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The wealth of nations revisited

Pekka SutelaAalto University30 March 2015

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Keynes and Hayek: differences revisited

Hayek• Looks at an economy at or

near full resource use: consumption and investment are substitutes

• Interest rate equilibrates savings and investment of loanable funds

• Over business cycle, change in structure of production is crucial

Keynes• Looks at a depression

economy: consumption and investment are complements

• Interest rate is at best secondary in determining savings and investment

• Over business cycle, change in labour markets is crucial

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Why was Keynes so persuasive?

• Offered reason for optimism: Depression can be fought!– And this can be done without losing freedom and liberal

values• Offered another path of thought in contrast with

received wisdom, which had been tainted by the Great Depression

• The theory could be put in a simple form– Which then formed the base of econometric models

• The theory seemed to be consistent with empirical facts

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”The Keynesian revolution”

• ”The ideas which are here expressed so laboriously are entremely simple and should be obvious. The difficulty lies, not in the new ideas, but in escaping from the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds.”

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Milton Friedman on Keynes, 1975

• ”I believe that Keynes’s theory is the right kind of theory in its simplicity, its concentration of a few key magnitudes, its potential fruitfulness. I have been led to reject it not on these grounds, but because I believe that it has been contradicted by experience.”

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Uncomfortable facts of life

• Does a long-run Phillips exist?• Co-existence of inflation and stagnation (stagflation)• Collapse of Bretton Woods exchange rate mechanism

– With floating exchange rates a different policy regime, different transmission of business cycles

– Fast growth of international capital flows– Who makes economic policy for a globalizing world?

• ”Bastard Keynesianism”: using permanent budget deficits to boost long-term growth– Excess debt and financial crises in Latin America, and not only

there

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Theoretical challenges• Monetarism

– Quantity theory of money is the oldest surviving theory in economics– Empirically Great Depression was caused by central bank mistakes (Friedman

and Schwartz 1963)– As discrete (Keynesian) policy is hampered by ignorance and lags, policy

should be based on rules• Balanced budget• Money supply rule

• Public choice– Politicians and bureaucrats do not aim at common good but private interests

(Buchanan and Tullock 1962). Policy should aim at rules constraining them.– Market failures and policy failures.

• Real business cycles– If economic agents utilize all relevant information, business cycles are

exogenous

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…and a practical precursor:

• The Austrian Carl Menger (1840-1921), in addition to emphasizing subjective marginal utility, believed in spontaneous economic order. Institutions like money are not established, but develop spontaneously as developing exchange benefits greatly from it. Institutions emerge because of their beneficial consequences.

• Among his followers were Hayek and Ludwig Erhard (1897-1977),who could not make an academic career in Germany, 1933-1945.

• After the war, Erhard worked for the US occupation regime and later became West German Minister of the Economy and Chancellor

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Wirtschaftswunder

• Nazi authorities had established price controls in 1936. Due to devastated economy, they were continued after the war.– As a strong Allied opinion wished to reduce Germany

into an agrarian country, much manufacturing was closed down

• Continued controls were supported by German Social Democrats and some Allied officials– Like John Kenneth Galbraith, who had been the head

of US price controls during the war

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• Erhard was however able to end rationing, liberalize prices in Summer 1948 and establish a stable currency. This is an early example of shock therapy. The rest is history, the West German economic wonder, Wirtschaftswunder, and the social market economy

• The Menger – Hayek thinking on economic freedom had been conveyed by Walter Eucken and other so-called ordoliberals (Ordnungsliberalismus), among them Erhard’s advisors

• However, this time reforms were consciously planned and implemented (and using the authority US – British occupation authorities!). They did not arise spontaneously.

• Instead of spontaneous order, the emphasis was on constitution and rules, as if substituting for Smith’s moral sentiments

• In a similar vein, Paul Collier (Oxford) has argued that some former colonies would be happier continuing to be colonies

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Back to the wealth of nations

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The foundations of growth theory

• Smith (1776)– No coherent growth theory– The Wealth of Nations

• The invisible hand: Pursuit of self-interest in free markets, within framework set by moral sentiments

• Wealth comes from production, not from accumulation of general purchasing power, that is gold and such

• Productive and unproductive work: accumulation over time• Little emphasis on machinery and equipment• Removal of institutional barriers to growth

– Free trade vs mercantilism– Competition vs guilds, privileges

• Emphasis on division of labour, size of markets– Population growth good for growth! – Free trade internally and externally increases the size of markets

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Ricardo (about 1820)• The three-class model

– Workers with subsistence wages– Land-owners with land rent– Capitalists with residual profits

• Investment financed from profits

• Towards the stationary state– As population grows, agriculture faces decreasing returns, share of rent in national

income increases and that of profits declines. Therefore investment and the economy tends to stagnation

– Role of counterfactual argument: stagnation can be prevented through free trade (relative advantage) and technical progress

• ”On machinery”– Labour does not always adjust automatically to technical progress

• John Stuart Mill– Stationary state imminent and to be welcomed

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Marx (since 1848)

• The phases of socio-economic development– When the forces of economic development, including

technical progress (the base), force institutional change (the superstructure)...

• Schemes of reproduction– Das Kapital, vol. II– Elementary theory of two-sector growth– Roles of investment and consumption goods

• Declining rate of profit– Increasing capital intensity of production

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”The bougeoisie cannot survive without causing continuous revolutions in means of production”• ”The need for ever greater sales of produce drives the

bourgeoisie to all corners of the world. It must settle everywhere, create ties to everywhere.”

• ”During its class dominance of less than a hundred years the bourgeoisie has created more numerous and immense forces of production than all the previous generations together.”

• ”Which previous century could imagine that such forces of production were sleeping inside social labour.”– Marx and Engels: Manifesto of the Commuinist Party (1848) –

slightly free translation

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The mirror image: poverty

• There are three premises for antipoverty policies:– Poverty is a social bad– Poverty can be eliminated– Public policies can help do that

• Until 19th century poverty was typically not only seen as inevitable, but also as a social good:– “Everyone but an idiot knows that the lower classes must be

kept poor or they will never be industrious” (Arthur Young, 1771)– This view was consistent with Mercantilist thinking on national

competitiveness– Adam Smith was a partial exception to this thinking

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• In 1820 an estimated 84% of global population lived in extreme poverty (< 1USD per day at 1985 PPP)– Today, using a similar measure, about one billion still do, but most

of them might escape extreme poverty by 2030– This still leaves much relative poverty

• Thinking started to change in late 18th century– British Poor Laws for maintaining social security through charity– Immanuel Kant (1785): all humans are an end in itself, not only a

mean– French Revolution (1789): Liberté, Égalité, Fraternité– Worries about incentive effects of Poor Laws general. Preferred

alternative were work houses

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• Technical progress set higher demands on quality of labor. Therefore emphasis on free public schooling (Smith, Marx & Engels, Marshall…)

• Approaching modern social policy: Germany second half of 19th century (Bismarck)

• Marx & Engels also: progressive taxation– JS Mill in a modest form

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The ghost of diminishing returns

• Smith (with exceptions), Malthus, Ricardo• Marx (like Smith): unequal distribution of social power• Wicksell: “extraordinary material progress” in “the

civilized world in general” not sustainable:– “The unprecedented growth of the population recently

witnessed in Europe, and still more in some extra-European countries, will certainly, sooner or later – probably in the course of the present century – prepare the way for much slower progress and possibly for completely stationary state”

• Also Keynes in 1930: fast population growth and major wars might endanger the end of scarcity

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Meanwhile elsewhere: Joseph Schumpeter (1883-1950)

• Austria, Germany, USA (Harvard)• A life with great goals and major failures (including as

the Minister of Finance of Austria and a private banker)• ”A great economist, but what did he actually invent?”

– The missing link between Darwinian evolution and economics?

– Theorie der wirtschaftlichen Entwicklung (1912)– Business Cycles (1939)– Capitalism, Socialism and Democracy (1942)– History of Economic Analysis (1954) – finalized by Elizabeth

Boody Schumpeter

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Entrepreneurship and creative destruction

• The primacy of the entrepreneur– Not historical laws (Marx) or impersonal competitive markets,

but entrepreneurs drive development– They make innovations in new products, new production

methods, new raw materials, new markets and new institutions– Innovations happen in waves, when critical mass appears– Availability of credit is a key condition

• The inevitability of creative destruction– Old products, firms and production branches disappear as new

ones emerge– Compare Ricardo’s ”On machinery”

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Business cycles

• Three types of cycles– Short run: about five years– Medium run: about ten years– Long run: sixty years (Kondratyev (1892-1931?))

• Capitalism is not about Walrasian equilibrium– But about continuous disequilibrium, searching for the

competitive advantage– With tendency for monopoly and imperfect competition

• Schumpeter emphasised disequilibrium dynamics, while Joan Robinson (1933) and Edward Chamberlin (1933) analyzed partial equilibrium market models

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Capitalism, development and socialism

• Inherent tendencies of bureaucratisation subdue entrepreneurship and creative destruction

• The critical attitude of highly educated intellectual finally leads to nationalisation of firms and state control

• Socialism may be superior to capitalism as there is no uncertainty of intentions of competitors

• There is no choice of social models– this is how it goes– But whatever happened to the free agency of entrepreneurs– Pessimist echoes of Vienna in 1913/1918!– 1933-1945: Bureaucratised, state-controlled Nazi Germany and Stalinist

Soviet Union as the alternatives to big-enterprise, partially state-controlled capitalism