Forget everything you know about economics. In Classical Economic Theory and the Modern Economy, economist Steven Kates explains why economics has failed for more than 100 years.
As Dr. Kates tells it, throughout most of the 19th century economists agreed that the purpose of economics was to generate wealth and improve living standards, which meant growing the number and quality of goods and services on the market. Proper economic policies therefore aimed at expanding production (the “supply side”). Spending (the “demand side”) warranted little attention because it was understood to follow from production.
To understand why, imagine survivors of a shipwreck starting from scratch on an island. To build a prosperous economy, they would need to trade with one another; to do that, they would first have to produce things to trade. For example, if person A wanted the spear of person B, person A would have to make something—say, sandals—and trade his sandals for the spear. In effect, his production of sandals constitutes his demand for the spear. Ergo, production creates demand. In economics, this is known as Say’s law.
A corollary of this was the understanding that a “general overproduction”—a situation where an economy produces more than it consumes (or “total demand deficiency”)—was an impossibility. Economic disturbances, recessions, and depressions were seen to be caused by disruptions in the structure of production, but never as the result of too little demand. As David Ricardo, who expressed the prevailing belief of the profession at the time, put it, “men err in their productions; there is no deficiency of demand.”
This explains why classical economists regarded entrepreneurs as vitally important. Not only did they innovate technological advancements and improve methods of production, but they also had to manage resources responsibly, including structuring the production process to correctly anticipate consumer demand. That was no easy task. Failure to produce what consumers desired resulted in discoordination between supply and demand in the economy, which frequently ended in recession.
Furthermore, unlike popular modern caricatures, Kates emphasizes that classical economists were never so naïve as to ignore the obvious role money played. On the contrary, they took for granted the plain fact that analyzing “real” economic variables—that is, the goods and services, the physical and intellectual forms of capital and labor—was critical for properly understanding how the economy works. Only after the real economy was carefully understood was money introduced, lest one confuse the former with the latter and confound sound economic thinking.
Following the “Marginal Revolution” of “Austrian” economists in the 1870s, however, a shift in economic analysis took place. Rather than focusing on the economy as a whole and wealth production in particular, the Austrians turned their investigations toward the individual and his or her subjective preferences to explain value.
Early classical economists like Adam Smith and David Ricardo had advanced a “labor theory of value,” which posited that labor alone determined the value of a good or service, ignoring factors like product desirability and total production cost (not merely labor cost). Worse, Karl Marx later adopted the labor theory in his condemnation of capitalism. Thus, partly to parry Marx’s broadsides, the Austrians argued that value was determined not by labor but by “marginal utility,” or how much satisfaction a consumer derives from an additional unit of a product.
In rightfully rebuking Marx and the labor theory, however, the Austrians incautiously strafed the classical school, overlooking the fact that leading classicalists by that time had abandoned the labor theory. Kates cites as an example John Stuart Mill, who developed a “cost of production” theory of value, which anticipated many of the Austrian insights. Regrettably, however, Mill’s economics were neglected, and therewith emerged “a shift of orientation from the supply side of the economy to the demand side, with marginal analysis focused on utility rather than production costs,” writes Kates.
In short, although the classical framework survived the Marginal Revolution, the holistic supply-side focus receded into the background while the individual and utility entered the fore. Thus, when in 1936 John Maynard Keynes published his General Theory, few economists were sufficiently trained in the classical postulates to withstand the Keynesian shockwave and marshal a counterattack.
The Archimedean point for Keynes was demand (in the short run). Classical economists before Keynes knew that demand was the byproduct of production, and that elevating the former over the latter in explaining the business cycle constituted regress, not progress, in understanding the economy. But in formulating his demand-oriented theory, Keynes scarcely bothered reading classical thought. Instead he simply attributed to classicalists cartoonish views of the economy which he then set ablaze.
For example, he claimed their model assumed an economy in perpetual prosperity because, in his reckless imagination, it offered no explanation for recessions. He also ascribed to them the fatuous belief that “supply creates its own demand,” as if they naively assumed that producing a product, no matter how undesirable to consumers, guarantees its sale.
Both claims were demonstrably false. Classical economists had well-developed explanations for downturns (they simply rejected demand deficiency as one), and none of them were so jejune as to assume that merely producing something assures that someone will buy it. Nevertheless, Keynes’s caricatures received little blowback, which partly explains why he successfully dislodged production and entrenched demand at the center of short-run economic analysis.
One of the most enduring features of his victory, Kates chronicles, has been the transformation from observing the economy in “real” terms to analyzing it in “nominal” terms. In other words, instead of observing the economy in terms of resources, economists today tend to see it in terms of money. This shift has profoundly altered how we set economic policy. The “real” lens, in recognizing the reality of resource scarcity, prioritizes obtaining greater output from less input—ie, pumping up productivity—to maximize wealth. By contrast, the “nominal” lens, in analyzing flows of money, tends to mask resource constraints and puts a premium on the policy goal of maximizing employment, which often ends in wasted resources and depleted wealth.
For instance, a growing number of economists argue that we need major jobs and other programs, and that we need not worry about cost because we can “afford” them. But the central question is not “affordability,” but what private businesses might do with those resources—ie, the capital goods and labor—were they not commandeered for government purposes. Consider that, because private firms must employ resources that cover production costs plus a profit in order to survive, their projects tend to add value and grow wealth. Government initiatives, however, face no similar constraints and therefore generally deflate wealth.
This classical insight is best illustrated by an observation from Milton Friedman. While travelling in another country, Friedman saw workers using shovels to build a bridge. When he asked why the workers were using shovels rather than machinery, his host responded, “because using machinery would result in fewer jobs.”
“Oh,” Dr. Friedman replied, “I thought you were interested in building a bridge. If you want to create more jobs, why not give the workers spoons instead of shovels?”
Put simply, “jobs” policies ignore the fact that by employing the most productive means for accomplishing tasks—by building the bridge with machinery rather than shovels—human labor is saved, freeing up workers to either be employed elsewhere in the economy or enjoy leisure. In other words, “jobs” policies usually reduce wealth.
But as Classical Economic Theory and the Modern Economy elucidates, economists long ago abandoned the light of economic clarity for the cave of unregenerate confusion. The result is that policymakers have been complacently swinging at shadows ever since.
The good news is that, by reintroducing classical principles, Kates charts a path out of those caverns. The bad news is that, after living long in the dark, many may be blinded by the light.
This article, The Classical Economists Were Smarter than You Think, was originally published by the Foundation for Economic Education and appears here with permission. Please support their mission.