Book Review: An Austrian Perspective on The History of Economic Thought, Part II

Posted on May 18, 2012 by

Note: This is Part II of a four-part book review.


Mercantilism enabled the ruling castes (the king and nobility) of nation-states to build up individual power and wealth with high government expenditures, military conquest, the granting of monopoly guilds and cartels, the establishment of export subsidies and tariffs on imports, and high taxes. Mercantilism concentrated on proto-Keynesian full-employment, and often did so by forced labor, which also (and conveniently) happened to lower wage rates. It was during this time that the world’s first central bank was thought up, the Bank of England.

The BoE is an interesting case study in how hostile central banking is to private banking and a stable currency, and how central banks enable runaway inflation, precipitate boom-bust cycles, spur the unchecked growth of government, and swell the public debt. As to the latter, when it came time to “pay the piper” as it were, the BoE, armed with the power of government, can and frequently did suspend specie payment and, armed with legal tender laws, prevented the populace from shifting away from depreciating government paper to sound competing currencies. The ill effects of central banking were easily observable, as various pamphleteers and government officials argued strenuously for sound money, attacked currency debasement, and central banking in general, culminating win an 1854 survey of banks throughout the world by Otto Huebner, where he stated that “banks were soundest and least in danger where they were freest and least controlled. Privileged central banks tend to be wildly run and are in danger of insolvency”.  Piling on, Rothbard writes:

From then on, Great Britain, and eventually the rest of the world, was stuck with a fractional reserve banking system issuing demand deposits, pyramidizing on top of a central bank monopolizing the issue of notes and centralizing the nation’s gold, and generating an endless round of boom-bust cycles of inflation and recession

Also during the mercantilist period, we see the rise of empiricism–political arithmetic–or the Enlightenment-inspired theory that human behavior can be quantitatively measured, studied, and predicted (as opposed to received wisdom, natural law, or inductive reasoning). What Rothbard calls “quantophrenia” entered the field of economic study during the mercantilist period; indeed, we see in empiricism the contrast with the Austrian perspective that economic theories and models can never be proven by experimentation, because true experiments are not possible. In the field of economic study, as opposed to the physical sciences, it is not feasible to hold all variables constant and move just one. Moreover, all quantophrenic attempts to prove mathematical models fall victim to the “n-body” problem (rapidly increasing computational complexity as n increases), making solving economic problems short of “assuming away” variables practically impossible:

Economic theory, in short, must choose between formally elegant but false and distorting mathematical models, and the ‘literary’ analysis of real human life itself

Thus we have the modern economists’ persistent habit of simplifying economic models to make their models “work”…as well as a term for such simplification so as to make economic computations tractable…the “Ricardian Vice”. Who knew that we moderns would be such slaves to an Enlightenment-inspired fad from 500 years ago?

Some noteworthy economic theorists during this period were John Locke, the esteemed Classical Liberal champion of property rights and later, religious liberty, the latter in response to a Continental scene where governments, particularly Catholic ones, ran roughshod over property rights. Locke, a Protestant, resurrected Scholastic natural law theory and transformed vague “notions of natural law into the clear-cut, firmly individualistic concepts of natural rights for every individual human being”. Locke also attacked currency debasement and price controls, which he observed led to shortages. Unfortunately, he also promulgated the quantity theory of money, a false doctrine in which a change in the total supply of money causes a uniform, proportional, and simultaneous change in prices at all locations throughout an economy. John Law later picked up on this theory and advocated for blatant inflation, claiming that an increase in the money supply “vivif[ies] trade, increase[s] employment and production”…a proto-Keynesian theory.

On the Continent, the French were busy thinking up laissez-faire, leveraging Locke’s work. Most notable of these Frenchmen was Turgot, who fully implemented Lockean natural law theory and applied it to the state. Turgot set aside mercantilist baggage and argued for complete (i.e., internal and external) free enterprise and free trade, and trade without subsidies, monopolies, or restrictions. Turgot also attacked the self-contradictory mercantilist focus on trade imbalances and massing unused hoards of specie (“losing rather than gaining wealth in real terms”). Moreover, in Turgot, Rothbard located the formal application of self-interest for the benefit of all [3] in contrast to the pursuit of virtue for virtue’s sake, while also arguing that one man can never amass sufficient knowledge to make decisions in the interests of every, or even most, men. Today, Turgot is best known for his “law of diminishing returns“, while the bulk of laissez-faire theory is comparatively out of style.

[3] The French physiocrats, typified by Turgot, emphasized self-interested behavior harnessed for the good of all. Some, particularly the atheist Italian Renaissance thinker Machiavelli, defined virtuous behavior as self-interested behavior as that which increases or cements an individual’s power…and in Machiavelli’s The Prince, whatever a prince must do to maintain and/or increase his power is therefore virtuous. A far cry from the Scholastic’s take on virtue and the virtuous life, for sure.

A contemporary of Turgot, Cantillon, was an Irishman living in France who extended and elaborated upon Turgot’s work. Cantillon was among the first to split economic study from ethical and political concerns, as contrast to medieval and Renaissance thought which embedded economic thought in a moral and theological framework. Cantillon introduced the first sophisticated analysis of the demand versus price mechanism, and continued the Continental theme of value as a function of the consumer’s valuation. Prices, to Cantillon, determined what production costs could be incurred, as opposed to the Smithian “costs = price” concept. Cantillon was the first thinker to stress and analyze the individual entrepreneur in the market: the bearer of risk, the person who forecasted, and invested, adjusted and balanced supply and demand in the market at the point of exchange. The entrepreneur, Cantillon wrote, absent government intervention, is what makes the market naturally self-regulating.

English Classical Economics

[H]istorians of economic thought…have habitually treated the development of science as a linear and upward march into the truth. Each scientist patiently formulates, tests, and discards hypotheses, and thereby each succeeding one stands on the shoulders of the one who came before. [However,] the Kuhn theory [of paradigms] is that a very few people patiently test anything, particularly the fundamental assumptions or basic paradigm of their theory: and shifts in paradigms can take place even when the new theory is worse than the old. In short, knowledge can be and is lost as well as gained, and science often proceeds in a zig-zag rather than linear manner. As a result, paradigms and basic truths get lost

Thus does Rothbard introduce Adam Smith, not as the Father of Economics but as a blatant plagiarist who corrupted the thought of his immediate forebears and contemporaries, from Cantillon to Turgot to (his own teacher) Hutcheson, to the Spanish Scholastics, and even his own earlier political and economic work. His turgid, vague, and self-contradictory Wealth of Nations, perhaps because it was so turgid, vague, and studded with inconsistencies, overshadowed out the writings of other more technically correct economists, and according to Rothbard, quoting Schumpeter, “shunted economics off on a wrong road, a road unfortunately different from that of his Continental forebears”. So, while Smith did cement limited laissez-faire in popular governance, at least for a while, and helped propagate the notion that men, acting in their own self-interest, serve the best interests of society (i.e., the “Invisible Hand“), and while he did promote savings and investment to the exclusion of proto-Keynesian “hoarding” or underconsumption, overall, Rothbard assesses Smith’s impact on economics as a net negative. For instance, Smith re-invigorated the by-then discredited institution of fractional reserve banking (a “highway in the air” of putatively free money), obscured the role of the entrepreneur as a price-setting mechanism and a bearer of risk (leading to spasms of class warfare between capitalists and ‘exploited’ labor for generations), and was “almost solely responsible” for injecting the disastrous labor theory of value into classical economic thought, thus providing the beachhead by which socialists and Marxists would launch their class-warfare attacks a century later. Indeed, from the Austrian perspective

The most unfortunate aspect of the total Smithian takeover in economics was…the blotting out of knowledge of the rich tradition of economic thought that had developed before Adam Smith. As a result, the Austrians and their nineteenth century predecessors, largely deprived of knowledge of the pre-Smith tradition, were in many ways forced to re-invent the wheel, to painfully claw their way back to the knowledge that many pre-Smithians had enjoyed long before.

Due to his popularity, Smith had a number of followers in the Anglophone world, including such well-known men like David Ricardo, John Mill, and Mill’s son, J.S. Mill. Each extended and propagated Smithian economic thought…Ricardo took Smith’s “law of absolute advantage” and generalized it to become his famous “law of comparative advantage“.[4]  He continued Smith’s focus on long-run equilibrium (the better to simplify his economic model), a disregarding of the entrepreneur, and a focus on constructing mathematical, predictive aggregative models built on flawed assumptions (such as perfect economic knowledge and static environments). This focus would lead Schumpeter to coin the phrase “Ricardian Vice”, to describe the act of building elegant abstract economic models built on shaky assumptions and often gross oversimplifications. One way Ricardo kept his models neat and elegant (and also incorrect) was by designating labor as homogeneous…there was no variation in talent or productivity from worker to worker in Ricardo’s world, an assumption that Marx would adopt later. Similar to Smith, who crafted a generalized cost-of-production theory, Ricardo promulgated a labor theory of cost and therefore value, by assuming land would gain zero rent and profits would be uniform across the economy…ergo the price of a good is driven by the labor hours (plus a small profit) used to produce it. As a result, Ricardo’s economic theory has class warfare built into it, by postulating that the real wage rates would always be at subsistence level, the laborer would never get ahead, while the capitalist reaps his small profit with no effort (remember, Ricardo assumes away entrepreneurial risk) on his own, based on nothing but his ownership of land.[5]  Ricardo errs further in his focus on the macro; Rothbard counters that there are no such things as macroeconomic laws, only the consequences of micro economic laws linking together economic agents on a market scale.

Others in the Smithian vein include James and J.S. Mill, father and son, the former adding the “law of comparative advantage” to the body of economic thought (and mentor of Ricardo) while the latter seizing upon the Smithian conceptualization of the inevitable friction between capitalists and labor and amplifying it to Marx’s great class-warfare glee. It was also the younger Mill who rehabilitated Ricardo, after Ricardo’s theories had been thoroughly trounced in the early nineteenth century by various thinkers and pamphleteers. J.S. Mill would re-install Ricardian economic theory in the place of primacy in British economic thought.

[4] Rothbard claims that Ricardo did not postulate the law of comparative advantage and claims that an English physiocrat named William Spencer first articulated it in 1807.

[5] Ricardo glosses over the Austrian claim that landlords to perform an economically useful function: they allocate land to its best and productive use.

Regarding the J.S. Mill-led resurgence of Ricardianism, Rothbard wrote: “for not the first or the last time in the history of economic or social thought, error displaced truth from the post of dominance in the intellectual world”. Indeed, J.S. Mill was a towering figure in the British intellectual scene in the mid- to late-nineteenth century, and he did much to scrub proto-Austrian thought from the British consciousness. Not only did he single-handedly re-institute elite support for labor theory of value, Ricardian rent theory, and Malthusian wage and population theory, but he administered the coup de grace to flagging British enthusiasm for laissez faire. From J.S. Mill forward, with his penchance for moderate versus full-fledged democracy, moderate statism, mild support for socialism, advocacy for positivism, inductivism, and organicism (as contrasted to Austrian praxeological techniques), and generalized laissez-faire apostasy, the British intelligentsia adopted a materialist view of wealth and came to view man as “Economic Man” (i.e., man’s only interest is in acquiring wealth, that is, when he’s not shirking). Mill also promulgated the notions that economic distribution could be split from production, and that the State could and should shape distribution through taxation, subsidies, manipulation of the money supply, or other State intervention. Mill was among the first to articulate the recurring nature of business cycles, celebrating the inflationary boom as the cure for Ricardian-style economic stagnation. A Malthusian, Mill also supported first-wave feminism and advocated birth control as a means to control population growth, as well as led the gradual British rejection of classical liberalism in favor of a more aggressive “white man’s burden”-style messianic imperialism that encouraged the installation of benevolent despotisms over barbarous peoples. Quoth Rothbard, citing Mill: “I have always been for a good stout despotism, for governing Ireland alike India”. A curious statement indeed for a fellow that wrote a landmark essay entitled “On Liberty” that so resolutely defends the individual rights of man (and women… JS Mill was a through-and-through feminist).

Standing in sharp relief to the English classical economists was a Continental French contemporary of Ricardo, Jean-Baptiste Say. In Austrian thought, Say is a towering figure of the French laissez-faire tradition. With his focus on real-world interactions instead of long-run equilibrium, Say redeemed the entrepreneur from Smithian purgatory. He added the concept of (entrepreneurial) risk premium to the concept of interest, posited that it is related to the supply (inverse) and demand (proportional) of capital, and made the case that interest–usury–is morally indistinguishable from rent or wages. He was virulently laissez-faire, opining thusly about government intervention in the market, compared to entrepreneurs

The producers themselves are the only competent judges of the transformation, export, and import of these various matters and commodities; and every government which interferes, every system calculated to influence production, can only do mischief

Say was a minarchist of the first order, being possessed of a cynical attitude toward government in general (the “services government provides are to itself and to its favorites”), of the opinion that government spending was pure consumption, that government was a “grievous public nuisance” and “an aggressor upon the peace and happiness of domestic life”, and stating (paraphrasing) “that government is best (least bad) when it spends and taxes the least”. Accordingly, and in anticipation of Keynes, Say was critical of government measures to ‘stimulate’ consumption without attendant production, for it is of

no benefit to commerce; for the difficulty lays in supplying the means, not in stimulating the desire for consumption; and we have seen that production alone furnishes the means…the only real consumers are those who produce on their part, because they alone can buy the produce of others, [while]…barren consumers can buy nothing except by the means of value created by producers

Moreover, also seemingly anticipating Keynes, Say argued that savings do not leak out of an economy, and that cash hoarding in a free market will eventually clear itself out–prices will fall, and when they do, hoarded cash will re-enter the market. Say is also generally credited with popularizing what is commonly referred to as “Say’s Law“, which, loosely speaking, postulates that production of a product will ‘stimulate’ demand for other products, as individuals engage in production of their products so as to enable their consumption of others’ production. What Say called “barren consumers” do not produce, and therefore do not stimulate others’ production in and of themselves. Unfortunately, in keeping with the principle that rectitude does not necessarily have bearing on the dominance of a particular economic theory, Say’s work is largely unknown except to economists of the Austrian school, eclipsed as it was by the blazing hot sun of the Millian resurrection of Ricardianism.

Next: Marxism