of foreign commodities will notincrease. England's entrepôt trade will grow. Inaddition, Mun's theory provided a justification forthe East India Company, of which he was adirector, being allowed to export bullion to India.This was necessary because the Company could notfind suitable goods for export.

The Rate of Interest and the Case for Free Trade

From the restoration of Charles II to the end of theseventeenth century a recurring question waswhether or not legislation should be passed tolower the rate of interest. In 1668 a bill wasintroduced into Parliament to lower the maximumlegal interest rate from 6 to 4 per cent per annum.The most influential advocate of the proposal wasSir Josiah Child (1630–99), a merchant who hadmade money through supplying the Royal Navy andwho was one of the chief defenders of the EastIndia Company. Child was in many respects arepresentative of what one scholar has called the‘old style' of doing economics: ‘he looks like anadvocate rather than theorist, a purveyor of patentremedies, an interested party asserting hisobjectivity, an imperfect copyist rather than avigorous innovator, and only an occasional liberal’.7(The new style was that of the objective scientist.)His Brief Observations Concerning Trade and Interestof Money (1668) opens by asking why the Dutchare so much more successful than the English. Heoffers fifteen explanations, but claims that the last,a low rate of interest, is the most important, beingthe cause of the other causes of Dutch wealth.

Child supports his case with two types of evidence.The first is that previous reductions in the legalmaximum interest rate (from 10 to 8 per cent inthe 1620s, and from 8 to 6 per cent in the 1640s)were followed by increases in both the number ofmerchants and their individual wealth. The secondis evidence from comparing different countries.Parts of Italy paid 3 per cent interest and wereprosperous; Spain paid between 10 and 12 per centand was desperately short of money; France, with 7per cent, was in the middle. According to Child,countries are ‘richer or poorer in exact proportionto what they pay, and have usually paid, for theinterest of money’.8 This rule, he claimed, neverfailed.

Child recognized that such evidence did notestablish that a low interest rate was the causerather than the effect of prosperity. However, heoffered almost no arguments to support his claimthat it was. He claimed that reducing the interestrate from 6 per cent to 4 per cent or 3 per centwould double the nation's capital stock, but he didnot explore this and turned instead to answeringother people's objections to lowering the interestrate. In response to the absence of usury laws inthe Netherlands, he argued that other Dutch

institutions had the same effect: high-qualitysecurities, banks, the use of bills of exchange, andlow public spending.

The opposite case was argued by John Locke(1632–1704), secretary to Lord Ashley, thenChancellor of the Exchequer, in a pamphlet entitledSome Consequences That are Like to Follow uponLessening of Interest to 4 per cent (1668). AlthoughLocke is not completely consistent and makes clearmistakes (perhaps not surprising, since it was hisfirst venture into economics), his pamphlet differsfrom Child's in that its method is to construct tightlogical arguments.

Restricting the rate of interest to 4 per centwould, Locke argued, reduce the supply of fundsavailable for lending. Going beyond this, he arguedthat there was a ‘natural' rate of interestdetermined by the quantity of money in a countryrelative to the volume of that country's trade: ‘Bynatural use [interest] I mean that rate of moneywhich the present scarcity makes it naturally at.’9Unlike Child, who focused exclusively on the rateof interest, Locke saw that if a lower rate ofinterest was produced by increasing the supply offunds (by banks, the use of bills and so on) itseffects were very different from the effects of

imposing a statutory maximum interest rate.If interest depended on the amount of money

needed for trade, how much money was requiredby a nation? Petty's calculations, discussed above,could be seen as an attempt to provide a definiteanswer to this question. Locke's answer introducedthe idea of ‘quickness of circulation’:Because it depends, not barely on the quantity of money, but thequickness of its circulation – which since it cannot easily be traced[observed]… to make some probable guess we are to consider howmuch money it is necessary to suppose must rest constantly in eachman's hands as requisite to the carrying on of trade.10

Such arguments took Locke away from the rateof interest into the broader questions of monetaryeconomics, such as the relationship between themoney supply and the price level. Echoingsixteenth-century writers such as Navarrus andBodin, he argued that the value of money (orequivalently the value of commodities) dependedon the quantity of money in relation to trade.Plenty of money would mean that money would becheap and commodities dear. If the economy wereisolated, this would mean that the quantity ofmoney would not matter: if the quantity of moneywere lower, prices would be lower and more trade

could take place.On the other hand, in a country open to world

trade and that used the same money as itsneighbours, there must be a particular ratio ofmoney to trade. The reason is that, if a country hasless money (relative to trade) than its neighbours,then either prices must be lower or else goods mustremain unsold, there being insufficient money tobuy them at the prices prevailing abroad. If homeprices were lower than foreign prices, the countrywould lose through paying more for its importsthan it received for its exports. In addition, thecountry would risk having workers migrate tocountries with higher wages.

Locke was not alone in insisting that low interestwas the result of wealth, not its cause. Anotherwriter to argue this was Dudley North (1641–91),who made a fortune trading with Turkey, beforereturning to England to become a commissioner forthe customs and then the Treasury. His Discoursesupon Trade (1691) was stimulated by renewedmoves to lower the legal maximum rate of interest.It was published with a preface in which hisbrother Roger North (1653–1734), anaccomplished political writer, emphasized theimportance of abstraction and of reasoning being

based on ‘clear and evident truths’. Knowledgearrived at in this way had become ‘mechanical’.This Cartesian method of reasoning, Roger Northargued, was characteristic of his brother Dudley'swork: ‘He begins at the quick, from principlesindisputably true; and so proceeding with greatcare, comes to a judgement of the nicest disputesconcerning trade… he reduceth things to theirextreams, wherein all discriminations are mostgross and sensible, and then shows them.’11

Dudley North's starting point was that trade was‘a commutation of superfluities’.12 Those men whoare most diligent, grow the most crops or producethe most goods will be wealthy even if no one hasany gold or silver. However, in order to get thegoods they require, such people have to exchangetheir surplus produce for goods that other peoplehave produced. It is differences between peoplethat lead to trade.

North then applied this argument to interest.Some men, he argued, will have much stock(capital) but lack the skill to use it; while otherswill have the required skills but no stock. Thosewho have too much stock will lend it to those whohave too little, in return for interest. It is exactlythe same as with land. Those with too much land

allow others to use it in return for rent. Interestand rent are essentially the same. It follows, Northcontinued, that if stock and land are plentiful,interest and rent will be low; if they are scarce,interest and rent will be high. Dutch interest rateswere, he claimed, low because stock was plentiful,not the other way round.

If interest were lowered by legislation, Northcontinued, the supply of loans would be reduced.Many lenders would be unwilling to accept a lowerrate of interest, for it would not compensate themfor the risk involved. They would prefer to hoardtheir wealth or turn it into plate. Alternatively,people might resort to ‘underhand bargains' toavoid the law. A notable feature of North'sargument here, consistent with his underlyingpremisses, is that not all borrowers and lenders arethe same, so the same interest rate will not beappropriate for all transactions. Lenders andborrowers should be free to make their ownbargains. Take away interest, North contended, andyou take away borrowing and lending.

North's analysis of money followed the samelines. It rested on the premiss that wealth arisesnot from having money but from ‘land at farm,money at interest, or goods in trade’.13 Gold and

silver are ‘nothing but the weights and measures,by which traffick is more conveniently carried onthan could be done without them; and also aproper fund for a surplusage of stock to bedeposited in’.14 Thus, if someone cannot sell theirgoods, the reason must be that too much is beingoffered for sale, overseas sales are wanting, orpoverty is keeping down domestic sales. The reasoncould not be a shortage of coin, for a rich nationcould obtain the money it needed through trade.

A consequence of this view was a favourableattitude towards luxury spending. The ‘mercantilist'view was that luxury spending should be curbed byrestrictions on imports or by sumptuary laws.Imported luxuries, it was argued, caused money toleave the kingdom unnecessarily. North, on theother hand, saw that spending was necessary ifgoods were to be sold and if people were to beemployed. Perhaps equally important, luxuryconsumption provided an incentive to work: ‘Themain spur to trade, or rather to industry andingenuity, is the exorbitant appetites of men, whichthey will take pains to gratifie, and so be disposedto work, when nothing else will incline them to it;for did men content themselves with barenecessaries, we should have a poor world.’15

Though Dudley North did not take his argumentsso far, in his preface Roger North argued that anytrade that profited individuals was beneficial to thepublic, and that regulations on trade were alwaysharmful:

That there can be no trade unprofitable to thepublick; for if any prove so, men leave it off; andwherever the traders thrive, the publick, of whichthey are a part, thrives also… That no laws can setprices in trade, the rates of which, must and willmake themselves: but when such laws do happento lay any hold, it is so much impediment to trade,and therefore prejudicial… That all favour to onetrade or interest against another, is an abuse, andcuts so much of profit from the public.16

The Recoinage Crisis of the 1690s

North's pamphlet and Locke's writing on interestillustrate the great change that had taken place ineconomic thinking since the early seventeenthcentury. The reason for most writing was still to

influence policy, and pamphlets were still writtenby men actively engaged in trade or with intereststo defend. There had, however, been an enormouschange in the arguments used. In the writing ofMun and most of his contemporaries, economicthinking was mixed together with advice on how tobe a successful merchant: England's Treasure byForraign Trade was primarily a manual on goodbusiness practice. In contrast, though Locke andNorth certainly had interests to defend, they wereattempting to stand back to distance themselvesfrom their material and to analyse it in what theyunderstood to be a scientific way. The influence ofthinkers such as Bacon, Descartes and even Hobbesis evident.

Equally important was a profound change thathad taken place in attitudes towards economicgrowth. At the beginning of the seventeenthcentury the idea that the role of government was tomaintain a stable, established order was stillstrong. Malynes's advocacy of the Royal Exchangefollowed naturally from such a perspective. Thisview was challenged by merchants who used thedoctrine of the balance of trade as an argument infavour of greater freedom. They promoted a viewof the economy in which the objective was growth,

fuelled by the money brought in by a balance-of-trade surplus. Resources were to be developed inorder to promote exports, and government policywas to be subordinated to this end. Economicgrowth was seen purely from the producers' andmerchants' point of view – it was not based on thegoal of increasing consumption.

The merchants' perspective on growth wasradically different from the Tudor and early Stuartemphasis on the importance of preserving anestablished social order. It was, however, unable toexplain England's increasing wealth after theRestoration in 1660 – something remarked on bynumerous writers, including Petty. London wasmagnificently rebuilt after the Great Fire of 1666,and the city's prosperity attracted comment fromboth critics and admirers. There was also,especially from the 1670s, controversy over Indiancottons and silks, imports of which had increaseddramatically since the freeing of trade in bullion in1663. English clothiers began to use the balance-of-trade doctrine to criticize the activities of the EastIndia Company in promoting Indian manufacturingand trade.

The response to this was the emergence, in theworks of many writers, including Dudley North, of

new ways of thinking about wealth and economicgrowth. Instead of seeing trade through the eyes ofproducers, they focused on the role of trade insatisfying consumers' demands. Consumptionrather than production came to be seen as the aimof economic activity. It was linked to growthbecause the only way in which people could satisfytheir desires was by increasing their purchasingpower. They could do this only by selling moregoods in impersonal markets where supply anddemand ruled, which meant that producers had tolower their costs and become more competitive.The outcome was a literature in which self-interestwas assumed to rule human affairs. This challengedlong-established conceptions of society (one reasonwhy Hobbes's ideas were thought so scandalouswas his assumption that men formed governmentssolely because of self-interest) and had potentiallyradical political implications in its view that themarket provided a way of holding society together.

However, not everyone accepted this new viewof the market. As trade expanded and commercialrelations increasingly dominated economic life,some sectors fell behind. Clothiers and landownersfound their incomes rising less rapidly than thoseof merchants, and they also faced the burden of

the rising taxes (levied locally) needed to supportthose without any means of supporting themselves.Pointing to the problems faced by the poor, suchmen denied that individual and public interestscoincided. Indian manufactures, with whichEnglish woollens could not hope to compete, wereseen as wrecking businesses, causingunemployment and producing poverty. Thesolutions offered were to encourage investmentand to restrict imports. Whereas in the 1620s thebalance-of-trade doctrine had been used as anargument against traditional regulation of theeconomy, in the 1690s it came to be used todefend manufacturing and landed interests againstthe threat presented by free trade and commercialexpansion.

This conflict came to a head in the recoinagecrisis of the 1690s. Since the Restoration, Englishsilver coins had fallen significantly in weight,owing to their edges being clipped as well as tonormal wear and tear. It was widely accepted thata recoinage was essential, especially now thatmilled edges could be used to prevent furtherclipping. The controversial issue was how muchsilver should be in the new shillings (the mainsilver coins in circulation). If their original silver

content were restored, there would be fewer coinsin circulation and the result would be deflation. Somen who emphasized the importance of expandingdemand wanted the recoinage to reflect the declinein the shilling's silver content that had taken placeduring the preceding decades. In contrast, creditorswanted deflation and the restoration of thecurrency's original silver content. Unlike men in theCity of London, where the subject was widelydebated, many landowners probably failed to graspthe issues involved in the recoinage crisis, eventhough they may have understood the balance-of-trade doctrine and the link between trade andemployment.

The scheme adopted by the government (andadvocated by Locke) involved recoining shillings attheir full value. Not only was this in itselfdeflationary, but the government agreed to acceptold shillings at their face value for the first sixmonths. The result was that Gresham's Law wentinto effect. This law – named after Sir ThomasGresham (1519-79), a financier under Elizabeth I,though it was known to medieval writers – isusually summarized as ‘Bad money drives outgood.’ If someone has a coin containing the fullweight of silver and also a badly worn, clipped coin

with the same face value, he will choose to spendthe bad one and keep the good one. Good coinswill therefore be hoarded and bad ones willcirculate. In the 1690s this meant that, as oldshillings went into the Mint for recoining, the newfull-weight coins were largely melted down andexported. Estimates suggest that the value of silvercoins in circulation may have fallen from £12million in December 1695 to only £4.2 million inJune 1696. Though there was no corresponding fallin the circulation of either gold coins or banknotes(usable only for large transactions), there was asharp deflation. Prices fell, and landlords andcreditors reaped the benefit. The long-term effectwas that England went on to a de-facto goldstandard, as silver, now overvalued, began todisappear from circulation. The theory underlyingthis transition was Locke's. This held that it wasgold and silver that were the instruments ofcommerce. They had an intrinsic value, determinedby common consent. The only thing that wasdifferent about money was that it contained astamp confirming its weight and fineness.

Against this, men such as Nicholas Barbon (d.1698) claimed that it was money (coins), not thesilver in them, that drove trade. This meant that

when the government coined more (or fewer)shillings from a certain weight of silver it raised (orlowered) the money supply. It was money, notsilver, to which people attached value. However, itwas Locke's natural-law theory, supported by theself-interest of landowners and creditors, thattriumphed. The price established for gold in 1717 –£3 17s. 10½d. per ounce – came to be regarded asan almost magical figure, and was not finallyabandoned until 1939. The arguments of the free-traders such as North were able to explainEngland's prosperity since the Restoration.However, the balance-of-trade doctrine provedbetter able to serve the needs of the dominantpolitical class.

Economics in Seventeenth-Century England

Seventeenth-century England falls squarely into theso-called ‘mercantilist' era. It produced the balance-of-trade doctrine – arguably the hallmark ofmercantilism – and Mun's England's Treasure byForraign Trade was the book that Adam Smith was

later to attack as representative of mercantilistthinking. However, it is clear that such a simplecharacterization of this period's economic thoughtis grossly misleading. Even the balance-of-tradedoctrine, used to justify protection late in thecentury, was used by its inventors, Misselden andMun, to defend economic freedom.

During the seventeenth century, Englandexperienced numerous economic problems thatprovided merchants and government advisers withan incentive to advocate policies that were in theirown interests. In an environment largely free ofcensorship, and in a political system wherereasoned argument might influence policy, they didthis in an unprecedented number of pamphlets oneconomic questions. The manner in which theyargued their case was strongly influenced byscience, a subject in which men were alsopassionately interested. At the same time, thecentury's political turmoil raised fundamentalquestions about what held society together.Though Hobbes's work fell squarely in the realm ofpolitical philosophy rather than economics, thechallenge he posed related to the whole of societyand was taken up, especially in the eighteenthcentury, by many writers whose work counts

unambiguously as economics.

5

Absolutism and Enlightenment in Eighteenth-Century France

Problems of the Absolute State

The conditions that led to the proliferation ofwriting on economic questions in seventeenth-century England had no parallel in France. Manymore feudal institutions remained than in England(although some feudal obligations had effectivelybecome marketable commodities), and the kingpossessed absolute power. Throughout theseventeenth and eighteenth centuries it wasfrequently dangerous to express opinions that thestate might view as subversive. Of the writersdiscussed in this chapter, Boisguilbert sufferedexile and Mirabeau imprisonment for theireconomic opinions. In private, however, radicalopinions could be, and were, expressed even insalons patronized by the royal family. Political andsocial criticism could also be left implicit byformulating it as general principles or by directing

it against practices found in other countries. Thus,while French writing on economic questions wassparse during the seventeenth century, it grewsubstantially during the eighteenth, and by the1750s and 1760s Paris had become the centre ofEuropean economic thinking, to which most of theleading figures came.

The structure of French government policy waslaid down in the seventeenth century by JeanBaptiste Colbert (1619–83), finance minister underLouis XIV (r. 1643–1715) from 1661. Colbert wasnot an economist. He did not write on economicquestions, and he is not even known to have readwidely on the subject. His policies, however,characterize an important type of mercantilismduring this period. His primary aim was not to raisethe welfare of the population but to increase thepower of the King. Internally, he wanted to unifythe country, economically as well as politically, sothat, for example, famine in one region could notcoexist with plenty in another. Externally, thevolume of trade was taken as fixed, so that onecountry's gain had to be matched by acorresponding loss elsewhere. If France were togain, it could only be at the expense of England orthe Netherlands.

Colbert's policies followed logically from thesebeliefs. He sought to increase exports and reduceimports, thereby both achieving national self-sufficiency and accumulating the treasure whichwould drive trade. Attempts were made to increasethe population and to keep wages low, thus forcingpeople to work hard. Immigration of skilledworkers was encouraged through subsidies, andColbert tried to stop emigration. Trade wascarefully regulated and new industries were set up,sometimes with foreign workers.

France had long faced severe financial andeconomic problems, and Colbert's policies failed tosolve them. It was not until much later that deathsfrom famine became a thing of the past.Throughout the century, shortages of food,sometimes occurring alongside surpluses in otherparts of the country, were common. Such shortageswere particularly acute in towns, for these werebeginning to outgrow the resources of theirtraditional hinterlands. The government resorted tonumerous measures in order to deal with theproblem, including price-fixing, prohibitingspeculation in grain, and direct coercion ofproducers. However, it did not remove the taxesand barriers to the internal movement of food that

lay at the problem's heart. The government alsofaced chronic financial difficulties, these being duein large part to military expenditures incurred bothby Louis XIV and his successors. The state wascontinually on the verge of bankruptcy. The clergyand the nobility, who owned most of the nation'swealth, were largely exempt from direct taxation,and among those who were liable the burden ofsuch taxes was very uneven. Collection of taxeswas arbitrary and inequitable. A major reason forthis was that the state did not have theadministrative apparatus to collect them itself, butfarmed the job out to private companies. Thesewould pay an agreed sum to the exchequer inreturn for the right to collect certain levies. Thisprocess was inefficient, and unjust methods ofcollection were often used. On top of this, in 1738the corvée, or system of forced labour, wasextended from specific regions to the wholecountry.

Early-Eighteenth-Century Critics ofMercantilism

One of the early critics of Louis XIV's economicpolicies was Pierre de Boisguilbert (1646–1714). InDétail de la France (published in 1695, but possiblywritten some years earlier), and in a series of otherpublications during the following two decades,Boisguilbert sought to explain what he saw as thedisastrous decline in the French economy underLouis XIV. Income had, he claimed, halved duringthe previous thirty years. The starting point of hisanalysis was the necessity of exchange. Aseconomic development took place, exchangebecame more and more complex, making itnecessary to use money. However, money did notin itself create wealth. It had to circulate actively ifit were to be effective. If money could circulaterapidly – perhaps being augmented by moneysubstitutes such as bills of exchange – this wouldbe as efficient as having a larger money supply.Paper money could perform the functions ofmetallic money, and had the advantage of costingnothing to produce.

What kept money circulating, Boisguilbertargued, was consumption, for one man's spendingis another man's income. Consumption and incomewere therefore equivalent. Thus the decline inFrench income could be attributed to a decline in

consumption. What had caused this? Boisguilbert'sanswers included the burden of taxation; thedistribution of income away from the poor, whospent money quickly, to the rich, who were morelikely to hoard it; and the uncertainty that madethe propertied class less willing to invest. Morefundamentally, however, Boisguilbert linkedprosperity to the price system: prosperity requiresthat there be a balance or equilibrium betweendifferent goods and that ‘prices are kept inproportion with one another and with the costsnecessary for creating the goods’.1

This perspective led Boisguilbert to conclude thatnature alone, not the state, can maintain order andpeace – laissez faire la nature. Though buyers andsellers are both motivated by profit, the balancebetween the needs to buy and to sell forces bothsides to listen to reason. Thus, although individualsare concerned only with their own interests,provided the state does not interfere they willcontribute to the general good. The state's role is toestablish security and justice.

However, although Boisguilbert saw markets asestablishing order, they would sometimes fail.Uncertainty and incorrect expectations meant thatoutput prices would fluctuate. This was particularly

noticeable in the market for grain, where pricesfluctuated violently. High prices would mean thateven the worst land could profitably be cultivated,leading to a glut that pushed prices so low that allfarmers made a loss. Boisguilbert thus proposed anexception to his rule of laissez-faire: thegovernment should intervene to stabilize the priceof grain, holding stocks that could be bought andsold to achieve this.

The idea proposed by Boisguilbert that papermoney could fulfil the functions of gold and silverat lower cost was taken even further by aScotsman, John Law (1671–1729), in Money andTrade Considered: A Proposal for Supplying the Nationwith Money (1705). Like Boisguilbert, Law startedfrom the premisses that the value of goodsdepended not on the quantity of money but on theratio of the quantity of goods to the demand forthem, and that the role of money was to facilitatetrade. An increase in the quantity of money wouldtherefore raise employment, cause more land to becultivated, and increase output and trade. Lawworked on the assumption that there werenormally unemployed resources that could bebrought into use when activity increased. However,whereas the mercantilist response was to argue for

measures to accumulate bullion, Law argued for anexpansion of paper currency. Apart from beingcheaper, a paper currency would have theadvantage that its supply could be regulated so asto stabilize its value and the level of economicactivity. Security would be provided by the titles toland against which loans would be issued. By beinglinked to the value of land, which Law claimed wasmore stable than the value of silver, the value ofthe currency could be assured.

Law's proposal was designed to revive theScottish economy, and he submitted it,unsuccessfully, to the Scottish parliament in 1705.In 1706, however, he was forced to flee Scotlandto avoid being arrested for murder. The reason wasthat in 1694 he had killed a man in a duel and,after being arrested, had escaped from prison withthe connivance (and possibly the assistance) of theauthorities. Union with England in 1707 raised theprospect that he would be rearrested. He settled inFrance, where he persuaded the Regent under LouisXV to put some of his ideas into effect as a way ofsolving France's financial problems.

In 1716, in Paris, Law formed the BanqueGénérale, which in 1718 was nationalized as theBanque Royale. Notes issued by the bank were to

be accepted in payment of taxes. In return Lawoffered to put the French finances, severelyweakened by Louis XIV's wars, into order throughreducing the rate of interest to 2 per cent.However, the bank's capital was only 825,000livres, in comparison with a total government debtof around 450 million livres. The result was thatthe bank had little control over interest rates. As aresult Law became drawn into debt management.The Compagnie d'Occident (Company of the West),established by Law in 1717, was given exclusivetrading rights in Louisiana in return for taking overa large quantity of government debt, and tax farmswere also centralized within the company. To payfor the government debt, shares were issued. Lawused numerous marketing devices to sell shares inthe Compagnie d'Occident, and through 1719 theyrose in value, supported by lending from theBanque Royale. In May 1719 shares were selling forless than their nominal value of 500 livres, but byDecember they sold for as much as 10,025 livresper share. In January 1720 Law was appointedController-General of Finances, the highestadministrative post in France, and from January toMarch plans were made for the demonetization ofgold and silver.

In May 1720, however, Law realized that thefinancial situation still needed to be brought undercontrol and he proposed a plan gradually to reducethe price of shares from their unsustainable valueof 9,000 livres per share to 5,000 livres per shareby the end of the year. This outraged the public,who had counted on shares rising in value (therewas a highly developed forward market, with sometrades taking place on the basis that shares wouldrise as high as 15,000 livres), and by September theprice had fallen to only 4,367 livres per share. Thisconceals the extent of the collapse, for during thisperiod overissue of banknotes had reduced theshares' value substantially. Valued in sterling, tiedto gold, the value had fallen from £302 per share to£47 per share. Much of the public's financialwealth had been destroyed, though the governmentbenefited through having its debts substantiallyreduced. Despite the collapse in the company'sshare price, Law persisted in believing that it couldhave survived had it not been for the arrival ofplague in Marseilles in 1720. This caused people todemand coins instead of banknotes and created aliquidity crisis for the bank.

Cantillon on the Nature of Commerce in General

One of those who saw the flaws in Law's schemeand got out in time to save his fortune was RichardCantillon (c. 1680/90–?1734). Cantillon was anIrish merchant banker who spent most of his life inFrance. He is surrounded in mystery. His homeburned down, and for a long time it was assumedeither that he was killed in the fire or that the firewas started by an aggrieved servant to cover up hismurder. A year later, some of his papers were takenby an unknown traveller to Surinam, leading to theidea that the fire might have been a ruse byCantillon to cover his disappearance. The motivemay have been to escape the lawsuits againstwhich he still had to defend the fortune he hadacquired through his activities with Law in the1720s. The fire, however, had destroyed most ofhis papers. He published one book, An Essay on theNature of Commerce in General, probably written in1730, but not published until 1755. It appeared inFrench, purporting to be a translation from Englishin order to get round the French censorship laws.Some scholars have seen this book as so significantas to mark the birth of the subject of economics.

Cantillon's Essay opens with the statement that

land is the source of wealth: ‘The land is the sourceor matter from whence all wealth is produced. Thelabour of man is the form which produces it: andwealth is nothing but the maintenance,conveniences and superfluities of life.’2 Labour,regarded by many economists as the source ofwealth, simply adjusts to demand. If there are toomany labourers in a country, they will emigrate orbecome poor and starve. In an implicit criticism ofColbert's policy, Cantillon argues that it isimpossible to raise wealth by training morecraftsmen. He likens this to training more seamenwithout building more ships. It is land thatdetermines wealth, and the number of labourerswill adjust automatically.

Cantillon attaches particular importance,however, to one type of labour – that of theentrepreneur. Entrepreneurs are people who buygoods either to engage in production or to tradethem, without any assurance that they will profitfrom their activities. For example, the farmer, whois an agricultural entrepreneur employing people towork for him, cultivates land without knowingwhether corn will be cheap or dear, or whether theharvest will be good or bad. Merchants buy goodsin bulk without knowing whether demand from

consumers will be high or low, or how many saleswill be lost to competitors. However, althoughentrepreneurs perform an important function inundertaking risky activities, they are still, likelabourers who work for a wage, dependent on theproprietors of land.

Two implications follow from this view of landas the source of wealth. The first is that land is thesource of value. Cantillon's analysis is based on theconcept of ‘intrinsic value’. This is not the same asmarket price. It is the amount of land and labourthat enters into the production of a commodity. Iflabour is valued according to the amount of landneeded to maintain the labourers, this reduces to aland theory of value. To produce corn, for example,requires land on which to grow it plus the landnecessary to produce the labourers' subsistence. Incontrast, market price depends on supply anddemand and may fluctuate above or below theintrinsic value of a commodity.

The second implication that Cantillon drawsfrom his view of land as the source of wealth isthat all other classes are maintained at the expenseof the landowners. Only the landowners are‘naturally independent’, for it is their spending thatdetermines how resources are allocated between

different uses and, as a result, the values ofdifferent goods. To quote one of Cantillon's chaptertitles, ‘The fancies, the fashions, and the modes ofliving of the prince, and especially of thelandowners, determine the use to which land is putin a state and cause the variations in the marketprice of all things’.3 He gives the example of a largeself-sufficient estate that is initially cultivated bythe owner himself, who directs overseers tomanage it so as to produce the goods that herequires. The division of the estate into pasture,arable, parkland, orchards, gardens and so on willbe determined entirely by the owner's tastes(though he will of course have to allocate sufficientland to produce the goods that his labourersconsume). Cantillon then considers what wouldhappen if the owner decentralized decision-making,setting up his overseers as independent producers,equipped with the relevant amounts of land, andlinked to him and to each other through markets.His conclusion is that everyone on the estate wouldlive in exactly the same way as before. Only if theowner changes his consumption pattern willeconomic activity change:For if some of the farmers sowed more corn than usual they mustfeed fewer sheep, and have less wool and mutton to sell. Then there

will be too much corn and too little wool for the consumption ofthe inhabitants. Wool will therefore be dear, which will force theinhabitants to wear their clothes longer than usual, and there willbe too much corn and a surplus for the next year. And as wesuppose that the landowner has stipulated for the payment insilver of the third of the produce of the farm to be paid to him, thefarmers who have too much corn and too little wool, will not beable to pay him rent… So a farmer who has arrived at about theproportion of consumption will have part of his farm in grass, forhay, another for corn, wool and so on, and he will not change hisplan unless he sees some considerable change in the demand; but inthis example we have supposed that all the people live in the sameway as when the landowner cultivated the land for himself, andconsequently the farmers will employ the land for the samepurposes as before.4

If the landowner were, for example, to dismisssome of his domestic servants and to increase thenumber of horses on his estate, corn wouldbecome cheap (for demand would be less) and haydear (demand having increased). Farmers wouldthen turn corn fields into grassland.

Throughout this discussion, as in his discussionof value, Cantillon makes it clear that he is dealingonly with long-run equilibrium: ‘I do not considerhere the variation in market prices which may arisefrom the good or bad harvest of the year, or theextraordinary consumption which may occur fromforeign troops or other accidents, so as not tocomplicate my subject, considering only a state in

its natural and uniform condition.’5After considering production and wealth,

Cantillon turns to money. Here his ideas owe muchto Locke, for he focuses on the circulation ofmoney, accepting the link between the price leveland the money supply. However, he criticizes Lockeon the grounds that, while ‘he has clearly seen thatthe abundance of money makes everything dear,…he has not considered how it does so’.6 To resolvethis, Cantillon considers the way in which moneyenters the economy and the channels throughwhich it flows. He considers three main sourcesfrom which an increase in the money supply mightarise: gold and silver mines, the balance of trade,and subsidies paid by foreign powers.

If money comes from mines, the first people tobe affected will be the mine owners and workers inthe mining industry. Their incomes will rise andthey will spend more, which will raise the prices ofthe goods they buy. This will increase the incomesof the farmers and manufacturers from whom thegoods are bought, who will in turn increase theirspending, raising other prices and incomes. Moneywill gradually spread out throughout the country,raising prices as it goes. Classes on fixed incomes,such as landowners whose rents are fixed by long-

term agreements, will be worse off until theirleases can be renegotiated. As prices rise,producers will find that their costs have risen,forcing them to raise prices further. As pricescontinue to rise, people will be encouraged to buyabroad, where goods are still cheap. This will ruinmanufacturers. When the inflow of new moneyceases – perhaps because the mines are exhausted– incomes will fall and people will have to cut backtheir spending. Money will become scarce, andpoverty and misery will follow. Because much ofthe gold and silver will have gone abroad to pay forthe increased imports, the state will not end upwith any more money than its neighbours. This,Cantillon argued, was roughly what had happenedin Spain after the discovery of America.

In contrast, if the inflow of money arises from afavourable balance of trade, it will first accrue tomerchants. This will in turn raise the incomes ofthose who produce the goods being exported. Theprices of land and labour will in turn also be raised.However, because the money will accrue toindustrious people who are keen to acquireproperty, they will not raise their consumption butwill save money until they have sufficient to investit at interest or to buy land. Only then will they

raise their consumption. The rise in prices willcause goods to be imported, but such a situation,Cantillon argues, can continue for many years. Theeffects will be different from those of an increasein money from mines, because the money will bereceived by different classes of people, whosespending behaviour will be different.

The effects of subsidies from foreign powers willdepend on whether the monies are hoarded orspent. Only in the latter case will they have anyeffect, raising prices.

Cantillon recognized what has come to betermed the price–specie-flow mechanism – thenotion that a rise in the money supply will raiseprices, resulting in a trade deficit that causesmoney to flow out of the country. In its pure form,this mechanism implies that attempts to increasethe money supply are self-defeating. Cantilloncould thus write that when a state's money supply,and hence its wealth, is at its greatest, the state‘will inevitably fall into poverty by the ordinarycourse of things'.7 This would appear to underminethe ‘mercantilist' notion that increases in themoney supply bring prosperity. However, Cantilloncould also write that ‘It is clear that every statewhich has more money in circulation than its

neighbours has an advantage over them so long asit maintains an abundance of money.’8 Higherdomestic prices will mean that the same quantityof goods exported will purchase more imports. Inaddition, plenty of money makes it easier for theruler to raise taxes. For prices to rise in this way itis necessary that the money be retained within thestate. This is more likely if it were obtained fromtrade than if it were obtained from mines, for theincomes would be received by those more likely toinvest it rather than engage in luxury consumption.

Having discussed money, Cantillon could moveon to finance. The issues he covered includedforeign exchange, variations in the relative valuesof different metals used as money, debasement ofthe currency, and, finally, banks. Like Law, he sawthat banks could be of value to a nation, this valuebeing measured by the paper currency that enteredinto circulation. He estimated that the Bank ofEngland kept reserves equal to around 1 millionounces of silver, but its notes amounted, onaverage, to 4 million ounces of silver. When thecirculation of money needed to be speeded up, thissituation was, he claimed, of great benefit toEngland. Banks were of particular benefit to smallstates where silver was scarce. However, given the

experiences of the early 1720s, when both Englandand France had experienced major speculativebubbles which had burst dramatically, Cantillonpointed out the dangers of insolvency should abank increase its note issue too far. The example ofLaw's scheme, from which he had managed to getout in time, was one that he could never haveforgotten.

The Enlightenment

Some of the most important ideas underlying theEnlightenment can be traced to seventeenth-century England – to Locke and to the scientificrevolution associated above all with Bacon andNewton. The Enlightenment involved a belief inreason, progress, liberty and toleration. Reason wasbelieved to be man's central capacity, whichenabled him to think and act correctly. Because allmen were equal by virtue of their having reason, itfollowed that everyone should be free to act andthink as his reason directed. The Enlightenmentwas therefore a revolt against the alleged unreason

of earlier ages – reason was to replace religiousauthorities, sacred texts and traditions as thecriterion by which all things were to be judged.Above all, however, the Enlightenment wascharacterized by a belief in progress. Replacingsuperstition by reason would enable man toprogress without any divine assistance. Newtonhad shown that the physical world could beunderstood in terms of a system of laws,comprehensible through reason, and Locke hadshown that the human mind could build complexideas from the basic data of sensory experience.Innate or externally supplied ideas were notneeded: reason was sufficient. In the same spirit,Locke had also offered a utilitarian framework formorality, and provided a theoretical basis forrepresentative government.

Such challenges to traditional ideas weresuppressed in France under Louis XIV. Censorshipstill persisted under Louis XV (r. 1715–74), thoughless rigorously. Printing was still controlled formany years, with the result that unorthodox ideas,circulating only in manuscript form, could notspread as rapidly as if they were printed. However,the relaxation was sufficient to release a pent-upflood of criticism of established ideas and

institutions. In the mid 1740s censorship wassignificantly decreased, and the following decadesaw a profusion of new ideas from men such asDiderot (1713–84), on the relativity of knowledgeand morals, Montesquieu (1689–1755), on the ruleof law, and Condillac (1715–80), who developedLocke's psychology. The optimism of the movementwas captured by Diderot and d‘Alembert (1717–83), who edited an encyclopedia that would bringtogether all human knowledge and serve topropagate the new ideas. Between 1751 and 1772,despite periodic attempts by the authorities tosuppress it, twenty-eight volumes were published.Covering practical as well as theoretical knowledge,the Encyclopédie included articles on economicquestions.

Physiocracy

The Physiocrats, or Les Économistes, were the firstorganized group of economists. Physiocratic ideaswere developed between 1756 and 1763 by twomen, Francois Quesnay (1694–1774) and Victor

Riqueti, Marquis de Mirabeau (1715–89), at a timewhen the Seven Years War with England wasputting great strain on French finances. They heldregular meetings to discuss Physiocratic ideas, theyhad a journal, Éphémerides, that published theirideas between 1767 and 1772, and their La Philo-sophie rurale (1763) could be regarded as atextbook in Physiocratic economics. Physiocracyattracted devoted followers, including Du Pont deNemours (1739–1817) and Mercier de la Rivière(1720–93). There were also economists such asTurgot (see pp. 104–7) who were sympathetictowards Physiocracy, though not in completeagreement with its ideas. Physiocratic ideasunderlay some of Turgot's reforms during his termas Controller-General of Finances from 1774 to1776.

By the time Quesnay turned to economics, hehad acquired a considerable reputation as a doctor,first as a surgeon and then as a physician (at thetime regarded as having significantly higher status,in England as well as in France). His position in theFrench court was as physician to Madame dePompadour, mistress of Louis XV, and it was for hismedical services that he received a title andconsiderable wealth. His medical background is

important, as it influenced his perspective oneconomics. In turning to economics, Quesnaysought to analyse the pathology of society and topropose remedies. Influenced strongly byBoisguilbert and Cantillon (on whose workMirabeau drew heavily), he focused on thecirculation of money – a clear analogy with thecirculation of blood within the body, discoveredover a century earlier. It is tempting to suggest thatthe term ‘Physiocracy’, meaning the rule of nature,reflected the attitude of an experienced physicianwho knew the importance of working with naturein effecting a cure. Equally significant, thePhysiocratic system rested on a clear analysis ofthe structure of French society.

To understand society, Quesnay and Mirabeauclaimed in La Philo-sophie rurale, it is necessary tounderstand the means by which it obtains itssubsistence. Politics and law both rest on this.They outlined the evolution of society, culminatingin the commercial societies that had grown upalongside agricultural ones. Trade was essential,which meant that it afforded a secure means ofobtaining subsistence, but agriculture remainedfundamental. The main reason for this was that italone, the Physiocrats argued, yielded net revenue

– a surplus over the necessary costs of production(see p. 102). They expressed this by describingagriculture as productive and other sectors (tradeand manufacturing) as sterile.

The Physiocrats' assumptions about differentclasses were developed from Quesnay'sobservations on agriculture, first published in anarticle in Diderot's Encyclopédie. Most land wascultivated by share-croppers, who paid a fraction(usually one half) of their produce to thelandowner in return for the use of the land and theloan of seed and livestock. Their methods werehardly more productive than those employed bypeasant proprietors who cultivated their lands withminimal capital. In contrast, there had developedin parts of northern France, as in England, a newclass of farmers – agricultural entrepreneurs. Thesewere able to improve the lands they rented fromtheir proprietors (usually the nobility or theChurch) and produce large surpluses. The crucialdifference between them and the share-cropperswas that they had access to capital, for it was thisthat made it possible for them to employ moreproductive techniques. In contrast, though it wasessential in order to produce goods that peopleneeded, industry produced no surplus. It simply

covered its costs. Agricultural capital was thereforethe key to economic growth.

The relationship between agricultural capital andeconomic growth was explained by Quesnay inseveral versions of his Tableau économique, the firstof which was published in 1758. This was adiagram that showed the circulation of money andgoods between the three classes in society(proprietors, farmers and artisans) on theassumption that policies were ideal for agriculturaldevelopment. In different versions of the Tableau,Quesnay listed up to twenty-four conditions thathad to be satisfied in order for the economy tooperate in the way he outlined. These included thefollowing. (1) The entire revenue enters intocirculation. (2) People are not led by insecurity tohoard money. (3) Taxes do not destroy the nation'srevenue. (4) Farmers have sufficient capital toachieve a net revenue (surplus) of at least 100 percent. (5) There is free external trade in rawproduce. (6) The needs of the state are met onlythrough the prosperity of the nation, not throughraising credit from financiers. (7) People are free tocultivate their land as they think best. Given thatnone of these conditions was satisfied, obtainingthem would amount to a very substantial policy

agenda.The starting point for the Tableau is a situation in

which farmers have capital, or an ‘annual advance’,of £2 million (in corn) and proprietors have a stockof money of £2 million. Agriculture produces asurplus of 100 per cent, which accrues to theproprietors as rent. Consider first the circulation ofmoney. Proprietors spend half their revenue (£2million) on food and half on manufactured goods,so £1 million flows to each sector. This generatesincomes which are spent, again half on food andhalf on manufactures. Each sector thus gains afurther £0.5 million from the other. Whensuccessive rounds of income are added up, theycome to £2 million for each sector (£1 million +£0.5 million + £0.25 million + £0.125 million +…). Each sector thus receives an income of £2million and spends £2 million on buyingconsumption goods from the other sector. There is,however, an important difference between the twosectors. Manufacturing uses its remaining £1million to purchase raw materials from agriculture,with the result that it generates no surplus. Theentire stock of money (£2 million) thus ends up inthe agricultural sector. Agriculture ends up with afinancial surplus of £2 million, which is paid to the

proprietors as rent.The reason why agriculture can generate this

financial surplus is that, unlike manufacturing, itproduces a surplus of goods. The ‘advance' of £2million in corn is used to produce output worth £5million. Of this, £1 million is sold as food to theproprietors, and £2 million is sold to themanufacturing sector, half as food and half as rawmaterials. This leaves £2 million worth of corn toreplenish agriculture's capital stock for thefollowing year. The accounts balance.

This numerical example is discussed in detail tomake an important point. Although thefundamental insight about the circulation ofincome came from Boisguilbert and Cantillon,Quesnay tried to develop his argument with adegree of rigour that was absent from their work.Quesnay's numbers may seem arbitrary, but theywere not. They reflected such statistics as wereavailable about the French economy of his day. Thefigure of 100 per cent for the surplus, for example,reflected Quesnay's belief about what could beachieved in capitalist farming if sufficient capitalwere available to employ the most efficienttechniques (using horses). These techniques wereused on large farms in southern England and parts

of northern France, but many French farmers couldnot afford them. Such numerical examples alsoenabled Quesnay, in successive versions of theTableau, to explore the sensitivity of the economicsystem to various changes. For example, he showedthat if a tax of £25,000 were imposed on bothsectors, the result would be a decline in the annualadvance in agriculture from £2 million to£1,950,000. Agriculture would lose £25,000directly and £25,000 indirectly through reducedsales to the manufacturing sector. The result wouldbe economic decline, for less output would beproduced the following year. Similarly, he couldshow that a fall in productivity (perhaps due togovernment intervention or keeping the price ofcorn low) or the diversion of spending fromagriculture to manufacturing would reduce output.

The Physiocratic system, centred on the Tableauéconomique, was used to defend a clear andcontroversial political agenda. The state wasneeded to maintain markets and the circular flowof income. Quesnay performed exercises with theTableau to show how output would be reduced ifhis initial assumptions were not satisfied. Taxation,interference with agriculture, artificial stimulationof manufacturing, keeping food prices low – all

policies pursued by the governments of Louis XIVand Louis XV – were all harmful and should beabandoned. The laws of nature providedconstraints on what the state could undertakewithout undermining the prosperity on which itdepended. However, this did not rule out all stateactivity. The surplus accruing to the proprietorscould be taxed (as was necessary to raise the fundsneeded to support the market), but taxation couldnot rise too far. The reason was that theproprietors' spending was necessary to maintain theannual flow of income and spending.

Turgot

Not all reformers belonged to the Physiocraticschool. One group that stood apart from thePhysiocrats, though it supported them oneconomic policy, was centred on Vincent deGournay (1712–59). Gournay was a businessmanwho made himself a public servant by purchasingthe office of Intendant of Commerce, a position heheld from 1751 to 1759. His work involved visiting

different parts of France to investigate trade andmanufacturing there. Gournay popularized thephrase ‘laissez faire, laissez passer’, and he probablyarranged for the publication of Cantillon's Essay. Hewrote little, but exerted an important influence onothers – including Turgot.

Anne Robert Jacques Turgot (1727–81), in aeulogy written in 1759, argued that Gournay sawhimself not as a systematizer but as someone whooffered common-sense maxims. Mercantilistregulations that allowed one city in France to treatcitizens of other cities as foreigners, preventingthem from working within its precincts, or thatruined a weaver because his cloth was inferior tothat produced by a guild, did not make sense.Turgot claimed that, though Gournay saw mattersas common sense, there was a principle underlyingthem: that ‘in general every man knows his owninterest better than another to whom it is of noconcern’. Gournay, he argued, reached theconclusion thatwhen the interest of individuals is precisely the same as the generalinterest, every man ought best to be left at liberty to do what helikes. Now in the case of unrestrained commerce, M. de Gournaythought it impossible for the individual interest not to concur withthe general interest.9

The government should therefore restore liberty toall branches of commerce – removing barriers totrade, simplifying taxes, and giving everyone theright to work. This would ‘excite the greatestcompetition in the market, which will infalliblyproduce the greatest perfection in manufacturing,and the most advantageous price to buyers’.10

Turgot's first contribution to economics was acritique of Law's monetary theory in 1749. In the1750s, however, he met Gournay and worked withhim, translating a book by the English economistJosiah Tucker (1712–99), and accompanyingGournay on tours of inspection in the provinces. In1761 he was appointed intendant in the Limousin,a backward region in France, where he engaged in aprocess of reform. Areas affected includedtaxation, the system of forced labour during theharvest, and the road system. It was during thisperiod that his main contributions to economicswere written. His commitments as a governmentofficial meant that these were mostly letters andreports. The two exceptions were Reflections on theFormation and Distribution of Wealth (1766) and anunfinished essay, ‘Value and Money' (1769).

In 1774 Turgot was promoted to Controller-General of Finances and moved to Paris. Here, too,

he engaged in reform. His response to the perennialproblem of food shortages was to free the graintrade, though he still prohibited the export of cornand made special provision for the supply of grainto Paris. He replaced the inefficient privatecompany that held the monopoly of saltpetre(needed in the manufacture of gunpowder) with astate-owned firm, run by the chemist Lavoisier.Postal services were also transferred to agovernment department, and further similarreforms were projected. In 1776 Turgot sought toliberalize the corn trade still further, to abolish theguilds that restricted access to many industries,and to fund road building through a tax onlandowners instead of through forced labour. Healso spoke up in favour of tolerating Protestants.These measures, however, trampled on numerousvested interests. As a result, Turgot lost the supportof other ministers and was attacked in theparlements, restored by his predecessor. He tried toforce through his reforms using the King'sauthority, but his opponents managed to turn LouisXVI against him and he was dismissed. Many of hisreforms were abandoned.

Though Turgot's reforms may have beenpragmatic, they were consistent with the view of

economic phenomena outlined in his two mostsystematic writings on economics. The earlysections of the Reflections could have been writtenby a Physiocrat. They discuss the origins ofexchange and the pre-eminence of agriculture ofthe husbandman over the artisan and distinguishbetween a productive and an unproductive class.Like Quesnay, Turgot discusses different ways inwhich agriculture can be organized, arguing thatfarming by tenant-entrepreneurs is most efficient,but that it is possible only if there is sufficientcapital. However, he takes the argument in adifferent direction when he argues that lendingmoney can also contribute to the creation ofwealth. This leads into a discussion of the role ofmoney in commerce, and eventually to a very un-Physiocratic perspective on the role of industry increating wealth.

When people save, they accumulate capital thatthey can then use in a variety of ways: they canlend it at interest, purchase land (which yieldsrent), or employ it as an advance in industry (whichyields profit). Because people have this choice,Turgot argued, the returns on all three of these usesof capital will be linked. They will not be equal,because the risks are different. If you lend money

the borrower may fail to repay you, but if youpurchase land you are secure. Land will thus yield alower return than lending at interest. Similarly,investing in industry is more risky and will carry ahigher return. Competition will therefore establishan equilibrium between the returns on thesedifferent ways in which capital can be employed.If, for example, the value of land is too high(equivalent to the return being too low) comparedwith other uses of capital, owners will exchange itfor other types of capital and its price will bepushed down.

The equilibrium rate of interest is determined bysupply and demand: it ‘depends directly on therelation between the demand of the borrowers andthe offer of the lenders’.11 Thrift increases thenumber of lenders and reduces the number ofborrowers, while luxury consumption has theopposite effect. Europe's falling rate of interest,Turgot argued, showed that thrift had prevailedover luxury, producing a rise in the amount ofcapital. This view led him to insist that the rate ofinterest was a price like any other and shouldtherefore be determined by ‘the course of trade' likethe price of any commodity. The rate of interestwould determine which lands were sufficiently

profitable to cultivate and which industrialactivities were sufficiently profitable to beundertaken.

Important features of this view can be found inseventeenth-century writing, notably by Locke onthe rate of interest and by Mun on capital.However, Turgot integrated the various elements ofthis theory better than any of his predecessors.Furthermore, he used the theory to answer moreclearly than anyone at that time the question ofwhat constitutes a nation's wealth. His answer wasthat it comprises, to use modern terminology, thepresent value of the net revenue from land (thevalue of the land) plus the stock of movable goods.This, in essence, is the answer any moderneconomist would give. Turgot pointed outexplicitly that to include ‘capitals on loan'(financial assets) would involve double countingand that, though money was the object of saving,specie (a movable good and therefore part ofwealth) was but a very small component of wealth.

In the course of this argument about the natureof wealth, Turgot explored the nature of value, atheme he developed in his later unfinished work.He started from the assumption that the value, orworth, of a good was unique to each individual. It

depended on the fitness of the good to serve thepurposes for which it was required, and on thedifficulty of obtaining it. This concept of valuecould be described as ‘esteem value’, for valuedepended on the esteem in which a good was held.Turgot argued that there is no natural unit in whichto measure value, and that the value of one goodhas to be measured in terms of another good. It ispossible, for example, to say how many armfuls offirewood have the same value as a measure ofgrain. In practice, given that there are many goods,value is measured in terms of an arbitrary unitgiven by convention – a numéraire. If all goods aremeasured in terms of the same numéraire, then therelative value of any pair of goods can readily becalculated.

Turgot's discussion of ‘esteem value' wasapplicable to an isolated person. From there heproceeded to consider exchange between twopeople who would generally value goodsdifferently. He assumed that two goods would beexchanged at the average of the two parties' esteemvalues. If this were not the case, one would benefitless than the other from the exchange and wouldforce the other to come closer to his price. Thisestablished what Turgot called ‘exchange value’.

Though conceptually different from the term‘price’, which denotes the sum paid for a good,exchange value and price are numerically the sameand can, in many contexts, be usedinterchangeably. Finally, Turgot introduced asecond pair of traders, so that he had four peoplein communication with each other, two sellingwood and two selling corn. He outlined howcompetition would force both sellers of each goodto accept the same price.

Turgot was not alone in developing a subjectivetheory of value. On the contrary, there was a longtradition of such theories, going back throughnatural-law philosophers such as Samuel Pufendorf(1632–94) and Hugo Grotius (1583–1645) to thescholastics and Aristotle. In the eighteenth century,however, the clearest statements of subjective-value theories came from Italian economists, ofwhom Ferdinando Galiani (1728–87) is perhaps theoutstanding representative. In 1751 Galianipublished Della Moneta, one of the few works citedby Turgot in his essay on value. In 1759 he wasappointed to the Neapolitan Embassy in Paris,where he stayed for ten years. This decade wasprecisely the time when, due to Quesnay, politicaleconomy had become fashionable. Galiani,

however, was not a Physiocrat, and criticized thepolicy of allowing free export of corn while therewere still extensive barriers to internal trade. DellaMoneta clearly states the doctrine, taken up byTurgot, that value is subjective and measurableonly in relation to the value of other goods. Utilityand scarcity are the main factors explaining value.Galiani's argument that man is the commonmeasure of value was, Turgot claimed, ‘one of thenewest and most profound truths which thegeneral theory of value contains’.12

Economic Thought under the Ancien Régime

When the once-strict French censorship laws wererelaxed sufficiently to allow the publication ofwritings that could be used against thegovernment, the main issue driving economicthought was reform. Taxes and regulations wereseen by many to be stifling trade. Against thisbackground it is not surprising that the doctrine oflaissez-faire was developed by a wide variety ofwriters, from Boisguilbert at the start of the century

to Turgot on the eve of the French Revolution. Theeffects of government restrictions on agriculture nodoubt provide part of the reason (though not thewhole reason) why the Physiocrats emphasized theproductivity of agriculture so strongly. They neededto counter the assumption, underlying Colbertism,that resources had to be shifted intomanufacturing.

However, though economic thought was largelystimulated by urgent policy questions, manyabstract ideas were developed. Cantillon's mainwork was on the nature of commerce in general.The Physiocrats went even further, developing anabstract numerical model of economic activity.Turgot, even while involved in the running of theFrench state, and trying to reform it, probed intothe meaning of abstract concepts such as wealthand value. The result was that the Frencheconomists of this period produced ideas thatproved able to be taken up and used in verydifferent contexts in the following century. Frenchideas fed into English classical economics throughAdam Smith, who was strongly influenced byQuesnay and Turgot, as well as through writersworking after the Revolution, such as Jean BaptisteSay (see p. 142). Though his economic views could

hardly be more different, the Tableau économiqueinspired Karl Marx (see pp. 156–63).

6

The Scottish Enlightenment of the EighteenthCentury

Background

The Scottish Enlightenment is the name given tothe remarkable flourishing of intellectual activity inwhat, at the time, was a very backward part ofEurope. It was sufficiently remarkable that evencontemporaries were aware of it. David Hume wasnot alone in observing, in 1757, that it ‘really isadmirable how many Men of Genius this Countryproduces at present’.1 The universities inEdinburgh, Glasgow and Aberdeen were central tothis activity, out of which arose some of theeighteenth century's most notable contributions toeconomic thought (and to social thought moregenerally).

The social thought associated with the ScottishEnlightenment had several features which, if notunique, were taken further in Scotland than bythinkers in other countries. It was secular. It did

not deny the tenets of established religion (suchdenial was still dangerous at this time, especiallyfor people in university positions and in the earlydecades of the century), but it focused on themundane, everyday aspects of reality. It was alsocommitted to detachment and scientific objectivityrather than to orthodoxy. The thinkers of theScottish Enlightenment were consciously the heirsof Bacon, Newton and the scientists of theseventeenth century, as well as inheritingimportant elements of natural-law philosophy. Inaddition, and more distinctively, the ScottishEnlightenment had a clear social and above allhistorical focus. Its writers were aware thatdifferent societies had different customs, and theysought to discover the causes of these. In this theywere following Montesquieu's Spirit of the Laws(1748), a work Hume was responsible fortranslating into English. However, the Scottishwriters – in particular Adam Smith – went furtherthan Montesquieu in that they also sought toexplain how human societies changed. They soughtto provide an account of the history of civilsociety.

A major theme in these studies was that humannature was the same at all times. History, Hume

argued very clearly, could be used to discover whatthese ‘constant and universal principles of humannature' were.2 The writers of the ScottishEnlightenment, however, also sought to examinethe changing environment in which human natureoperated. Man's action could change theenvironment and produce a new situation in whichbehaviour was different, even though theunderlying human nature had not changed. TheScottish writers were led to the view that societyhad progressed through several historical stages.Primitive society was based on hunting andgathering the fruits of nature, without anyantecedent social organization. Pasture followedfrom the domestication of animals and, becauseproperty could now be appropriated, led toinequality and differences in social status. This wasfollowed by the agrarian stage, in which landbecame regarded as property that could beappropriated. This was the stage in whichinheritance became important. The legal systemdeveloped accordingly. Finally there was theexchange economy, in which society becamedivided into classes who gained their livelihoods indifferent ways. Division of labour raisedproductivity and also made people more dependent

on each other. This was an evolutionary theory ofsocial organization in which economics, politicsand law were all bound up together.

The fact of social evolution led both to a beliefin progress and to a historical relativism. AdamFerguson (1723–1816), a historian prominent inthe Scottish Enlightenment, could write that ‘thepresent age is perfecting what a former age began;or is now beginning what a future age is toperfect’.3 Such an outlook had clear politicalimplications. The Jacobite rising of 1745, whichattempted to restore the Stuarts to the throne, wasbackward-looking; the future lay elsewhere. At thesame time, however, the writers of the ScottishEnlightenment became convinced that it wasimportant to judge societies according to thecustoms of each society's own age. It wasinappropriate to judge them according to thecustoms of modern society.

One factor behind the Scottish Enlightenmentwas an awareness that Scotland was backward incomparison with the south and east of England.The Scottish supporters of the 1707 Act of Unionhad hoped that the act would stimulate theireconomy. They were also confronted with thedramatic contrast between the relatively developed

Lowlands and the very backward Highland regions.However, despite union with England, Scotlandremained different in key respects. The Church ofScotland was Presbyterian, with a Calvinistemphasis on decisions made by the individual.More importantly, the Scottish legal system was,unlike the English, based on Roman law. Naturallaw, not common law, was fundamental. Feudalelements had survived (as was still the case in thetwentieth century). There was thus great interest incomparisons with England, where Roman law wasnot recognized.

Hutcheson

Francis Hutcheson (1694–1746), who held thechair of Moral Philosophy at Edinburgh from 1729until his death, is generally regarded as theoriginator of the Scottish Enlightenment. However,he owed much to his predecessor GershomCarmichael (1672–1729). It was Carmichael whohad introduced the German natural-lawphilosopher Samuel Pufendorf to Scotland,

publishing an edition of one of his most importantworks together with a set of substantial andinfluential notes. The link from Aristotle to AdamSmith came through Pufendorf and Carmichael.Carmichael's doctrine that the value of acommodity depended both on the commodity'sscarcity and on the difficulty of acquiring it, andthat a good could be of value only if it was eitheruseful or imagined to be useful, was very squarelyin the Aristotelian tradition.

The significance of Hutcheson's view of humannature is made clear in his criticism of Mandeville.Bernard Mandeville (1670?-1733), was a Dutchmanwho settled in England in 1699 and becamenotorious for The Grumbling Hive: or Knaves TurnedHonest (1705), a twenty-six-page poem that waslater expanded into The Fable of the Bees: or PrivateVices turned Public Benefits (1714). This aroused apublic outcry for, not only did it argue for freemarkets and competition, it was also a forthrightattack on puritan morality according to whichabstinence was a virtue and luxury consumption avice. Mandeville challenged the notion thatChristian morality was what held society together.

Mandeville's Fable was about a large, prosperoushive, well stocked with bees. Vice abounded, in

that all the bees were driven by lust and vanity.Wealth was unequally distributed, but all the bees,even the poorest, were better off than they wouldotherwise have been. The reason was that highconsumption created employment. Every bee waskept busy attempting to satisfy another's demands.Even crime and fraud provided opportunities forhonest employment – burglars providedemployment for locksmiths. Despite prosperity andeconomic growth, however, the bees felt insecure.Then one day a puritan moral revolution broke out.Crime and military spending ceased, and luxurywas spurned. The result was unemployment andthe collapse of entire industries. Many bees fled thehive.

The moral of the tale was clear. People arenaturally selfish, but in a well-ordered society theywill be induced voluntarily to do what is best.Private vices produce public benefits. Vices shouldnot be encouraged, but they should be recognizedand turned to good effect. Mandeville did notadvocate laissez-faire, however. The market couldbe allowed to coordinate much economic activity,but he still favoured regulation of foreign trade inorder to create employment and to stock the nationwith money. There were also many projects that

the government could undertake to provideemployment for the poor. Mercantilist ideas thuscoexisted with his recognition of the importance ofthe market.

Hutcheson's criticism of Mandeville challengedthe assumption that men were purely self-interested. Men were, Hutcheson claimed, altruisticand cared for their fellows. This meant thatMandeville was wrong to argue that luxuryspending was needed for nations to prosper. Menwould seek to ensure that other people had thegoods they needed, and so there would be no needfor luxury spending till all demands for necessarygoods were satisfied. Whereas Mandeville hadassumed that people were selfish, Hutcheson, likemany of his fellow Scots, viewed people as drivenby a variety of motives. These included the desireto look after oneself, feeling for others, and thedesire to better one's condition. As one mightexpect from someone influenced by Pufendorf andCarmichael, Hutcheson had a supply-and-demandtheory of value, and this was taken up a few yearslater by Sir James Steuart (see pp. 117–21).Hutcheson also emphasized the importance of thedivision of labour, so important to Adam Smith(see pp. 121–9), combining this with a labour

theory of property derived from Locke.

Hume

David Hume (1711–76) is now best known for hisphilosophical writing, but to his contemporaries hewas known as a historian, for his History of England(1754–62). A historical perspective permeates hisapproach to economics, contained in a series ofnine essays published in 1752 as part of a volumeof Political Discourses. In view of contemporaryscepticism about the value of abstract reasoning ineconomics, it is interesting to note that Humeopens this group of essays with a defence ofapplying what he calls ‘refined and subtile'reasonings to such ‘vulgar' subjects as commerce,money, interest, taxes and public credit. He appealsto his readers not to be prejudiced against what hehas to say merely because his ideas are ‘out of thecommon road’.4 The public good, Hume argues,depends on a multitude of causes, not on chanceand the caprices of a few individuals. This meansthat the type of historical account that one might

give to explain, say, foreign policy, is inappropriateto this subject matter, and that more generalreasoning, that may yield unfamiliar conclusions, isrequired.

Hume's concern in these essays is with thegreatness of a state. He starts by distinguishingbetween this and the happiness of the state'ssubjects. The latter will be increased by luxuryconsumption and will thus be reduced if the statediverts resources from this into defence and foreignventures. In this sense, there is a trade-off betweenthe happiness of the people and the power andinfluence of the state. However, luxury spending isimportant to the state, for it is necessary topersuade people to work. This is whymanufacturing is needed – the manufacture ofluxury goods provides husbandmen (farmers) withan incentive to work more than the minimumamount required to subsist. Without such anincentive, they would prefer to be idle for much ofthe time. This desire for luxury goods benefits thestate because, if husbandmen are producing asurplus over what they need for their subsistence,resources are available to which the sovereign canlay claim in order to raise fleets and armies. In asociety of self-sufficient farmers, there would be no

surplus available to be appropriated. Humesupports this claim with evidence from ancientGreek and Roman history.

The basis for Hume's argument about commerceand wealth is the theory that labour is the basis forwealth and that labour will be supplied only ifpeople have an incentive to do so. He writes, ‘Everything in the world is purchased by labour; and ourpassions are the only causes of labour.’5Manufacturing is valuable because it enables labourto be stored up, available for use in times of need:[M]anufactures encrease the power of the state only as they storeup so much labour, and that of a kind to which the public may layclaim, without depriving anyone of the necessaries of life. Themore labour, therefore, is employed beyond mere necessaries, themore powerful is any state; since the persons engaged in thatlabour may easily be converted to the public service. In a statewithout manufactures, there may be the same number of hands;but there is not the same quantity of labour, nor of the same kind.All the labour is there bestowed upon necessaries, which can admitof little or no abatement.6

For much the same reason, foreign commerce isvaluable. It increases the stock of labour in anation.

Having established that the strength of a statedepends on labour and commerce, Hume proceedsto demolish the argument that money is wealth.

Money, he claims, is simply ‘the oil which rendersthe motions of the wheels [of trade] more smoothand easy’.7 There is no benefit to be had fromhaving a greater quantity of money, for prices willbe higher in the same proportion. The onlyexception to this is that, if gold and silver areplentiful, the sovereign will have more resourcesthat can be drawn upon in times of war. In otherrespects, a large quantity of money is adisadvantage – higher prices will causemanufacturing industries to shift abroad, wherecosts will be lower. Labour will be lost to the state.Hume was thus opposed to the use of papermoney, for this harmed manufacturing without theoffsetting benefit of raising the state's stock of goldand silver.

However, although the quantity of money was ofno importance, a rising money supply did make adifference – inflation could be beneficial.‘Accordingly we find, that, in every kingdom, intowhich money begins to flow in greater abundancethan formerly, every thing takes a new face: labourand industry gain life; the merchant becomes moreenterprising, the manufacturer more diligent andskilful, and even the farmer follows his plough withgreater alacrity and attention.’8 The explanation

was that, although money raises prices, it does notdo so immediately. There is thus an interval duringwhich the money supply has increased by morethan prices, and during this interval industry will bestimulated. Conversely, a falling money supply willhave damaging effects on industry – a conclusionthat Hume was able to support with muchhistorical evidence.

Hume concluded that the best policy was to keepthe money supply continually increasing. However,he was strongly opposed to trying to do thisthrough ‘mercantilist' policies. Attempting tomaintain a balance-of-payments surplus would beself-defeating, for the inflow of money would raiseprices, causing manufacturing to go abroad, thusundermining the policy. He likened money to waterin the sea: it is possible to raise the water level inone region only if it is cut off from the rest of thesea. If there is communication between differentregions, money will, like water, find its own level.The only effect of mercantilist policies, therefore,was to interfere with trade. Furthermore, if onewanted to increase reserves of gold and silver foruse in wartime, the right method was to hoard it,not to spend it. If money disappeared fromcirculation into hoards, it would no longer affect

prices. This was in contrast with the mercantilistview, exemplified by Mun, that the purpose ofincreasing the money supply was to increase thecirculation.

Sir James Steuart

Many themes from the work of Hutcheson andHume can be found in the book that has beendescribed as the first systematic treatise oneconomics in the English language, the full title ofwhich was An Inquiry into the Principles of PoliticalOeconomy: Being an Essay on the Science of DomesticPolicy in Free Nations, in which are ParticularlyConsidered Population, Agriculture, Trade, Industry,Money, Coin, Interest, Circulation, Banks, Exchange,Public Credit and Taxes (1767). The title introducedinto English the term ‘political economy’, atranslation of the term ‘œconomie politique ' used byAntoyne Monchrétien (c. 1575–1621) in the title ofa book published in 1615. This was to become thestandard name for economics as the subject beganto achieve a separate identity during the nineteenth

century. The English book was also the first workto use the phrase ‘supply and demand' to explainhow prices were determined:The nature of demand is to encourage industry; and when it isregularly made, the effect of it is, that the supply for the most partis to be found in proportion to it… And when it is irregular, that is,unexpected, or when the usual supply fails,… [this] occasions acompetition among the buyers and raises the current, that is, theordinary prices.9

This explanation of prices was followed up witha detailed account of competition. Particularattention was paid to what the author called‘double competition’, in which there wascompetition both between buyers and betweensellers. This was important because it set upper andlower limits to price and caused the interests ofdifferent individuals to balance each other. Thisbalance, however, vibrated, with the result thatbuyers and sellers could not observe it exactly.Their decisions had to be based on the price forwhich they expected to be able to resell the goods.The conclusion was drawn that forestalling (buyinggoods in order to resell them when there was ashortage) was a crime because it diminished thecompetition that ought to take place and thatwould ensure that goods sold for their real value.

The author of the book was Sir James Steuart(1712–80). He was part of the ScottishEnlightenment, but stood apart from other writersin that he was a Jacobite, and supported the 1745rebellion. Sent by Charles Edward Stewart, theYoung Pretender, as an ambassador to France,Steuart remained in exile after the defeat of theJacobites at Culloden, not returning to Scotlanduntil 1763. During this period he travelled widelyin Europe.

Steuart's experience during his exile influencedhis book. He became very sceptical about generalrules concerning political matters, on the groundsthat everything needed to be considered in relationto the circumstances of the country in question.Different countries had different customs, andthese needed to be taken into account. He thuswrote that the merit of his book, in so far as it hadany merit, arose from ‘divesting myself of Englishnotions, so far as to be able to expose in a fairlight, the sentiments and policy of foreign nations,relatively to their own situation’.10 Continentalinfluences account for Steuart's emphasis on therole of the statesman (used as a shorthand for theking, Parliament, or whoever was ruling a nation).His book was, as he put it, ‘addressed to a

statesman’, even though its object was ‘to influencethe spirit of those whom he governs’.11 This wentagainst the prevailing mood, which was in favourof liberty and playing down the importance of stateaction.

Steuart's historical perspective echoed that ofHutcheson, though he distinguished only threestages in history: hunting and gathering,agriculture, and exchange. Growth was seen interms of an increase in population, this beinglimited by the supply of food. In the first stage ofhistory, population was limited by the spontaneousfruits of the earth, but, when ‘labour and industry'were applied to the soil, a further quantity of foodcould be produced, enabling a larger population tobe supported. However, if farmers were to beinduced to produce more than they needed fortheir own consumption, there had to be a marketfor their produce – the third stage. This led Steuartto state two principles:[1] Agriculture among a free people will augment population, inproportion only as the necessitous are put in a situation topurchase subsistence with their labour… [2] That agriculture,when encouraged for the sake of multiplying inhabitants, mustkeep pace with the progress of industry; or else an outlet must befound for all superfluity.12

These principles, he claimed, were confirmed byexperience. We can see him here arguing for abalance between the more extreme views ofmercantilist support for industry and Physiocraticsupport for agriculture – views that he wouldobviously have encountered during his stay inEurope.

Like Hume, Steuart saw a close link betweenlabour and wealth. However, in line with the trendin English economic thought from the lateseventeenth century, he placed much greateremphasis on the need to keep people employed. Herecognized that employment would fail from timeto time, and he believed that the state should seekto mitigate this as much as possible. Maintainingemployment required that there should be abalance between supply and demand: ‘The greatestcare must be taken to support a perfect balancebetween the hands in work and the demand fortheir labour.’13 Demand must be neither too highnor too low, and it was the statesman's duty to seethat this was achieved.

Steuart had what has come to be called a‘Malthusian' view of population growth.Procreation was not the same as multiplication ofthe population, for, if the birth rate were too high,

fewer children would survive. It followed thatpopulation could grow in response to the demandfor labour, but only if agriculture could producemore food. There were, however, limits to whatagriculture could provide, the main one being risingagricultural costs. Rising food prices would raisethe price of subsistence and hence wage costs. Thestatesman would then be caught in a dilemmabetween encouraging ‘expensive improvements ofthe soil' (which require high food prices) and cheapimports which enable wages costs to be kept low.This dilemma could be resolved, Steuart argued,only by ‘right application of public money’.14 This isone example of the ways in which Steuart believedthat the state might have to use governmentspending or alterations to the money supply inorder to achieve a balance between supply anddemand. Public money could be used to raisedemand and reduce unemployment, but care hadto be taken not to lean too far the other way.

Given such an attitude, it is not surprising thatSteuart did not accept the quantity theory ofmoney. The theory of the relationship betweenmoney and prices proposed by Montesquieu andHume, he conceded, was ‘so simple, and soextensive, that it is no wonder to see it adopted by

almost everyone who has written after them’.However, he argued that ‘in this, as in every otherpart of the science of political economy, there ishardly such a thing as a general rule to be laiddown’.15 The reasons he gave for this were thatdemand and competition determined prices, andthat these depended on wealth and on thecircumstances of the economy, not on how muchcoin people happened to have:Let the specie of a country, therefore, be augmented or diminished,in ever so great a proportion, commodities will still rise and fallaccording to the principles of demand and competition; and thesewill constantly depend upon the inclinations of those who haveproperty or any kind of equivalent whatsoever to give; but neveron the quantity of coin they are possessed of.16

Throughout his Principles, Steuart emphasized therole of the statesman. It would, however, be amistake to see him either as a totalitarian planneror as someone who was simply looking back to apre-market era. Not only did he assume people tobe self-interested, he regarded this as essential ifgovernment policy were to be effective:The principle of self-interest will serve as a general key to thisinquiry; and it may, in one sense, be considered as the rulingprinciple of my subject… This is the main spring, and only motivewhich a statesman should make use of, to engage a free people to

concur in the plans which he lays down for their government…[W]ere every one to act for the public, and neglect himself, thestatesman would be bewildered, and the supposition is ridiculous.17

One can see from this passage that Steuart liesfirmly in the approach to politics that goes back,through Hobbes and Locke, to Machiavelli.

For a few years, Steuart's Principles was wellreceived. Hume welcomed the book, and Steuart'sadvice was sought by the British government.However, the book rapidly fell into oblivion, atleast in Britain. The main reason was clearly thepublication of Adam Smith's Wealth of Nations onlya few years later. Smith's work caught the publicimagination far more effectively than Steuart's, andSmith adopted the effective rhetorical strategy ofcompletely ignoring the earlier book. Part of thereason, however, may have been Steuart's ramblingstyle, which did not always make his message clear.In Germany, however, where Steuart's mercantilistideas found a more receptive audience, the bookcontinued to be read, and his discussion of supplyand demand received considerable attention in theearly nineteenth century (see p. 146).

Adam Smith

Adam Smith (1723–90), who came from aninfluential Scottish family, was a student ofHutcheson's and, after a year holding the chair ofLogic, held the chair of Moral Philosophy atGlasgow from 1752 to 1764. During this time helectured on rhetoric and belles-lettres,jurisprudence and moral philosophy. His work oneconomics arose out of this, and formed part of abroader inquiry into the science of society. Thisinquiry was squarely in the tradition of the ScottishEnlightenment, with its focus on history and on thefoundations of civil society. The book thatsustained Smith's reputation for subsequentgenerations, dominating nineteenth-centuryeconomics as did the work of no other economist,was An Inquiry into the Nature and Causes of theWealth of Nations, first published in 1776, the yearof the American Declaration of Independence. InSmith's lifetime, however, his reputation was basednot on this book, but on The Theory of MoralSentiments, published in six editions between 1759and 1790. Smith regarded both books as part of hisbroader inquiry into social science. Therelationship between the two books was described

at the beginning of the sixth edition of The Theoryof Moral Sentiments:In the… first Edition of the present work, I said, that I should inanother discourse endeavour to give an account of the generalprinciples of law and government, and of the different revolutionswhich they had undergone in the different ages and periods ofsociety; not only in what concerns justice, but in what concernspolice, revenue and arms, and whatever else is the object of law. Inthe Inquiry concerning the Nature and Causes of the Wealth ofNations , I have partly executed this promise; at least so far asconcerns police, revenue and arms. What remains [is] the theory ofjurisprudence.18

This last part of his project was never completed.The main concern of The Theory of Moral

Sentiments was with the criteria on which moraljudgements can be based. Smith thus explored thebasis for the sense of propriety, the sense ofapprobation, and judgements of merit and virtue. Akey element in his approach was provided by theconcept of sympathy – the ability to see thingsfrom someone else's point of view, and to see ourown behaviour from the perspective of an impartialspectator. The reason why this is relevant to socialscience is that, in undertaking this inquiry, Smithwas exploring the question of what makes itpossible for men to live in society. How is it thatselfish desires can be restrained in order to prevent

men from injuring one another? The simplestanswer is the desire to please others – a desire forthe approbation of other people. We view our ownbehaviour from the point of view of the impartialspectator, and act accordingly. This motive,however, will not be strong enough. When wecontemplate our actions before we act, ‘eagernessof passion' – the desire to do things – will bias ourjudgement. After an action has been taken, on theother hand, the desire not to think badly ofourselves will lead to bias. Neither beforehand norafterwards, therefore, can we take an unbiasedview of our actions. Further guidance is needed.This is provided by moral rules – generalizationsfrom our experience of what types of action areapproved of and disapproved of. However, moralrules are in themselves insufficient and need to bebacked up, in some cases, by positive laws.

If people are held together by mutual affectionand give each other the support that they need‘from gratitude, from friendship, and esteem’,society can flourish. However, Smith argued thatsuch motives are not necessary:Society may subsist among different men, as among differentmerchants, from a sense of its utility, without any mutual love oraffection; and though no man in it should owe any obligation, or

be bound in gratitude to any other, it may still be upheld by amercenary exchange of good offices according to an agreedvaluation.19

A commercial society can flourish even thoughpeople do not have strong affections for eachother. On the other hand, this is emphatically notthe same as saying that a society can flourish ifthere are no limits to behaviour:Society, however, cannot subsist among those who are at all timesready to hurt and injure one another… If there is any societyamong robbers and murderers, they must at least… abstain fromrobbing and murdering one another. Beneficence, therefore, is lessessential to the existence of society than justice. Society maysubsist, though not in the most comfortable state, withoutbeneficence; but the prevalence of injustice must utterly destroyit.20

This is the context for the Wealth of Nations.Smith is exploring how a commercial society canprosper, even though men are pursuing their owninterests. He is, however, assuming a framework ofjustice, without which society would be destroyed.The society he is talking about differs from aHobbesian state of nature in that men are assumedto be guided by morality and restrained by a justlegal system. Within this framework Smith explainsthe benefits that arise from a system of liberty.

Division of Labour and the Market

More clearly than any previous writer, Smith wasconcerned with the process of economic growth.Of the five ‘Books' that make up the Wealth ofNations, the first discusses ‘the causes ofimprovement in the productive powers of labour'and how produce is distributed among the differentclasses of society. Book 2 considers capitalaccumulation, and Book 3 what Smith calls ‘thedifferent progress of opulence in different nations’.He then turns to government policy, offering inBook 4 critiques of both the ‘mercantile system'and the ‘agricultural system' (Physiocracy), and inBook 5 a discussion of government revenue andtaxation. Taken as a whole, the work is a vastcompendium of theory, economic history andpolicy advice. Its variety and range provide part ofthe explanation of why economists have been ableto interpret it in very different ways.

The most important cause of economic growth,Smith claimed, is the division of labour. Onintroducing the idea, he illustrated it with a ‘verytrifling manufacture' – pin making. He pointed outthat, without being trained in the industry andwithout the assistance of the right machinery (and

both training and machinery were the result ofdivision of labour), a worker could probably makeno more than one pin per day and certainly nomore than twenty. In contrast, in the modernindustry, where the task of making a pin wasdivided into eighteen different operations (drawingthe wire, straightening it, cutting it, grinding it,putting the head on, whitening the pin, putting thepins into paper, and so on), a team of ten mencould make upward of 48,000 pins per day.Division of labour was, Smith claimed, carriedfurthest in the most advanced countries.

However, although Smith introduced the divisionof labour by considering its application within asingle factory, just as important for his case wasthe social division of labour, where differentpeople perform different tasks, obtaining what theyneed through exchange. The division of labour, heargued, was ‘the necessary, though very slow andgradual consequence of a certain propensity inhuman nature… to truck, barter, and exchange onething for another’.21 This led him to the propositionthat the division of labour was limited by theextent of the market. In a village, people had toperform for themselves many of the tasks that, in acity, would be performed by specialists. A country

carpenter, Smith observed, was not only acarpenter, but a joiner, a cabinetmaker, a woodcarver and a wagon maker, each of which would bea separate trade in a larger market. Thedevelopment of water transport, Smith observed,was crucial to this process of opening up moreextensive markets.

Having established the link between economicgrowth and the expansion of markets, Smith thenturned to the question of how markets operated.This took him into the fields of value and thedistribution of income. Three concepts areparticularly important to his analysis of theseproblems. The first is the distinction between thereal and the nominal prices of commodities. In anexchange economy it is more convenient to usemoney than to engage in barter and, as a result,prices are measured in terms of money (thenominal price). However, the real price of acommodity is ‘the toil and trouble of acquiring it’.This is a quantity of labour, not a quantity ofmoney – though, given the problems involved inmeasuring labour, it might best be measured interms of other commodities. Variations in the valueof gold and silver would cause the nominal and realprices of commodities to differ from each other. It

is the real price that matters and that his theory ofvalue sought to explain.

The second important concept in Smith's valuetheory is the breaking down of the prices ofcommodities into their component parts – wages,profits and rents, the returns to labour, capital andland. This is the basis for the third key concept: thedistinction between the market price and thenatural price of commodities. The market price of acommodity is the price it fetches in the market,which will depend on supply and demand. Ifsupply is insufficient to meet demand at the goingprice, the market price will rise; if there is a surplusof goods, the market price will fall. Because pricescan be broken down into their component parts, itfollows that, if the market price rises, so too mustat least one of the components of price. Thenatural price of a commodity is thus defined as theprice at which labour, capital and land are allreceiving their natural prices. It is, Smith argued,‘the central price, to which the prices of allcommodities are continually gravitating’.22 Themechanism that causes this to happen iscompetition. If, for example, the rate of profit inproducing hats is higher than the natural rate ofprofits, and if capitalists are free to move their

capital from one industry to another, they willmove into hat-making. This will increase the supplyof hats and bring the price of hats down to thenatural price. Alternatively, if workers in mining areearning more than the natural rate of wages, otherworkers will become miners, pushing wagesdownward.

This mechanism is the basis for Smith'sconclusion that the market can work like aninvisible hand, causing people to produce whatother members of society want, even whenindividuals have no intention to do anything foranyone else. It is the reason why self-interest canproduce an outcome that is in the interests ofsociety – why a commercial society can prospereven though people have no affection for eachother. Its crucial element is what Smith called‘liberty’, the freedom of individuals to move theircapital and labour from one activity to another asthey choose. It was a concern to promote libertythat led Smith to denounce mercantilist restrictionson industry and trade. Such restrictions wouldbenefit particular individuals but would hinder theoperation of competition.

Capital Accumulation

Book 1 of the Wealth of Nations, with its emphasison division of labour and the link between labourand wealth, falls squarely within the ScottishEnlightenment tradition. In Book 2, on the otherhand, Smith emphasizes the role of capital in a waythat makes him much closer to Turgot than toHutcheson or Hume. A precondition for thedivision of labour, Smith contended, is theaccumulation of what he called ‘stock’. Thisincludes both the tools that workmen need andalso the provisions that they need while they areworking. If growth is to occur, stock has to beincreased, and to achieve this it is necessary toemploy labour productively. This leads to Smith'sdistinction between productive and unproductivelabour.

The basic idea underlying this distinction is thatproductive labour ‘adds to the value of the subjecton which it is bestowed’. It ‘fixes' itself ‘in apermanent subject or vendible commodity' that isthere when the labour is finished, and which canthen be sold to obtain more labour.23 Unproductivelabour, however, does not add to the value ofanything. Thus the labour of a manufacturer who

adds to the value of the materials with which heworks, or of the farmer who produces a tangibleoutput at the end of the year, is productive. Incontrast, the labour of the menial servant or evenof the sovereign or judges or the army isunproductive. Given that all labour has to bemaintained by annual produce, the accumulationof capital depends on the proportion of labouremployed productively. Consider the extremecases. If the entire labour force were employedunproductively, there would be no produce at allthe following year. At the other extreme, if labourwere all employed productively, produce must behigher.

The need for capital accumulation is the reasonwhy Smith sees a link between saving andeconomic growth. ‘Capitals are increased byparsimony, and diminished by prodigality andmisconduct.’24 He argues forcefully that there is noneed for luxury spending to maintain demand, forsavings are spent just as much as is expenditure onconsumption goods:What is annually saved is as regularly consumed as what isannually spent, and in nearly the same time too; but it is consumedby a different set of people. That portion of his revenue which arich man annually spends, is in most cases consumed by idle guests,and menial servants, who leave nothing behind them in return for

their consumption. That portion which he annually saves, as forthe sake of profit it is immediately employed as capital, isconsumed in the same manner, and nearly in the same time too, butby a different set of people, by labourers, manufacturers, andartificers, who re-produce with a profit the value of their annualconsumption… The consumption is the same, but the consumersare different.25

In other words, saving (which for Smith meansinvestment, for otherwise savers could not earn aprofit, which is their objective) is employingproductive labour, whereas consumption isemploying unproductive labour.

Smith and Laissez-Faire

Smith advocated what he described as the systemof ‘natural liberty’, to be contrasted with the othertwo systems of political economy that hediscussed: the mercantile system and the system ofagriculture (Physiocracy). The main characteristicof this was the freedom of any individual to bringhis capital into competition with that of any otherman. He opposed monopoly, which in his day wasnormally the result of privileges granted by the

government: ‘Monopoly… is a great enemy to goodmanagement, which can never be universallyestablished but in consequence of that free anduniversal competition which forces every body tohave recourse to it for the sake of self-defence.’26

Free competition would result in resources beingmoved into those activities where they were mostneeded. The individual would be ‘led by aninvisible hand to promote an end which was nopart of his intention’.27 Though Smith made littleuse of the phrase ‘the invisible hand' (it appearsonce in each of his major books), this can be seenas his contribution to the debate on what holdssociety together, opened up by Hobbes over acentury earlier. However, Smith was not arguing forcomplete laissez-faire, for he saw an important rolefor government.

The main reason why government was neededwas that the arguments of the Wealth of Nationspresupposed a system of justice. Without justice,the system of natural liberty would be unable tofunction. Men would be insecure, continually beingdamaged by each other. Spending on the legalsystem and on the armed forces might be classifiedas unproductive, but it was nonetheless essentialfor the system to work. For Smith, to maintain law

and order was therefore the first duty of thesovereign. It is worth noting that this involvedsome significant exceptions to the principle oflaissez-faire. In particular, Smith supported theNavigation Acts (which severely restrictedcompetition in shipping), on the grounds that theycontributed to the strength of the Royal Navy.

Defence and justice, however, were not the onlyexceptions Smith saw to the principle of laissez-faire. The third duty of the sovereign was that oferecting and maintaining those publick institutions and thosepublick works, which, though they may be in the highest degreeadvantageous to a great society, are, however, of such a nature,that the profit could never repay the expence to any individual orsmall number of individuals, and which it, therefore, cannot beexpected that any individual or small number of individuals shoulderect or maintain.28

His main examples concerned transport (bridges,roads and canals) and primary education. However,although he argued the case for intervention, hesought to make use of tolls and fees whereverpossible. This was for two reasons. He wantedusers (for example of roads) to pay as much aspossible, and he wanted employees (such asteachers) to have an incentive to do their workproperly. Thus, immediately after saying that the

cost of education might ‘without injustice' be metout of public funds, he declared that it would bebetter for it to be paid by those who benefitedfrom schooling. His view was that privatelyprovided education was, in his day, better thanpublic education. He was scathing in his criticismof universities, in which teachers failed to teachand students failed to learn.

One area where Smith saw no role whatsoeverfor the government was in maintaining the level ofemployment. Writers from Misselden (in the earlyseventeenth century) to Steuart (writing only a fewyears before Smith) had seen the disruption thatfluctuations in trade could produce and had soughtto design policies that would mitigate the resultingunderemployment. Mercantilist policies can beseen, at least in part, as attempts to reduceunemployment by increasing the circulation ofmoney. The defence of luxury consumption bynumerous writers in the seventeenth andeighteenth centuries was also a response to periodswhen demand was seen to be inadequate. Smith,on the other hand, with his doctrine that savingconstituted spending, denied that there was aproblem. If there were perfect liberty, men wouldmove into an occupation where there was a

demand for their services. Monetary economicsthus played a minor role in Smith's system. Thisseparation of monetary economics from problemsof value, income distribution and growth stood inclear contrast with mercantilist ideas, and was todominate economic thinking throughout thenineteenth century.

Economic Thought at the End of the EighteenthCentury

For contemporaries, as much as for subsequentgenerations of economists, the crowningachievement of eighteenth-century economicthought was Smith's Wealth of Nations. This aroseout of the long-standing controversy over the roleof Christian morality in holding society together towhich Hobbes and Mandeville had made suchdramatic contributions. Smith approached thequestion from the perspective of moral philosophy.He combined this with a focus on theinterdependence of the various sectors of theeconomy. This was a pervasive theme in

eighteenth-century thought, in both Britain andFrance, and it can even be found as far back as thesixteenth century (as in the Discourse on theCommon Weal), but it was Smith's version of it thatcaught the imagination of his contemporaries. Overtime, however, the origins of the Wealth of Nationsin this debate over the morality of commercialsociety became forgotten, resulting in Smith's workbeing seen in a different light. He became seen asthe advocate of laissez-faire – a perspective thatwould have surprised his contemporaries, whowould have been aware how much further he wasfrom such a position than, for example, manyFrench authors.

Smith's debts to his predecessors andcontemporaries are so great that somecommentators have gone so far as to argue that theWealth of Nations contains not a single originalidea. Supply and demand as the explanation ofvalue has a history too long to summarize briefly.Elements of the labour theory of value can betraced to Petty and to some scholastic writers. Thephrase ‘division of labour' was coined byHutcheson, and the concept was widelyunderstood in Xenophon's day. The importance ofcapital was recognized by Turgot. The notion of a

spontaneous order can be found in Mandeville andCantillon. And so on. It was, however, Smith'sinterpretation of these themes that found its wayinto nineteenth-century economics, especially inBritain. This neglect of the past had significantcosts. For example, subjective-value theory, thoughit remained strong in France and Germany, waspushed aside by Smith and most of his Englishfollowers, who minimized the role of demand indetermining prices. The seeds were sown for whathas come to be known as classical politicaleconomy and, within that, the Ricardian ‘detour’.

7

Classical Political Economy, 1790–1870

From Moral Philosophy to Political Economy

Smith's Wealth of Nations was part of a muchbroader inquiry into the foundations of society. Itwas inseparable from moral philosophy from theproject of seeking to find a basis on which peoplecould live together when the Church no longerprovided an unquestioned set of answers toquestions about how society should be organized.Smith's economics should therefore be seen as aresponse to Mandeville, and before him Hobbes, asmuch as to the Physiocrats or the mercantilistwriters. In the half-century or so after Smith'sdeath, however, political economy, thoughdominated by the framework set out in the Wealthof Nations, became independent of moralphilosophy. It acquired a more ‘scientific' characterthat appealed to a class of radicals, many of whomwanted to explain social phenomena withoutreference to a deity.

To understand this transition, it is important to

remember that the discipline was thoroughlyinvolved with politics, and that the politicalcontext changed dramatically during this period.Among the political-economic issues facing Smithwere the relationship between Britain and theAmerican colonies (especially trade and taxpolicies), restrictions on both domestic and foreigntrade caused by the creation of monopolies, andthe appropriateness of intervention in the marketfor food in order to prevent famine. In the 1780sand 1790s, as the growth rate of the populationincreased, the problem of poverty and itsalleviation increased, with the phrase ‘the labouringpoor' coming into widespread use to describe asupposedly new category of workers who wereunable to achieve a decent standard of living eventhough they were able-bodied and had work. (Theneed for public support for the old, the sick andchildren was never questioned.) The‘Speenhamland System’, introduced in the 1790s,involved the payment of allowances linked to theprice of bread to men earning low wages. Thesepayments were financed from local taxation, andaroused great controversy. Some people arguedthat the system depressed wages, exacerbating theposition of the poor instead of relieving it.

The French Revolution in 1789 and the ensuingwars (1793–1815) had a profound effect oneconomic thought. The Revolution raised thespectre of republicanism, and popular unrest was aconstant worry for the ruling classes in Britain,especially after the outbreak of war in 1793. Thewar also created acute economic problems. Afinancial crisis in 1797 led to the suspension of theconvertibility of sterling into gold, and Britainremained on a paper currency until 1819. Duringthe decade and a half after the suspension, thenumber of banknotes issued by the Bank ofEngland increased and prices rose. A particularproblem was the rise in the price of grain, whichraised agricultural rents and caused an expansion inthe amount of cultivated land. Farmers andlandlords prospered. At the same time, people werebecoming aware that the ‘manufacturing system'was growing rapidly. Steam power, though stillused only on a small scale, was spreading, andmechanization was rapidly transforming the long-established woollen industry and making possiblethe dramatic growth of the newer cotton industry.The mix of social unrest caused by high food pricesand the social dislocation caused by industrialchange was a potent one, especially when

combined with fear of French republicanism.A key figure in the transition from the moral

philosophy of Hume and Smith to classical politicaleconomy was Thomas Robert Malthus (1766–1834). In the 1790s, radicals, of whom WilliamGodwin (1756-1836) and the Marquis deCondorcet (1743–94) were most prominent, arguedthat private property was the root of social ills andthat resources should be distributed more equallyso as to provide everyone with a decent standard ofliving. Given Condorcet's links with the policiesthat developed in France, under Robespierre, intothe Terror (in which Condorcet was killed), thiswas regarded as a seditious doctrine by much ofthe British Establishment. Malthus, a clergyman inthe Church of England, responded to sucharguments with his Essay on the Principle ofPopulation. This was published as a small,anonymous, tract in 1798, then considerablyexpanded and published under his name in thesecond edition of 1803. In it, Malthus offered aseries of related arguments against utopian views,focusing in particular on Godwin. Far from being asource of harm, Malthus argued, private propertywas essential, for otherwise self-love would fail tohave the beneficial effects that Smith had pointed

out. Giving money to the poor would not improvetheir condition unless someone else was preparedto consume less, for it would have no effect on thequantity of resources available. Furthermore, anyextension of poor relief would increase thedependence of the poor on the state – somethingMalthus viewed with apprehension. Under the PoorLaws, the poor were ‘subjected to a set of grating,inconvenient, and tyrannical laws, totallyinconsistent with the genuine spirit of theconstitution… utterly contradictory to all ideas offreedom… [and adding] to the difficulty of thosestruggling to support themselves withoutassistance’.1

Though it was only one among many ideaspresented in the Essay, Malthus has become mostwidely associated with the argument that there is acontinual tendency for population to outstripresources. He expressed this by claiming that, ifunchecked, population would grow according to ageometric progression (1, 2, 4, 8, 16,…), whereasfood supply could grow only in an arithmeticprogression (1, 2, 3, 4, 5,…). Population was helddown by two types of check: preventive checks,which served to lower the birth rate, and positivechecks, which raised the death rate. These two

types of check fell into two categories: misery (war,famine) and vice (war, infanticide, prostitution,contraception). In the second edition of the Essayhe added a third category, moral restraint, whichcovered postponement of marriage notaccompanied by ‘irregular gratification’. This thirdcategory enabled him to reconcile his theory withthe evidence he had collected, between 1798 and1803, that his original theory was not supported bythe facts. Moral restraint was very importantbecause it opened up the possibility of progress.However, although Malthus softened the hard linetaken in the original Essay, he never sharedGodwin's or Condorcet's optimism, for he did notshare their belief in the goodness of human nature.Men required moral guidance, and Malthus soughtto provide it. The term ‘moral' restraint wascarefully chosen.

Malthus, therefore, was operating within thesphere of eighteenth-century moral philosophy. Hebased his case against the utopians on laws ofsociety – the security of property and theinstitution of marriage. Socialism was at faultbecause it violated natural laws. In arguing alongthese lines, Malthus was arguing that Christianity,properly interpreted, was consistent with the

Enlightenment – indeed, that it was the highestform of enlightenment. Though he disagreed withGodwin's and Condorcet's conclusions, he sharedwith them a belief in reason, presenting himself asapplying Newtonian principles to the art of politics.He criticized them for endangering the enlightened,Newtonian, view of science by fostering hopes ofprogress that could never be realized.

This belief in the power of reason was not sharedby Malthus's ‘Romantic' critics, Robert Southey(1774–1843), Samuel Taylor Coleridge (1772–1834) and the other ‘Lake poets’. During his ownlifetime, the term ‘Malthusian' came to be used as aterm of abuse, referring to the materialistic,spiritually impoverished outlook of what was alsocalled ‘modern political economy’. This was areaction that continued throughout the nineteenthcentury, notably with Thomas Carlyle (1795–1881),who coined the phrase ‘the Dismal Science’, andJohn Ruskin (1819–1900). The term ‘economist'came to denote someone with an identifiableapproach to politics and a congenitally hard heart.

The Wealth of Nations, with its optimism aboutthe prospects for growth, offered little guidance topoliticians facing the problems of wartime. Malthusreoriented political economy so as to respond to

these problems, and in doing this he helped lay thefoundations for classical political economy.However, he continued to work within theeighteenth-century tradition in which politicaleconomy was closely linked to the science ofmorals and politics. Other economists, though theyacknowledged an equally great debt to the Wealthof Nations, did not share this perspective andsought to turn political economy into a secularscience.

Utilitarianism and the Philosophic Radicals

After Adam Smith, the main influence on theclassical economists was Jeremy Bentham (1748–1832), a man idolized by his followers. Hisutilitarianism arose out of the natural-law tradition,though Bentham rejected the idea of natural law.Moral codes did not reflect natural laws, but aroseto serve the needs of society. Civil laws, needed toprovide rules by which conduct was to begoverned, should be based on moral codes, butboth might become outdated and need to be

changed. The standard by which moral rules andcivil laws should be judged was ‘the principle ofutility' – the maximization of the sum of thehappiness of the individuals that make up asociety. This was also the standard that should beused to judge government actions.

Bentham's interpretation of utilitarianism restedon some clear-cut value judgements. (1) Society'sinterest is the sum of the interests of the membersof society. (2) Every man is the best judge of hisown interests. (3) Every man's capacity forhappiness is as great as any other's. These resultedin a philosophy that was both egalitarian andindividualist and served as the foundation forBentham's elaborate schemes for legal and penalreform. For Bentham, however, the principle ofutility did not reduce policy-making to a simplerule. Utility had several dimensions (intensity,duration, certainty, and nearness), and it wasnecessary to balance these against each other. Theutilitarian principle nonetheless provided a roughguide that policy-makers could follow.

Bentham wrote on economic questions,acknowledging his debt to Smith, but his majorinfluence was indirect, through his followers, thePhilosophic Radicals. Among these, the most

eminent were James Mill (1773–1836), Mill'sintellectual protégé, David Ricardo (1772–1823),and John Stuart Mill (1806–73). James Mill studieddivinity in Edinburgh and briefly became aPresbyterian preacher before turning to teaching. In1802 he moved to London to pursue a career as ajournalist and writer. His major work was A Historyof British India (1818), after which he obtained apost in the India Office, rising to the position ofChief Examiner, the senior permanent post in thegovernment of India. In London he became a closeassociate of Bentham. Ricardo, the son of astockbroker, came from a Jewish family. Hemarried a Quaker and was subsequently disownedby his father. At Mill's instigation, he became aMember of Parliament. John Stuart Mill was theson of James Mill and received a very rigorouseducation from his father. At three he startedGreek, and at eight Latin, algebra, geometry anddifferential calculus. Political economy and logiccame at twelve. He spent many years working atthe India Office, rising to the same position as hisfather, and in 1865 he became a Member ofParliament.

The Philosophic Radicals were actively engagedin politics, using utilitarianism as the basis for

criticizing the institutions of society andadvocating policies of reform. By the standards ofthe day they were genuine radicals, even thoughtheir schemes were far removed from the socialismof Godwin and Condorcet or of some of theircontemporaries such as Robert Owen (1771–1858),author of the New Lanark socialist experiment.They remained, like Malthus, Whigs. However,though James Mill and Ricardo were close toMalthus on many issues (Ricardo and Malthus wereclose friends, constantly debating economicissues), they did not share his commitment toeconomics remaining a moral science. For themeconomics was political economy, but they soughtto make it a rigorous discipline offeringconclusions as certain as those offered byEuclidean geometry. This resulted in the subjectbecoming, in Ricardo's hands, more abstract andless inductive than in the hands of either Smith orMalthus.

Ricardian Economics

Ricardian economics was a response to thesituation in Britain during the Napoleonic Wars(1804–15), when the price of corn (wheat) andagricultural rents rose dramatically and the marginof cultivation was extended. Ricardo sought todemonstrate two propositions: that, contrary towhat Smith had argued, the interests of thelandlords were opposed to the interests of the restof society, and that the only cause of a decliningrate of profit was a shortage of cultivable land. It iseasy to see how such a perspective arose fromBritain's wartime experience. Influenced by JamesMill, with his desire to make political economy asrigorous as Euclidean geometry, in his Principles ofPolitical Economy and Taxation (published in threeeditions, 1817–23) Ricardo constructed a systemthat was unprecedented in the analytical rigourwith which it was developed.

Ricardo's system rested on three pillars: aSmithian perspective on the link between capitalaccumulation and growth, the Malthusian theory ofpopulation, and the theory of differential rent. Thelast of these was worked out, apparentlyindependently, by Malthus, Ricardo, Edward West(1782–1828) and Robert Torrens (1780–1864), in1815. The theory rested on two assumptions: that

different plots of land were of different fertility,with the result that applying the same labour andcapital to them would yield different quantities ofcorn, and that agricultural land had no alternativeuse. Competition would ensure that the least fertileplots of land under cultivation would earn no rent:the corn produced would sell for just enoughrevenue to cover production costs, with the resultthat there would be nothing left for the landlord. Ifthere were a surplus, more land would be broughtunder cultivation; if costs were not covered, theland would not be cultivated. All other plots ofland, however, because they must by definition bemore fertile, would yield a surplus. Being the ownerof the land, the landlord would be able to demandthis surplus as rent. The result was that rentemerged as the surplus earned by land that wasmore fertile than the least fertile land undercultivation.

The theory of differential rent explained theshare of national income that was received bylandlords. The Malthusian population theory wasthen used to explain the share of income receivedby workers. While wages might rise above or fallbelow this level if the population were growing ordeclining, they were linked, in the long run, to the

subsistence wage rate. The residual after deductingrent and wages was profit, the share of incomeaccruing to capitalists. From there it was a shortstep to a theory of economic growth. High profitswould encourage capitalists to invest, raising thecapital stock. This would raise the demand forlabour, keeping wages high and causing populationgrowth. However, as the population grew, so toowould the price of corn, the result being that themargin of cultivation would be extended: moreland would be cultivated, and plots already undercultivation would be cultivated more intensively.As this happened, rents would rise, eating away atprofits (wages could not fall, at least for very long,below subsistence, so could not be reduced). Thisfall in profits would cause the rate of capitalaccumulation, and hence the rate of growth, to fall.

It was thus apparently a short step to Ricardo'stwo key propositions. As capital accumulated, rentsrose but profits fell. Given that capital createdemployment, this was bad for the workers too. Inaddition, Ricardo had shown that fallingproductivity in agriculture, caused by the need tobring decreasingly fertile land into cultivation, wasthe cause of a declining profit rate. There werecomplications, however. The first was that, as

growth took place and demand for food increased,it might be possible to import food, thus removingthe necessity to extend the margin of cultivation.These imports would have to be paid for throughexports of manufactured goods. In itself thiscaused no analytical problems: capitalists wouldinvest in either agriculture or manufacturing,depending on the rate of profit available in each,so, if agriculture could not be expanded withoutlower profits, capital would move intomanufacturing, creating the necessary exports.

However, the introduction of a manufacturingsector into Ricardo's model raised major theoreticalproblems. The first was that, if there were twogoods (food and manufactures), Ricardo needed toexplain their relative price: he needed a theory ofvalue. For this he turned to the labour theory ofvalue – the theory that prices of commodities willbe proportional to the labour required to producethem. The problem here, cutting through animmensely technical issue, is that, undercompetition, prices will be proportional toproduction costs and production costs will dependon the amount of capital used, not just thequantity of labour. It follows that the ratio of priceto labour cost will vary according to the ratio of

capital to labour in an industry. The labour theoryof value will not hold. Ricardo struggled to find away out of this problem, but in the end he had toresort to an act of faith – he used a numericalexample to argue that, in practice, variations inlabour time explained virtually all variations inrelative prices (93 per cent in his example).

The existence of manufactured goods alsocreated problems for Ricardo's claim thatdiminishing agricultural productivity was the onlycause of a declining profit rate. If workersconsumed only corn, this would be true.Agriculture would be self-contained (corn would bethe only output and the only input), and the rate ofprofit would not depend on conditions inmanufacturing. Competition would ensure that therate of profit earned in manufacturing, and hencein the whole economy, would equal that earned inagriculture. On the other hand, if workers'subsistence were to include, say, clothing as wellas food, then the subsistence wage would dependon the cost of producing clothing as well as thecost of producing food. Agriculture would not beself-contained. The result would be that the rate ofprofit would depend on conditions inmanufacturing as well as on those in agriculture.

Ricardo's theorem that agricultural productivitywas the only determinant of the profit rate wouldbe undermined.

It is clear, even from this account, that inRicardo's economics we are dealing with a level ofanalytical rigour that is to be found in few, if any,of his predecessors. Ricardo simplified the worldhe was analysing to the point where he was able toshow with strict logic that his conclusionsfollowed. When account is taken of the aspects ofhis system that are not discussed here (notably histheories of international trade and money) theseremarks apply a fortiori.

Ricardo's two propositions, though rooted inwartime conditions, had clear political implicationsin the nineteenth-century post-war world. After thewar, corn prices remained high because of the CornLaws, which prevented a price fall by severelyrestricting imports. His message that the interestsof the landlords were opposed to the interests ofthe rest of society resonated with many politicalagitators: workers wanted cheaper corn so thattheir wages would buy more, and manufacturerswanted cheaper corn in the belief that it wouldreduce wages. Furthermore, Ricardo's theoryargued that, unless the Corn Laws were repealed,

profits would fall and growth would come to ahalt. However, even if the Corn Laws wererepealed, there would still be problems, the reasonbeing that, if Ricardo's theory were correct, growthwould involve the progressive expansion ofmanufacturing relative to agriculture. Britain wouldbecome the workshop of the world, exportingmanufactured goods and importing corn. This wasunacceptable to conservatives such as Malthus.

One of the most significant points aboutRicardo's predictions is that they were based on afallacy in his reasoning. He argued that it wouldnot be in the interest of landlords to undertakeimprovements. Rises in productivity would simplycause the margin of cultivation to contract, withthe result that rents would not rise. This, however,refers to rents in the economy as a whole. WhatRicardo failed to see is that, even if aggregate rentsdo not rise, it will still be in the interests ofindividual producers to make improvements. Thismeans that improvements will be introduced. Ifimprovements are made, his predictions about thefalling rate of profit and class conflict areundermined. The reason why this apparently smalltechnical detail is so important is that Ricardo'smistake followed directly from his method. He

theorized about aggregates, viewing agriculture asone giant farm. This approach allowed him to reachstriking conclusions, but was potentiallymisleading.

Alternatives to Ricardian Economics

Ricardian economics made a deep impression. Inthe words of one commentator, it ‘burnt deep scarson to the classical-economic consciousness’.2 Itwas also the origin of Marx's economic theory andof many concepts that were used in more orthodoxeconomics in the nineteenth and twentiethcenturies. The idea that the rate of profit dependedon the marginal cost of growing corn (the cost ofgrowing an additional unit of corn, which wouldtypically be higher than the unit cost of the cornthat was already being grown) – arguably thedefining theme in Ricardian economics – persistedthroughout English economics up to the 1880s. Inthis sense, Ricardo had a lasting influence.However, Ricardian economics in its purest form(including the labour theory of value, Ricardo's

deductive method and the theory of population)dominated the subject for only a brief period in theearly 1820s.

The labour theory of value was strongly criticizedby Samuel Bailey (1791–1870) in 1825. Baileyargued for a subjective theory of value in whichvalue depended, not on costs, but on ‘the esteem inwhich an object is held’.3 Nassau Senior (1790–1864), appointed to the first chair of PoliticalEconomy at Oxford, moved away from both theMalthusian population doctrine and the labourtheory of value. He introduced the idea that profitswere not a surplus but a reward to capitalists forabstaining from consuming their wealth. He alsoformulated the idea that the value of an additionalunit of a good (the concept that, in the 1870s,came to be called marginal utility) declined asmore of the good was consumed. John RamsayMcCulloch (1789–1864), Professor of PoliticalEconomy at University College London from 1828to 1837 and the most prolific economic writer inthe Whig Edinburgh Review, was at one time astaunch Ricardian. However, he substantiallymodified his views, placing a much greateremphasis on history and inductive research thandid Ricardo. He rejected Ricardo's view of class

conflict. He considered it fallacious on the groundsthat individual landlords would always have anincentive to introduce improvements. This wouldraise the productivity of land and would offset thetendency of the rate of profit to fall.

In short, English classical economics was notpurely Ricardian. It reflected the work of a varietyof individuals, and encompassed a plurality ofviews on most questions. If one work dominated, itwas not Ricardo's Principles but Smith's Wealth ofNations, with its more catholic blending of theoryand history. Even in 1900 there were still textbooksorganized on Smithian lines.

Outside England, the influence of Ricardianeconomics was even less strong. In France, Smith'smain interpreter was Jean Baptiste Say (1767–1832), a member of the Tribunate under Napoleon,and later an academic economist. Say was widelyconsidered the leading French economist of hisgeneration. Though a supporter of Smithian ideas,he advocated a subjective theory of value,consistent with a long-standing French traditiongoing back at least to Condillac. He also developedthe law of markets. This was the proposition,previously put forward by Bentham and James Mill,and accepted by Ricardo, that there could never be

a shortage of demand in general: that supplycreates its own demand. Depressions arise not froma shortage of demand in the aggregate, but fromshortages of demand for particular commodities.

Equally important, there developed in France along tradition of applying mathematical analysis toeconomic problems. Condorcet had paved the waywith his analysis of voting theory. He had shown,for example, that if there were three or morecandidates in an election, majority voting mightresult in the election of a candidate who wouldlose in all two-candidate contests. However, theperson who made what to modern economists isthe most remarkable contribution was AntoineAugustin Cournot (1801–77). Cournot was brieflyProfessor of Mathematics at Lyon, but spent mostof his career as a university administrator. Makingthe assumption that each producer maximizedprofit, and that sales in the market wereconstrained by demand, he derived equations todescribe the output that would result if there weredifferent numbers of firms in an industry. Startingwith a single producer (a monopolist) he showedhow output would change as the number of firmsrose, first to two, and then towards infinity. ForCournot, competition was the limiting situation as

the number of firms approached infinity. In acompetitive market, no firm could affect the priceit received for its product.

Cournot is also considered to have been the firsteconomist to use a diagram to explain how supplyand demand determine price in a competitivemarket. The demand curve (MN in Cournot'sdiagram below) shows that the amount that peoplewish to buy falls as price rises. The supply curve(PQ) shows that the amount that producers wish tosell increases as price rises. The market price (OT)is the price at which supply and demand are equal.Cournot went on to show how the diagram couldbe used to show how market price would change inresponse to events such as the imposition of a taxon the commodity.

An emphasis on demand for goods was alsocharacteristic of the work undertaken by engineersat the École des Ponts et Chaussées (School ofBridges and Highways). Their work was promptedby the need to find a basis for deciding the meritsof civil-engineering projects. In the 1820s, theconventional view was that such projects should beself-liquidating – that they should completely covertheir costs. Claude Louis Marie Henri Navier (1785–1836), well known to engineers for his work on

mechanics, challenged this in an article, publishedin 1830 in Le Génie civil (a civil-engineering journal)and in 1832 in the Annales des ponts et chaussées.His argument was that a public work, such as acanal or a bridge, could raise public welfare.Taxpayers would get goods more cheaply, and theexpansion in trade caused by the

Fig. 1 Supply and demand curves

project would increase tax revenues in general. Heestimated benefits derived from a project bymultiplying the quantity of goods carried using thecanal or bridge by the reduction in transport costproduced. If these benefits were greater than theongoing annual cost of the project, theconstruction cost should be financed out oftaxation. Navier thought that tolls should be zero,but if they had to be levied they should cover onlyinterest payments and regular maintenance. Heextended these ideas in later articles and in hislectures at the École des Ponts et Chaussées, takingaccount of such things as the relation betweencosts and the length of a railway line. He alsoconsidered whether public works should beprovided by the state or franchised to private firms,and the type of regulation that should be imposed.

These problems were also tackled, independentlyof Navier, by Joseph Minard (1781–1870), anotherengineer, who wrote what he viewed as a practicalmanual to guide civil engineers involved in public-works projects. He used the idea of a downward-sloping demand curve to argue that Navier'smethod (quantity of goods carried times the cost

saving) would overstate the benefit derived from aproject. The reason is that some of the peopleusing the canal or bridge would not have madetheir journeys had it not been built, which meansthat the benefit they get from it will be less thanthe cost saving. He used arguments about thedistribution of income between those who use thecanal and those who do not to propose that tollsshould be charged to cover annual costs. He alsoproduced a formula (involving interest andinflation rates) to calculate the benefits from aproject that took time to build, would not last forever, and had an annual maintenance cost.However, though Minard wrote his manuscript in1831, the course for which he planned to use itwas not approved for many years, with the resultthat he did not publish his work until 1850. By thattime, other articles on the subject had appeared.

Jules Dupuit (1804–66), another engineerconcerned with methods by which the benefits ofpublic-works projects could be estimated, alsoargued, in a series of articles in the 1840s and1850s, that Navier's method overestimated thebenefits. First, what mattered was not thereduction in transport costs but the reduction inthe price of products. When production rose

following the construction of a new bridge orcanal, goods would be transported over longerdistances. The result was that production costswould not fall as much as the cost of transportover a given distance. Second (and here he wasmaking a point similar to Minard's) Dupuit arguedthat the utility of an additional unit of a goodcould be measured by the price the consumer waswilling to pay for it. This price would fall asconsumption rose. Dupuit went on to argue thatthe benefit obtained from building a canal orbridge could be measured by subtracting the costof the project from the area under the demandcurve. The demand curve, used by Cournot simplyto analyse behaviour, could be used as a measureof welfare.

The three engineers discussed here form part of along, well-established tradition at the École desPonts et Chaussées in the middle decades of thenineteenth century. Starting with the practicalproblem of evaluating civil-engineering projects,they developed an alternative to the orthodoxtheory of value associated with Smith and Say.Some of Dupuit's later articles were published inthe Journal des économistes, but much of theengineers' work was published in journals where

economists would not see it. Say did express aninterest in Minard's work in 1831, but he died ayear later.

Another tradition, owing little to Ricardo, isfound in the writers of economics textbooks inGermany, notably Karl Heinrich Rau (1792-1870),Friedrich Hermann (1795–1868), Hans vonMangoldt (1824–68) and Wilhelm Roscher (1817–94). These were Smithian in that they acceptedSmith's ideas about the importance of saving anddivision of labour for economic growth. However,they rejected the labour theory of value. Instead,they took from Steuart the idea that prices aredetermined by supply and demand. Unlike most ofthe English classical economists, they attachedgreat importance to demand. Hermann, forexample, wrote explicitly about how changes indemand can cause changes in costs. Theirtextbooks discussed demand before supply, andexplored the connections between demand andhuman needs. The result was a subjective theory ofvalue in which the value of a good depended onwhat other goods people were prepared to forgo inorder to obtain it – subsequently known as anopportunity-cost theory.

As in the French engineering tradition, supply

and demand were represented graphically.Independently of Cournot, Rau used a supply-and-demand diagram in the fourth edition (1841) of histextbook. (He began the convention, followed inmost of the modern literature, of putting quantityon the horizontal axis and price on the verticalaxis.) Unlike Cournot, he analysed not only theequilibrium (where demand and supply are equal)but also the stability of this equilibrium. If pricewere too high, supply would exceed demand,pushing price down; if price were too low, demandwould exceed supply, pushing price up. These ideaswere taken further by Mangoldt in his textbook(1863). He argued that the shape of the supplycurve would depend on the behaviour of costs asoutput increased and he used his curves to see howprices would change in response to changes insupply or demand.

For most of the nineteenth century, Germanywas not a single country but a mosaic of smallstates. It is thus not surprising that differentapproaches to economics could coexist alongsideeach other. One such tradition is represented byJohann Heinrich von Thünen (1783–1850). Thünenwas a farmer who became, by 1827, aninternationally known authority on agriculture. His

main work, Der isolierte Staat (The Isolated State),was published in three instalments between 1826and 1863. It is best known for its analysis oflocation, in which the profitability of agriculture(and hence the level of rent and the type ofagriculture that will be undertaken) depends onhow far farms are from the city. He took as hisstarting point a city located in the centre of a large,fertile plain in which there were no rivers or othernatural factors affecting transport costs. On such aplain, farming would be organized in a series ofconcentric circles. Closest to the city would behorticulture and market gardening, the produce ofwhich cannot be transported far. Furthest awaywould be hunting, for which large tracts of landwere needed and where transport costs were not aproblem. In between would be various types offorestry, arable farming and pasture.

Perhaps as significant as Thünen's theory oflocation was his method. He tackled the questionof how much capital and labour to use by regardingit as a maximization problem. Farmers use thequantities of capital and labour that will maximizetheir profits. Thünen formulated this problem usingalgebra, and solved it using differential calculus. Bythese methods he obtained the result that the wage

paid will equal the contribution to output made bythe last worker to be employed – the marginal-productivity theory of distribution. These methodsalso led him to see the problem of forestmanagement as one involving time and the rate ofinterest. If the essence of capital is seen as beingthat it allows production to take place over time (aview later developed by Austrian economists), thiscan be seen as a marginal-productivity theory ofthe rate of interest.

Government Policy and the Role of the State

The British classical economists wrote during theperiod when economics was only just beginning tobecome institutionalized as an academic discipline.They were linked by organizations such as thePolitical Economy Club (a group, founded in 1821,that met each month to discuss economicquestions), the Royal Society, the Royal StatisticalSociety and the British Association. The journals inwhich their ideas were published did not specializein economics, but addressed the educated classes

in general and were frequently identified by theirpolitical leanings, not by their disciplinarycoverage. The Edinburgh Review was Whig, theWestminster Review was Benthamite, and theQuarterly Review was Tory. Some economists heldacademic posts (often for short periods, not as alifelong career), but most did not. For example,Ricardo was a stockbroker; Torrens had served inthe army and was a newspaper proprietor, Westand Mountifort Longfield (1802–84) were lawyers,and McCulloch (a professor for a brief period) wasa civil servant and for a short time editor of theScotsman. Many had a legal training, and many heldgovernment appointments at some stage in theircareers. However, though abstract issues werediscussed, political economy was never far fromquestions of economic policy. Many economistsand many members of the Political Economy Clubwere Members of Parliament. Even when they werenot involved in policy-making, however, almost allthe economists formed part of the circles in whichpolicy-makers moved, and they played an activerole in discussions of economic policy. In the1830s, after the Reform Act of 1832 (whichextended the franchise to most of the propertiedclasses), the Philosophic Radicals formed an

identifiable group in Parliament.Though there were enormous differences

between economists, it is a fairly safegeneralization to say that they were in generalpragmatic reformers. Like Smith, they opposedmercantilism. In so far as there was an ideologicaldimension to this, it stemmed from opposition tothe corruption associated with mercantilism ratherthan any commitment to non-intervention. It wasgenerally accepted that government had animportant but limited role to play in economic life.Even the Philosophic Radicals, who favoured moreradical reforms than most economists, wereutilitarian – adhering to a philosophy that placedutility above freedom. They were quite willing tosee the government regulate, provided thatlegislation did not undermine the security ofprivate property, an institution they regarded ascrucial in stimulating economic growth. Theirattitudes and the changes that took place in thepolitical context are best illustrated by consideringsome of the major questions that arose in the firstthree-quarters of the century: trade policy, poorrelief, and labour-market policies.

The classical economists were basically free-traders, and produced a wide range of arguments to

support their stance. Not only was there the‘invisible hand' argument found in the Wealth ofNations, they also pointed to the opportunities thatprotection provided for corruption and thedistortion of domestic industry in favour ofpowerful groups. There were debates over whetherfree trade should be imposed unilaterally or on thebasis of commercial treaties, but on the whole theysupported unilateral free trade. The mostcontentious issue in trade policy, however,concerned the Corn Laws. Ricardo's theory wasaimed at precisely this issue and provided a strongcase for repeal, but this was not the ground onwhich most economists argued. They wereinfluenced more by Smith. Thus McCulloch andSenior rejected Ricardo's arguments that theinterests of the landlords differed from those ofother classes in society. Some economists evensupported the levying of tariffs to raise revenue,provided that these were not sufficiently high todistort trade flows.

The Poor Law was an issue for which theMalthusian theory had direct implications. Malthusand Ricardo favoured the abolition of the PoorLaw, though both wanted this to be done gradually.Others thought this solution impracticable and

favoured radical reform. Senior, for example,argued for the policy embodied in the Poor LawAmendment Act (1834), under which relief for theable-bodied poor was confined to those living inworkhouses and which tried, in vain, to enforce theprinciple of less eligibility (that those out of workshould be worse off than anyone in work). Most ofthe classical economists, however, were morerelaxed about the provision of poor relief, beingsceptical about the Malthusian argument that itwould inevitably stimulate growth in the number ofpaupers. They wanted to continue ‘outdoor' relief,and were not insistent on enforcing the principle ofless eligibility.

Industrialization was changing dramatically theconditions under which an increasing proportion ofpeople worked, and there was pressure forgovernment regulation. In addition, trade unionsbegan to be formed after the repeal of theCombination Laws (under which the formation ofunions was illegal) in 1824. On neither issue didthe economists adopt a doctrinaire position. Thefirst act regulating factory conditions had beenpassed in 1802, and during the following decades aseries of acts was passed increasing the degree ofregulation. In much of this legislation the main

target was children's and women's hours andconditions of work, but legislation here inevitablyaffected men too. There was a tendency to refrainfrom regulating adult men's hours, on the groundsthat this would interfere with the principle offreedom of contract, but in general the economistswere pragmatic and responded to events. They keptup with public opinion rather than leading it. Ontrade unions, the economists' position wasgenerally to favour high wages and to view unionsas counterbalancing employers' higher bargainingpower.

The classical economists accepted the Smithiancase for free enterprise, and many of them viewedthe encroachments of the state on individualliberty with great suspicion. On neither, however,were they doctrinaire. They judged particular casesaccording to the principle of utility. The result wasa pragmatic outlook in which the role for laissez-faire was severely circumscribed.

Money

Monetary policy was a major concern of theclassical economists from the 1790s onwards. In1793 and 1797 serious financial crises took placeagainst the background of a banking system thathad changed significantly since Hume's work on thesubject. These formed the background to An Inquiryinto the Nature and Effects of the Paper Credit ofGreat Britain (1802) by a banker, Henry Thornton(1760-1815). Thornton viewed banknotes and billsof exchange as assets that people hold, with theresult that he placed great emphasis on confidence.If people became uncertain about the value of theassets they were holding (whether bills of exchangeor notes issued by banks outside London), theywould increase their holdings of the more secureasset. In Thornton's day this meant notes issued bythe Bank of England. Thornton thus perceived thatthere was a hierarchy within the banking system. Intimes of crisis, when they experienced a run ontheir reserves, the country banks (outside Londonand generally small) would turn to theircorrespondents in London for support. These inturn would turn to the Bank of England forliquidity. The Bank of England thus stood at theapex of a pyramid of credit.

This had enormous implications for the policy

that the Bank of England should pursue. Thenormal practice for a bank facing a loss of reserveswas to cut back on its lending. However, Thorntonargued that this was exactly the wrong policy forthe Bank of England, which should increase itslending when it experienced a loss of reserves tothe country banks. The reason was that, if therewere a crisis of confidence, an increase in theavailability of credit from the Bank of Englandwould serve to restore confidence and providereserves that the rest of the banking systemrequired. This was different from the case of thecountry banks – an increase in their note issuewould reduce confidence in their ability to redeemtheir notes. In other words, the Bank of England,Thornton argued, should be acting as a centralbank, taking responsibility for the financial systemas a whole.

After 1804 the price of gold bullion rosesignificantly above its par value, established byNewton at £3 17s. 10½d. per ounce. In otherwords, the value of the Bank of England's notes hadfallen. Ricardo, in 1810, argued that the rise in theprice of bullion reflected the overissue of notes bythe Bank of England. He argued that the directorsof the Bank could not be trusted to manage the

issue of notes, and that convertibility should berestored – albeit gradually. This was the strictbullionist position – that notes should beconvertible into bullion. This was also Thornton'sposition, though unlike Ricardo he accepted thatthe link between note issue and the price of bullionmight be weak in the short run. In the short run itwas possible for factors that affected the balanceof payments – such as bad harvests (which causedan increase in imports of corn), subsidies to foreigngovernments, or overseas military expenditure – toraise the price of bullion independently of the noteissue.

The anti-bullionist position can be found in thewritings of the directors of the Bank of England.They denied that the quantity of banknotes incirculation bore any relationship to the price ofbullion. Their argument was the so-called ‘real-billsdoctrine’. This was the theory that, provided a banklent money against ‘real bills' (bills issued tofinance genuine commercial transactions, not tofinance speculation), the bills would automaticallybe repaid when the transaction was complete. Theamount of currency in circulation would thereforeexactly equal the demand for it. It was assumedthat no one would borrow money and pay interest

if they did not need to. The answer to this wasoffered in Thornton's Paper Credit. Thorntonpointed out that the decision on whether to borrowmoney from a bank would depend on how theinterest rate on the loan compared with the rate ofprofit that could be obtained through investing themoney. If the interest rate were below the profitrate, people would have an incentive to increasetheir borrowing, the circulation of banknoteswould increase, and prices would rise. This processwould continue for as long as the interest rate wasbelow the profit rate. Conversely, if the interestrate exceeded the profit rate, the quantity of notesissued and the price level would fall. The real-billsdoctrine, with its assumption that no one wouldborrow money unnecessarily if interest had to bepaid on it, was thus flawed.

A parliamentary report into the currency in 1810,largely drafted by Thornton, supported thebullionist case, and as a result the government tookthe decision to return to convertibility, this beingachieved in 1819. However, this did not enddiscussions of monetary policy. The period after1815 was one of severe deflation – of depressionand falling prices. Although the policy ofmaintaining convertibility of sterling into gold was

not questioned, it became clear that this in itselfwas not enough. The Bank of England's policy hadto be organized so as to ensure that its bullionreserves were always sufficient for convertibility tobe maintained. This led into a debate over whatwould nowadays be termed counter-cyclical policy:economists debated the merits of alternative waysof coping with fluctuations in the demand forcredit.

The banking school argued that monetary policyshould be conducted according to the needs of thedomestic economy. In a depression there was ashortage of credit, and so the note issue should beexpanded. If too many notes were issued, theywould be returned to the Bank – the so-called‘doctrine of reflux’. It stressed that notes weremerely one among many forms of credit. One ofthe main supporters of the banking school, ThomasTooke (1774–1858), countered Thornton'sargument that low interest rates led to inflationwith extensive statistical evidence to show thatinflation typically occurred when interest rateswere high. In opposition to this view, the currencyschool, of which Lord Overstone (1796–1883) wasthe leading member, advocated the so-called‘currency principle’, or ‘principle of metallic

fluctuation’. This was the principle that a papercurrency should be made to behave in the sameway as a metallic currency would behave. Thismeant that, if the Bank of England lost gold, itshould reduce its note issue pound for pound. Themoney supply would thus be linked to the balanceof payments. This was, like the banking school'sproposal to meet the needs of trade, a counter-cyclical policy, for it was designed to ensure thatcorrective policies would be implemented beforean expansion had gone too far. Without thecurrency principle, the currency school argued,action would be taken too late. Thus, whereas thebanking school focused on policy to alleviatedepressions, the currency school sought to design apolicy that would make them less likely to occur.

John Stuart Mill

That Ricardian economics exerted an influencebeyond the 1820s is due to two people, both majorfigures in nineteenth-century intellectual history.The first of these was John Stuart Mill. Mill was

educated by his father to be a strict disciple ofBentham. In the 1820s and 1830s he was amember of the Philosophic Radicals. Around 1830he wrote a series of essays on economics in whichhe built upon the Ricardian approach toeconomics, but he had problems in finding apublisher and they were not published till 1844,after the great success of his System of Logic(1843). After his father's death in 1836, andinfluenced by Harriet Taylor (1807–58), whom hemarried in 1851, Mill moved away from a narrowutilitarian position and became much moresympathetic to socialism – albeit a form ofsocialism very different from what is now meant bythe term, in that he did not advocate stateownership of the means of production. His maincontribution to economics was his Principles ofPolitical Economy, published in several editionsbetween 1848 and 1873. This served as the pointof departure for most British and many Americaneconomists until the publication of AlfredMarshall's Principles of Economics in 1890.

Mill's achievement in the Principles was to retainthe Ricardian framework but at the same time totake into account the many points made byRicardo's critics. Given that Mill did not lay claim

to originality and that he claimed to be doing littlemore than updating Smith's Wealth of Nations, theresult was a book that has been dismissed aseclectic. This, however, is to understate Mill'soriginality and creativity. The basic theory of value,income distribution and growth was Ricardian, butMill modified it in important ways. He placed muchgreater emphasis on demand in explaining value,and the way in which he conceived demand (as aschedule of prices and quantities) marked asignificant change from the Smithian and Ricardianconcept. When applied to international trade (inhis theory of reciprocal demand), the result was atheory that went far beyond Ricardo in two ways.It allowed for the possibility that costs mightchange with output, and it explained the volume ofgoods traded. He followed Senior in accepting thatprofits might be necessary to induce capitalists tosave.

Perhaps the main significance of Mill's Principles,however, was that, although it retained the basicRicardian framework, it embodied a radicallydifferent social philosophy. Mill wrote of seeking toemancipate political economy from the old school,making it less doctrinaire than it had become inmany quarters. In this he was strongly influenced

by socialist writers, notably a group known as theSaint-Simonians, named after Claude Henri Saint-Simon (1760–1825), who advocated a form ofsocialism in which the class structure of societywas changed but in which production wascontrolled by industralists. Mill reconciled hisadherence to Ricardian theory with a social outlookthat verged on socialism through introducing, atthe start of the Principles, a distinction between thelaws of production and the laws of distribution.After a survey of the evolution of societies,reminiscent of the Scottish Enlightenment, heargued that the production of wealth depended onfactors beyond human control:The production of wealth… is evidently not an arbitrary thing. Ithas its necessary conditions. Of these, some are physical, dependingon the properties of matter, and on the amount of knowledge ofthose properties possessed at the particular place and time…Combining these facts of outward nature with truths relating tohuman nature it [political economy] attempts to trace thesecondary or derivative laws, by which the production of wealth isdetermined.4

These laws of production were based on thephysical world, knowledge of that world, andhuman nature. In contrast, the laws governing thedistribution of wealth depended on human

institutions:Unlike the laws of production, those of distribution are partly ofhuman institution: since the manner in which wealth is distributedin any given society, depends on the statutes or usages thereinobtaining.

He added, however, the qualification thatthough governments have the power of deciding what institutionsshall exist, they cannot arbitrarily determine how these institutionsshall work.5

Political economy could discern the laws governingeconomic behaviour, enabling governments tocreate appropriate institutions. Social reformtherefore involved redesigning the institutions ofcapitalism.

The institutions through which Mill sought toimprove society were ones that gave individualscontrol over their own lives. He supported peasantproprietorship, giving small farmers the incentiveto improve their own land and raise their incomes.He advocated producers' cooperatives andindustrial partnerships (involving profit-sharing) asinstitutions that would enable workers to shareresponsibility for the successful conduct ofbusiness. These schemes all had the characteristic

that they maintained incentives. He described suchschemes as socialist – the difference betweensocialism and communism, as he used the terms,being that socialism preserved incentives whereascommunism destroyed them. He still accepted theMalthusian theory of population growth, but hebelieved that education of the working classes(including education about birth control) wouldlead them to see the advantages of limiting familysize and that living standards would then be able torise. This outlook also affected his view of thestationary state. Growth might slow down, but ifworkers turned to self-improvement there would beno cause for concern.

As his book On Liberty (1859) makes clear, Millwas a liberal in the classical nineteenth-centurysense. He believed in individual freedom. He waseven prepared to argue that there should be ageneral presumption in favour of laissez-faire.However, he was far from an unqualified supporterof laissez-faire, going so far as to describe theexceptions as ‘large’. He listed five classes ofactions that had to be performed by the state,ranging from cases where individuals were not thebest judges of their own interests (includingeducation) to those where individuals would have

to take action for the benefit of others (includingpoor relief) if the state were not involved. Heargued that anything that had to be done by joint-stock organizations, where delegated managementwas required, would often be done as well, if notbetter, by the state. Even more radically, Millargued that there might be circumstances in whichit became desirable for the state to undertakealmost any activity: ‘In the particular circumstancesof a given age or nation, there is scarcely anything,really important to the general interest, which itmay not be desirable, or necessary, that thegovernment should take upon itself, not becauseprivate individuals cannot effectually perform it,but because they will not.’6 Having made the casefor laissez-faire, Mill thus qualified it so heavily asto leave open the possibility of a level of stateactivity that many would regard as socialist.

Karl Marx

The other major mid-nineteenth-century economistto build on Ricardo's economics was Karl Marx

(1818–83). However, whereas Mill remained withinthe classical framework laid down by Smith andRicardo, Marx sought to provide a radical critiqueof orthodox ‘bourgeois' political economy. Hisstarting point was the study of ancient philosophyat the University of Berlin, then dominated by theideas of Georg Wilhelm Friedrich Hegel (1770–1831). Central to Hegel's work was the idea ofdialectics, according to which ideas progressedthrough the opposition of a thesis and anantithesis, out of which a synthesis emerged.However, whereas Hegelian dialectics applied tothe realm of ideas, Marx offered a dialecticalanalysis of the material world and the evolution ofsociety (historical materialism). Each stage ofhistory produced tensions within itself, theoutcome of which was a move to a new, higher,stage of society. Feudalism gave way to capitalism,which in turn would give way to socialism andeventually to communism, the highest stage ofsociety. This dialectical analysis of the materialworld is Marx's historical dialectics.

Marx's writings fall into several distinct stages. Inthe early 1840s Marx worked as a journalist in theRhineland, where he had to tackle economic issuessuch as free trade and legislation on the theft of

wood. The theoretical framework that underlies hislater work was completely absent – he consideredthe notion of surplus value (an idea central to hislater work) an ‘economic fantasy’. In 1844,however, Friedrich Engels (1820–95), a cottonmanufacturer with interests in Britain andGermany, who became Marx's lifelong friend,supporter and collaborator, introduced him toEnglish classical economics. In an article publishedthe previous year, Engels had argued that theintensity of competition among workersimpoverished them. Capitalists could combine toprotect their own interests and could augment theirindustrial incomes with rents and interest, whereasworkers could do neither. Marx, in 1844, went onto explain low wages in terms taken straight fromSmith. If demand for a product falls, at least onecomponent of price (rent, profits or wages) mustfall below its natural rate. He argued that, withdivision of labour, workers became morespecialized and therefore found it harder to movefrom one occupation to another. The result wasthat when prices fell it was the workers whoseincomes were reduced below the natural rate.Capitalists were able to keep the competitive priceof their product above the natural price – to charge

more than the value of their produce, and hence toextract a surplus.

In the next three years Marx studied Ricardofurther and adopted the labour theory of value.However, whereas Ricardo had used the term‘value' to mean the price of a commodity, Marxdefined value as something that lay beneath price:the labour time required to produce a commodity.Value and price were distinct. The significance ofthis was that it provided him with a rigorousexplanation of how exploitation could arise, evenin equilibrium. Exploitation was inherent in thebasic relationships of capitalist production.

The year 1848 saw publication of The CommunistManifesto and Marx's involvement in the revolutionsthat took place (especially the one in Paris),followed by his exile to Britain. In London heturned again to economics and started work on amore systematic, scientific treatment of thesubject. The main manuscript dating from thisperiod, the Grundrisse, was never finished forpublication (though it was published many yearslater). By the end of the 1850s all he had publishedwas a short introduction to the subject, AContribution to the Critique of Political Economy(1859), his first major economic work. In

correspondence with Engels, he outlined a projectinvolving six volumes, dealing with capital, landedproperty, wage labour, the state, internationaltrade, and the world market. His major work,Capital, was thus conceived as the first volume of amuch larger study. Capital itself grew to threevolumes, only one of which was published inMarx's lifetime, in 1867; the remaining twovolumes were published by Engels in 1885 and1894. (Marx also wrote the material on the historyof economic thought later published as Theories ofSurplus Value, planned as the fourth volume ofCapital.)

Capital is characterized by the method of inquiry(discussed in more detail in the Grundrisse) thatsome scholars have termed ‘systematic' dialectics.In this method, ideas are criticized from within (asMarx was analysing capitalism from within acapitalist society) in a series of stages that leadfrom the abstract to the concrete. Because theanalysis started with very abstract categories, itcould explain only very general phenomena in itsearly stages. At each stage, it failed to explain morecomplex empirical phenomena. However, thisfailure carried the analysis forward to morecomplex and concrete categories. This movement

from the abstract to the concrete is reflected in theorganization of the three volumes of Capital.Volume 1 starts with the concept of a commodityand the process of capitalist production. Itdiscusses value and the production of surplus value(explained in the next paragraph), and analyses theantagonism between capital and labour. Volume 2discusses the circulation of capital and the variousforms that capital can take. Volume 3 investigatescompetition and the antagonism betweencapitalists. Whereas Marx dealt with capital andsurplus value as very abstract concepts in Volume1, by Volume 3 these categories have becomemuch more complex. The result is that he is able toexplain many more empirical features ofcapitalism, such as the division between interestpayments and entrepreneurial profits, and thetendency of the rate of profit to fall.

Marx's argument about exploitation rested on thedistinction between labour and labour power. Thevalue of an individual's labour power was, like thevalue of anything else, its cost of production(measured in labour time). If it took, for example,six hours' labour to produce the goods a workerneeded in order to subsist and reproduce, the valueof his labour power was six hours. However, it

might be possible to force the worker to work forten hours – his labour. The worker produced goodsto the value of ten hours' labour, but his wageswould be only six hours' labour, for this was thevalue of his labour power. The result would be thecreation of surplus value equal to four hours'labour. This surplus value, Marx contended, wasthe source of profit. The reason why capitalistscould exploit labour in this way was that theyowned the means of production. Becausecapitalists owned the means of production,workers could not undertake productionthemselves. They were forced to sell their labourpower to the capitalists. Exploitation thus lay atthe heart of the capitalist system: it was not anaccidental feature that could be removed withoutaffecting the entire structure of the system.

The surplus value created by extracting unpaidlabour from workers and fixing it in commoditieswas realized by the capitalist as a sum of money.Capital, however, was not simply money. Tofunction as capital, it had to be transformed firstinto means of production and labour power, theninto capital in the production process, then intostocks of commodities, and finally, once thecommodities were sold, into money again. The

simplest form of this circuit was summarized byMarx as M–C–M' (money–commodities–moremoney). He analysed this in two stages. The firstwas ‘simple reproduction’, in which an economyreproduced itself on an unchanged scale. Thesecond was ‘extended reproduction’, where capitalwas increasing. He agreed with Smith that capitalaccumulated not because capitalists hoardedmoney but because they used money to employlabour productively.

In Volume 2, after an extensive discussion of thecirculation of capital and the different forms thatcapital took in the process of circulation, Marxillustrated the process with some numericalexamples – his reproduction schemes – inspired byQuesnay's Tableau. These were based on a divisionof the economy into two ‘departments' or sectors.Department 1 produced capital goods, andDepartment 2 produced consumption goods thatmight be consumed by either capitalists or workers.He also distinguished two of the forms that capitalcould take: constant capital (machinery etc.) andvariable capital (used to employ labour). Theeconomy started with given stocks of constant andvariable capital. Simple reproduction occurredwhen, after capitalists had used their surplus value

to purchase consumption goods, the produce ofthe two departments was exactly sufficient toreproduce the capital used up in production.Extended reproduction occurred when stocks ofcapital at the end of the process were larger than atthe beginning, with capitalists turning part of theirsurplus into constant and variable capital. Marxwas using what would nowadays be called a ‘two-sector' model to analyse the process of capitalaccumulation.

Volumes 1 and 2 remained at a very abstractlevel, analysing the movement of capital as awhole. In Volume 3 Marx considered the concreteforms taken by capital – notably costs ofproduction, prices and profits. He analysed the wayin which surplus value was converted into variousforms of profit and rent. Here he addressed theproblems that Ricardo had encountered whenworking out his labour theory of value. Priceswould be higher than values in industries thatemployed a high proportion of fixed capital, andlower in industries where little fixed capital wasused. Prices, therefore, would not be proportionalto labour values. For Marx, this arose as thetransformation problem – the problem of howvalues were transformed into prices. As he defined

values in terms of labour time, this problem did notundermine his labour theory of value as it didRicardo's.

Marx's analysis of the dynamics of capitalismwent far beyond his reproduction schemes. It is notpossible to cover all the details, but several pointsneed to be made. The first is that Marx predictedthat capitalist production would become moremechanized and more centralized. Increasedmechanization led to what Marx called a rising‘organic composition of capital' – a risingproportion of capital would take the form ofconstant (fixed) capital, and a lower proportionwould take the form of variable capital. Becausesurplus value was produced by variable capital (byexploiting living labour), this meant that surplusvalue per unit of capital would fall and with it therate of profit. Capitalists would attempt to offsetthis by increasing the exploitation of workers bymeans such as increasing the length of the workingday and forcing workers to work more intensively.

Marx was also led into analysing economic crisesand the business cycle. Capitalists, he argued, wereforever striving to accumulate capital. From time totime capital would accumulate so rapidly that theywould be unable to sell all the output that they

were producing. The result would be a crisis inwhich they failed to realize their profits. Capitalwould be liquidated as some businesses failed andothers simply failed to replace the capital that waswearing out. Eventually the rate of profit wouldrise to the point where new investments werestarted and the system would move fromdepression into a new period of expansion. Marxtherefore saw capitalism as undergoing successiveperiods of depression, medium activity, rapidexpansion, and crisis. There would be a cycle, theperiod of which depended on the turnover rate orlife cycle of capital goods. He assumed that thishad increased, and that by the time he was writingit was around ten years in the ‘essential branches ofmodern industry’.7

It is also important to note that Marx sawcapitalism as containing the forces that would leadto its downfall. The main force was theconcentration of capitalistic production:This expropriation is accomplished by the action of the immanentlaws of capitalistic production itself, by the centralization ofcapital. One capitalist always kills many. Hand in hand with thiscentralization, or this expropriation of many capitalists by few,develop, on an ever-extending scale, the cooperative form of thelabour process, the conscious technical application of science, themethodical cultivation of the soil, the transformation of the

instruments of labour into instruments of labour only usable incommon, the economizing of all means of production by their useas the means of production of combined, socialized labour, theentanglement of all peoples in the net of the world-market, andwith this the international character of the capitalistic regime.8

This centralization would at the same time increasethe misery of the working class and cause it tobecome more organized:Along with the constantly diminishing number of the magnates ofcapital, who usurp and monopolize all advantages of this processof transformation, grows the mass of misery, oppression, slavery,degradation, exploitation; but with this too grows the revolt of theworking class, a class always increasing in numbers, anddisciplined, united, organized by the very mechanism of capitalistproduction itself.9

Eventually capitalism, which up to that point hadbeen a progressive force, would become animpediment to further development and would beoverthrown:The monopoly of capital becomes a fetter upon the mode ofproduction, which has sprung up and flourished along with, andunder it. Centralization of the means of production andsocialization of labour at last reach a point where they becomeincompatible with their capitalist integument. This integument isburst asunder. The knell of capitalist private property sounds. Theexpropriators are expropriated.10

Marx never finished Capital, let alone the otherbooks that would have filled out his analysis of thecapitalist system. After his death, Volumes 2 and 3of Capital were edited by Engels from hisunfinished manuscripts. There were further delaysof around twenty years before these volumes weretranslated into English. His early writings were notpublished in German until 1932, and the Grundrissenot until 1953, with English translations of theseappearing only during the 1970s. The result of thedelay in publication was that for many years hiswork was virtually unknown. Though written muchearlier, and reflecting the situation of the 1860sand 1870s, Marx's economics became widelyknown only in the 1880s and 1890s. During thetwentieth century, interpretations of his workchanged as new evidence became available. Giventhat Marx's writings extended far beyondeconomics, into philosophy and social science, anyinterpretation of Marx offered here is inevitablyvery limited: it is one among many differentpossibilities.

The first point to make about Marx is that hiseconomics is classical in that he built upon theeconomics of Smith and Ricardo. Marx's labourtheory of value clearly owes much to his reading of

Ricardo. It is therefore possible to view Marx as aRicardian. To do this, however, is to miss the pointthat, though he started with the classical analysis,he transformed it and produced a radicallydifferent type of economics. For the classicaleconomists, the laws of production were laws ofnature. For Marx, on the other hand, the laws ofproduction were based on the laws and institutionsof capitalism, a specific historical stage in history.Capital could exist only because people had theright to own the produce of other people's labour.Wage labour – common in British industry, but inMarx's time far less widespread than it is today –was another institution central to the process ofexploitation. Exploitation, the circulation of moneyand goods, capital, and the institutions ofcapitalism were therefore intertwined.

Despite its roots in classical economics, Marxisteconomics developed largely independently of themainstream in economic thought. Its other roots inHegelian philosophy were foreign to the Anglo-Saxon traditions that increasingly dominated theeconomics profession. The association of Marxianeconomics with socialist political movements –and, after 1917, with Russia and the Soviet Union –provided a further barrier. As economics distanced

itself from other branches of social thought, theMarxian amalgam of economic and sociologicalanalysis became remote from the concerns of mosteconomists.

Marx's economics was, however, important evenfor non-Marxian economists. The obvious reason isthat attempts were made by non-Marxianeconomists to rebut Marx, and Marxists responded.The most notable example was perhaps the debatebetween the Austrian economist Eugen von Böhm-Bawerk (see p. 211) and the Marxist RudolfHilferding (1877–1941) following the publicationof Volume 3 of Capital. Much more importantly,however, Marxian ideas fed into non-Marxianthinking – sometimes directly, sometimesindirectly. Marx's analysis of the business cycle interms of fixed-capital accumulation fed, via thework of the Russian economist Mikhail IvanovichTugan-Baranovsky (1865–1919), into twentieth-century business-cycle theory, which came to focuson relations between saving and investment (seeChapter 10). His analysis of the waste caused bycompetition between capitalist producers was acrucial input into the debates over the possibilityof rational socialist calculation in the inter-warperiod (see pp. 275–9). Marx's vision of the future

of capitalism stimulated economists to offer theirown alternatives, as in Joseph Alois Schumpeter'sCapitalism, Socialism and Democracy (1943) (see p.209).

Conclusions

Classical political economy comprised a greatvariety of theories and ideas. These ideas were heldtogether by their roots in Smith's Wealth of Nations.Ricardo had created a far more rigorous systembased on much more abstract reasoning, but hisdeductive style of argumentation did not winwidespread support. Even Mill – responsible forsustaining the Ricardian tradition after interest in itwaned in the 1820s – reverted in his Principles tothe combination of inductive, historical analysisand deductive reasoning that characterized theWealth of Nations.

Classical economics was never far from issues ofeconomic policy: academics formed part of thesame intellectual community as politicians,journalists and men of letters. At one end of the

political spectrum were supporters of doctrinairelaissez-faire, and at the other were the Ricardiansocialists. Most economists, however, fell betweenthese two extremes. They succeeded in using theframework laid down by Smith to address first thepolicy problems arising during the revolutionaryand Napoleonic wars, and later those arising fromindustrialization and the immense social changesthat accompanied this. In Smith's day Britain wasruled by a narrow oligarchy, whereas by the 1870s,although corruption had not been eliminated, itsscope had been very much reduced by reformssuch as the extension of the franchise, secretvoting and competitive examinations for the civilservice. The extension of the franchise to includethe working classes a process started in the 1867Reform Act and extended in 1884 – placedsocialism much higher on the political agenda thanit could ever have been in the days of Smith andBentham. Mill and Marx, in radically different ways,showed that the Smithian structure, modified byRicardo, could still be used in this changedenvironment.

However, although classical theory provedadaptable, it was becoming outdated. Even Millhad no analytical tools suitable for tackling

problems of monopoly. Towards the end of thenineteenth century, problems of big businessbecame more and more prominent, especially inGermany and the United States. Competitionbetween industrial nations meant that free tradecould not be taken for granted in the way that ithad been as late as the middle of the century.Above all, real wages had, at least since the 1850s,risen substantially, with the result that theMalthusian population theory, which underlay thewhole of classical economics, was becoming hardto defend. On top of this, Romantic critics ofeconomics, such as Ruskin, were questioning thevalue judgements on which the subject was based.Thus by the 1860s the confidence in the subjectthat had enabled Senior to describe the GreatExhibition of 1851 as a triumph of politicaleconomy had dissipated.

8

The Split between History and Theory inEurope, 1870–1914

The Professionalization of Economics

In the closing decades of the nineteenth century,economics, like many other disciplines, becameprofessionalized. It came to be dominated by men(there were few women) who specialized in thesubject. Most of them were full-time academics.This marked a dramatic contrast with the world ofSmith, Malthus, Ricardo and their contemporaries.This change took place in both Britain and theUnited States. In addition, research began to bepublished in specialist journals, such as theQuarterly Journal of Economics, established in 1886,the Economic Journal (1890) and the Journal ofPolitical Economy (1892).

In continental Europe these changes had takenplace earlier. In Germany, with a long tradition ofCameralwissenschaft (the science of economicadministration), centred on the training of public

servants, academics had dominated economics formuch of the century. The Humboldt University ofBerlin, as it later came to be known, founded in1849, had established a strong research traditionon the basis of providing professors with securityand freedom from pressure to teach particulardoctrines. This freedom was later extended to otherGerman universities by Bismarck. Specialistacademic journals had been established muchearlier than in the English-speaking world – theZeitschrift für die gesamte Staatswissenschaft (whichhas since become the Journal of Institutional andTheoretical Economics) in 1844 and the Jahrbücherfür Nationalökonomie und Statistik (Yearbook ofEconomics and Statistics) in 1863. In France,economic ideas had been developed by universityprofessors such as Say and Cournot, and byengineers in elite colleges such as the École desPonts et Chaussées.

There were also important changes in theintellectual environment in which economic ideaswere developed. Newtonian ideas inspiredeconomists for much of the eighteenth andnineteenth centuries. Smith and Malthus both sawtheir work as deriving Newtonian laws applicableto the social realm. Even in the seventeenth

century, science had influenced the way in whicheconomic questions were tackled. In thenineteenth century, however, the idea of the‘scientist' became established, the term beingcoined by William Whewell (1794–1866) in 1833.People stopped referring to science as ‘naturalphilosophy’, and the gap between science andphilosophy widened. This affected economics inseveral ways. People with backgrounds in naturalscience turned to economics. They sought toemulate the achievements of science notablyphysics, widely regarded as the most successfulscience. Some sought to strengthen thefoundations of economics through basing it onexperimental psychology (very different fromBentham's psychology). Others were inspired toapply Darwinian ideas on evolution to economics(the Origin of Species was published in 1859).

These developments were associated withchanges in the way in which economics wasconceived. Though many of the questions tackledby the subject remained the same, economicsmoved, or at least appeared to move, away from itsorigins in political philosophy. By 1900 the term‘economics' was beginning to displace ‘politicaleconomy' as the generally preferred label for the

discipline. The use of mathematics was becomingmore common (although it remained a minorityactivity), and the idea that students should be ableto specialize in economics, rather than coming to itthrough mathematics or philosophy, was gainingground.

Jevons, Walras and Mathematical Economics

Throughout the nineteenth century there had beenFrench and German economists who had usedmathematics. In France this tradition went back toCondorcet's social mathematics and includedCournot and the engineers at the École des Ponts etChaussées. In Germany there were the examples ofThünen and Hermann Heinrich Gossen (1810–59).The bulk of the subject, however, remained non-mathematical. In Britain, if we leave aside Ricardo'suse of numerical examples, none of the classicaleconomists used mathematics. From the 1870s,however, mathematical analysis began to be usedmuch more widely, as economists sought to followthe example set by physics. Along with this came

several other changes: there was a greater focus onindividual behaviour, and the subject moved awayfrom the classical themes of long-termdevelopment to focus on narrower problems. Twopeople were at the forefront of this process: inBritain, William Stanley Jevons (1835–82) and, atLausanne, the French economist Léon Walras(1834–1910).

Jevons was a meteorologist, a chemist and theauthor of The Principles of Science (1874), a widelyread treatise on scientific method. He was also autilitarian. These elements in his background had amajor influence on his approach to economics.Although his training in economics was (typicallyfor the time) based on Mill's Principles, he reactedstrongly against Mill and the Ricardian tradition ineconomics in his The Theory of Political Economy(1871). He disagreed with Ricardo over the theoryof value. Ricardo, following Smith, had argued that,although a good must have utility if it is to havevalue, its value is determined by its productioncost, not by its utility. Jevons argued that this waswrong, and that value depended entirely on utility.In particular, value depended on the benefit aconsumer received from the last unit consumed(the marginal utility or, as Jevons put it, the ‘final

degree of utility’). There was a link between valueand cost of production, but it was indirect. Hesummarized it as follows:Cost of production determines supply;Supply determines final degree of utility;Final degree of utility determines value.1

Jevons started The Theory of Political Economy byarguing that economics was inherentlymathematical because it dealt with quantities. Hewas optimistic about the possibilities of measuringeconomic quantities, pointing out that numericaldata abounded – in account books, price lists, bankreturns, government data and so on. The problemwas not the absence of data but that economistsdid not know how to use them, and that the datawere incomplete. Establishing economics as ascience was, for Jevons, closely linked to the exactmeasurement of economic quantities.

Jevons's starting point was Bentham's theory ofutility, in which utility was defined as the ability toincrease pleasure or to reduce pain. Thoughfeelings and motives could not be measureddirectly, Jevons argued that it was possible tomeasure them indirectly. The goods someone buysor sells will depend on comparisons of the pleasure

to be obtained from various goods, which meansthat comparative pleasures can be measured byobserving behaviour in the marketplace. He used ananalogy with the measurement of gravity throughmeasuring the movements of a pendulum. Jevonsthus devoted much attention to the problem ofdefining utility and working out how it might bemeasured, drawing extensively on contemporarypsychology. Only then could he use the theory toanalyse economic phenomena.

In The Theory of Political Economy Jevons usedutilitarianism to explain behaviour. This involvedassuming that individuals sought to maximize theirutility – to increase pleasure and reduce pain asmuch as possible. He suggested four ways in whichthis might be accomplished, and analysed each inturn: (i) allocating stocks of a good betweendifferent uses in the best possible way; (2)exchanging goods with other people; (3) working toproduce goods; and (4) through employing capital.He used differential calculus to express theconditions for utility maximization in each of thesefour settings. In the context of exchange, forexample, he derived the condition that utilitywould be maximized when the ratio of the marginalutility of two goods was equal to the relative price

of the two goods. For example, if an apple coststwice as much as a banana, the pleasure obtainedfrom the last apple purchased must be twice aslarge as the pleasure of an additional banana. If itwere less, the individual would give up an apple toget two extra bananas. With labour, the equivalentresult is that a worker works the number of hourssuch that the pain of an additional hour's work isexactly equal to the pleasure obtained from theadditional commodities that that hour's labourenables him or her to purchase.

Walras, too, was concerned to make economicsscientific through making it mathematical, and hedeveloped many of the same results as Jevonsconcerning consumer behaviour and thedetermination of prices in competitive markets.However, he reached these conclusions by a verydifferent route, and his focus was also verydifferent. Walras was not a utilitarian but insteadstarted from the notion – well established in theFrench tradition going back through Say toCondillac – that value depended on scarcity. Hemeasured this scarcity in terms of what he called‘rareté' – the intensity of the last want satisfied.Using this he derived conclusions similar to thoseworked out by Jevons. However, whereas Jevons

analysed markets in terms of exchange betweentwo individuals (allowing for competition withother potential traders), Walras focused on anorganized market in which everyone faced a marketprice. In this situation, an individual would decidehow much of each commodity he or she wished tobuy or sell. This led Walras to construct demandand supply curves, relating desired purchases orsales to price: as price rose, demand wouldtypically fall and supply would typically rise. Themarket would be in equilibrium where the twowere equal.

Up to this point there were only minordifferences in the conclusions reached by Jevonsand Walras. The main difference between them wasthat Walras went on to discuss the problem ofmulti-market equilibrium – the problem of howprices are established in a large number of marketsat the same time. He started by deriving demandand supply curves for the case of two-commodityexchange. People have stocks of two commodities,and exchange them with each other so that theyend up with the combination of the twocommodities that they prefer, given the relativeprice of the two commodities. Walras thenextended his analysis to the exchange of many

commodities. After that he introduced production,assuming that entrepreneurs moved resources fromone activity to another until all opportunities forprofits were eliminated. Introducing productionmeant bringing in markets for factor services(markets for renting the labour and machinery usedto produce goods). Finally he added a market forcredit, in order to explain the rate of interest. Thiswas then used to link the rental rates on capitalgoods to their purchase price.

The end result was that Walras had amathematical model – a set of simultaneousequations – describing an entire economy in whicheverything, in principle, depended on everythingelse. For example, a change in fashion mightreduce the demand for beer and increase demandfor tea. This could affect not just the prices of beerand tea but the prices of all other goods, wages,and even the rate of interest. Given the complexityof the set of equations and the very abstract levelof his analysis, Walras confined his attention todoing two things. First, he sought to show that hisset of equations had a solution: that there was a setof prices and quantities that satisfied all hisequations. This is the problem of existence ofequilibrium. He achieved this by counting the

number of equations and showing that it was equalto the number of unknowns (the prices andquantities). Second, he sought to show that thesolution to his set of equations was stable in thesense that, if the economy started with anyarbitrary set of prices, it would end up with the setof prices that satisfied his equations. This is theproblem of stability of equilibrium. Walras's methodwas to postulate that if supply of a commodityexceeded the demand the price of the commoditywould fall, and vice versa. This was the tâtonnementprocess, through which an economy ‘groped' itsway towards the equilibrium.

Walras knew that real economies did not solvesets of simultaneous equations. He claimed thatthe tâtonnement described the trial-and-errorprocess through which real-world economiesdetermined prices, but argued that the economistcould reach the same solution by solving thesimultaneous equations. Both methods gave thesame answer. The theory he had derived was ‘pure'economics, and it needed to be applied. However,while Walras applied his ideas to a variety of policyissues, he failed to get much attention for them.His most radical proposal was for a tax onincreases in land values or rents. He used his model

to argue for the Ricardo-like conclusion that, overtime, the share of rents in national income wouldrise. This meant that, over time, a tax on theincrease in rents would yield more and morerevenue. Such a tax was consistent with Walras'sviews on justice. To tax labour income would beunjust, because people were entitled to the fruitsof their own labour, whereas the value of landderived from society, which meant that it waslegitimate for it to accrue society in the form oftaxation.

Jevons also saw his abstract mathematical theoryas comprising only part of economics. His appliedeconomics was statistical and inductive. This wasconsistent with his view about science being to dowith measurement. He became famous for The CoalQuestion (1865), in which he examined the effectsof Britain's coal reserves becoming exhausted.When Britain ran out of coal, he concluded, growthwould cease. He made this case with detailedstatistics, not only on stocks of coal but also on theexpansion of British industry. He was, however,wrong, for he failed to appreciate howtechnological change would transform thesituation. In the 1860s he also tackled the questionof the effect of the Californian gold discoveries on

the price of gold. The main characteristic of thiswork was his use of index numbers to quantify therise in prices that had taken place during the1850s. However, perhaps Jevons's most innovativework was on the trade cycle. He used statisticalseries to establish the existence of fluctuations ineconomic activity every ten years. At the time,sunspots were believed to affect the weather, andso he sought to establish a correlation betweensunspot activity and the business cycle on theassumption that there were strong links betweenthe weather and the harvest. To test this idea hecollected and analysed large quantities of data onprices.

Walras and Jevons came to their ideas aboutmarginal utility and prices independently (Jevonshad presented his ideas almost a decade earlier, butno one had taken any notice of them). Theydiscovered each other's work in the mid-1870s, andagreed to cooperate in furthering mathematicaleconomics and opposing Ricardian doctrines.During the following decade, however, the spreadof mathematical economics was slow. They wereboth social reformers, Walras going so far as to callhimself a socialist on the basis of his views on landtaxation. Jevons, in contrast, used his utilitarianism

as the basis for a series of piecemeal, pragmaticsuggestions for reform, much in the manner of J. S.Mill.

Economics in Germany and Austria

In the second half of the nineteenth century,German economics was dominated by thehistorical movement – usually divided into the‘older' historical school, headed by WilhelmRoscher and the ‘younger' historical school, headedby Gustav Schmoller (1838–1917), even though theformer was much less of a school than the latter.Classical economics could be found in Germany,but it drew on Smith and French theorists such asCondillac, not on Ricardo. Before the emergence ofthe historical schools there was no orthodoxy inGerman economics, merely a variety of groups,such as the so-called ‘Romantic' school, havinglittle in common with each other. The term‘Smithianism' was associated with an extremevariety of liberalism.

The historical movement in German economics

was established by Roscher with his Grundriss zuVorlesungen über die Staatswissenschaft nachgeschichtlicher Methode (Outline of Lectures onPolitical Economy According to the Historical Method)of 1843. In this book, Roscher argued not thatclassical political economy was wrong, but that itwas inappropriate given the political and industrialconditions in the Germany of his day. Economictheories needed to take account of thecircumstances in which different countries foundthemselves. It was, furthermore, important to workout laws and stages of historical development.However, despite such views, the works of theolder historical school did not differ markedly fromthose of Smith or Mill, both of whom mixedextensive empirical and historical material withtheir theoretical arguments.

The younger historical school was more radical.Schmoller shared the older historical school'sattitude towards classical economics, and soughtto broaden the subject to include what would nowbe termed economic sociology. He was scepticalabout the idea of laws of history, arguing that theywere frequently no more than dubiousgeneralizations or psychological truths – they boreno relationship to the laws of the natural sciences.

It was, he argued, important for economicpropositions to be based on detailed empiricalobservation, for only then could proper account betaken of the circumstances of particular times andplaces. He was not opposed to theory, but heargued for extreme caution in ascertaining the factsof the case before making any generalizations. Themethod by which the necessary empirical basiswould be established consisted of detailedhistorical studies.

Politically, Schmoller was conservative, asupporter of the Hohenzollern monarchy. However,he was a social reformer committed to the viewthat economists should be involved in the processof economic and social change. To this end, heorganized committees that would work outdesirable social policies within the Verein fürSozialpolitik (Union for Social Policy), founded in1872. The members of this organization becameknown as academic socialists. They were liberal butwere supporters of the existing regime, and wereequally opposed both to communists and to ultra-liberals. They were committed to piecemeal studiesthat could result in social reform on topics such asworking hours, social insurance and factorylegislation.

In Austria, a different type of theoreticaleconomics was offered by Carl Menger (1840–1921), in his 1871 Grundsätze derVolkswirtschaftslehre (translated into English asPrinciples of Economics). Though an Austrian, basedin Vienna, he drew on the German tradition ofsupply-and-demand analysis established by writerssuch as Rau, Hermann and Roscher. In contrast toJevons and Walras, Menger was not seeking tomake economics scientific according to thestandards of contemporary physics. Rather, hisapproach was closer to Aristotelian philosophywith its desire to uncover the essence of economicphenomena – to discover their real nature.However, despite this radically differentperspective, he also argued that value wasdetermined at the margin – by the value of anadditional unit of a commodity.

Menger started from the presupposition that thepurpose of economic activity was the satisfactionof human needs. Goods were things thatcontributed to this purpose:If a thing is to become a good… all four of the followingpropositions must be simultaneously present:

1. A human need.2. Such properties as render the thing capable of being brought

into a causal connection with the satisfaction of this need.3. Human knowledge of this causal connection.4. Command over the thing sufficient to direct it to the

satisfaction of the need.2

To be a good, not only must a thing be able tosatisfy human needs, but also people must knowabout how they can use it to this end, and theymust have sufficient control over it.

What about things that appear to satisfy nohuman needs? Menger's answer is that goods maysatisfy needs either directly (he called these low-order goods) or indirectly (higher-order goods).Goods can thus be arranged in a hierarchy, withgoods that satisfy needs directly at the bottom andones that satisfy them extremely indirectly at thetop. Bread would be at the bottom, whereassteelworks would be much higher up.

From here, Menger went on to define value asthe importance of a good in satisfying needs: it isthe satisfaction derived from command over agood. The value of a particular commodity is thusthe needs that would not be met if the good werenot available. Menger assumed that this value fellas the quantity of the good increased – the conceptof diminishing marginal utility. This was a conceptthat could easily be extended to higher-order goods

– to goods that do not satisfy human needsdirectly: ‘The value of a given quantity of aparticular good of higher order… is equal to theimportance of the satisfactions provided for by theportion of the product that would remainunproduced if we were not in a position tocommand the given quantity of the good of higherorder.’3 What Menger is saying here is that if ahigher-order good (for example, a kilogram ofwheat) is not available, a certain quantity of lower-order goods (two loaves of bread) will not beproduced. The value of the kilogram of wheat is thehuman needs satisfied by the two loaves of bread.

As defined by Menger, the concept of value doesnot involve either exchange or price. Price entersonly with exchange, and is determined by values.In an exchange between two isolated individuals,all that can be said about price is that it will bebetween the limits set by the values which the twoindividuals place on the goods being exchanged,otherwise one of them would opt out. Where thereis competition, the level of indeterminacy will beless.

Menger's verbal analysis of price determinationcan be compared with the mathematical analysis ofJevons and Walras. All three assumed that prices

depended on marginal utility and rejected theRicardo–Marx labour theory of value. However,simply to bracket Menger with the other two is tooverlook important points to which his, lessformal, analysis drew attention. Menger did notassume that markets were in equilibrium, withindividuals maximizing utility. On the contrary,individuals would frequently have limitedknowledge of the possibilities available to them.Entrepreneurs emerge as people who seek out andtake advantage of opportunities for profit, creatinggoods that previously did not exist and finding newways to create existing goods. Competition,therefore, was for Menger a dynamic process thathad much more in common with Adam Smith'sview of competition than with the static conceptfound in Walras or Jevons. For Menger,competition was not the absence of monopoly buta process through which monopolies wereprogressively eliminated: ‘the need for competitioncalls forth competition, provided there are nosocial or other barriers in the way’.4

A further characteristic of Menger's economicswas his stress on the way in which institutionsarose from the nature of goods. The mostimportant of these institutions was private property

itself. Property, he argued, ‘is not an arbitraryinvention, but rather the only practically possiblesolution to the problem that is… imposed upon usby the disparity between requirements for, andavailable quantities of, all economic goods’.5 Thelegal order, therefore, had an economic origin.However, while institutions might have hadeconomic origins, they had often not beendesigned by anyone. Rather, they emerged as theunintended consequences of individuals' actions.For example, money, Menger claimed (seeminglyoverlooking the substantial evidence concerningthe role of the state in setting monetary standards),was not planned, but arose unplanned from theactions of individuals seeking to satisfy their needsas best they could.

Menger's Grundsätze was dedicated to Roscher,the founder of the historical school. His subjective-value theory continued the earlier Germantradition, and met with little resistance. There wasno sense of a break with the past. In 1883,however, Menger published a methodologicalcritique of the (younger) historical school as it wasdeveloping under Schmoller. He sought to providea rigid distinction between theoretical andhistorical economics. Theoretical economics, he

argued, dealt with ‘exact' laws based onassumptions of pure self-interest, omniscience andfreedom of movement. To test the resulting theoryinvolved a misunderstanding, because it was basedon abstractions: in the real world, ‘pure self-interest' cannot exist any more than can ‘pureoxygen’. Menger also objected to mathematicaleconomics, on the grounds that all thatmathematics could demonstrate was relationshipsbetween quantities: it could not establish theessence of economic phenomena, which was hisconcern. To analyse interdependence and mutualdetermination, as did Walras, was to lose sight ofcausal connections. Menger also put forward twodoctrines that, though minor themes in the book,subsequently became very important in Austrianeconomics. One was methodological individualism(the idea that all analysis must start with theindividual, not with aggregate or collectiveconcepts). The other was the idea that there is aspontaneous order underlying social phenomena.

Schmoller reviewed Menger's book very critically,and the outcome was a bitter controversy – theMethodenstreit, or Struggle over Method. In theensuing discussion, many issues were confused. Ithas been argued that the dispute was as much over

policy (Schmoller supporting protection andMenger opposing it) and about jockeying fordominance as about substantive issues. It isarguable that Schmoller and Menger couldotherwise have agreed that different methods wereneeded to answer different questions. Thedisagreement had, however, the effect of splittingthe economics profession in Germany.

Historical Economics and the MarshallianSchool in Britain

In Britain, historical methods were advocated byRichard Jones (1790-1855), who used them tocriticize Ricardo's theory of rent. With Malthus heestablished the Statistical Society of London, laterthe Royal Statistical Society. However, the writerwho bore most responsibility for stimulatingdebate on the issue of whether economics shouldbe a historical subject was Thomas Edward CliffeLeslie (1827–82). In 1870 Leslie took up the point,made by the German historical schools, thateconomic laws were not universal, but varied from

place to place. He also challenged the prevailingconception of Smith's Wealth of Nations. Smith,Leslie contended, had adopted an inductiveapproach (though he had not taken this far enough)and he had not assumed that behaviour was selfish.Leslie called for the replacement of abstractpolitical economy with a more inductive, historicalapproach that took into account the whole varietyof human motivations and the evolution ofeconomic, political and social institutions.Competition and movement of capital wereincreasing the complexity of the world and alsoincreasing uncertainty, undermining theassumptions of orthodox theory.

These arguments – that economics had becometoo abstract and that the conclusions of politicaleconomy were of limited relevance – weredeveloped by other writers in the following years.The 1880s also saw the appearance of pioneeringworks on English economic history by J. E. ThoroldRogers (1823–90), William Cunningham (1849–1919) and William James Ashley (1860–1927). Oneof the most influential (perhaps because he died soyoung and came to be regarded by many of hisgeneration as a saint) was Arnold Toynbee (1852–83), who popularized the term ‘the Industrial

Revolution’. Toynbee was committed to socialreform, and succeeded in inspiring a generation ofOxford students to take up economics in order toachieve this end. He refused to accept that ethicscould be separated from economics, at least onquestions of distribution, and he insisted that tounderstand current economic and social problemsit was necessary to consider their history. Heargued the case for economic and social history asautonomous from, though dependent on, othertypes of history.

Though there were sharp differences between theadvocates of theoretical and historical economics,British economics avoided being split in the sameway as the German profession. One reason for thiswas the attitude of Alfred Marshall (1842–1924),the economist who, from his position as Professorof Political Economy at Cambridge, dominated theBritish economics profession from the 1880s untilaround 1930. Another was the different structureof the British university system, which did not haveany centralized process of appointing professors.

Marshall came to economics through translatingMill's doctrines into mathematics, a task heundertook during the late 1860s. This involvedmathematical representations of demand and

supply. In attempting this, he was stronglyinfluenced by the German writers, notably Rau,Hermann and Thünen. After reading Jevons's TheTheory of Political Economy, he grafted utility theoryon to his theory of supply and demand by using itto explain the demand curve. The result was asystem of equations describing a static equilibrium,comparable to those of Jevons or Walras. However,whereas Walras's analysis remained at a veryabstract level, Marshall continually sought to berealistic. In particular, he wished to take properaccount of time. To do this, he could not analysegeneral equilibrium, allowing for all the possibleinstances of interdependence in the economy, buthad to deal with one market at a time. He thereforedeveloped the method of partial-equilibriumanalysis, in which one part of the economy isanalysed on its own.

There was, however, a further reason whyMarshall adopted this approach. Like many of hiscontemporaries, he was very interested in biology,and in particular in evolutionary ideas. Biologicalmetaphors were, he argued, more useful thanmechanical ones in dealing with economics. Thismeant that he was sceptical about the mathematicsused by Jevons and Walras, so closely linked with

mechanics. This passion for evolutionary ideascame out in several ways. He consideredcontinuous, gradual change as typical ofeconomics, adopting the motto ‘Natura non facitsaltum' (‘Nature does not make jumps’). He did nottake individuals' behaviour as given, but assumedthat they would modify this in response to theirenvironment. Thus if workers spent their incomeon wholesome goods and activities, the resultwould be an increase in their strength andintelligence, and their productivity would rise. Incontrast, if they indulged in ways of living thatwere unwholesome, both physically and morally,neither efficiency nor character would improve.Evolution also affected Marshall's view of firms,which he saw as progressing through a life cycleanalogous to that of the individual. They beganyoung and vigorous, but after a period of maturitythey became old and were displaced by newer,more efficient firms. An industry, therefore, waslike a forest – it might remain the same when seenas a whole, even though every tree in it waschanging.

The foundation of Marshall's economics is thetheory of supply and demand. Time is taken intoaccount through the device of distinct periods.

These are defined not in terms of calendar time butin terms of what is free to change within eachperiod. The calendar time involved in each periodmight vary from one problem to another. Theshortest possible time period is defined as themarket period. There is a certain quantity of goodsavailable, as there is no time to produce more. Ifthe commodity is perishable, such as fish (beforethe advent of refrigeration), it will be sold forwhatever it can fetch. Price will be determinedentirely by demand. But if the commodity can bestored without great expense (for example, wheat),price will be governed primarily by the price thatsellers expect to prevail in the future: sellers will bereluctant to accept a lower price, even if demand islow. The result is that demand will determine sales,not price.

Marshall's next time period, the short run, issufficiently long to allow variations in the level ofproduction to take place. In the short run, firms areable to alter the quantity of unskilled labour theyemploy, but not the amount of skilled labour andmachinery, or their production methods. The resultis that output can be increased, but only atincreasing unit cost. Supply and demand thereforedetermine price. If demand increases, price will

rise, because of rising production costs caused bythe limited stock of skilled labour and machinery.

In the long run, Marshall's next longest timeperiod, however, firms have time to change theskilled labour and machinery they use and toorganize in different ways. Under thesecircumstances, Marshall believed, expansion ofoutput will result in falling costs. An increase indemand will therefore result in output increasingand price falling.

Finally, Marshall postulated a very long period, inwhich ‘there are very gradual or secular movementsof normal price, caused by the gradual growth ofknowledge, or population, or capital, and of thechanging conditions of demand and supply fromone generation to another’.6

Like Toynbee and so many others of hisgeneration, Marshall came to economics becausehe believed it offered a way to improve society.Social reform was providing a partial replacementfor the Christian faith that was being lost.However, Marshall was equally concerned thateconomics be established as a scientific discipline.This meant that he was extremely reluctant to getinvolved in public controversy, for he believed thatthis would undermine the authority of the subject.

The role of the economist was not to propoundtruths about the economy, but to develop anagreed body of economic principles that could beused to tackle economic problems. This was one ofthe reasons why, in his Principles of Economics (firstedition 1890, eighth edition 1920) – a book thatwas still used as a textbook as late as the 1950s –he presented his results verbally in the text.Diagrams were relegated to the footnotes, andalgebra was banished to an appendix. In this way,he hoped, the subject could be made accessible tobusinessmen as well as to professional economists.Such an arrangement also accorded with hissuspicion of mathematical arguments.

Marshall was trained as a mathematician, anddeveloped his economics using mathematics. Hewas an innovative theorist, developing many of thetheoretical concepts that have become standard inmodern economics. However, he always remainedvery sceptical about the use of mathematics ineconomics. He wanted economics to be realistic,but the use of mathematics made it very easy toderive results that had no foundation in reality. Ifmathematical results could not be translated intoEnglish, he was suspicious of them. His papers, forexample, contain a mathematical model of

economic growth, but, because he was doubtfulabout the value of the equations, he did notpublish it. His methodological pronouncementsemphasize the need for quantitative and statisticalmethods, but, unlike with Jevons, the empiricalevidence he used appears anecdotal rather thanstatistical, and illustrative rather than essential.This is true not only of the Principles but also ofIndustry and Trade (1919), a volume that containedan enormous amount of information on theorganization of industry. This attitude towardsevidence must have arisen, at least in part, from hisstrong desire to keep theory and reality closetogether.

A similar ambiguity underlay Marshall's attitudetowards history. As a young lecturer, Marshall wasenthusiastic about history. In the first edition ofthe Principles he began with economic history. Hemixed factual material and history in most chaptersof the book, and argued that only one part – on thegeneral relations of supply, demand and value –should be considered ‘theory’. However, in latereditions the historical element was played downand moved into appendices. When the time cameto appoint a successor to the chair at Cambridge,Marshall supported A. C. Pigou (1877–1959),

strongly inclined towards theory, in preference tothe historian H. S. Foxwell (1849–1936). Thehistorical content of the first edition of thePrinciples had been strongly criticized byCunningham (his review was entitled ‘Theperversion of economic history’). Marshall mayhave decided that it was safer to avoid controversyand to accept a disciplinary division of labour, inwhich history was left to historians.

European Economic Theory, 1900–1914

By the start of the twentieth century, marginalisteconomics – economics based on marginal utilityand individual maximization – had become wellestablished. Walras's successor in the chair atLausanne, Vilfredo Pareto (1848–1923), haddeveloped and refined his general-equilibriumsystem. A fellow Italian, Enrico Barone (1859–1924), had applied general-equilibrium theorizingto the problem of a hypothetical socialist economy.In Sweden, Knut Wicksell (1851–1926) hadintegrated Walras's general-equilibrium theory with

Böhm-Bawerk's capital theory (see pp. 211–12). Intheir work, marginal-productivity theory displacedclassical theories of wages and profits. In England,Marshall had imposed his view of economics onCambridge and dominated the discipline,promoting a supply-and-demand analysis that builton the French and German traditions as well as onBritish writers. Economics had ceased to bepolitical economy and was in the process ofbecoming dominated by an abstract, ‘pure'economic theory. At the London School ofEconomics, established by the historians andsocialists Beatrice and Sidney Webb (1858–1943and 1859–1947), and at Oxford, a slightly morehistorically minded economics was being pursued,but these institutions were dwarfed by Marshall'sCambridge. Furthermore, because LSE, despite thesocialist element in its origins, was committed tofree inquiry, it also included economic theoristsand supporters of laissez-faire. (By the 1930s, withLionel Robbins and Friedrich von Hayek – see pp.239 and 217 – these elements had become veryprominent.) Theory and history, despite Marshall'sdesire to keep them together, had separated. InEngland (unlike in the United States), historicaleconomics was about to turn into economic

history, leaving economics behind. In the German-speaking world, the Methodenstreit had split theprofession and reduced chances of cooperation.

Not only was mathematics, in particulardifferential calculus, increasingly used, buteconomics had almost lost the classical concernwith long-run dynamics. Static theory – moreamenable to treatment with the mathematical toolseconomists had begun to use – received moreattention. However, some economists wereconcerned with dynamics. Several economistsinvestigated the business cycle, notably ArthurSpiethoff (1873–1957), a student of Schmoller's,Mikhail Ivanovich Tugan-Baranovsky (1865–1919),a Russian influenced by Marx, and Albert Aftalion(1874–1956), a professor in France, though born inBulgaria. In 1912 Joseph Alois Schumpeter (1883–1950) – an Austrian working in the tradition ofFriedrich von Wieser (1851–1926) and Böhm-Bawerk (Menger's two disciples) – publishedTheorie der Wirtschaftlichen Entwicklung (The Theoryof Economic Development), in which he argued thattechnical progress was the motive force underlyingthe cycle and economic growth. Innovation movesthe economy out of equilibrium, creating newopportunities for entrepreneurs to make profits and

causing an expansion as these are taken up. Whenthese opportunities are exhausted, slower growthand depression occur as the economy settles downto a new equilibrium before it is disturbed by anew wave of innovations. Such ideas, however, canbe regarded as marginal to the pure theory that wasbecoming increasingly prominent.

This divide between theorists and historiansextended to questions of economic policy.Theorists tended to support free trade, whereashistorians (in both Germany and England) weremore sympathetic towards protection. This wasstarkly revealed in England in 1903 when fourteenBritish economists (including Marshall, FrancisYsidro Edgeworth (1845–1926) and Pigou) wrote aletter to The Times supporting free trade. This wasan attempt to bring the authority of the professionto bear on an urgent political issue. However, itseffect was to show that the British profession wassplit. With two exceptions, the theorists supportedfree trade and the historians protection.

Most of the economists involved in thesedevelopments were social reformers. Though theywere far from being Marxists, they were notcontent with the status quo. If their work wasideologically motivated, their goal was to develop

policies that would reduce poverty and improve thecondition of the working class. They generallyfavoured piecemeal reform and were opposed toradical schemes such as those of Marx or theAmerican Henry George (1839–97), whoseenormously successful and widely read bookProgress and Poverty (1879) proposed replacing alltaxes with a single tax on rent. But they were by nostretch of the imagination doctrinaire defenders ofcapitalism. Even the Austrians, who were suchstrong critics of Marx, wrote of the need forcapitalism to be reformed. However, economicshad become an academic discipline. Mosteconomists were motivated by strong socialconcern, but the discipline had become much moreclearly separated from politics than was the case inthe classical era.

9

The Rise of American Economics, 1870–1939

US Economics in the Late Nineteenth Century

In retrospect, the most significant developmenttowards the end of the nineteenth century was therapid development of economic thought in theUnited States. There is still dispute about whetherAmerican economics in the mid nineteenth centuryshould be considered entirely derivative ofEuropean economics. However, by the 1880s, ifnot earlier, the profession was expanding rapidly inthe United States, and American economists weremaking original contributions to the subject.Furthermore, the context of US economics wassignificantly different from that in Europe. With theexpansion of the frontier, many states were settingup institutions of higher education, and in many ofthese a culture where research was important wasbecoming established. However, Americanacademics were subject to pressures different fromthose facing their European counterparts. Researchwas dominant in relatively few institutions, and the

quality of different institutions was extremelyvariable. There was no central control of highereducation, and personal and institutional rivalrieswere strong. Academics were regarded asemployees who could be dismissed very easily ifwhat they said was unacceptable to their sponsors,but at the same time they were expected toundertake work that was relevant to the problemsfacing their society. Though this was an extremecase, in the 1880s the University of Pennsylvaniainsisted that its economists were not to supportfree trade. Popular interest in economic and socialquestions was high, and academic economists wereexpected to have ‘sound' opinions to offer aboutthem. The result was a tendency towards aprofessional (though not political) conservatism.

For most of the nineteenth century the tariff hadbeen the dominant issue in US economic policy.Manufacturers generally favoured high taxes onimports of manufactured goods, whereas farmerscomplained that such tariffs raised the prices theyhad to pay. By the 1890s, however, it had becomeclear that there was no possibility of protectivetariffs being removed and the issue received lessattention than money and the control of business.

Money was a perennial issue in American history,

but the Civil War, financed by the issue ofinconvertible currency (the greenbacks), served tofocus attention on the question. Rapid territorialexpansion, a weak banking system, the deepdepression of the late 1870s and continueddepression during the 1880s ensured that monetaryproblems remained on the agenda. Opinion wasdivided between those who regarded papercurrency as tantamount to fraud and the cause ofmuch speculative activity and those who welcomedthe additional purchasing power it created. Theformer ranged from those who wanted the issuingof paper currency severely curtailed to those whowanted it abolished altogether, or at least wantedall currency to be backed 100 per cent by goldreserves. The latter included farmers and otherswho wanted higher prices. On top of this there wasthe silver question, relating to the terms underwhich silver should enter the currency alongsidegold. Given the interests of states that producedthe two metals and the uneven distribution ofagriculture and manufacturing across thecontinent, sectional interests were strong.

Control of business was a more important issuethan in Britain because of the concentration thathad accompanied the growth of railroads. Not only

were railroads large organizations in themselves,control of them was also widely used to further thetycoons' interests in other industries. Pools, trustsand other devices were used to counteract thepotentially damaging effects of competition.Farmers and industrialists alike complained, withgood reason, about high and discriminatory freightrates. Consumers and rival industrialists objectedto trusts as raising prices to take advantage ofmonopoly positions. In response, the operators ofcartel arrangements responded that these wereessential in industries where unlimited competitionwould force prices below cost, creating instabilityin the industry. Competition was thus high on theagenda facing economists.

The expansion of economics in the 1880s sawimportant developments in the Americaneconomics profession. The first independenteconomics department was established at Harvardin 1879, responsible for the Quarterly Journal ofEconomics a few years later (see p. 166). TheAmerican Economic Association was established in1885. This was soon designed as a broad, inclusiveorganization, open to anyone sufficiently interestedto pay a membership fee, and served as a focus forserious discussion of economic questions. Though

the Association did not publish its own journaluntil 1910, it produced a series of scholarlypublications.

The main European influence during this periodcame from Germany, not Britain. The historicalschool, with its notion that economic theoriesneeded to be adapted to fit different historicalsituations, had strong appeal to those who believedthat economic conditions in the United States weredifferent from those in Europe. Thoughpostgraduate training developed in the UnitedStates, especially after the establishment of JohnsHopkins University in 1876, many economists hadgone to Germany for their postgraduate work. TheVerein für Sozialpolitik, with its emphasis on socialreform, was the model underlying the AmericanEconomic Association. Though it expressed acommitment to non-partisan inquiry, the firstconstitution of the Association expressedopposition to doctrinaire laissez-faire and, as aresult, several economists of the ‘old school'refused to join. By the 1890s, however, theoffending clauses had been removed and most ofthe ‘old school' economists were members.

John Bates Clark

One of the most eminent figures during this periodof American economics was John Bates Clark(1847–1938). Like many American economists ofhis generation, he was educated in Germany,studying in Heidelberg under Karl Knies (1821–98),a member of the older historical school. It is thusnot surprising that in his first book, The Philosophyof Wealth (1886), he sought to broaden thepremisses on which economics was based. Hewanted to take account of elements in humannature that were more ethical and less mechanicalthan those taken into account in conventionaltheory. In addition, he sought to apply toeconomics an organic concept of society. Thus,although he proposed a theory of marginal utility(which he attributed to what he had learned fromKnies, not from Jevons, Menger or Walras), heunderstood ‘effective utility' (his name for marginalutility) somewhat differently from others. Themarket, he argued, measures the value that society,not just the individual, places on a commodity.This shift of attention from the individual to thesocial reflected his organic conception of society,and was something that the European marginal-

utility theorists would not have considered.The American context explains Clark's treatment

of competition, for he brought in ethicalconsiderations to distinguish between‘conservative' competition – competition in whichcompetitors try to provide a better or cheaperservice than each other – and ‘cut-throat'competition – in which ethical constraints onbehaviour are abandoned. The idea of competitionwithout moral restraints was, for Clark, absurd. Tofind it we would have to go back to ‘the isolatedtroglodyte, the companion of the cave bear’.1Ethics also entered his analysis of what he saw asthe dominant problem facing contemporaryAmerican society – highly aggressive ‘competition'between firms that eventually forced all but one ofthem out of business, thereby creating a monopoly.The solution, he suggested, lay in cooperativeventures and profit-sharing, with arbitration beingavailable until these were more widely developed.Such institutions would result in a just outcomeand, once imposed, society would accept them.

In The Distribution of Wealth (1899), based onarticles written over the previous decade, Clarkproposed a theory of income distribution in whicheach factor of production (land, labour and capital)

received a reward equal to the marginal value of itscontribution to output. The wage rate, for example,would be equal to the money that an employerwould lose if he had to employ one fewer worker.Clark applied the theory to capital by likening thisto a fund: individual capital goods (machines,buildings etc.) come and go, but the fund remainsintact. The rate of interest, he argued, was themarginal product of this fund of capital – theadditional revenue that could be obtained if capitalincreased by one dollar. There was no essentialdifference between land and capital goods: theyboth yielded a return that was determined by therate of interest. As in his previous book, he drewethical conclusions – in this case the conclusionthat, if there is competition, each agent ofproduction gets what it is entitled to. This was apotentially conservative doctrine, criticized byradicals for justifying the profits earned bycapitalists. It countered socialist claims thatcapitalists took a share of the produce thatrightfully belonged to labour.

Clark defended the use of static theories (inwhich prices and quantities settled down to valuesthat did not change) by using the analogy of anocean. Oceans are continually in motion, but

provided we are not concerned about fine detail astatic theory is adequate:A static ocean is imaginary, for there was never such a thing: butthere has never been a moment in the history of the stormiest seas,when the dominant forces that controlled them were not thosewhich, if left entirely alone, would reduce their waters to a staticcondition. Gravity, fluidity, pressure, and nothing else, would havethe effect of making the sea level and motionless… If we take abird's eye view of the ocean, we are tempted to say that a staticphilosophy of it is sufficient and that we may treat waves andcurrents as minor aberrations due to ‘disturbing causes’.2

This is a clear statement of the view to whichKeynes (see p. 222) was later to object when heclaimed that it was useless for the economist to saythat, when the storm had passed, the sea would becalm again. Clark was concerned not with short-runfluctuations but with what he believed to be theunderlying phenomena.

Like his European contemporaries Marshall andSchumpeter, Clark regarded the study of statics asthe prelude to studying dynamics. An innovation,he argued, would move the economy out ofequilibrium, creating profits for entrepreneurs. Intime, wages would respond, reducing profits backto their normal level; but before that could happenanother innovation would usually occur, disturbing

the equilibrium again.Clark illustrates very clearly the characteristics of

American economics during this period. Ethicalconsiderations permeated his approach, and,although he was a critic of American society, hisstance could be described as conservative, notbreaking radically with established methods. Hewas driven by a concern with the problem of bigbusiness, and he adopted an approach tocompetition that was the result of this concern. Inhis earlier book he, like many of hiscontemporaries, was alarmed by the problem ofmonopoly, and he proposed cooperation as themeans of tackling it. In his later book he was muchless concerned about the problem. ‘Latent' orpotential competition would prevent firms fromraising prices too far, and the growth of capitalwould lead to new competition. Furthermore, thecosts to consumers of higher prices would be offsetby the benefits that would accrue from theaccumulation of capital. He became distinctly moreoptimistic about capitalism, and moved away fromthe Christian social-ism of his youth.

Mathematical Economics

Mathematical Economics

Other American economists proposed moremathematical versions of marginalism. SimonNewcomb (1835–1909), an astronomer andmathematician, defended the methods employedby Jevons (though he argued that Cournot wassuperior) and criticized the old school of Americaneconomists for deprecating them. He claimed thatthese economists criticized mathematical theorybecause they did not understand it: their owntheories were substantially the same, even thoughthey did not use mathematics. His own use ofmathematics in economics was prompted by thecurrency question, in particular the problems afterthe Bland–Allison Silver Act of 1878, whichreintroduced and increased the coinage of silver.He argued that fluctuations in prices were harmfulbecause, when prices changed, people did notrealize that the value of the dollar had changed. Ina time of falling prices, such as the 1880s, workerswould resist cuts in wages because they did notrealize that prices had fallen even more than theirwages were being cut. If prices fell but wages didnot, employment and production would bereduced. Newcomb's remedy was the creation of a

dollar whose value was linked to an index numberof prices – a novel idea in the United States. Thisdollar would be a paper currency, and the amountof precious metal it represented would be changedfrom time to time, to compensate for changes inprices. Contracts in such dollars would be index-linked, reducing the problems that arose fromignorance about what was happening to prices.This was a scheme that had already been proposedin Europe, but Newcomb developed it in moredetail.

Newcomb was also responsible for amathematical formulation of the quantity theory ofmoney. His equation was V x R = K x P. This statedthat, in any period, the quantity of currency incirculation, R, multiplied by its velocity ofcirculation (the number of times that each dollar is,on average, used to make a transaction), V, equalsthe amount of business undertaken, K, times theprice level, P. (In different statements of thequantity theory, K might be replaced with totaltransactions or total income. Though theinterpretation might differ, the essentials of thetheory were the same.) Newcomb used thisequation to argue that, if the quantity of currencyincreased and other things stayed the same, the

price level would rise. However, his main interestwas astronomy and, although he remained anardent supporter of mathematical methods, he didnot develop his economic ideas or continuepublishing in economics after around 1886.

The first American with a rigorous training inmathematics to pursue a full-time career ineconomics was Irving Fisher (1867–1947). He wasinfluenced by Willard Gibbs (1839–1903), achemist and physicist, known for his work onstatistical mechanics. Fisher's doctoral dissertation,Mathematical Investigations in the Theory of Value andPrices (1892), provided a rigorous mathematicaltreatment of the marginal-utility theory of value.However, although he used the concept of utility inhis mathematics, he stripped it of any connectionwith pleasure and pain: it was merely a way todescribe individuals' behaviour and was not basedon psychology. The only psychological assumptionnecessary for the theory was that ‘each individualacts as he desires’. Utility meant simply ‘intensityof desire’, and implied nothing about thepsychology underlying desires for different goods.Fisher's greater proficiency in the use ofmathematics meant that his theory was moregeneral than that of Jevons or Walras and that he

was able to tackle some of the technical problemsthat they had ignored.

Fisher's mathematical approach to the theory ofvalue had much in common with the approach thatcame to dominate the subject after the 1930s. Atthe time, however, it gained little support. Otherversions of marginalism, such as those of J. B.Clark or Frank Albert Fetter (1863-1949), whichoffered ethical or psychological interpretations ofutility, and which eschewed the use ofmathematics, were more widely used. It wasthought that special genius was needed to be ableto handle economics mathematically without beingled astray into making unjustified speculations.Thus Arthur T. Hadley (1856–1930) suggested thatthe use of the mathematical method made itpossible to frame a hypothesis and then end uptreating it as a rigorously verified proposition. Onlyexceptional men, such as Jevons, Walras or Fisher,could avoid this trap. It is interesting to note howclose this objection was to Marshall's reservationsabout the use of mathematics in economics.

In contrast to his early work on value theory,which was not widely appreciated, Fisher's work onmoney, capital and interest attracted widespreadattention and respect. He developed his ideas in a

series of books written after his move from themathematics department to the economicsdepartment at Yale in 1895. They includedAppreciation and Interest (1896), The Nature ofCapital and Income (1906), The Rate of Interest(1907, later much extended as The Theory ofInterest, 1930) and The Purchasing Power of Money(1911). In them he tackled a series of fundamentalconceptual issues in economic theory relating tocapital, prices, the rate of interest and money.Appreciation and Interest developed the idea of thereal rate of interest. If interest is 10 per cent, forexample, and the inflation rate is 8 per cent, thereal return on the loan is only 2 per cent. Giventhat it is the real rate of interest that matters topeople, if inflation were to change, one wouldexpect the nominal rate to change by the sameamount. He then offered a theory of the real rate ofinterest as the outcome of decisions to save andinvest. These depended on two things. The firstwas individuals' attitudes towards consumptionnow and in the future. If people were moreimpatient, they would need a greater inducementto save (i.e. they would have to be paid a higherrate of interest) than they would if they were morecontent to postpone their consumption. The

second was the productivity of capital – how muchadditional income could be created by postponingconsumption in order to invest the resources.Fisher produced a mathematical theory to showhow the real rate of interest was determined bythese two forces of time preference andproductivity.

In The Purchasing Power of Money Fisher took upNewcomb's mathematical version of the quantitytheory of money, extending it to cover bankdeposits as well as currency and providing a morethorough exposition, linking it with his theories ofcapital and interest. He also attempted to provide astatistical verification of the theory. His centralthesis was that changes in the money supplywould, in the long run, produce correspondingchanges in the price level, but that there would bewhat he termed ‘transition periods' during whicheverything would change. His theory of the relationbetween inflation and the rate of interest played animportant role in his analysis of these transitionperiods and the processes that caused the level ofproduction to change.

Fisher approached economics as amathematician who was concerned to makeeconomics scientific along the lines of physics and

mechanics. One effect of this was his ability to usewhat, for economists of his generation, wereadvanced mathematical techniques. Possibly moreimportant, however, was his persistent use ofmechanical analogies. This is perhaps clearest inhis work on money, where he persistently uses twotypes of analogy. One was the idea of a balance (inthe sense of scales) in which money appeared onone side and commodities on the other. (Here,Fisher was simplifying by focusing purely ontransactions that involved buying and sellingcommodities, ignoring the use of money to supporttransactions in financial assets, property and soon.) The lengths of the arms corresponded to thevelocity of circulation and the price level.3 Theother was the levelling of fluids in a

Fig. 2 Fisher's balance model of the quantity theoryof money

system of cisterns. In the following diagram, stocksof gold and silver are represented by the levels ofliquids in two barrels. Both barrels have leaks(corresponding to losses of metal to non-monetaryuses) and inflows (gold and silver entering thecirculation). Liquid is free to flow from each ofthese into the central cistern, in which a movablemembrane keeps them separate from each other.The pressure from each liquid will ensure that thelevel of the liquid is the same in all three cisterns.This illustrates the operation of a bimetallicsystem. If a model were constructed, it could beused to illustrate changes such as the effects that asilver discovery would have on the equilibrium.This use of diagrams, representing physical models,was also a feature of Fisher's doctoral dissertation.

Fig. 3 Fisher's cistern model of bullion flowsMuch of Fisher's work dealt with relatively

abstract conceptual issues. However, he was alsoan ardent reformer and felt impelled to offersolutions to the problems his books discussed andto some problems his books did not cover, evenwhen colleagues complained that these weresometimes quick fixes rather than solutions to thebasic difficulties. His work on economic policyformed part of a programme that included causessuch as health, eugenics, prohibition (arguingagainst allowing the sale of alcohol) and worldpeace. On all of these he was an active campaignerand organizer, and on some of them he could beregarded as a fanatic. The Stable Money League,which propagated his views on money, was merelyone of many such organizations in which he wasinvolved. He worked hard to get his scheme for a‘compensated dollar' implemented. This wouldhave varied the weight of gold in the dollar in orderto stabilize an index number of prices.

Thorstein Veblen

Another major figure in American economics in thefirst half of the twentieth century was ThorsteinBunde Veblen (1857–1929). Like Marx, Veblen wasa strong critic of bourgeois society and of orthodoxeconomics. However, whereas the background toMarx's work was the England of the 1840s and1850s – vividly described in the novels of CharlesDickens – Veblen was concerned with Americancapitalism at the very end of the nineteenthcentury. He spent the first sixteen years of his lifein an isolated, almost self-sufficient, Norwegiancommunity in Wisconsin. This community wasthen destroyed by technological change in the flourindustry, which caused farmers to switch toproducing a single crop and brought railroads andan extension of the money economy. Even after heleft the community of his childhood and enteredacademia, he remained an outsider to themainstream of American society. This was clearlyreflected in his writing. In The Theory of the LeisureClass (1899) he satirized the lifestyles and mores ofthe capitalists of his day, developing the conceptsof conspicuous consumption and pecuniaryemulation. Consumption had, for the very wealthy,ceased to be undertaken for its own sake but hadinstead become part of a process whereby people

sought to establish their place in society – certaintypes of consumption were desirable because theywere expensive and demonstrated success inacquiring wealth. Such behaviour, he argued, was arelic of a predatory, barbarian past.

This perspective on the wealthy classes inAmerica was part of an attempt to apply Darwinianevolutionary ideas systematically to the analysis ofsociety. Human behaviour developed in response tocircumstances, including the prevailing technology.Habits of thought – or ‘institutions' as Veblentermed them – could become stuck, remaining evenwhen the circumstances that produced them haddisappeared. People become conditioned to acceptcertain ideas, and these ideas persist – oftenbecause of vested interests. A modern examplemight be attitudes towards the environment andthe use of energy. These attitudes, which have theirorigins in an era when resources appeared plentiful,have become strongly entrenched in theinstitutions of society and do not change eventhough they are ill suited to a world in which theenvironment is threatened. Sometimes, however,technological developments result in the creationof new habits of mind that are strong enough tooverthrow existing institutions. But in time these

too become entrenched and out of phase with thematerial environment.

Veblen's analysis of American industrial societyas he found it in the 1890s rested on thedistinction between two institutions: the machineprocess and business enterprise. The machineprocess denoted the entire system of production inwhich mechanized processes were used. Itcomprised a set of delicately balanced sub-processes, none of which was self-sufficient. Thevalues it required and which it engenderedreflected the instinct of workmanship and includedprecision and uniformity – mechanicalstandardization was more important thancraftsman-like skill in enabling the machine processto operate efficiently. These values were verydifferent from the pecuniary standards of businessenterprise, concerned not with making goods butwith making money. Businessmen might gain notby enabling the machine process to run smoothlybut by disrupting the system, opening upopportunities for profitable speculation.Depression and the manipulation of markets couldmake it possible to buy business assets cheaply,enabling their purchasers to make money withoutundertaking any productive activity. The creation

of monopoly power, through acquisition of otherbusinesses or through advertising, would raiseprofits though contributing nothing to production.Advertising, for example, was competitive, andbusinesses were forced to undertake it even thoughit added nothing to the value of the goodsproduced. Veblen was therefore critical of theemergence of what he called ‘parasitic' lines ofbusiness that were useless or harmful to thecommunity at large but were profitable forindividual businessmen.

It followed that the machine process andbusiness enterprise would engender completelydifferent spiritual attitudes. The machine process,with its enforcement of a standardization ofconduct, would engender the habit of explainingthings in terms of cause and effect: ‘Itsmetaphysics is materialistic, and its point of view isthat of causal sequence.’4 In contrast, businessenterprise is centred on the concepts of ownershipand property: ‘The spiritual ground of businessenterprise… is given by the institution ofownership. “Business principles” are corollariesunder the main propositions of ownership; they arethe principles of property, – pecuniary principles.’5In the United States, Veblen contended, business

enterprise was dominant, for it provided themechanism whereby different parts of the machineprocess were linked. The machine process, thoughit had a logic of its own, had been extended tomeet the objectives of business enterprise – inorder to make money. The habits of mindassociated with business enterprise had affectedAmerican culture, conspicuous consumption by thevery wealthy being but one manifestation of this.

However, there was a potentially disruptiveelement in this process. The machine processinculcates habits of mind that conflict with thoseof business enterprise. Veblen therefore predictedthat two types of people would emerge: oneemployed in running business and the other inrunning the machine process. These two groupswould have different ways of thinking: the formerin terms of natural rights, the latter in terms ofcause and effect. The working classes would ceaseto think in terms of natural rights and would thusbe unable to understand the justification forbusiness enterprise. They would turn to socialism,threatening the status quo. In The Engineers and thePrice System (1921) Veblen saw the possibility thatthe regime of business might be overthrown not byworkers but by the engineers on whom the system

depended but whose values were so different fromthose of the businessmen for whom they worked.He wrote,And there is the patent fact that such a thing as a general strike oftechnological specialists in industry need involve no more than aminute fraction of one per cent. of the population; yet it wouldswiftly bring a collapse of the old order and sweep the timewornfabric of finance and absentee sabotage [disruption of industry byabsentee owners] into the discard for good and all.6

Like Marx, Veblen held out the prospect thatinternal contradictions within capitalism wouldlead to its overthrow. The nature of thesecontradictions and the manner of this overthrow,however, were different for Marx and for Veblen.

Veblen's critique of orthodox economicsfollowed naturally from this evolutionaryperspective. Orthodox economics – which includedboth classical and marginalist economics – was pre-Darwinian. It took human nature as given, not aschanging in response to material conditions, and itexplained society in terms of natural laws. It washedonsitic (individuals were assumed to bemotivated solely by the pursuit of pleasure),teleological (changes in society were explained asmovement towards an ideal) and taxonomic(involving mere classification without explanation).

It had emerged at an earlier stage of industrialdevelopment, antedating the emergence ofbusiness enterprise, and had become entrenchedeven though it was no longer appropriate.Orthodox theory might be defended as hypotheticalspeculation, but it nonetheless influenced the waythe world was perceived:Of course, this perfect competitive system, with its untainted‘economic man'… is an expedient of abstract reasoning; and itsavowed competency holds… only in so far as the abstraction holds.But, as happens in such cases, having been once accepted andassimilated as real… it becomes an effective constituent in theinquirer's habits of thought, and goes on to shape his knowledge offacts.7

These criticisms applied equally to classicalpolitical economy (Smith, Ricardo and Mill) and tomodern writers such as Alfred Marshall, for whomVeblen coined the term ‘neoclassical’. What wasrequired, Veblen argued, was the replacement ofsuch economics with a Darwinian evolutionaryeconomics that took account of changes in humannature and was based on cause-and-effectreasoning. However, he never managed to specifythis method clearly.

John R. Commons

John Rogers Commons (1862–1945) was an ardentsocial reformer. He was a student of R. T. Ely(1854–1943), who had taken his Ph.D. atHeidelberg with Karl Knies and whose approach toeconomics was strongly influenced by the Germanhistorical school. Because of his radical views,Commons found it hard to find a long-termacademic post until, in 1904, Ely managed tocreate a position for him at Wisconsin, where heremained until his retirement in 1932. In his earlywork he sought to reconcile Austrian utility theorywith the historical school's emphasis on the role oflaw and the use of statistics.

By the 1920s Commons had come to base hiswork on the idea that economic activity dependedon the underlying legal and institutionalrelationships, and that these evolved over time. Theeconomist should not take these as given, but mustexplain them. This led Commons into detailedhistorical research, notably his four-volume Historyof Labor in the United States (1918–35), a project hetook over from Ely, and The Legal Foundations ofCapitalism (1924). However, although he attachedgreat importance to empirical research, he

developed a distinctive theoretical framework,culminating in Institutional Economics (1934).

The main feature of Commons's analysis of thelegal and institutional foundations of capitalismwas that he took transactions as the basic unit ofanalysis. Transactions involve the transfer ofproperty rights, but do not necessarily take placethrough the market. In addition to ‘bargaining'transactions (ones that do take place throughmarkets), he distinguished ‘managerial' transactions(as when a manager orders a subordinate to dosomething) and ‘rationing' transactions (as whenthe state levies taxes). The main characteristics ofbargaining transactions are that, unlike the othertwo types of transaction, they are between legalequals and that there is a double transfer ofownership. Each side has the legal right not toparticipate, and each party gives something to theother. This focus on transactions led Commons toanalyse not just markets but the whole range ofinstitutions through which transactions areorganized. These include ‘going concerns’, such asthe state, corporations, trade unions, families andChurches, each of which has its own ‘workingrules’. These rules evolve over time in such a waythat the organization is enabled to function.

Commons's view was that collective action wasnecessary to maintain order. Without externalsanctions, including the threat of force, individualswould not respect the institutions on which societyrelied. This immediately put him at odds withconservatives, who rejected the idea that individualfreedom had to be controlled, and led to the chargeof socialism being applied to his work. However, hedenied that his ideas were socialist. Rather, heemphasized that collective action was necessary topreserve individual freedom. Collective action canprevent people from interfering with the liberties ofothers, and provides a framework within whichpeople can act. Freedom within a market system,for example, is possible only if property rights existand if it is possible to make contracts that will behonoured.

The main source of external sanction wasprovided by the legal system. Commons attachedparticular importance to property rights, and in TheLegal Foundations of Capitalism he explored in detailthe way in which these had evolved as a result ofdecisions made by the courts. For example, heshowed how the United States Supreme Court had,in the late nineteenth century, dramaticallychanged the notion of property. It had moved from

an interpretation of the law that assigned propertyrights only to physical objects to one that assignedthem to the expected earning power of physicalobjects. He argued that the courts regularly tookaccount of economic effects when reaching theirdecisions.

Commons was a pragmatist who devoted muchof his career to the task of reform. He did not try tofind ideal solutions, but looked for solutions thatworked. In this he was extremely successful,influencing legislation both in Wisconsin and at thefederal level. This included civil-service reform,factory legislation, workmen's compensation,unemployment insurance, interest-rate control,rural credit schemes, inheritance taxation,property-assessment laws, immigration policy, andindustrial relations. Through his students, many ofwhom went into government, in the 1930s he hadan indirect influence on Roosevelt's New Deal, theprogramme of economic measures, including largepublic-works projects, designed to lift the UnitedStates out of the Depression.

Inter-War Pluralism

J. B. Clark, Fisher, Veblen and Commons representfour of the many approaches that were to be foundin US economics in the early twentieth century. Bythe 1920s the subject was genuinely pluralist, inthat it was dominated by no single approach. Theconventional way to view this pluralism is in termsof a split between ‘neoclassicals' and‘institutionalists’. The neoclassicals, including J. B.Clark and Fisher, emphasized individuals'maximizing behaviour and the role of competitivemarkets. Institutionalists, inspired by Veblen,denounced this approach and argued for a moreholistic view in which economy and society couldnot be separated. Such a characterization is,however, very misleading, for the picture was muchmore complicated. There was great diversity ofapproach within both neoclassical and institutionaleconomics. Even more significant, there were manyindividuals who defy such classifications. EvenJohn Maurice Clark (1884–1963), one of thefounders of institutionalism as a self-consciousmovement, is best seen as standing on theboundaries between institutionalism andneoclassicism. He supported institutionalism, and

yet he saw his work as being continuous with thatof his father, John Bates Clark. Allyn Young (1876–1929), who exerted an immense influence in ashort career, during which he worked at Chicago,Harvard and LSE, is another such figure whom it ishard to classify as either neoclassical orinstitutionalist.

Neoclassical economics clearly includedmathematical economists such as Fisher. Therewas, however, a great difference between hisapproach and the more traditional, non-mathematical and more ethical approach of J. B.Clark. Fisher and Clark had different attitudestowards both the use of mathematics and themeaning of the concept of utility. There were othereconomists who were closer to Marshall or even tothe English classicals, such as Jacob Viner (1892–1970), Frank Taussig (1859–1940) and FrankKnight (1885–1972). If such economists are to bedescribed by a single term, ‘traditionalist' isprobably better than ‘neoclassical’.

What united institutionalists was a commitmentto making economics scientific through basing iton strong empirical foundations and abandoningtheories that rested simply on axioms about humanbehaviour for which there was little evidence.

Though he was not the originator of this approach,the clearest representative of it is Wesley ClairMitchell (1874–1948). In his presidential addressto the American Economic Association in 1924, hespoke of the need to quantify economic theory.Now that economists were in a position to estimatedirectly relationships such as that between thedemand for a quantity and its price, ‘it seemsunlikely that the quantitative workers will retain akeen interest in imaginary individuals coming toimaginary markets with ready made scales of bidand offer prices. Their theories will probably betheories about the relationships among thevariables that measure objective processes.’8

In similar vein Mitchell interpreted Veblen'sdistinction between business and industry in termsof the relationship between two groups of timeseries, one group measuring physical quantities ofgoods, the other sums of money. Quantitativeworkers would enjoy tackling the relationshipsbetween these two groups of data. Such aprogramme was consistent with Mitchell's role inthe National Bureau of Economic Research,founded in 1920. This was an outgrowth of thesense of frustration at the inadequacies of thestatistics available during the First World War, and

was responsible for a wide range of statistical andempirical investigations into income, wealth andthe business cycle.

Inter-War Studies of Competition

These features of US economics during the inter-war period can be illustrated by the work of threeeconomists: Frank Knight, J. M. Clark and EdwardChamberlin. All three tackled the problem that thetheory of competition appeared inadequate toexplain the behaviour that was observed in mostcapitalist economies, but they tackled this problemin very different ways.

Knight was a social scientist with wide-ranginginterests, spanning ethics and political philosophy,but was a traditionalist in economic theory. In hisPh.D. dissertation, published as Risk, Uncertaintyand Profit (1921), he described his task as being oneof ‘refinement, not re-construction’,9 and he arguedthat the essentials of his arguments differed littlefrom ones to be found in J. S. Mill or Marshall.Critics of the theory of competition had, he argued,

never understood it properly. He was also a ferventliberal. In 1927 he moved to the economicsdepartment at the University of Chicago. There,with Viner, he was instrumental in consolidatingthe Chicago school, established by James LaurenceLaughlin (1850–1933), on the basis of acommitment to the virtues of free markets andcompetition. Knight is therefore a major figure inthe history of neoclassical economics, even thoughhis own approach was pluralistic and encompassedideas that hardly fit into conventional views of theneoclassical approach.

Knight's most well-known analytical contributionwas his separation of risk and uncertainty, an ideahe attributed to nineteenth-century Germanwriters, in particular Thünen and Mangoldt. Risk ismeasurable and can be expressed in terms ofprobabilities. Thus games of chance involve risk – itis impossible to predict which card will be drawnfrom a well-shuffled pack, but the probability of aparticular card is precisely 1 in 52. Uncertainty, onthe other hand, cannot be measured. For example,it is impossible to calculate in the same way theprobability that a particular new product will besuccessful, because it depends on too manyunknown and unpredictable factors. Having drawn

this distinction, Knight went on to argue that therewas a connection between uncertainty and profits.Given that the main difference between theory andreality that required explanation was the existenceof profits in excess of the normal return on capital,Knight could claim that his theory explained thedifference between competition as described intheory and competition as experienced in theUnited States.

However, although he defended traditionaltheory, Knight was at the same time acutely awareof its limitations. Like Marshall, he contended thatman is a complex creature, driven by a range ofmotives and values. Economic analysis isconcerned only with actions directed towards thesatisfaction of wants, and hence with only a smallpart of human activity or even of economicbehaviour. This limitation, he argued,is far more sweeping in its scope and import than is easilyimagined. It raises the fundamental question of how far humanbehaviour is inherently subject to scientific treatment. In his viewson this point the writer is very much an irrationalist. In his viewthe whole interpretation of life as activity directed toward securinganything considered as really wanted, is highly artificial andunreal.10

Human behaviour is not predictable, and thus

economic laws can be no more thanapproximations. If science were measurement,Knight claimed, then economic science would notbe possible.

Knight also denied that it was possible toseparate positive and normative economics – toseparate questions about what is from questionsabout what ought to be. His reasons for this lay inhis theory of knowledge. ‘Reality is not what islogical, but what it suits our purposes to treat asreal.’11 Knowledge is simply a way of making senseof the world in order to achieve our objectives.Given that motives are varied, it follows that strictobjectivity is impossible. This in turn means thatscientific method is of limited usefulness ineconomics, for it is necessary to take account ofhuman feelings and attitudes even though thesecannot be measured or analysed scientifically.

The orthodox theory of perfect competition,defended by Knight, describes a world in whichsupply equals demand and resources are efficientlyallocated, with labour and capital moving freelyinto those activities where they are most valuable.J. M. Clark, in his first major work, Studies in theEconomics of Overhead Costs (1923), sought toexplain why the actual economic system did not

work like that. Why was it that there was instabilityin many markets and that capital and labour oftenlay idle? He found the answer in ‘overhead costs’.These were costs that the producer incurredwhatever the level of output. If overhead costswere sufficiently high, they would cause unit coststo fall as production increased and there would beno such thing as ‘normal' costs at which pricewould settle. Clark argued that the enormousgrowth in investment in fixed capital haddramatically increased the importance of overheadcosts, and that for many businesses full-capacityoperation would require a price so low that itwould fail to cover them. Theoretical argumentsreinforced this conclusion by suggesting thatcompetition would cause price to cover onlyvariable costs such as the costs of labour andmaterials.

Clark argued that businesses responded to thissituation in two ways. They might try to operateprice discrimination, charging different prices todifferent customers. For example, they mightestablish brands, charge different wholesale andretail prices, or charge different prices in differentplaces. Alternatively, they might engage in cut-throat competition: pushing prices so low as to

drive competitors out of the market in order toestablish a monopoly and charge higher prices. Ifthis happened, the higher prices might in turnattract new competition.

In Studies in the Economics of Overhead Costs,Clark offered a view of competition that wasradically different from the world of perfectcompetition, in which all firms have to accept thegoing market price, each being too small to haveany influence on the market. Clark's world was onein which unrestrained private enterprise offered toomany advantages to large-scale production. It wasnecessary to find ways in which business could becontrolled without undermining competition. InThe Social Control of Business (1926) he exploredhow this might be done and steps that had beentaken to achieve this in the United States since the1870s. These included anti-trust laws, regulation ofpublic utilities, labour legislation, minimum-wagelaws, food standards, urban planning and manyother measures. Significantly, he did not see suchcontrol as something imposed on business – as analternative to laissez-faire. Pure laissez-faire, Clarkcontended, was impossible. Furthermore, socialcontrols were a part of business activity, involvinginformal agreements and customs, legislation and

rules developed by the legal system in the course ofsettling disputes. This was very close to theperspective of Commons.

Edward Chamberlin (1899–1967), in adissertation submitted in 1927 and published asThe Theory of Monopolistic Competition (1933),addressed the same problem of the discrepancybetween competition in theory and in practice. Hissolution, however, was to focus on marketstructure. He defined monopoly as the ability of afirm to control price through altering supply, andhe defined ‘pure' competition as competition inwhich monopoly elements were absent. Purecompetition was not necessarily perfect, forknowledge of the future might be limited, orfreedom of movement from one activity to anothermight be limited. He argued that the reason whyreal-world competition diverged from purecompetition was that firms in practice experiencedsome degree of monopoly power. Markets wereboth competitive (firms were competing with eachother) and monopolistic (firms had control over theprice of the goods they sold).[I]t is monopolistic competition that most people think of inconnection with the simple word ‘competition’. In fact, it mayalmost be said that under pure competition the buyers and sellers

do not really compete in the sense in which the word is currentlyused. One never hears of ‘competition' in connection with the greatmarkets [such as those for agricultural commodities], and thephrases ‘price cutting’, ‘underselling’, ‘unfair competition’,‘meeting competition’, ‘securing a market’, etc., are unknown. Nowonder the principles of such a market seem so unreal whenapplied to the ‘business' world where these terms have meaning.12

In order to explain the world of business it wastherefore necessary to construct a theoryintermediate between those of monopoly (wherecompetition was absent) and the pure competitionto be found in organized markets such as those forcommodities or financial assets. Clark, Knight andothers, Chamberlin claimed, had been led intoconfusion by being insufficiently clear in theirassumptions about market structure. He reachedthe conclusion that the reason why economictheory appeared remote from reality was not thatits method was wrong but that its assumptionswere too far from the facts.

Chamberlin analysed market structure in terms oftwo dimensions: the number of firms in an industryand the degree to which each one produced adifferentiated product. Small numbers led to theproblem of oligopoly, in which each firm has totake account of how its competitors will react toany changes in its pricing or sales policy. Product

differentiation means that each firm has a degreeof monopoly power in that it can raise its pricewithout losing all its customers. In such a world,advertising and selling costs are important in a waythat they are not under pure competition.

In seeking to find a theory intermediate betweenpure competition and monopoly, Chamberlinwanted to develop a theory of value that was moregeneral than Marshall's. His thesis was thatelements of monopoly and competition interact inthe determination of most prices, and that a hybridof these two theories was needed to analyse firms'pricing behaviour. His book thus dealt with thewhole of value theory. He brought Marshall's theoryup to date by taking into account phenomena thathad become increasingly important, such asadvertising and product differentiation.

The Migration of European Academics

The period from 1914 to 1945 was a time ofpolitical turmoil in Europe. The First World War ledto the Bolshevik Revolution in Russia, and the post-

war settlement led to the redrawing of manynational boundaries. Many people were uprootedand forced to find new homes. During the 1920sand 1930s this problem was increased dramaticallyby the rise of the Nazi Party in Germany. Manypeople were forced to leave Germany and, as Hitlerconquered neighbouring countries, to leave thecontinent of Europe. The result was that, duringthis period, many economists migrated to theUnited States. In the 1920s they came mostly fromRussia, and in the 1930s and 1940s mostly fromGerman-speaking countries. Not only were theynumerically significant, they also included somevery prominent individuals who made a significantimpact on the profession. They were particularlyimportant in developing mathematical andquantitative economics.

Harvard attracted two of the most prominentémigrés: Leontief and Schumpeter. Wassily Leontief(1906–99) was Russian. In 1925 he moved toBerlin to complete a Ph.D., and then in 1930 hemoved to the United States, taking up anappointment at Harvard in 1931. While in StPetersburg he had written a paper arguing thatWalras's general-equilibrium system could besimplified in such a way as to analyse real-world

economies. He spent the rest of his careerdeveloping this idea into what is known as input–output analysis. The essential idea is that theeconomy is divided into a number of industries orsectors, and a table is constructed showing howmuch each industry buys from each of the othersectors. For example, if there are three industries,the table contains three rows and three columns. Ifone of these industries is mining and another is thesteel industry, one of the cells in the table willcontain the steel industry's purchases of coal andiron ore and another cell will contain the miningindustry's purchases of steel. If it is assumed thatthe proportions in which each industry buys otherindustries' outputs do not change, it is possible touse the input–output table to calculate the effectson all industries of various changes in theeconomy. For example, if exports of steel werereduced, this would have repercussions on all othersectors of the economy: less coal and iron orewould be bought, and these industries would inturn have to reduce their purchases from otherindustries, and so on. The changes can becalculated using an input–output table. Thelimitation of this technique is that it does not takeaccount of price changes, which limits the range of

problems to which it can provide useful answers.Whereas Leontief devoted his career to input–

output analysis, the activities of the Austrian-trained Joseph Alois Schumpeter were much morewide-ranging. Schumpeter's The Theory of EconomicDevelopment (1912) placed the entrepreneur at thecentre of the process of capitalist development.Entrepreneurs are responsible for the innovations(new products, new sources of supply, newproduction methods, new forms of organization)that open up opportunities for profit, disturbingthe system. Successful entrepreneurs will earn highprofits and will attract imitators. Over time,imitation will eliminate the profits earned by theoriginal innovator and the system will settle downto a new equilibrium until it, in its turn, isdisturbed by another innovation. Schumpeter'svision of capitalism was thus one of a system incontinuous motion, the impetus for change comingfrom the entrepreneur.

Schumpeter had a brief political career, at onetime being Finance Minister in Austria, butemigrated to the United States in 1932. During the1930s he worked on the problem of businesscycles, building on his earlier work by explainingthe cycle in terms of swarms of innovations that

create profits that are subsequently eroded byimitators. The result was Business Cycles (1939), intwo volumes. However it received an extremelycritical review from Simon Kuznets (see p. 241),and in the face of Keynesian economics (see pp.228ff.) it failed to attract support. In contrast,Capitalism, Socialism and Democracy (1943), whichhe viewed as a potboiler, was very successful. Inthis book, Schumpeter argued that Marx was wrongin his diagnosis of why capitalism would breakdown. The success of capitalism would createrising living standards for all classes. Theproletariat would have no reason to rise up andoverthrow the system. Nevertheless, capitalismwould eventually destroy itself, for it woulddestroy the values on which its success was based.Entrepreneurs would give way to bureaucracies,self-interested individualism would undermineworkers' loyalties, and capitalist values would giveway to a desire for security, equality andregulation. By weakening the resistance to change,the Second World War had contributed to thisprocess, as the First World War had done inEurope.

Schumpeter was also the author of one of theclassic books on the history of economics – his

History of Economic Analysis (1954), edited by hiswife, Elizabeth Boody Schumpeter (1898–1953),and published posthumously. (Views from thisbook are discussed on pp. 325–6.)

US Economics in the Mid Twentieth Century

It is hardly an exaggeration to say that the positionof US economics had been transformed since themiddle of the nineteenth century. Up to 1914 itwas still true that the dominant economic ideascame from Europe and that, although it containedsome distinguished and original economists, theUnited States followed Europe. By the 1940s,however, this was no longer true. To take theexample discussed earlier in this chapter, newtheories of competition were being developed inCambridge by critics of Marshall, such as PieroSraffa (1898–1983) and Joan Robinson (1903–83).Theories of oligopoly were also developed inGermany, by Heinrich von Stackelberg (1905–46),Frederik Zeuthen (1888–1959) and others. TheAmerican theories, however, were developed

independently and had characteristics that setthem apart from their European counterparts.American economics exhibited a breadth ofapproaches to the subject that was absent in thesmaller British profession. With the substantialmigration of economists from Germany and otherparts of Europe in the 1930s and 1940s, and theeffects of the Second World War on the discipline,the strength of American economics was increasedstill further.

10

Money and the Business Cycle, 1898–1939

Wicksell's Cumulative Process

The central figure in early-twentieth-century workon money and the business cycle was the Swedisheconomist Knut Wicksell. In Interest and Prices(1898) and his Lectures on Political Economy (1906)he developed a theory of the relationship betweenmoney, credit and prices – his so-called ‘cumulativeprocess’. Wicksell's theory was based on the theoryof capital developed by the Austrian economist(and student of Menger) Eugen von Böhm-Bawerk(1851–1914), in which the rate of interest isessentially the price of time. There are two sides tothis coin. If someone is receiving an income, shehas a choice to make. She can spend it onconsuming goods and services immediately, or shecan save it in order to be able to consume goods ata future date. The way people save is to buyfinancial assets, thereby lending income tosomeone else, and in return for this they receiveinterest. The higher the rate of interest, the more

future consumption can be ‘bought' by deciding tosave rather than to consume now. If the rate ofinterest rises, people have a greater incentive topostpone their consumption by saving part of theirincome.

The other side of the coin is investment.Businesses have to choose between investing inproduction processes that yield revenues veryquickly and investing in other processes that aremore productive but take longer to yield revenue.For example, the owner of a vineyard can choosewhether to sell grapes immediately after theharvest or to ferment them and produce wine.Having produced the wine, there is then a choice ofhow long to store it. If the wine is allowed tomature, it will become more valuable. Wicksellfollowed Böhm-Bawerk in assuming that ‘long'processes of production (ones which take a longtime to yield a revenue) will be more productivethan ‘short' processes. However, because resourcesare committed for longer, such processes willrequire more capital. This means that, if the rate ofinterest rises, long processes of production willbecome more expensive relative to shorter ones.

The rate of interest, therefore, influencesconsumers' decisions about whether to consume

goods now (using short processes) or in the future(using long processes), and also influencesproducers' decisions about whether to invest inprocesses that will produce goods now or in thefuture. A rise in the rate of interest will cause a risein saving, as consumers decide it is worthpostponing more consumption, and a fall ininvestment, as producers move towards shorterproduction processes. Wicksell argued that therewill be some rate of interest at which these twotypes of decision are balanced. This is his ‘natural'rate of interest. At the natural rate of interest, theamount that consumers wish to lend is exactlyequal to the amount that producers wish to borrowin order to finance their investment: there is inter-temporal equilibrium.

This part of Wicksell's theory drew on Böhm-Bawerk. The next stage was to introduce a bankingsystem that created credit. The rate at which bankslent money was the ‘market' or ‘money' rate ofinterest. The cumulative process arose when themarket rate of interest, for some reason, fell belowthe natural rate. Businesses would increase theirinvestment, borrowing from the banking system thefunds that they could not obtain from savers. Theincrease in investment would cause an increase in

demand for resources, with the result that priceswould be bid up. At the same time, the increasedsupply of credit would enable purchasers to paythese higher prices. Wicksell went on to show that,in what he called a pure credit economy, wheregoods were bought and sold using only bankmoney, not gold and silver, this process couldcontinue indefinitely. As long as the market rate ofinterest was lower than the natural rate, priceswould continue to rise. (Conversely, if it werehigher than the natural rate, prices would fallindefinitely.) This was his cumulative process. Ifthe country concerned were on a gold standard, theprocess would be brought to an end when thebanks began to run out of gold reserves. This wouldforce them to raise interest rates and cut back theirlending, bringing the process to a halt.

Wicksell held a ‘real' theory of the business cycle,in the sense that he believed that the cycle arosebecause of changes in the natural rate. Forexample, inventions that raised productivity wouldcause the natural rate to rise, as would wars thatdestroyed resources. But the interest rate wouldnot respond immediately to such changes, theresult being that cumulative rises and falls in priceswould be initiated. Furthermore, the quantity of

currency (gold) played a purely passive role in theprocess. The active element in the system was thebanking system. There was no fixed link betweenthe volume of credit and the supply of currency.Despite this, however, Wicksell did not considerhimself as a critic of the quantity theory but aselaborating on it, showing how changes in thequantity of money changed prices.

Though the basic theory was simple, there wereseveral serious problems with it. Two of these wereparticularly important for subsequentdevelopments. The first concerned the use of theAustrian theory of capital to determine the naturalrate of interest. Though the notion of a period ofproduction is an appealing one, capturing theinsight that capital is associated with taking time toproduce goods, it is riddled with technicalproblems. There may be no clear link between theperiod of production and the rate of interest. A fallin the rate of interest may cause the period ofproduction to rise or fall, with damagingconsequences for the notion of inter-temporalequilibrium. The second major problem can beexplained by noting that the natural rate of interestis the rate of interest at which (i) savings equalinvestment, (2) there is no new credit being

created, and (3) prices are constant. In general,however, it is not clear that all three conditionswill be satisfied at the same rate of interest. Forexample, in a growing economy, stable prices willrequire an increasing quantity of credit to financethe growing volume of transactions. This meansthat some credit creation, resulting in an inequalityof saving and investment, may be compatible withprice stability. In addition, if productivity is rising,equality of the money and real rates of interest willlead to falling prices.

Wicksell was aware of these problems, andcarefully made assumptions that avoided them. Hissuccessors, however, responded to them in verydifferent ways and, as a result, developed verydifferent theories. To understand these, it isnecessary to understand some of the economicevents of the inter-war period.

The Changed Economic Environment

The inter-war period was one of unprecedentedeconomic instability. By the end of the First World

War the dominant country in the world economywas clearly the United States. Like much of theworld, it experienced a brief boom in 1920,followed by a very sharp depression, when pricesfell and unemployment rose, in 1921. For the restof the 1920s, however, the country experiencedunparalleled industrial growth and prosperity.Unemployment remained low, electricity spreadthroughout the country, with profound effects forindustry and domestic life, the number of carsregistered rose from 8 million to 23 million, andthere was an enormous amount of new building. Atthe end of the decade, Herbert Hoover, as apresidential candidate, claimed that the countrywas close to triumphing over poverty. The stockmarket boomed, and investors thought thatprosperity would continue indefinitely. Few othercountries fared as well as the United States (Japanand Italy were unusual in growing faster), but mostcountries prospered during the 1920s. Countriesthat stagnated included many in eastern Europe(including the newly formed Soviet Union),Germany and Britain.

Britain, like the United States, shared in theimmediate post-war boom and the depression thatfollowed. Prices rose by 24 per cent in 1920, and

then fell by 26 per cent in 1921. Unemploymentrose to 15 per cent of the workforce in 1921, andremained around 10 per cent for the rest of thedecade. Prices fell, and industry stagnated. In 1925– by which time US industrial production had risento 48 per cent above its 1913 level – Britishindustrial production was still 14 per cent below itslevel in 1913. The British economy had notrecovered from the effects of the war.

However, the most spectacular examples ofinstability in the 1920s were in central Europe. InGermany, prices nearly doubled in 1919, and thenmore than trebled in 1920. After a brief respite in1921, they then rose by over 1,600 per cent in1922. In 1923 the currency completely collapsed.Prices rose by 486 million per cent – truehyperinflation. The value of the mark fell so farthat the exchange rate, which had been US$I = 4.2marks in 1913, fell to US$I = 4.2 billion marks. Atthe same time, unemployment rose to almost 10per cent of the workforce. At the end of the year anew currency was issued, and prices rose gently forthe rest of the decade. However, unemploymentremained high, averaging over 10 per cent.

The Great Crash came in October 1929. In theUnited States, the downturn which had begun

earlier that summer developed into an enormousslump in which industrial production, agriculturalprices and world trade collapsed. Unemploymentrose dramatically. In the next few years USindustrial production fell to a little over half of its1929 level, and unemployment rose to over 25 percent of the labour force. It was not until 1937 thatunemployment fell below 15 per cent, and then afurther slump pushed it back up to 19 per cent.Similar levels of unemployment were recorded inmany other countries. In 1933, unemployment was26 per cent in Germany, 27 per cent in theNetherlands, 24 per cent in Sweden, 33 per cent inNorway, and 21 per cent in Britain. It was aproblem affecting the entire capitalist world, and itpersisted throughout the 1930s. In some countries,such as the Netherlands, unemployment remainedat similar levels right up to 1939. In others, such asBritain and Sweden, unemployment recoveredslowly to just over 10 per cent by the end of thedecade. Only in Germany, under the Nazi regimebrought to power by the crisis in 1933, wasunemployment brought down to low levels (2 percent by 1938).

Almost inevitably, these events attracted theattention of the world's economists. Though the

underlying causes of the period's economicinstability remained controversial, it became clearto most economists that the dominant theories ofthe pre-war period were inadequate to explain whatwas going on. Most important, it became clear thatit was necessary to be able to offer a coherenttheory of the level of economic activity. Changes inthe level of industrial production andunemployment, on both of which statistics werebeginning to be calculated during the 1920s, hadbecome too important to be regarded as asecondary phenomenon. It was also clear that, insome way, changes in the level of economicactivity were linked to money and finance. TheGerman case, where hyperinflation completelydestroyed the value of the currency and renderednormal economic activity virtually impossible, mayhave been an extreme example, but it was a veryimportant and salutary one. It was also hard not tolook for a connection between the financialactivities that caused boom and bust in the USstock market and the unprecedented depth of thefollowing depression.

In addition, behind all this was a world economythat was very different from before the war. Inparticular, intergovernmental debts, almost

unknown before 1914, were a major problem.European governments had borrowed heavily fromeach other and, in particular, from the UnitedStates. They sought to recover these costs fromGermany through extracting reparations. Therewas, and is, scope for disagreement over the roleplayed by reparations in the German hyperinflation,or how far the causes of the Crash and theDepression should be sought in Germany andeastern Europe. There was, however, no doubt thatthe new situation in international finance was anintegral part of the world trading system that, after1929, proved to be so fragile.

The different experiences of the Europeancountries and the United States meant that, thoughthe economists involved formed a singlecommunity in the sense that Europeans drew onAmerican literature, and vice versa, theirperspectives were different. In the United States itwas natural throughout the 1920s to be optimisticabout the prospects for the long-term stability ofthe economy. When the Great Depression came, itwas natural to see it, at least at first, as anunusually bad cyclical downturn. In contrast, bythe end of the 1920s British economists had cometo see unemployment as a structural problem, not a

cyclical one. There was a further difference in that,whereas Britain had not experienced financial panicand bank failures since the 1860s, these were stillregular events in the United States. The FederalReserve System, established in 1913, had yet toestablish a reputation as lender of last resortcomparable with that of the Bank of England. Theresult was that Americans were much moreinterested in finding policy rules that wouldalleviate the cycle. The situation was differentagain on the Continent. In Germany, for example,memories of the hyperinflation of 1922–3remained long after the event.

Austrian and Swedish Theories of the BusinessCycle

The main proponents of the Austrian theory of thebusiness cycle were Ludwig von Mises (1881–1973)and Friedrich von Hayek (1899–1992). Both werefrom Vienna, but Hayek moved to the LondonSchool of Economics in 1931. Mises's main ideaswere set out in The Theory of Money and Credit, first

published in 1912, but they came into their ownonly in the 1920s and early 1930s. They wereapparently vindicated by the German hyperinflationand the sudden collapse of the American economyafter the greatest boom in its history.

Mises and Hayek started from Wicksell's theory,but developed it into a monetary theory of thecycle. They placed great stress on the Austriantheory of capital underlying Wicksell's natural rateof interest, and argued that monetary policy wasliable to interfere in the normal working of creditmarkets. In a credit economy, not constrained bythe gold standard, bankers would be under pressureto keep interest rates low. If they yielded to thispressure, and the market interest rate fell below thenatural rate, this not only would cause inflation butwould also interfere with the inter-temporalallocation of resources. What would happen wasthat low interest rates would cause entrepreneursto invest in production processes that were toolong – too capital-intensive – compared with whatwas appropriate given the level of saving. Becauseinvestment in capital goods was too high, capital-goods prices would rise relative to the prices ofconsumer goods. This would cause a problembecause, although producers were shifting

resources into processes that would yield returnsonly in the future, consumers were given noincentive to postpone their consumption. Theresult would be excessive demand for consumergoods.

As long as credit continued to expand, such asituation might continue for a long time, buteventually the credit expansion would have to end.When the credit expansion ended, interest rateswould rise and the result would be a fall in outputand a rise in unemployment. The reason would bethat the long, capital-intensive productionprocesses that were started when interest rateswere low would suddenly become unprofitable andbe closed down. The resources put into them(embodied in stocks of unfinished goods,equipment and so on) would typically beunsuitable for the newly profitable shorterprocesses, and would lie idle.

Mises and Hayek used this theory to condemnthe use of expansionary monetary policy as ameans of raising the level of economic activity. Itmight be possible, they argued, to use creditexpansion to sustain a boom, but the result wouldbe that, when it came, the eventual collapse wouldbe greater. This fitted the American experience of

the 1920s. An exceptionally long boom, sustainedby massive credit expansion, had been followed byan equally massive depression. According to Misesand Hayek, this was inevitable. They advocatednon-intervention and a policy of ‘neutral' moneywhereby the rate of interest would be set so as tokeep the level of money income constant. Even in adepression as severe as that of 1929–32, it wouldbe foolish to lower interest rates and expand themoney supply, for it was important that thestructure of production be allowed to adjust.

In contrast, the Stockholm school – Erik Lindahl(1891–1960), Erik Lundberg (1907–89), GunnarMyrdal (1898–1987) and Bertil Ohlin (1899–1979)– developed Wicksell's theory in a completelydifferent way. They argued that technical problemswith Austrian theory of capital meant that it wasimpossible to argue that the natural rate of interestwas determined by the productivity of capital. Sucha concept was impossible to define. Instead, theytook up the idea, previously developed by IrvingFisher, that capital should be understood as thevalue of an expected stream of income. Thedemand for loans would depend on expectationsabout the future. This perspective led them to takeissue with the idea of neutral money, claiming that

equilibrium between saving and investment wascompatible with any rate of inflation. The reasonwas that, so long as it was correctly anticipated,the rate of inflation could be taken into account inall contracts for the future and therefore need nothave any effect. It was unexpected changes inprices that would disrupt the relationship betweensaving and investment.

Members of the Stockholm school were thereforeled to abandon two of the ways in which Wickselldefined the natural rate of interest and to focus onthe relationship between saving and investment.They analysed this through investigating dynamicprocesses, tracing the interaction of incomes,spending, prices and so on from one period to thenext. Among other problems, they analysed how itwas that a discrepancy between savers' andinvestors' plans (termed an ex ante imbalancebetween saving and investment) could be turned,by the end of the relevant period (ex post), into anequality. For the most part the processes theyanalysed started from a situation of fullemployment, with the result that they analysedcumulative processes similar to Wicksell's.However, they took very seriously the idea thatprices and wages might be very slow to change,

with resulting consequences for output. They alsoinvestigated processes that started with a situationof unemployment, and were able to show howlowering interest rates might lead to a prolongedincrease in production.

One reason why the Swedish economists did notreach a more definite view of the cycle was thattheir theory was very open-ended. They explored aseries of related models, showing that a wide rangeof outcomes was possible. This fitted in with theirvery pragmatic attitude towards policy. They wereopen to the idea of using not only monetary policybut also government spending to reduceunemployment. This was in marked contrast to therigid liberalism of the Austrians.

Britain: From Marshall to Keynes

Leaving aside Hayek and his followers at LSE,British thinking on money and the business cyclehad its roots in the work of Alfred Marshall. Hisfirst work on the problem was in The Economics ofIndustry (1879), written jointly with Mary Paley

Marshall and strongly influenced by J. S. Mill. In aperiod of rising demand, confidence is high, thelevel of borrowing increases, and prices rise. Atsome point, however, lenders reassess the situationand start to cut back on their loans, with the resultthat interest rates rise. This precipitates a fall inprices as confidence falls. Businesses are forced tosell their stocks of goods, causing further falls inprices. The reason why this leads to fluctuations inoutput is that prices fluctuate more than costs, inparticular wages and fixed costs. In the boom,prices rise faster than costs, causing firms toincrease their production. After the crisis, pricesfall more rapidly than costs, causing businesses toreduce output.

The main factor underlying this account offluctuations in economic activity is confidence.Referring to the depression stage, Marshall andMarshall wrote:The chief cause of the evil is want of confidence. The greater partof it could be removed almost in an instant if confidence couldreturn, touch all industries with her magic wand, and make themcontinue their production and their demand for the wares ofothers… [The revival of industry] begins as soon as traders thinkthat prices will not continue to fall: and with a revival of industryprices rise.1

Crises occur because businessmen, including thosewho supply credit, become overconfident, causingexpansions to go on too long.

Over the following forty years, Marshallintegrated into his account of the cycle a clearstatement of the quantity theory of money and thedistinction between real and nominal interest rates.However, the essentials of the theory remainedunchanged. In particular he continued to argue thatfluctuations in demand caused prices to fluctuate.Output changed only when prices and costs movedin such a way as to raise or lower profits. This wasthe framework underlying the work of hisfollowers. The most important of these were ArthurCecil Pigou, Marshall's successor as professor atCambridge, Dennis Robertson (1890–1963), RalphHawtrey (1879–1975) and John Maynard Keynes(1883–1946). The theories they developed were allfirmly rooted in the Marshallian tradition,emphasizing the role of expectations and errorsmade by businessmen in explaining the cycle.However, this tradition encompassed a greatvariety of views.

Hawtrey, whose most influential book wasCurrency and Credit (1919, revised in 1927 and1950), held a purely monetary theory of the cycle.

His theory had several distinctive features, but themost important was his emphasis on what hetermed ‘effective demand' – the total level ofspending, including both consumers' spending andinvestment. He argued that changes in the moneysupply would affect the level of effective demandand that, because prices and wages were slow torespond to this, output would change. Theexistence of time lags in the various processesinvolved meant that expansions and contractionsof credit would go too far, with the result thatthere would be cycles, not steady growth.

In contrast, Robertson, in his Theory of IndustrialFluctuations (1915), explained the cycle in terms ofshocks caused by inventions that raisedproductivity. Following Aftalion, Robertson usedthe gestation lag (the time that elapses betweenundertaking an investment and obtaining theoutput) and other features of investment to explainwhy such shocks would produce a cycle. A decadelater, in Banking Policy and the Price Level (1926),his emphasis shifted. Though he did not abandonthe idea that inventions caused fluctuations ineconomic activity, he switched to arguing that,because of monetary factors, cyclical fluctuationswere much larger than they needed to be. Suitable

banking policy could mitigate this, but, unlike theAustrians, he did not believe that this couldcompletely stabilize the economy.

Pigou's work is revealing because it illustrates theway in which British economists reacted to thepersistence of high unemployment during the1920s. He published a theory of the business cycle,first in Wealth and Welfare (1912) and later in AStudy of Industrial Fluctuations (1927). Like several ofhis contemporaries, he emphasized the importanceof entrepreneurs' expectations of profit, and, likeHawtrey, he stressed the role of demand. Ifdemand were sufficiently low, there might be nopositive wage rate at which entrepreneurs wouldwish to employ the whole labour force. However,in discussing the cycle, Pigou was thinkingprimarily of cycles experienced before 1914. He didnot think of himself as explaining theunemployment experience of the 1920s, for whicha different approach was required. To explain this,he focused much more on wages and the labourmarket, publishing The Theory of Unemployment in1933. This was very Marshallian in discussing theproblem in terms of supply and demand for labour.

One of the most orthodox Marshallians in theearly 1920s was Keynes. He had achieved celebrity

status in 1919 when he resigned from the Treasuryteam at the Versailles peace conference to write hisbest-selling book The Economic Consequences of thePeace. This provided a devastating critique of thepeace treaty and of the way in which thenegotiations were conducted. He argued not onlythat it was immoral for the allied governments todemand high reparations payments from Germany,but also that Germany would not be able to paywhat they were demanding. Then, in 1923, heturned his attention to monetary policy and thecycle in his Tract on Monetary Reform. Theanalytical framework he adopted was Marshall'sversion of the quantity theory, though, in commonwith his Cambridge colleagues, he emphasized therole of expectations. Because the demand for cashbalances (the key element in Marshall's quantitytheory) depended on expectations about the future,it was liable to change at any time. In the absenceof suitable changes in the money supply, the resultwould be fluctuations in the price level. Strictproportionality of the price level to the moneysupply was true only in the long run. Referring tothe notion that doubling the money supply woulddouble the price level, Keynes argued:Now ‘in the long run' this is probably true. But this long run is a

misleading guide to current affairs. In the long run we are all dead.Economists set themselves too easy, too useless a task if intempestuous seasons they can only tell us that when the storm islong past the ocean is flat again.2

There were also disturbances caused by changes inforeign prices, which were linked to British pricesvia the exchange rate.

This posed a dilemma for the monetaryauthorities. If they stabilized the domestic pricelevel (increasing the supply of money whendemand for it rose, and contracting it whendemand fell) the result might be changes in theexchange rate. Alternatively, if they chose tostabilize the exchange rate (as Britain was thendoing by trying to return to the gold standard) theresult would be instability of domestic prices.Keynes argued two things. The first was that theevils of falling prices were worse than the evils ofeither rising prices or changing exchange rates. Inthe context of the early 1920s, when prices werebeing pushed downward as the government soughtto raise the exchange rate to its pre-war value, thisled Keynes to oppose returning to the goldstandard. The second was that the authorities hadto make a decision about the exchange rate: it wasnecessary for them to recognize that the economy

had to be managed and that they could not claimthat the price level was determined by forcesbeyond their control:In truth, the gold standard is already a barbarous relic. All of us…are now primarily interested in preserving the stability of business,prices and employment, and are not likely, when the choice isforced on us, deliberately to sacrifice these to the outworndogma… of £3.17s 10½d per ounce [the pre-war exchange rate interms of gold]. Advocates of the ancient standard do not observehow remote it now is from the spirit and the requirements of theage. A regulated non-metallic standard has slipped in un-noticed. Itexists . Whilst the economists dozed, the academic dream of ahundred years, doffing its cap and gown, clad in paper rags, hascrept into the world by means of the bad fairies – always so muchmore potent than the good – the wicked ministers of finance.3

He developed this idea, that policy-makers had totake conscious decisions about managing theeconomy, in The End of Laissez Faire (1926).

During the 1920s Keynes worked closely withRobertson and other Cambridge economists onproblems of money and the cycle, and in 1930 hepublished A Treatise on Money, intended to be hisdefinitive treatment of the problem. The core of hisanalysis was thoroughly Wicksellian. He definedsaving and investment in such a way that they neednot be equal. They would be equal only if ‘windfallprofits' (profits over and above the normal level of

profits necessary to keep firms in business) werezero. He then used the relationship between savingand investment to analyse the impact of monetarypolicy on the level of activity. For example, a lowinterest rate would cause a rise in investment and afall in saving. This would raise prices and windfallprofits, causing firms to increase production.Conversely, if the interest rate rose, investmentwould be less than saving, windfall profits wouldbecome negative, the price level would fall, andoutput would contract. As with his previous work,he emphasized the role of expectations in thisprocess. The link between money and interest rateswould depend on the level of ‘bearishness' or thedegree to which people were worried about thefuture. If bearishness were high, for example,people would want to hold more money as a hedgeagainst future uncertainty, with the result that anincrease in the money supply would be needed toprevent interest rates from rising.

In 1931 Hayek arrived at LSE, and he and Keynesclashed over the theory of the cycle. Their theorieswere both in the Wicksellian tradition, but theyreached diametrically opposed conclusions aboutthe role of monetary policy. They completely failedto understand each other in what was a heated

dispute.

The American Tradition

For reasons mentioned earlier, there arose adistinctive American tradition in monetaryeconomics. The 1920s were a time of immenseprosperity, and the Federal Reserve System wasonly beginning to work out how it should conductits operations. The result was that, unlike inEurope, American economists paid great attentionto the question of designing rules to govern theconduct of monetary policy. However, althoughthere was widespread support for using monetaryand fiscal expansion to combat the depression after1929, without the strong opposition to suchpolicies associated with Mises and Hayek, therewas no consensus on any underlying theory. In thewords of a recent commentator:It is difficult to think of any explanation for the event itself [theGreat Depression], or any policy position regarding how to copewith it, that did not have its adherents. Moreover, virtually everytheme appearing in the European debates… found an echosomewhere in American discussions.4

The variety of ideas discussed means that it ispossible to do no more than outline a few of them.

The most prominent exponent of the quantitytheory throughout this period was Irving Fisher. Heexpressed great scepticism about the existence ofanything that deserved to be termed a businesscycle. Prices fluctuated, which meant thatsometimes they would be high and sometimes low(he used the phrase ‘the dance of the dollar’). Thatwas not enough to make a cycle, which implied aregular pattern of cause and effect. What wasneeded was to stabilize prices, which was why hewas active in organizing the Stable Money Leaguein 1921 (which subsequently developed into theNational Monetary Association and the StableMoney Association). He was also influential, duringthe 1920s, in promoting legislation to require theFederal Reserve System to use all its powers topromote a stable price level. Consistent with this,in the early 1930s he argued for a series of schemesto raise the price level, thereby helping to restorestability. He continued to argue that the idea of acycle was a myth, but he produced several theoriesthat might explain how a recession could be sosevere. The most prominent was his debt-deflationtheory. According to this, falling prices raised the

real value of debts, forcing debtors to cut back ontheir spending, which forced prices still lower,worsening the situation.

At the other extreme were those who argued thatthere was no link between monetary policy and theprice level, justifying this with a version of the real-bills doctrine. They argued that prices normallychanged for non-monetary reasons, and that, if themoney supply was not allowed to expand toaccommodate this, the velocity of circulationwould rise instead. Provided the banking systemlent money only for proper commercialtransactions, the result would not be inflationary.When the Great Crash came, such economistsargued that credit had been overextended (a viewnot unlike that of the Austrians) and that no usefulpurpose would be served by monetary expansion.Thus Benjamin Anderson (1886–1949) wrote, ‘it isdefinitely undesirable that we should employ thiscostly [cheap money] method of buying temporaryprosperity again. The world's business is not amoribund invalid that needs galvanizing by anartificial stimulant.’5

Austrian views were represented in America, butfew economists took them up. Gottfried Haberler(1900–1997), who arrived in 1936, used Hayekian

arguments about capital to explain why theDepression was more than a monetaryphenomenon and would last a long time.Schumpeter, who went to Harvard in 1932, did notadopt a Hayekian approach. His explanation of theDepression was that it was so severe because itmarked the coincidence of a number of cycles, allof different length. There was the Kondratiev longcycle (around forty years long), the Juglar cycle(around ten years long) and the Mitchell–Personsshort cycle (around forty months long). These werecycles for which previous economists claimed tohave found statistical evidence, and all of themturned down in 1930–31. This perspective wasshared by Alvin Hansen (1887–1975). Hansenadded the hypothesis that this coincidence of thethree cycles came on top of a long-term decline inprices caused by a world shortage of gold and anaccumulation of gold stocks in France and theUnited States. Both Schumpeter and Hansen weresceptical about the possibility of using monetaryexpansion to get out of the Depression. TheDepression might be painful, but it paved the wayfor improved production methods and higherstandards of living.

Another strongly anti-quantity-theory position

was that of the underconsumptionists, mostprominent of whom were William Truffant Foster(1879–1950) and Waddil Catchings (1879–1967).Foster and Catchings argued that monetaryexpansion would stimulate activity only if itstimulated consumers' spending. Any other form ofmonetary expansion, even if linked to rises ingovernment spending, would have no effect. J. A.Hobson (1858–1940), a British economist who hadfirst put forward underconsumptionist theories in1889, and who had coined the term‘unemployment' in 1896, was widely read.

Other economists adopted a more moderateposition. One of the most influential of these wasAllyn Young (who had many students while atHarvard), who was in turn strongly influenced byHawtrey's Currency and Credit. Young argued thatmonetary policy was needed to stabilize business,but that this required the establishing of soundtraditions, not the imposition of a simple rule suchas Fisher and others were proposing. He alsosupported the use of government spending toalleviate the cycle. He was able to show, through adetailed statistical analysis, that bank reserve ratiosfluctuated greatly with seasonal movements offunds between New York and the rest of the

country. Following Hawtrey, he emphasized theinstability of credit – something that a strictquantity theorist would not accept. Young died in1929, but one of his students, Laughlin Currie(1902–93), applied Hawtrey's theory to theDepression, finding evidence that monetary factorswere important. He used statistics on the behaviourof a range of measures of the money supply toargue that the Federal Reserve System could haveprevented much of the collapse had it chosen to doso. The claim that it was powerless was not borneout by the evidence.

During this period the economist most firmlyassociated with empirical research on the businesscycle was Wesley Clair Mitchell, director of theNational Bureau of Economic Research. Hepopularized the notion of the cycle, and sought todocument, statistically, exactly what happenedduring cycles. He was sceptical about theories thatsought to explain the cycle in terms of a singlecause, preferring to analyse individual cycles indetail. However, he was convinced that its causeslay in what Veblen had called the ‘pecuniary'aspects of economic life. The cycle could not bedivorced from its monetary aspects, though thesewere not all that mattered. When the Depression

came in 1929, Mitchell argued that the only puzzlewas why it was so severe and so prolonged. Hisexplanation was that several shocks happened tooccur on top of each other: depression inagriculture, the after-effects of excessive stock-market speculation, political unrest, increased tariffbarriers and so on. The effects of these shocks wereexacerbated by changes that reduced the powers ofthe economic system to stabilize itself. People werebuying more semi-durable goods (such as cars andelectrical appliances), with the result that ifincomes fell they could more easily reduce theirspending. There was less self-sufficiency inagriculture, and large firms were increasinglyreluctant to cut prices when demand fell. Mitchell'sresponse to this was that laissez-faire was provinginadequate and that greater national planning wasrequired. However, beyond supporting public-works policies and the dissemination ofinformation and forecasts, he did not work outplans in any detail.

In the early 1930s a number of economists, withvery different theoretical views, endorsed the ideaof requiring the banking system to hold 100 percent reserves. Supporters of such a rule includedCurrie, Paul Douglas (1892–1976), Fisher, and

Henry Simons (1899–1946), all for differentreasons. Currie supported the rule on the groundsthat, if the government issued the entire moneysupply, this would provide the government withthe best possible control over it. It would be easyto expand or contract the money supply as much aswas required. In contrast, Simons supported itbecause he regarded ‘managed currency withoutdefinite, stable, legislative rules [as] one of themost dangerous forms of “planning”’.6 In the‘Chicago plan' in 1933, Simons argued for 100 percent reserves combined with a constant growthrate of the money supply and a balanced-budgetrule for government spending. This, he believed,would stabilise prices and restrain governmentspending. However, by 1936 he had come round tothe view that this rule would merely lead tovariability in the amount of ‘near monies' (assetsthat do not count as money but which can be usedinstead of money). As a result, he moved towardssetting price stability as the goal of policy.

The history of the support for 100 per centmoney illustrates the way in which, even thoughthere was enormous diversity within Americanmonetary economics at this time, there were alsogreat overlaps. Simons moved from a money-

growth rule towards Fisher's price-stability rule. Atthe same time, Fisher took up the Chicago positionof 100 per cent money. Though the case for 100per cent money was based on a monetaryinterpretation of the Great Depression, laterassociated with Simons and his fellow Chicagoeconomist Milton Friedman (see pp. 295–7), thisinterpretation originated with Currie. He workedwithin the theoretical framework laid down byHawtrey and developed by Young, his teacher atHarvard. Other overlaps include the views onmonetary policy shared with Austrian economistsand the advocates of the real-bills doctrine.

Keynes's General Theory

In his early work, in the 1920s and before, Keyneswas a quantity theorist in the Marshallian tradition.In A Treatise on Money he moved away from this toa perspective closer to Wicksell's, focusing on thelinks between money, saving, investment and thelevel of spending. However, he still considered theprice level as central to the whole process. Changes

in spending led to changes in prices and profits,thereby inducing businesses to change theirproduction plans. This raised a technical problemat the heart of his analysis. He developed a theoryto explain changes in prices and profits on theassumption that output did not change. He thenused that theory to explain why output wouldchange. This was unsatisfactory, and soon after thebook was published he began to rethink the theorywith the help of younger colleagues at Cambridge.The results of this process of rethinking wereeventually published in 1936 as The General Theoryof Employment, Interest and Money.

Perhaps the crucial transition made in theGeneral Theory was towards thinking in terms of aneconomy where the first thing to change inresponse to a change in demand was not prices butsales. If demand fell, firms would find that theirsales had fallen, and that their inventories ofunsold goods were higher than they hadanticipated. They would then adjust theirproduction plans. One stimulus to this way ofthinking came as a result of discussions onemployment policy in the 1920s and early 1930s. Itwas commonly agreed that public-worksexpenditure could raise employment, but there was

no basis for working out by how much employmentwould rise. This problem was tackled by RichardKahn (1905–89), who in an article published in1931 put forward the idea of the multiplier. (Thisidea was also found in Hawtrey's work in the1920s, though not named as such.) The questionhe asked was the following. If an additional workeris employed on a public-works scheme, and thatworker buys goods that need to be produced byother workers, how many additional workers willend up being employed? He found that themathematics of the problem yielded a clear answer,and that it depended on how much of the newlygenerated income was spent on consumptiongoods. In a subsequent article a Danish economist,Jens Warming (1873–1939), pointed out that if aquarter of income were saved, a rise in investmentof 100 million would lead to a rise in income of400 million. Saving would rise by 100 million –exactly enough to finance the initial increase ininvestment. The size of the multiplier (the ratio ofthe rise in income to the initial investment) wasdetermined by the fraction of income saved.

The multiplier provided Keynes with a linkbetween investment and the level of demand in theeconomy. He based this link on the notion of what

he called the ‘fundamental psychological law' that,when someone's income rises, his or’ herconsumption rises, though by less than the fullamount. He labelled the ratio of the rise inconsumption to the rise in income the ‘propensityto consume’. He then needed a theory ofinvestment. He adopted an approach similar toFisher's, arguing that the level of investmentdepended on the relationship between theexpected return on investment (which he termedthe ‘marginal efficiency of investment’) and the rateof interest. For a given marginal efficiency ofinvestment, a rise in the interest rate would cause afall in investment and vice versa. However,although he talked of a negative relationshipbetween investment and the interest rate, Keynesplaced equal emphasis on the role of expectationsand the importance of uncertainty in influencinginvestment.

He analysed the relationship between uncertaintyand investment through arguing that the marginalefficiency of capital depended on what he called‘the state of long-term expectation’. This coveredall the factors that were relevant to deciding theprofitability of an investment, including thestrength of consumer demand, likely change in

consumers' tastes, changes in costs, and changes inthe types of capital good available. All these had tobe evaluated over the entire lifetime of theinvestment, and were matters about whichinvestors knew little.The outstanding fact is the extreme precariousness of the basis ofknowledge on which our estimates of prospective yield have to bemade. Our knowledge of the factors which will govern the yield ofan investment some years hence is usually very slight and oftennegligible. If we speak frankly, we have to admit that our basis ofknowledge for estimating the yield ten years hence of a railway, acopper mine, a textile factory, the goodwill of a patent medicine,an Atlantic liner, a building in the City of London amounts to littleand sometimes to nothing.7

Faced with this uncertainty, investment woulddepend not on rational calculation of futurereturns, but on the state of confidence.

In practice, expectations are governed byconventions – in particular the convention that ‘theexisting state of affairs will continue indefinitely,except in so far as we have specific reasons toexpect a change’.8 The implication of this is that,because expectations are based on conventions,they are liable to change dramatically in responseto apparently minor changes in the news. Thesituation is made worse in a world, such as Keynes

saw around him, where investment policy isdominated by professional speculators. Suchpeople are not trying to make the best long-termdecisions but are concerned with working out howthe stock market will move, which means they areforever trying to guess how other people will reactto news. The result is great instability.

The other determinant of investment is the rateof interest. To explain this, Keynes introduced theidea that money is required not only to financetransactions in goods and services but also as astore of value. People may hold money becausethey are uncertain about the future and wish to beable to postpone their spending decisions, orbecause they expect holding money to yield abetter return than investing in financial assets. (Ifthe price of bonds or shares falls, the return may benegative – less than the return from holdingmoney.) This was the theory of liquiditypreference, which led Keynes to argue that thedemand for money would depend on the rate ofinterest. He even claimed that, under somecircumstances, the demand for money might be sosensitive to the rate of interest that it would beimpossible for the monetary authorities to lowerthe rate of interest by increasing the money supply

– the liquidity trap.When put together, these three components –

the propensity to consume, the marginal efficiencyof investment, and liquidity preference – formed atheory of output and employment. For example,given liquidity preference, a rise in the moneysupply would cause a fall in the rate of interest.Given the state of long-term expectations, thiswould cause a rise in investment and hence a risein output and employment. It was a theory inwhich output was determined by the level ofeffective demand, independently of the quantity ofgoods and services that businesses wished tosupply.

Keynes's strategy in developing his theory was totake the wage paid to workers as given. Towardsthe end of the book he considered what wouldhappen if wages were to change, and advanced avariety of arguments about why changes in wagerates would have no effect on employment. Cuttingwages would not raise employment unless doing soraised the level of effective demand. He wentthrough all the ways this might happen, concludingthat this was very unlikely.

The Keynesian Revolution

Keynes presented his book as an assault on anorthodoxy – the ‘classical' theory that, he claimed,had dominated the subject for a hundred years,since the time of Ricardo. According to thisorthodoxy, the level of employment wasdetermined by supply and demand for labour, andif there were unemployment it must be becausewages were too high. The ‘classical' cure wastherefore to cut wages. If wages were flexible, theonly unemployment would be frictional (associatedwith turnover in the labour market) or structural(caused, for example, by the decline of certainindustries). The classical theory was alsocharacterized by Say's Law, according to whichthere could be no general shortage of aggregatedemand. Keynes went on to argue that the classicaltheory was a special case, and that his own theorywas more general. ‘Moreover, the characteristics ofthe special case assumed by the classical theoryhappen not to be those of the economic society inwhich we actually live, with the result that itsteaching is misleading and disastrous if we attemptto apply it to the facts of experience.’9

This dramatic claim, together with Keynes's

celebrity status, was one reason why the GeneralTheory made such an enormous impact on itspublication. It appealed in particular to youngeconomists who relished the prospect ofoverthrowing the orthodoxy supported by theirelders. Paul Samuelson (see pp. 258–9), perhapsthe most prominent Keynesian in the early post-warperiod, and a student at Harvard when the bookcame out, compared Keynesian economics to adisease that infected everyone under the age offorty, but to which almost everyone over forty wasimmune. In so far as the reaction of the oldergeneration was generally critical, Samuelson's pointappears justified. Older economists found faultwith Keynes's logic and took issue with his claim tobe revolutionizing the subject. There was, however,much more to the Keynesian revolution than this.

For economists who read the General Theory forthe first time in the late 1930s or the early 1940s,it was a difficult book. For some of the oldergeneration, the reason lay in the mathematics – bythe standards of the time, it was a mathematicalbook. There were, however, deeper reasons. Thefirst was that Keynes spoke of a classicalorthodoxy, but, as will not be surprising in view ofthe range of theories surveyed in this chapter, it

was not clear just what the classical orthodoxywas. The second difficulty was that the GeneralTheory contained many lines of argument, and itwas not clear which ones mattered and whichcould be left to one side. This was a problem notonly for non-economist reviewers, many of whomsaid that they awaited the judgement of Keynes'sprofessional peers, but also for economists whoread the book. Economists, therefore, had to makesense of what Keynes was saying.

A number of economists tried to make sense ofKeynes's central argument by translating it into asystem of equations. The first was DavidChampernowne (1912–2000), who, in an articlepublished in 1936, within months of the GeneralTheory, reduced Keynes's system to threeequations. Over the next few months, othereconomists worked with similar sets of equations,trying to use these to explain what Keynes wassaying. The most influential of these was JohnHicks (1904–89). Hicks's equations were verysimilar to those developed by Champernowne andothers, but he managed to reduce Keynesianeconomics to a single, simple diagram showingrelationships between output and interest rate. TheLM curve showed combinations of output and the

rate of interest that gave equilibrium in the moneymarket, and the IS curve showed combinations thatmade savings equal to investment. Hicks thenargued that, if the LM curve were fairly flat, Keyneswas right – increases in government spendingwould shift the IS curve to the right, and outputwould rise. On the other hand, if the LM curve werevertical, shifts in the IS curve caused by changes ingovernment spending would simply change the rateof interest, leaving output unaffected. Hicksprovided a solution to the puzzle about what thedifferences between Keynes and the classics reallywere. His diagram also provided a valuableteaching tool, for students could learn how tomanipulate the IS and LM curves to show theeffects of a wide range of policy changes. The mazeof pre-Keynesian business-cycle theory wasapparently simplified into a single diagram.

Hicks's diagram was taken up by Hansen, whobecame the leading exponent of Keynesian ideas inthe 1940s. He refined Hicks's diagram into whatbecame known, after the labels attached to its twomain

Fig. 4 Hicks's curves showing relationshipsbetween output and interest rate

components, as the IS–LM model. At the sametime, other economists such as Franco Modigliani(1918–) and Don Patinkin (1922–97) continued theprocess of making sense of Keynes's theory. They

translated it into mathematical models that mademicroeconomic sense, working out just what hadto be assumed in order to get Keynesian results.Keynesian ideas also entered into the elementarytextbooks, of which Samuelson's was the mostsuccessful. By the end of the 1940s, in a survey ofcontemporary economics organized by theAmerican Economic Association to help withtraining returning servicemen, Keynes was far andaway the most frequently cited author.

The myth of the Keynesian revolution, whichKeynes himself propagated, is that Keynesoverthrew something called ‘classical economics’.It is that he showed for the first time how changesin government spending and taxation could be usedto stabilize the level of employment, thereby layingthe foundations of modern macroeconomics. This,however, is a serious distortion of what happened.The literature of the 1920s and 1930s contained awide range of approaches to macroeconomicquestions by economists working in manycountries, notably the United States, Britain andSweden. That literature paid attention to problemsof expectations – the relation between saving,investment and effective demand – and much of itsupported the idea that both monetary policy and

control of government spending might be neededto alleviate unemployment. The General Theoryarose out of that literature and did not mark acomplete break with what went before it. Thisresolves the puzzle of how, if the General Theorywas as revolutionary as the myth suggests,Keynesian policies were being employed in severalcountries long before the book was published.Roosevelt's New Deal, for example, began in 1932.

The Transition from Inter-War to Post-SecondWorld War Macroeconomics

The main reason why post-war macroeconomicswas so different from pre-war monetary economicsand business-cycle theory is that, from the late1930s, macroeconomics began to be based, asnever before, on working out the properties ofclearly defined mathematical models. Theseinclude the mathematical models of Keynesianeconomics associated with Hicks andChampernowne, as well as the dynamic business-cycle models of Samuelson and Ragnar Frisch (see

p. 248). This process affected not justmacroeconomics, but also other branches ofeconomics. The reason why Keynesian economicsdominated the subject so completely is that itprovided a framework that could be translated intoa mathematical model that proved extremelyversatile. In this sense, therefore, the outcome ofthe Keynesian revolution was the IS-LM model.10

Having said this, two important qualifications needto be made. The first is that, though it is arguablethat the IS–LM model captures the centraltheoretical core of the General Theory, much is leftout. This is an inevitable consequence offormalizing a theory. In the case of the GeneralTheory, what was left out included Keynes'sdiscussions of dynamics and of expectations. As aresult, there are many economists who argue thatKeynes's most important insights were lost, andthat the IS–LM model represents a ‘bastard'Keynesianism, to use Joan Robinson's phrase. If wemake the comparison between post-war economicsand the entire business-cycle literature of the1920s and 1930s, the amount that was forgottenappears even greater. One reason for this may bethat, by the 1960s, many economists had(mistakenly) come to believe that Keynesian

macroeconomic policies had made the businesscycle a thing of the past.

The second, and perhaps more important,qualification is that, despite the triumph ofKeynesianism (at least in its IS–LM version), theearlier traditions did not die out completely, eventhough they became marginalized. Hayek, forexample, dropped out of mainstream economics,moving into what is usually considered politicalphilosophy. In the 1970s, however, there was aresurgence of interest in his ideas. Moresignificantly, the institutionalist traditionrepresented by Mitchell left an influential legacy.Hansen, though he presented himself as aKeynesian, was making arguments that can betraced back to what he was doing before theGeneral Theory appeared. Even more significantly,the monetary economics of Milton Friedman liessquarely in the tradition established by Mitchell atthe National Bureau, emphasizing the importanceof detailed statistical work of a type very differentfrom much modern econometrics. Friedman'sinfluential Monetary History of the United States,1867–1960 (1963) (see p. 296) is very much inMitchell's style, and his explanation of the GreatDepression is similar to that offered by Currie in

the early 1930s. It can also be argued that the‘Chicago' view of monetary policy, with whichFriedman has been so strongly associated, goesback via Simons to Currie, and through him toHawtrey. Behind all this, however, the influence ofFisher, with his analysis of the rate of interest asthe price linking the present and the future, ispervasive.

11

Econometrics and Mathematical Economics,1930 to the Present

The Mathematization of Economics

Between the 1930s and the 1970s economicsbecame mathematized in the sense that it becamethe normal practice for economists to develop theirarguments and to present their results, at least toeach other, using mathematics. This usuallyinvolved geometry (particularly important inteaching) and algebra (particularly differentialcalculus and matrix algebra). In the 1930s only asmall minority of articles published in the leadingacademic journals used mathematics, whereas bythe 1970s it was unusual to find influential articlesthat did not. Though the speed of the changevaried from one field to another, it affected thewhole of the discipline – theoretical as well asapplied work.

Mathematics is used in two ways in economics.One is as a tool of theoretical research. Algebra,

geometry and even numerical examples enableeconomists to deduce conclusions that they mightotherwise not see, and to do so with greater rigourthan if they had used only verbal reasoning. Thisuse of mathematics has a long history. Quesnayand Ricardo had made such extensive use ofnumerical examples in developing their theoriesthat they were criticized in much the same waythat the use of mathematics in present-dayeconomics is criticized critics argued thatmathematics rendered their argumentsincomprehensible to outsiders. Marx also madeextensive use of numerical examples. The use ofalgebra goes back at least to the beginning of thenineteenth century, though in retrospect the mostsignificant development was the use of differentialcalculus by Thünen (1826) and Cournot (1838).With the work of Jevons, Walras and their turn-of-the-century followers notably Fisher the use ofmathematics, in particular calculus andsimultaneous equations, was clearly established asan important method of theoretical inquiry.

The second use of mathematics is as a tool inempirical research – to generalize fromobservations (induction) and to test economictheories using evidence (usually statistical data)

about the real world. Given that calculatingaverages or ratios is a mathematical technique, thishas a very long history. A precondition for the useof such methods is the availability of statisticaldata. This has meant that the scope for such workincreased dramatically with the extensivecollection of such data early in the nineteenthcentury by economists and statisticians such asMcCulloch, Tooke and William Newmarch (1820–82), Tooke's collaborator on his History of Prices(1838–57). More formal statistical techniques,including correlation and regression analysis, weredeveloped in the late nineteenth century by FrancisGalton (1822–1911), Karl Pearson (1857–1936),and Edgeworth. Jevons had speculated that itmight one day be possible to calculate demandcurves using statistical data, and early in thetwentieth century several economists tried to dothis, in both Europe and the United States. In theperiod before the First World War, economistsbegan to address the problem of how to choosebetween the different curves that might be fitted tothe data.

Despite these long histories of the use ofmathematics in deductive and inductive arguments,the mathematization of economics since the 1930s

represents a major new departure in the subject.The reason is that it has led to a profound changein the way in which the subject has beenconceived. Economics has come to be structurednot around a set of real-world problems, butaround a set of techniques. These include boththeoretical and empirical techniques. Theoreticaltechniques involve not just mathematicaltechniques such as constrained optimization ormatrix algebra but also received assumptions abouthow one represents the behaviour of individuals ororganizations so that it can be analysed usingstandard methods. Similarly, empirical techniquesinvolve assumptions about how one relatestheoretical concepts to empirical data as well asstatistical methods.

This development has had profound effects onthe structure of the discipline. The subject hascome to be considered to comprise a ‘core' oftheory (both economic theory and econometrictechniques) surrounded by fields in which thattheory is applied. Theory has been separated fromapplications, and, at the same time, theoretical andempirical research have become separated. Thesame individuals frequently engage in both(mathematical skills are highly transferable), but

these are nonetheless separate enterprises. Thesechanges have also loosened the links (very strong inearlier centuries) between economic research andeconomic problems facing society. Much researchhas been driven by an agenda internal to thediscipline, even where this has not helped solveany real-world problems.

The theoretical basis for this approach to thesubject was provided, in 1933, by Lionel Robbins(1898–1984) in The Nature and Significance ofEconomic Science. In this book, Robbins argued thateconomics was not distinguished by its subjectmatter – it was not about the buying and selling ofgoods, or about unemployment and the businesscycle. Instead, economics dealt with a specificaspect of behaviour. It was about the allocation ofscarce resources between alternative uses. Inessence it was about choice. The theory of choice,therefore, provided the core that needed to beapplied to various problems. The message thateconomics was centred on a common core thatcould be applied to a variety of problems was alsoencouraged by Paul Samuelson in his extremelyinfluential The Foundations of Economic Analysis(1947), even though his concerns were in otherrespects different from those of Robbins. (Unlike

Robbins, he did not denigrate data collection andanalysis as inferior activities.) Samuelson started bypresenting the theory of constrained optimization,and then applied it to problems of the consumerand the firm. By doing this, he emphasized themathematical structure common to seeminglydifferent economic problems.

Robbins also encouraged the view that the majorpropositions of economics could be derivedwithout knowing much more than the fact thatresources are scarce. This suggested that theorycould be pursued largely independently ofempirical work. Furthermore, for many yearseconomists found a large research agenda inworking out the properties of very generaltheoretical models; detailed reference to empiricalwork was frequently thought not to be necessary. Itbecame more common for economists to beclassified as theorists, econometricians or appliedeconomists (who were frequentlyeconometricians). Theorists could ignore empiricalwork, on the grounds that testing theories was atask for econometricians. When economists wrotearticles that had both theoretical and empiricalcontent, it became standard practice for thesearticles to be divided into separate sections, one on

theory and another on empirical work.

The Revolution in National-Income Accounting

These changes in the structure of the disciplinecame about at the same time as another majorchange was taking place. This was the large-scale,systematic collection of economic statistics andnational accounts. In the 1920s, comprehensivenational-income accounts did not exist for anycountry. The pioneering attempts by people such asPetty and King had involved inspired guesses asmuch as detailed evidence, and were not based onany systematic conceptual framework. Even in thenineteenth and early twentieth centuries, whenestimates of national income were made in severalcountries, including the United States and Britain,gaps in the data were so wide that detailedaccounts were impossible. In the United States, themost comprehensive attempt was The Wealth andIncome of the People of the United States (1915) byWillford I. King (1880–1962), a student of IrvingFisher's. King showed that national income had

trebled in sixty years, and that the share of wagesand salaries in total income had risen from 36 to47 per cent. He concluded that, contrary to whatsocialists were claiming, the existing economicsystem was working well. In Britain, A. L. Bowley(1869–1957) was producing estimates based on taxdata, population censuses, the 1907 census ofproduction, and information on wages andemployment. However, this work, like that beingundertaken elsewhere, remained very limited in itsscope. In complete contrast, by the 1950s,national-income statistics were being constructedby national governments and coordinated throughthe United Nations. By 1950, estimates existed fornearly a hundred countries.

In the inter-war period, national-income statisticswere constructed right across Europe. Interest inthem was stimulated by the immense problems ofpost-war reconstruction, the enormous shifts in therelative economic power of different nations, theDepression of the 1930s, and the need to mobilizeresources in anticipation of another war. Duringthe 1930s Germany was producing annualestimates of national income with a delay of only ayear. The Soviet Union constructed input–outputtables (showing how much each sector of the

economy purchased from every other sector)through most of the 1920s and the early 1930s.Italy and Germany had worked out a conceptualbasis for national accounting that was as advancedas any in the world. By 1939, ten countries wereproducing official estimates of national income.However, because of the war, the countries thathad most influence in the long term were Britainand the United States. Unlike these two, Germanynever used national income for wartime planning,and stopped producing statistics.

In the United States there were three strands toearly work on national-income accounting. The firstwas that associated with the National Bureau ofEconomic Research, established by Mitchell in1920. Its first project was a study of year-to-yearvariations in national income and the distributionof income. Published in 1921, its report providedannual estimates of national income for the period1909–19. These were extended during the 1920s,and were supplemented in 1926 by estimates madeby the Federal Trade Commission. The FTC,however, failed to continue this work. With theonset of the Depression, the federal governmentbecame involved. In June 1932 a Senate resolutionproposed by Robert La Follette, senator for

Wisconsin, committed the Bureau of Foreign andDomestic Commerce to prepare estimates ofnational income for 1929, 1930 and 1931.

In January 1933, after six months in which littlewas achieved, the BFDC's work was handed toSimon Kuznets (1901–85), who had been workingon national income at the NBER since 1929. At theNBER he had prepared plans for estimating nationalincome, later summed up in a widely read articleon the subject in the Encyclopedia of the SocialSciences (1933). Within a year, Kuznets and histeam produced estimates for 1929–32.(Recognizing the importance of up-to-datestatistics, they had included 1932 as well as theyears required by La Follette's resolution.) Kuznetsmoved back to the NBER, where he worked onsavings and capital accumulation, andsubsequently on problems of long-term growth.The BFDC study of national income becamepermanent under the direction of Robert Nathan(1908– ). The original estimates were revised andextended, and new series were produced (forexample, monthly figures were produced in 1938).

At this time, the very definition of nationalincome was controversial. Kuznets and his teampublished two estimates: ‘national income

produced’, which referred to the net product of thewhole economy, and ‘national income received’,which covered payments made to those whoproduced the net product. In order to baseestimates on reliable data, they had excluded manyof the then controversial items. These estimates ofnational income covered only the market economy(goods that were bought and sold), and goods werevalued at market prices. The basic distinctionunderlying Kuznets's framework was betweenconsumers' outlay and capital formation.

At the same time, Clark Warburton (1896–1979),at the Brookings Institution, produced estimates ofgross national product (a term he was the first touse, in 1934). This was defined as the sum of finalproducts (i.e. excluding products that areremanufactured to make other products) thatemerge from the production and marketingprocesses and are passed on to consumers andbusinesses. This was much larger than Kuznets'sfigure for national income, because it also includedcapital goods purchased to replace ones that hadbeen worn out, government services to consumers,and government purchases of capital goods.Warburton argued that GNP minus depreciationwas the correct way to measure the resources

available to be spent. He produced, for the firsttime, evidence that spending on capital goods wasmore erratic than spending on consumers' goods.Economists had long been aware of this, but hadpreviously had only indirect evidence.

The third strand in American work on nationalincome was the work associated with LaughlinCurrie. In 1934–5 he began calculating the ‘pump-priming deficit’. This was based on the idea that,for the private sector to generate enough demandfor goods to cure unemployment, the governmenthad to ‘prime the pump' by increasing its ownspending. Currie and his colleagues focused on thecontribution of each sector to national buyingpower – the difference between each sector'sspending and its income. A positive contribution bythe government (i.e. a deficit) was needed to offsetnet saving by other sectors.

In Britain, the calculation of national-incomestatistics was the work of a small number ofscholars with no government assistance throughoutthe inter-war period. Of particular importance wasColin Clark (1905–89). In 1932 Clark used theconcept of gross national product and estimatedthe main components of aggregate demand(consumption, investment and government

spending). This work increased in importance afterthe publication of Keynes's General Theory (1936),and soon after its publication Clark estimated thevalue of the multiplier. His main work was NationalIncome and Outlay (1937). One of his followers haswritten of this book that it ‘restored the vision ofthe political arithmeticians [Petty and Davenant]…[It] brought together estimates of income, output,consumers' expenditure, government revenue andexpenditure, capital formation, saving, foreigntrade and the balance of payments. Although hedid not set his figures in an accounting frameworkit is clear that they came fairly close toconsistency.’1

Clark's work was not supported by thegovernment. (When he had been appointed to thesecretariat of the Economic Advisory Council in1930, the Treasury had even refused to buy him anadding machine.) Questions of income distributionwere too sensitive for the government to want topublish figures. Industrialists did not want figuresfor profits revealed. The government did calculatenational-income figures for 1929, but denied theirexistence because the estimates of wages werelower than those already available. Officialinvolvement in national-income accounting did not

begin until the Second World War. Keynes usedClark's figures in How to Pay for the War (1940).

In the summer of 1940 Richard Stone (1913–91)joined James Meade (1907–94) in the CentralEconomic Information Service of the War Cabinet.During the rest of the year, encouraged andsupported by Keynes, they constructed a set ofnational accounts for 1938 and 1940 that waspublished in a White Paper accompanying theBudget of 1941. The lack of resources available tothem is illustrated by a story about theircooperation. They started with Meade (the seniorpartner) reading numbers which Stone punchedinto their mechanical calculator, but soondiscovered that it was more efficient for their rolesto be reversed. Though the Chancellor of theExchequer said that the publication of their figureswould not set a precedent, estimates were fromthen on published annually.

During the Second World War, estimates ofnational income were transformed into systems ofnational accounts in which a number of accountswere related. Its position in the war effort, togetherwith the work of Kuznets and Nathan at the WarProduction Board, ensured that the United Stateswas the dominant country in this process.

However, the system that was eventually adoptedowed much to British work. In 1940 Hicksintroduced the equation that has become basic tonational-income accounting: GNP = C + I + G(income equals consumption plus investment plusgovernment expenditure on goods and services). Hewas also responsible for the distinction betweenmarket prices and factor cost (market prices minusindirect taxes). Perhaps more important, Meadeand Stone provided a firmer conceptual basis forthe national accounts by presenting them as adouble-entry production account for the entireeconomy. In one column were factor payments(national income), and in the other columnexpenditures (national expenditure). As with alldouble-entry accounts, when calculated correctlythe two columns balanced.

From 1941 the United States moved away fromnational accounts as constructed by Kuznets andNathan to ones constructed on Keynesian lines,using the Meade–Stone framework. This was thework of Martin Gilbert (1909–79), a former studentof Kuznets's, who was chief of the National IncomeDivision of the US Commerce Department from1941 to 1951. One reason for this move was therapid spread of Keynesian economics, which

provided a theoretical rationale for the new systemof accounts. There was no economic theoryunderlying Kuznets's categories, which derivedfrom purely empirical considerations. The changealso appeared desirable for other reasons. Inwartime, when the concern was with the short-term availability of resources, it was not necessaryto maintain capital, which meant that GNP was therelevant measure of output. In addition, it wasimportant to have a measure of income thatincluded government expenditure. Finally, theMeade–Stone system provided a framework withinwhich a broader range of accounts could bedeveloped. After the war, in 1947, a League ofNations report, in which Stone played an importantrole, provided the framework within which severalgovernments began to compile their accounts sothat it would be possible to make cross-countrycomparisons. Subsequently, Stone was alsoinvolved in the work of the Organization forEuropean Economic Cooperation and the UnitedNations, which in 1953 produced a standardsystem of national accounts.

The Econometric Society and the Origins ofModern Econometrics

The Econometric Society was formed in 1930, inChicago, at the instigation of Charles Roos (1901–58), Irving Fisher and Ragnar Frisch (1895–1973).Its constitution described its aims in the followingterms:The Econometric Society is an international society for theadvancement of economic theory in its relation to statistics andmathematics… Its main object shall be to promote studies that aimat a unification of the theoretical-quantitative and the empirical-quantitative approach to economic problems and that arepenetrated by constructive and rigorous thinking similar to thatwhich has come to dominate in the natural sciences.2

In commenting on this statement, Frisch emphasized that theimportant aspect of econometrics, as the term was used in theSociety, was the unification of economic theory, statistics andmathematics. Mathematics, in itself, was not sufficient.

In its early years the Econometric Society wasvery small. Twenty years before, Fisher had tried togenerate interest in establishing such a society buthad failed. Thus when Roos and Frisch approachedhim about the possibility of forming a society hewas sceptical about whether there was sufficientinterest in the subject. However, he told them thathe would support the idea if they could produce a

list of 100 potential members. To Fisher's surprise,they found seventy names. With some further onesadded by Fisher, this provided the basis for theSociety.

Soon after the Society was formed, it was put intouch with Alfred Cowles (1891–1984). Cowleswas a businessman who had set up a forecastingagency but who had become sceptical aboutwhether forecasters were doing any more thanguessing what might happen. He thereforedeveloped an interest in quantitative research.When he wrote a paper under the title ‘Can stockmarket forecasters forecast?’ (1933), he gave it thethree-word abstract ‘It is doubtful.’ His evidencecame from a comparison of the returns obtainedfrom following the advice offered by sixteenfinancial-service providers and the performance oftwenty insurance companies with the returns thatwould have been obtained by following randomforecasts. Over the period 1928–32 there was noevidence that professional forecasts were anybetter than random ones. With Cowles's support,the Econometric Society was able to establish ajournal, Econometrica, in 1933. In addition, Cowlessupported the establishment, in 1932, of theCowles Commission, a centre for mathematical and

statistical research into economics. From 1939 to1955 it was based at the University of Chicago,distinct from the economics department, afterwhich it moved to Yale. This institute provedimportant in the development of econometrics.

Econometrics grew out of two distinctivetraditions – one American, represented by Fisherand Roos, and the other European, represented byFrisch (a Norwegian). The American tradition hadtwo main strands. One was statistical analysis ofmoney and the business cycle. Fisher and othershad sought to test the quantity theory of money,seeking to find independent measures of all thefour terms in the equation of exchange (money,velocity of circulation, transactions, and the pricelevel). Mitchell, instead of finding evidence tosupport a particular theory of the cycle, hadredefined the problem as trying to describe whatwent on in business cycles. This inherentlyquantitative programme, set out in his BusinessCycles and their Causes (1913), was taken up by theNational Bureau of Economic Research, underMitchell's direction. It resulted in a method ofcalculating ‘reference cycles' with whichfluctuations in any series could be compared. Analternative approach was the ‘business barometer'

developed at Harvard by Warren Persons (1878–1937) as a method of forecasting the cycle. Therewas also Henry Ludwell Moore (1869–1958) atColumbia University, who sought, like Jevons, toestablish a link between the business cycle and theweather. A few years later, in 1923, he switchedfrom the weather to the movement of the planetVenus as his explanation. Moore's work is notablefor the use of a wider range of statisticaltechniques than were employed by othereconomists at this time. The other strand in theAmerican tradition was demand analysis. Mooreand Henry Schultz (1893–1938) estimated demandcurves for agricultural and other goods.

None of this work brought mathematicaleconomic theory together with statistical analysis.Fisher's dissertation had involved a mathematicalanalysis of consumer and demand theory, but thisremained separate from his statistical work, whichwas on interest rates and money. Mitchell wassceptical about the value of pursuing simplifiedbusiness-cycle theories that emphasized oneparticular cause of the cycle. For him, statisticalwork provided a way to integrate different theoriesand suggest new lines of inquiry. Mitchell was also,like Moore, sceptical about standard consumer

theory. He hoped that empirical studies ofconsumers' behaviour would render obsoletetheoretical models, in which consumers weretreated as coming to the market with ready-madescales of bid and offer prices. In other words,statistical work would replace abstract theoryrather than complement it. Moore criticizedstandard demand curves for being static and fortheir ceteris paribus assumptions (assumptionsabout the variables, such as tastes and incomes,that were held constant). As long as the attitude ofstatisticians was one of scepticism concerningmathematical theory, this theory was unlikely to beintegrated with statistical work. This unlikelihoodwas reinforced by the scepticism expressed bymany economists (including Keynes andMorgenstern – see p. 263) about the accuracy andrelevance of much statistical data.

The European tradition, which overlapped withthe American at many points, including research onbusiness cycles and demand, had differentemphases. Work by a variety of authors in the late1920s led to an awareness of some of the problemsinvolved in applying statistical techniques, such ascorrelation, to time-series data. George Udny Yule(1871–1951), a student of Karl Pearson's, explored

the problem of ‘nonsense correlations' – seeminglystrong relationships between time series thatshould bear no relation to each other, such asrainfall in India and skirt lengths in Paris. Heargued that such correlations often did not reflect acause common to both variables but were purelyaccidental. He also used experimental methods toexplore the relationship between random shocksand periodic fluctuations in time series. TheRussian Eugen Slutsky (1880–1948) went evenfurther in showing that adding up random numbers(generated by the state lottery) could producecycles that looked remarkably like the businesscycle: there appeared to be regular, periodicfluctuations. Frisch also tackled the problem oftime series, in a manner closer to Mitchell andPersons than to Yule or Slutsky, by trying to breakdown cycles into their component parts.

Frisch, Tinbergen and the Cowles Commission

The first econometric model of an entire economywas constructed by the Dutch economist Jan

Tinbergen (1903–94), who came to economicsafter taking a doctorate in physics and spent muchof his career at the Central Planning Bureau in theNetherlands. However, to understand whatTinbergen was doing with this model, it is worthconsidering the theory of the business cycle thatFrisch published in 1933. He took up the idea(taken from Wicksell) that the problem of thebusiness cycle had to be divided into two parts –the ‘impulse' and ‘propagation' problems. Theimpulse problem concerned the source of shocks tothe system, which might be changes in technology,wars, or anything outside the system. Thepropagation problem concerned the mechanism bywhich the effects of such shocks were propagatedthrough the economy. Frisch produced a modelwhich, if left to itself with no external shocks,would produce damped oscillations – cycles thatbecame progressively smaller, eventually dying out– but which produced regular cycles because it wassubject to periodic shocks. Following Wicksell, hedescribed this as a ‘rocking-horse model’. If left toitself, the movement of a rocking horse willgradually die away, but if disturbed from time totime the horse will continue to rock. Such a model,Frisch argued, would produce the regularly

occurring but uneven cycles that characterize thebusiness cycle.

The distinction between propagation andimpulse problems translated easily into themathematical techniques that Frisch was using.The propagation mechanism depended on thevalues of the parameters in the equations and onthe structure of the economy. In 1933 Frischsimply made plausible guesses about what thesemight be, though he expressed confidence that itwould soon be possible to obtain such numbersusing statistical techniques. The shocks wererepresented by the initial conditions that had to beassumed when solving the model. Using hisguessed coefficients and suitable initial conditions,Frisch employed simulations to show that hismodel produced cycles that looked realistic.

In 1936 Tinbergen produced his model of theDutch economy. This went significantly beyondFrisch's model in two respects. The structure of theDutch economy was described in sixteen equationsplus sufficient accounting identities to determineall of its thirty-one variables. The variables itexplained included prices, physical quantities,incomes and levels of spending. It was thereforemuch more detailed than Frisch's model, which

contained only three variables (production ofconsumption goods, new capital goods started, andproduction of capital goods carried over fromprevious periods). Most important, whereas Frischhad simply made plausible guesses about thenumbers appearing in his equations, Tinbergen hadestimated most of his using statistical techniques.He was able to show that, left to itself, his modelproduced damped oscillations, and that it couldexplain the cycle.

Three years later Tinbergen published twovolumes entitled Statistical Testing of Business-CycleTheories, the second of which presented the firsteconometric model of the United States (whichcontained three times as many equations as hisearlier model of the Netherlands). This work wassponsored by the League of Nations, which hadcommissioned him to test the business-cycletheories surveyed in Haberler's Prosperity andDepression (1936). However, although Tinbergenmanaged to build a model that could be used toanalyse the business cycle in the United States, thetask of providing a statistical test of competingbusiness-cycle theories proved much tooambitious. The available statistical data waslimited. Most theories of the cycle were expressed

verbally and were not completely precise. Moreimportant, most theories discussed only one aspectof the problem, which meant that they had to becombined in order to obtain an adequate model. Itwas impossible to test them individually. WhatTinbergen did manage to do, however, was toclarify the requirements that had to be met if atheory was to form the basis for an econometricmodel. The model had to be complete (containingenough relationships to explain all the variables),determinate (each relationship must be fullyspecified) and dynamic (with fully specified timelags).

With the outbreak of the Second World War in1939, European work on econometric modelling ofthe cycle ceased and the main work ineconometrics was that undertaken in the UnitedStates by members of the Cowles Commission.However, many of those working there wereEuropean émigrés. A particularly important periodbegan when Jacob Marschak (1898–1977) becamethe Commission's director of research in 1943.(Marschak illustrates the extent to which manyeconomists' careers were changed by world events.A Ukrainian Jew, born in Kiev, he experienced theturmoil of 1917–18. He studied economics in

Germany and started an academic career there, butin 1933 the prospect of Nazi rule made him moveto Oxford. In 1938 he visited the United States fora year, and when war broke out he stayed.)Research moved away from seeking concreteresults towards developing new methods that tookaccount of the main characteristics of economictheory and economic data, of which there werefour. (1) Economic theory is about systems ofsimultaneous equations. The price of a commodity,for example, depends on supply, demand and theprocess by which price changes when supply anddemand are unequal. (2) Many of these equationsinclude ‘random' terms, for behaviour is affected byshocks and by factors that economic theoriescannot deal with. (3) Much economic data is in theform of time series, where one period's valuedepends on values in previous periods. (4) Muchpublished data refers to aggregates, not to singleindividuals, the obvious examples being nationalincome (or any other item in the national accounts)and the level of employment. None of these fourcharacteristics was new – they were all well known.What was new was the systematic way in whicheconomists associated with the CowlesCommission sought to develop new techniques

that took account of all four of them.Though many members and associates of the

Cowles Commission were involved in thedevelopment of these new techniques, the keycontribution was that of Trygve Haavelmo (1911–).Haavelmo argued that the use of statisticalmethods to analyse data was meaningless unlessthey were based on a probability model. Earliereconometricians had rejected probability models,because they believed that these were relevant onlyto situations such as lotteries (where preciseprobabilities can be calculated) or to controlledexperimental situations (such as the application offertilizer to different plots of land). Haavelmodisputed this, claiming that ‘no tool developed inthe theory of statistics has any meaning – except,perhaps, for descriptive purposes – without beingreferred to some stochastic scheme [some modelof the underlying probabilities]’.3 Equallysignificant, he argued that uncertainty enterseconomic models not just because of measurementerror but because uncertainty is inherent in mosteconomic relationships:The necessity of introducing ‘error terms' in economic relations isnot merely a result of statistical errors of measurement. It is asmuch a result of the very nature of economic behaviour, its

dependence upon an enormous number of factors, as comparedwith those which we can account for, explicitly, in our theories.4

During the 1940s, therefore, Haavelmo and othersdeveloped methods for attaching numbers to thecoefficients in systems of simultaneous equations.The assumption of an underlying probability modelmeant that they could evaluate these methods,asking, for example, whether the estimatesobtained were unbiased and consistent.

In the late 1940s this programme began to yieldresults that were potentially relevant for policy-makers. The most important application was byLawrence Klein (1920–), who used models of theUS economy to forecast national income. Klein'smodels were representative of the approach laiddown by Marschak in 1943. They were systems ofsimultaneous equations, intended to represent thestructure of the US economy, and they weredevised using the latest statistical techniques beingdeveloped by the Cowles Commission. Klein'sapproach led to the large-scale macroeconometricmodels, often made up of hundreds of equations,that were widely used for forecasting in the 1960sand 1970s.

The founders of the Econometric Society and the

Cowles Commission sought to integratemathematics, economics and statistics. Thisprogramme was only partly successful.Mathematics and statistics became an integral partof economics, but the hoped-for integration ofeconomic theory and empirical work neverhappened. Doubts about the value of trying tomodel the structure of an economy using themethods developed at Cowles remained. It was notclear whether structural models, for all theirmathematical sophistication, were superior tosimpler ones based on more ‘naive' methods. Theaggregation problem (how to derive the behaviourof an aggregate, such as market demand for aproduct, from the behaviour of the individuals ofwhich the aggregate is composed) proved verydifficult. The outcome was that towards the end ofthe 1940s the Cowles Commission shifted towardsresearch in economic theory. (Research intoeconometrics continued apace, mostly outsideCowles, but without the same optimism as hadcharacterized earlier work.) The Commission'smotto, ‘Science is measurement' (adopted fromLord Kelvin), was changed in 1952 to ‘Theory andmeasurement’. As one historian has expressed it,‘By the 1950s the founding ideal of econometrics,

the union of mathematical and statisticaleconomics into a truly synthetic economics, hadcollapsed.’5 There are, however, two other strandsto this story that need to be considered.

The Second World War

In the 1930s the British Air Ministry started toemploy civilian scientists to tackle militaryproblems. Though some of the problems related tophysics and engineering, it was increasinglyrealized that certain questions had an economicaspect, and from 1939 the scientists turned toeconomists for advice. For example, the questionof whether it was worth producing more anti-aircraft shells involved balancing the numbers ofenemy bombers shot down (and the damage thesemight have inflicted) against the resources requiredto produce the shells. This was an economicquestion. The US forces followed, employingeconomists through the Office of Strategic Services(the forerunner of the CIA). These economistsbecame engaged in a wide range of tasks, ranging

from estimating enemy capacity and the design ofequipment to problems of military strategy andtactics. The last of these included problems such asthe selection of bombing targets and the angle atwhich to fire torpedoes. These were not economicproblems, but they involved statistical andoptimization problems that economists trained inmathematics and statistics proved well equipped tohandle. This was, of course, in addition to the roleof the economist in planning civilian production(see pp. 291–2), price control and other tasks moretraditionally associated with economics.

Many of these tasks involved optimization andplanning how to allocate resources. These requiredthe development of new mathematical techniquesin order to obtain precise numerical answers. Asmany of the problems involved random errors,statisticians were particularly important. The resultwas intense activity on problems that are bestclassified as statistical decision theory, operationsresearch and mathematical programming. After thewar, the US military, in particular, continued toemploy economists and to fund economic research.

These activities by economists had a significanteffect on post-war economics. They raisedeconomists' prestige. Many of them were directly

related to the war effort and, though less obviousthan the achievements of natural scientists, whohad produced new technologies such as nuclearweapons, they were widely recognized to havebeen important. In addition, the economistsinvolved in these activities worked in closeproximity with physicists and engineers. Theboundaries between statisticians and economistswere blurred. Much of these professionals' workwas closer to engineering than to what had beentraditionally thought of as economics.

Some of the research undertaken to solveproblems of specific interest to the military provedto have wider applications. The most importantexample was linear programming. This is mosteasily explained using some examples. If goodshave to be transported from a series of factories toa set of retail stores, how should transport bearranged in order to minimize total transport costs?If a person needs certain nutrients to survive, anddifferent foods contain these in differentproportions, what diet supplies the requirednutrients at minimum cost? To solve theseproblems and others like them, it was assumed thatall the relationships involved (such as between costand distance travelled, or health and nutrient

intake) were straight lines.Linear programming was developed

independently by two statisticians, George Dantzig(1914–), working for the US Air Force, and TjailingKoopmans (1910–85), a statistician with aninterest in transportation problems who also madesignificant contributions to econometrics at theCowles Commission. During the war, Koopmanswas involved with planning Allied freight shipping,and Dantzig was trying to improve the efficiencywith which logistical planning and the deploymentof military forces could be undertaken. After thewar, linear programming and the related set oftechniques that went under the heading of ‘activityanalysis' proved to be of wide application.

The development of such techniques dependedon developments before the war. Dantzig's startingpoint was the input–output model developed byWassily Leontief. By assuming that each industryobtained inputs from other industries in fixedproportions, this had reduced technology to alinear structure. Koopmans's interest in transportdated from before the war. Unknown to either ofthem, Leonid Kantorovich (1912–86), at Leningrad,where input–output techniques had acomparatively long history, had arrived at linear

programming as a way to plan productionprocesses. Other techniques developed during thewar arose even more directly out of pre-war civilianproblems. Statistical methods of quality control,for example, had been used in industry before thewar, but were taken up and developed by themilitary.

General-Equilibrium Theory

In the 1940s and 1950s general-equilibrium theory(also termed competitive-equilibrium theory)became seen as the central theoretical frameworkaround which economics was based. It remained aminority activity, requiring greater mathematicalexpertise than most economists possessed, but onewith great prestige. Its roots went back to Walrasand Pareto, but during the 1920s, when Marshall'sinfluence was dominant, it had been neglected.Interest in general-equilibrium theory remained lowuntil the 1930s, when several different groups ofeconomists began to investigate the subject.

One of these groups was based on the seminar

organized in Vienna in the 1920s and early 1930sby the mathematician Karl Menger (1902-85) – notto be confused with his father, Carl Menger. Theso-called Vienna Circle's manifesto, The ScientificView of The World, was published in 1929, andVienna was attracting mathematicians andphilosophers from all over Europe. One of thesewas Abraham Wald (1902–50), a Romanian with aninterest in geometry. He was put in touch with KarlSchlesinger (1889–1938), whose Theorie der Geld-und Kreditwirtschaft (Theory of the Economics ofMoney and Credit, 1914) had developed Walras'stheory of money. They discussed the simplifiedversion of Walras's set of equations for generalequilibrium found in The Theory of Social Economy(1918), written by the Swedish economist GustavCassel (see p. 276). Cassel had simplified the set ofequations by removing any reference to utility.Schlesinger noted that, if a good was not scarce, itsprice would be zero, which led him to reformulatethe equations as a mixed system of equations andinequalities. For those goods with positive prices,supply was equal to demand, but where goods hada zero price, supply was greater than demand. In aseries of papers discussed at Menger's seminar,Wald proved that, if the demand functions had

certain properties, this system of equations wouldhave a solution. Using advanced mathematicaltechniques (in particular a fixed-point theorem, amathematical technique developed in the 1920s),and using Schlesinger's reformulation of theequations, Wald had been able to achieve whatWalras had tried to do by counting equations andunknowns. He proved that the equations forgeneral equilibrium were sufficient to determine allthe prices and quantities of goods in the system. In1937 Wald (like Menger) was forced to leaveAustria and he moved to the Cowles Commission,where he worked on mathematical statistics.

Another mathematician to take an interest ingeneral equilibrium was John von Neumann (1903–57), a Hungarian who, after several years in Berlin,joined Princeton in 1931, having spent the previousyear there as a visitor. In 1932 he wrote a paper inwhich he proved the existence of equilibrium in aset of equations that described a growing economy.He discussed this work at Menger's seminar in1936, after which it was published in Ergebnisseeines mathematischen Kolloqui-ums (Results of aMathematical Colloquium, 1937) in an issue editedwith Wald. Von Neumann focused on the choice ofproduction methods, and he developed a novel way

of treating capital goods. This was in contrast toWald's focus on the problem of allocating givenresources. However, they had used similarmathematical techniques to solve the problem ofexistence of equilibrium.

It was, however, not mathematicians such asWald and von Neumann who revived interest ingeneral-equilibrium theory. At the London Schoolof Economics, Lionel Robbins, who had a greaterknowledge of Continental economics than mostBritish economists of his day, introduced JohnHicks to Walras and Pareto. In the early 1930sHicks, with R. G. D. Allen (1906–83), reformulatedthe theory of demand so as to dispense with theconcept of utility, believed to be a metaphysicalconcept that was not measurable. Individuals'preferences were described instead in terms of‘indifference curves’. These were like contours on amap: each point on the indifference-curve diagramrepresented a different combination of goods, andeach indifference curve joined together all thepoints that were equally preferred (that yielded thesame level of welfare). In the same way thatmoving from one contour on a map to anothermeans a change in altitude, moving from oneindifference curve to another denotes a change in

the consumer's level of welfare – the consumer ismoving to combinations of goods that are eitherbetter or worse than the original one. Thesignificance of indifference curves was that, inorder to describe choices, it was not necessary tomeasure utility (how well off people were – theequivalent of altitude). So long as one knew theshape of the contour lines and could rank themfrom lowest to highest, it was possible to find thehighest point among those that were available tothe consumer. Hicks and Allen argued that this wassufficient to describe behaviour.

This was followed by Hicks's Value and Capital(1939). This book contained an English-languageexposition of general-equilibrium theory. It restatedthe theory in modern terms (albeit usingmathematics

Fig. 5 Indifference curves

that was much simpler than that used by Wald, vonNeumann or even Samuelson), basing it on theHicks–Allen theory of consumer behaviour. It also

integrated it with a theory of capital and provided aframework in which dynamic problems could bediscussed. Though Hicks did not refer to the IS–LMmodel in Value and Capital, most readers, at leastby the end of the 1940s, understood him to haveshown how macroeconomics could be viewed asdealing with miniature general-equilibrium systems.In short, the book showed that general equilibriumcould provide a unifying framework for economicsas a whole.

There was, however, the problem that general-equilibrium theory was a theory of perfectcompetition. Hicks dealt with this by arguing thatthere was no choice: imperfect competition raisedso many difficulties that to abandon perfectcompetition would be to destroy most of economictheory – a response that was virtually an admissionof defeat. He followed Marshall in relegating thealgebra involved in his work to appendices,confining the mathematics in the text to a fewdiagrams, so that the book was accessible toeconomists who would be unable to make sense ofa more mathematical treatment. Value and Capitalwas very widely read, and was instrumental inreviving interest in general-equilibrium theory inmany countries.

At the same time as Hicks was working on Valueand Capital, Paul Samuelson (1915–) was workingon what was to become The Foundations ofEconomic Analysis. (The book was completed in1941, but publication was delayed for six yearsbecause of the war.) After studying economics atChicago, Samuelson did postgraduate work atHarvard, learning mathematical economics from E.B. Wilson (1879–1964). As well as being amathematical economist and statistician, Wilsonhad an interest in physics, having been the lastprotégé of Willard Gibbs, a physicist who laid thefoundations of chemical thermodynamics andcontributed to electromagnetism and statisticalmechanics. (Irving Fisher had previously beentaught by Gibbs.) Samuelson was also influencedby another physicist, Percy Bridgman (1882–1961),who proposed the idea of ‘operationalism’,according to which any meaningful concept couldbe reduced to a set of operations – concepts weredefined by operations. Although Bridgman wasresponding to what he saw as ambiguities inelectrodynamics, Samuelson appliedoperationalism to economics. In the Foundations, heinterpreted this idea as meaning that economistsshould search for ‘operationally meaningful

theorems’, by which he meant ‘hypotheses aboutempirical data which could conceivably be refuted,if only under ideal conditions’.6 Much of the bookwas therefore concerned to derive testableconclusions about relationships betweenobservable variables.

Samuelson's starting point was two assumptions.The first was that there was an equivalencebetween equilibrium and the maximization of somemagnitude. Thus the firm's equilibrium (chosenposition) could be formulated as profitmaximization, and the consumer's equilibriumcould be formulated as maximization of utility. Thesecond assumption was that systems were stable:that, if they were disturbed, they would return totheir equilibrium positions. From these, Samuelsonclaimed, it was possible to derive many meaningfultheorems. The book therefore opened withchapters on mathematical techniques – one onequilibrium and methods for analysingdisturbances to equilibrium, and another on thetheory of optimization – and these techniques werethen applied to the firm, the consumer and a rangeof standard problems.

Unlike Value and Capital, Foundations placed greatemphasis on mathematics. Like his teacher, Wilson,

Samuelson believed that the methods of theoreticalphysics could be applied to economics, and hesought to show what could be achieved by tacklingeconomic problems in this way. However, therewere important similarities between the two books.Hicks and Samuelson both emphasized that allinteresting results in the theory of the consumercould be derived without assuming that utilitycould be measured. They both discussed dynamicsand the stability of general equilibrium.Samuelson's assessment of the relationshipbetween the two books was that ‘Value and Capital(1939) was an expository tour de force of greatoriginality, which built up a readership for theproblems Foundations grappled with and for theexpansion of mathematical economics that sooncame.’7

One of the most significant features of therevival of general-equilibrium theory in the 1930sand 1940s was that those involved came to it fromvery different backgrounds. Hicks approached it asan economist, bringing ideas influenced by Robbinsand Continental economists into the Britishcontext, then dominated by Marshall. Samuelson'sbackground was mathematical physics asdeveloped by Gibbs and Wilson, whose techniques

he sought to apply to economics. He emphasizeddynamics and predictions concerning observablevariables. In contrast, the way in which Wald andvon Neumann approached general equilibriumarose directly from their involvement inmathematics.

In the first three decades of the twentiethcentury, enormous changes in mathematicalthinking had taken place. Acceptance of non-Euclidean geometry (discovered early in thenineteenth century but not fully axiomatized until1899) raised questions concerning the foundationsof mathematics. It became impossible to defendthe idea that geometry simply formalized intuitivenotions about space. Non-Euclidean geometriesviolated everyday experience, but were quiteacceptable from a mathematical point of view.Euclidean geometry became only one of manypossible geometries, and after the theory ofrelativity it was not even possible to argue that itwas the only geometry consistent with the physicalworld. Another blow to earlier conceptions of howmathematics related to the real world came withquantum mechanics. It was possible to integratequantum mechanics and alternative theories, butonly in the sense that it was possible to provide a

more abstract mathematical theory from whichboth could be derived. Mathematics was, in thisprocess, becoming increasingly remote fromeveryday experience.

David Hilbert (1862–1943) responded to thissituation by seeking to reduce mathematics to anaxiomatic foundation. In his programme, in whichhe hoped to resolve several paradoxes in set theory,mathematics involved working out the implicationsof axiomatic systems. Such systems includeddefinitions of basic symbols and the rulesgoverning the operations that could be performedon them. An important consequence of thisapproach is that axiomatic systems areindependent of the interpretations that may beplaced on them. This means that when general-equilibrium theory is viewed as an axiomaticsystem it loses touch with the world. The symbolsused in the theory can be interpreted to representthings like prices, outputs and so on, but they donot have to be interpreted in this way. The validityof any theorems derived does not depend on howsymbols are interpreted. Thus when Wald and vonNeumann (whose earlier work includedaxiomatizing quantum mechanics) provided anaxiomatic interpretation of general-equilibrium

theory, the way in which the theory wasunderstood changed radically.

From the point of view of economists, Wald andvon Neumann were on the periphery of theprofession. In the late 1940s, however, the CowlesCommission, having moved away fromeconometric theory, encouraged work on general-equilibrium theory. Two economists working there,Kenneth Arrow (1921–) and Gérard Debreu(1921–), published, in 1954, an improved proof ofthe existence of general equilibrium. The Arrow–Debreu model has since come to be regarded as thecanonical model of general equilibrium. Itsdefinitive statement came in Debreu's Theory ofValue (1959). In the preface, Debreu wrote:The theory of value is treated here with the standards of rigor ofthe contemporary formalist school of mathematics… Allegiance torigor dictates the axiomatic form of the analysis where the theory,in the strict sense, is logically entirely disconnected from itsinterpretations.8

It is no coincidence that Debreu came toeconomics from mathematics, and that as amathematician he was involved with the so-calledBourbaki group, a group of French mathematiciansconcerned with working out mathematics with

complete rigour, who published their work underthe pseudonym ‘Nicolas Bourbaki’. Theory of Valuecould be seen as the Bourbaki programme appliedto economics.

Debreu's Theory of Value provided an axiomaticformulation of general-equilibrium theory in whichthe existence of equilibrium was proved undermore general assumptions than had been used byWald and von Neumann. The price of thisgenerality and rigour was that the theory ceased todescribe any conceivable real-world economy. Forexample, the problem of time was handled byassuming that futures markets existed for allcommodities, and that all agents bought and soldon these markets. Similarly, uncertainty wasbrought into the model by assuming that there wasa complete set of insurance markets in whichprices could be attached to goods under everypossible eventuality. Clearly, these assumptionscould not conceivably be true of any real-worldeconomy.

In the early 1960s, confidence in general-equilibrium theory, and with it economics as awhole, was at its height, with Debreu's Theory ofValue being widely seen as providing a rigorous,axiomatic framework at the centre of the

discipline. The theory was abstract, not describingany real-world economy, and the mathematicsinvolved was understood only by a minority ofeconomists, but it was believed to providefoundations on which applied models could bebuilt. Interpretations of the Arrow–Debreu modelcould be applied to many, if not all, branches ofeconomics. There were major problems with themodel, notably the failure to prove stability, butthere was great confidence that these would besolved and that the theory would be generalized toapply to new situations. The model provided anagenda for research. However, this optimism wasshort-lived. There turned out to be very few resultsthat could be obtained from such a generalframework. Most important, it was proved, firstwith a counter-example and later with a generalproof, that it was impossible to prove stability inthe way that had been hoped. The method wasfundamentally flawed.

In addition, there were problems that could notbe tackled within the Arrow–Debreu framework.These included money (attempts were made todevelop a general-equilibrium theory of money, butthey failed), information, and imperfectcompetition. In order to tackle such problems,

economists were forced to use less general models,often dealing only with a specific part of theeconomy or with a particular problem. The searchfor ever more general models of generalcompetitive equilibrium, that culminated in Theoryof Value, was over.

Game Theory

Though economists have moved away fromgeneral-equilibrium theory, they have continued tosearch for a unifying framework on whicheconomics can be based. They have found it ingame theory. Though this has a longer history,modern game theory goes back to work by vonNeumann in the late 1920s, in which he developeda theory to explain the outcomes of parlour games.The simplest such game involves two players whocannot cooperate with each other, each of whomhas a choice of two strategies. In such a game,there are four possible outcomes. Von Neumannwas able to prove that there will always be anequilibrium, defined as an outcome in which

neither player wishes to change his or her strategy.To ensure this, however, he had to assume thatplayers can choose strategies randomly (forexample by tossing a coin to decide which strategyto play). There was thus a parallel between socialinteraction and the need for probabilistic theoriesin physics. Such work was an attempt to show thatmathematics could be used to explain the socialworld as well as the natural.

From 1940 to 1943 von Neumann cooperatedwith Oskar Morgenstern (1902–77) on whatbecame The Theory of Games and Economic Behavior(1944). Morgenstern was an economist whosucceeded Hayek as director of the Institute forBusiness Cycle Research in Vienna from 1931, untilhe moved to Princeton in 1938. In the course of hiswork on forecasting and uncertainty, he introducedthe Holmes–Moriarty problem, in which SherlockHolmes and Professor Moriarty try to outguess eachother. If Holmes believes that Moriarty will followhim to Dover, he gets off the train at Ashford inorder to evade him. However, Moriarty can workout that Holmes will do this, so he will get offthere too, in which case Holmes will go to Dover.Moriarty in turn knows this… It is a problem withno solution. Though expressed in different

language from the problems that von Neumann wasanalysing, it is a two-person game with twostrategies.

In Vienna, Morgenstern became involved withKarl Menger and came to accept that economicproblems needed to be handled formally if preciseanswers were to be obtained. Unlike many Austrianeconomists, he believed that mathematics couldplay an important role in economics (he hadreceived tuition in the subject from Wald), and hehad an eye for seeing points where mathematicswould be able to contribute. However, unlike vonNeumann, he was critical of general-equilibriumtheory and did not believe that it could provide asuitable framework for the discipline. Game theoryprovided an alternative. In the course of hiscooperation with von Neumann, during which hecontinually put pressure on him to get their bookout, he asked provocative questions and offeredideas on equilibrium and interdependence betweenindividuals that von Neumann was able to develop.In developing their theory, von Neumann andMorgenstern were responding to the sameintellectual environment – formalist mathematics –that lay behind the developments in general-equilibrium theory during the same period. Indeed,

some of the key mathematical theorems involvedwere the same.

The Theory of Games and Economic Behavior was apath-breaking work. It analysed games in whichplayers were able to cooperate with each other,forming coalitions with other players, and ones inwhich they were not able to do this. It suggested away in which utility might be measured. Mostsignificant of all, it offered a general concept ofequilibrium that did not depend on markets,competition or any specific assumptions about thestrategies available to agents. This concept ofequilibrium was based on the concept ofdominance. One outcome (call it x) dominatesanother (call it y) ‘when there exists a group ofparticipants each one of whom prefers hisindividual situation in – to that in y, and who areconvinced that they are able as a group – i.e. as analliance – to enforce their preferences’.9Equilibrium, or the solution to a game, comprisesthe set of outcomes that are not dominated by anyother outcome. In other words, it is an outcomesuch that no group of players believes it can obtainan alternative outcome that all members of thegroup prefer. Given that the notion of dominancecould be interpreted in many different ways, this

offered an extremely general concept ofequilibrium.

The Theory of Games and Economic Behavior wasreceived enthusiastically, but by only a small groupof mathematically trained economists. One of themain reasons was that, even as late as 1950, manyeconomists were antagonistic towards the use ofmathematics in economics. Another was thedismissive attitude of von Neumann andMorgenstern to existing work in economics.(Morgenstern had published a savage review ofValue and Capital, and von Neumann was privatelydismissive of Samuelson's mathematical ability.)The result was that for many years game theorywas taken up by mathematicians, particularly atPrinceton, and by strategists at the RANDCorporation and the US Office of Naval Research,but was ignored by economists. The main source ofmathematically trained economists was the CowlesCommission, several of whom wrote substantialreviews of The Theory of Games, but even they didnot take up game theory.

One of the Princeton mathematicians to take upgame theory was John Nash (1928–). In a series ofpapers and a Ph.D. dissertation in 1950–51, Nashmade several significant contributions. Starting

from von Neumann and Morgenstern's theory, hetoo distinguished between cooperative games (inwhich players can communicate with each other,form coalitions and coordinate their activities) andnon-cooperative games (in which suchcoordination of actions is not possible). He provedthe existence of equilibrium for non-cooperativegames with an arbitrary number of players (vonNeumann had proved this only for the two-playercase), and in doing this he formulated the conceptthat has since come to be known as a Nashequilibrium: the situation where each player iscontent with his or her strategy, given thestrategies that have been chosen by the otherplayers. He also formulated a solution concept(now called the Nash bargain) for cooperativegames.

During the 1950s there were many applicationsof game theory to economic problems ranging frombusiness cycles and bank credit expansion to tradepolicy and labour economics. However, theseremained isolated applications that did notstimulate further research. The main exception wasdue to Martin Shubik (1926–), an economist atPrinceton, in touch with the mathematiciansworking on game theory. His work during the

1950s culminated in Strategy and Market Structure(1959), in which he applied game theory toproblems of industrial organization. It was not untilindustrial economists became disillusioned withtheir existing models (notably what was termed thestructure–conduct-performance paradigm, whichassumed a hierarchical relationship between thesethree aspects of markets) that game theory becamewidespread in the subject. During the 1970s,industrial economics came to rely more and moreon game theory, which displaced the earlier,empirically driven approach which containedrelatively little formal theory. By the 1980s gametheory had become the organizing principle forunderlying theories of industrial organization. Fromthere it spread to other fields, such as internationaltrade, where economists wanted to model theeffects of imperfect competition and strategicinteraction between economic agents.

The Mathematization of Economics (Again)

In the 1960s and 1970s, economics was

transformed. The mathematization of the subject,which had gained momentum in the 1930s,became almost universal. Though there wereexceptions, training in advanced mathematics cameto be considered essential for serious academicwork – not least because without it it wasimpossible to keep up with the latest research. Itbecame the norm for articles in academic journalsto use mathematics. The foundations for thischange, which was so profound that it canlegitimately be described as a revolution, were laidin the preceding three decades and encompassedeconometrics, linear models, general-equilibriumtheory and game theory. Ideas and techniques fromthese four areas spread into all branches ofeconomics.

The use of mathematical models enabledeconomists to resolve many issues that wereconfusing for those who used only literary methodsand simple mathematics. Topics on whicheconomists had previously been able to say little(notably strategic interaction) were opened up.However, the cost was that economic theoriesbecame narrower, in the sense that issues thatwould not fit into the available mathematicalframeworks were ignored, or at least marginalized.

Theories became simpler as well as logically morerigorous and more numerous. There were equallydramatic changes in the way in which economictheories were related to empirical data. Thougholder, more informal, methods never died out,statistical testing of a mathematical model becamethe standard procedure.

The variety of economists involved is evidenceagainst any very simple explanation of this process.The motives and aims of Tinbergen, Frisch, Hicks,Samuelson, von Neumann and Morgenstern wereall very different. However, some generalizationsare possible. The subject saw an enormous influxof people who were well trained in mathematicsand physics. They brought with them techniquesand methods that they applied to economics. Morethan this, their experience in mathematics andphysics affected their conception of economics.This extended much more widely than the obviousexample of von Neumann. The mathematization ofeconomics was also associated with the forcedmigration of economists in the inter-war period. Inthe 1920s the main movement was from Russiaand eastern Europe, and in the 1930s fromGerman-speaking countries, with some economistsbeing involved in both these upheavals. By the

1950s there had been an enormous movement ofeconomists from central and eastern Europe to theUnited States. The mathematicians involved inMenger's seminar in Vienna (including Mengerhimself) were merely the tip of an iceberg. In 1945around 40 per cent of contributors to the AmericanEconomic Review, most of whom lived in the UnitedStates, had been born in central and easternEurope, and a large number of these were highlytrained in mathematics.

The aim of the Econometric Society, whichfostered much of the early work involvingmathematics and economics, was to integratemathematics, statistics and economics. In a sense,its goals were realized, perhaps more conclusivelythan its founders had hoped. It becameincreasingly difficult to study economics withoutknowledge of advanced mathematics and statistics.However, less progress was made in integratingeconomic theory with empirical work. From thelate 1940s econometrics and mathematical theorydeveloped as largely separate activities withineconomics. There have been times when they havecome together, and there has been considerablecross-fertilization; however, the goal thateconometric techniques would make it possible for

economic theory to be founded securely onempirical data, instead of on abstract assumptions,has not been achieved. In part this reflects theinfluence of formalist mathematics. In part itreflects the overconfidence of the earlyeconometricians and their failure to appreciate thedifficulty of the task they had set themselves. Themain justification for the key assumptions used ineconomic theory remains, as for Marshall and hiscontemporaries, that they are intuitivelyreasonable.

Economists have responded to this situation indifferent ways. The one most complimentary toeconomic theory is to argue that theory is ‘aheadof' measurement. This implies that the challengefacing economists is to develop new ways ofmeasuring the economy so as to bring theories intoa closer relationship with evidence about realeconomic activity. An alternative way to view thesame phenomenon is to argue that economictheory has lost contact with empirical data – thatthe theoretical superstructure rests on flimsyfoundations. From this perspective the onus is ontheorists to develop theories that are more closelyrelated to evidence as much as on empiricalworkers to develop new evidence.

Doubts about the mathematization of economicshave gone in cycles. In the long post-war boom,confidence in economics grew and reached its peakin the 1960s. General-equilibrium theory was theunifying framework, affecting many fields, and, asthe cost of computing power fell, econometricstudies were becoming much more common. Asinflation increased and unemployment rosetowards the end of the decade, however, doubtswere increasingly expressed. With the emergence ofstagflation (unemployment and inflation risingsimultaneously) in the mid-1970s, and the failureof large-scale econometric models to forecastaccurately, confidence in economics was shakeneven further. In the 1980s confidence returned asgame theory provided a new unifying frameworkfor economic theory and the advent of powerfulpersonal computers revolutionized econometrics.However, this increased confidence in the subjecthas been accompanied by persistent dissent.Outsiders and some extremely influential insidershave argued that the assumptions needed to fiteconomics into the mathematical mould adoptedsince the 1930s have blinded economists toimportant issues that do not fit. These includeproblems as diverse as the transition of the Soviet

Union from a planned to a free-market economy orthe environmental catastrophe that will result frompopulation growth and policies of laissez-faire.

12

Welfare Economics and Socialism, 1870 to thePresent

Socialism and Marginalism

The closing decades of the nineteenth century sawthe rise of socialism as a large-scale movement.Socialist parties were formed across Europe, and inmany countries their support grew rapidly.Extension of the franchise to include the workingclass led to an expansion of socialist representationin European parliaments. There was great pressurefor social reform, both from socialist partiesthemselves and from conservatives (such asBismarck, the German Chancellor, and Disraeli, theBritish Prime Minister) who sought to lessen thepressure for more radical change. Governmentactivity was extended into many new fields, neworganizations emerged, and the role of the stateincreased. Labour unions were expanding toinclude unskilled as well as craft workers, and werebeginning to exact improved working conditions.

Though there were clear exceptions, the rise oftrade unions and the rise of socialism were stronglylinked.

The socialist movements that arose acrossEurope and in the United States took many forms.They covered a spectrum ranging from mildreformism to revolutionary Marxism. Foreconomists, the rise of social-ism presented twotypes of challenge. The first was to developprinciples for working out the appropriate role ofthe state. When, where and how should the stateintervene in economic life? The second was toevaluate socialist and communist schemes forreorganizing society. Could an economy organizedon socialist principles operate successfully?Though these questions clearly overlapped, theyprovide a useful way to think about some of themain lines of economic thought during this period.

The challenges posed by socialism came at thetime when economists were increasingly taking upmarginalist theories. These theories provided aframework within which problems such as theregulation of industry, the provision of welfarebenefits, the establishment of governmententerprises and tax policy could be tackled thatwas very different from that available to previous

generations of economists. Smith and J. S. Mill haddiscussed the problem of state intervention, buttheir analysis had centred on long-run growth. Theyoffered general principles by which state activitiescould be judged, and their observations on specificcases contained many perceptive insights, but theirability to tackle specific questions about howresources should be allocated was severely limited.Marginalism, with its mathematical apparatus ofutility and profit maximization, appeared to be ableto fill this gap.

Some of the early marginalists – notably theAustrians – acquired a reputation for being hostileto socialism. Some undoubtedly were. For the rest,however, although they may generally have beenbiased in favour of laissez-faire and individualism,this was in practice outweighed by more pragmaticconsiderations. Most marginalists were on the sideof reform, even if their approach was sometimespaternalistic or if they were hostile to radicalchange. For example, although Jevons started hiscareer a supporter of laissez-faire, by his last book,published in 1882, he had arrived at a positionwhere he saw ‘hardly any limits to the interferenceof the legislator’.1 What had happened was that,during the 1870s, he found more and more

contexts where state intervention was justified, tobe financed mostly by continual increases in localtaxation: public health, working conditions,education, transport, and many others. Marshall,the dominant economist of the followinggeneration, saw a smaller role for state interventionthan did Jevons. However, he still assigned asignificant role to the state, going along with thewider movement towards support for progressivetaxation (where the rich are subject to higher taxrates than the poor). Though his socialism wassomewhat limited, Walras even described himselfas a socialist. If there was a causal link betweensocialism and marginalism, therefore, it did notinvolve marginalism being adopted as a way ofdefending laissez-faire against socialist criticism.Marginalism was used to argue in favour of socialreform.

The State and Social Welfare

In the English-speaking world, the dominantapproach to problems of social welfare and reform

was, for several decades, the Cambridge tradition,which originated with Henry Sidgwick (1838–1900). The fundamental part of Sidgwick'sargument was a distinction between two senses inwhich the term ‘wealth' was used. The first was asthe sum of goods produced, valued at marketprices. The second was as the sum of individuals'utilities – what we would now term welfare. Heoffered reasons why these might be different. Theclearest example is free goods: goods for which noprice is paid. Such goods raise individuals' utilities– people value them – but they do not enter intothe first concept of wealth at all, for their price iszero. More generally, the market value of a good toa consumer will measure the value of the last unitconsumed. If the value of an additional unit falls asconsumption rises, this will be less than theaverage value of the good to that consumer. If theratio of price to average utility were the same forall goods, this would not matter at all. However,the ratio of price to average utility will depend onhow fast marginal utility falls, and there is noreason to suppose that this will be the same for allgoods. Some goods have an average utility that ishigh relative to their price and will be undervaluedin calculations of wealth at market prices. Free

goods, which have positive value but a zero price,are enough to make this point.

In developing these arguments, Sidgwick madeuse of Jevons's utilitarianism, according to whichindividuals' utilities could be measured andcompared. This meant that if the marginal utility ofa particular good were higher for one person thanfor another, total utility could be raised byredistributing goods to those who valued themmost. This would leave wealth at market pricesunchanged. For example, the value of an additionalloaf of bread to a poor person may be higher thanits value to a rich person; it may therefore bepossible to increase welfare by taking a loaf fromthe rich person and giving it to the poor person. Inother words, a community's welfare depends onhow goods are distributed, not simply on the valueof goods being consumed.

Having provided reasons why wealth and welfaremight differ, Sidgwick argued that, for practicalreasons, wealth had to be measured using marketprices, except in specific cases where ‘thestandards of the market fail us’.2 This provided thejustification for an approach to welfare economicssimilar to that of the classical economists such asSmith and Mill, tackling problems of welfare by

analysing first the production and then thedistribution of wealth. Sidgwick also followed Millin his analysis of the role of government. Thegeneral principle was laissez-faire, but this wassubject to numerous exceptions that he explored indetail. These included cases where individualscould not obtain adequate reward for the servicesthey provided to society (lighthouses, afforestationand scientific discovery) and also those where thegains to individuals exceeded those to society(duplicating an existing railway line). There werealso cases, such as the control of disease, wherecooperation was required. However, even thoughSidgwick defended the classical perspective, hisseparation of two concepts of wealth made itpossible, arguably for the first time, to conceive ofwelfare economics as something distinct fromeconomics in general.

Marshall followed in the same tradition, butmade Sidgwick's analysis more precise. He definedwealth very clearly as a sum of money values –national income, or national dividend as he calledit – that was distinct from utility or welfare. Hismain contribution, however, was to develop a wayto measure utility in terms of money. This was thetheory of consumers' surplus. An individual

consumer's surplus is the difference between whatthe consumer is willing to pay for a commodity andwhat he or she actually pays. Marshall showed thatsuch surpluses could be added together and usedto measure changes in social welfare only undercertain circumstances: in particular, the value of anadditional unit of income had to be the same for allindividuals. In general, this would not be true. Hisresponse was to confine his use of consumers'surplus to situations where it could plausibly beargued that it was approximately true.On the whole, however, it happens that by far the greatest numberof events with which economics deals, affect in about equalproportions all the different classes of society; so that if the moneymeasures of the happiness caused by two events are equal, there isnot in general any very great difference between the amounts ofhappiness in the two cases.3

Marshall confined his use of consumers' surplus togoods that accounted for only a small proportionof consumers' spending. This meant that a changein price would have a negligible effect on realincome and would have only a minor effect on thevalue to the consumer of an additional unit ofincome.

The practical, utilitarian approach to welfareeconomics reached its culmination in the work of

Pigou (who gave the subject its name), in his twobooks Wealth and Welfare (1912) and TheEconomics of Welfare (1920). Pigou's welfareeconomics was utilitarian, in that he regarded theelements of welfare as ‘states of consciousness'that could be compared with each other.4 LikeSidgwick and Marshall, he focused on nationalincome and the way in which it was distributed.National income was linked to what he called‘economic welfare' – ‘that part of welfare that canbe brought, directly or indirectly, into relation withthe measuring rod of money’.5 In other words, herecognized that there were aspects of welfare aboutwhich economists could say little.

Pigou's main innovation was to replace Marshall'sconcept of consumers' surplus with an analysis ofmarginal private and social products. If themarginal private product of an activity (the benefitsobtained by the person undertaking the activity)were different from its marginal social product (thebenefits to society), welfare was unlikely to bemaximized. There were, Pigou argued, manysituations where private and social products wouldbe different from each other. One was where oneperson owned an asset (for example, land or abuilding) that was managed by a tenant. If the

benefits accrued to the landlord, the tenant mighthave no incentive to improve or even to maintainthe asset. The marginal social product of improvingland, therefore, would be higher than the marginalprivate product to the tenant. Another situationwas where one person's activities directly affectedsomeone else's welfare. The obvious examples ofthis are pollution and traffic congestion. Monopolywould also cause private and social products todiffer: instead of simply looking at the value of theadditional output, the monopolist will also takeaccount of the effect of increased sales on theprice of goods that are already being produced.Economic policy therefore involved eliminatingdifferences between marginal private and socialproducts. Using this approach, Pigou offered adetailed programme for economic policy, virtuallyproviding a blueprint for the welfare state.

The Lausanne School

Unlike the Cambridge economists, Walras andPareto at Lausanne did not assume that the welfare

of different individuals could be measured andadded together. Instead, Walras started from thenotion of justice in exchange – ‘commutativejustice’. He argued that this type of justice requiredthat every trader faced the same price for a givenproduct and that prices did not change. He thenshowed that, given justice in exchange, freecompetition would produce maximum welfare. Thesignificance of this result was that it offered a wayin which questions of welfare could be analysedwithout either adding up or comparing the well-being of different individuals. This approach wasdeveloped by Pareto, who defined a socialoptimum as a situation in which any change wouldbe agreeable to some individuals and disagreeableto others – in other words, a position where it wasimpossible to make anyone better off withoutmaking someone else worse off.

Though Walras, like his English counterparts,proposed detailed policies of social reform, centredon getting rid of monopolies, he also consideredthe question of socialism at a more abstract level.Central to this was a proposal for landnationalization that would, he contended, providea way to reconcile individualism and socialism.Pareto took the discussion of socialism a stage

further, paying attention to the question of how asocialist state might be organized. He observedthat, even if the state owned the entire stock ofcapital and prohibited all buying and selling, pricesand rates of interest would have to remain, at leastas accounting entities:The use of prices is the simplest and easiest means for solving theequations of equilibrium; if one insisted on not using them, hewould probably end up by using them under another name, andthere would then be only a change of language, and not of things.6

Without prices and interest rates, ‘the ministry ofproduction would proceed blindly and would notknow how to plan production’.7 Individuals' desiresand the obstacles to satisfying them would be thesame under a collectivist organization of society asunder capitalism, with the result that both societieswould have to solve similar problems. The maindifference between socialism and capitalism wasthe principles by which the distribution of incomewas determined. Under capitalism, incomes werelinked to ownership of means of production (andhence by the way in which society has evolved),whereas under socialism they were determinedaccording to ethical and social considerations.

Pareto's argument was in turn taken a stage

further by one of his students, Enrico Barone(1859–1924). Barone pointed out that the sameconditions had to be fulfilled in a collectivisteconomy seeking to maximize the welfare of itsmembers as in a perfectly competitive equilibrium.The ministry of production in a socialist state couldstart with the prices and wages inherited from theprevious regime. It could then raise or lower them,in a process of trial and error, until two conditionswere fulfilled: prices were equal to costs ofproduction and costs of production wereminimized. These arguments led him to claim thatsuch a ministry would face an immense task,though not an impossible one.

The Socialist-Calculation Debate

The period of ‘war communism' in Soviet Russia in1918–21 was a brief attempt to dispensecompletely with markets and prices – the basis ofcapitalist economies – replacing them withcentralized planning. This resulted in chaos, andwas followed in the early 1920s by the New

Economic Policy, which reintroduced markets formany goods, though maintaining extensive statecontrol over the economy. The time was thus rightfor a more detailed examination of socialism. Hadthe Soviet experiment in instituting a non-marketeconomy collapsed because of the intensepressures created by wartime, or because it wastheoretically flawed? Several economists took upthe challenge of showing that it was the latter.

One such economist was Gustav Cassel (1866–1945), who used the example of a socialisteconomy to make certain points that applied to anyexchange economy. The socialist economy had theadvantage that it was the simplest possibleeconomy, with the result that it offered abenchmark against which more complex economiescould be assessed. Comparison with socialismwould reveal which institutions were essential andwhich could be dispensed with. This led him toelaborate on Barone's point that, even if a socialiststate tried to dispense with prices and wages, thesewould inevitably re-emerge, for they reflectedfundamental economic realities. However, he wentfurther than Barone in arguing that, in the absenceof private property and a fully developed system ofexchange, a socialist state would be unable to

direct production in the best way. The necessaryprices would not be available.

The economist who provided the most radicalcritique of socialism was Mises, in his article‘Economic calculation in the socialistcommonwealth' (1920). This provoked what hascome to be known as the socialist-calculationdebate, in which many of the period's leadingeconomists participated. In his article, Misesargued, in uncompromising terms, that socialismwas impossible – it could never work. His reasoningwas that, in any economy, rational calculationrequired the existence of freely established moneyprices for both consumers' and producers' goods.Without such prices it would be impossible foranyone to work out how resources should best beused. This was, Mises emphasized, not a purelytechnical problem, as some socialists seemed toassume. The main difficulty arose not withconsumer goods (one might not need prices to say,for example, that 1,000 litres of wine was morevaluable than 500 litres of oil) but with producers'goods. A railway, for example, is valuable becauseit reduces costs for other industries, enabling themto produce more of the goods that consumersrequire. Without money prices, it would be

impossible to calculate whether or not it should bebuilt.

In a static economy, where nothing changed,rational calculation might be possible. A socialiststate could continue the pattern of production thatprevailed under a previous competitive system.However, the world is not static. Tastes andtechnology are forever changing, with the resultthat new ways of producing goods have continuallyto be worked out. In a socialist state, there wouldbe no one with the responsibility and initiative tochange the way in which activities were organizedin response to these changes. Managers ofcapitalist enterprises, Mises argued, have aninterest in the businesses they administer that isquite different from anything that could be foundin public concerns. ‘Commercial-mindedness' willnot exist when people are moved from businessinto public organizations. Even if human naturecould be changed so that people all exertedthemselves as much as if they were subject to thepressure of free competition, there would still be aproblem. In the absence of prices, people wouldnot know what it meant to economize – to balancethe costs and benefits of alternative activities.

The main response to Mises came from a group

of economists who have come to be known as‘market socialists’, including Fred M. Taylor (1855–1932), H. D. Dickinson (1899–1969) and OskarLange (1904–65). The reason for this label is thatthey argued that it was possible to design aneconomy that was socialist in the sense that thestate owned the means of production but in whichthere were markets for consumer goods and labour.Households would thus be free to sell labour andto buy consumption goods in response to marketwages and prices. Production would be organizedby plant managers, who would be given the task ofproducing at minimum average cost and settingprices equal to marginal cost (the cost of anadditional unit of output). Behind these plantmanagers would be industry managers, who wouldmake investment decisions, including when toopen new plants and close old ones. A centralplanning board would monitor the whole process,setting the prices on which the decisions ofindustry managers would be based.

The reasoning behind these rules was that, ifthey were followed, it would be possible for asocialist economy to mimic the behaviour of aperfectly competitive one. If the market-socialistsystem were correctly administered, both systems

would give the same outcome. There might bepractical problems with socialism (no one disputedthis), but it was argued that socialism wastheoretically possible.

The most forceful response to this came fromHayek, in a series of articles the first of whichappeared in 1935. Hayek argued that the marketsocialists had not shown that rational calculationwas possible under socialism. They had just shownthat if one had complete knowledge of all therelevant data (including knowledge of consumers'tastes and of all the technical possibilities forproducing goods) it would be possible to solve aset of equations to determine what goods shouldbe produced. However, this did not solve theproblem of how efficiency could be achieved undersocialism it showed that it had not beenunderstood. In a real-world economy, fullinformation on technical conditions of productiondoes not exist. What does exist is engineers withtechniques of thought that enable them to discovernew solutions when confronted with newproblems. In other words, the knowledge requiredby socialist planners does not exist it needs to becreated. This means that the initiative in adoptingnew methods, developing new products and so on

has to come not from planners, but from managerswho are aware of new developments and are ableto respond to them. The problem with socialism isnot merely a computational problem: it is one ofgenerating the information required for the systemto operate. The market socialists, by takingtechnical conditions as given, simply assumed theproblem away.

Hayek also raised further problems with themarket-socialist arguments. In equilibrium, pricescan be calculated by solving a set of simultaneousequations. But the economy never is in equilibrium.It is not clear how the planners should operate outof equilibrium. It might not even be appropriate tostart with existing prices, for there was no reasonto believe that the transition to socialism wouldnot produce large changes in equilibrium prices.Such problems would be compounded by theproblem of new goods: planners would have noidea about which new goods should be producedand in what quantities. Comparisons with stateenterprises in a capitalist economy would provideno guidance, for it would no longer be possible tomake comparisons with the private sector.

This critique of the so-called ‘competitivesolution' to the problem of socialist planning was

developed by Hayek into a theory of competitionthat differed radically from the one that had, by the1930s, come to dominate the profession. Wherethe theory of perfect competition focused on anequilibrium in which no firm was able to affect theprices it faced, Hayek focused on rivalry. Theessence of competition was that businessescompeted with each other, discovering newtechnologies and new ways in which productioncould be organized. The importance of the marketwas that it provided a means wherebydecentralized decision-making by individual firmscould be coordinated. Prices conveyed informationthat would not otherwise be available to decision-makers. Competition was not only a means ofmoving the economy towards equilibrium, but alsoa procedure for discovering new ways of doingthings.

Welfare Economics, 1930–1960

The socialist-calculation debate overlapped withanother controversy that arose in the 1930s. This

was about the foundations – of welfare economics.Lionel Robbins argued that there was no scientificbasis on which interpersonal comparisons ofwelfare could be made. Though people made suchjudgements all the time, they should not form partof the science of economics. This undermined thefoundations of the Cambridge tradition in welfareeconomics. There was therefore a need to rebuildthe subject. The outcome was what came to becalled the ‘new welfare economics’, developed byLange and a group of Robbins's younger colleaguesat LSE, notably Hicks, Abba Lerner (1903–82) andNicholas Kaldor (1908–86). There was a close linkwith the calculation debates, for it was impossibleto ask whether a socialist economy could operateefficiently without examining what an efficientallocation of resources might look like. Lange, oneof the architects of market social-ism, was also amajor contributor to the new welfare economics.

The main contribution of the new welfareeconomics was the development of the conceptthat came to be known, using the term coined byIan Little (1918–) in 1950, as ‘Pareto optimality' or‘Pareto efficiency' (the two terms are usedinterchangeably). This is the situation, described byPareto, where it is impossible to make one person

better off without making someone else worse off.The contribution made by Hicks, Lange, Lerner andtheir contemporaries in the 1930s was to work outthe conditions that had to be met if this conditionwere to be satisfied. There was, however, aproblem with the criterion of Pareto optimality andthe associated concept of a Pareto improvement (achange that would make at least one person betteroff without making anyone worse off): they failedto provide any guidance on real-world policychanges, which virtually always benefited somepeople and harmed others. A stronger criterion wasrequired.

Hicks and Kaldor, again taking up an idea foundin Pareto, tried to strengthen the Pareto criterionby introducing the idea of a ‘compensation test’. Achange would be beneficial if the gainers couldcompensate the losers and still remain better off. Ifthis criterion were met, the result would be apotential Pareto improvement. It would not be anactual Pareto improvement, of course, unlesscompensation was actually paid; however, theconcept of a compensation test was thought toprovide a way in which the question of whetherresources were being used efficiently could beseparated from questions of income distribution.

But the idea turned out to be flawed. TiborScitovsky (1910–) showed in 1940 that it was easyto find examples where the compensation testwould be satisfied in both directions: it gavecontradictory results.

In the course of these discussions, economistsapproached the problem of social welfare in manydifferent ways, often deriving different versions ofthe conditions for a social optimum. One of themain problems was that, though economists wroteof ‘optimality' and ‘ideal output’, it was never madeclear exactly what it was that was optimized in asocial optimum. An answer was provided by AbramBergson (1914–), who proposed the idea of asocial-welfare function. This was a relationshipbetween social welfare and all the variables onwhich social welfare might depend. In itself, thiswas entirely devoid of content: it simply stated thatsocial welfare depended on whatever variables itdepended on. However, it provided a frameworkwithin which different approaches to the problemcould be analysed. It was possible to use the social-welfare function to analyse the implications ofdifferent value judgements or ethical criteria. Forexample, individualism implies that the onlyvariables entering the social-welfare function are

variables affecting individuals' levels of well-being.The Pareto criterion implies that if an individual'swelfare increases (without anyone else's changing)social welfare must increase. Using sucharguments, it was possible to clarify the meaning ofthe concept of Pareto optimality and to resolve theparadoxes surrounding compensation tests.

During the 1950s economists worked extensivelyon welfare economics. Kenneth Arrow's SocialChoice and Individual Values (1951) completelyreoriented welfare economics by proposing asocial-welfare function that was very different fromBergson's. Arrow thought of a social-welfarefunction (or social-choice function) as being similarto a voting mechanism. Every voter has apreference for a particular political party, and avoting mechanism is a rule that translates suchindividual preferences into a social choice (agovernment is elected). Possible mechanismsinclude simple majority voting as well as muchmore complicated procedures. Arrow viewed theproblem of social choice in exactly the same way –as the problem of getting from individuals' viewsabout how society should be organized to a socialdecision.

The way in which Arrow managed to say

anything about such an abstract problem was byspecifying a list of conditions that any votingprocedure, or social-choice function, shouldsatisfy. These included conditions such as ‘Ifeveryone prefers A to B, then A should be chosen'(this is known as the Pareto principle); ‘Noindividual should be a dictator’; and so on. He thenproved that, although every condition lookedextremely reasonable, there was no social-welfarefunction that would satisfy all of them. This washis so-called ‘impossibility' theorem. It stimulatedthe emergence of an entirely new field ofeconomics – social-choice theory – which hadstrong links with the analysis of voting rules bypolitical scientists.

At around the same time, Arrow, together withGérard Debreu, formulated what have becomeknown as the two ‘fundamental theorems ofwelfare economics’. These results formalized whathad been discovered in the 1930s with the newwelfare economics. The first theorem is that everycompetitive equilibrium is Pareto efficient. In otherwords, that in a competitive equilibrium it isimpossible to make anyone better off withoutmaking someone else worse off. The secondtheorem approaches the problem the other way

round. It is that any Pareto-efficient allocation ofresources can be made into a competitiveequilibrium, provided that income is distributed inan appropriate manner.

The Arrow–Debreu theorems mark theculmination of a particular approach to welfareeconomics, as their inventors' existence proof didfor the theory of general competitive equilibrium.They establish all that can be said about the meritsof perfect competition as a way in which toallocate resources. Their limitations, however, arethat Pareto optimality is an extremely weakoptimality criterion and that they tell us nothingabout what happens when some of the criteria foroptimality are not satisfied. For example, if thereare monopolies in several other industries, will itbe socially beneficial to remove a tax that distortsincentives in a particular industry? In 1956 RichardLipsey (1928–) and Kelvin Lancaster (1924–),worked out their theory of the ‘second best’, whichshowed that this would generally not be the case.If there were distortions in other parts of theeconomy (such as monopolies or taxes) thenremoving a distortion was as likely to make theoverall situation worse as to improve it.

The result of these developments was that by the

end of the 1950s the outlook for welfareeconomics looked very bleak. The new welfareeconomics had failed to provide any welfarecriterion stronger than Pareto optimality. Arrow'simpossibility theorem had shown that there was noacceptable way to get from individual preferencesto a social preference. Lipsey and Lancaster hadundermined the idea that piecemeal reforms couldbe shown to be beneficial. Arrow and Debreu hadestablished the precise relationship betweenperfect competition and Pareto efficiency, butnothing could, in general, be said about whetheractual policy changes would raise or lower socialwelfare.

Market Failure and Government Failure

The displacement of the ‘old' welfare economics ofSidgwick, Marshall and Pigou by the ‘new' welfareeconomics did not mean that the old problemswere neglected. In 1951 Samuelson worked out thetheory of pure public goods. Public goods aregoods (like the services of a lighthouse, a healthy

environment, or a public fireworks display) that, ifthey are provided at all, are provided for everyone.People cannot be excluded from benefiting fromthem, and one person can benefit from themwithout reducing the benefits available to anyoneelse. (The qualification ‘pure' is used toacknowledge that these conditions describe anideal – problems of congestion, for example, meanthat after some point many goods cease to exhibitthese characteristics.) The significance of publicgoods is that, as Samuelson showed, the amountsupplied will typically be less than the amount thatis socially desirable. Everyone benefits, but no onehas an incentive to pay. Similar problems arise withexternalities (of which pollution is the mainexample), where one person's action causes harm(or possibly benefit) to a third party.

Public goods and externalities are both examplesof market failure where competitive markets fail toallocate resources in a Pareto-efficient way. Ifallocations are not Pareto-efficient, it means thatthere can be unanimous agreement that a betterallocation of resources is possible (at least oneperson can be made better off without anyonebeing harmed). These concepts have been widelyused to justify government intervention. The

government has the responsibility to provide goodsthat the market will not supply in sufficientquantities, and to use its power to tax in order tocorrect defects in the market mechanism. In the1960s such beliefs fitted in well with the beliefthat the government also had to intervene at themacroeconomic level to ensure full employment.Since then, however, this rationale for governmentintervention has been challenged.

The first challenge arose with what has come tobe called the ‘Coase theorem’, proposed by RonaldCoase (1910–) in 1960. Coase made the point thatmost discussions of externalities, like Pigou's, failedto take account of the legal framework withinwhich economic activities were undertaken. Thefailure of markets to allocate resources efficientlyshould, Coase argued, be attributed not to a failureof competition but to the absence of clearlydefined property rights. If property rights wereclearly defined, markets could develop that wouldensure efficient use of resources. For example, ifthe rights over the use of a river were clearlyestablished, a factory owner wishing to pollute theriver and fishermen with an interest in clean watercould negotiate over the amount of pollution thatwould be allowed. If the factory owner held rights

over the river, fishermen could pay him or her tolimit pollution; if fishermen held the rights, thefactory owner could buy the right to pollute. Theresult of this perspective was that Coase saw amuch greater scope for the market and a morelimited role for the state than did Pigou.

The second challenge to the conventional viewof the role of government, also around 1960, camewith the development of theories of how voters,governments and bureaucracies behaved. Thesetheories, developed by economists such as JamesBuchanan (1919– ), Gordon Tullock (1922– ),Mancur Olson (1932–98) and Anthony Downs(1930– ), abandoned the notion that governmentsare disinterested organizations that act in thepublic interest (see p. 312). They replaced it with aview of governments as made up of individualswho are seeking to achieve their own ends.Politicians offer policies that will maximize supportin elections. Managers run their organizations inways that increase their own status and income.Taxes and government spending came to be seen asthe outcome of political processes in whichcompeting interests were expressed. The result wasthat the concept of government failure came to beplaced alongside that of market failure.

Conclusions

Since at least the eighteenth century economistshave been concerned with the question of whetherthe market mechanism is an effective way toorganize economic activity. In this sense they havealways been concerned with welfare economics.The major theme in Adam Smith's Wealth of Nationswas that a system of natural liberty, or freecompetition as it came to be called, wouldpromote economic growth and hence increasewelfare. Producers would be led, as if by aninvisible hand, to serve the public good eventhough they were concerned only with furtheringtheir own interests. This was a theorem aboutcompetition and economic welfare.

During the period covered by this chapter, theway in which welfare economics was conceivedchanged dramatically. Theories of marginal utilityprovided a new way to analyse markets.Economists began to focus on whether theresources available at any moment were allocatedefficiently. Concern with the growth of resourcesfaded into the background. At the same time,economists began to think of competition in adifferent way. Instead of Smith's vision of natural

liberty, in which competition meant activelycompeting with other people, competition came tomean a situation in which market power – theability to influence prices – was absent. Thischange was clearly illustrated in the socialist-calculation debate, in which the market socialists –for many years perceived as the clear victors –defended socialism on the grounds that it waspossible to design a socialist system in whichresources would be allocated efficiently. Theyfailed to recognize that Mises and Hayek, like Smithand the classical economists, had a different visionof what competition involved and of how theefficiency of an economic system should bejudged.

Economists were, as so often in the history ofthe subject, also trying to make economics more‘scientific’. In the 1930s many of them interpretedthis to mean that value judgements should beeliminated from the core of the discipline. In thisthey were possibly influenced by the argumentsmade in philosophy by the Viennese logicalpositivists (and brilliantly conveyed to the English-speaking world by A. J. Ayer). The ‘old' welfareeconomics of Sidgwick, Marshall and Pigou wasstrongly criticized and replaced by the ‘new' welfare

economics based on the principle of Pareto-optimality. It turned out, however, that few clearresults could be obtained. The Pareto criterion wastoo weak a foundation on which to base welfareeconomics. However, the Arrow-Debreu theoremsabout the efficiency of a competitive equilibriummade it possible to claim that Smith's problem ofthe invisible hand had now been rigorously proved.What was less often noted, however, was that theinterpretation of the invisible-hand theorem hadchanged dramatically. It was no longer (as it wasfor Smith) a proposition about the dynamic effectsof competitive rivalry in the real world; instead ithad become a theorem about optimal resourceallocation in an abstract world where market powerwas absent.

From around the 1970s the situation began tochange. The work of Buchanan, Tullock and othershas already been mentioned. In addition, social-choice theory developed as an abstract disciplinethat sat somewhere between economics, ethics andpolitical science, strongly influenced by Arrow'simpossibility theorem. Social-choice theorists suchas John Harsanyi (1920–) and Amartya Sen (1933–)explored issues such as whether it might bepossible to measure individuals' utility, the nature

of individual rights, and the ethical criteria onwhich social decisions might be based. Morewidely, economists began to use models not toprovide a value-free science but to explore theconsequences of different possible valuejudgements.

There were also important changes in the way inwhich markets were conceived. In the mid-1970s‘Austrian' economics experienced a revival. It wasactively promoted as an alternative to conventionaleconomics, based on radically differentconceptions of knowledge and the market process.However, although support for this approach grew,and Hayek once again became a widely knownfigure within the profession, it remained very mucha minority tradition. Within the mainstream of thesubject, economists began to construct models inwhich there was uncertainty about the future andinformation was scarce. Joseph Stiglitz (1943–)showed that, once information was introduced,markets could not be completely efficient. Ifsomeone tried to use information he or shepossessed (say by trading on the stock exchange),the very act of trading would reveal information toothers, reducing its value. Differences in theinformation available to different agents were

shown to produce results that were far removedfrom the perfectly competitive ideal. For example,if banks were unable properly to monitor theperformance of businesses to whom they had madeloans, it might be rational for them to maintain alow rate of interest and ration borrowers. Therewere also attempts to construct more dynamicmodels of competition in which firms activelycompeted against other firms, trying to be the firstto patent a new technology.

The economics of socialism versus capitalismreceived a sharp stimulus from the break-up of theSoviet Empire around 1990. It is too soon to seethis in proper perspective. To many economists itseemed to offer the final vindication of the claimmade by Mises and Hayek that socialism could notwork, although it was only one type of socialism,implemented in very peculiar circumstances, thathad failed. However, it is tempting to argue thatthe developments described in this chapter provedof little help in designing a rational transition fromsocialism to capitalism. One might claim that themost important lesson the reformers needed was tobe found in Adam Smith, who emphasized theimportance to any capitalist system of a secureframework of law, morality and property rights.

The socialist-calculation debate, along with mostwelfare economics, missed this point entirely.

13

Economists and Policy, 1939 to the Present

The Expanding Role of the EconomicsProfession

Since the Second World War the economicsprofession has grown enormously. There have beenrises both in the number of economics graduatesand in the number obtaining postgraduate degrees.In part this has reflected a rise in the number ofpeople entering higher education, and in part ageneral expansion in the social sciences. Demandfor the rising supply of graduates, at both first-degree and Ph.D. levels, has come not just fromacademia but increasingly from business,government and international organizations.Economists have been employed as technicalexperts on a scale unknown before the war. Withthis have come changes in the way the subject hasbeen conceived.

One reason why the Second World War was, inmany countries, a watershed in the growth of the

profession was that this was when economists firstbecame firmly established in government. In theUnited States, in 1940 Laughlin Currie becameeconomic adviser to the President – the firsteconomist to be employed full-time at such a highlevel. The role of economists at the heart of the USgovernment was institutionalized with theestablishment, in 1946, of the Council of EconomicAdvisers. The exact scope and the effectiveness ofthis varied according to the economic climate andthe attitudes of the Council's chairman, but itsexistence indicated that economists had acquired anew role. The list of economists serving on theCouncil or associated with it includes some ofthose whose academic work shaped the post-wardiscipline: Robert Solow (1924–), James Tobin(1918–) and Joseph Stiglitz. Similar developmentsoccurred in Britain with the establishment, in 1941,of the Economic Section in the War CabinetSecretariat. After the war, however, the EconomicSection and its successor, the GovernmentEconomic Service, remained small (around twentymembers) until 1964, but by 1970 the numbersemployed had risen tenfold. In both countries therewas also a large increase in the number ofstatisticians as governments became increasingly

involved in the production of national accountsand economic statistics.

Economists were also employed in internationalorganizations. There was a precedent for this inthat the League of Nations and the InternationalLabour Organization (ILO) had both employedeconomists. The League of Nations had sponsoredeconomic research by Haberler and Tinbergen onthe business cycle. After 1945, however, thenumber of such organizations increaseddramatically, and with it the employment ofeconomists. In addition to the ILO (establishedbefore the war) there were the United Nations,which had regional commissions, the InternationalMonetary Fund (IMF), the World Bank (originallythe International Bank for Reconstruction andDevelopment) and the General Agreement onTariffs and Trade (GATT). These were laterfollowed by the Organization for EconomicCooperation and Development (OECD), originallythe Organization for European EconomicCooperation (OEEC), and the United NationsConference on Trade and Development (UNCTAD).

These organizations were largely concerned withpractical policy questions, and economists werenot always influential. However, despite the fact

that the organizations' primary goals weretechnical, economists based in them undertookimportant economic research, including theoreticalresearch, and could make an impact on economicthinking. One example was Jacques Polak (1914–),who at the IMF in the 1950s was engaged ininfluential work on exchange rates and the role ofmoney in determining a country's balance ofpayments. Another was Raúl Prebisch (see pp. 302–3), who at the UN's Economic Commission forLatin America developed a theory about therelationships between industrial and developingcountries.

In its early years the World Bank was concernedmore to establish its credibility as a sound bankinginstitution than with applying economic analysis,with the result that, as in most other internationalorganizations, economists were marginalized. Thissituation did not change until the 1960s, underRobert McNamara (1916–), when between 1965and 1969 the number of economists employed rosefrom 20 to 120. McNamara also encouraged theidea that, because the World Bank's loans wouldalways be small relative to any country's totalinvestment, the dissemination of ideas wasimportant. As a result the importance attached to

economic research increased, and by the early1990s the World Bank employed around 800economists, many doing research comparable withthat done in universities. Nowhere else was theresuch a large concentration of economists. Giventhat these were all working on issues related insome way to development, they had a noticeableinfluence.

Keynesian Economics and MacroeconomicPlanning

These changes in the economics profession wereclosely linked to the spread of Keynesian ideas. Therelationship is, however, not a simple one. Keynes'sGeneral Theory provided an enormous stimulus tothe idea that governments could, and should, takeresponsibility for controlling the level of economicactivity. It was also of great importance to thedevelopment of national-income statistics. Interest-rate policy and changes in government spendingand taxation could be used to keep unemploymentlow. In the 1940s the United States and Britain

both introduced clear commitments to fullemployment. However, it is important not toexaggerate the influence of Keynesian ideas onthese developments. Roosevelt's New Deal, whichbegan four years before Keynes's book waspublished, owed much to Rexford Tugwell (1891–1979), an advocate of economic planning. Theconcept of ‘American planning' was widelydiscussed in policy-making circles during the 1930sas something different from the socialist planningfound in the Soviet Union or Nazi Germany. Equallyimportant, in both the United States and Britain theSecond World War showed that economic planningcould be used to achieve national goals.Economists played an important role in the wareffort, and arguably made a significant contributionto the Allied victory. In addition, a significantnumber of economists (or people whosubsequently entered economics) spent the warworking as statisticians. Although they worked ontechnical problems, such as quality control inmunitions production, making the best use oflimited shipping resources, or even the design ofgunsights, many of the techniques they developedand the attitudes they acquired influenced thediscipline when the war was over.

A further factor was that, although Keynesianeconomics swept through the universities,governments were more resistant. Britainintroduced a Budget organized along Keynesianlines in 1941, and the concept of the inflationarygap – described by Keynes in How to Pay for the War(1940) – was used to calculate how much could bespent without causing inflation, and hence howmuch needed to be taken out of the economy bytaxation or compulsory saving in order to avoidinflation. However, it is arguable that Keynesianideas were not fully accepted in the Treasury until1947. In the United States it was only in the 1960s,under the Kennedy administration, that Keynesianfull-employment policies were systematicallyapplied. In much of continental Europe (notablyFrance and Germany) Keynesian ideas neverdominated the policy agenda.

Macroeconomic planning of the type thatgovernments tried to use during the post-wardecades was made possible by the revolution thattook place in national accounting and the provisionof statistics during the inter-war period and theSecond World War (see pp. 240–45). The use thatcould be made of national-income analysis wasclearly demonstrated by wartime experiences in

Britain and the United States. In Britain, theestimates of national income produced by Meadeand Stone were used to calculate the inflationarygap. In the United States, Kuznets and Nathan usednational income to show that Roosevelt's ‘VictoryProgram’, in which he promised vast increases inmilitary production in 1942–3, was achievable. (Itwas achieved.) After the attack on Pearl Harbor,when the military dramatically increased itsdemand for hardware, Kuznets and Nathan (at theWar Planning Board) continued to apply thesemethods. This time, however, goals had to berevised down, not up. Gilbert, in charge ofnational-income accounts, focused on providingrapidly available information on the state of thewar economy.

The work of Kuznets and Nathan has beendescribed as ‘one of the great technical triumphs inthe history of the economics discipline’.1 They settargets that turned out to be feasible at a timewhen military procurement rose from 4 per cent to48 per cent of US national income in four years.Not only was this an invaluable contribution to thewar effort, it also provided a clear indication ofwhat could be achieved using national accountingas a tool for economic planning. It amounted to

turning military procurement into a science: if toolittle were demanded, war would be prolongedunnecessarily; if too much were demanded, costswould rise without any more being produced.

Keynesian economics and national-incomeaccounting came together in econometric models.During the 1960s, as electronic (mainframe)computers became more widely available, thesemodels grew in both size and sophisticationcompared with the earlier models of Tinbergen (seep. 249) and Klein (see p. 251). For example, in1964 Klein produced a model of the United Statesbased on quarterly data, comprising thirty-sevenequations and estimated using more advancedstatistical techniques than had been employed inhis earlier work. The larger size of the model wasthe result of a much more detailed modelling ofvariables such as consumption (broken down intodurable goods, non-durables and services) andinvestment (where Klein took account ofinventories and new orders). The key development,however, was the Brookings model, first publishedin 1965. This started with around 200 variables,which later increased to over 400, and provided amuch more detailed analysis of the economy thansmaller models could provide. For example, it had

separate equations for automobile sales and forspending on food and drink. Housing wasdistinguished from nonresidential construction,and several industries were analysed. Equallyimportant, it was the result of a collaborativeresearch effort, involving economists from differentuniversities and other institutions. This wasfollowed by a series of other models on a similarscale during the 1960s and 1970s. Unlike theearlier models, several of the new models wereproduced by commercial organizations. As thishappened, the emphasis shifted away fromexploring new techniques and developing newconcepts towards keeping the models up to date sothat they could provide business with the forecaststhat were being demanded. The hope was that, byusing an increasingly detailed model, estimated byever more sophisticated statistical techniques,more accurate forecasts would be produced.Though there were national differences, similardevelopments occurred in other countries.

Though there were exceptions, these modelswere generally Keynesian in their broad structure:aggregate demand for goods and services wasmodelled in great detail, being broken down intovarious categories following the national accounts.

These accounts adopted the Keynesian categoriesof consumption, investment, government spendingon goods and services, exports, and imports. Eachof these was then subdivided into a more detailedclassification. This core, in which national incomewas determined by the level of aggregate demand,was supplemented by other equations to determinevariables such as productive capacity, prices, wagesand interest rates.

A particularly important equation was thePhillips curve. Its author, A. W. Phillips (1914–75),was an engineer who turned to economics at LSEand was responsible for the ‘Phillips machine’, inwhich coloured water was pumped through asystem of transparent tanks in such a way thatflows of water represented flows of income in theKeynesian system. This was ‘hydraulicKeynesianism' in the most literal sense of the term:the metaphor of a circular flow of income wastranslated into real flows of water. Phillips's curve,published in 1958, showed a negative relationshipbetween inflation and the unemployment rate –high unemployment was associated with lowinflation, and vice versa. Because unemploymentcould not fall below zero, however high inflationmight be, and because wages fell by little, even

when unemployment rose to 20 per cent during theGreat Depression, the result was a curve ratherthan a straight line.

Phillips's curve was an empirical relationship thathe found in British data. It was, however, soongiven a theoretical interpretation by Lipsey, who in1960 also provided an interpretation of the curve'sdistinctive shape. His explanation of the curve wasbased on the idea that if supply of any good(including labour) exceeds demand the price willfall, and if demand is greater than supply the pricewill rise. This means that there will be a negativerelationship between wage inflation and the gapbetween supply and demand for labour.Unemployment, when adjusted for so-called‘frictional unemployment' (unemployment thatarises because workers are different from eachother and have to be matched with the right jobbefore they can be employed), was a measure ofthe difference between demand for and supply oflabour.

In the same year, Samuelson and Solow found asimilar relationship for the United States. They alsoargued that the Phillips curve could provide aframework within which to think about economicpolicy. Governments faced a trade-off between

inflation and unemployment, but could usemonetary policy and changes in governmentspending and taxation to achieve the point on thecurve that they preferred. Some governments mightchoose to have low unemployment at the cost of ahigh inflation rate, whereas others might preferlower inflation at the cost of higherunemployment.

Its relevance for policy-making was one reasonwhy economists took up the idea of the Phillipscurve with such enthusiasm. There were, however,two further reasons. The first was that it provided asatisfactory way to ‘close' the macroeconomicmodels that were in use at the time. The IS–LMmodel (see pp. 233–4) had become the standardmodel of how the levels of output and employmentwere determined, but it did not explain the pricelevel. The Phillips curve provided the missing link,completing the model. In so far as they wereconstructed along Keynesian lines, the same wastrue of the large econometric forecasting models:when augmented with a Phillips curve, they couldbe used to forecast prices – something that clearlyneeded to be forecast. The second reason was thatduring the 1960s, as more and more economistshad access to mainframe computers, estimating the

Phillips curve provided an ideal agenda foreconometric research. It was soon found that theoriginal formulation of the Phillips curve did not fitthe data very well, and numerous attempts weremade to improve it by adding new variables andmodifying the form of the equation.

Inflation and Monetarism

The 1960s saw the high tide of Keynesianeconomics. In the United States, under PresidentKennedy, Keynesian policies were used to move theeconomy towards full employment by the end ofthe decade. However, this coincided with theescalation of the war in Vietnam and an enormousrise in military expenditure. In the rest of theworld, too, the late 1960s and early 1970s were aperiod of rapid expansion, and inflation began torise rapidly. The collapse of the Bretton Woodssystem, dating from 1944, which had fixedexchange rates for the previous quarter-century,meant that countries could expand withoutworrying about the effect it would have on their

balance of payments. An important feature of thisboom was a rise in commodity prices. In 1973 theOrganization of Petroleum Exporting Countriescontributed to this rise by successfully reaching anagreement to cut supplies of crude oil in order toraise its price. The Yom Kippur War, between Israeland the Arab states, disrupted oil supplies. Theoutcome was that oil prices rose by 66 per cent inOctober 1973 before doubling again in January1974, and there was an acute shortage of oil.Furthermore, because oil revenues rose morerapidly than oil exporters could spend them, therewas a sudden shortage of demand in oil-importingcountries, which found themselves withunprecedented balance-of-payments deficits. Theworld was plunged into recession.

The novel feature of this depression was thatinflation and unemployment rose simultaneously.The Phillips curve ‘broke down' (the negativerelationship between inflation and unemploymentdisappeared), and Keynesian theory no longerprovided an adequate framework on which policy-making could be based. Rising unemploymentimplied that spending should be increased, buthigh inflation required that it be reduced. A furtherconsequence was that, as the decade went on, it

became clear that the large-scale econometricmodels that were used for forecasting were notperforming well. Something had gone seriouslywrong with the way in which economists wereanalysing current problems. It was under thesecircumstances that the profession took a moreserious interest in monetarism as expounded byMilton Friedman (1912–).

Starting with a widely read article in 1956,Friedman had been trying to revive interest in thequantity theory of money. This theory argued thatthe main factor explaining inflation was increasesin the quantity of money (the stock of currency incirculation plus the stock of bank deposits). Thisran counter to the Keynesian consensus of thetime, which emphasized fiscal rather thanmonetary policy. Friedman sought to prove his casethrough extensive empirical work on therelationship between money, prices and interestrates, culminating in his Monetary History of theUnited States, 1867–1960 (1963), written jointlywith Anna J. Schwartz (1915– ). He argued, inparticular, that the money supply did not respondpassively to other developments in the economy,and that changes in the money supply exerted apowerful effect on the economy. In the short run a

rise in the money supply would raise output, buteventually output would return to its original leveland the only effect would be on the price level.However, it was not possible to use thisrelationship as the basis for controlling thebusiness cycle, because the effects of monetarychanges were felt only after a long andunpredictable lag. If a central bank were to raisethe money supply, the effects might be felt a year,or perhaps two years, later. The conclusionFriedman drew was that the aim of policy shouldbe to prevent money from being a source ofdisturbance, and the way to do this was to ensurethat the stock of money grew at a constant, knownrate.

Against the background of 1968–73, when manygovernments had allowed the money supply toincrease, Friedman's analysis of inflation waspersuasive. Rapid monetary expansion around 1971had been followed, about two years later, by anequally rapid rise in inflation. (Inflation in 1973was clearly linked to the oil price rises of that year,though monetarists could argue that, were it notfor monetary expansion, prices would not haverisen so much.) During the 1970s, therefore,government after government broke with

Keynesianism and implemented targets for thegrowth of the money supply. In some countries,such as Britain, this process was assisted bypressure from the IMF, which had for some yearsbeen working on the links between money and thebalance of payments.

Overturning the Keynesian consensus, however,required much more than this. Three developmentswere particularly important: Friedman'sexpectations-augmented Phillips curve; the failureof Keynesian forecasting models; and rationalexpectations. The first of these – Friedman'salternative to the conventional theory of inflation –was proposed in his presidential address to theAmerican Economic Association in 1967. Hisargument was that the conventional Phillips curvewas incorrectly specified. What mattered to peoplenegotiating over wages was not the money wagerate but the real wage rate – the wage adjusted forthe purchasing power of money. This meant that,when bargaining over wages, people would takeaccount of expected inflation. If people expectedinflation to be 5 per cent, they would requirewages to rise by 5 per cent more than if theyexpected the inflation rate to be zero. The resultwas that, if the inflation rate increased, the Phillips

curve would shift upward by the same amount.This implied that there would be no stable trade-offbetween inflation and unemployment.

Friedman claimed that there was a singleunemployment rate – the natural rate ofunemployment – that was consistent with aconstant inflation rate. He argued that if agovernment tried to peg unemployment at a levelother than the natural rate, the inflation rate wouldrise or fall indefinitely. Low unemployment couldnot be bought at the price of a high inflation rate –only at the price of an ever-accelerating inflationrate, which must, at some point, becomeunsustainable. Governments had to accept that,though they might be able to influenceunemployment for a short period (before peoplerealized what was happening to inflation), theycould not do this for long. Eventuallyunemployment would have to return to the naturalrate. This completely undermined the basis forKeynesian demand-management policy.

It is interesting to note that the authors of theoriginal Phillips-curve theory – Phillips, Lipsey,Samuelson and Solow – had all been well awarethat wage increases would depend on expectedinflation. Their economic theory told them this

very clearly. However, in the late 1960s there wasno such relationship in the data. Inflation was lowand had changed little, with the result that therewas no detectable relationship betweenexpectations and wage increases. They thusdropped price inflation from their equations. By theearly 1970s, however, after inflation rates had risenfor a sustained period, econometric studies beganto reveal a significant effect of expected inflationon wages, and by the mid 1970s the relationshipwas the very strong one that Friedman hadpredicted. This provided empirical support forFriedman's position. From the late 1970s,therefore, economists began to accept that in thelong run the Phillips curve must be vertical – thatthere was no trade-off between inflation andunemployment.

The theory of the expectations-augmentedPhillips curve reinforced Friedman's earlierarguments over the quantity theory. If governmentscould not control unemployment and faced thedanger of accelerating inflation, there was a strongcase for using monetary policy to control the onevariable they could control, namely the rate ofinflation. This doctrine came to be known by aterm coined by Karl Brunner (1916-89), one of its

supporters, as ‘monetarism’. Though this is simply adoctrine about the relationship between moneyand inflation, many of its supporters, such asFriedman, combined it with more general supportfor free markets and non-intervention. ‘Monetarism'therefore came to be associated, especially in theminds of non-economists, with measures such asprivatization, deregulation, income-tax cuts andreductions in social-welfare provision. The meaningof the term became even looser where, as underMargaret Thatcher's government in Britain in the1980s, attempts were made to implement so-called‘monetarist' policies using methods (namely cuts ingovernment spending) that were far removed fromthose advocated by Friedman. By this stage theterm had become almost meaningless.

The New Classical Macroeconomics

In the 1970s, in the wake of the first oil crisis,macroeconometric forecasting models began toforecast very badly. Attempts were made to repairthem, introducing new equations and redesigning

existing ones. However, such attempts were notvery successful. It became clear that, despite theenormous resources that had been put into them,these models did not perform significantly betterthan much simpler ones. An explanation of whythis was so was provided by Robert E. Lucas Jr(1937–) in 1976. The essential argument in whathas come to be called the ‘Lucas critique' is that thebehaviour of the private sector depends on people'sexpectations of what the government is going todo. For example, consumption patterns will dependon the tax and social-security policies thatconsumers expect to face. This means that aconsumption function estimated under one taxregime will no longer work when tax policychanges. Thus, even if forecasting models offeredaccurate accounts of the way the economyoperated when they were built in the 1960s, theywere bound to break down when policy changedduring the 1970s. Lucas concluded that a differenttype of model was required.

In a series of papers starting in 1972, Lucasargued that macroeconomic models ought to bebased on the assumption that individuals werecompletely rational and that they took advantageof all opportunities open to them. He interpreted

this to imply that all markets must be modelled asbeing in equilibrium, with supply equal to demand.If supply were greater than demand, for example,some suppliers would be unable to sell all thegoods they wanted to sell. They would thus havean incentive to undercut their competitors, causingprices to fall, so bringing the market intoequilibrium. To assume that markets were not inequilibrium, therefore, was to assume that peoplewere not being fully rational. Similarly, he arguedthat if people were fully rational, their expectationswould take account of all the information that wasavailable to them. Here Lucas added the novel twistthat modellers should assume that agents in theirmodel know the true structure of the model. Thereare several ways in which this assumption can bejustified, the most convincing of which is theargument that, if they do not do this, agents willmake mistakes and change their behaviour. Theonly possible equilibrium, therefore, is one wherepeople know the true model of the economy.

These two assumptions – known as ‘continuousmarket clearing' and ‘rational expectations' – havedramatic implications. They undermine the idea,basic to Keynesian economics, that people areunemployed because they cannot find work.

Instead it is assumed that, if people would accept alower wage rate, they would find work – that theyhave ‘chosen' to be unemployed, in that they havedecided that the wage they would obtain fromworking is not enough to compensate them for theleisure they would lose. Fluctuations in output andemployment arise because unanticipated shockscause people to make mistakes in their estimates ofinflation. It follows from this that systematicchanges to government policy (such as following arule that says expand the economy whenunemployment is high and contract whenunemployment gets low) will have no effect. Theeffects of such a rule will be predictable and hencewill not affect output. The private sector willdiscount the policy changes in advance.

The business cycle presents a major challenge tosuch a theory. Though precise changes in outputcannot be predicted, the economy generallyfollows a rough cyclical pattern of boom andslump, with the cycle lasting several years. In the1970s Lucas tried to explain this as the result ofmonetary shocks. These would raise or lowerdemand, causing people to make mistakes thatwould cause output to fluctuate around its long-term trend. Much effort was put into measuring

these shocks and explaining how they mightproduce fluctuations similar to those observed inthe real world. Eventually, however, Lucas'sexplanation was abandoned in favour of one whichexplained the cycle in terms of ‘real' shocks –primarily shocks to technology (new inventions andso on). The result was the ‘real business cycle'theory first proposed by Fynn Kydland (1943– )and Edward Prescott (1940– ). This was based onthe same assumptions as Lucas's theory – notablycontinuous market clearing and rationalexpectations – but differed in its assumptionsabout the source of shocks to the system and useda new set of econometric techniques (so-called‘calibration' methods).

Though many economists remained scepticalabout the extreme policy conclusions reached bywhat came to be called the ‘new classicalmacroeconomics’, the main thrust of the newclassical argument – that economic models shouldassume fully rational behaviour – came to bewidely accepted. Keynesians, who in the 1970s hadbeen exploring models where markets weregenerally out of equilibrium and traders facedrationing, changed their research strategy. Theystarted to search for explanations of

unemployment that did not violate the assumptionof rationality. They built models using assumptionssuch as asymmetric information (where firmscannot tell how productive a worker will be untilafter he or she has been hired) or imperfectcompetition (where firms or unions have power toinfluence the prices at which they buy or sell).These models were based on the main new-classical assumptions, but produced Keynesianconclusions.

The main reason why the new classicalmacroeconomics had such a big impact was that itwas in many ways a natural development fromwhat had been happening in microeconomics sincethe 1930s. There were two elements to this. Thefirst was ever greater mathematical rigour in theanalysis of problems. Enough simplifyingassumptions were made to permit rigorousmathematical techniques to be applied to whateverproblem was being analysed. The second was themodelling of individual behaviour in terms ofoptimization – assuming that firms maximizedprofits and individuals maximized utility. In such aworld, everything rested, in the last resort, ontechnology and individual tastes. One result of thiswas that the distinction between microeconomics,

dealing with the behaviour of individual firms andhouseholds, and macroeconomics, dealing with theeconomy as a whole, was broken down.

Development Economics

A field that exhibits certain parallels withmacroeconomics is development economics. Thisemerged in its modern form after the Second WorldWar. The United States – then clearly the dominantWestern power – was anti-colonialist, and from the1940s many colonies began to achieveindependence, receiving a political voice throughthe United Nations. As a result the ‘colonialeconomics' of the inter-war period, with its stresson the development of resources by colonialpowers, was clearly out of date. Attention had alsobeen focused on the economics of underdevelopedcountries during the war. Paul Rosenstein-Rodan(1902–85) had tackled the theory ofunderdevelopment, focusing on south-easternEurope. The statistical work of Colin Clark andSimon Kuznets revealed, for the first time, the

extent of income differences between rich andpoor countries. Finally, governments in NorthAmerica and western Europe were taking an activeinterest in measures that might be taken topromote growth (and capitalism) in the rest of theworld, partly in response to competition with theSoviet Union. Various agencies associated with theUnited Nations had a commitment to economicdevelopment from the start, and when Europeanreconstruction was completed, the World Bankbecame concerned just with development. TheOrganization for European Economic Cooperation(OEEC) became the Organization for EconomicCooperation and Development (OECD).

There were strong links between Keynesianeconomics and early theorizing on problems ofdevelopment. Keynesian economics was based onthe presumption that economies could get stuck insituations of mass unemployment orunderemployment (where workers have jobs butare not fully employed) from which they could notescape unaided. Underdeveloped countries weresimilarly thought to have become stuck insituations from which they needed assistance toescape. (The term ‘underdeveloped countries' isused here as it was the one used at the time. Since

then, a series of euphemisms for poor countries hasbeen used: ‘underdeveloped countries’, ‘lessdeveloped countries’, ‘developing countries’,‘emergent nations’, ‘the Third World' and, mostrecently, ‘the South’.)

There were several theories about why this wasthe case. One of the most common focused on thedifference between economy-wide growth andgrowth in a single sector of the economy. If asingle industry (or a single business) were toexpand, it would soon come up against barrierssuch as a lack of demand for its products andshortages of skilled labour. In contrast, if it werepossible to engineer an expansion of the wholeeconomy, each industry would create demand forother industries' products and would contribute tothe growth of a pool of skilled labour on which allindustries could draw. Such thinking underlay thetheories of Rosenstein-Rodan, economic adviser tothe World Bank in its early years, and RagnarNurkse (1907–59), an economist at the League ofNations who, after the war, became an advocate ofthe need for balanced growth.

Not all explanations of underdevelopment wereof this type. At the UN Economic Commission forLatin America, Raúl Prebisch (1901-86) explained

the contrast between rich and poor countries asbeing the outcome of unequal interaction betweena ‘core' of industrial countries, exporting mainlyindustrial goods, and a ‘periphery' of poorcountries, whose main exports were primarycommodities. Because workers in industrialcountries had great bargaining power, productivitygains led to rising real wages. In contrast, workersin underdeveloped countries did not have suchbargaining power and so were unable to translateproductivity gains into wage rises. Instead, wagesstayed the same and prices fell. This difference ledto primary commodities becoming ever cheaper inrelation to industrial goods. The terms on whichtrade took place thus became more and morefavourable to industrial countries, and it becamemore difficult for countries in the periphery toescape from poverty. Prebisch drew the conclusionthat development required state intervention todevelop industries (protected by tariff barriers) thatwould compete with goods currently beingimported – a strategy of ‘import substitution’.

Other economists produced theories of ‘dualistic'development. Arthur Lewis (1915–91), for example,distinguished between a modern sector in whichfirms maximized profits and used mechanized

production methods and a ‘traditional' sector inwhich family relationships ensured that everyonewas employed on the land, even if their presencedid not raise output. Economies that were splitbetween sectors in this way were characterized bysurplus labour in the traditional sector. Economicdevelopment involved the growth of the modernsector. Labour moved out of a sector in which itsproductivity was zero into one where it wasproductive.

Few of these theories went unchallenged. ‘Big-push' balanced-growth theories, for example, werevigorously challenged by Albert Hirschman(1915–), who argued that development requireddisequilibrium – unbalanced growth. Expansion ofa single industry would create opportunities forother industries and would promote thedevelopment of new activities. Prebisch's theorieswere also challenged. There was a vigorous debateover whether statistical evidence supported theclaim of a falling trend in commodity prices.Dualistic theories were vulnerable to the chargethat it was in practice very difficult to identifysectors that were as different as the theoriesrequired.

The common feature of these theories is that

they were ‘structural' theories. They attributed theproblem of underdevelopment either to thestructure of the economies themselves or to thestructure of the world economy. These structuralfeatures meant that the market mechanism would,on its own, be insufficient to ensure development.Planning and state intervention of some kind werea necessity. This fitted in with the Keynesianperspective in two ways. The first was thatdifferent types of theory were seen as being neededfor different problems. Just as macroeconomicswas needed as a subject distinct frommicroeconomics in order to tackle problems ofunemployment, so development economics wasneeded to deal with problems specific tounderdeveloped countries. The second was that itwas believed that markets could not be left alone –that government intervention was necessary ifmarket economies were to operate in a beneficialway.

In the 1970s, however, this way of thinkingabout development fell out of favour. Attempts toplan development – whether they involved importsubstitution, export promotion, balanced orunbalanced growth, or the creation of disequilibria– were not particularly successful. It also became

increasingly clear that ‘developing' countries werefar from homogeneous – sub-Saharan Africa hadproblems that bore little if any relationship tothose faced by South-East Asia or Latin America. Ithad become apparent that economic growth didnot automatically reduce poverty. The result mightsimply be the emergence of an affluent modernsector amid poverty that was as great as before, oreven greater. There was also an ideological shiftagainst planning and in favour of solutions thatplaced greater emphasis on markets. The successstories of economic development were seen asarising from free-market economies such as thoseof Singapore, Taiwan and Korea (even though thesehad strong and authoritarian governments thatintervened actively in industry). The assumption,central to many structural theories of development,that people in developing countries behaved insome way differently from people in developedcountries became harder to sustain. The result wasan increasing tendency to apply to problems ofdeveloping countries the same analyticaltechniques as were being used to analyse problemsof developed countries. Everyone, whether rich orpoor, was assumed to behave according to theprecepts of rational behaviour.

There was therefore a significant change in theway in which development was tackled in the1970s. Grand theories, often based on Keynesianmacroeconomics, increasingly gave way tomicroeconomic theories in which prices played amuch greater role. In 1969 Ian Little and JamesMirrlees (1936–) produced for the OECD a manualon project evaluation that presented techniquesthat were widely used. It was argued that projectsshould be evaluated not on the basis of marketprices, which might be seriously distorted, but onso-called ‘shadow prices' that reflected theconstraints facing developing countries. In a similarvein, the concept of effective protection, firstdeveloped in the 1960s, came into morewidespread use. Economists also focused more onthe concept of poverty, seeking better ways tomeasure it. ‘Basic needs' indices, taking account offactors such as nutrition levels, mortality andliteracy rates, became more prominent. Economicgrowth, though still important, was no longer thesole criterion by which development wasmeasured. The theoretical tools used were, as inmacroeconomics, increasingly those ofcontemporary microeconomics. For example, in the1970s development economists took up models of

risk and incomplete information. In the 1980s,again following macroeconomics, these wereextended to include imperfect competition and thelatest developments in growth and trade theory.Parallel changes took place both in academia andin international organizations, though there was nouniformity, even among the latter. For example, inthe 1970s the OECD and UNIDO (the UN IndustrialDevelopment Organization) took up Little–Mirrleesmethods of project appraisal and cost-benefitanalysis, but the World Bank did not.

One of the main developments during the 1980swas the increasing prominence of the World Bankin setting the agenda for development. In 1980 itabandoned its earlier policy of lending only tofinance specific projects and introduced ‘structural-adjustment lending’. This was lending designed tohelp countries get over medium-term balance-of-payments problems without impeding growth.Loans were made on condition that the borrowingcountries implemented a programme of reform,including measures such as allowing exchange ratesand interest rates to be determined by worldmarkets, reducing the size of the public sector,deregulating markets, and removing controls oninvestment. This was based on the so-called

‘Washington consensus' – the idea thatdevelopment required free markets and a trade-oriented development strategy. The debt crisis ofthe early 1980s worsened the situation for manydeveloping countries, and the World Bank'sinsistence that lending be accompanied bymeasures to liberalize trade and capital flows andopen up domestic markets became a major issue.Critics of the World Bank argued that structural-adjustment policies served to place the burden ofadjustment on the poor in developing countries, forthe result would frequently be unemployment andcuts in public services. Supporters focused on theneed for such reforms if developing countries'problems were to be solved.

The context of development economics changedeven more dramatically with the fall of the SovietEmpire in 1989–91. Economists – including bothacademics and those in international organizations– turned on a large scale to problems of ‘transition'and ‘emerging markets’. The establishment ofmarket economies in eastern Europe and theformer Soviet Union had clear parallels with thesituation of ‘traditional' developing countries facingstructural adjustment. It was believed that, in thelong run, the establishment of a market economy

would raise living standards, but the short-termeffects were high unemployment and extremepoverty alongside extreme affluence.

Conclusions

After the Second World War, economics became amuch more technical subject, and mathematicaltechniques were systematically applied to all itsbranches. This was not a neutral development, butwas accompanied by a transformation of thesubject's content as theories were refined in such away that they could be treated using the availablemathematical tools. The meaning attached even tosuch basic terms as ‘competition’, ‘markets' and‘unemployment' changed. These developmentswere something that could happen only in anacademic environment, for many theories weredeveloped that had only tenuous links, if any, withreal-world problems. Comparisons with ‘basic' or‘blue-sky' research (not aimed at any specific use)in science and medicine were used to justify suchinquiries.

At the same time as economics became moretechnical, it also became more international.(Cause and effect are hard to tie down, but therewere many causes of internationalization otherthan the spread of mathematical techniques.)While there are still many economists who can beidentified with a single country, there are manywho cannot. It became common for an economistto be born in one country, to study in anothercountry (or in two other countries), and to spendhis or her career moving between institutions in avariety of other countries. Communicationnetworks have also become international. Theresult is that the nationality of economic ideas hasbecome harder than ever to pin down – there is areal sense in which it has become a meaninglessconcept. Economic ideas have become essentiallyinternational. Even where schools have retainednational labels (such as ‘Austrian' economics) theyhave become international.

The country at the centre of this process was theUnited States. Universities, even in countries withlong-established academic institutions, such asGermany and Britain, have increasingly modelledtheir graduate teaching on the US model. Americantextbooks have been widely used in all countries.

American criteria for academic advancement,emphasizing the publication of articles in learnedjournals, have become widespread. In addition,because of the sheer size of the US academicsystem, American economics has increasinglydominated the pages even of European academicjournals. Americans clearly dominate the list ofNobel Prize winners, and have been responsible forthe most influential new ideas in the subject. Theprocess therefore seems to be one ofAmericanization rather than internationalization.However, against this has to be set the fact that theideas on which the current consensus is based havesignificant European roots: mathematicaleconomics in German mathematics of the 1920s;econometrics in Tinbergen's work in theNetherlands; and macroeconomics, throughKeynes, in Cambridge, England. In addition, one ofthe reasons for the apparent American dominancehas been the migration of economists from Europeand elsewhere in the first half of the twentiethcentury (see p. 207). Many of the key players in thetransformation of the subject came from German-speaking countries or eastern Europe. If economicshas been Americanized, there is a sense in whichthis is because the American academic system has

been so large, so wealthy and so open tointernational influences.

This, however, is only one side of the story ofeconomics becoming more technical. The other isthe increased involvement of economists ingovernment, international organizations andbusiness. Economists have come to be seen astechnical experts whose advice is essential todecision-making – a process greatly stimulated bythe Second World War. This has gone beyondsimply forecasting, though that remains important.Especially in the United States, where the processhas perhaps gone further than elsewhere,economists are regularly used in tasks such asdesigning the rules by which industries are to beregulated or the procedures by which franchises areto be sold. During the 1990s they were heavilyinvolved in designing measures to protect theenvironment. In some fields, ideas were developedin academia and then applied by economistsworking in government or business, as one mightexpect. However, this simple relationship is notalways found. Macroeconomics and developmentare two fields where it is hard to draw a clear linebetween research done in academia and researchdone in government, central banks and

international organizations. Research in these fieldshas been dominated by policy problems, and therehas been continual interaction between economistsin universities and in other organizations, withmany staff moving back and forth betweendifferent types of institution. There has thereforebeen a convergence between, for example, theways in which central banks and academiceconomists think about monetary policy, and inways of tackling economic development.

The academic environment, dominated by theUnited States, in which economic ideas weredeveloped in the second half of the twentiethcentury is very important. The way in whicheconomic thought developed during this periodcannot be understood apart from it. However, therole of economists as policy advisers should not beneglected, especially in particular fields.

14

Expanding the Discipline, 1960 to the Present

Applied Economics

As economics has become more technical andeconomic theory more abstract and mathematical,applied fields have proliferated. Writing in the1940s, Schumpeter distinguished between fivetypes of applied field. The first type comprisedfields such as money and banking that were widelyconsidered part of general economics but weretaught separately so that they could be treated inmore detail. A second type included fields such asactuarial science and insurance that were separatefrom economics for purely historical reasons. Thethird included fields based on public policy, suchas agriculture, labour, transport and public finance.The last two comprised a mixture of fields such associalism and comparative economic systems andarea studies. Reflecting on this, he commented:There is evidently no permanence or logical order to this jumble ofapplied fields. Nor are there definite frontier lines to any of them.They appear or vanish, they increase or decrease in relative

importance, and they overlap with one another as changinginterests and methods dictate. And… this is as it should be.1

It would be possible to make very similarremarks about the situation at the end of thetwentieth century. However, in the second half ofthe century the situation had changed in severalways. One was that the division of the subject intoapplied fields became institutionalized. Appliedfields ceased to be simply convenient labelsattached to courses offered to students, but beganto be reflected in the way in which the professionwas organized. Much more than in the 1940s, theyacquired their own societies, conferences andjournals. The most obvious sign was theproliferation of specialist journals. Economistsworking within applied fields began to talk muchmore to each other rather than to economists ingeneral.

However, a second development was thateconomics came increasingly to be viewed ashaving a theoretical ‘core' that is applied todifferent problems. The core comprises micro- andmacroeconomics, which are then applied – alongwith econometrics (seen primarily as a body ofstatistical techniques) – to problems such as

labour, development, money, the public sector andso on. This hierarchy is reflected in the fact thatmost degree programmes will require training incore subjects, but will allow students to choosewhich applied fields to study. This developmenthas had two effects. It provides a much clearerbasis for applied fields than was available in the1940s, when the distinction between the core andapplications was much less clearly defined. At thesame time it unifies the subject in a specific sense.Because applied fields have increasingly been basedon a common core – especially since the 1970s,when the distinction between ‘micro' and ‘macro'was significantly reduced – there is a level at whichall economists can speak to each other, whateverfield they specialize in. It could be said thateconomists speak different dialects of a sharedlanguage.

The histories of these applied fields are varied.Some fields are clearly linked to outside, politicaldevelopments. In the era of the Cold War,‘comparative economic systems' had a clear role. Itowed much to the earlier ‘economics of socialism’,a field whose history went back to the nineteenthcentury, but it was far from identical with it. Withthe collapse of the Soviet Empire around 1990 and

the extension of market activities in China, thecapitalist system appeared, at least to mosteconomists, to have won. Comparative economicsystems, focusing on the choice betweencapitalism and socialism, had lost its raison d'être,even if there remained more subtle differencesbetween different types of socialist and capitalistsystems that remained to be understood. It gaveway to the economics of transition and emergingmarkets. In contrast, the history of laboureconomics probably exhibits greater continuity,with problems such as wage determination and theorganization of labour markets being of perennialconcern. A technical field such as econometrics hasno doubt emerged as a separate field because ofthe specialized range of mathematical techniquesemployed: a large investment is necessary to learnthem. Though external political or ideologicalchanges have had an impact, for example inchanging the type of questions thateconometricians have been expected to answer,these are probably less important in econometricsthan in less technical fields of economics.Developments in information technology haveprobably been the main external factor influencingthe recent history of econometrics, for modern

computing has opened up possibilities about whichearly econometricians could only dream.

Economic Imperialism

A significant development, especially in the 1960sand beyond, was the development of applied fieldsthat extended the boundaries of economics.Economic analysis was applied to problemspreviously considered to lie in the realm of othersocial sciences, notably sociology and politicalscience. Gary Becker (1930–) has applied standardprice theory to, among other sociological topics,crime and the family. Criminal activity is modelledas an optimization problem in which potentialcriminals weigh up the gains to be obtained fromsuccessful crimes against the potential losses theywould incur in the event of being caught andconvicted. Given that, even if they are guilty, theyare not certain to be caught and convicted, this canbe formulated as a standard problem of choiceunder uncertainty. It is possible to use such modelsto decide, for example, how effective increased

sentences are likely to be in deterring crime. Similarmodels can be used to analyse decisions within thefamily, such as the circumstances under whichhusbands or wives are more likely to go out towork, and even whether changes in economicfactors will raise or lower the chances of couplesdeciding to marry or to divorce. Thesedevelopments have led to economists becomingthe butt of many jokes, such as in an article on theeconomics of brushing teeth which parodiedBecker's method of analysis.2

Another applied field that has extended theboundaries of economics is public-choice theory.Although this field has origins that go further back,in particular to the theory of voting and Arrow'simpossibility theorem, it originates with the workof Buchanan, Tullock, Downs and Olson around1960. This applied standard economic techniquesto decisions by governments and bureaucracies.Voters, politicians and bureaucrats were allassumed to be rational agents who maximized theirown utility. Inability to monitor their actionsperfectly and the impossibility of designingcontracts that covered every eventuality gave riseto the possibility of government failure. Theseideas, however, did more than add a new topic to

existing courses in microeconomic theory. ‘Publicchoice' developed as an identifiable applied field,and in the 1970s it acquired its own scholarlysociety and journal. It went off in new directions.There were several reasons for this. The fact thatthe two most influential public-choice theorists,Buchanan and Tullock, were to the right of thepolitical spectrum may have helped them obtainfunding more easily than might otherwise havebeen the case. Probably more important, however,was the fact that they preferred verbal argumentsto mathematical models. This set them apart fromthe bulk of the profession and may, at least in part,explain why they found it difficult to get their workpublished in the major journals. Once regularconferences, graduate programmes and specialistjournals were established, it became possible forpublic choice to develop in ways that would nototherwise have been possible.

This type of imperialism raises difficult questionsabout where the boundaries of economics shouldbe drawn. Should rational-choice sociology, whichhas affinities with Becker's work, be regarded aseconomics? Should public-choice theory beregarded as political science? In themselves, thesequestions are not interesting. The boundaries of

academic disciplines are artificial constructions.However, the fluidity of the boundaries of moderneconomics echoes similar changes that have takenplace over the history of the subject. For most ofthe period covered by this book, economics did notexist as a distinct discipline. Early chapters traceideas about questions that we now define as‘economic' in writings on law, philosophy andtheology. Even after the subject emerged, inEngland, as a distinct body of ideas around thebeginning of the nineteenth century, its boundariesremained very fluid. They could hardly beotherwise when the identities of ‘neighbouring'disciplines (such as psychology, sociology,geography and political science) were also notclear.

The process of differentiation continuedthroughout the twentieth century as newdisciplines and new fields in economics emerged.The development of management science raised afresh set of boundary questions. For example,personnel management – now clearly located inmanagement – was at one time considered part ofeconomics. Another example is economic history,settled uneasily on the boundaries of economicsand history, with its place influenced by

institutional factors as well as by intellectualdevelopments. In the field of development,economics, politics and sociology continuallyconfronted each other. (Hirschman described hiscareer as involving ‘crossing boundaries' and‘trespassing’.)3 Demography, associated witheconomics since Petty and Graunt, has almostdropped out of the discipline, even though itthrives. New developments such as public-choicetheory and rational-choice sociology continuallychallenge conventional assumptions about whereboundaries should be drawn.

Many of these are developments of which manyother social scientists have been critical.Economists have spoken of economics as the‘hardest' of the social sciences (on account of itsuse of rigorous mathematical theory, comparablewith that used in physics) or as the ‘queen of thesocial sciences’. The response to this has been toregard economists as arrogant and imperialistic.

Heterodox Economics

The last quarter of the twentieth century sawenormous homogenization within the mainstreamof economic thought. When economics becameprofessionalized towards the end of the nineteenthcentury, there was still great variety within thediscipline. It encompassed historical economics(especially in Germany), a wide variety ofinterpretations of marginalism (from themathematical approach of Walras and Fisher to theless mathematical and very different approaches ofJ. B. Clark and the Austrians), Veblen's evolutionaryeconomics, and Commons's law-based institutionaleconomics. The historian may look back and saythat these were all ‘economics' in some sense, butit is hard to claim that this plethora of approachesrested on a single foundation. The differencesbetween, for example, Fisher, Commons andVeblen were simply too great.

In the second half of the twentieth century,however, this began to change. On the basis ofdevelopments that took place during the 1930s –notably new ways of modelling individualbehaviour and Keynesian macroeconomics – therange of approaches began to narrow significantly.Most noticeably, historical economics was eitherassimilated (it became applications of standard

economics) or pushed aside into other fields, andinstitutionalism withered away as a significantforce in the discipline. However, there was still nouniform approach to the subject. It was acceptedthat general-equilibrium theory – the dominantparadigm in microeconomics – could not explaineverything. As a result, Keynesian macroeconomicsand development economics were regarded asdistinct, each being appropriate to its distinctivesubject matter. Even industrial economics, centredon the structure–conduct–performance paradigm,developed as a partly autonomous, empiricallydriven discipline.

From the 1970s, however, with the waning ofKeynesianism, this too began to change. There wasa narrowing of the subject as field after field cameto be based on rigorous rational-choicefoundations. The mathematical level of thediscipline moved up a step. For most of theprofession, increasingly dominated by those trainedafter 1950, who took for granted the need formathematics in economics, these changesconstituted progress. Even when economistsdisagreed with the assumptions being made (forexample, those underlying the new classicalmacroeconomics), most of them could accept the

principle that more rigorous theorizing wasessential. There were, however, minorities whosedissent remained more radical.

Some dissenting groups have a long history.Marxist economics, sustained by its politicaldimension, goes back to the nineteenth century.American institutionalism never completely diedout. John Kenneth Galbraith (1908–), whose TheAffluent Society (1958) offered a withering critiqueof consumerism and the role of large corporationsin American society, fits into the institutionalisttradition. However, though he became president ofthe American Economic Association, and thoughhis books were best-sellers, his ideas were nevertaken seriously by the majority of the profession.(In 1950, on the eve of what became known as theGerman economic miracle, he told the AmericanEconomic Association that removing price controlswould wreck the German economy.) In the 1970s,however, the coalescing of economics around acentral core stimulated the rise of new ‘heterodox'groupings that brought together economists whofelt that their ideas were being systematicallyexcluded from the profession's main journals. In1973 Alfred Eichner (1937–88) and Jan Kregel(1944–) argued the case for a ‘post-Keynesian'

alternative to orthodox economics. This was tointegrate Eichner's theory of oligopoly pricing withKeynesian economics as interpreted in particular byJoan Robinson. She had never accepted the IS–LMinterpretation of the General Theory, and in herlater career she repudiated her earlier work onimperfect competition, along with neoclassicaleconomics, as paying insufficient attention toproblems of time and uncertainty. Usingterminology from the historian of science ThomasKuhn (1922–96), Eichner and Kregel argued thatpost-Keynesian economics offered a new paradigmfor the subject: a radically new conceptualframework within which to think about economicproblems.

Another dissenting movement that emerged atthis time was ‘radical economics’, established afterthe 1968 meeting of the American EconomicAssociation. This grew out of disillusion with theAmerican Establishment and opposition to theVietnam War. Radical economics had much incommon with Marxist economics, in that itemphasized exploitation, discrimination and theinequalities produced by American society, andwas critical of the role of the military in theAmerican economy. However, it did not commit

itself to the Marxist theoretical framework, andsought new ways to analyse these issues. Like post-Keynesian economics, it became established as anidentifiable group (the Union of Radical PoliticalEconomy) within the profession.

At around the same time, ‘Austrian' economicsbegan to coalesce into an organized, heterodoxschool of economics. A conference in 1974brought together a wide-ranging group ofeconomists, united in finding inspiration in thework of Carl Menger and his followers, in particularMises and Hayek, who had been marginalized bypost-war developments. Politically, the Austrianswere conservative (in contrast with the radicals andpost-Keynesians, who identified clearly with theLeft), and they had considerable success in raisingprivate funds. They emphasized methodologicalindividualism (the doctrine that economic theoriesshould be based on theories about individualbehaviour), and they viewed individuals aseconomizing (making choices in response to theprices and opportunities they faced). However, likeMenger, they refused to model this usingmathematics, preferring to rely on verbal logic.They took up Hayek's view, which had dropped outof orthodox economics, of competition as a

dynamic process – a discovery procedure – viewingthe market as a means for disseminatinginformation in a changing, uncertain world.

One of the main reasons why heterodox groupsbegan to organize was the perceived trend towardsgreater homogeneity of the mainstream. In anenvironment where academic economists wereunder continual pressure to publish, economistswith unorthodox views felt threatened, andorganization was important for their survival. Thatthey were able to organize was a result of theprofession having become sufficiently large that itcould accommodate dissenting groups. Dissenterswere not spread uniformly across universities, butrelied on particular institutions for support.Chicago (with Friedman, George Stigler (1911–91),Becker and Lucas) was the centre of orthodox free-market economics, and Yale, Harvard and MIT(Massachusetts Institute of Technology) were thecentres of orthodox Keynesianism. Public-choicetheory (close to being heterodox, though not quitedeserving of the label) was centred in Virginia, andAustrian economics in the New York and Auburnuniversities. The variety of the American universitysystem was vital.

New Concepts and New Techniques

At the same time as self-styled heterodoxeconomists were trying to break loose from whatthey saw as the stranglehold of an increasinglyentrenched orthodoxy, that orthodoxy began tochange. New concepts and new techniques weredeveloped, and these enabled economists to tackleproblems that had previously been consideredbeyond formal economic analysis. Many of thesedevelopments are too recent for it to be possible toassess their long-term significance in any detail, butit is nonetheless important to consider them. Theyillustrate the great variety of ways in which theboundaries of economics are being extended. Moreimportant, they show how strands in what isconsidered mainstream or orthodox economicshave abandoned what were previously consideredto be central elements in orthodox theory. Forexample, at one time it would have been said thatorthodox ‘neoclassical' economics assumed perfectinformation. However, from the 1960s evenChicago economists – notably Stigler – began towork with theories in which agents had onlyimperfect or limited information about theirenvironment. These developments explain why it is

that many economists fail to recognize the picturepainted by ‘heterodox' economists of a disciplinedominated by a monolithic orthodoxy.

The first example is the set of developmentscentred on the concept of transaction costs.Transaction costs are the costs of transferringownership from one person to another. They arisefor many reasons:The parties to a contract have to find each other, they have tocommunicate and to exchange information. The goods must bedescribed, inspected, weighed and measured. Contracts must bedrawn up, lawyers may be consulted, title is transferred andrecords have to be kept. In some cases, compliance needs to beenforced through legal action and breach of contract may lead tolitigation.4

The term ‘transaction cost' was first used byMarschak in 1950, but the idea has a long history.Economists frequently referred to ‘frictions’, andused the metaphor of money being the oil thatreduces such frictions. In the 1920s Commonsargued that transactions (which he defined verybroadly, to include much more than the exchangeof goods and services) should form the focus ofeconomists' attention. In 1937 Coase argued thattransaction costs could explain the existence andsize of firms. Coase pointed out that activities

could be organized in two ways. One is through themarket. The other is by management within a firm.Both methods involve transaction costs, but thecosts are different. He then argued that theboundary of the firm – the dividing line betweenactivities organized managerially and those that areorganized through the market – should be the onethat minimizes transaction costs. In other words,transaction costs explain why firms should exist(why some transactions are undertaken outside themarket) and why the economy is not organized asone giant firm (a centrally planned economy). Itwas not until around 1970 that economists beganto see the significance of Coase's idea. OliverWilliamson (1932–) and others began to find waysto make the idea of transaction costs operational.They used it to answer questions such as whycertain industries are vertically integrated (thesame firms control the supply of materials,production and distribution) whereas others arenot.

The significance of this idea was that it offeredan alternative to the conventional theory of thefirm. The traditional view saw the firm as atechnical unit for transforming inputs into outputs.Its size was determined by technology – steel firms

are large because production costs are lower forlarger firms than for smaller ones, whereasgreengrocers can be small because small shops canbe as efficient as large ones. Coase, instead, sawthe firm as an organization or, as Williamson put it,as a governance structure. This is, of course,obvious. However, it was not until Coaseintroduced the idea of transaction costs thateconomists had any way in which to analyse this.Many economists had studied the organization ofindustry (a classic example is Marshall's Industry andTrade, 1919), but such work was largelydescriptive. Economists had not found a theoreticalframework that could explain why industries wereorganized as they were. ‘Industrial organization'existed as a field within economics, and courseswere taught, but they focused on problems such asmonopoly, regulation and anti-trust laws. Theytook the way industry was organized as a datum.

As reinterpreted by Coase, Williamson andothers, the theory of the firm becomes a theoryabout the efficiency of different types of contract.This is an example of a much broader problem –the economic analysis of the law. This field –usually known as ‘law and economics' – began todevelop in its modern form in the mid-1960s. A

1960 article by Coase on social cost5 argued thatthe establishing of property rights (a legal question)was crucial to any efficient solution of externalityproblems. He analysed how the courts in Britainand the United States had tackled the problem,claiming that the way in which judges hadinterpreted phrases such as ‘reasonable' and‘common or ordinary use' frequently reflectedeconomic considerations. Property rights were alsoanalysed by Armen Alchian (1914– ) and HaroldDemsetz (1930– ). Another dimension wasprovided by work on torts, such as that by GuidoCalabresi (1932–). Though it remained distinct, thiswork fitted well with the emerging field of public-choice theory.

Although it provoked much empirical research,the concept of transaction cost was a theoreticalinnovation – a new way of thinking abouteconomic phenomena. In contrast, experimentaleconomics involved the creation of a new empiricalprocedure whereby economic theories could betested. Like the concept of transaction costs, it hasa long history. Psychologists have always usedexperiments to establish and test theories aboutbehaviour, and economists followed suit. Themodern literature on the subject dates from the

1930s and 1940s, and the early work addressedseveral types of problem. The earliest was the useof experiments to determine consumers'preference. In 1931 L. L. Thurstone (1887–1955)did this by asking subjects, repeatedly, to choosebetween alternative bundles of goods. This wasstrongly criticized (subjects were not making realchoices), but in the early 1950s other economistscontinued this type of study. A second type ofwork was the use of experiments to find out howmarkets operated. In 1948 Chamberlin constructedan experiment to find out whether a group ofsubjects would hit on the competitive-equilibriumprice at which supply equalled demand.

Interest in both types of experiment increasedsignificantly after the publication of von Neumannand Morgenstern's 1944 book on game theory (seep. 263). During the 1950s and 1960s, however –even though some influential results werediscovered, and systematic attention began to bepaid to questions of how experiments should beconducted experimental economics remainedsmall-scale. In the 1970s the subject attractedmore funding, including support from the NationalScience Foundation in the USA, and it grew rapidly.By the end of the 1980s it had become a generally

recognized (if still controversial) way to doresearch in economics, and by the end of the 1990sit had entered the mainstream, in that it wasdiscussed in introductory textbooks. It had ceasedto be an activity undertaken only by specialists.

The significance of experimental economics istwofold. It provides a way to test economictheories in a manner that had previously beenthought impossible. Unfortunately, as far as manyeconomists are concerned, it suggests that some ofthe fundamental assumptions made by economists,such as utility maximization, are probably false.Experimental evidence suggests that people do notbehave as they would if they were maximizingutility. Some economists have responded bydeveloping theories of decision-making thatreconcile experimental results with utilitymaximization. Others simply ignore such results,sometimes expressing scepticism about whetherthe artificial conditions of the laboratory (ofteninvolving students playing abstract games ofchance to earn small sums of money) reflect real-world situations.

Experimental economics has also provided a wayto try out alternative ideas about how institutionsshould be designed. For example, much work has

been undertaken on auctions. When it wassuggested that the winners of competitive tendersfor oilfields systematically earned low returns,experiments were able to confirm the phenomenonof the ‘winner's curse’. The idea behind this is that,if firms are bidding for oil rights or some otherasset whose value is unknown, the winner willtypically be someone who has overestimated theasset's value. This provides bidders with anincentive to be cautious in their bids. This is therationale for awarding contracts to the second-highest bidder: knowing that a bid will besuccessful only if one other bidder is willing to paymore makes it safer to put in a high bid. Auctiondesign has been an area where experiments haveproved useful in testing ideas that economictheorists have produced.

Experimental economics requires organizationand resources. (It is now generally considered thatreal money has to change hands if experimentalsubjects are to behave as they would in real life.)The establishing of the field in the 1980s and1990s is therefore to be explained in terms of thesociology of the profession. However, there is inprinciple no reason why it could not have emergedmuch earlier had economists been less suspicious

of such work.In contrast, modern econometric methods would

have been impossible without recent technologicaldevelopments. The availability of cheap, powerfulcomputers has been crucial to the transformationof the statistical techniques available toeconomists. Many of the estimation methods andstatistical tests that have proliferated in the pasttwenty years would have been inconceivablewithout modern computers.

The use of computers has also produced datathat would have been impossible to imagine eventen years ago. For example, the computerization oftrading in financial markets means that it ispossible to monitor stock prices and individualtransactions minute by minute. The result is datasets that contain enough information to study thedetailed operation of these markets, such as theway in which news affects prices. The use of neweconometric techniques and the availability oflarge data sets have transformed empirical researchin this area. Similarly, computers have made itpossible for labour economists to study samples ofthousands of individuals. Using such large datasets, economists can calculate things such as theeffect on employment of a change in

unemployment benefits while controlling for theeffects of differences in personal characteristics(gender, education, health and employmenthistory, and so on).

Economics in the Twentieth Century

In 1912, Schumpeter summarized contemporarydevelopments in economics in the following words:The more we approach modern times the less possible it becomes tocharacterize briefly the wealth of currents and cross-currents andthe more untrue, forced and misleading appears any systematicarrangement and grouping… We must add that hand in hand withthe progressing specialization resulting from the increase of thesubject-matter and from the advances in analysis, which turnedmany of the best workers into laymen in all branches except theirown special ones, a tendency established itself in most recent timesto break down the barriers between the various specializedbranches.6

Though written nearly a century ago, these wordssum up many of the themes discussed in the lastfive or six chapters of this book. Economics,especially since the middle of the twentiethcentury, has become much larger. The number of

economists has increased, as have the range offields covered by the discipline and the amount tobe learned about each. In this book, order wasimposed by picking out certain very broad themes,from the rise of mathematical economics andeconometrics to the expanded role played byeconomists in advising governments. However,although a sometimes-bewildering variety of ideasis discussed, even more has been left out.Schumpeter's judgement that as we approachmodern times it becomes less possible to offer abrief characterization of the subject remains welljustified.

When we turn to Schumpeter's vision of thestructure of the discipline, the picture is muchmore complicated. He wrote at a time when theinstitution of the academic school, based in aparticular institution and often dominated by asingle individual (Schmoller and Marshall being thebest examples in economics), was at its zenith.Such groupings were, he argued, becoming lessimportant:The slogans used to designate certain outstanding groups are muchsimpler than is warranted by the actual conditions. These slogans,moreover, are partly coloured by non-scientific factors… [T]heyappear with a claim to universal validity, while in fact in everybranch of the social sciences, and often with different problems in

the same branch, conditions are different.7

In other words, the slogans about historical andtheoretical methods were oversimplified. Peoplehad to use different methods alongside each other,with the result that barriers between differentspecializations were breaking down.

However, although the academic school asSchumpeter had known it was coming to an end,the division of the subject into schools of thoughtcontinued. During the inter-war period, Americaneconomics exhibited a variety of approaches,loosely covered by the extremely oversimplifiedlabels of ‘institutionalism' (notably Commons,Mitchell and Veblen) and ‘neoclassical economics'(of which J. B. Clark and Fisher were the mosteminent representatives). In Britain there was thedivide between the Cambridge school (continuedby Pigou and Keynes) and LSE (where Robbins andHayek had displaced the historical approach of theWebbs).

In the post-war period, schools continued, theircharacter changing yet again. The neoclassicalsynthesis of Keynesian economics and general-equilibrium theory developed into the dominantorthodoxy. Self-consciously heterodox schools

(such as Austrians and post-Keynesians) formed inrebellion against this. These, however, remainednumerically small and marginal to the discipline.More important was the emergence of newapproaches to the subject from within themainstream. These approaches shared much withthe prevailing view, but pursued different,controversial, lines of inquiry, with the result thatlabels such as ‘orthodox' or ‘heterodox' were hardto apply. Examples include Friedman's ‘monetarism’and the Chicago school – resolutely ‘neoclassical'and yet challenging the consensus – public-choicetheory, transaction-cost economics and so on.

In the late nineteenth century, schools wereassociated with hierarchical university systems anda lack of international communication andpublication opportunities. In contrast, a centurylater, schools were made possible by easycommunications and the burgeoning variety ofoutlets for economic research. Present-day schoolsmay be dominated by the work of certainindividuals, but this is usually because thoseindividuals' ideas have stimulated others to emulatethem. Schools are more diffuse and more fluid thana century earlier, for they comprise networks oflike-minded economists who do not necessarily

share any institutional ties other than choosing topublish in certain places and to join certainsocieties. The boundaries and significance ofschools change as some ideas become commoncurrency and others become unfashionable.

Similar remarks can be made about appliedfields. On one hand, the growth of the disciplinehas increased the barriers between fields (asSchumpeter perceived). For example, it is difficultfor a single economist to be familiar, in detail, withthe latest developments in more than one or twofields. This effect has been reinforced by theemergence of specialized journals and conferences,which make it much easier to be unaware of whatis happening in other fields. On the other hand,there are forces operating to reduce these barriers.The emergence of a common core of economictheory has served to unify fields. It is possible to bean expert in a particular set of techniques and toapply these in a variety of fields. This means that atheorist who works on models of imperfectcompetition may write articles on industrialorganization, macroeconomics and internationaltrade. Whereas, for previous generations, ‘macro'and ‘micro' were very separate disciplines, thebarrier between them became much lower during

the 1980s and 1990s.Schumpeter had hoped that the ‘non-scientific

factors' behind the slogans of various groups woulddiminish, that economists would stop makingexcessive claims for their ideas. It seems safe to saythat this has not happened. General-equilibriumtheory and then game theory have both held outhopes of providing the organizing frameworkwithin which disputes might be clarified andresolved. However, while some disputes have beenresolved, new ones have emerged and old oneshave re-emerged. Econometrics has madeenormous advances, but its power to settletheoretical disputes arguably remains extremelycontroversial. Schumpeter's hope of developingscientific economic techniques that would rendereconomics uncontroversial remains a chimera. Ontop of this, the increased competitiveness of theacademic system provides people with an incentiveto oversell their ideas – to claim excessiveoriginality. To achieve tenure in an Americanuniversity typically requires publication of half adozen articles, and few economists can expect tohave this many genuinely original ideas by theirlate twenties. Once past this barrier, promotion andsalary depend on regular publication, and

reputations are made by claiming much, not bybeing modest. The founder of a controversialschool will be rewarded by frequent citations of hisor her work, and high citation counts are taken as ameasure of prestige. Ending a controversy does notproduce many citations. On top of this, politics andideology intrude as much as ever.

Epilogue: Economists and Their History

There have been times in the history of economicsin which there has been a strong tendency towardsintegration. Schumpeter identified two such‘classical situations' in the subject. The firstemerged after 1890, based on Smith's Wealth ofNations. The second emerged from the innovationsmade by Jevons, Walras and Carl Menger after thecontroversy with the historical school had settleddown: ‘the leading works exhibited a large expanseof common ground and suggest a feeling of repose,both of which created, in the superficial observer,an impression of finality – the finality of a Greektemple that spreads its perfect lines against acloudless sky’.1 In such situations it was natural foreconomists to adopt attitudes such as ‘It's all inMarshall.’

It can be argued that the period around 1960 –the age of the ‘neoclassical synthesis' – alsoconstituted such a classical situation. Keynes hadprovided a framework on which macroeconomicscould be based, and Hicks, Samuelson, Arrow andDebreu had shown how microeconomics could be

built around general-equilibrium theory. Patinkinhad synthesized micro- and macroeconomics, andthe Cowles Commission had shown howtheoretical models could be tested against therapidly growing quantity of statistical data.

In a time of integration, it becomes easy to viewthe past from the point of view of the present.McCulloch and many nineteenth-centuryeconomists were able to take the view that AdamSmith had established the basic framework of thesubject and that all that remained was to fill in thedetails. In similar vein, Schumpeter was confidentthat there was one general-equilibrium system andthat Walras had discovered it. This enabled him tomake remarks such as: as far as pure theory isconcerned, Walras is in my opinion the greatest ofall economists. His system of economicequilibrium… is the only work by an economistthat will stand comparison with the achievementsof theoretical physics. Compared with it, most ofthe theoretical writings of that period – and beyond– look like boats beside a liner, like inadequateattempts to catch some particular aspect ofWalrasian truth.2

For Schumpeter, Walrasian general-equilibrium

theory provided the integrating framework withinwhich all economics could be understood. Thehistory of economic theory was the history ofattempts to perceive what Walras was the first tosee clearly. For the economists of the neoclassicalsynthesis, influenced so strongly by Walras, theclassic history was Economic Theory in Retrospect(1962) by Mark Blaug (1927–). This resolutelysought to appraise past ideas from the perspectiveprovided by contemporary economics. Pasteconomists' ideas were recast using moderntheoretical tools.

However, this period of integrative tendenciesduring which one might have said ‘It's all inSamuelson [or Keynes, or Hicks, or Arrow, orPatinkin]’ did not last. It has been followed by aproliferation of schools. In macroeconomics thereare Keynesians, post-Keynesians, New Keynesians,traditional monetarists, real-business-cycletheorists, and others. In addition, there areeconometricians whose approach is inductive, andapplied economists who spurn both abstracttheories and technical econometrics. Inmicroeconomics there are game theorists general-equilibrium theorists, transaction-cost theorists,experimental economists sceptical about rational-

choice theory, Paretian welfare economics, social-choice theory, and various non-Paretian approachesto welfare. ‘New' fields (including new growththeory, new economic geography and new tradetheory) proliferate. The emphasis is on theoriginality, or at least partial originality, of ideas.

In such a world, appraising the past from theperspective of the present becomes much moredifficult. There are too many modern theories tochoose from, each of which may give a differentperspective on the past. History starts to mattermuch more, because it is the only way to get asense of where the subject is going amid the welterof competing claims. It becomes important for theprofessional historian of the discipline to expandand correct the partial and often biased historiesthat economists create in order to justify andexplain what they and their colleagues are doing.

In a classical situation, when economic theoriesare being integrated into a generally acceptedframework, it is common to write the history ofeconomics as one of progress. The story can betold by tracing the history of central economicideas from their inchoate origins in the ancient,medieval or early-modern worlds through to theirpresent-day incarnations. For example, the history

of supply and demand in competitive markets canbe traced from the ancients, through thescholastics and early-modern writers, to AdamSmith. After Smith, the story becomes one ofincreasing precision and mathematical rigour,culminating in the work of Arrow and Debreu.Although it may exhibit numerous detours andfalse trails on the way, the story is one of progress:economic theories become more refined, morerigorous, and more clearly focused on specificallyeconomic problems. Alongside this runs a story ofimprovements in the data and statistical techniquesavailable to economists.

Such histories, however, conceal as much as theyreveal. Behind the facade of increasedmathematical rigour and precision lie fundamentalchanges in the meanings that have been attachedto central concepts and in the ways in whicheconomists have understood what they were doing.For Adam Smith and his contemporaries,competition was a process: people competed witheach other in the same way that horses competedon the racecourse. Smith spoke of the system of‘natural liberty' or of ‘free competition’, in whichone man could bring his capital into competitionwith that of any other person. As the concept of

competition became formalized and mathematized,however, this concept of competition became lost.Following the lead of Cournot, the professionmoved towards a theory of ‘perfect' competition.Perfect competition was a situation in whichbuyers and sellers were so numerous that no buyeror seller had any influence on price and in whichno producer was able to earn more than normalprofits. Competition had ceased to be a processand had become an end-state a situation underwhich no firm had any incentive to engage incompetitive activities. As late as the 1930s,economists were still aware of this distinction.Chamberlin, for example, wrote: One never hears of‘competition' in connection with the great markets[i.e. commodity markets], and the phrases ‘pricecutting’, ‘underselling’, ‘unfair competition’,‘meeting competition’, ‘securing a market’, etc. areunknown. No wonder the principles of such a[perfectly competitive] market seem so unrealwhen applied to the ‘business' world where theseterms have meaning.3

However, by the 1960s the earlier, dynamic,concept was virtually lost. The economicsprofession failed to understand Hayek because it

failed to realize that he was working with the older,process, version of competition.

This example raises doubts about whether theconcept of progress itself may be misleading. Whatconstitutes a ‘detour' is crucially dependent onwhat one takes to be the true story against whichprogress and regress are to be judged. In a periodof proliferating schools, it is easier for economiststo understand these problems. Different schoolswill construct their own histories, picking out thoseideas that provide a route into their own, whilebeing aware that other stories can be told. The roleof the historian is to bring these stories together,correcting and amplifying them where appropriate,showing where they fit into a larger story. Thehistory that is written ceases to be eitherconservative (celebrating the achievements ofmodern economics) or revolutionary (revealing itsfatal errors in order to overthrow contemporaryorthodoxy) . It serves to provide economists with avision of where their own work fits into a widerstory.

A Note on the Literature

In one sense, the best suggestion for furtherreading is to read the original sources cited in thetext. Many of these are as accessible as moderncommentaries. Smith and J. S. Mill, for example,wrote for a wide audience, and it is tempting to saythat no one's economic education is completewithout having read them. The suggestions offeredhere, however, are almost entirely secondarysources. Listing them also serves as a way ofacknowledging some of the works on which I drewin writing this book. Nevertheless, I should pointout that this list does not indicate everything I readwhile writing this book. There are many books thatI found helpful but which are reflected in only asingle sentence or even a short phrase. To list allthese would stretch the patience of publisher andreaders. In particular, I have cited only referencesthat discuss economic ideas directly. Generalhistories on which I relied for backgroundinformation are not mentioned here.

Readers should be warned that the dual functionof this bibliography means that the technical level

of the material listed varies considerably.

General Reading

There exist many histories of economic thought,most written by economists. Perhaps the classic isJ. A. Schumpeter, History of Economic Analysis,

London: Allen & Unwin, 1954; Routledge,1986.

Although some of Schumpeter's judgements havenot stood up to more recent scholarship, thisremains an outstanding book. Also useful isJ. A. Schumpeter, Ten Great Economists: From

Marx to Keynes, New York: OxfordUniversity Press, 1951; London: Routledge,1997.

For a more recent attempt to provide a history ofeconomics on the same scale as Schumpeter'smagnum opus, seeM. Perlman and C. R. McCann, The Pillars of

Economic Understanding: Vol. 1, Ideas andTraditions; Vol. 2, Factors and Markets, AnnArbor, Mich.: University of Michigan Press,

1998, 2000.Among many textbooks, two stand out:

M. Blaug, Economic Theory in Retrospect, 5thedn, Cambridge: Cambridge University Press,1997;

H. W. Spiegel, The Growth of EconomicThought, 3rd edn, Durham, N.C.: DukeUniversity Press, 1991.

Blaug reviews economic ideas from the lateeighteenth century to the present day from thepoint of view of modern economic theory in amanner likely to be accessible only to those trainedin economics. Spiegel is wide-ranging and providesa particularly thorough coverage of early material.It is also worth mentioning two sets of lectures,both transcribed from tape recordings and students'notes:W. C. Mitchell, Types of Economic Theory: from

Mercantilism to Institutionalism, ed. J.Dorfman, 2 vols., New York: A. M. Kelley,1967;

L. C. Robbins, A History of Economic Thought:The LSE Lectures, Princeton: PrincetonUniversity Press, 1998.

The above books are all very substantial works.

Readers wanting something shorter and lesscomprehensive should try the following:R. L. Heilbroner, The Worldly Philosophers,

Harmondsworth: Penguin Books, 1973.The same author has compiled a volume of shortextracts from original sources together with briefcommentaries:R. L. Heilbroner, Teachings from the Worldly

Philosophy, New York: W. W. Norton, 1996.For readable essays on a selection of important

twentieth-century economists, seeW. Breit and R. L. Ransom, The Academic

Scribblers, 3rd edn, Princeton: PrincetonUniversity Press, 1998.

Finally I mention two of my own books. The firstattempts to place a selection of economic ideas inthe context of the corresponding periods' economichistory. The second focuses on the twentiethcentury and provided the starting point for some ofthe later chapters in this book:R. E. Backhouse, Economists and the Economy:

The Evolution of Economic Ideas, 2nd edn,New Brunswick, N.J.: Transaction Press,1994;

R.E. Backhouse, A History of Modern Economic

Analysis, Oxford: Basil Blackwell, 1985.Useful reference books include

M. Blaug, Great Economists before Keynes andGreat Economists since Keynes, Cheltenham:Edward Elgar, 1997, 1998;

M. Blaug, Who's Who in Economics, 3rd edn,Cheltenham: Edward Elgar, 1999;

S. Pressman, Fifty Major Economists, London:Routledge, 1999.

The most valuable reference work, however, isJ. Eatwell, M. Milgate and P. Newman (eds.),

The New Palgrave: A Dictionary of Economics,4 vols., London: Macmillan, 1987.

This contains numerous biographical entries as wellas entries on important topics. It can be dauntingfinding the information required, but there is a lotof material there.

The Internet

Much material on this subject is available over theInternet. One of the main sources of out-of-

copyright texts, mostly from the sixteenth to thenineteenth centuries, is the site maintained by RodHay at McMaster University:http://socserv2.socsci.mcmaster.ca/~econ/ugcm/3113/index.html,with a UK mirror athttp://www.ecn.bris.ac.uk/het/ index.htm. TheHistory of Economics Society's site at http://www.eh.net/HE contains links to further sites.

Ancient and Medieval Economics

Of the textbooks mentioned above, Spiegel isparticularly good on this period. A general survey isprovided inB. Gordon, Economic Analysis before Adam

Smith: Hesiod to Lessius, London: Macmillan,1975.

The work of writers from ancient Greece tosixteenth-century scholastics is discussed inS. T. Lowry and B. Gordon (eds.), Ancient and

Medieval Economic Ideas and Concepts ofSocial Justice, Leiden: E. J. Brill, 1998;

B. B. Price (ed.), Ancient Economic Thought,

London: Routledge, 1997.The most comprehensive account of ancient

Greek ideas, focusing on the idea of anadministrative order, isS. T. Lowry, The Archaeology of Economic

Ideas: The Classical Greek Tradition, Durham,N.C.: Duke University Press, 1987.

The outstanding writer on scholastic economicsis Odd Langholm, who has written a series of bookson the subject. The best starting points in his workare his article in the Lowry and Gordon collectioncited above andO. Langholm, The Legacy of Scholasticism in

Economic Thought: Antecedents of Choice andPower, Cambridge: Cambridge UniversityPress, 1998.

Focusing on the link between justice andcompulsion, this book also offers valuable insightsinto ancient and particularly Roman thought, aswell as some links to seventeenth-century and morerecent economic thought. The period is alsocovered byL. Baeck, The Mediterranean Tradition in

Economic Thought, London: Routledge, 1994.

Early Modern Economics

A useful collection of primary texts (includingtranslations from languages other than English) isA. E. Monroe, Early Economic Thought:

Selections from Economic Literature Prior toAdam Smith, Cambridge, Mass.: HarvardUniversity Press, 1965.

Spanish writings are translated, withcommentary, inM. Grice Hutchison, The School of Salamanca:

Readings in Spanish Monetary Theory, 1544–1605, Oxford: Clarendon Press, 1952.

For further essays on Spanish thought, seeM. Grice Hutchison, Economic Thought in Spain,

ed. L. S. Moss and C. K. Ryan, Cheltenham:Edward Elgar, 1993.

The literature on mercantilism goes beyondeconomic thought to economic policy andeconomic history. It is, however, worth mentioningwhat is probably the classic work and somevolumes containing reprints of many articles on thesubject:M. Blaug (ed.), Pioneers in Economics: Vol. 4,

The Early Mercantilists; Vol. 5, The Later

Mercantilists, Cheltenham: Edward Elgar,1991;

D. C. Coleman (ed.), Revisions in Mercantilism,London: Methuen, 1969;

E. Heckscher, Mercantilism (1935), 2 vols.,London: Routledge, 1994.

Almost compulsory reading on the economic andpolitical thought of this period isA.O. Hirschman, The Passions and the Interests:

Political Arguments for Capitalism before itsTriumph, Princeton: Princeton UniversityPress, 1977.

English writings are discussed inJ. O. Appleby, Economic Thought and Ideology

in Seventeenth-Century England, Princeton:Princeton University Press, 1978;

W. Letwin, The Origins of Scientific Economics:English Economic Thought, 1660–1776,London: Methuen, 1963;

B. E. Supple, Commercial Crisis and Change inEngland, 1600–1642, Cambridge: CambridgeUniversity Press, 1959.

The only comprehensive survey of the eighteenthcentury prior to Smith isT. W. Hutchison, Before Adam Smith: The

Emergence of Political Economy, 1662–1776,Oxford: Basil Blackwell, 1988.

Biographies of two of the period's most importantwriters areA. Murphy, John Law: Economic Theorist and

Policy-Maker, Oxford: Clarendon Press,1997;

A. Murphy, Richard Cantillon: Entrepreneur andEconomist, Oxford: Clarendon Press, 1986.

For a discussion of Cantillon's ideas, seeA.A. Brewer, Richard Cantillon: Pioneer of

Economic Theory, London: Routledge, 1992.

The Enlightenment and Classical Economics

Once we reach the Physiocrats, Adam Smith andclassical economics, the volume of literature, bothprimary and secondary, expands dramatically. Thefollowing represents an even tinier proportion ofwhat is available than is the case with previousperiods. A useful short introduction is provided inD. Winch, ‘The emergence of economics as a

science, 1750–1870’, in C. M. Cipolla (ed.),The Fontana Economic History of Europe, Vol.3, The Industrial Revolution, London:Fontana, 1973, Chapter 9.

A useful collection of eighteenth-century readingsis contained inR. L. Meek (ed.), Precursors of Adam Smith,

1750–1775, London: Dent, 1973.On the Physiocrats and Turgot, see

W. A. Eltis, The Classical Theory of EconomicGrowth, London: Macmillan, 1984;

P. D. Groenewegen, The Economics of A. R. J.Turgot, The Hague: Martinus Nijhoff, 1977.

As its title implies, the former also discussesclassical economics. For an outstanding andconcise survey of this subject seeD. P. O'Brien, The Classical Economists, Oxford:

Clarendon Press, 1975.Because of his status (whether deserved or not)

as a free-market icon and as the major figure inclassical economics, one of the most intensivelyresearched areas in the history of economicthought, the literature on Adam Smith is vast.Recent literature is surveyed inV. Brown, ‘“Mere Inventions of the

Imagination”: a survey of recent literatureon Adam Smith’, Economics and Philosophy,13 (2), 1997, pp. 281–312.

Mention has to be made of the work of AndrewSkinner, one of the editors of the ‘Glasgow' editionof Smith's books (reprinted by Liberty Classics):A. S. Skinner, A System of Social Science:

Papers Relating to Adam Smith, Oxford:Clarendon Press, 1979.

See alsoD. D. Raphael, Adam Smith, Oxford: Clarendon

Press, 1985.The transition to classical economics has beenplaced in its political context inE. Rothschild, Economic Sentiments: Adam

Smith, Condorcet and the Enlightenment,Cambridge, Mass., and London: HarvardUniversity Press, 2001;

D. Winch, Riches and Poverty: An IntellectualHistory of Political Economy in Britain, 1750–1834, Cambridge: Cambridge UniversityPress, 1996.

(The former appeared too late to be used in writingthis book.) See alsoD. Winch, Malthus, Oxford: Oxford University

Press, 1987.From the mass of literature on Ricardo, one of

the best accounts isT. Peach, Interpreting Ricardo, Cambridge:

Cambridge University Press, 1993.Accessible editions of major works, with useful

introductions, includeT. R. Malthus, Essay on the Principle of

Population, ed. A. Flew, Harmondsworth:Penguin Books, 1970;

J. S. Mill, Principles of Political Economy, ed. D.Winch, Harmondsworth: Penguin Books,1970;

D. Ricardo, Principles of Political Economy andTaxation, ed. R. M. Hartwell,Harmondsworth: Penguin Books, 1971;

A. Smith, The Wealth of Nations, ed. A. S.Skinner, Harmondsworth: Penguin Books1970.

The French engineering school is discussed indetail inR. B. Ekelund and R. F. Hebert, The Secret

Origins of Modern Microeconomics: Dupuitand the Engineers, Chicago: ChicagoUniversity Press, 1999.

The literature on Marx is voluminous. A smallselection of the most accessible items includesA. A. Brewer, A Guide to Marx's Capital,

Cambridge: Cambridge University Press,1984;

D. McLellan, The Thought of Karl Marx,London: Macmillan, 1971.

For a discussion of German economics inrelation to Menger's marginalism, seeE. Streissler, ‘The influence of German

economics on the work of Menger andMarshall’, in B. Caldwell (ed.), Carl Mengerand his Legacy in Economics, Durham, N.C.:Duke University Press, 1990.

The Late Nineteenth and Early TwentiethCenturies

An old, though still extremely valuable, coverage ofthis period is provided byT. W. Hutchison, A Review of Economic

Doctrines, 1870–1929, Oxford: Oxford

University Press, 1953.A useful collection of essays on the so-called

‘marginal revolution' isR. D. C. Black, A. W. Coats and C. D. W.

Goodwin (eds.), The Marginal Revolution inEconomics, Durham, N.C.: Duke UniversityPress, 1972.

Several essays on this period's economics inBritain and the United States are contained inCoats's two volumes of collected papers:A. W. Coats, British and American Essays: Vol.

1, On the History of Economic Thought; Vol.2, The Sociology and Professionalization ofEconomics, London: Routledge, 1992, 1993.

For more detailed discussion of Marshall andEnglish historical economics seeP. D. Groenewegen, A Soaring Eagle: Alfred

Marshall, 1842–1924, Cheltenham: EdwardElgar, 1995;

A. Kadish, Historians, Economists and EconomicHistory, London: Routledge, 1989;

G. M. Koot, English Historical Economics, 1870–1926, Cambridge: Cambridge UniversityPress, 1987;

J. Maloney, The Professionalization of

Economics: Alfred Marshall and theDominance Economics: Alfred Marshall andthe Dominance of Orthodoxy, NewBrunswick, N.J.: Transaction Publishers,1991.

American economics is comprehensivelysurveyed in the five volumes ofJ. Dorfman, The Economic Mind in American

Civilization, 5 vols., New York: Viking, 1946–59.

Volumes 3–5 are particularly useful for the materialcovered here.

The transformation of American economics inthe first half of the twentieth century is covered inthe many essays inM. S. Morgan and M. Rutherford (eds.), From

Interwar Pluralism to Postwar Neoclassicism,Durham, N.C.: Duke University Press, 1998;

M. Rutherford, The Economic Mind in America:Essays in the History of American Economics,London: Routledge, 1998.

The period's monetary economics is brilliantlysurveyed inD. Laidler, The Golden Age of the Quantity

Theory, Deddington: Philip Allan, 1991.

Also useful isT. M. Humphrey, Money, Banking and Inflation,

Cheltenham: Edward Elgar, 1993.

Microeconomics and Mathematical Economicsin the Twentieth Century

This is a topic on which widely divergent views canbe found, ranging from accounts premissed on theassumption that the mathematization of economicshas been a great success to ones that regard it as atotal failure. From this large literature, a helpfulstarting point can be found in a symposium inDaedalus, 1997, especially in contributions by R. M.Solow and D. Kreps, two eminent economictheorists. Another excellent short account isM. S. Morgan, ‘The formation of “modern”

economics: engineering and ideology’, in T.H. Porter and D. Ross (eds.), The CambridgeHistory of Science, Vol. 7, Modern Social andBehavioural Sciences, Cambridge: CambridgeUniversity Press, forthcoming.

For very critical views of these developments seeM. Blaug, ‘The formalist revolution or what

happened to orthodox economics after WorldWar II?’, in R. E. Backhouse and J. Creedy(eds.), From Classical Economics to the Theoryof the Firm: Essays in Honour of D. P. O'Brien,Cheltenham: Edward Elgar, 1999;

T. W. Hutchison, Changing Aims in Economics,Oxford: Basil Blackwell, 1992.

The history of general-equilibrium theory hasbeen tackled by several people (the following willprovide references to other works by the sameauthors):B. Ingrao and G. Israel, The Invisible Hand:

Economic Equilibrium in the History ofScience, Cambridge, Mass.: MIT Press, 1990;

M. Mandler, Dilemmas in Economic Theory:Persisting Foundational Problems ofMicroeconomics, Oxford: Oxford UniversityPress, 1999;

P. Mirowski, ‘The when, the how and the whyof mathematical expression in the history ofeconomic analysis’, Journal of EconomicPerspectives 5, 1991, pp. 145–57;

E. R. Weintraub, How Economics Became a

Mathematical Science, Durham, N.C.: DukeUniversity Press, forthcoming.

The book by Mandler offers observations on avariety of aspects of microeconomics.

For reprints and translations of some influentialworks, seeW. J. Baumol and S. M. Goldfield (eds.),

Precursors in Mathematical Economics: AnAnthology. Series of Reprints of Scarce Workson Political Economy, 19, London: LondonSchool of Economics, 1968.

On game theory, Leonard's works are crucial:R. J. Leonard, ‘From parlor games to social

science: von Neumann, Morgenstern and thecreation of game theory, 1928–1944’, Journalof Economic Literature, 33 (2), 1995, pp. 730–61;

R. J. Leonard, ‘Reading Cournot, reading Nash:the creation and stabilisation of the Nashequilibrium’, Economic Journal, 104, 1994,pp. 492–511.

See alsoS. Nasar, A Beautiful Mind, London: Faber and

Faber, 1999;E. R. Weintraub (ed.), Toward a History of

Game Theory, Durham, N.C.: Duke UniversityPress, 1992.

The former is a biography of Nash.One of the leading players in the rise of

mathematical economics has given his ownaccount of the genesis of his work:P. A. Samuelson, ‘How Foundations came to be’,

Journal of Economic Literature, 36 (3), 1998,pp. 1375–86.

The conceptions of competition in the socialist-calculation debate are thoroughly discussed inD. Lavoie, Rivalry and Central Planning,

Cambridge: Cambridge University Press,1985.

Several of Hayek's articles and some usefulmodern commentaries are reprinted inS. Littlechild (ed.), Austrian Economics, Vol. 3,

Cheltenham: Edward Elgar, 1990.The best introduction to theories of imperfect

competition and the theory of the firm areD. P. O'Brien, ‘Research programmes in

competitive structure’, Journal of EconomicStudies, 10, 1983, pp. 29–51, and ‘Theevolution of the theory of the firm’, in F. H.Stephen (ed.), Firms, Organization and

Labour, London: Macmillan, 1984. Both arereprinted in Methodology, Money and theFirm: The Collected Essays of D. P. O'Brien. 2vols., Cheltenham: Edward Elgar, 1994;

A. Skinner, ‘E. H. Chamberlin: the origins anddevelopment of monopolistic competition’,Journal of Economic Studies, 10, 1983, pp. 52–67.

Quantitative Economics

On the history of US national-income accounting,seeC. Carson, ‘The history of the United States

national income and product accounts: thedevelopment of an analytical tool’, Review ofIncome and Wealth, 21, 1975, pp. 153–81;

J. W. Duncan and W. C. Shelton, Revolution inUnited States Government Statistics, 1926–1976, Washington, DC: US Department ofCommerce, 1978;

J. W. Kendrick, ‘The historical development ofnational accounts’, History of Political

Economy, 2,1970, pp. 284–315;M. Perlman, ‘Political purpose and the

national accounts’, in The Character ofEconomic Thought, Economic Characters andEconomic Institutions: Selected Essays ofMark Perlman, Ann Arbor, Mich.: Universityof Michigan Press, 1996.

Stone's contribution is discussed inL. Johansen, ‘Richard Stone's contributions to

economics’, Scandinavian Journal ofEconomics 87 (1), 1985, pp. 4–32.

On the development of econometric techniques,seeR. J. Epstein, A History of Econometrics,

Amsterdam: North Holland, 1987;M. S. Morgan, A History of Econometric Ideas,

Cambridge: Cambridge University Press,1990.

Edited versions of early articles on the subject arereprinted with substantial commentary inD. F. Hendry and M. S. Morgan (eds.), The

Foundations of Econometric Analysis,Cambridge: Cambridge University Press,1995.

There are several pieces on the history of the

Cowles Commission, includingC. F. Christ, ‘The Cowles Commission's

contributions to econometrics at Chicago,1939–55' Journal of Economic Literature, 32(1), 1994, pp.30–59;

C.F. Christ, ‘History of the Cowles Commission1932–1952’, in Cowles Commission (ed.),Economic Theory and Measurement, Chicago:Cowles Commission, 1953.

Macroeconomics in the Twentieth Century

By far the best source on inter-warmacroeconomics isD. Laidler, Fabricating the Keynesian

Revolution: Studies in the Inter-WarLiteratureon Money, the Cycle and Unemployment,Cambridge: Cambridge University Press,1999.

The literature on Keynes is vast. A good startingpoint is recent biographies:D. Moggridge, Maynard Keynes: An Economist's

Biography, London: Routledge, 1992;

R. Skidelsky, John Maynard Keynes: Vol. 1,Hopes Betrayed, 1883–1920; Vol. 2, TheEconomist as Saviour, 1920–1937; Vol. 3,Fighting for Britain, 1937–1946, London:Macmillan, 1983, 1992, 2000.

These authors have both also written much shorterbiographies:D. E. Moggridge, Keynes, London: Fontana,

1976;R. Skidelsky, Keynes, Oxford: Oxford

University Press, 1996.A simpler account is offered in:M. Blaug, John Maynard Keynes: Life, Ideas,

Legacy, London: Macmillan, 1990.From the rest of the literature on Keynes, I list justtwo pieces by one of the leading post-warmacroeconomic theorists:D. Patinkin, Anticipations of the General

Theory?, Oxford: Basil Blackwell, 1982;D. Patinkin, ‘On different interpretations of the

General Theory’, Journal of MonetaryEconomics, 26, 1990, pp. 205–43.

Macroeconomics since Keynes has not beencomprehensively surveyed. Works that providedetailed coverage of particular themes include

W. Young, Interpreting Mr Keynes: The IS–LMEnigma, Cambridge: Polity Press, 1987.

This discusses the way in which the IS–LM modelemerged from discussions of the General Theory.P. G. Mehrling, The Money Interest and the

Public Interest: American Monetary Thought,1920–1970, Cambridge, Mass., and London:Harvard University Press, 1997.

This explores the role of non-Keynesian monetarythought on post-war macroeconomics.J.D. Hammond, Theory and Measurement:

Causality Issues in Milton Friedman'sMonetary Economics, Cambridge: CambridgeUniversity Press, 1996;

K. D. Hoover, The New ClassicalMacroeconomics, Oxford: Basil Blackwell,1988.

The titles of these are self-explanatory.R. E. Backhouse, Interpreting Macroeconomics:

Explorations in the History of MacroeconomicThought, London: Routledge, 1995, Chapters8–10;

R. E. Backhouse, ‘The rhetoric andmethodology of modern macroeconomics’, inB. Snowdon and H. R. Vane (eds.),

Reflections on theDevelopment of ModernMacroeconomics, Cheltenham: Edward Elgar,1997.

These provide brief surveys of post-warmacroeconomics from a variety of perspectives.

Finally, a revealing way into modernmacroeconomics is to read some of the manyinterviews that have been conducted with leadingeconomists:A. Klamer, The New Classical Macroeconomics:

Conversations with New Classical Economistsand their Opponents, Brighton: Wheat-sheafBooks, 1987;

B. Snowdon and H. R. Vane (eds.),Conversations with Leading Economists:Interpreting Modern Macroeconomics,Cheltenham: Edward Elgar, 1999.

Heterodoxy, Applied Economics and theBroadening of the Economics Discipline

The varieties of American institutionalism –

perhaps the most important twentieth-centuryheterodoxy – are discussed in several of the bookscited in the section on early-twentieth-centuryeconomics. Useful over-views areM. Rutherford, ‘American institutionalism and

the history of economics’, Journal of theHistory of Economic Thought, 19, 1997, pp.178–95;

M. Rutherford, ‘Institutionalism as “scientific”economics’, in R. E. Backhouse and J. Creedy(eds.), From Classical Economics to the Theoryof the Firm: Essays in Honour of D. P. O'Brien,Cheltenham: Edward Elgar, 1999;

M. Rutherford, Institutions in Economics: TheOld and the New Institutionalism, Cambridge:Cambridge University Press, 1994.

The last of these also covers the newinstitutionalism centred on transaction costs.

The phenomenon of heterodoxy is discussed in asymposium in the Journal of the History of EconomicThought, 22 (2), June 2000, and inM. Desai, ‘The underworld of economics:

heresy and heterodoxy in the history ofeconomic thought’, in G. K. Shaw (ed.),Economics, Culture and Education: Essays in

Honour of Mark Blaug, Cheltenham: EdwardElgar, 1991.

The origins of modern Austrian economics arechronicled inK. Vaughn, Austrian Economics in America: The

Migration of a Tradition, Cambridge:Cambridge University Press, 1994.

Essays on applied economics – interpreted asreferring both to applied fields and to theapplication of techniques – are brought together inR. E. Backhouse and J. Biddle (eds.), Toward a

History of Applied Economics, Durham, N.C.:Duke University Press, 2000.

Further such essays can be found in Part 2 ofJ. B. Davis (ed.), New Economics and its History,

Durham, N.C.: Duke University Press, 1988.For other essays on specific fields seeC. D. Goodwin, Economics and National

Security: A History of their Interaction,Durham, N.C.: Duke University Press, 1991;

I. McLean, ‘Economics and politics’, in D.Greenaway, M. Bleaney and I. Stewart (eds.),Companion to Contemporary EconomicThought, London: Routledge, 1991;

W. C. Mitchell, ‘Political science and public

choice: 1950–70’, Public Choice, 98, 1999, pp.237–49;

A. Peacock, Public Choice Analysis in HistoricalPerspective, Raffaele Mattioli Lectures,Cambridge: Cambridge University Press,1992;

W. W. Rostow, Theorists of Economic Growthfrom David Hume to the Present: With aPerspective on the Next Century, New Yorkand Oxford: Oxford University Press, 1990.

During the past two decades there have beenmany volumes of autobiographical essayspublished which give a picture of the burgeoningvariety of approaches to economics includingR. E. Backhouse and R. Middleton (eds.),

Exemplary Economists: Vol. 1, North America;Vol. 2, Europe, Asia and Australasia,Cheltenham: Edward Elgar, 1999;

G. M. Meier and D. Seers (eds.), Pioneers inDevelopment, and G. M. Meier (ed.), Pioneersin Development, Second Series, Oxford:Oxford University Press, 1984, 1987.

The former contains references to many morevolumes of such essays.

For examples of biographical essays, see

R. Holt and S. Pressman (eds.), Economics andits Discontents: Twentieth Century DissentingEconomists, Cheltenham: Edward Elgar,1998;

W. J. Samuels, American Economists of the LateTwentieth Century, Cheltenham: EdwardElgar, 1996.

The international dimension of economic ideas isexplored in:A. W. Coats (ed.), The Development of

Economics in Western Europe since 1945,London: Routledge, 2000;

A. W. Coats (ed.), The Post-1945Internationalization of Economics, Durham,N.C.: Duke University Press, 1996.

References

Prologue

1. L. C. Robbins, An Essay on the Nature andSignificance of Economic Science (1932), 2nd edn,London: Macmillan, 1935, p. 16.2. A. Marshall, Principles of Economics (1890), 8thedn, London: Macmillan, 1920, p. 1.

1 The Ancient World

1. Hesiod, Theogony and Works and Days, trans. M.L. West, Oxford: Oxford University Press, 1988, p.39.2. Ibid., p. 38.3. B. F. Gordon, Economic Analysis before AdamSmith: Hesiod to Lessius, London: Macmillan, 1975,p 11.4. W. I. Matson, A New History of Philosophy, Vol. 1,London: Harcourt Brace Jovanovich, 1987, p. 67.5. This term is taken from S. T. Lowry, TheArchaeology of Economic Ideas: The Classical GreekTradition, Durham, N.C.: Duke University Press,1987.

6. Aristotle, Nichomachean Ethics, trans. David Ross,Oxford: Oxford University Press, 1980, p. 110.

2 The Middle Ages

1. Genesis 1:28, 2:15.2. Isaiah 2:6–8.3. Amos 8:4–6.4. Exodus 22:25–6.5. Ecclesiastes 11: 1–2.6. J. J. Spengler, ‘Economic thought of Islam: IbnKhaldun’, Comparative Studies in Society and History,6, April 1964, p. 290.7. Quoted in O. Langholm, Economics in theMedieval Schools, Leiden: E. J. Brill, 1992, pp. 54–5.8. Summa Aurea, quoted in Langholm, Economics inthe Medieval Schools, p. 71.9. Langholm, Economics in the Medieval Schools, p.71.10. Quoted in Langholm, Economics in the MedievalSchools, p. 187.11. Luke 6:35.12. Quoted in O. Langholm, The Legacy of

Scholasticism in Economic Thought: Antecedents ofChoice and Power, Cambridge: Cambridge UniversityPress, 1998, p. 59.13. Quoted in A. E. Monroe, Early EconomicThought: Selections from Economic Literature Prior toAdam Smith, Cambridge, Mass.: Harvard UniversityPress, 1965, p. 101.

3 The Emergence of the Modern World View –the Sixteenth Century

1. Quoted in M. Grice Hutchison, The School ofSalamanca: Readings in Spanish Monetary Theory,1544–1605, Oxford: Clarendon Press, 1952, p. 94.2. Ibid., p. 95.3. It has also been attributed to John Hales (d.1571), a Member of Parliament. For a detaileddiscussion see D. Palliser, The Age of Elizabeth:England under the Later Tudors, 1547–1603, London:Longman, 1983, Appendix 2.4. M. Dewar (ed.), A Discourse of the Common Wealof this Realm of England, Charlottesville: UniversityPress of Virginia, 1959, p. 59.

5. Ibid., p. 54.

4 Science, Politics and Trade in Seventeenth-Century England

1. W. Petty, The Economic Writings of Sir WilliamPetty, Vol. 1, ed. C. H. Hull, Cambridge: CambridgeUniversity Press, 1899, p. 244.2. Ibid., pp. 244–5.3. Ibid., p. 304.4. Quoted in A. O. Hirschman, The Passions and theInterests: Political Arguments for Capitalism before itsTriumph, Princeton: Princeton University Press,1977, P. 39.5. Quoted in Hirschman, The Passions and theInterests, pp. 25–6.6. T. Mun, England's Treasure by Forraign Trade(1664), quoted in A. E. Monroe, Early EconomicThought: Selections from Economic Literature Prior toAdam Smith, Cambridge, Mass.: Harvard UniversityPress, 1965, p. 180.7. W. Letwin, The Origins of Scientific Economics:English Economic Thought, 1660–1776, London:

Methuen, 1963, p. 3.8. J. Child, Brief Observations Concerning Trade andInterest of Money (1668), athttp://www.ecn.bris.ac.uk/het/child/trade.txt,accessed 24 May 2001.9. J. Locke, Locke on Money, Vol. 1, ed. P. H. Kelly,Oxford: Clarendon Press, 1991, p. 216.10. Ibid., pp. 235–6.11. J. R. McCulloch (ed.), Early English Tracts onCommerce, London: Political Economy Club, 1856;reprinted Cambridge: The Economic HistorySociety, 1952, p. 510.12. Ibid., p. 516.13. Ibid., p. 525.14. Ibid., pp. 529–30.15. Ibid., p. 528.16. Ibid., pp. 513–14.

5 Absolutism and Enlightenment in Eighteenth-Century France

1. Quoted in T. W. Hutchison, Before Adam Smith:

The Emergence of Political Economy, 1662–1776,Oxford: Basil Blackwell, 1988, p. 111.2. R. Cantillon, Essai sur la Nature du Commerce enGénérale (1755), trans. and ed. H. Higgs, London:Macmillan, 1931, p. 3.3. Ibid., p. 59.4. Ibid., pp. 61–3.5. Ibid., p. 65.6. Ibid., p. 161.7. Ibid., p. 185.8. Ibid., p. 189.9. Quoted in P. D. Groenewegen, The Economics ofA. R. J. Turgot, The Hague: Martinus Nijhoff, 1977,p. 26.10. Ibid., p. 29.11. Ibid., p. 84.12. Ibid., p. 141.

6 The Scottish Enlightenment of the EighteenthCentury

1. Quoted in A. S. Skinner, A System of Social

Science: Papers Relating to Adam Smith, Oxford:Clarendon Press, 1979, p. 1.2. Ibid., p. 5.3. A. Ferguson, Principles of Moral and PoliticalScience, Vol. 1, Edinburgh, 1792, p. 47.4. D. Hume, Writings on Economics, ed. E. Rotwein,Edinburgh: Nelson, 1955, p. 5.5. Ibid., p. 11.6. Ibid., pp. 11–12.7. Ibid., p. 33.8. Ibid., p. 37.9. J. Steuart, An Inquiry into the Principles of PoliticalEconomy (1767), ed. A. S. Skinner, Edinburgh:Oliver & Boyd, 1966, p. 153.10. Ibid., p. 5.11. Ibid., p. 12.12. Ibid., pp. 40, 41.13. Ibid., p. 195.14. Ibid., p. 198.15. Ibid., p. 339.16. Ibid., p. 345.17. Ibid., pp. 142–3.18. A. Smith, The Theory of Moral Sentiments (1759–90), ed. D. D. Raphael and A. L. Macfie, Oxford:

Oxford University Press, 1976, p. 3.19. Ibid., p. 86.20. Ibid.21. A. Smith, An Inquiry into the Nature and Causes ofthe Wealth of Nations (1776), ed. R. H. Campbell, A.S. Skinner and W. B. Todd, Oxford: OxfordUniversity Press, 1976, p. 25.22. Ibid., p. 75.23. Ibid., p. 330.24. Ibid., p. 337.25. Ibid., pp. 337–8.26. Ibid., pp. 163–4.27. Ibid., p. 456.28. Ibid., p. 723.

7 Classical Political Economy, 1790–1870

1. T. R. Malthus, An Essay on the Principle ofPopulation (1798), ed. A. Flew, Harmondsworth:Penguin Books, 1970, p. 100.2. D. P. O'Brien, The Classical Economists, Oxford:Oxford University Press, 1975, p. 45.3. S. Bailey, A Critical Dissertation on the Nature,

Measure and Causes of Value (1825), London: LSEReprints, 1925, p. 1.4. J. S. Mill, Principles of Political Economy with Someof their Applications to Social Philosophy (1848),London: Longmans, 1873, ‘Preliminary remarks’, p.13.5. Ibid, pp. 13–14.6. Ibid., Book V, Chapter IX, Section 16, p. 590.7. K. Marx, Capital, Vol. 2 (1885), London:Lawrence & Wishart, 1974, p. 189.8. Ibid., Vol. 1 (1867), trans. S. Moore and E.Aveling, pp. 714–15.9. Ibid., p. 715.10. Ibid.

8 The Split between History and Theory inEurope, 1870–1914

1. W. S. Jevons, The Theory of Political Economy(1871), ed. R. D. C. Black, Harmondsworth:Penguin Books, 1970, p. 187.2. C. Menger, Principles of Economics (1871), trans.J. Dingwall and B. F. Hoselitz, Grove City, Pa.:

Libertarian Press, 1994, P. 52.3. Ibid., p. 164.4. Ibid., p. 217.5. Ibid., p. 97.6. A. Marshall, Principles of Economics (1890), 8thedn, London: Macmillan, 1920, p. 315.

9 The Rise of American Economics, 1870–1939

1. J. B. Clark, The Philosophy of Wealth (1886), 2ndedn, Boston, 1887, pp. 151.2. J. B. Clark, The Distribution of Wealth (1899), 2ndedn, New York, Macmillan, 1902, pp. 401–2.3. This and the following diagram are taken from I.Fisher, The Purchasing Power of Money, New York:Macmillan, 1911.4. T. B. Veblen, Theory of Business Enterprise, NewYork: Scribners, 1904, p. 67.5. Ibid., p. 66.6. T. B. Veblen, The Engineers and the Price System(1921), New York: A. M. Kelley, 1965, pp. 81–2.7. T. B. Veblen, ‘The preconceptions of economicscience II’, Quarterly Journal of Economics, 13,

1899, p. 422.8. W. C. Mitchell, ‘Quantitative analysis ineconomic theory’, American Economic Review, 15,1925, p. 5.9. F. H. Knight, Risk, Uncertainty and Profit (1921),London: LSE Reprints, 1933, p. vii.10. Ibid., pp. 52–3.11. F. H. Knight, The Ethics of Competition (1935),New Brunswick, N.J.: Transaction Publishers, 1997,p. 87.12. E. H. Chamberlin, The Theory of MonopolisticCompetition, Cambridge, Mass.: Harvard UniversityPress, 1933, p. 10.

10 Money and the Business Cycle, 1898–1939

1. A. Marshall and M. P. Marshall, The Economics ofIndustry (1879), Bristol: Thoemmes Press, 1994, pp.154–5.2. J. M. Keynes, The Collected Writings of JohnMaynard Keynes: Vol. 4, A Tract on Monetary Reform(1923), London: Macmillan, 1971, p. 65.3. Ibid., p. 138.

4. D. Laidler, Fabricating the Keynesian Revolution:Studies of the Inter-war Literature on Money, the Cycleand Unemployment, Cambridge: CambridgeUniversity Press, 1999, p. 243.5. Quoted in Laidler, Fabricating the KeynesianRevolution, p. 215.6. Ibid., p. 241.7. J. M. Keynes, The Collected Writings of JohnMaynard Keynes: Vol. 7,

The General Theory of Employment, Interest andMoney (1936), London: Macmillan, 1971, pp. 149–50.8. Ibid., p. 152.9. Ibid., p. 3.10. This way of putting it is due to Laidler,Fabricating the Keynesian Revolution.

11 Econometrics and Mathematical Economics,1930 to the Present

1. R. Stone, ‘The accounts of society’, AmericanEconomic Review, 87 (6), 1997, p. 20.2. Quoted in R. Frisch, ‘Editorial’, Econometrica, 1,

1933, p. 1.3. T. Haavelmo, ‘The probability approach ineconometrics’, Econometrica, 12 (supplement),1944, p. iii. (Italics have been removed from theoriginal.)4. T. Haavelmo, ‘The statistical implications of asystem of simultaneous equations’, Econometrica,11,1943, p. 1.5. M. S. Morgan, A History of Econometric Ideas,Cambridge: Cambridge University Press, 1990, p.264.6. P. A. Samuelson, Foundations of EconomicAnalysis, Cambridge, Mass.: Harvard UniversityPress, 1947, p. 4. (‘Hypothesis' has been changed tothe plural.)7. P. A. Samuelson, ‘How Foundations came to be’,Journal of Economic Literature, 36 (3), 1998, p.1382.8. G. Debreu, Theory of Value: An Axiomatic Theoryof Economic Equilibrium, New Haven: YaleUniversity Press, 1959, p. x.9. J. von Neumann and O. Morgenstern, The Theoryof Games and Economic Behavior, Princeton:Princeton University Press, 1944, p. 38.

12 Welfare Economics and Socialism, 1870 tothe Present

1. W. S. Jevons, The State in Relation to Labour(1882), 3rd edn, London, 1894, p. 14.2. H. Sidgwick, The Principles of Political Economy(1883), 2nd edn, London: Macmillan, 1887, p. 71.3. A. Marshall, Principles of Economics (1890), 8thedn, London: Macmillan, 1920, p. 108.4. A. C. Pigou, The Economics of Welfare, London:Macmillan, 1920, p. 10.5. Ibid., p. 11.6 V. Pareto, Manual of Political Economy (1906),trans. A. S. Schwier, New York: A. M. Kelley, 1971,p. 155.7. Ibid., p. 268.

13 Economists and Policy, 1939 to the Present

1. M. Perlman, The Character of Economic Thought,Economic Characters and Economic Institutions:Selected Essays of Mark Perlman, Ann Arbor, Mich.:University of Michigan Press, 1996, p. 217.

14 Expanding the Discipline, 1960 to thePresent

1. J. A. Schumpeter, A History of Economic Analysis,London: Allen & Unwin, 1954, p. 23.2. A. Blinder, ‘The economics of brushing teeth’,Journal of Political Economy, 82, 1974, pp. 887–91.3. A. O. Hirschman, Essays in Trespassing: Economicsto Politics and Beyond, Cambridge: CambridgeUniversity Press, 1981; Crossing Boundaries: SelectedWritings, New York: Zone Books, 1998.4. J. Niehans, ‘Transactions costs’, in J. Eatwell, M.Milgate and P. Newman (eds.), The New Palgrave: ADictionary of Economics, London: Macmillan, 1987,Vol. 4, p. 676.5. R. Coase, ‘The problem of social cost’, Journal ofLaw and Economics, 3, 1960, pp. 1–44.6. J. A. Schumpeter, Economic Doctrine and Method(1912), trans. R. Aris, London: Allen & Unwin,1954, p. 152.7. Ibid.

Epilogue: Economists and Their History

1. J. A. Schumpeter, A History of Economic Analysis,London: Allen & Unwin,1954, p. 754.2. Ibid., p. 827.3. E. H. Chamberlin, The Theory of MonopolisticCompetition, Cambridge, Mass.: Harvard UniversityPress, 1933, p. 10.

Index

Abelard, Peter 41Abraham 31Achilles 11Act of Union 112actuarial science 309Adam 31administrative order 17Aeschylus 13Africa 304Aftalion, Albert 183, 221aggregation problem 252agricultural economics 309agriculture 101–4, 106, 109, 119, 141Albert the Great (Albertus Magnus) 43–4Alchian, Armen 319Alembert, Jean le Rond d' 100Alexander the Great 24Alexandria, as centre of Greek culture 24Allen, R. G. D. 256Ambrose, St 46

American Economic Association 187, 202, 315Amos 32Anaximander 13ancient world, end of 29Anderson, Benjamin 225Anti-bullionism 151–2applied economics/fields 238–9, 309–11, 323–4Aquinas, Thomas 43–4, 47, 65Arabia, Muslim conquest of 35Aristophanes 15Aristotle 1, 2, 6, 19–24, 26–7, 34, 36–7, 42–4, 47,

52, 65, 67, 108, 112Arrow, Kenneth J. 260, 281–2, 286, 312, 325–7Arrow-Debreu model 260–62

see also general-equilibrium theoryAshley, William James 178Asia, South-East 304Athens 14–15auctions 320Augustine, St 34, 44Augustus 25, 30Aurelius, Marcus 26Austrian economics 286, 307, 315–16

Averroes 36–7, 41axiomatic methods in mathematics and

economics 260–61Ayer, A. J. 285

Bacon, Francis 67–8, 71, 73, 84, 99, 110Bailey, Samuel 141balance, analogy of 193balance of trade 64, 78–9, 84–7, 97Bank of England 98, 150–53bank failures 216banking 98, 133, 150–52, 212–13, 217–18, 227banking school 153Banque Générale 92Barbon, Nicholas 87Barone, Enrico 182, 275–6‘bastard' Keynesianism 236bearishness 223Becker, Gary S. 311–12, 316beehive fable 113Bentham, Jeremy 136, 142, 165, 167, 169Bergson, Abram 280–81Berlin, Humboldt University of 166

bimetallism 194biology, in Marshall 179–80Bismarck 166, 269Black Death 40–41, 47Bland-Allison Silver Act 190Blaug, Mark 326blood, circulation of 101Bodin, Jean 62, 65, 81Böhm-Bawerk, Eugen von 163, 182–3, 211–12Boisguilbert, Pierre de 89, 91, 101, 103, 109bombing 252–3boundaries

of disciplines 312–13of schools 323

Bourbaki 261Bowley, A. L. 240Boyle, Robert 68, 71Brahe, Tycho 53Bretton Woods system 295Bridgman, Percy 258Britain

financial crisis of 1797 133franchise extended 164–5

Government Economic Service 289inter-war economy 314–15national accounting 243–4Parliament 148War Cabinet, Economic Section 243, 289see also England

British Association 148Brookins model 292–3Brunner, Karl 298Buchanan, James 284, 286, 312bullionism 151–2Bureau of Foreign and Domestic Commerce 241–2bureaucracy, theory of 284, 312business, control of 186, 205business cycle 161, 164, 172, 183, 202, 208, 211,

213, 216–28, 233, 235–6, 239, 246–50, 265,289, 296, 300

business enterprise 196–7business and industry 202

Calabresi, Guido 319calculation, socialist 275–9, 287see also socialism

calendar 52calibration methods 300California, gold discoveries 172Calvin, Jean 54–5Cambridge, University of 178, 182, 209, 220,

222–3, 229, 271, 279, 307, 323Cameralwissenschaft 166canon of great works 8Cantillon, Richard 94–9, 101, 103, 109, 130capital 4, 21, 31, 38, 42, 69–70, 78, 80, 101–3,

106–7, 126–7, 129, 138–9, 147, 153–4, 158–64, 169–70, 182, 188–90, 192–3, 204, 211–13, 217–18, 230, 242, 256–7, 274concentration of 161–2organic composition of 161

capitalism 155, 157–64, 184, 190, 195, 197, 199,209, 275, 286, 301, 310

Carlyle, Thomas 135Carmichael, Gershom 112, 114Cartesian method 82

see also Descartes, RenéCassel, Gustav 255, 276Catchings, Waddil 226cause-and-effect reasoning 198

censorship 99, 109Central Intelligence Agency 253Chamberlin, Edward 9, 202, 205–7, 319, 327Champernowne, David 233, 235Charlemagne 40, 55Charles 173Charles II 73, 79Charles V 47, 49Charles Martel 35, 39–40checks to population growth 134Chicago, University of 316–17, 323Child, Josiah 79–80China 310Christian socialism 190Christianity 29–30, 33–4, 39, 135, 181cisterns, analogy of 194cities, growth of 57Civil War, English 74civilization, Ibn Khaldun on 37–8Clark, Colin 243, 301Clark, John Bates 187–90, 192, 201, 313, 323Clark, John Maurice 201–2, 204–6classes 101

classical economics 109, 131–65, 168, 173, 182–4, 198, 201, 272, 285see also neoclassical economics; new classical

macroeconomicsclassical situations 325, 327classical theory 232–4clipping, of coins 48coal, Jevons on 172coalitions 263Coase, Ronald 283–4, 318–19Colbert, Jean Baptiste 59, 89–90Coleridge, Samuel Taylor 135collective action 199colonial economics 301commerce, justification for 42

see also tradeCommons, John Rogers 198–201, 314, 317, 323communism 155, 157commutative justice, see justiceCompagnie d'Occident 92–3comparative economic systems 310compensated dollar 194compensation tests 279–80

competition 45, 106, 113, 117, 128, 138, 157,164–5, 176, 186, 188–90, 202–7, 258, 265,277–9, 281–2, 284, 300, 305–6, 316, 327–8

computing 267, 321concentration of capital 161–2Condillac, Étienne Bonnot de 100, 142, 170, 173Condorcet, Marquis de 133–5, 137, 142, 167confession 41–2Constantine, Emperor 29Constantinople, fall of 29, 51consumers' surplus 272–3continuous market clearing 299Copernicus, Nicolaus 52–3core of economics 238–9, 310, 324core and periphery 302–3Corn Laws 140, 149correlations 247–8Cournot, Augustin 143, 146, 166–7, 237, 327Cowles, Alfred 245–6Cowles Commission 246, 250–2, 260Crash, Great 215, 225creation stories 12crime, theory of 311

Cromwell, Oliver 73cumulative process 211–12, 219Cunningham, William 178, 182currency principle 152Currie, Laughlin 226, 228, 236, 242, 288cynicism 26, 33Cyrus the Great 17Cyrus the Younger 16

damnum emergens 46Dantzig, George 254Darwin, Charles 2Davenant, Charles 72, 243Debasement, Great 63Debreu, Gérard 260, 261, 281–2, 325, 327debt 216, 305demand

curve 145, 247effective 220theory 256–7, 259see also supply and demanddemography 313

Demsetz, Harold 319

Depression, Great 224, 293Descartes, René 53, 67–8, 84development

of capitalism 208Ibn Khaldun on 38stages of 111, 118, 163

development economics 301–6, 310, 313–14dialectics 157–9Dickens, Charles 195Dickinson, H. D. 277Diderot, Denis 100–101diet problem 253al-Dimashqi 36Diogenes 26Dionysius II 19discoveries, sixteenth-century 57‘Dismal Science' 135Disraeli, Benjamin 269division of labour 17, 123–4, 126, 130dollar, compensated 194dominance, in game theory 264Dominicans 43Douglas, Paul 227

Downs, Anthony 284, 312Du Pont de Nemours, Pierre-Samuel 100dualism, in development 303Dupuit, Jules 145dynamics and statics 189

East India Company 66, 79, 85École des Ponts et Chaussées 143, 145, 167–8econometric model, requirements for 250Econometric Society 245–6, 252, 267econometrics 239–40, 245–52, 267, 300, 307,

310–11, 321, 324see also macroeconometric models

economic history, discipline of 178, 181–3, 313economics

beginnings of 5–6definition of 3–4, 239history of 1–3, 209, 326–8origin of term 167profession, sociology of 321–4;see also boundaries; schools; universitiesprofessionalization of 166pure 171

see also economics preceded by agricultural;applied; Austrian; classical; colonial;development; experimental; historical;industrial; Keynesian; labour; monetary;neoclassical; post-Keynesian; public;radical; welfare and also new classicalmacroeconomics; political economy

Économistes, see PhysiocracyEdgeworth, Francis Ysidro 183, 238effective demand 220Eichner, Alfred 315Elizabeth I 57, 86Ely, R. T. 198–9employment 3, 58, 77, 85–6, 92, 113, 119–20,

129, 139, 190, 200, 219, 221, 223, 226, 228–32, 235, 239–40, 242, 250, 268, 283, 290–1,293–5, 297–300, 302, 304, 306, 321see also business cycle; full-employment

policyenclosures 63–4Encyclopédie 100–101Engels, Friedrich 157–8engineering 143–6, 197, 252–3England

commercial crisis of 1620s 76–7recoinage crisis of 1690s 84–7Tudor 62–4see also Britain

Enlightenment 58, 99–100, 135Scottish 110–112, 121, 154

entrepreneur 176, 183, 208, 221Epicurus 26equations, counting 255equilibrium

assumption of 299existence of 171, 255–6partial and general equilibrium 179stability of 171

error terms 251, 253estate, in ancient world 12estate management 16, 23ethics 20, 26, 36, 189, 287

see also justice; moral philosophy; propertyeugenics 194Euripides 13Europe

inter-war economy 215–16

post-First World War reconstruction 241south-eastern 301

evolution 111, 154, 167, 179, 195, 198, 314ex ante/ex post distinction 219exchange 11–12, 20–24, 27, 43–5, 170exchange rate, and policy 222exchange value, see valueexpectations, determination of 230–31experimental economics 319–21, 326exploitation 161externalities 283, 319

Factory Acts 150family 311Federal Reserve System 224–5Federal Trade Commission 241Ferguson, Adam 111Fetter, Frank Albert 192feudalism 39–41, 89, 157firm, theory of 318–9Fisher, Irving 191–4, 201, 218, 224–5, 227–8,

230, 236, 238, 240, 245–7, 258, 313–14, 323fluitschip 76

forecasting 246, 294, 308foreign exchange 77Foster, William Truffant 226Foxwell, Herbert Somerton 182France

agricultural productivity 101economic problems under Louis XIV 89–91Revolution of 1789 132Turgot's reforms 105–6unification of 90

franchise, extension of 164–5, 269free trade 148–9, 183, 305

see also laissez-fairefriction 317Friedman, Milton 228, 236, 295–8, 323Frisch, Ragnar 235, 235–6, 248–9, 266full-employment policy 290–91, 295

Galbraith, John Kenneth 314Galiani, Fernando 108Galileo Galilei 53Galton, Francis 238game theory 262–5, 268, 319, 326

General Agreement on Tariffs and Trade 289general-equilibrium theory 170, 182, 207, 254–63,

267, 314, 325–6geography 313geometry, Euclidian 137–8George, Henry 184Germany

hyperinflation 216–17national accounting 241reparations 222rise of Nazi Party 207, 215see also historical economics, German

Gibbs, Willard 191, 258–9Gilbert, Martin 244, 291Godwin, William 133–5, 137going concerns 199gold, see moneygold standard 87, 222–3Goldsmith, James 3good life, ancients on 22–4goods

higher-and lower-order 175public 283

Gossen, Hermann Heinrich 168Gournay, Vincent de 104–5government

analysis of 312economists in 308spending 219, 235theory of 284

Graunt, John 72, 313Great Crash 215, 225Great Depression 224, 293Great Exhibition (1851) 165Greece, ancient 11–24

Averroes and Greek thought 36–7Gregory IX 42Gresham, Thomas 86Gresham's Law 86gross national product, see national-income

accountingGrotius, Hugo 56, 108growth, economic 84, 102, 118, 124, 126–7, 138,

179, 302–5

Haavelmo, Trygve 251

Haberler, Gottfried 225, 249, 289habits of mind, see institutionsHadley, Arthur T. 192Hansen, Alvin 226, 233, 236Harsanyi, John 286Harvard University 316Hawtrey, Ralph 220–21, 226, 228, 236Hayek, Friedrich von 183, 217–19, 224, 236, 263,

278–9, 285–6, 316, 323, 328Hector 11Hegel, Georg Wilhelm Friedrich 157Henry VII 62Hermann, Friedrich 146, 174, 179Herodotus 14Hesiod 12–13heterodoxy 313–17, 323Hicks, John R. 233, 235, 256–9, 266, 279–80,

325–6Hilbert, David 260Hilferding, Rudolf 163Hirschman, Albert 303, 313historical economics

British 178

German 173–4, 178, 187, 199, 313history, in Scottish enlightenment 111, 121

see also development, stages ofhistory of economics 1–3, 209, 326–8Hobbes, Thomas 56, 68, 73–5, 84–5, 88, 120,

128, 130, 132Hobson, J. A. 226Holmes-Moriarty problem 263Homer 11–12, 14,17Hooke, Robert 68, 71Hoover, Herbert 214human needs, Carl Menger on 174–5Hume, David 74, 110–111, 114–6, 119–20, 126,

133, 150Hutcheson, Francis 112–14, 126‘Hydraulic' Keynesianism 293

Ibn Khaldun 37–9Ibn Rushd, see Averroesideal state, of Plato 18–19ideology 324idleness, and corruption 34Iliad 11–12

imperialism, economic 311–13impossibility theorem, Arrow's 281, 312impulse and propagation problems 248–9incentives, J. S. Mill on 155income distribution, Ricardo on 138–40index number, of prices 190India, James Mill's history of 136indifference curves 256–7industrial economics 265, 314, 318industrialization 149, 178inflation 57, 62–3, 222–3, 297

see also money, quantity theory of; Phillipscurve

inflationary gap 291information 278, 286, 300, 317injustice, of business practices 32innovation 183input-output analysis 207–8, 241, 254Institute for Business Cycle Research, Vienna 263institutionalism 201, 236, 314–5, 323institutions 195–7, 199–200, 320insurance 309integrating tendencies, in economics 326–6

integration, vertical 318interest rate, 79–80, 82–3, 106–7, 152, 192, 211–

13, 217–20, 223, 236see also usury

interests, and human nature 73, 74International Bank for Reconstruction and

Development,see World Bank

International Labour Organization 289International Monetary Fund 289internationalization, of economics 306–7, 323investment, Keynes on 230invisible hand 126, 128, 149Ireland, political anatomy of 70–71IS-LM model 235–6, 294, 233–4Islam 29–30, 35–9

James I 73James II 73Jean le Bon 49Jesus 33Jevons, William Stanley 167–70, 172, 174, 176,

179, 188, 190–92, 237–8, 246, 270–71, 325

John, St 33Jones, Richard 177Joseph, father of Jesus 42journals

Anglo-American 142, 148, 166, 187, 266French 100, 146German 166mathematics in 265–6specialist 310

jubilee, in Old Testament 31Judaism 30–32Juglar cycle 226just price 21, 43–5, 55, 61justice 20–22, 27, 31, 128

Kahn, Richard 229Kaldor, Nicholas 279, 280Kantorovich, Leonid 254Kelvin Lord 252Kennedy, President J. F. 291, 295Kepler, Johann 53Keynes, John Maynard 1, 8, 189, 220–24, 228–34,

236, 243, 247, 290–91, 307, 323, 325–6

Keynesian economics 232, 235, 290–93, 296,299–302, 304, 314–16, 323, 326‘ bastard' 236‘ hydraulic' 293

Keynesian revolution 232–6King, Gregory 72King, Willford I. 240Klein, Lawrence 251, 292Knies, Karl 187, 188, 198Knight, Frank 201–4, 206knights, and feudalism 39–40knowledge, see informationKondratiev cycle 225Koopmans, Tjallling 254Koran 35Kregel, Jan 315Kuhn, Thomas S. 315Kuznets, Simon 208, 241–2, 244, 291–2, 301Kydland, Fynn 300

La Follette, Robert 241laboratory, economic 320labour 94–5, 115, 119, 126, 132, 159

labour economics 309–11Laissez-faire 91–2, 104, 109, 113, 127–9, 130,

150, 156, 164, 183, 187, 205, 227, 268, 270–71, 305

Lancaster, Kelvin 282land 23–4, 94landowners, consumption of 95–6Lange, Oskar 277, 279–80Latin America 304Laughlin, James Laurence 203law and economics 199, 312, 319

framework of 287Roman 26–7, 112

Law, John 91–4, 98–9, 105law of markets, see Say's LawLeague of Nations 244, 249legal reform, Bentham on 136leisure class, theory of 195Leonardo da Vinci 52Leontief, Wassily 207, 208, 254Lerner, Abba P. 279–80Leslie, Thomas Edward Cliffe, 148Lewis, Arthur 303

liberty 156Lindahl, Erik 218linear programming 253–4Lipsey, Richard G. 282, 293, 297liquidity preference 231liquidity trap 231literae humaniors 52Little, Ian 279, 305LM curve, see IS-LM modellocation, Thünen on 147Locke, John 56, 68, 80–81, 84, 86–7, 96–7, 99–

100, 107, 114, 120logic 153logical positivism 285London School of Economics 182, 323Longfield, Mountifort 148Louis XIV 89–91, 99, 104Louis XV 93, 99–100, 104Louis XVI 106Lucas, Robert E., Jr 298–9, 300, 316Lucas critique 298–9lucrum cessans 46Lundberg, Erik 218

Luther, Martin 54–5luxury spending 64, 83, 113, 114, 115, 129

McCulloch, John Ramsay 142, 148–9, 238, 325Machiavelli, Niccolò 59, 60, 65, 73, 75, 120machine process 196–7McNamara, Robert 290macroeconometric models 251, 292, 295, 298

see also econometrics; Tinbergen, Janmainstream, homogeneity of 316Malthus, Thomas Robert 2, 133–5, 137–8, 140,

149, 166–7, 177Malynes, Gerard 3, 77, 78, 84management 313Mandeville, Bernard 112–13, 130, 132Mangoldt, Hans von 146, 203manufacturing, growth of 133, 139Marcus Aurelius 26marginal efficiency of investment 230–31marginal private and social products 273–4marginal utility 169, 172, 175, 182, 188, 284marginalism 269–70, 313market, extent of 124

market structure 206, 265markets, and coordination 49, 64, 85, 91–2, 103,

113, 284Marschak, Jacob 250–51, 317Marshall, Alfred 4, 154, 178–83, 189, 192, 201,

203, 207, 209, 219–20, 222, 254, 258–9, 270,272–3, 282, 285, 318, 322, 325

Marshall, Mary Paley 219, 220Martel, Charles 35, 39–40Marx, Karl 1, 8, 109, 141, 156–65, 183–4, 195,

197–8, 237Marxism 184, 269, 314–15Massachusetts Institute of Technology 316mathematics

twentieth-century developments in 259–61use of 21–2, 142–3, 167–8, 170, 179, 181,

183,190–93, 201, 229, 232–5, 237–8, 245,255–6, 258–9, 263–8, 301, 306–7, 309,312, 314, 316

maximization 169, 176, 182, 201, 258–9, 270,320see also optimization

Meade, James 243–4, 291measurement 168–9, 252

mechanical laws 53mechanical reasoning 82Menger, Carl 174–7, 188, 255, 316, 325Menger, Karl 255–6, 263, 266Mercado, Thomas de 62mercantililsm 57–9, 70, 87, 89, 91, 98, 104, 113,

116, 121, 129, 132, 148merchant adventurers 66, 77Mercier de la Riviére, Pierre-Paul 100metallic fluctuation, principle of 153Methodenstreit 177methodological individualism 316Michelangelo 52Middle Ages, end of 51migration

of European economists 207, 210, 266, 307under Colbert 90

Mill, James 136–7, 142Mill, John Stuart 236–7, 153–6, 164–5, 168, 172,

179, 198, 203, 219, 270, 272Minard, Joseph 145Mirabeau, Marquis de 58, 89, 100–101Mirrlees, James 305

mirror for princes 36Mises, Ludwig von 217–18, 224, 276–7, 285–6,

316Misselden, Edward 78, 87, 129Mitchell, Wesley Clair 202, 227, 236, 246, 247–8,

323Modigliani, Franco 234monasteries 39–40Monchrétien, Antoyne 117monetarism 295, 298, 323monetary economics, see monetary policy; moneymonetary policy 150–53, 218, 224, 226–8, 236,

296money 36, 47–9, 58, 61–2, 71, 77–87, 91–2, 96–

8, 101–3, 115–116, 120, 159, 176, 186, 218,289, 296 100 per cent 227–8quantity theory of 120, 191, 193, 213, 220,

222, 246, 296see also monetary policy

monopoly 165, 196, 273see also competition

Montesquieu, Baron de 100, 110–11, 120Moore, Henry Ludwell 246–7moral philosophy 112, 121–3, 132–3, 135

Morgenstern, Oskar 247, 263–4, 266, 319Moses 31multiplier 229Mun, Thomas 3, 78–9, 84, 87, 116mutuum 46Myrdal, Gunnar 218

Napoleon 142Nash, John 264–5Nash equilibrium 265Nathan, Robert 242, 244, 291–2National Bureau of Economic Research 202, 227,

236, 241national income, and welfare 272national-income accounting 69–70, 72, 240–45,

289, 291National Science Foundation 320nationalism 56–7, 64natural law 26, 42–3, 45, 56, 110, 112, 136natural liberty 127natural philosophy 167natural price 125Navarrus 60–62, 81

Navier, Claude Louis Marie Henri 143–5Navigation Acts 128neoclassical economics 201, 203, 317, 323neoclassical synthesis 323, 325–6Neoplatonism 52–3Netherlands, Central Planning Bureau 248Neumann, John von 255–6, 259–63, 265–6, 319new classical macroeconomics 298–30New Deal 200, 235, 290New World, discovery of 29Newcomb, Simon 190–91, 193Newmarch, William 238Newton, Isaac, 2, 53, 68, 99, 110Newtonianism 135, 167Nobel Prize 307Norman conquests 40North, Dudley 82–5, 87North, Roger 82–3numéraire 107Nurske, Ragnar 302

ocean, analogy with 189, 222Ockham, William of 54

Odyssey 11–12Ohlin, Bertil 218oil, price of 295–6Old Testament, see Judaismoligopoly 206, 209Olson, Mancur 284, 312operationalism 258optimization 239, 253, 311Oresme, Nicole 47–9organic composition of capital 161Organization for Economic Cooperation and

Development 302, 305Organization for European Economic Cooperation

245, 289, 302Organization of Petroleum Exporting Countries

295originality, emphasis on 326overhead costs 204Overstone, Lord 153Owen, Robert 137

Pandora's box 12Pareto, Vilfredo 182, 254, 256, 274–5, 280

Pareto improvements 279–80Pareto optimality 279–80, 281–2Paris, University of 41passions, see interestsPatinkin, Don 234–6Paul, St 33Pearson, Karl 238, 247pecuniary principles 197Pennsylvania, University of 185Pepys, Samuel 68Pericles 14period of production 211–13, 217Persons, Warren 246, 248Peter, St 33Petrarch 51–2Petty, William 68–9, 71–2, 81, 85, 243, 313Phillips, A. W. 293, 297Phillips curve 293–5, 297–8Phillips machine 293Philosophic Radicals 136–7, 148, 153physics 252–3, 258–9, 262, 266Physiocracy 100–104, 132Pigou, Arthur Cecil 182–3, 220–21, 273–4, 282–3,

285, 323pin making 124plague 69

see also Black Deathplanning 275–9, 290–92, 304Plato 11, 14–15, 18–19, 21, 23–4, 27, 34, 36pluralism, in US economics 201Polak, Jacques 3, 289political arithmetic 69–72political economy 117, 135Political Economy Club 147–8political science 312, 313Pompadour, Madame de 100Poor Laws 57, 134, 149population 69, 70, 119, 155, 165post-Keynesian economics 315–16poverty 132, 305Prebisch, Raúl 289, 302, 303Prescott, Edward 300price, see just price; valueprice mechanism,

see competition;markets, and coordination;

valueprice–specie–flow mechanism 98privatization 298probability, and statistical methods 251product differentiation 206–7professionalization of economics 166profits 36–7, 42, 46, 50, 55, 61, 64–5, 69–70,

106, 154, 159, 182–3, 188–9, 203, 208, 223,243declining rate of 137, 139–40, 142

progress, histories of 327–8progressions, arithmetic and geometric 134prohibition 194project evaluation 305propensity to consume 230property 34, 42–4, 134, 176property rights 199, 283–4, 287, 319Protagoras 15psychology 167, 191–2, 203–4, 313, 319Ptolemy 52public-choice theory 312–13, 319, 323public economics 309–10public goods 283

Pufendorf, Samuel 56, 108, 112, 114pump-grinding deficit 242Pythagoras 13Pythagorean science 52

quality control, statistical 254quantification, of economic theory 202queen of the social sciences, economics as 313Quesnay, François 100–113, 106, 108–9, 160, 237

radical economics 315RAND Corporation 264random numbers 247–8Raphael 52rational-choice sociology 312–13rational-choice theory 314, 326, 329rationality 18–19, 49, 299, 312

see also rational-choice theoryRau, Karl Heinrich 146, 174, 179real-bills doctrine 152, 225reason,

see Enlightenment;rationality

recoinage crisis 86–7reference cycle 246reflux, doctrine of 152Reformation, Protestant 54–6relativism, historical 111religion 110

see also Christianity; Islam; JudaismRenaissance 29, 51rent, theory of 138reproduction, simple and extended 159–60Ricardo, David 8, 136–42, 146, 148–9, 151, 154,

157, 160, 163, 165–6, 168, 171, 173, 198,232, 237

Richelieu, Cardinal 74Riqueti, Victor, see Mirabeau, Marquis de 100risk, 32, 203rivalry 279Robbins, Lionel 3, 183, 239, 256, 259, 279, 323Robertson, Dennis 220–21, 223Robespierre, Maximilien François Marie Isidore de

133Robinson, Joan 209, 236, 315Rogers, J. E. Thorold 178

Roman Empire 23–4, 29, 30, 35, 51see also law, Roman

Romanticism 135, 165, 173Rome, St Peter's Basilica 52Roos, Charles 245, 246Roosevelt, Franklin Delano 200, 235, 290Roscher, Wilhelm 173–4, 176Rosenstein-Rodan, Paul 301–2Royal Exchange 78, 84Royal Society 67, 68, 71, 148Royal Statistical Society 148Ruskin, John 135, 165Russia 207, 275

see also Soviet Union

sabbatical, in Old Testament 31Saint-Simon, Claude Henri 154Salamanca, school of 60–62, 65Samuelson, Paul A. 232, 234–5, 239, 256, 258–9,

264, 266, 282–3, 288, 294, 297, 325–6saving, and growth 127, 129, 218–19, 229Say, Jean Baptiste 109, 142, 146, 166, 170Say's Law 142, 232

scarcity 12–13, 31, 63, 170, 239Schlesinger, Karl 255Schmoller, Gustav 173–4, 177, 183, 322schools 322, 326Schultz, Henry 247Schumpeter, Elizabeth Boody 209Schumpeter, Joseph Alois 164, 183, 189, 207–9,

226, 309, 321–2, 324–6Schwartz, Anna J. 296science, and economics 52–3, 66–8, 167, 201–2,

285scientist, use of term 167Scitovsky, Tibor 280Scotland 92, 111–12, 118

see also Enlightenment, Scottishsecond best, theory of 282self-interest 60, 65, 85, 113, 120, 123, 177Sen, Amartya 286Senior, Nassau 141–2, 149, 165Sermon on the Mount 46shadow prices 305Shubik, Martin 265Sidgwick, Henry 271–3, 282, 285

silver, see moneySimons, Henry 227–8, 236simultaneous equations 171, 250Slutsky, Eugen 248Smith, Adam 1–2, 5, 8–9, 58, 72, 87, 109, 111–

12, 114, 121–30, 132–3, 136–7, 142, 146,148–9, 160, 163–8, 173, 176, 178, 198, 270,272, 284–5, 287, 325, 327

Smith, Thomas 63–5social-choice theory 281, 285, 326social cost 319

see also marginal private and social productssocial reform 181, 194, 198, 200, 270–71social-welfare function 280–82socialism 137, 153–7, 182, 197, 200, 209, 269–

70, 275–9, 285–6, 290, 309–10sociology, discipline of 311, 313sociology of economics profession,

see economics, profession, sociology ofSocrates 15–16Solon 14Solow, Robert M. 288, 294, 297Sophists 15Sophocles 13

Southey, Robert 135sovereign, duties of 128–9sovereignty, Reformation and 55–6Soviet Union 241, 286, 301, 306, 310Spain 61–2, 98spectator, impartial 122Speenhamland System 133spending, and employment 229–31Spiethoff, Arthur 183spontaneous order 130Sraffa, Piero 209Stable Money League 194, 225Stackelberg, Heinrich von 209stages of development 111, 118, 163states of consciousness, and welfare 273Statistical Society of London 177statisticians, see statisticsstatistics 238, 247, 253, 258, 289, 291, 301, 325

see also national-income accountingSteuart, James 114, 117–21, 129, 146stewardship 31, 33Stewart, Charles Edward 118Stigler, George J. 316–17

Stiglitz, Joseph 286, 289stock, see capitalStockholm School 218–19Stoicism 26, 33, 56Stone, Richard 243–5, 291structural adjustment 305–6structuralism 303–4structure-conduct-performance paradigm 265, 314supply and demand 61, 117, 121, 130, 180, 182,

299diagram 143–4, 146, 170, 179

Swift, Jonathan 68sympathy 122

Tableau économique 102–4, 109, 160Tamerlane 37tatônnement 171Taussig, Frank 201Taylor, Fred M. 277Taylor, Harriet 153Teeth, brushing 311tenancy 273terms of trade 303

textbooks, German 146Thales 13Thatcher, Margaret 298Theodosius 29theory, and measurement 267thesis and antithesis 157Thomas of Chobham 3, 42, 46Thornton, Henry 150, 151, 152Thucydides 14Thünen, Johann Heinrich von 147, 168, 179, 203,

237Thurstone, L. L. 319Times, The, economists' letter to 183Tinbergen, Jan 248–9, 250, 266, 289, 292, 307Tobin, James 288Tooke, Thomas 153, 238Torrens, Robert 138, 148tort 319Toynbee, Arnold 178, 180trade 42, 81–4, 101, 115, 154trade cycle, see business cycletrade unions 149–50trading companies 66

Trajan 25transaction costs 317–19, 323, 326transactions 199, 317transport 253–4, 309Troy 11Tucker, Josiah 105Tugan-Baranovsky, Mikhail Ivanovich 164, 183Tugwell, Rexford 290Tullock, Gordon 284, 286, 312Turgot, Anne Robert Jacques 100, 104–9, 126,

130

uncertainty 230, 311underconsumptionism 226unemployment, see employmentUnion of Radical Political Economy 315United Nations 245, 301–2United Nations Conference on Trade and

Development 289United Nations Industrial Development

Organization 305United States of America 185–6, 214–16, 240–45,

301, 307–8, 316, 324Commerce Department 244

Council of Economic Advisers 288Office of Naval Research 264Office of Strategic Services 252Supreme Court 200War Planning Board 291

universals 27universities 2, 15, 41, 110, 129, 166, 178, 185,

290, 291–2, 307–8, 316, 323–4usury 35, 42, 46, 55Utilitarianism 136, 148, 153, 168, 169–70, 271Utility 191, 201

see also marginal utility; maximization;utilitarianism

utopianism, Malthus on 134

value 95–6, 107–9, 112, 114, 125, 129–30, 139,141–2, 146, 154, 157–8, 160, 163, 168, 170,175see also competition; supply and demand

Veblen, Thorstein Bunde 195–8, 201–2, 227, 314,323

Verein für Sozialpolitik 174, 187Versailles peace conference 221via moderna 53–4

Victory Program 291Vienna Circle 255Viner, Jacob 201, 203voting theory 142–3

Wald, Abraham 255–6, 259–61, 263Walras, Léon 167, 168, 170–72, 174, 176, 179,

182, 188, 191–2, 207, 237, 254–6, 274, 313,325–6

Warburton, Clark 242Warming, Jens 229wars 72, 75–7, 100–104, 137, 252–4, 288, 290–

92, 295, 301, 310, 315Washington consensus 305wealth 22–4, 31–2, 36, 74, 83, 94, 107, 115, 119,

154–5, 240, 271–4, 301see also national-income accounting

Webb, Beatrice 182, 323Webb, Sidney 182, 323welfare economics 271–5, 279, 284–5, 326West, Edward 138, 148wheat, price of 137Whewell, William 167Whig history 7–8

see also progress, histories ofWicksell, Knut 182, 211–13, 217, 219, 228, 248Wieser, Friedrich von 183William III 73William of Auxerre 42–3Williamson, Oliver 318Wilson, E. B. 258–9windfall profits 223winner's curse 320Wisconsin, University of 199workshop of the world, Ricardo's doctrine of 140World Bank 289–90, 302, 305–6

Xenophon 13–17, 23, 34, 130

Yale University 316Young, Allyn 201, 226, 228Young Pretender 118Yule, George Udny 247

Zeno 26Zeuthen, Frederik 209Zwingli, Ulrich 54