History of Economic Doctrines

Lecture 6

Economics Prior to Adam Smith (cont.)

Mercantilism: [England and Spain, etc., before Hume and Smith]

Mercantilists, who were primarily merchants who fancied themselves economic philosophers of empire; thought that the path to wealth was collecting gold. Mercantilists made a logical error in not anticipating the fallacy of composition (what is true for a part, may not be true for the whole: [Ex. you may be better off if you have more gold, but if everyone has more gold, no one is better off.]. Most mercantilists:

1. believed that a balance of trade should be aimed at surpluses, which then allowed a country to accumulate gold.
2. contended that a country should always export more than it imported[X>M]; negating competitive advantage.
3. also believed in colonialism and imperialism.
4. supported the divine right of kings to govern and substantial central planning. *

The Transition from Mercantilism to Advocacy of Laissez Faire Markets

Sir William Petty [1623-1687] William Petty, physician, royal counselor, empiricist, and entrepreneur, was born poor, but at one point, he was probably the richest man in the world – on paper. Although he lived in an era dominated by mercantilism and shared some mercantilist ideas, his economic theories were far more insightful and sophisticated than those proposed by most mercantilists.

Petty condemned most of the conventional wisdom of his time and most of the arguments offered by his contemporaries as “… using only comparative and superlative words and intellectual arguments.” In contrast, Petty insisted that economic discussions should be centered in measured quantities, and strove to accumulate the best data available to buttress his analysis. For example, because he thought the relative populations of Ireland, Scotland, England, and France to be important in determining wise national policies, he was a driving force in the development of vital statistics [data on birth rates, death rates, and other demographic data]. He also insisted on collecting data on revenues and trade, and was arguably the first person to attempt measurement of balances of payments and what we now call gross domestic product.

Petty was an amazing personality, who combined superb mathematical intuition with practical skills that enabled him to reach the corridors of power in both his native England and in France. He was, for a period, in charge of the Royal Treasury of France after Louis XIV’s government teetered on the brink of bankruptcy, and can be thought of as a major force in the development of partial reserve banking. Alas, an enormous speculative bubble set off by Petty’s policies ultimately burst, so that Petty’s attempts to straighten out France’s fiscal woes ultimately failed. With that failure, the personal fortune Petty had amassed evaporated. Truly an extraordinary man, whose life was an amazing adventure.

Richard Cantillon: Anti-Mercantilist and Unrecognized Pioneer

Richard Cantillon (1680-1734) was a successful Irish entrepreneur who distinguished “intrinsic value” from “price” and “market price”, and viewed market prices as determined by interactions between demand and relative scarcity. Cantillon described an even earlier version of what became known as David Hume’s “specie-flow{ mechanism, which was an early version of the quantity theory of money. However, Cantillon did not view the money supply as neutral because he perceived increases in the money supply as not being introduced into an economy in a uniform way, and argued that inflation distorts prices and economic decisionmaking, anticipating what would later be labeled the Austrian theory of the business cycle. It is also clear that Cantillon had a subjective theory of price. The value of anything is the amount someone is willing to pay for it. Thus, Cantillon anticipated the Austrian subjective approach to pricing.

Cantillon believed entrepreneurship to be the driving force in developing new technology and fostering economic growth. He also described a variant of Adam Smith’s “invisible hand” idea. Cantillon asserted that government had mishaps because they set prices incorrectly and inefficiently. Thus, society does not need the king since everything is automatic. In particular, government erroneously grants rights to individuals who are relatively ill-equipped to deal with those rights. [Ex: Government may grant a person a piece of land even though they have no real interest in or knowledge about the land.] Unfortunately, Cantillon’s writings were published in French and were unknown to most English economists until almost 150 years after his death.

The Physiocrats: Early Opposition to Mercantilist Theory FRANCOIS QUESNAY (1694-1774) was inspired to consider economic issues by Pierre Le Pesant, sieur de Boisguillebert [1646-1714]. Quesnay was a physician to the royal court of France who, like William Petty, was born poor but became prominent through brilliance and hard work. Quesnay wrote “Tableau Economique” and conceived an early circular flow model to explain commerce. Goods and services flow perpetually through this circle.

Look at Paris, where almost no food is produced, yet Parisians usually have just enough food. How does this happen? And why? Because farmers bring food to Paris.

If there is too little food then the prices will go up, and suppliers would want to sell more food at the higher prices. If there is too much then prices will fall, and suppliers would not want to bring in more food. Result: Market provides optimum solution through price adjustments.

Quesnay led the Physiocrats and contended that all wealth came from “nature” and agriculture. He questioned whether monarchy should allocate resources and believed that the market did reasonably well in delivering food and other necessities. The high regard for agriculture and dismissal of manufacturing was mirrored later in North America in the preferences of Thomas Jefferson and James Madison for agriculture over commerce or industry.

David Hume (1711-1776): Another Early Opponent of Mercantilist Theory

Hume described a specie-flow mechanism, which states that more gold leads to an increase in domestic prices; this then changes the terms of trade for the recipient [“surplus”] nation.

-An example of the problem Hume identified was the impact of Columbus and later Spanish explorers [conquering Aztecs in Mexico, Incas in the Andes] on the economy of Spain. The “Conquistadores” sent gold back to Spain. The surplus gold created, not real wealth, but instead, inflation. Spain purchased imported goods but the fixation on gold took attention off of manufacturing and industry, which left the Spanish economy stagnant. [Modern parallel: OPEC countries rely on sale of oil and neglect economic development in their home countries.]

Hume’s theories about money and the price level were not the first of this type. Zhong, a Chinese thinker [roughly 300 BC] had written that money affects the level of prices.

More recent Equations of Exchange- replaced Hume’s “specie-flow mechanism” with a more mathematical approach to the quantity theory of money in the late 19^th and early 20^th century.

Cambridge equation: Md= ky (demand for money equals k which is a fixed coefficient and Y which is income). Fisher equation: MV=PQ [more on this later in the course]

Perspective: Alternative Views of Property Rights

Why discuss property rights? Answer: because markets cannot operate smoothly unless property rights are well defined.

	Thousands of habits of behavior and of enforced laws had to be developed over millennia to establish the nature and the minutiae of property rights before we could have buying and selling, instead of each man just taking what he wanted if only he was strong enough. ... Each set of rights begins as a conflict about what somebody is doing or wants to do which affects others... An economic transaction is a solved political problem. Economics has gained the title of queen of the social sciences by choosing solved political problems as its domain. Abba Lerner The Economics and Politics of Consumer Sovereignty
	Coase theorem:	If (a) property rights are fully specified and enforced and (b) transaction costs (information, mobility, and contracting costs) are zero, then voluntary exchange will yield Pareto efficient solutions to all economic problems. Corollary: Firms survive only by reducing transaction costs in transforming resources into goods and conveying goods from the ultimate owners of the resources to purchasers of final goods. Corollary: Transaction costs underpin any alleged efficiency failures of markets (e.g., problems of public goods, externalities, or monopoly power). Corollary: If income effects are absent, Pareto efficient resource allocations are unaffected by patterns of resource ownership. Named after Nobel Prize Winner Ronald Coase.
Plato (427-347 BCE) favored a “philosopher king” who would justly allocate property rights. Medieval scholastics relied on the church as the final arbiter of property rights, although the management of society would be left up to heads of state (kings) who in turn would set up courts to settle disputes. Ideally, these courts would do the bidding of the church.

Hugo Grotius (1583-1645): Property rights arise from a social consensus, and may be revised when a social consensus changes. That which society grants, society can take away.

Thomas Hobbes (1588-1679): Leviathan = a dictator/king governs in all matters so that we can avoid the trauma deriving from Hobbes’ belief that “life in a state of nature is nasty brutish and short.” Thus, property rights derive from government.

John Locke (1632-1704): Labor and Property Rights: Mixing labor with gifts of nature (land, air, minerals, etc.) creates value and rights. Thus, according to Locke, who was a physician in addition to being a scholar and political theorist, all value derives from labor, as do all property rights.

David Hume (1711-1776) adopted a similar theory of value and property rights.

The labor theory of value is the idea that the value of anything is exactly proportional to the labor time socially necessary for its production. The labor theory of value was the standard economic explanation of price in most economic theories developed in England until late in the 19^th century. Ex: if a pencil takes 1 hour of labor and a book takes 4 hours, Then the book will cost 4x as much as the pencil.

Note: The fixation on production [labor] costs as the foundation for value caused most English economists to emphasize the supply side of the market until late in the 19^th Century, to the exclusion of demand. In this view, the competitive drive for profit would yield price equal to production cost – a supply-side phenomenon. Demand as a determinant of price was largely ignored, with Richard Cantillon (1680?-1734) being a notable exception. [See next day’s notes.]

Issue: Are property rights sacrosanct, so that it is evil or immoral or unethical for the government to alter property rights? How about eminent domain? Under what circumstances is it okay for the government to take property, and how can property be taken in a proper way, if at all? If the government is the final arbiter of property rights, will too frequent reassignments of property rights result in inefficient losses of production because of disincentives and uncertainty?

Pierre-Joseph Proudhon (1809-1865): “Property is theft.” [His famous assertion partially derives from Locke’s labor theory of value.]

KARL MARX (1818-1883): The labor theory of value is still an article of faith among orthodox Marxists. Marx accepted the labor theory of value and condemned rent, interest, and profit as “surplus values” expropriated [stolen] from workers.

Note: Most modern economists perceive as nebulous and impractical the concept that labor generates ownership claims, and so they tend to agree with Grotius (or Hobbes) in viewing property rights as established by law. Any changes in law or regulation effectively changes property rights. For example, changes in traffic laws may more closely limit what an owner can legally do with a car. There is a possibility, however, that a market system may become very inefficient if property rights are constantly in flux, creating widespread uncertainty because of unpredictable changes in government policies.

Recent:

Harold Demsetz-(1930 - ): In “Toward a Theory of Property Rights" [1967, American Economic Review], Demsetz started from the theory developed by Ronald Coase that fully specified property rights are necessary for market efficiency. Demsetz’s writings assert that with population growth, as land and other property is increasingly congested and contested, society configures rights in ever-more efficient fashion because those who value most are likely to expend the most resources to secure property rights. The legal system and resource markets combine to shift property rights to those who will use assets most productively and efficiently.

John Rawls (1921-2002): A Theory of Justice; [Harvard University Press, 1971]. Rawls contended that maximizing personal utility will lead to a fair society if the individual who designs society designs it behind a “veil of ignorance,” not knowing in advance the position in society where he/she might land (whether they’d be the richest/poorest, doctor/trash collector, man/woman, etc.). Mental experiment: The film Groundhog Day: What would be a good rule to force you back behind the veil of ignorance to redesign the rules repeatedly until you “got it right?”

Robert Nozick (1938-2002): Anarchy, Utopia, and the State [1974]: Nozick asserted that where property rights are concerned possession is 9/10 of the law. The passage of time also tends to legitimize property rights. Society should maintain the status quo unless the individual arguing against the status quo can clearly prove entitlement. More specifically, those who believe that they are entitled to property “owned” by another must prove entitlement because of earlier legitimate claim to property (by, e.g., ancestor) that was wrongly taken.

i. Ex: Reparations to former slaves; one would go to court check each other’s ancestors and see if there was a theft.

ii. Nozick also dismissed Locke’s Labor Theory of Value, which asserted that if a person mixes their labor with land then it creates value and it is the person’s to either keep or trade. He rebutted Locke by giving the example of a hypothetical fifteenth century European explorer mixing his blood with the Pacific Ocean. Locke’s theory might be interpreted as implying that, “all the things mixed with this blood are now his property”.

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These web pages are significantly edited and elaborated versions of student notes based on lectures by Ralph Byrns, 2002-2005.