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Living Economics

Yesterday, Today, and Tomorrow

The Independent Institute

Economics for Yesterday, Today, and Tomorrow

The latest "new economics," and in my opinion rather the worst for fallacious doctrine and pernicious consequences, is that launched by the late John Maynard (Lord) Keynes, who for a decade succeeded in carrying economic thinking well back to the dark age. ... The serious fact is that the bulk of the really important things that economics has to teach are things that people would see for themselves if they were willing to see. ... "The time has come to take the bull by the tail and look the situation square in the face."

— Frank H. Knight

Introduction

AN IMPORTANT UNSUBTLE point should be stressed in every economic conversation with peers, students, policymakers, and the general public concerning the great recession since 2008. John Maynard Keynes was wrong in both his analysis of capitalist instability and reasons for persistent unemployment in 1936, and he was wrong in 2008. The ideas Keynes developed in The General Theory of Employment, Interest, and Money (1936) were as wrongheaded in the nineteenth century as they were in the twentieth century, and as they are in the twenty-first century. Keynesian economics is simply bad economics. And it is vitally important to always remember that in the field of economics, bad economic ideas lead to bad public policies, which in turn result in bad economic outcomes. The realization of this string of logically connected "bads" might be long and varied, but it is inevitable. The Keynes of The General Theory was never right when it came to how an economy operates, let alone how to fix it when it teeters during crises. And the resurrection of Keynes among professional economists, public intellectuals, and especially politicians and policymakers in the wake of the global financial crisis of 2008 has been one of the most disappointing developments I have witnessed in my career as an economist.

Keynes was wrong because his analysis was based on a set of flawed premises. The earlier analysis of "effective demand" failure was first pioneered by Malthus but vehemently opposed by Ricardo and the other "classics," and was forced, according to Keynes, to exist "below the surface, in the underworlds of Karl Marx, Silvio Gesell or Major Douglas." Keynes believes that the complete victory of the "classics" is a mystery and reflects an unwillingness of professional economists after Malthus to recognize that disconnect between their theory and the basic facts of observation. "It may well be that the classical theory," Keynes argued, "represents the way in which we should like our Economy to behave. But to assume it actually does so is to assume our difficulties away."

But there are good reasons why economists forced these theories into the underworld of economic opinion. They reflected bad economic analysis. What I mean by that is that these theories implicitly assume away scarcity and believe the fundamental problem of modern society is poverty amidst plenty; they explicitly deny both actor rationality and the coordinating role of prices, as well as the function prices serve in guiding decisions and the feedback and discipline provided by profit and loss. If you postulate a world of post scarcity, then neither the coordinating role of the price system, nor the incentives of the property rights structure is critical, and if you don't allow the individuals that populate your economy to learn from market signals, and you don't allow those signals to actually work, then of course the economy will not work! This is not mysterious. Without prices and the market process continually guiding economic actors on a path of learning and discovery "amid the bewildering throng of economic possibilities," the economic future will indeed be ensnared by the "dark forces of time and ignorance."

It is important to stress, as J.B. Say did in his Letters to Mr. Malthus (1821), that all discussions of overproduction or underconsumption make reference to the price system. The cure to a "glut," Say argued, was neither monetary expansion nor fiscal stimulus, but allowing the prices to adjust to clear the market. In response to Malthus's theory of the "general glut," Say painstakingly explains how the market process coordinates the production plans of some with the consumption demands of others through market price adjustments. Say simply points out that "the slightest excess supply beyond the demand is sufficient to produce a considerable alteration in price." And this focus on market prices and the role price plays in the self-regulation of the market economy (and not his value theory, as Malthus had argued), Say argues, forms the true cornerstone of Adam Smith's lasting contribution to the science of political economy.

It is this last point raised by Say that I want to emphasize, namely that the cornerstone of Adam Smith's economics is his analysis of the price system and the self- regulating capacity of the market economy. This is where we find what is enduring in economics, whereas what is fleeting is found in that underworld of economic thinking that denies that analysis. Unfortunately, as has been pointed out by thinkers such as F.A. Hayek, James Buchanan, and more recently Luigi Zingales, the Keynesian message appeals to technocrats and politicians.

This is the economists' age-old plight, what is fleeting in economics is politically popular, whereas what is enduring in economics is politically unpopular. Hayek describes the economists' conundrum as consisting of being called upon to consult with politicians on matters of pubic policy more often than any other social scientists, only to have their advice based on the principles of the science dismissed as soon as it is uttered. Not only are the teachings of the discipline dismissed, but public opinion on the matters at hand seems to run in precisely the opposite direction of that of the economist. This position, Hayek argued, was not unique to his time, as it has been the plight of classical economists as well. But what is most fascinating as an issue for a theory of social change is that economists' ideas in general are not dismissed because public opinion clearly reflects the ideas of economists of the previous generation. Unfortunately, the ideas that dominate are those that Keynes pointed to that had been relegated to the underworld. This is precisely the situation we find ourselves in today. And as economic educators, we must, as the epigraph from Knight argues, stare the situation square in the face, acknowledge the ugly and unpleasant nature of things in our profession and the body politic, and take up the challenge of teaching the principles of economics to those who refuse to learn and in most instances even seriously listen.

What Adam Smith Did Not Say, and What He Did Say

Adam Smith was not the first economic thinker. But Adam Smith synthesized existing knowledge and did so in a way that has captured the imagination of intellectuals ever since. His is one of the towering achievements in the scientific and literary history of Western civilization. Even to this day, Smith's legacy is hotly debated.

A new generation of scholars such as Emma Rothchild and Sam Fleischacker are battling to save Smith's legacy from the Adam Smith tie-wearing conservative policy community. Stressing the human and egalitarian sides of Smith's theory, they seek to counter the reading of Smith that focuses exclusively on self-interest and market efficiency. This caricature of Smith, as this egalitarian and progressive reading of Smith points out, is false. Smith never said "Greed works" and that is that. His argument is much different. But the Smith of Rothchild and Fleischacker is also a confused caricature. Smith was not an egalitarian social democrat. He was an analytical egalitarian, but he was also a classical liberal political economist. The Wealth of Nations develops the positive science of political economy, and Book V can be read as an attempt to provide a set of rules that an enlightened statesman who desired to produce the "good society" could follow on the basis of that positive science. In Smith's work, the scale and scope of government is limited. While not nonexistent, it is limited to basically the "night watchman" state of classical liberal political philosophy: protections from foreign aggressors, protection of person and property and the administration of justice domestically, and the provision of essential public works. Only a distorted reading of Smith could produce either the institutionally antiseptic "self-interest" — only interpretation, or the Smith as precursor of the modern social democratic welfare state. The more modern social democratic reading of Smith is a consequence of the caricature prevalent in our culture of the "self-interest" reading as that of the laissez-faire economists in general. To distance Smith from the "economists," they offer an interpretation that is more compassionate to the poor and the dispossessed.

An older literature exists in intellectual history, which also tried to drive a wedge between Smith's Theory of Moral Sentiments (1758) and The Wealth of Nations (1776). Called the Das Adam Smith Problem, it argued that Smith built his theory of moral sentiments on human sympathy, whereas self-interest drove his theory of the economy. In one book we get other-regarding behavior, whereas in the other we get self-regarding behavior — how can we reconcile these works? Many attempts have been made to address this problem, including Vernon Smith's "The Two Faces of Adam Smith." The bottom line is that the "problem" is really not a problem.

The Wealth of Nations is about social order among strangers — a social order in which our span of moral sympathy moves far beyond the realm of the familiar. "In civilized society," Smith argued, man "stands at all times in need of the co-operation and assistance of great multitudes, while his whole life is scarce sufficient to gain the friendship of a few persons." The market economy is about cooperation in anonymity, cooperation with strangers. In the chapter just before the cited passage, Smith presents the reader with the basic mystery of economic life. The number of exchange relations that must be coordinated to produce even the most common products we take for granted "exceeds all computation."

The source of the wealth of nations arises from social cooperation under the division of labor, and to realize this social cooperation certain fundamental institutions in society must be in place — the delineation and enforcement of private property, the keeping of promises through contract, and the acceptance of the legitimacy of the transfer of property by consent. Benevolence would not be able to achieve this social cooperation under the division of labor. The relationships exist at the outer bounds of our span of moral sympathy. But when the institutions of property, contract, and consent are in place, then the self-interest of individuals can be marshaled to realize the mutual gains from trade and the benefits of every refined division of labor in society. Our moral sentiments do not disappear as the span of moral sympathy moves from the intimate order to the extended order of the market. They are omnipresent, but we must be mature about them; otherwise, our moral intuitions will be in conflict with the moral demands of the market order. The moral sentiments within a commercial society manifest themselves in more general rules of just conduct (related to the institutions of property, contract, and consent), rather than specific outcomes of just division given a fixed resource endowment. The rules of the intimate order do not transfer to the extended order without sacrificing the gains from social cooperation under the division of labor, in which case we sacrifice the extended order itself.

Smith certainly did not teach that individuals should pursue their self-interest at all costs. But he also didn't even teach the more subtle presentation that the pursuit of self- interest will automatically translate into public benefits. The Wealth of Nations actually has plenty of examples in which the pursuit of self-interest can lead to socially undesirable outcomes. His discussion of the vocation of teaching in Oxford (bad) and in Glasgow (good) provides a classic example. In Glasgow, the teacher had a strong incentive to provide valuable instruction because salary was a function of fees paid by the students, whereas in Oxford, because an endowment guaranteed a teacher's salary, the professors had long ago given up even the pretense of teaching. Smith's work is full of such comparative institutional analysis. The pursuit of self-interest in one case leads to a socially desirable outcome, whereas in the other it leads to an undesirable one. The key point: Smith's analysis does not turn on the behavioral postulate of self-interest but instead on the institutional specifications that are in operation. The institutional specification of a private property market economy guided by price signals and disciplined by profit and loss accounting will steer self-interested behavior in the direction of social cooperation. The vast division of labor is coordinated throughout the world, and the most common products — from a woolen coat in Adam Smith's time to a pencil in Milton Friedman's — are made available to individuals who will never know who played a part in the production of that good, and who if required to produce this product all by themselves wouldn't know where to start.

This is just another way to state Smith's "invisible hand" proposition. Individuals pursuing their own self-interest within an institutional setting of property, contract, and consent will produce an overall order that, although not of their intention, enhances the public good. Absent that institutional setting, self-interest may very well not produce publicly desirable outcomes and, in fact, may produce the opposite. What matters for Smithian political economy is the institutional filter that individual actors work within, and which produces unique equilibrating processes.

J.B. Say in his Letters to Malthus states that he revered Smith: "he is my master." As I mentioned before, Say had such a strong affinity to Smith because of his exposition of the fundamental role of prices in coordinating economic activity. As Say argued, exchange and the market prices that emerged in the "higgling and bargaining" among individuals formed the cornerstone of Smith's political economy. Smith's economics was price theoretic economics, but it was also institutional economics. The link between the abstract function of price and the concrete role of institutions that Smithian political economy provides supplies the foundation for what endures in economics. However, in understanding the full implications of Smith's message about market theory, the price system, and the role of institutions, we also reveal why technocrats and meddlesome politicians find it unpopular.

Hayek has argued that Smith designed his political economy to be robust against both the stupidity and arrogance of actors within the system. Smith and his contemporaries (e.g., Hume) sought to discover a system of governance in which bad men can do the least harm and which did not require for its operation that only the best and the brightest be in charge. They sought, in other words, a system of societal governance that treated men as they are — sometimes good, sometimes bad; sometimes intelligent, sometimes not so bright — and that would use their human variety to produce peace and prosperity. The classical political economists of the eighteenth and nineteenth century discovered that the private property market economy provided the basis for just such a system.

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Excerpted from Living Economics by Peter J. Boettke. Copyright © 2012 The Independent Institute. Excerpted by permission of The Independent Institute.
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