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Wednesday, June 27, 2012

The Clash of Economic Ideas

At England’s stately University of Cambridge in fall 1905, a clever postgraduate mathematics student named John Maynard Keynes began his first and only course in economics. He would spend eight weeks studying under the renowned Professor Alfred Marshall. During the summer Keynes had read the then-current (third) edition of Marshall’s Principles of Economics, a synthesis of classical and new doctrines that was the leading economics textbook in the English-speaking world. Marshall was soon impressed with Keynes’s talent in economics. So was Keynes himself. “I think I am rather good at it,” he confided to an intimate friend, adding, “It is so easy and fascinating to master the principle of these things.” A week later he wrote: “Marshall is continually pestering me to turn professional Economist.”

At an Austrian army encampment on the bank of the Piave River in northern Italy during the last months of the First World War, a lull in combat gave a young lieutenant named Friedrich August von Hayek the chance to open his first economics texts (not counting the socialist pamphlets he had read during college), two books lent to him by a fellow officer. He later wondered why the books had not given him “a permanent distaste for the subject” because they were “as poor specimens of economics as can be imagined.” Returning to the University of Vienna after the war, the young veteran “really got hooked” on economics when he discovered a book by the retired professor Carl Menger. Menger’s Principles of Economics (Grundsätze der Volkswirtschaftslehre) of 1871 had colaunched a marginalist-subjectivist revolution in economic theory, a revolution that provided the new ideas in Marshall’s synthesis. Hayek found it “such a fascinating book, so satisfying.”

Keynes and Hayek would come to play leading roles in the clash of economic ideas during the Great Depression. Their ideas have informed the fundamental debates in economic policy ever since. In 2010 and 2011 their intellectual rivalry even became the subject of two viral rap videos.

Keynes flatly rejected Adam Smith’s doctrine of the invisible hand. In the opening paragraph of a 1924 lecture published in 1926 as an essay entitled “The End of Laissez-Faire,” he declared: “The world is not so governed from above that private and social interest always coincide. It is not so managed here below that in practice they coincide. It is not a correct deduction from the principles of economics that enlightened self-interest always operates in the public interest.” Specifically, Keynes denied that decentralized market forces were adequate for determining the volumes and allocations of saving and investment: “I do not think that these matters should be left entirely to the chances of private judgement and private profits, as they are at present.” In his book The General Theory of Employment, Interest, and Money (1936) Keynes would emphasize his view that market forces could not be counted on to deliver a great enough volume of investment in the aggregate. An enlightened government should take control.

Keynes was a leading advocate of the view that government should take greater control over the economy. Hayek was a leading advocate of the view that government should interfere less with market forces. They serve as useful representatives of the opposing sides because of their wide influence, not because either took the most polar position available. Keynes did not want to abolish markets the way communist thinkers would. Keynes explicitly rejected Russian communism for three reasons: (1) It “destroys the liberty and security of daily life”; (2) its Marxian economic theory is “not only scientifically erroneous but without interest or application for the modern world” and its Marxist literature more generally is “turgid rubbish”; and (3) it “exalts the boorish proletariat above the bourgeois and the intelligentsia”—in other words, sneers at people like Keynes and his circle. Hayek did not want to abolish government the way anarcho-capitalist thinkers would. (Yes, there really are serious proponents of a stateless market economy.)

For most of the twentieth century, Keynes’s view that government should take on a greater role in the economy prevailed among opinion-makers. And the role of government grew. While Keynes was not an advocate of complete state planning, he did endorse greater planning. In a letter to Hayek, responding to Hayek’s critique of state planning in The Road to Serfdom (1944), Keynes wrote: “I should say that what we want is not no planning, or even less planning, indeed I should say that what we almost certainly want is more.”

Political Economy in America’s Progressive Era

Economic ideas supporting the expansion of government’s role in the economy certainly did not begin with Keynes. Indeed, they did not even begin in the twentieth century. In the late nineteenth century the United States, for example, entered a period of ideological change toward more active government, a period now called the Progressive Era. Numerous economists played important roles in the ideological and political movement, developing arguments and promoting legislation to increase the role of the federal government in the economy, from the Sherman Antitrust Act (1890) to the Pure Food and Drug Act (1906) to the Federal Reserve Act (1913).

In the late 1870s and 1880s young American economists were returning from graduate training in Germany with ideas and approaches that they developed into a school of thought that came to be known as institutionalist economics. In 1885 the 31-year-old Richard T. Ely of Johns Hopkins University led a group of these economists in founding the American Economic Association (AEA). The AEA quickly became (and remains) the leading professional organization of economists, but among its original missions was to organize economists opposed to laissez-faire ideas. The AEA’s initial Statement of Principles affirmed “the state as an agency whose positive assistance is one of the indispensable conditions of human progress.”

Ely and his compatriots saw themselves as a “new school” of dissenters from classical or neoclassical economics and from the doctrine of laissez faire. He described the “new school” thinkers as scientific truth-seekers whose historical investigations had uncovered the benefits of labor unionization and strikes, had found in socialism “important and fruitful truths which have been unfortunately overlooked,” and had “overthrow[n] many cherished dogmas” of orthodox finance. As a result there were now “political economists teaching different doctrines from the theories previously received by the more influential elements in society.” Ely explicitly tied the new school in America to the teachings of German historical economists.

That many economists before 1930 developed anti-laissez-faire arguments and supported Progressive causes may surprise those who think that professional economists have almost always favored leaving the market free, or at least did so before Keynes. Fortunately or unfortunately, the devotion of economists to the doctrine of laissez faire has been grossly exaggerated, both for economists before the Great Depression and for economists today. Keynes himself exaggerated the views of the earlier economists, as did Nobel laureate (2009) and New York Times columnist Paul Krugman, when he wrote in 2007 that “Until John Maynard Keynes published The General Theory of Employment, Interest, and Money in 1936, economics—at least in the English-speaking world—was completely dominated by free-market orthodoxy. Heresies would occasionally pop up, but they were always suppressed.”

In fact a large number of prominent English-speaking economists promoted “heresies” from free-market ideas during the five or six decades before 1936. They were not relegated to the fringes of the economics profession, and their ideas were not “always suppressed.” (To be sure, the profession has always marginalized heretical amateurs, but more for their amateur status than for their policy views.) Ely and other American institutionalists were prominent in economics. Fred M. Taylor’s 1928 presidential address to the AEA was even a proposal for “The Guidance of Production in a Socialist State.” Nor were the leading neoclassical theorists—like Henry Sidgwick, Alfred Marshall, and Arthur Pigou at Cambridge or Irving Fisher at Yale—marginalized or suppressed when they criticized laissez faire. Marshall in a 1907 speech declared that “Economists generally desire increased intensity of State activities for social amelioration,” while Fisher in the same year noted with satisfaction “the change from the extreme laissez faire doctrines of the classical economists to the modern doctrines of governmental regulation and social control” that had taken place over the previous decades.

The ongoing clash of economic ideas reflects not only deep-seated philosophical differences about the value of individual liberty but also theoretical differences about the relative merits of free markets and government for steering the economy. Are competitive markets, guided by impersonal forces of profit and loss, better than government command-and-control for directing investment toward the greatest prosperity? The key insight of economics as a discipline—its greatest contribution to understanding the social world and to avoiding harmful policies—is that, under the right conditions (property rights, rule of law, free entry), an economic order arises without central design that effectively serves the ends of its participants. In Adam Smith’s analysis and famous phrase, investors are “led by an invisible hand” that aligns their private pursuit of profits with (what is no part of their intention) the greatest contribution to the economy’s overall prosperity. This Smithian idea has ever since been reaffirmed and elaborated by a long line of economists. Though challenged by others, it has been repeatedly borne out by the experiences of the last hundred years.

This article is excerpted from the introduction and chapter 1 of The Clash of Economic Ideas: The Great Policy Debates and Experiments of the Last  Hundred Years, by Lawrence H. White. Copyright © 2012 Lawrence White. Reprinted with the permission of Cambridge University Press.

Find a Vietnamese translation of this article here.