Happy Birthday Smith and Keynes

Jonathan reminds me that it is John Maynard Keynes and Adam Smith's joint birthday today! The two are ranked together in the highest echelons of economic science for good reason. To a large extent (and admittedly simplifying many other great economists) they provide bookends to an interlude in economics where one simply fact was often forgotten: we do not sit comfortably and automatically on a production possibilities frontier. Smith destroyed the poor arguments of British protectionists by discussing how the division of labor and mutually beneficial exchange could make us more wealthy with the same inputs. After Smith, the Ricardians and the classical economists slipped the discipline into a world of diminishing returns - not because it was necessarily realistic, but for the sake of tractability. Themes of increasing returns, innovation, and spillovers from specialization were underemphasized (although thankfully the gains from trade were still maintained as a theme in classical economics). There were innovations in this Ricardian interlude - the marginal revolution being the chief among them. And while Walras made important contributions in this respect, his general equilibrium system continued the tradition of a perfectly calibrated, balanced systems where general gluts were inconceivable. At the Walrasian auction block, everything was sold and everyone was employed. Keynes revived the tradition of Smith in a subtle way. Smith studied the economy as it really existed and uncovered the key to rapid economic growth and innovation beyond a production possibilities frontier. Keynes filled in the other side of the equation and explained how the complex emergent system of Smith could discoordinate and collapse at regular intervals. The key was the relationship between money, the interest rate, and investment levels. The economics of Ricardo, Walras, and the classics was both Panglossian and stagnant. Smithian economics dispells the stagnation of the classics, while Keynesian economics unravels the Panglossian myth.

It is fitting that two of the greatest economists we have and two of the greatest champions of liberalism share a birthday.

Some History of Economic Thought Links

I came across two interesting links discussing the history of economic thought this morning that I thought might be worth sharing.

The first, from Mark Thoma, covers Adam Smith's version of laissez-faire. Everyone knows Smith was an ardent foe of mercantilism and a proponent of free trade, but for some reason that gets leveraged into the claim that Smith was some sort of proto-libertarian (as if libertarians are the only people that support free trade). That's not really true. Smith advocates things that I defend against modern libertarians, and he was active in the 18th century! Usually I give leeway to earlier writers. In a traditional agricultural economy I would probably be more libertarian too. I understand that when circumstances change so does the proper role of government. But even back then, Smith had a very modern view of the role of government, the importance of externalities and public goods, etc. It is a very classically liberal view of government - there is no fetishization of the state. But it's not a libertarian view. Mark Thoma channels Gavin Kennedy on these issues here.

The second link is from Brad DeLong, who extensively catalogue's Thomas Robert Malthus's views on "general gluts", or depressions. Malthus is most famous for his theory of population dynamics, which heavily influenced Charles Darwin. But he wrote more traditional works of political economy as well, including a protracted debate over the possibility of a "general glut". Most economists in Malthus's time believed that the economy naturally operated at a full employment level. Any economic downturns could be attributed to frictions or temporary miscalculations. Malthus (along with Sismondi and a few others) argued that economies could stay depressed for a very long time, operating in a sub-optimal equilibrium rather than simply struggling through a temporary friction. Of course, for this reason, Malthus is considered the premier proto-Keynesian. And during his lifetime, Keynes made it quite clear that Malthus was one of his inspirations. I would also recommend Lawrence Klein's discussion of all the "proto-Keynesians" in his book The Keynesian Revolution, which I am almost done reading. He does a good job not just explaining what the early theorists of general gluts thought, but how they fit into the Keynesian schema (i.e. - what parts of the Keynesian system they were missing that prevented them from producing a full model of underemployment).

And this seems as good a time as any to highlight the New School for Social Research's history of economic thought site, which is quite simply the most comprehensive and most in depth resource on the history of economic thought available on the internet today. It's like Wikipedia on steroids specifically geared towards the history of economic thought: not something I would ever cite, but it provides tremendous detail and background and it provides excellent links and source material for further study.

The Rev. Thomas Robert Malthus

Smith's Theory of Moral Sentiments

This year is the 250th anniversary of the publication of Adam Smith's "Theory of Moral Sentiments" - the work of moral philosophy that in many ways served as a precursor to his "Wealth of Nations". Econtalk.org is marking the occasion with an audio series on the book, the first installment of which was recently released.

I, like many, am far less familiar with Moral Sentiments than I am with Wealth of Nations. And also, like many, my understanding of Wealth of Nations is largely restricted to the popular cookie-cutter interpretation of that work. To summarize: the pursuit of self-interest is actually beneficial to society, and restrictions on the pursuit of self-interest often have unintended negative consequences. The foundational "human motivation" in Wealth of Nations and most subsequent works of economics is this self-interested pursuit of "utility" or "profit". The few exceptions, including institutionalists like Thorstein Veblen, or heterodox thinkers like John Kenneth Galbraith (I'm thinking of the Galbraith of The Affluent Society primarily, rather than the Galbraith of The New Industrial State) seem to prove the rule.

There are many reasons to believe that any model of society based exclusively or even primarily on the motive of utility maximization is likely to imperfectly represent (and perhaps more substantially, imperfectly predict) reality. It should be self-evident (and I don't appreciate the casual use of that hallowed phrase) that we are motivated in our own lives by other things than self-interest. In many cases, when economists confront this reality, they explain it away by suggesting that alternative motivations aren't directly relevant to the marketplace. Yes, altruism, jealousy, etc. may motivate much of human activity - but greed and self-interest exercise such primacy in market decisions and any model determining production and allocation can safely disregard other motivations.

Adam Smith used his "Theory of Moral Sentiments" to outline the major facets of human motivation beyond self-interest, and for that reason it should serve as a motivator for economists who cling to utility or profit maximization models. This is not to say that self-interest should be marginalized. It will always be central to economics. But I would like to see (I would like to design myself) models that explicitly model the optimization of some combination of relative wealth and absolute wealth. We know people "keep up with the Jones's" - why do we pretend that relative wealth is irrelevant in our models?

Often we look back to Adam Smith, accept the foundational insights into the market that he introduced, and then proceed to qualify the Smithian worldview with various externalities and market failures that economists have come up with since the 18th century. The Wealth of Nations earns it's place of honor on our bookshelves (I have three copies myself, my favorite of which is about 125 years old and looks quite handsome, safely nestled on it's shelf, four feet above the floor), but it is rarely cracked open for actual guidance. I've never read Moral Sentiments, but I think it holds the possibility of exploding the profit-maximizing myth of modern economics. If economics is really going to be a science of human decision making, it should more explicitly encompass the full range of human motivations.