Murray Rothbard begins his discussions about economics from Aristotelian times, but my main interest is in the recent era. The main lessons were around four characters: Richard Cantillon, Anne Robert Jacques Turgot, David Hume, and Adam Smith. Below are my notes, consolidated from previous posts.

Richard Cantillon

(From Richard Cantillon, the Founder of Modern Economics.)

Richard Cantillon (1680-1734), an Irish-French banker/merchant predating Adam Smith, is arguably the founder of modern economics. The book he wrote shortly before his demise, Essay on the Nature of Trade in General, officially published in 1755, was an influential and highly citied document, before it was overshadowed by the retardation of economics that would follow in the form of Adam Smith’s Wealth of Nations (1776).

Cantillon rescued economic analysis from its traditional conflation with politics and ethics. In the words of Friedrich Hayek, “this gifted independent observer, enjoying an unsurpassed vantage point in the midst of the action, coordinated what he saw with the eyes of the born theoretician and was the first person who succeeded in enterating and presenting to us almost the entire field which we now call economics.”

Thought Experiments (The Ceteris Paribus Method)

Unlike natural sciences where one can isolate the effects of a single variable by holding others constant, economics does not lend itself to such experimentation. Cantillon compensated by using Gedanken-experiments: he analyzed the effects of changes to a single variable by assuming other variables to be constant. Thus, through these thought experiments, Cantillon introduced the ceteris paribus method that would become a mainstay in economics.

Value and Price

Cantillon maintained that it was the subjective valuation of the consumers that determined the prices of goods, rather than the intrinsic value of these goods. (Intrinsic value, here, approximately refers to the value of labor and capital that enter into the production.) In a competitive market, laborers and entrepreneurs move in and out of various lines of production, until selling prices match production cost. Thus, in the long term, prices tend towards the intrinsic value.

However, neither is intrinsic value something that spontaneously exists, nor does price automatically approach this intrinsic value. The cost of production does not determine selling price. Rather, it is the price offered by the market that determines the magnitude of the production cost that can be incurred.

Uncertainty and Entrepreneurship

Cantillon emphasizes the role of entrepreneurship. The market is not characterized by stasis or perfrect information; it is filled with uncertainty. The entrepreneur bears this uncertainty by investing his resources and hoping to make a profit. The market is never exactly at equilibrium, but the entrepreneur serves an equilibriating function by forecasting, investing, and helping adjust supply according to the demands of different markets. Profits are a result of successful uncertainty-bearing, accurate forecasting, and effective/efficient production.

Population Dynamics

According to Cantillon, the long-run wage rate depends on population, which depends on the population growth rate. The population growth rate, in turn, depended on factors such as natural resources, cultural preferences, and technological development. Cantillon acknowledged the human tendency to mulitply without limit as well as the ability of culture to alter this tendency. It is not in the purview of economics to determine whether it is better to have a large population of poorer people or a smaller population with a higher standard of living. That is a choice depended on the values of the citizens.

Spatial Economics

Cantillon also founded the field of spatial economics. Spatial economics deals with distances (transportation costs and location of activities) and areas (geographical development and market boundaries). His work integrated location theory into microeconomic analysis. He realized that even when money and monetary prices were at equilibrium, the prices of produce in cities would be higher by the amount of associated transportation costs and risks than they would be near the location of production.

Money and Process Analysis (The Cantillon Effect)

Cantillon noted that inflation (expansion of the supply of money) affected price levels in a non-uniform, heterogeneous manner. Those who gain access to new money early are able to increase their spending according to their preferences at prevailing prices, thus exerting upward pressure on the prices of these items. Those who do not receive the new money at all or receive it after prices have increased suffer a loss in their purchasing power. (See Effects of Inflation: Wealth Redistribution).

Furthermore, because the early recepients do not make purchase decisions in proportion to their previous allocation (that is, they might purchase different goods in different proportions with the new money), all price levels do not rise to the same degree. If the new money is allocated to consumption, prices of different goods will rise according to their new demand. The same is true if the new money is allocated towards investments.

The effect on interest rates also depends on who gets the new money first. If it goes to the lenders, an increase in availability of loanable funds would cause a drop in interest rates. If it goes to the borrowers instead, the interest rates would rise.

International Monetary Relations

Cantillon did not believe in the existence of an equilibrium distribution of money among different countries. He was a semi-equilibrium analyst, believing that the economy went through endless disequilibrium cycles. More export/less import would lead to more inflow of money, which would lead to domestic price increases. This would result in more export/less import and thus, more outflow of money. With less money in circulation, the domestic prices would fall, and thus there would be more export/less import. And so on.

Anne Robert Jacques Turgot

(From Turgot’s Brilliance.)

Anne Robert Jacques Turgot (1726-81) was a French bureaucrat following Richard Cantillon but preceding Adam Smith who made some brief but remarkable contributions to economic thought. This post focuses on his writings about Laissez-faire/free trade. Jacques Claude Marie Vincent de Gournay (1712-59), his mentor in economics, played an influential role in shaping his thoughts.

Unfortunately, Turgot’s works were not sufficiently considered by his contemporaries and immediate successors. His political associations also might have dissuaded people from citing him. In the words of Joseph Schumpeter, “It is not too much to say that analytic economics took a century to get where it could have got in twenty years after the publication of Turgot’s treatise had its content been properly understood and absorbed by an alert profession.”

Free Trade

  1. Turgot regarded industry regulation as a system of coerced cartelization and special privileges conferred by the state. Regulations effectively serve as taxes which increase costs incurred by the producers/sellers, which reduce competition and discourage innovation. Rather than protecting consumers, these regulations compel them to buy inferior products at higher prices.
  2. Economic activities involve the use of the particular knowledge in sole possession of individual market participants. It is not possible for a government or a theorist to obtain or use all such such knowledge. The owners of labor and capital are best suited to employ these factors to the most advantageous use with the help of their skills, experiences, and expectations.
  3. Commerce is necessarily reciprocal. People transact because these transactions make them better off. Individuals benefiting from trade results in the society benefiting overall. If a business defrauds its customers, it would lose customers, and thus be punished by the market. If the government tries to prevent fraud by mounting regulations, it effectively treats every seller as corrupt and every buyer as gullible. It creates needless friction for the honest and capable many to save the few who are unwilling to do their own research.
  4. In light of the above, instead of creating regulation, the government should restrict itself to protecting the nation from invasion and upholding the rights of the sellers to sell and the buyers to buy.

Taxation

  1. Besides promoting free trade, Turgot argued against taxes and tariffs. Due to the reciprocal nature of trade, Turgot pointed out the absurdity of wanting only to export while not importing. Protective tariffs, set up to discourage imports, were described as war of all against all using state monopoly privilege at the expense of consumers. They led to a system of reciprocal oppression between industries and a balance of annoyance and injustice which made everyone worse off.
  2. Turgot also noted that taxes crippled commerce. Urban taxes distorted the location of towns and encouraged evasion of duties. Taxes on capital destroyed thrift and discouraged investments. Taxes on merchandise led to smuggling.
  3. To minimize the distortion caused by taxation, Turgot advocated for a single tax on the product of land.

Utility Theory

  1. Turgot recognized subjective utility and diminishing marginal utility of products. Turgot realized that economic valuations of goods is subjective and ordinal in the minds of the economic agents. Furthermore, these valuations change across time: Turgot derived an early version of the idea of diminishing marginal utility of a good. This provided a good resolution of the water-diamond paradox (See also: Adam Smith’s treatment of the matter in Theory of Value): water, due to its abundance, is not considered precious in a well-watered country where it is easy to obtain in large quantities when necessary.
  2. Turgot described economics as allocation of scarce resources to a limited number of alternative ends. He recognized that to achieve the satisfaction of his wants, man has to put to use his strength, time, and resources, each of which is limited in quantity.
  3. Turgot formed a rudimentary version of the later Austrian idea of opportunity costs. All costs are opportunity costs, sacrifices of certain amount of resources that could have been deployed elsewhere.

Markets

  1. The act of exchange increases the wealth of both parties.
  2. Market processes are the results of expectations. The economy is not at equilibrium. The participants do not possess perfect knowledge.
  3. Bargaining : “The bargaining process, where each party wants to get as much as he can and give up as little as possible in exchange, results in a tendency towards one uniform price of each product in terms of the other.”
  4. Pricing : “The price of any good will vary in accordance with the urgency of need among the participants. There is no ’true price’ to which the market tends, or should tend, to conform.”

Production and Distribution

  1. Division of Labor : “If the same man who, on his own land, cultivates these different articles, and uses them to supply his own wants, was also forced to perform all the intermediate operations himself, it is certain that he would succeed very badly. The greater part of these operations require care, attention and a long experience, such as are only to be acquired by working continuously and on a great quantity of materials.”
  2. Turgot recognized land, labor, and time as the main factors of production. (Notice that capital is not separately mentioned. Turgot operated in a largely agricultural economy.)
  3. Law of Diminishing / Variable Returns : “It can never be assumed that double the advances will yield double the product.” The increase in output is sublinear with respect to the employment of input (beyond a certain point). After a certain maximum is reached, the marginal returns are negative.

Capital, Entrepreneurship, Savings, Investment

  1. Wealth accumulation requires saving (thus, not consuming) a part of what is produced. Savings are stored as money, and then invested in various capital goods. Foregoing consumption precedes savings, savings precedes investments.
  2. A capitalist-entrepreneur must accumulate savings to pay his employees while a product is being developed. This capitalist-entrepreneur also bears market risks.
  3. Production, and stages of production, require time. The owner of capital is willing to wait for the time required to produce, sell, and to make profit.
  4. The interest return on investment is the payment by laborers to the capitalist for the service of advancing money in the present so they need not wait years for their income. (There is an incompleteness in this argument. It is not just a matter of the laborer waiting for the income. It is a matter of risk aversion. Even if all of the profits owing to the particular contributions of a laborer is promised to him when such profits are accrued, laborers, due to their aversion to risk, would likely decline the offer.)
  5. Anticipation of Say’s Law : Savings do not leak out of the economy. They are how advances of capital are generated. Also, it is incorrect to assume that savings lead to a removal of money from circulation, and thus a reduction of price levels. Savings flow back into the economy through investment in capital goods, payments to employees, or loans.

Interest

  1. Turgot recognized interest return on investment as the price paid by laborers to capitalist-entrepreneurs for advances of savings in the form of present money.
  2. He also noted that interest on money loans tend towards the natural rate of interest through the process of capital rebalancing. Demonstration:
    1. If the interest rate is lower than the natural rate, people begin to borrow more and invest in businesses where they can earn higher returns. This relative increase in borrowing will increase the interest rate, making it approach the natural rate from below.
    2. If the interest rate is higher than the natural rate, people will divest from businesses or liquidate assets and begin to loan out their funds. This will increase the relative supply of loans, which will decrease the interest rate, making it approach the natural rate from above.
    3. Capital rebalancing is consistent with this proposition of David Hume: “no man will accept of low profits, where he can have high interest; and no man will accept of low interest where he can have high profits.”
  3. He described the positive relationship between risk and interest rate: Less risky loans would have lower interest and vice-versa. Since government bonds would be the safest, they should bear the lowest rates.
  4. Along with the note on the interest rate of governement bonds, Turgot attached how pernicious to the economy such debts would be. They would effectively result in an interest rate floor, diverting funds to sterile investments. Public debts crowd out productive use of private savings by maintaining artificially high rates.
  5. Lending and borrowing at interest is a reciprocal contract, advantageous to both parties. Hence, usury laws are absurd on moral grounds: the contracts are voluntary and no one is injured.
  6. Turgot also arrived at the Austrian conception of time preference. Interest accounts for the difference in the value of the promise of a sum of money compared to the value of the money available now. The lender of funds needs to be compensated, in the form of interest, for the following:
    1. The sacrifice of the utilization of the funds at the present moment,
    2. The risk associated with the possibility of losing forever all or a part of the amount loaned.
  7. Turgot also defined the concept of capitalization: present capital value of land or other capital good on the market tends to equal the sum of its expected future rents or returns, discounted by the rate of time-preference/interest.
  8. Turgot described the relationship between quantity of money and interest. Interest rate depends on the savings-spending ratio of the population. Increase in money supply can both increase or decrease the rate of interest, depending on the spirit of thrift or the spirit of luxury. (The logic is similar to that noted in point 2.)

Money

  1. Money is not merely a conventional token. It has value in itself. (In any exchange, objects of equal value are transferred. Money, being one of the transfers, must be in itself valuable.)
  2. Turgot described money as a form of language, one that brought forms of various conventions into a common standard.
  3. He described two kinds of money: real money (metal coins), and fictitious money (numeraire, units of account).
  4. He acknowledged that the relative values of gold and silver would fluctuate according to their relative supplies at any given time.

David Hume

(From The Errors of David Hume.)

David Hume (1711-76) was a Scottish philosopher and an influence on Adam Smith. His brief works on economics consisted of several serious errors, as noted by Murray Rothbard below.

As a proponent of the quantity theory of money and its corollary, the price-specie-flow mechanism, Hume recognized that the abosolute quantity of money in an economy did not matter: prices would adjust according to the quantity of money in circulation. He believed that changes to the money supply mattered in the short-term; specifically, that an injection of money would stimulate the economy in the short term. However, this effect would disappear as the new (higher) price levels reflected the increased money supply. Hume believed that this adjustment in prices would be quick and proportionate. This is problematic in the following ways.

  1. This analysis of aggregates lacks the sophistication of the micro-process analysis of his predecessor, Richard Cantillon. There is no reason why the new prices would rise in a proportionate manner to the new equilibrium. The outcome would depend on who got the new money first and what they put it towards.
  2. Unlike Cantillon, Hume failed to account for the ‘income effect’: in addition to exerting an upward pressure on local prices, the new money would lead to increased domestic income, enticing an increase in imports. This effect would, in general, work faster than the effect on prices.
  3. Hume’s analysis jumps from one equilibrium to another, with complete disregard for the intermediate dynamics. Improper treatment of dynamics lead to miscalculations about the final equilibrium. This analysis comparative statics will be a recurring error.

Recognizing that the effects of the money injection would dissipate, Hume suggests the economy should receive a continued injection, so as to maintain this stimulation phase indefinitely.

  1. It is problematic that Hume labels the distortion of the functioning of the economy caused by the monetary injection as stimulation. The added monetary balances induce economic actors to engage in consumption and investment behaviors that they would have refrained from had the price signals in the market not been distorted with the added money. When the prices eventually rise, and the money illusion disappears, they face the adverse consequences of inflation.
  2. If inflation (injection of new money) stimulates the economy through the recruitment of factors of production previously idle, why were these factors idle to begin with? Hume never bothers to ask this question. The answer may be found in William Hutt’s Theory of Idle Resources. In short, there exist many reasons why the owners of these factors might decide to withhold their employment; to induce them to utilize them through misinformation supplied by inflationary measures is grossly immoral.

On the one hand, Hume lauds inflation, but on the other hand, he advocates for the ultra-hard money policy of 100% reserve banking. There are good reasons to avoid fractional reserve banking.

  1. Nevertheless, this is not consistent with Hume’s previously described position.

Hume aptly notes that the interest rate and the rate of profit in a free market would tend to equate. As he put it, “no man will accept of low profits, where he can have high interest; and no man will accept of low interest where he can have high profits.”

  1. However, he leaves the analysis incomplete by not considering how the lowering of time preference leads to greater capital accumulation, which, in turn, leads to the lowering of interest and profits.

Consistent with the emphasis on comparative statics, Hume viewed the economy as residing for the most part in equilibrium. Futhermore, he maintained that when it moved from an equilibrium to another, it did so quickly.

  1. Long-run equilibrium, in reality, does not exist. It refers to a direction in which the economy is headed. The underlying information about supply and demand is every changing, and so is the ultimate equilibrium. The long-run refers to a series of short-run states, and analyzing the transient dynamics of these states is precisely what is important.

The final point Rothbard makes is regarding Hume’s treatment of money as mere convention, rather than something that is itself a valuable marketable commodity. Money is valuable because of the importance it holds in the minds of the economic actors, but its origin, Rothbard points out, must be as something with instrinsic value (like gold or silver). I have considered this topic in a previous post (Is Pure Money Possible?), especially considering the rise of Bitcoin. The widespread distribution of something without inherent value with the promise that it might, once sufficiently distributed, remains a problem.

Adam Smith

(From The Problem of Adam Smith.)

The following passages from Adam Smith’s An Inquiry Into the Nature and Causes of the Wealth of Nations have received enormous attention over the centuries following their publication in 1776.

  1. “[A man] will be more likely to prevail if he can interest their self-love in his favour, and show that it is for their own advantage to do for him what he requires of them … It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity, but to their self-love, and never talk to them of our own necessities but of their advantages.”
  2. “As every individual, therefore, endeavours as much as he can both to employ his capital in the support of. . .industry, and so to direct that industry that its produce may be of the greatest value; every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. . .(B)y directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention.”
  3. “Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good.”

These passages are seen as evidence of Adam Smith promoting laissez-faire capitalism. Note the introduction of the “invisible hand” meme in the second passage, one that has been propagated around without much regard for context. These famous quotes convey the idea that it is through the selfish pursuit of our own goals that the good of the economy results, and this is more desirable than a direct, motivated pursuit of social good. The anti-free market positions advocated by Adam Smith, therefore, come as a shock to those who imagine him as the paragon of the laissez-faire paradigm.

The Anti-Libertarian Positions of Adam Smith

Below is a short list of statist policies advocated by Adam Smith.

  1. Government education as a way to tame the masses, dissuading them from opposing the government.
  2. Militarization of the nation state.
  3. Government control of coinage.
  4. Regulation of banking, in addition to allowing fractional reserve banking . Note that fractional reserve banking was rightly viewed as inflationary and opposed by economists who were his contemporaries.
  5. Expansion of public works.
  6. Government control of the post office.
  7. Interest rate ceilings (capping rates at 5%), which would effectively eliminate most forms of lending.
  8. A large array of taxes.

Not the Founding Father of Economics

Instead of being the founding father of Economics (Cantillon, Turgot, and others preceded him), Adam Smith was responsible for much retardation of the field. His models were rife with inconsistencies, providing broken solutions to problems answered long earlier. His writings lent themselves to various contradictory interpretations; both capitalists and Marxists would go on to find inspiration from his works.

Faulty Proclamations

Division of Labor

Adam Smith, in his view of economics, emphasized division of labor to the point it superseded other important matters such as the role of capital accumulation and technological progress. The established common sense explanation that two individuals enter an exchange due to both benefiting or expecting to benefit from the consequence of the exchange was replaced by the Smithian notion of irrational, innate propensity of humans to “truck, barter, and exchange.” Smith’s egalitarian outlook could not accommodate differences in natural skills and personal preferences of workers. All laborers, to him, were equal; all differences among laborers were a result of division of labor, rather than the cause of such division.

Division of labor itself is presented in contradictory light within The Wealth of Nations. In book 1, he lauds division of labor for promoting civilization, expanding human intelligence, and increasing affluence. In book 5, he turns around, blaming division of labor for intellectual and moral degeneration.

Unproductive Labor

Adam Smith made stark distinction between productive and unproductive labor. Agriculture was productive. The production of capital goods was productive. But the production of consumer goods (including durable consumer goods such as housing) was unproductive. Similarly, he held that services were unproductive. Any labor (outside of agriculture) engaged in the production of something to be consumed was unproductive labor. Thus, there was an exclusive emphasis on capital production and accumulation.

Theory of Value

The mental gymnastics around the water-diamond paradox is a curious case. (The paradox is as follows. Water is essential for life, yet is free. Diamond, which is nonessential, commands a high price. Are diamonds more valuable than the very thing that sustains life?) Adam Smith, in his early years, resolved it by presenting arguments around relative scarcity between the two commodities. While not as elegant a resolution as the marginal utility argument that would be formulated later by Ludwig von Mises, it was far better than the dubious dichotomy of “value in use” vs “value in exchange” presented in The Wealth of Nations, per which Smith concluded that water had great utility and small value.

Much emphasis is also exerted on the idea of long term normal (equilibrium). Rather than treating it as a tool to make inferences about the direction of market movements, and recognizing that this equilibrium is never really achieved because of the flux in the fundamentals of supply and demand resulting in shifting of the equilibrium, Smith instead held that the economy remained in equilibrium most of the time with occasional deviations from it. The role of the entrepreneur, the capital allocation, the risk assumption, etc, are entirely dismissed as a result.

Smith also presents various erroneous notions about the cost of production theory (that prices are proportionate to wages + rent + profit, ignoring market supply and demand), the quantity of labor pain theory (that the relevant cost of production that determines equilibrium price is simply the quantity of labor embodied in the production process), and labor command theory along the way.

Theory of Money

Adam Smith failed to notice the relationship between the quantity of money supply and prices and balance of trade. He supported fractional reserve banking and did not see excess money printing as inflationary. Bank notes were necessarily tied to the underlying money, in his view; and any excess bank notes in circulation would simply return to the banks, without exerting any upward pressure on prices.

Usury Laws

Smith, as noted above, supported interest rate caps. He, in other words, supported laws against usury. Jeremy Bentham, one of the influences of Smith, came out against these restrictions in his 1787 book, Defence of Usury. Bentham noted that such laws created a scarcity of credit; thus, rather than protecting the poor, these laws hurt them by preventing access to loans. Government induced artificial scarcity creates conditions for the emergence of black markets, which these poor people would have to resort to at even greater costs.

Usury is victimless: both the lender and the borrower consent to the terms of the contract voluntarily. Thus, no crime is committed in the process. If, however, the consent is obtained unfairly or unfreely, the process involves defraudment or extortion, which are crimes themselves. Legal prohibitions exist against them; no additional laws are needed.

Bentham regards lending as “exchanging present money for future” and the lender as someone with “the resolution to sacrifice the present to the future”. Appropriate interest needs to be provided to lender to compensate him for his time preference as well as the risks incurred for giving the loan.

Lessons

The theory of linear progress holds that knowledge builds upon itself (that scholars and researchers study those who came before them, test their ideas carefully, and incorporate their knowledge into their own bodies of work), and that science progresses upward in a straight line over time. Whether this belief is valid needs to be examined. The Kuhnian paradigm is more apt. People seldom study, or have the time to patiently test anything. Knowledge is often lost to history. Adam Smith, the man, the meme, has somehow successfully blotted out the works of the great economists who came before him. It is on us to excavate the works of scholars such as Cantillon and Turgot, and later on, the Austrians, who in the modern era are sidelined by a different kind of retardation of Economics (one brought about by blind mathematization).

References

  1. Murray Rothbard, Economic Thought Before Adam Smith (1995), Chapter 12, 14, 15, 16, 17.
  2. Richard Cantillon, Essay on the Nature of Trade in General (1755).
  3. ARJ Turgot, Reflections (1766).
  4. Adam Smith, And Inquiry Into the Nature and Causes of the Wealth of Nations (1776).
  5. Jeremy Bentham, Defence of Usury (1787).
  6. See Joseph Schumpeter, History of Economic Analysis (1954), for the above quote about Turgot.