Last week we discussed the importance of economic and population growth in measuring the wealth of nations. We observed that there was a long period of stagnant economic growth from antiquity, and a limited improvement in aggregate living standards. The period from antiquity to 1700 is often referred to as the Malthusian era.
What we observed in the data was that it was only from the late 18th century, and the subsequent period of capitalist development from the 19th century onward, when economic growth really began to take off. What explains this divergence?
This was the fundamental question of ‘classical political economy‘.
Classical political economy is a term coined by Karl Marx in the first edition of Das Kapital, to describe those British economists that sought to explain the ‘internal framework [Zusammenhang]’ of the “bourgeoise mode of production”.
Classical political economy is a term usually associated with the normative defence of free markets (as opposed to state protectionism), and it’s origins are identified with the time period between 1750 and 1867.
Today, it is a term that primarily describes those group of political, moral and economic thinkers who drew upon and revised Adam Smith’s ‘An Inquiry Into the Nature and Causes of the Wealth of Nations‘.
The objective of classical economic thinkers such as Thomas Malthus, David Ricardo, and John Stuart Mill was to analyze the production, distribution, and exchange of commodities in market societies.
But what really interested them was the impact of commerce on society; the role of the state in shaping the economy; and the emergence of industrial capitalism.
Put simply, they were interested in the politics of capitalist development, and the question why some countries are rich, and some countries poor?.
Adam Smith (and the division of labour):
Adam Smith’s Wealth of Nations, published in 1776, opens with a discussion on the core concept that has shaped all theories of classical political economy: the division of labour.
For Smith, the division of labour explains the determinants of economic growth, as it is the key to productivity improvements in the process of capitalist development.
But what exactly does the division of labour mean?
- It suggest that dividing the production process into different stages enables workers to focus on specialized tasks, which improves efficiency and enhances overall productivity. This, in turn, leads to technology improvements. In sociology, it is a concept that is used to describe the division of tasks in any given society.
One of Smith’s most popular examples to describe the division of labour is the manufacture of a pin. He describes each stage in the production process and shows that one person doing all 18 tasks can produce 20 pins a day, whereas if the 18 different tasks are divided among 18 different people they can produce over 300 pins a day.
For Smith, the most important outcome of the division of labour is skill specialisation.
The outcome of skill specialisation (which Smith describes as something that involves dexterity, tacit knowledge, skill and judgement) is a diversified economy, whereby each person is dependent upon the labour of another person.
In this context, everyone is compelled to co-operate freely in a process of exchange, as everyone is reciprocally dependent on everyone else.
This leads to his next observation:
The division of labour is wealth improving when the size of the market is bigger, and more diversified. Large markets increase the incentive to specialise.
Large markets, in turn, are made possible by “trust, reciprocity, good government, free trade and geography”.
It is often assumed that Adam Smith was a radical advocate of individual self-interest. But for Smith “man has constant occasion for the help of his brethren… he will most likely prevail if he can interest their self-love in his favour….it is by barter that we obtain from one another those mutual good office that we stand in need of“.
It is through individuals pursuing the satisfaction of human needs: food, clothing, hunger, which gives rise to commercial trade in a market society.
In summary: for Adam Smith, the wealth of a nations comes from the commercial expansion of markets, and productivity growth, which is dependent upon skill specialisation, and the division of labour.
Adam Smith (and the division of society):
Adam Smith’s labour theory of value led him to divide society into three different “classes” of person: landlords, wage-earners and capitalists.
Those who live by rent, those who live by wages and those who live by profits.
In Smith’s commercial society the hidden hand of the market acts a horizontal mechanism to ensure a diverse economy meets supply and demand. This horizontal market supplants a hierarchical model of society governed by elites.
Only productive labour, he argues, contributes to the wealth of nations. When citing unproductive labour he includes “politicians, poets, musicians, lawyers and economists”.
These are all necessary forms of labour but they are not wealth producing.
The hero of Smith’s tale of wealth accumulation (told in four historical stages) is the capitalist entrepreneur. Trade is considered more profitable than agriculture, even if the agricultural labourer is the most “virtuous of all persons” in craft and skill.
At the core of the human psyche for Smith, and classical political economy more generally, is need and desire (not rational optimal utility calculation associated with the marginal utility revolution of contemporary economics).
The desire to save and the desire to consume is what drives individual effort.
Free commercial trade, the division of labour and the expansion of markets is what enables this individual effort to come to fruition.
Contrary to popular conceptions of Adam Smith as the defender of vice and unfettered free markets he considers prudence the core virtue of capitalism.
For it is only through hard work and saving for the future that one can ensure the respect of their peers (sociability) and generate wealth (savings) for investment.
The role of the government, for Smith, is to get out of the way of commerce. But government in this context means protectionist, monarchic and authoritarian rule.
But Smith was also quite clear on what government (the sovereign) should do: provide security, infrastructure, administer justice and public education.
Adam Smith was under no illusion about the tradeoffs associated with commercial expansion, and capitalist development.
He states that commerce ultimately renders the merchant “deceitful”, whilst the idle landlord usually ends up “stupid”. If natural man is a “merchant”, then “the virtuous man is a farmer”.
Despite his romanticism for agriculture, he regularly points out that it cannot lead to aggregate wealth. A growth in national income depends on commercial expansion.
It is important to note that the Wealth of Nations is a historical and empirical text.
Smith examined both the historical predecessor to market society: feudal agrarianism, and the subsequent emergence of ‘mercantilism’.
Mercantilism was associated with state sponsored export-led growth and production (the promotion of exports over imports, and savings surpluses at expense of other nations).
Smith agreed with the French anti-mercantilist thinkers that mercantilism is consonant with absolutist rule, and a beggar thy neighbour strategy of commercial expansion.
Adam Smith (on self-love not selfishness):
For Smith, self-interest is the connecting force between ethical and economic conduct.
But self-interest is not to be confused with selfishness. It is better understood, in his words, as “self-love”, which is closely connected to reciprocity (exchange).
The term laissez-faire was never used by Smith. Further, he only ever used the term “hidden hand”, three times in his book.
For Smith, the expansion of commercial markets would ensure greater social and economic equality, which must be primarily understood as the dissolution of feudalism.
Finally, contrary to neoclassical economics, classical economic theory was built around the theory of labour value, and it’s impact on the material production of society (and the division of social classes: rentier, wage-earner and capitalist) that it gives rise to.
Remember Piketty’s core concern is that the rentier has replaced the capitalist in modern market economies. He’s arguing that the capitalist always becomes a rentier.
David Ricardo (on rent, profit and wages):
Building on the foundations laid by Smith, the classical political economists began to focus on the specialisation of the division of labor as the source of increasing wealth.
David Ricardo became interested in economic theory after readings Smith’s Wealth of Nations. In 1817, he published his famous Principles of Political Economy and Taxation.
The first line of the book states that the principal problem of political economy is that of sharing national income between rent, profit and wages (therefore he was interested in the distribution of income and not just it’s production or creation).
For Ricardo, the societal division between rent, wages and profit is the product of the commercial economic system; the volume of production within it, and the absolute income received by each person within the system.
In the late 18th century, national income was divided up between landlords, workers and capitalists. He takes this tripartite division of society directly from Adam Smith.
But unlike Smith he is deeply concerned with the rise and fall of real wages (what we would call purchasing power today) as a percentage share in national income.
He was concerned that too much of national income was being accrued in the form of rent to landowners.
As we will see Marx effectively borrowed, in total, Ricardo’s labour theory of value.
David Ricardo (and comparative advantage)
Ricardo is most famously known for his theory of comparative advantage.
This implies that a nation should specialise in the production of those industries in which it is most internationally competitive. It should then trade with other nations to import those products that it no longer specialises in at home. Swapping wine for bread.
Think about this today. What does Ireland specialise in? China? USA? France?
David Ricardo (on scarcity and rising rents)
But in his Principles (which is of most interest to us) he is primarily concerned with the long-term evolution of land prices and land rents.
His argument on scarcity and rising rents is as follows:
- Once population and output grows, land becomes more scarce. The law of supply and demand suggests that the price of land will continuously increase (it will become scarce). This implies higher rents for landowners. Landowners will therefore claim a growing share of national income, at the expense of profit and wages.
In response to this, Ricardo called for a tax on land rents to control price increases.
His concern proved to be misplaced in the long term. Land prices increased but with the industrial revolution, the value of farm land declined relative to other forms of wealth in national income.
But his ‘scarcity principle’ is an important concept for understanding why certain prices might rise to very high levels over a given period of time (and the wealth accrued to those who benefit from rising asset prices).
To recognise the importance of prices, and how they are capable of destabilising entire societies and markets (and therefore benefiting certain economic interests over others), just replace the price of farmland in Ricardo’s model with the price of housing in Dublin, San Francisco or London today.
What is a reasonable price for a basic human need like housing?
Does this need to insure a reasonable price imply that the state should introduce price (rent) controls? Or is it something that should be left to the ‘market’? Should the state build houses, and therefore remove the profit motive for house building?
Adam Smith once wrote: “in times of necessity the people will break through all laws. In a famine they will break open the granaries and force the owners to sell at what they think is a reasonable price”.
In theory there should be a simple mechanism to avoid rent controls: the law of supply and demand. If the price of housing or rent in Dublin is too high, then demand should fall. People would rent property in those places where prices are lower. They would move to Donegal and commute. This is obviously not realistic.
As we will see in the coming weeks, one of Piketty’s core observations is that we should be concerned about the idle use of private wealth.
Hence, an obvious solution to the housing crisis might be a public investment project to build more houses. This means using taxpayers money, or borrowing on markets.
The general point is that Ricardo was trying to demonstrate that a long lasting divergence in the distribution of wealth is intimately linked to changes in certain relative prices, such as housing or land (the scarcity principle).
Thomas Malthus (and the diabolical trade off)
Thomas Malthus was also concerned about the scarcity of resources and how this might affect the distribution of wealth.
He published his famous essay on ‘Principles of Population‘ in 1798, and argued that the primary threat to society was overpopulation.
He based his observations on what was occurring in France, the most populous country in Europe at the time (20 million compared to 8 million in the UK).
The rapid population increases contributed to the stagnation of agricultural wages (more workers than jobs) and an increase in land rents (more people than land).
All of this fed into the growing unpopularity of the landed aristocracy, and fed the conditions that gave rise to the French revolution in 1789.
Malthus was concerned that the mass poverty, associated with rapid population increases, would ultimately lead to political revolution in England, where he favoured separate houses of parliament for aristocrats and commoners.
He was concerned it would end the rule of the elite.
For Malthus, as population increases, food per person decreases. He called this the law of diminishing returns. This meant that there is an inverse relation between wages and population growth. This is what some call the ‘diabolical tradeoff’.
But there were natural adjustment mechanisms to deal with it: famine and war.
The Black death (1348-1350) was one of the largest determinants of population decline in history. In England, the Black Death wiped out 1.5 million people out of a population of 4 million.
In the absence of such natural adjustment mechanisms, Malthus called for an end to welfare assistance to the poor and proposed other mechanisms to reduce their reproduction habits.
Charles Dickens clearly disagreed with Mathus. His ‘Christmas Carol‘, published in 1843, can be read as an allegory against Malthusians.
If you remember, Scrooge repents in the end. There is no natural diabolical tradeoff between income and living standards/population increases.
But there might be a tradeoff about the rate of growth and the cost of public services i.e. people living longer cost the state more on pensions. Demographic changes put increased demand on public services, which raises the question: who pays?
This is a core fiscal problem that many European states are struggling to deal with today.
In fact, many argue that the crisis of contemporary capitalism is related to the crisis of fiscal democracy: public services require more investment, but everybody wants somebody else to pay.
Classical political economy is a term that is popularly used to describe a body of economic theory that advocates laissez faire, free market capitalism.
But it is more nuanced than this.
It is better understood as the beginning of a scholarly attempt to systematically analyze the emergence of commercial society, and the internal conflicts of capitalist development (particularly the determinant and destabilising effect of rising prices).
For the classical thinkers, the determinants of economic growth (and therefore increased living standards and the overall wealth of nations) is labour specialisation, human skill, productivity improvements, trade and the expansion of markets.
All of this was based on a particular political democratic theory of economic liberalism. Private property (against the state) was assumed to be the primary source of justice. Hence, it was what could be described as a normative political economy.
John Stuart Mill, for example, whom we have not discussed, favoured a different concept of private property. Markets provide an incentive mechanism to promote social utility.
Classical political economists assumed that greater social and economic equality would accompany the ever greater expansion of the market i.e. economic growth.
It was assumed more markets = more trade = more growth = rising tide lifts all boats. Whether this is true or not is what we will discuss on Weds.
The critical turn…..
The study of political economy, and political science, can be distinguished from the study of economics/econometrics because of it’s focus on:
In terms of power: whereas economists tend to analyze the market in terms of Pareto-optimality, political economists tend to analyze markets in terms of whose interests are being served by a given set of economic arrangements.
In terms of institutions: political economists tend analyze the economy as a diverse set of institutions that vary across time (history), and space (country).
These institutions are the rules of the game that shape actor behaviour.
In terms of distribution: political economists study the market as a social construct whose conception is not based on natural laws but the primacy of politics.
They are primarily interested in the question: who gets what, when and how.
This tradition stems from Adam Smith but took a critical turn when Karl Marx published the first volume of Capital in 1867, fifty years after Ricardo published his Principles on Political Economy.
- Think about the year 1867. What was happening across Europe?
It was twenty years after the 1848 European revolutions, which swept across Italy, France, Germany, Netherlands, Poland, the Austrian Empire, and even Ireland.
What all of these nationalist revolutions shared was the attempt to overthrow feudalism and to replace it with more participatory forms of democratic government.
This gave birth to the nation-state as we understand it today.
The revolutionary fervour began in Milan when 70 people were killed whilst protesting against tax increases on tobacco, imposed by their Austrian rulers. These protests spread to Sicily, where local citizens demanded a liberal constitution to replace the autocratic rule of King Ferdinand II.
Before long people were rioting in Geneva, Paris and across several cities in what we now call Germany.
It was against this background that Marx published Volume I of Capital.
Think about the context. England had the fastest growing economy in the world. Thousands had left the land to work in factories. All of these new labourers were living in urban slums. This is what inspired Charles Dickens to write his famous novel, Oliver Twist.
From 1840-1890 poverty was widespread, real wages were stagnant, whilst profits increased. It was not until the second half of the 19th century before real wages began to increase for the emergent industrial/working classes.
Keep in mind Adam Smith’s labour theory of value that we discussed last week.
National income (all earnings in a country) can be divided into wages, rent and profit. During this period of growth, the share of wages in national income did not rise.
The capital share of national income (industrial profits, land rents and building rents) increased massively in the first half of the 19th century.
As we will see from Piketty’s data, from 1870-1914 inequality stabilized at an extremely high level, marked by an increased concentration of wealth.
- The industrial revolution gave birth to a period of rapid economic and productivity growth, stagnant wages and a growth in economic inequality.
This is the historical context that led Marx to write the ‘communist manifesto‘ in 1848.
After this polemic, Marx spent the next twenty years writing Das Kapital, which he considered the first scientific attempt to systematically analyze the internal logical contradictions of the capitalist system (based on the Hegelian dialectic).
For Marx, the most important resource in a market economy is not land but capital.
He takes Adam Smith’s analysis and works through the logical outcome of commercial markets. He concludes that markets lead to centralisation not competition.
Keep in mind that Capital in 1868 was increasingly industrial (machines, factories) rather than landed property. Hence, contrary to Ricardo, for Marx there can be no limit to industrial capital. This led Marx to formulate his “principle of infinite accumulation“.
A free market for capital/money, when left to its own devices will keep accumulating and become more centralised. For Marx, this principle of infinite accumulation implies that capital is doomed to perpetual crises (in the Hegelian sense).
- For Marx, either the rate of profit will steadily decline (leading to violence amongst capitalists) or capital’s share in national income would increase indefinitely (leading to workers revolution).
- For Marx, there is no stable equilibrium in a capitalist society, it will “build it’s own gravediggers“.
The theory (M-C-M)
Let’s unpack this theory further.
First, it is crucial to note that Marx is in dialogue with Adam Smith. In chapter 2 of volume I he accepts the Smithean argument on exchange, reciprocity and private property and then proceeds to deconstruct it entirely.
He points out that contrary to the positive outcomes suggested by Adam Smith, competitive markets will lead to:
- the centralization of capital (markets lead to corporations)
- the concentration of capital (centralization leads to class power)
The entire book can then be read as a deconstruction of the system of free competitive markets, in order to show why they can never be ‘free’.
Marx, much like Smith, tell a story about capitalist development: the capitalist starts out with a certain amount of money. He then purchases two crucial commodities:
- Labor power and
- Means of production (raw materials, machines)
He then puts these two to work within a given technology to produce a fresh marketable commodity. This is then sold in the market place plus a surplus value to make a profit.
But it does not stop here. The capitalists does not consume all the profit as luxury. Rather he/she re-invests it to produce more commodities.
To do this, the capitalist must expand labour and apply new technologies to produce new and better commodities.
Why? For Marx the coercive laws of competition compels the entrepreneur to reinvest the surplus. If he/she does not he/she will be destroyed by his competitors.
The outcome is a simple formula for the circulation of capital: M-C-M. Money-commodity-Money.
The 5 crises tendencies
For Marx the capitalist mode of production always leads to crises. It contains 5 major problems that lead to the following questions:
- Money: Where does it come from?
- Solution: Secure the legal-state
- Labour: how to source supply and demand?
- Solution: Weaken organised labour
- Environment: How to deal with scarcity?
- Solution: Invest in technology
- Technology: The falling rate of profit?
- Solution: Source new markets
- Debt: How to keep the system liquid?
- Solution: Ensure aggregate demand
Keynes would later suggest that the role of the state and fiscal policy can be used to stimulate the economy if the market is faced with a lack of effective demand.
What is important to note is that these blockage points within the capitalist mode of production need to be overcome.
For Marx capital is a flow, if you stop the flow, capital gets lost. This is why Marxian economists are critical of Piketty, who thinks of capital as a stock of wealth.
For Marx, capitalist politics is a perpetual class struggle over all of these factors that keep the system intact. If there is no resolution then stagnation occurs. Crises = Revolution.
Why Marx was wrong
Marx predictions on the inevitable demise of the capitalism turned out to be wrong. He assumed that capitalism would collapse. It didn’t.
This mistaken judgement is not so much related to his insightful historical analysis, but to his use of dialectical Hegelian method, which assumes, by definition, implosion.
At the end of the 19th and into the 20th century, wages gradually began to increase, and the purchasing power of workers spread everywhere.
In Western Europe, workers and citizens explored the alternative avenue of social democracy, rather than communism.
Marx did not anticipate the emergence of a propertied middle class, the social state, nor the emergence of new technologies, or a steady increase in productivity.
The balance of power among different classes associated with trade unionization complemented the emergence of a new power configuration, with a a relatively autonomous state apparatus with the capacity to tax and spend.
This gave birth to the social state as we understand it today. Or capitalist democracy.
What did he get right?
Marx’s principle of accumulation contains an important insight that contemporary economists have tended to ignore: competitive markets have a tendency toward the centralization of ownership and the concentration of wealth.
Just think about the influence of large corporations, such as Google.
The accumulation and concentration of wealth does lead to the concentration of power, which has destabilising effects in both politics and economics.
It would be naive to think that growing income and wealth inequality does not impact on equality of opportunity and democracy.
Why then have economists tended to ignore the distributional question?
The narrative during the 20th century shifted away from apocalyptic predictions to happy endings. It was now assumed that a rising tide lifts all boats.
Simon Kuznets predicted that income inequality would automatically decrease in advanced stages of capitalist development, regardless of the economic policy choices pursued by government.
This theory was based on US data from 1913-1948. It built upon Robert Solow’s (1956) theory of a “balanced growth path”.
Economists increasing assumed that all the core economic variables in society: output, incomes, profits, wages, capital, asset prices, would progress at the same pace.
In the end, a market economy would benefit everyone, as it is the best way to achieve high levels of economic growth.
This was the opposite conclusion to Ricardo and Marx’s assumption of an inegalitarian spiral built into the process of capitalist development.
Kuznet’s was the first to analyze social inequality using sophisticated statistical and mathematical tools. His data (which Piketty has since developed) was based on federal income tax returns.
This allowed him to measure top incomes, particularly the income shares going to upper deciles and centiles, in the overall income distribution.
What he observed was a sharp decline in income inequality between 1913-1948.
In 1913, the upper decile (top 10 per cent of earners) claimed 45-50 percent of national income. By the late 1940’s this had declined to between 30-35 percent.
This decrease was equal to half the income of the poorest 50 percent of Americans.
This decline in income inequality shaped the debate on the politics of distribution in the USA, and various international organizations, throughout the Cold War.
Capitalism was clearly working for everyone whilst the Communist experiments were not. This was an important normative justification for market economies.
Kuznets delivered a paper titled ‘Economic Growth and Income Inequality‘ to the American Economic Association, which gave birth to a new theory: the ‘Kuznets curve’.
This predicted that inequality would initially increase during industrialization and decrease at a later advanced stage of capitalist development.
The internal logic of capitalist development was now assumed to be one of equalization not wealth concentration Market competition leads to a balanced growth path.
As we will see in the coming weeks, it is true that wealth and income inequality decreased in the 20th century, particularly after the shocks of two world wars.
But it is also true that wealth and income inequality have since increased, everywhere, since the late 1970s. This is the opposite prediction of Kuznets theory.
The income of the wealthiest have reached extraordinary levels whilst the incomes of the vast majority have stagnated. This is now clearly observable in the data.
This table and graph illustrate the point.
The question we need to ask is why this has occurred?
The important question we will now try to address is why there was a decline in inequality in the 20th century, and and a rapid rise during the 21st century.
There are two competing explanations: economists tend to focus on skills-based technological change. Political economists focus on politics and bargaining power.
What we will see over the coming weeks is that in the aftermath of WW2, various forms of progressive taxation, capital controls, collective bargaining, rents control, minimum wages and expanded social programs worked to redistribute capital across society.
These were the ‘happy days‘ of a growing middle class.
There is now growing skepticism about the assumption that growth is “naturally” balanced. There are clearly winners and losers. In the US, the top decile receives over 52 percent of national income (a new historical record).
What the data increasingly suggests is that the gains of “economic growth” are being distributed disproportionately to the top of the income ladder.
But to explain the U shaped curve of inequality from 1900-2013, we need to examine the structural origins of this inequality (1890-1913), which is what we will do next week.
The industrial revolution, in addition to the race to colonize the world, completely transformed the face of market society in Europe. Wealth was totally transformed.
slides: Week 3