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Economics for the Hurried - Part 1

Over the next few months, most of my MuseLetters and posts will be excerpts from a new book-in-progress with the working title 'The End of Growth'. Only some of the book's contents will be serialized this way. The final product, with graphs and footnotes, will be published by New Society Publishers in fall 2011.

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The first economists were ancient Greek and Indian philosophers, among them Aristotle (382-322 BC)—who discussed the “art” of wealth acquisition and questioned whether property should best be owned privately or by government acting on behalf of the people. Little of real substance was added to the discussion during the next two thousand years.

Adam SmithThe 18th century brought a virtual explosion of economic thinking. “Classical” economic philosophers such as Adam Smith (1723–1790), Thomas Robert Malthus (1766–1834), and David Ricardo (1772–1823) introduced basic concepts such as supply and demand, division of labor, and the balance of international trade. As happens in so many disciplines, early practitioners were presented with plenty of uncharted territory and proceeded to formulate general maps of their subject that future experts would labor to refine in ever more trivial ways.

These pioneers set out to discover natural laws in the day-to-day workings of economies. They were striving, that is, to make of economics a science on a par with the emerging disciplines of physics and astronomy.

Like all thinkers, the classical economic theorists—to be properly understood—must be viewed in the context of their age. In the 17th and 18th centuries, Europe’s power structure was beginning to strain: as wealth flowed from colonies, merchants and traders were getting rich, but they increasingly felt hemmed in by the established privileges of the aristocracy and the church. While economic philosophers were mostly interested in questioning the aristocracy’s entrenched advantages, they admired the ability of physicists, biologists, and astronomers to demonstrate the fallacy of old church doctrines, and to establish new universal “laws” by means of inquiry and experiment.

Physical scientists set aside biblical and Aristotelian doctrines about how the world works and undertook active investigations of natural phenomena such as gravity and electromagnetism—fundamental forces of nature. Economic philosophers, for their part, could point to price as arbiter of supply and demand, acting everywhere to allocate resources far more effectively than any human manager or bureaucrat could ever possibly do—surely this was a principle as universal and impersonal as the force of gravitation! Isaac Newton had shown there was more to the motions of the stars and planets than could be found in the book of Genesis; similarly, Adam Smith was revealing more potential in the principles and practice of trade than had ever been realized through the ancient, formal relations between princes and peasants, or among members of the medieval crafts guilds.

The classical theorists gradually adopted the math and some of the terminology of science. Unfortunately, however, they were unable to incorporate into economics the basic self-correcting methodology that is science’s defining characteristic. Economic theory required no falsifiable hypotheses and demanded no repeatable controlled experiments. Economists began to think of themselves as scientists, while in fact their discipline remained a branch of moral philosophy—as it largely does to this day.

The notions of these 18th and early 19th century economic philosophers constituted classical economic liberalism—the term liberal in this case indicating a belief that managers of the economy should let markets act freely and openly, without outside intervention, to set prices and thereby allocate goods, services, and wealth. Hence the term laissez-faire (from the French “let do” or “let it be”).

In theory, the Market was a beneficent quasi-deity tirelessly working for everyone’s good by distributing the bounty of nature and the products of human labor as efficiently and fairly as possible. But in fact everybody wasn’t benefiting equally or (in many people’s minds) fairly from colonialism and industrialization. The Market worked especially to the advantage of those for whom making money was a primary interest in life (bankers, traders, industrialists, and investors), and who happened to be clever and lucky. It also worked nicely for those who were born rich and who managed not to squander their birthright. Others, who were more interested in growing crops, teaching children, or taking care of the elderly, or who were forced by circumstance to give up farming or cottage industries in favor of factory work, seemed to be getting less and less—either proportionally (as a share of the entire economy), or often even in absolute terms. Was this fair? Well, that was a moral and philosophical question. In defense of the Market, many economists said that it was fair: merchants and factory owners were making more because they were increasing the general level of economic activity; as a result, everyone else would also benefit . . . eventually. See? The Market can do no wrong. To some this sounded a bit like the circularly reasoned response of a medieval priest to doubts about the infallibility of scripture. Nevertheless, despite its blind spots, classical economics proved useful in making sense of the messy details of money and markets.

Importantly, these early philosophers had some inkling of natural limits and anticipated an eventual end to economic growth. The essential ingredients of the economy were understood to consist of labor, land, and capital. There was on Earth only so much land (which in these theorists’ minds stood for all natural resources), so of course at some point the expansion of the economy would cease. Both Malthus and Smith explicitly held this view. A somewhat later economic philosopher, John Stuart Mill (1806-1873), put the matter as follows: “It must always have been seen, more or less distinctly, by political economists, that the increase in wealth is not boundless: that at the end of what they term the progressive state lies the stationary state. . . .”

But starting with Adam Smith, the idea that continuous “improvement” in the human condition was possible came to be generally accepted. At first, the meaning of “improvement” (or progress) was kept vague, perhaps purposefully. Gradually, however, “improvement” and “progress” came to mean “growth” in the current economic sense of the term—abstractly, an increase in Gross Domestic Product (GDP), but in practical terms, an increase in consumption.

A key to this transformation was the gradual deletion by economists of land from the theoretical primary ingredients of the economy (increasingly, only labor and capital really mattered—land having been demoted to a sub-category of capital). This was one of the refinements that turned classical economic theory into neoclassical economics; others included the theories of utility maximization and rational choice. While this shift began in the 19th century, it reached its fruition in the 20th through the work of economists who explored models of imperfect competition, and theories of market forms and industrial organization, while emphasizing tools such as the marginal revenue curve (this is when economics came to be known as “the dismal science”—partly because its terminology was, perhaps intentionally, increasingly mind-numbing).

Karl MarxMeanwhile, however, the most influential economist of the 19th century, a philosopher named Karl Marx, had thrown a metaphorical bomb through the window of the house that Adam Smith had built. In his most important book, Das Kapital, Marx proposed a name for the economic system that had evolved since the Middle Ages: capitalism. It was a system founded on capital. Many people assume that capital is simply another word for money, but that entirely misses the essential point: capital is wealth—money, land, buildings, or machinery—that has been set aside for production of more wealth. If you use your entire weekly paycheck for rent, groceries, and other necessities, you may have money but no capital. But even if you are deeply in debt, if you own stocks or bonds, or a computer that you use for a home-based business, you have capital.

Capitalism, as Marx defined it, is a system in which productive wealth is privately owned. Communism (which Marx proposed as an alternative) is one in which productive wealth is owned by the community, or by the nation on behalf of the people.

In any case, Marx said, capital tends to grow. If capital is privately held, it must grow: as capitalists compete with one another, those who increase their capital fastest are inclined to absorb the capital of others who lag behind, so the system as a whole has a built-in expansionist imperative. Marx also wrote that capitalism is inherently unsustainable, in that when the workers become sufficiently impoverished by the capitalists, they will rise up and overthrow their bosses and establish a communist state (or, eventually, a stateless workers’ paradise).

The ruthless capitalism of the 19th century resulted in booms and busts, and a great increase in inequality of wealth—and therefore an increase in social unrest. With the depression of 1893 and the crash of 1907, and finally the Great Depression of the 1930s, it appeared to many social commentators of the time that capitalism was indeed failing, and that Marx-inspired uprisings were inevitable; the Bolshevik revolt in 1917 served as a stark confirmation of those hopes or fears (depending on one’s point of view).

Beginning in the late 19th century, social liberalism emerged as a moderate response to both naked capitalism and Marxism. Pioneered by sociologist Lester F. Ward (1841-1913), psychologist William James (1842-1910), philosopher John Dewey (1859-1952), and physician-essayist Oliver Wendell Holmes (1809-1894), social liberalism argued that government has a legitimate economic role in addressing social issues such as unemployment, health care, and education. Social liberals decried the unbridled concentration of wealth within society and the conditions suffered by factory workers, while expressing sympathy for labor unions. Their general goal was to retain the dynamism of private capital while curbing its excesses.

John Maynard KeynesNon-Marxian economists channeled social liberalism into economic reforms such as the progressive income tax and restraints on monopolies. The most influential of the early 20th century economists of this school was John Maynard Keynes (1883-1946), who advised that when the economy falls into a recession government should spend lavishly in order to restart growth. Franklin Roosevelt’s New Deal programs of the 1930s were a laboratory for Keynes’s ideas, and the enormous government borrowing and spending that occurred during World War II were generally credited with ending the Depression and setting the nation on a path of economic expansion.

The next few decades saw a three-way contest between the Keynesian social liberals, the followers of Marx, and temporarily marginalized neoclassical or neoliberal economists who insisted that social reforms and Keynesian meddling by government with interest rates, spending, and borrowing merely impeded the ultimate efficiency of the free Market.

Alan GreenspanWith the fall of the Soviet Union at the end of the 1980s, Marxism ceased to have much of a credible voice in economics. Its virtual disappearance from the discussion created space for the rapid rise of the neoliberals, who for some time had been drawing energy from widespread reactions against the repression and inefficiencies of state-run economies. Margaret Thatcher and Ronald Reagan both relied heavily on advice from neoliberal economists of the Chicago School (so called because of the widespread influence of the University of Chicago School of Economics, which graduated several generations of economists steeped in the ideas of monetarists like Milton Friedman, 1912-2006; as well as Austrian School economist Friedrich von Hayek, 1899-1992). One of the most influential libertarian, free-market economists of recent decades was Alan Greenspan (b. 1926), who, as U.S. Federal Reserve Chairman from 1987 to 2006, argued for privatization of state-owned enterprises and de-regulation of businesses—yet Greenspan nevertheless ran an activist Fed that expanded the nation’s money supply in ways and to degrees that neither Friedman or Hayek would have approved of. As a side note, it’s worth mentioning that the Austrian School of Ludwig von Mises (1881-1973) and Hayek should be distinguished from the Chicago School: the former has followed a more purely individualist, libertarian line of thinking, and usefully critiques central banks and fiat currencies; while the latter is more results-oriented and heterodox and accepts central banks and fractional-reserve banking as givens. Both reject Keynesian government intervention in favor of unfettered markets.

There is a saying now in Russia: Marx was wrong in everything he said about communism, but he was right in everything he wrote about capitalism. Since the 1980s, the nearly worldwide re-embrace of classical economic philosophy has predictably led to increasing inequalities of wealth within the U.S. and other nations, and to more frequent and severe economic bubbles and crashes.

Which brings us to the global crisis that began in 2008. By this time all mainstream economists (Keynesians and neoliberals alike) had come to assume that perpetual growth is the rational and achievable goal of national economies. The discussion was only about how to maintain it—through government intervention or a laissez-faire approach that assumes the Market always knows best.

But in 2008 economic growth ceased in most nations, and there has as yet been limited success in restarting it. Indeed, by some measures the U.S. economy is slipping further into a recession that might more correctly be termed a depression. This dire reality constitutes a challenge to both mainstream economic camps. It is clearly a challenge to the neoliberals, whose deregulatory policies were largely responsible for creating the housing bubble whose implosion is generally credited with stoking the crisis. But it is a conundrum also for the Keynesians, whose stimulus packages have failed in their aim of increasing employment and general economic activity. What we have, then, is a crisis not just of the economy, but also of economic theory and philosophy.

The ideological clash between Keynesians and neoliberals (represented to a certain degree in the escalating all-out warfare between the U.S. Democratic and Republican political parties) will no doubt continue and even intensify. But the ensuing heat of battle will yield little light if both philosophies conceal the same fundamental errors. One such error is of course the belief that economies can and should perpetually grow.

But that error rests on another that is deeper and subtler. The subsuming of land within the category of capital by nearly all post-classical economists had amounted to a declaration that Nature is merely a subset of the human economy—an endless pile of resources to be transformed into wealth. It also meant that natural resources could always be substituted with some other form of capital—money or technology. The reality, of course, is that the human economy exists within, and entirely depends upon Nature, and many natural resources have no realistic substitutes. This fundamental logical and philosophical mistake, embedded at the very heart of modern mainstream economic philosophies, set society directly upon a course toward the current era of climate change and resource depletion, and its persistence makes conventional economic theories—of both Keynesian and neoliberal varieties—utterly incapable of dealing with the economic and environmental survival threats to civilization in the 21st century.

For help, we can look to the ecological and biophysical economists, whose ideas have been thoroughly marginalized by the high priests and gatekeepers of mainstream economics—and, to a certain extent, to the likewise marginalized Austrian School, whose standard bearers have been particularly good at forecasting and diagnosing the purely financial aspects of the current global crisis. But that help will not come in the form that many would wish: as advice that can return our economy to a “normal” state of “healthy” growth. One way or the other—through planning and method, or through collapse and failure—our economy is destined to shrink, not grow.

What do you think? Leave a comment below.

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