Thursday, May 3, 2012

The "Official" history of Economic Thought in 1000 words or less

The official history of economic thought has a surprisingly short history. As the official history this is what many people already know(or at least partly know) and is what's generally taught and passed on. Like many "official" histories, it contains many myths that are quickly uncovered after a little questioning more on those myths on another day. For now, let's just stick to the "official" history. For we cannot debunk myths without understanding the myths first.  If you knew all of the following you could sound reasonably informed in most  any conversation about the history of economics.

Our story starts about 240 years ago. A man named Adam Smith set out to discover why some countries were exceedingly wealthy and others very poor. The result of his research resulted in the first book on economics: "The Wealth of Nations". In it he laid out the laws of supply and demand and price vs. Value. He concluded that through trade, an "invisible hand" guided individuals to make decisions that caused a spontaneous order to develop. One in which great things were accomplished by everyone making smaller decisions. He opposed government involvement in the economy because centralized planning wasn't as efficient as everyone making decisions based on prices set by supply and demand. Therefore, the best economies were the ones without government involvement and where individuals were allowed to make their own decisions.

If there was a problem with Adam Smith it was his "Theory of Value". Smith made a distinction between price and value and ran into a problem he couldn't explain. The problem is known as the diamond-water problem. Why is water, necessary to life and needed everyday, was practically free, but diamonds which have no inherent worth go for a higher price.  He concluded that supply and demand set the price of an object, and that it didn't always set it to its real value. (remember this is the "official" history)

The next set of figures in our history are David Ricardo, John Baptist Say, and Thomas Malthus.  They all existed around the same time in the early 1800s, but each left their own unique contribution to economic theory.

First up is John Baptist Say.  He is famous for "Says" law.  The theory that "products are paid for with product", and therefore there can be no general glut of goods that can cause a recession because price will even out in the end.  To put another way, anything that is produced will be consumed.  This was later simplified to "supply creates it's own demand".
Then there is David Ricardo who is still mentioned in modern textbooks for his theory of "comparative advantage".  Comparative Advantage showed "unequivocally" that "free trade" benefits both countries involved in the end.  He did some other stuff that people feel occasion to mention, but this is the only important thing to remember in the official history.
Finally, we come to Thoma Malthus.  The only reason to remember him in our "official" history is because of how stupid he was.  He predicted that mankind was headed for tragedy.  Eventually the world population would outstrip ability to produce food.  Thanks to technological advances we aren't there which proves how awesome free market capitalism is, and how stupid Malthus was.

Then, in 1867  Karl Marx published Das Capital which gave capitalism it's name.  That's it.  Nothing else to see here.  Move along now.

Then, circa 1870, something great happened in the world of economics.  It was called the Marginal Revolution!  Remember that whole "Labor Theory of Value" that Smith had wrong?  The Marginal Revolution fixed it.  The theory goes like this:  Everyone's needs and wants are subjective.  Additionally, each additional unit of "a thing" is less important than the previous.  For instance, a cup of water when thirsty is important.  However, the second, third, fourth, etc... cups are each less and less important as one's thirst is quenched.  That is why water is priceless because everyone has enough.  Additionally, diamonds are rare, and people subjectively want diamonds.  Adam Smith's water-diamond problem was solved and there was much rejoicing in the world of economics.

Then, something strange happens in our "official" history of economic though.  Nothing new and interesting happens for 60 years...

Then, the Great Depression happened in the 1930s:  A long run recession that "Say" said couldn't be possible.  Out of that, a rising star from Cambridge University had a thought.  "What if supply doesn't automatically create demand?  Maybe demand creates its own supply?"  That man, John Maynard Keynes then went on to write the second most important book in economics, "The General Theory of Employment, Interest, and Money".  In it he explained how "Demand creates its own Supply".  In it he said that governments should spend lots of money all willy nilly during depressions to fight unemployment, and then pay down the huge deficits in upticks so as to fight inflation. (Again, this is the "official" history as told today)  Capitalism would enter a "golden age" of growth for over 20 years.

In the 1970s, disaster struck.  Inflation and unemployment happened at the same time.  Something that the keynesians(as followers of Keynes were called) couldn't explain.  It just so happened, that there was a man, named Milton Friedman, who had predicted just such an event.  People flocked to this prophet and asked, "Mr. Friedman, what do we do, we're all so confused".  Mr. Friedman smiled and said, "you see, government is the problem.  Balance the budget and give control of the business cycle over to 'politically insulated' central bankers - they'll know what's in the nations long term interest".

It was 1981, and a form of Monetarism called "supply-side" economics was put into place.  Together they stated that Free Trade was good, remove rules and regulations because they only hamper industry, privatize public lands and utilities to increase efficiency, high taxes on the rich reduced investment and hampered growth, and only central bankers should try to control the business cycle.  The low inflation and high growth of the 80s "proved" that supply-side works.  Now we are at current day mainstream economics.

Over the next 25 years the country experienced low inflation and low(but steady) growth.  Economists called it "The Great Moderation" and patted themselves on the back for taming the business cycle.  They all rejoiced.  That is, until all hell broke loose in 2008, but that's closer to recent events than history so I won't go into it.

And so ends are fast paced journey through time in less than a thousand words(not counting the intro).  As I stated before, if you've made it this far, you're probably as well versed in economic history as most people are.  Unfortunately there are some myths in this "official" history.  Some myths are areas where the story the myth tells is flat-out wrong, and in others it leaves out important, sometimes crucial facts.

You'll note that I didn't link to anything in my "official" history.  This was deliberate.  I did it for 3 reasons.  The first reason is that the "official" history is so pervasive I don't feel required to have to justify it.  The second reason, is that links are usually required to "prove" something, and here I did nothing but repeat the common fable.  And the third reason, is that I will provide links to people repeating the common myth, and the debunking of the myth in separate posts.  I will, eventually, one-by-one, try to recreate the actual history of economic thought and compare it to the common myth.  If you're interested, I suggest you subscribe to my blog and watch for posts that start with the title Economic History debunked.
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