The classical economists, the marginalist revolution, and the “vision thing”

1. The classical economists, the marginalist revolution, and the “vision thing”

2. Outline • Economists as social reformers, versus analysts • Classical economists • Keynes • Marginalists • Was the marginalist revolution a backward step? • Substantive contributions of the marginalists and of contemporary economics • Institutional agnosticism of contemporary economics • Where is the social program? • The absence of the vision thing in contemporary economics

3. Economists as revolutionaries: Adam Smith • Rebelled against: mercantilist ideas and practices • Mercantilism: a system both of economics and of politics • Pursuit of accumulation of bullion through trade restrictions and other state policies • Tight relationship between sovereign and businesses • E.g., provision of monopoly rights through royal charters • Smith emphasized pernicious effect of producer interests on conduct of national economic policy • Removal of mercantilist restraints would increase competition, reduce prices, enhance consumer well being, and increase domestic product • Role of state not non-existent, but limited to defense, administration of justice, and public works.

4. Economists as revolutionaries: Karl Marx • Rebelled against: prevailing capitalist system which he viewed as exploitative • A deterministic view of the evolution of history: technological/material conditions determine social system • Capitalism as just the latest stage in historical evolution of socio-economic systems • Capitalists derive surplus by exploiting workers • Ultimately unstable as the interests of workers and capitalists collide • Technological progress would ultimately enable the establishment of a communist society without exploitation • The dictatorship of the proleteriat as a necessary transitional stage

5. Economists as revolutionaries: J.M. Keynes • Rebelled against: established practices that viewed the market economy as self-stabilizing (domestically and globally) • Unlike classicals, Keynes emphasized the instability of modern economies and the need for public action • Unlike Marx, he believed capitalism could be saved • Domestic agenda: role for counter-cyclical fiscal policy to counteract the tendency for market economies towards under-employment • Global agenda: the need to replace the Gold Standard with a system that created policy space for national governments • Keynes as architect of Bretton Woods regime, in particular the rules restricting capital flows

6. Methodological departures of marginalists • Use of mathematics to clarify argument and check its consistency • We use math not because we are smart, but because we are not smart enough • Simplification: analysis by way of models that strip down reality to its essential components • Analysis = breaking up a complicated reality into simpler components, and then building it back up • Separation of the positive from the normative • What is the effect of particular changes in exogenous conditions on economic variables of interest; versus • How do we evaluate the desirability of alternative social states

7. Substantive contributions of marginalists • Better theory of value: Explaining how consumer valuations and costs of production both played a role in shaping prices (Jevons) • P = MC = MU • Explanation of relative prices: general equilibrium theory (Walras) • Tools of analyzing interactions among markets • e.g., how does increase in demand in one market affect costs of production in another • Clarifying instances where private valuations would differ from social valuations, and markets “fail” (Marshall, Pigou) • Marshallian externalities: agglomeration • Pigovian externalities • Better understanding of the sense in which markets are “efficient” or “optimal” (Mill, Bentham, Jevons, Pareto, Marshall) • Difference between maximizing national product and “social welfare” • Markets => max. consumer surplus • Markets => Pareto optimality at best • P.O: cannot make someone better off without making someone else worse off

8. Illustration of substantive contributions: the invisible hand theorem • In what sense is a market economy a desirable state of affairs? • Adam Smith: • “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…. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.” • Contemporary general equilibrium theory • “A competitive equilibrium is Pareto-efficient under the following conditions…” • Everyone is a price-taker, there exist a full set of markets, information is complete, production does not take place under increasing returns, there are no “externalities” • Note, the formulation may sound as if it refers to a static equilibrium, but encompasses an inter-temporal, dynamic interpretation • Specifies precisely the conditions that must hold • Specifies precisely the normative criterion • Enables evaluation and diagnosis for “fixes” of allocative malfunctions

9. Illustration of substantive contributions: comparative advantage • Under what conditions can nations gainfully trade with each other? • David Ricardo demonstrated gains depend on comparative, not absolute advantage, but did so in a specific setting: • 2 countries, 2 goods, single factor of production (labor), constant returns to scale, perfect competition, full mobility of labor across industries, perfect immobility of labor across countries • Modern theory of trade (Samuelson and beyond) has relaxed each of these assumptions • General statement of theorem • Conditions under which failure of conditions generate possibility of losses from trade • Not at all trivial, judging from the amount of misunderstanding revealed in public discussions over trade policy • E.g., can technological progress in China make the U.S. worse off?

10. Where do institutions fit in all this? • Marx, Smith, and to some extent Keynes were keenly aware of the institutional context of their economics, because they desired to alter that institutional context • Contemporary economic theory largely takes institutions as given • It remains agnostic with respect to markets’ institutional embodiment • But it provides important tools which, supported by normative considerations from outside economics, are indispensable to the evaluation of alternative institutional forms

11. OBJECTIVE Productive efficiency (static and dynamic) UNIVERSAL PRINCIPLES Property rights: Ensure potential and current investors can retain the returns to their investments Incentives: Align producer incentives with social costs and benefits. Rule of law: Provide a transparent, stable and predictable set of rules. PLAUSIBLE DIVERSITY IN INSTITUTIONAL ARRANGEMENTS What type of property rights? Private, public, cooperative? What type of legal regime? Common law? Civil law? Adopt or innovate? What is the right balance between decentralized market competition and public intervention? Which types of financial institutions/corporate governance are most appropriate for mobilizing domestic savings? Is there a role for “industrial policy” to stimulate investment in non-traditional areas?

12. OBJECTIVE Macroeconomic and Financial Stability UNIVERSAL PRINCIPLES Sound money: Do not generate liquidity beyond the increase in nominal money demand at reasonable inflation. Fiscal sustainability: Ensure public debt remains “reasonable” and stable in relation to national aggregates. Prudential regulation: Prevent financial system from taking excessive risk. PLAUSIBLE DIVERSITY IN INSTITUTIONAL ARRANGEMENTS How independent should the central bank be? What is the appropriate exchange-rate regime? (dollarization, currency board, adjustable peg, controlled float, pure float) Should fiscal policy be rule-bound, and if so what are the appropriate rules? Size of the public economy. What is the appropriate regulatory apparatus for the financial system? What is the appropriate regulatory treatment of capital account transactions?

13. OBJECTIVE Distributive justice and poverty alleviation UNIVERSAL PRINCIPLES Targeting:Redistributive programs should be targeted as closely as possible to the intended beneficiaries. Incentive compatibility: Redistributive programs should minimize incentive distortions. PLAUSIBLE DIVERSITY IN INSTITUTIONAL ARRANGEMENTS How progressive should the tax system be? Should pension systems be public or private? What are the appropriate points of intervention: educational system? access to health? access to credit? labor markets? tax system? What is the role of “social funds”? conditional cash transfers? Redistribution of endowments? (land reform, endowments-at-birth) Organization of labor markets: decentralized or institutionalized? Modes of service delivery: NGOs, participatory arrangements., etc.

14. Contemporary economics doesn’t have a programmatic agenda… • As we have seen, early on economics had a programmatic agenda (Smith, Marx) • The marginalist revolution and formalism in later decades largely rendered it devoid of any programmatic agenda • marginalists for the most part, devoted their work to understanding how “a market system works” rather than to changing the world. • Economics as a discipline has become a mode of analysis, rather than a program (“pure economics”) • a set of highly contextual, “if-then” propositions • a set of analytical constructs that can be deployed, if so desired, in the service of any programmatic agenda • Economic analysis does not presuppose a set of socio-political arrangements, nor even a particular set of market institutions • It is a mistake to associate programs/visions that have made extensive use of its tools (e.g., market fundamentalism) with the tools itself • “Market fundamentalists” are distinguished not by their belief in economics, but by their presumptions about a particular version of the market economy • Nor does contemporary economics provide us with the imagination to think of alternative institutions

15. … but that doesn’t prevent contemporary economists from having one • Nothing prevents individual economists, qua social reformers, to have their own visions. Consider two dominant strands: • Chicago-school libertarians (“market fundamentalists”) (“ideological economics”) • Economics qua discipline + normative judgments on inequality + view of government as hopeless corrupt • Krugman-type liberals • Economics qua discipline + normative judgments on inequality + hopeful view of government • One may disagree with these visions, or one may think they are inadequate; still, it would not be correct to say they are not visions • Neither would it be correct to say that economics qua discipline is inimical to the development of a vision/program • In any case, not clear why developing vision/program should be province of economists or economics, as opposed to all of us.

16. Economics in the service of programmatic agendas • It is a mistake to think that tools of economic analysis do not have a useful role to play in the service of alternative visions/programs. • Such tools help us • think through the likely consequences of such arrangements, and • ascertain whether predicted effects are observed • Illustrations: • Role of incentives in determining behavior and resource allocation, for example in stimulating innovation • Role of informational asymmetries, for example in opportunistic behavior in finance • Role of multi-market interactions, for example in generating unexpected complications • Role of macroeconomic accounts, for example in ensuring fiscal sustainability of reform programs • The empirical reality informs the right “model” to apply, so ascertaining the nature of that reality is a critical aspect of the craft of applied economics (“equivocating economics”?) • Is price elasticity high or low; are people credit constrained or not; does learning spill over; etc. – these are all questions that can be empirically examined and dictate the “right” model • Even if we cannot rely on economics to train the visionaries of the next social revolution, we can expect it to prepare the foot soldiers