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September 2012 Policy Study, Number 12-9

   

A Short History of Economic Theory

   

Classical Economic Theory: From Adam Smith to Jean-Baptiste Say

   

 

The publishing of An Inquiry into the Origin and Causes of the Wealth of Nations by Adam Smith in 1776 was an event destined to change the world. By offering a powerful argument in favor of free markets, Smith helped to usher in an era of prosperity and to defeat the faulty premises of the mercantilists. However, the classical theory was not complete when Smith put pen to paper. It lay with Jean-Baptiste Say to complete what Smith had started and perfect the ideal of a capitalistic system of economics. Adam Smith laid the groundwork of classical economic theory through The Wealth of Nations, but because it lacked certain elements, Jean-Baptiste Say improved the theory with his entrepreneurial perspectives.

 

Adam Smith codified the tenets of capitalism in his magnum opus, outlining the principles of the division of labor, the nature of money, and the invisible hand, but neglected the value of entrepreneurs in an economy. The changes brought about by the Industrial Revolution were truly remarkable; it began a long period of unparalleled economic growth for the world. In The Making of Modern Economics, Mark Skousen pointed out that during the pre-Revolution era, a true compendium of economic thought had never been published. 1776 heralded the start of the modern economic saga. Before this watershed date, six millennia had passed without any comprehensive work being written on the topic that dictated every minute of nearly every human’s day: earning a source of revenue. The true per capita salary went practically unchanged for centuries. During the 1700s, when the typical adult did not live past the age of 40, the famous Enlightenment philosopher Thomas Hobbes asserted that life was “Solitary, poor, nasty, brutish, and short.”[17] At the dawn of the Industrial Revolution, during the 18th century, although great events were about to transpire, there was no concrete economic theory to explain it. Adam Smith stepped forward to rectify this situation.

 

Skousen writes that Smith saw the leading economic philosophy, mercantilism, as harmful and sought to swing the debate decisively towards free-market capitalism. Following more than a decade of writing The Wealth of Nations, its author was certain that he had found the correct type of economic theory to usher in worldwide prosperity. Smith believed this system to be one of “natural liberty.” It is now known as the classical model. Borrowing techniques from another Enlightenment scholar, Sir Isaac Newton, Smith advocated a similar system of universal laws governing economics. His greatest challenge was persuading others of the validity of the classical model, particularly the ruling elite of the 1700s. His goal was to detail the theory and convince his audience of its worth. By writing The Wealth of Nations, Smith issued a challenge to the mercantilists and the political authority, since he wanted to dismantle their erroneous view of wealth and move the world towards a great improvement in living standards, real wages, and life expectancy.[18] This challenge ultimately led to the downfall of mercantilism’s measure of wealth, which was simply “gold and silver,” and replaced it with Smith’s definition of labor and productivity as standards of value. To explain how such wealth could be amassed, Smith outlined the division of labor and its ability to enhance productivity.

 

While explaining the nearly automatic process of the division of labor in The Wealth of Nations, Smith foreshadowed his coming argument about the invisible hand. The great benefits stemming from the division of labor are not caused by any human intelligence that can foresee the general prosperity that will be brought about. Rather, it is an obligatory conclusion brought about little by little due to a uniquely human inclination to negotiate, bargain, and exchange the products of labor… Paradoxically, it is not caused by any formal agreement, but is simply the coincidental event of multiple desires for the same object at the same time.[19] Simply put, the division of labor allows greater productivity using free exchange between individuals. By defining the division of labor as an extension of the process of exchange, Smith took aim at the mercantilists and their definition of wealth.

 

The mercantilists viewed money itself as wealth, but Smith identified the use of money as a substitute for actual economic value. Following the initial division of labor, it is impossible for a man to supply all of his desires through the pure production of his labor. Rather, he supplies the vast majority of his wants by trading the surplus of his labor, in excess of his own consumption requirements, for the surplus of others’ labor, as he requires. In the course of time, everybody survives by the mechanism of free exchange, becoming of necessity a trader to some degree or another, and a nation will mature into a fully commercial society.[20] The idea that society could function through free exchange was radically new and overturned long-held assumptions about centralized authority. The tendency for free markets to allocate resources through exchange became Smith’s centerpiece argument. He called it the invisible hand.

 

Above all, Smith realized that the invisible hand did not function well with taxation and regulations, as Lisa Smith points out in her article Adam Smith: The Father of Economics. Policies such as minimizing taxation and government interference are central to a “hands-off” economic approach and are presented by Adam Smith along with his idea of an invisible hand that directs the laws of supply and demand. These concepts embody the principle that benevolent self-interests, i.e. everyone looking out for themselves, will lead to the best possible outcome for the community as a whole―by using their resources to create products consumers desire, the goal of producers is to increase their own wealth. Those that successfully satisfy their customers’ requirements are compensated with money. In a self-centered quest to make money, businesses provide products that people want. Smith argued that in such an economic marketplace, with an entire nation of productive laborers working for their own self-interest, a country’s wealth would rapidly rise, mirroring that of its citizens. Likewise, he noted that investment functions along similar lines: wealth will only be invested in companies that the investor sees as being able to produce a healthy return.[21] According to the theory of the invisible hand, production and investment can operate along the lines of benign self-interest. The invisible hand theory has a direct consequence in the modern understanding of economics.

 

In his textbook Public Finance, Harvey Rosen traces the development of the First Fundamental Theorem of Welfare Economics to Smith’s ideas in The Wealth of Nations. Using these standards, the First Fundamental Theorem of Welfare Economics comes into play, and a Pareto efficient distribution of goods and services occurs. Essentially, this shocking outcome means that a competitive economic system will mechanically distribute scarce resources efficiently, without the need for a central “command-and-control” authority…In effect, this economic law simply gives formal structure to the long-held intuition that a free market economy will be unbelievably productive when providing goods and services.[22] This idea, that resources can be managed productively and efficiently with a free-market system, was the foundation of the entire classical school of economic thought. Despite its visionary nature, Smith’s initial thesis had a flaw―he did not acknowledge the value of entrepreneurs in an economy.

 

Skousen points out this omission in The Making of Modern Economics, noting that Smith’s background probably played a role in this error. The precise translation of “entrepreneur” is “undertaker,” but due to the ambiguous nature of the word, it has been interpreted as “adventurer.” The mental picture of an entrepreneur is a venture capitalist or business start-up owner, who uses labor, intelligence, and capital to produce goods and services while turning a profit for the company. The author of The Wealth of Nations was a scholar, not a businessman. Since he had never experienced the role of a commercial “adventurer,” the subject of entrepreneurship was minimized in Smith’s book.[23] Although the classical model was a masterpiece, it was incomplete. The lack of dynamic growth in Smith’s model led Jean-Baptiste Say to refine and improve it.

 

Jean-Baptiste Say has been largely overshadowed by Smith in economic history, but his contributions completed the classical theory and provided it with a mechanism for expansion. In his Life and Works of Jean-Baptiste Say, David Hart examines the early life of Say, which influenced him to become an economist. Born on January 5, 1767, Jean-Baptiste Say lived for 65 years until his death on November 15, 1832. Say eventually became the primary political economist of his day, active during the beginning of the 1800s. Before his final career as a political economist, Say had experienced a wide variety of professions, including an apprenticeship at a business office, a journalist, a life insurance worker, a writer, a soldier, and a cotton-manufacturing entrepreneur. These sudden occupational shifts were caused by the tumultuous world events in the early 19th century, such as the French Revolution, Revolutionary Wars, the Napoleonic Wars, and the restoration of the Bourbon monarchy in France. Following this chaotic 25 years, Say became a teacher of political economy in Paris in 1815, which he continued to do until his death, 17 years later.[24] Say’s varied lines of work started him on a path of discovery that ultimately led to his career as a political economist and his improvements to Smith’s initial theory. The experience that he gained from starting and running a large manufacturing interest allowed Say to develop his refinements to the classical theory.

 

Hart points out the connection between Say’s experience as an entrepreneur and his disdain for French economic practices, which were based on mercantilism. Following his dismissal from the French government for opposing the economic policies of Napoleon, Say moved his family to Auchy, where he built a cotton-spinning factory and equipped it with imported British machinery. After eight years of success in his factory, which employed between four and five hundred workers, Say came back to Paris in 1813. He was more certain than ever that Napoleon’s economic regulation was leading to a depression: the “Continental System” which prohibited cheap British products, to the government licenses required to set up a business, to the prohibitively high tariffs on raw cotton, to the general wartime problems―all contributed to a stagnant French economy.[25] The Napoleonic government of France attempted to defeat England through economic warfare based on the faulty mercantilist ideas of high tariffs and wealth measured in gold, which backfired and caused economic calamity on the Continent. From this maelstrom, Say developed his first improvement to the classical theory, his famous Law of Markets.

 

Larry Sechrest pointed out in his Biography of Jean-Baptiste Say: Neglected Champion of Laissez-Faire that although Keynesians corrupted Say’s Law of Markets into a simplistic “supply creates its own demand” paradigm, it is still true that suppliers are a precondition of consumers, rather than vice versa. Say pointed out that the stabilizing process functioned in two ways. First, he asserted that although a certain part of income (which itself comes from production) is saved, if those savings are then invested in “productive employment,” there is not a decrease in the total or “aggregate” production, income, or consumption. This cycle of investment is started by the different profits entrepreneurs can earn. Scarce goods will have a higher price, which will attract investment, while plentiful goods, with a lower price, dishearten potential investors. Even in the extreme case of someone hoarding money, it is still intended to purchase something, so it will not harm demand as long as true economic value is being produced. Consumers can only exist after producers have created a product.[26] Say’s Law is actually quite simple and ties to Smith’s idea of free exchange and production: a supply of goods, not just “money,” will create consumer spending. In line with this philosophy, Say argued that money was merely a means of exchange and not an actual source of wealth.

 

Sechrest continued his analysis of Say’s theories with a look at the requirements for a “good” currency. Say identified consistency, high purchasing power, divisibility, portability, and longevity as the model properties of a medium of exchange. Using this standard, Say concluded that precious metals such as gold and silver are the best option for a reliable currency unit. In a free market, he asserted, most individuals will choose commodity money with intrinsic value. However, Say was not permanently attached to gold and silver as the ideal currency and acknowledged the possibility that the discovery of a new precious substance could lead to an equally acceptably monetary standard. In other words, although he supported specie as a unit of exchange, he did not believe that “money” automatically meant “gold and silver.”[27] While acknowledging the value of “hard” currencies, Say absolutely rejected the notion that they were intrinsically “wealth,” as the mercantilists claimed. Say linked his arguments about wealth to the concept of value, a hotly debated issue among early economists.

 

Skousen outlines another of Say’s major contributions to economic thought, his utility theory of value. Say found himself in opposition to David Ricardo, who led the British followers of Adam Smith, on the labor theory of value. Ricardo believed that a constant standard for the value of a product could be found in the labor required to produce it. However, Say saw it to be foolishness, and ridiculed the notion that an invariable measure of value was possible. In its place, Say wanted a subjective theory of value, which he called “utility.” The value of a product, wrote Say, was determined by the amount of utility it gave to consumers. Producers taking inputs and manufacturing outputs at a price covering the cost of production resulted in the creation of value.[28] Again, the influence of Say’s entrepreneurial background is clear, and he placed a high priority on profit and providing a useful service for consumers. Unifying the themes of his work, Say attacked taxation and the idea that a nation can “tax itself into prosperity.”

 

Sechrest points out that Say’s final improvement to Smith’s work was to differentiate between direct and indirect taxation and point out the harms inherent in each. Say looked at taxes as separated into two groups. Income and wealth taxes are “direct taxes.” “Indirect taxes” remove wealth through secondary means, like tariffs and sales taxes. No matter which system was used, Say believed that taxation removes productive capital from an economy and therefore harms production. He accused other economists of obfuscating this fact by claiming that taxation can increase a nation’s wealth while simultaneously removing a portion of it.[29] Preempting the coming Keynesians, Say argued that taxation was always harmful to the economy, regardless of the form that it took.

 

Jean-Baptiste Say used his entrepreneurial insights to add crucial features to Adam Smith’s foundation of classical theory, which he had presented earlier in The Wealth of Nations. The consequences of Smith and Say’s work were enormous. Together, they created the classical school of economic thought and gave the infant United States sound principles of free-market economics. The rapid industrialization and prosperity that took place in the Western World during the 19th century can be directly attributed to the work of these two men and the economic theory they created. Even today, their influence is still felt. As their 20th century disciple, Milton Friedman, said, “To judge from the climate of opinion, we have won the war of ideas. Everyone, left or right, talks about the virtues of markets, private property, competition, and limited government.”[30]

 

   

 

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