Lecture 5: Classical Political Economy

Introduction 

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 and Scottish 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.

What interested them was the development of commerce, the role of the state and the emergence of industrial capitalism.

Adam Smith (and the division of labour):

Adam Smith’s Wealth of Nationspublished in 1776, opens with a discussion on the core concept that has shaped all theories of classical political economy: the division of labour.

Smith dedicates the first book of his treatise to the question 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 specialization. This is the first crucial observation, as it is the origins of human capital theories.

The outcome of skill specialization (which Smith describes as dexterity, tacit knowledge, skill and judgement) is a diversified economy, whereby each person is dependent upon the labour of another.

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 specialize.

Large markets, in turn, are made possible by “trust, reciprocity, good government, free trade and geography”.

It is often assumed that Smith was a radical advocate of individual self-interest. This assumption simplifies his work. 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 favor….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 their self-love, understood as the satisfaction of human needs: food, clothing, hunger, which gives rise to commercial trade in a market society.

In summary: the wealth of a nations comes from commercial expansion and productivity growth, which is dependent upon skill specialization, 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 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 obvious 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 laborer 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.

But contrary to popular conceptions of Smith as the defender of vice and unfettered free markets he considers prudence to be a core virtue.

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 is to get out of the way of commerce. But government in this context means 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 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 cites 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 neighbor 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 that famous term ‘hidden hand’, three times.

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 specialization of the division of labor as the source of increasing national wealth.

David Ricardo became interested in economic theory after readings Smith’s Wealth of Nations. In response, he published his famous Principles of Political Economy and Taxation in 1817.

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 wealth and not just its 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 specialize 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 specializes in at home. Swapping wine for bread.

Think about this today. What does Ireland specialize 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).

Rising prices

To recognize the importance of price as a coordinating mechanism, capable of destabilizing entire societies and markets (and therefore benefiting certain economic interests over others), just replace the price of farmland in Ricardo’s model with the rental price of housing in Dublin, San Francisco or London today.

Rental prices in Dublin have increased by almost 35 per cent since 2011 whilst wages have remained stagnant (or even declined), and now exceed the peak of the housing bubble.

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 favored separate houses of parliament for aristocrats and commoners.

He was concerned it would up-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 welfare 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 nobody wants to pay.

Conclusion

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 destabilizing effect of prices).

For the classical thinkers, the determinants of economic growth (and therefore increased living standards and the overall wealth of nations) is labour specialization, 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.

The moral critique of an emergent group of economic socialists rejected this.

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 lecture slides can be download here. lecture-5

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