Economics. A History of Ideas
Sandmo, Agnar: Samfunnsøkonomi - en idehistorie Agnar Sandmo 20.04.07.Notes on the English translation.
Coverage.
The book covers the history of economics from ancient to modern times. The treatment of economic thinking before Adam Smith is cursory, and detailed exposition of economic theories and ideas begins with Smith. The coverage of the modern literature ends around 1970, although there is a final chapter that is concerned with trends in modern economics.
Style and ambitions.
The aim of this book is to present a history of economic ideas that is accessible to persons with some but not very extensive training in economics. In fact, most of the book will be accessible to people who have no formal training at all but who take an interest in economic ideas. Students of economics will on the other hand be able to relate the exposition in the book to the more formal theories that they are exposed to in courses on economic theory. Technicalities are avoided as much as possible; the limited amount of mathematics is in footnotes, and there are only a few diagrams.
The nature of the translation.
My plan is to do the translation myself. For most of the chapters this will involve a direct translation of the Norwegian text, with the exception of Chapter 16, which is about economics in Norway. I intend to rewrite this chapter as a history of modern quantitative approaches. Econometrics is already in that chapter, but I plan to include also some material about national accounting, input-output analysis, macroeconomic planning and related topics. The challenge is to make this exposition readable, but I believe that it can be done.
Sample translation.
The sample translation is of Chapter 14, “The great systems debate.” I chose this chapter because it is a little different from the material usually covered in histories of economic thought, but also because I believe that it is representative of the style of the book.
ECONOMICS: A HISTORY OF IDEAS.
Agnar Sandmo
Norwegian School of Economics and Business Administration.
Table of Contents*.
PREFACE. 11
CHAPTER 1. A SCIENCE AND ITS HISTORY. 13
What is economics? 13
Types of economists. 14
Why study the history of ideas? 15
Styles in the history of ideas. 18
Theory and empirical facts. 20
A subdiscipline of its own 21
CHAPTER 2. ECONOMICS BEFORE ADAM SMITH. 24
Economic thought in antiquity. 24
The schoolmen. 26
Mercantilism. 27
Cantillon. 28
David Hume. 29
Quesnay and the physiocrats. 31
Turgot. 32
Two paradox makers: Bernoulli and Cantillon. 34
On periods and schools. 35
CHAPTER 3. ADAM SMITH. 37
Wealth of Nations. 39
Smith’s theory of price. 40
The returns to factors of production. 43
The invisible hand: What did he say? 46
The invisible hand and Smith’s view of competition. 50
Free or perfect competition? 51
The public interest. 53
The state and the market. 54
Economic growth. 56
Adam Smith and the industrial revolution. 57
CHAPTER 4. THE CLASSICAL SCHOOL: THOMAS ROBERT MALTHUS AND
DAVID RICARDO. 59
Malthus. 59
The theory of population. 60
Economic policy: Poverty, free trade and unemployment. 65
The friendship with Ricardo. 67
Ricardo. 68
Price and distribution theory: Labour and capital. 70
The theory of rent. 72
Foreign trade. 74
The theory of taxation. 76
On machinery. 79
CHAPTER 5. CONSOLIDATION AND INNOVATION. JOHN STUART MILL. 82
Questions of method. 85
The formation of prices. 86
The labour market and wages. 90
Crises and unemployment. 92
Long-term development and the stationary state. 94
New questions: The progress of socialism and the future of the working class. 96
The public sector. 98
Utilitarianism, liberty and the rights of women. 100
The last classical economist? 102
CHAPTER 6. KARL MARX AS ECONOMIC THEORIST. 104
Life. 105
The Communist Manifesto. 108
Capital. 111
Capitalism and surplus value. 112
Marx’ labour theory of value. 113
Economic growth. 116
The falling rate of profit and the breakdown of capitalism. 117
The importance of Marx. 119
Marx and Engels. 120
CHAPTER 7. APART FROM THE CLASSICAL TRADITION:
THE FORERUNNERS OF MARGINALISM. 123
von Thünen. 124
Methods of cultivation and the analysis of location. 125
Factor use and wage formation. 127
The natural wage. 128
Cournot. 130
The law of demand. 131
Price formation under monopoly. 132
Competition among the few: Duopoly. 133
Dupuit. 136
The profitability of public projects. 136
Demand theory and optimal pricing. 138
Gossen. 140
Consumer behaviour. 141
Other contributions. 143
CHAPTER 8. THE MARGINALIST REVOLUTION I: JEVONS AND MENGER. 146
Jevons. 147
The mathematical method. 149
Marginal utility. 151
Prices and demand. 152
The sunspot theory. 155
Menger. 156
The theory of value. 156
The great Methodenstreit. 158
Engel. 160
The Austrian school: Böhm-Bawerk and Wieser. 161
CHAPTER 9: THE MARGINALIST REVOLUTION II: WALRAS. 165
Methodological issues. 167
The analysis of exchange: Two persons, two goods. 169
General equilibrium. 170
The road to equilibrium: The theory of tâtonnement. 173
The problem of existence. 174
Equilibrium and welfare. 175
A strange episode. 177
Perspective on Walras. 179
Was there a marginalist revolution? 180
CHAPTER 10: PARTIAL EQUILIBRIUM THEORY: ALFRED MARSHALL. 183
Style and ambition. 184
Supply and demand. 186
Partial and general equilibrium. 189
Utility, demand and welfare. 191
The concept of elasticity. 194
Externalities. 195
Factor markets and income distribution. 197
Economy and society. 199
The significance of Marshall. 200
CHAPTER 11. EQUILIBRIUM AND WELFARE: EDGEWORTH, PARETO
AND PIGOU. 203
Edgeworth. 203
Exact utilitarianism. 204
Equilibrium in an exchange economy. 206
Pareto. 210
The concept of utility and the theory of demand. 211
Market equilibrium and optimality. 213
The law of income distribution. 215
Pigou. 217
Utilitarianism and material welfare. 218
Efficiency and market failure. 220
Public economics. 221
Unemployment and public policy. 223
Why study economics? 224
CHAPTER 12. INTEREST AND PRICES: WICKSELL AND FISHER. 226
Knut Wicksell. 226
Production and distribution. 229
Capital and interest. 233
Macroeconomic theories. 234
Justice in taxation. 236
Irving Fisher. 238
Consumer and producer theory. 239
Saving and investment. 240
The quantity theory of money. 243
Income and taxes. 244
CHAPTER 13: A NEW VIEW OF THE MARKET: SIX APPROACHES TO
IMPERFECT COMPETITION. 247
Thorstein Veblen. 248
Edward Chamberlin. 251
Joan Robinson. 253
Harold Hotelling. 257
Heinrich von Stackelberg. 260
Frederik Zeuthen. 262
Perspectives. 264
CHAPTER 14. THE GREAT SYSTEMS DEBATE. 267
The challenge of von Mises. 268
Oskar Lange and Abba Lerner. 269
Friedrich von Hayek. 274
Joseph Schumpeter. 276
A broad view of the systems debate. 281
CHAPTER 15. JOHN MAYNARD KEYNES AND THE KEYNESIAN
REVOLUTION. 285
Life and works. 286
The General Theory. 288
Keynes and the classics on the labour market and wages. 291
Demand and employment. 293
The role of money. 296
Stabilization policy. 296
Keynes and the Keynesians. 298
The long run development of the market economy. 302
The Keynesian revolution. 303
Keynes’ other writings. 304
How original was Keynes? 305
CHAPTER 16. ECONOMICS IN NORWAY: RAGNAR FRISCH AND TRYGVE
HAAVELMO 308
Ragnar Frisch. 311
Demand and production theory. 312
Dynamic theory and the business cycle. 313
Econometric methods. 315
National accounting and planning. 316
Frisch as controversialist and systems critic. 318
Trygve Haavelmo. 319
Econometric theory. 320
Economic theory. 322
Haavelmo as teacher. 324
Leif Johansen. 325
The NHH environment: Karl Borch and Jan Mossin. 326
CHAPTER 17. MAIN THEMES IN ECONOMICS FROM KEYNES TO 1970. 329
Hicks, Samuelson and the modernization of economic theory. 330
Arrow, Debreu and the foundations of general equilibrium and
welfare economics. 336
von Neumann and Morgenstern and the theory of games. 339
Milton Friedman and the criticism of Keynesian stabilization policy. 343
Robert Solow and growth theory. 345
Normative approaches to public economics. 347
CHAPTER 18. LONG TERM TRENDS AND NEW PERSPECTIVES. 353
New perspectives in economic theory. 353
“Imperialism” and multidisciplinarity. 357
Increasing formalization. 359
More emphasis on empirical studies. 361
Development of a scientific profession. 362
Americanization and internationalization. 364
Do economists agree on fundamental issues? 367
Planning and the market. 369
References. 373
Index. 390
* Note: Each chapter or subdivision of chapter that deals with a major economist starts with a biographical sketch. This is not always obvious from the Table.
Chapter 14. 19.04.07.
The great systems debate
Around 1920 it had become a common view among economists that equilibrium in an economy with perfect competition implied an efficient use of society’s resources. Although Pareto’s welfare theory was not yet widely known, the proposition could claim support from Marshall’s conclusion that market equilibrium represented a maximum of the social surplus, as well as from similar formulations elsewhere in the literature. At the same time, however, many were doubtful whether the real market economy, with its increasing degree of concentration and other imperfections, could be said to bear any close resemblance to its theoretical ideal. The socialist alternative to an economy with free markets became increasingly prominent in public discourse, and many economists began to feel that the current economic theory did not really provide the defenders of the market system with much support. As pointed out in Chapter 11, Pareto had concluded that “pure economics” was unable to decide whether a market or socialist economy was the best system; in principle, an ideal planning system could also lead to satisfaction of the conditions for efficient resource allocation. This point was further elaborated by the Italian economist Enrico Barone (1908; 1935). Barone interpreted the Paretian efficiency conditions as a recipe for how “the ministry of production” in a socialist state could achieve an efficient allocation of resources. The theory of optimal resource use included, among other elements, a set of rules for the best allocation of the factors of production among alternative uses; for each factor of production, the value of its marginal productivity ought to be the same in all units of production. Rules like these ought to guide the decisions of the ministry of production. If it followed them, the result for society as a whole would be just as good as under perfect competition.
The challenge of von Mises
To begin with, Pareto’s and Barone’s thoughts about the choice between alternative economic systems received little attention from other economists. However, in 1920 the Austrian economist Ludwig von Mises (1881-1973) published an article that was destined to become of major importance for the debate about this question. Mises was a student of Menger and Böhm-Bawerk and was an enthusiastic spokesman for free markets as the system best suited for achieving both economic efficiency and individual freedom. He never obtained a top academic position in his home country, but from 1934 to 1940 he was professor of economics in Switzerland. In 1940 he emigrated to the United States, where he lived for the rest of his life.
In his famous article Mises maintained that in a socialist economy based on central planning, rational economic calculation is impossible. The reason for this is the absence of market-determined prices. Without prices that reflect scarcity and individual valuation, the planners will be unable to guide society’s resources to their most productive uses. Without prices it will not be possible to compare the value of factor inputs with the value of output; therefore it will not be possible to carry out rational project evaluation. From this conclusion he derived far-reaching consequences:
”Without economic calculation there can be no economy. Hence, in a socialist state wherein the pursuit of economic calculation is impossible, there can be - in our sense of the term - no economy whatsoever. In trivial and secondary matters rational conduct might still be possible, but in general it would be impossible to speak of rational production any more. There would be no means of determining what was rational, and hence it is obvious that production could never be directed by economic considerations. ... Would there, in fact, be any such thing as rational conduct at all, or, indeed, such a thing as rationality and logic in thought itself? Historically, human rationality is a development of economic life. Could it then obtain when divorced therefrom? ” (Mises 1920; 1934, p.105.)
These thoughts are not formulated with a high degree of theoretical precision, and Mises’ inclination towards metaphysical vagueness did not make it easier for him to gain the attention of the international research community. He is much clearer in his practical illustrations, e.g. when he discusses the calculations that are necessary for the planning of a new railroad:
”Should it be built at all, and if so, which out of a number of conceivable roads should be built? In a competitive and monetary economy, this question would be answered by monetary calculation. The new road will render less expensive the transport of some goods, and it may be possible to calculate whether this reduction of expense transcends that involved in the building and upkeep of the next line. That can only be calculated in money. It is not possible to attain the desired end merely by counterbalancing the various physical expenses and physical savings.” (Mises 1920; 1934, p.108.)
Without a price system which enables one to compare costs and revenues, rational economic calculation is accordingly impossible.
Mises’ article was translated into English in 1935, and it was then that the international debate in the academic community really started. In this connection, “international” means “English language”; at this stage, we are at the beginning of a development that would make English the universal language of scientific communication, also in economics. But in this case it is interesting to note that the main participants in the debate were not of English or American origin. They were Central Europeans who had come to view the socialist system as something far more than an intellectually fascinating theoretical model; they saw it as a very real political possibility for their respective home countries. Their hopes or fears for what this might imply explain much of the intensity and high temperature of the ensuing debate.
Lange and Lerner
Mises himself was not to become a central participant in this debate; his article was the spark that started the debate, with other writers taking the centre stage. [1] The first to take up the challenge from Mises was the Polish economist Oskar Lange (1904-1965). Lange began his university studies in Poland. After further studies at universities in Britain and the United States he returned to his home country to teach economics at the University of Krakow. In 1938 he left Poland to take up a position as professor of economics at the University of Chicago, where he remained until the end of the Second World War. After the war he once again returned to Poland where he combined academic work with a seat in the parliament; for some time he was also a member of the government.
Lange was a highly skilled economist with a broad range of interests, and the analysis of alternative economic systems was one that had occupied him from his early years. In a 1934 study, published together with another Polish economist, Marek Breit, he presented a plan for a socialist economy that implied the socialization of all production apart from that which took place in small enterprises. The socialized production in the individual plants was to be coordinated by trusts, one for each branch of industry. The trusts were to be supervised by a public bank which would play the role of a central planning board. [2] However, it was only after he had read von Mises’ article that Lange was led to formulate the model of a socialist economy for which he became famous. It was first presented to the economics profession in two journal articles in 1936 and 1937 which were later republished in book form (Lange and Taylor 1938).
Lange begins by saying that socialists ought to feel gratitude towards Professor Mises, who plays the role of devil’s advocate for their cause.
”For it was his powerful challenge that forced the socialists to recognize the importance of an adequate system of economic accounting to guide the allocation of resources in a socialist economy. ... Both as an expression of recognition for the great service rendered by him and as a memento of the prime importance of sound economic accounting, a statue of Professor Mises ought to occupy an honorable place in the great hall of the Ministry of Socialization or of the Central Planning Board of the socialist state. (Lange and Taylor 1938; 1964, p. 57.)
Lange’s response to Mises’ challenge was to develop the theory of decentralized or market socialism. He was familiar with the work of Walras and Pareto, but he had doubts whether the actual market economy could function in such a way as to satisfy the conditions for an optimal allocation of resources. In particular, he emphasized the trend that he perceived in the modern economy towards an ever increasing concentration of market power, with large companies working to limit competition by forming cartels or monopolies. [3] This development implied violations of the conditions for optimal resource use; through the concentration of industry and the use of monopoly power the free market system would create the basis for its own decline. Lange also claimed that political attempts to gain control of monopolies and cartels were doomed to failure, since the large and powerful companies would easily come to have more political influence than the supervisory institutions that were set up to control them. He concluded his diagnosis of the market economy as follows:
”... the most important part of modern economic life is just as far removed from free competition as it is from socialism; it is choked up with restrictionism of all sorts. When this state of things will have become unbearable, when its incompatibility with economic progress will have become obvious, and when it will be recognized that it is impossible to return to free competition, or to have successful public control of enterprise and of investment without taking them out of private hands, then socialism will remain as the only solution available.” (Lange and Taylor 1938; 1964, p. 120-121.)
At the same time Lange recognized that the theoretical model of perfect competition had in fact demonstrated how resources ought ideally to be allocated in the interests of society. The question was therefore whether the ideal model could be implemented in any other way than through a conventional market system.
Under Lange’s system of market socialism firms would be owned by the state, and they would be instructed by their owner to maximize profit, just like the firms in a market economy with private ownership. However, the prices of consumer goods and factors of production would not be determined by market forces but by the central planning bureau. In order for prices to lead the economy to an efficient resource allocation, they would have to be set so as to create equality between supply and demand in all markets. How was the planning bureau to identify these prices? It would of course have to collect data about costs and demand, but Lange’s central idea was that the setting of prices would have to be based on an experimental process of trial and error which bore a strong similarity to Walras’ tâtonnement process (see Chapter 9). If the planning bureau initially had set the prices of some goods and factors too high, there would be excess supply, and in the next round the bureau would lower the prices. For other goods and factors the prices might have been set too low, leading to excess demand, and the rules guiding the decisions of the planning bureau would lead it to raise the prices. Through this process the bureau would gradually approach a general equilibrium of supply and demand, implying an efficient use of resources. In other words, the functioning of the planning bureau would imitate the ideal version of the market as described in the theories of Walras and Pareto.
The fundamental difference between market socialism and the system of free markets is that Lange’s system requires all firms to take prices as given; it is impossible for any firm to exercise market power. Paradoxically, it is under socialism that the ideal version of the market system can be made to function! Lange also believed that the trend towards increasing concentration in modern industry was a major cause of the instability characteristic of contemporary capitalism, and that market socialism would be a system better designed to cope with the effects of the business cycle.
Lange admitted that market socialism, like other economic systems, could have some imperfections. In particular, he stressed the danger associated with an increasing bureaucracy that could follow from detailed state regulation of industry. However, he pointed out that this was a danger that would also be present in a private ownership economy dominated by large companies. At least, he argued, it was better to have public servants who were subject to democratic control than business managers who in his view were subject to no control whatsoever.
Many economists had argued that one of the most important points in favour of a private market economy was the incentives that it created to promote innovation and technical progress. It was Lange’s belief that the trend towards increasing concentration and power of monopolies had already weakened the dynamic forces of the market system, but he also realized that the lack of incentives could become a problem when managers were no longer guided in their decisions by a concern for private profit. However, the issue of how the democratic control of managers could be exercised so as to encourage efficiency and innovation was a subject that he had little to say about, and he expressed the view that this was a type of question that ought to be studied by sociologists, not economists.
In the course of the first decade following the publication of his vision of the new economic system, Lange seems to have modified his view of the desirable extent of public ownership under market socialism. In the first version of his plan it seems as if he thought that public ownership would gradually come to extend to the whole of private industry, but in a letter to his critic Friedrich Hayek in 1940 [4] he wrote:
“Practically, I should, of course, recommend the determination of prices by a thorough market process whenever this is feasible, i.e. whenever the number of selling and purchasing units is sufficiently large. Only where the number of these units is so small that a situation of oligopoly, oligopsony, or bilateral monopoly would obtain, would I advocate price fixing by a public agency.”
In an article that he wrote during the War about the prospects for democracy in Poland, Lange went even a bit further in this direction by recommending that public ownership and the control of prices be limited to a few key industries like banking and transport. What he came to think about these issues as he gradually came to occupy important positions in the Polish communist state, is less clear. Both his official status and the general lack of freedom of expression in the country make it difficult to know if his writings about alternative economic systems were determined by his economic thinking or by political considerations.
Oskar Lange also made a number of influential contributions to other areas of economics. In the 1930s and 40s he wrote some important articles both about Keynesian macroeconomic theory and the foundations of welfare economics. After his post-war return to Poland his interests appear to have turned more in the direction of technical analysis; he published a textbook of econometrics and wrote a number of studies of cybernetics (systems analysis). Maybe these were interests that were easier to cultivate in a political environment that did not tolerate very much in the way of deviations from official ideology.
Lange was not the only economist who took an interest in the theory of market socialism in this period. His chief ally in the scientific discussions that took place was Abba P. Lerner (1905-1982). Born in Rumania, Lerner’s academic career took him to several countries and universities. Already while he was a student at the London School of Economics, he wrote innovate papers about international trade theory which were published in the leading academic journals, and these were followed by contributions to macroeconomics and public economics. His political convictions were – especially for his time – a peculiar mixture of socialism and belief in the efficiency of the market mechanism. He was also firmly convinced of the importance of private firms for ensuring the individual’s freedom regarding the choice of occupation. He published articles that elaborated the analysis of Lange’s system, and it is Lerner’s clarifications of the price adjustment mechanism under market socialism that has made it widely known as the Lange-Lerner mechanism.
Lerner also wrote the first modern textbook of welfare economics. The Economics of Control (1944) presented the first systematic exposition, of the type that we find in modern texts, of the conditions for efficient or Pareto optimal resource allocation. He pointed out that there were three set of conditions that would have to be satisfied for the allocation to be Pareto optimal.
(1) Efficiency in consumption: For given total quantities of consumer goods, it must not be possible to make one consumer better off without making one or more others worse off.
(2) Efficiency in production: It must not be possible to increase the output of one commodity without reducing the output of one or more other commodities.
(3) Efficiency in the product mix: It must not be possible to alter the composition of production so as to make one consumer better off without making one or more others worse off.
Lerner showed that these conditions would be satisfied both under perfect competition and under market socialism; the crucial condition was that all consumers and firms faced the same prices. He emphasized strongly a more practical interpretation of the abstract efficiency conditions: Consumer prices should be equal to the marginal costs of production. Like Lange, Lerner’s perspective on the main results of the theory of welfare economics was they could be read as a handbook of optimal decisions under central planning. However, he paid little attention to the problems that would have to be overcome in their practical implementation.
Hayek
Friedrich von Hayek (1899-1992) was born in Vienna, where his university studies were concluded with doctoral degrees both in economics and political science; during his studies he also had close contacts with Mises. In 1931 he came to England as professor at the London School of Economics, and in 1950 he moved to the United States, where he was associated with a research institute at the University of Chicago. In 1962 he returned to Europe as professor at the University of Freiburg in Germany. Together with the Swedish economist Gunnar Myrdal he received the Nobel memorial prize in economics for 1974.
Hayek began his career with studies of monetary theory and the business cycle, and in the 1930s he became a prominent critic of the macroeconomic theories of John Maynard Keynes. Gradually, however, he became more interested in questions related to the choice among alternative economic systems, and in this area he became known as the foremost spokesman for von Mises’ side in the systems debate, and as the strongest critic of Lange’s views. In the post-war period his interests turned more in the direction of general social philosophy, with – among other things – a strong focus on the methodological problems that he saw as specific to the social sciences.
It was Hayek who took the initiative to having Mises’ article translated into English. With time, he himself came to believe that Mises views on prices and markets paid insufficient attention to two important aspects of the market mechanism - incentives and information. When private firms and their owners strive to maximize profits, it is because the profits accrue to themselves; they have therefore a strong personal incentive to make decisions which, under perfect competition, are in the interests of society. By contrast, in Lange’s socialist system the profit is collected by the state and this weakens the link between private interests and the good of society. The officials of the central planning bureau will have no personal incentives to ensure that the public companies actually maximize profit.
As important as the emphasis on the importance of incentives was Hayek’s analysis of the problems of information. In his view the major part of the economically relevant information in society is private in character. Consumers’ knowledge of their preferences and resources and firms’ insights in the technology of production are as a rule unavailable to outside observers like a state planning bureau. It is through their market transactions that individuals provide information about technology and preferences to the rest of the economy, and the fundamental role of prices is therefore to be carriers of information. The fact that economic agents take prices as given reflects the fact that they do not have any information about the economy beyond their own private sphere. In fact, they have also limited information about their own situation; in Hayek’s vision of the economic system consumers and firms are permanently searching for new information, also about their own preferences and technology. The price system develops spontaneously as a result of the actions of individual agents, and such a system cannot possibly be replicated by bureaucratic processes.
Probably the best expression of Hayek’s views is to be found in his article “The use of knowledge in society” (1945). Here he asks the question of what we mean by a rational economic system or, as he prefers to put it, a rational economic order. He points out that if we are in possession of all relevant information in the form of preferences and resources, then the solution to the problem of economic allocation is a matter of pure logic, and mathematical economists have shown us the conditions which must be satisfied to achieve an efficient allocation of resources. However, according to Hayek, this is definitely not the economic problem that with which society is in fact confronted:
“The peculiar character of the problem of a rational economic order is determined precisely by the fact that the knowledge of the circumstances of which we must make use never exists in concentrated or integrated form but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess. The economic problem of society is thus not merely a problem of how to allocate “given” resources - if “given” is taken to mean given to a single mind which deliberately solves the problem set by these “data”. It is rather a problem of how to secure the best use of resources known to any of the members of society, for ends whose relative importance only these individuals know. Or, to put it briefly, it is a problem of the utilization of knowledge not given to anyone in its totality.” (Hayek 1945, pp. 519-520.)
Prices transmit information to the individual economic agent, and this induces him to make socially rational decisions, even if his own information about the economy as a whole is severely limited. Hayek illustrates this point by the following example: Let us assume that somewhere in the world there emerges a new industrial use of tin, or, as an alternative assumption, that the estimated reserves of tin have been significantly reduced. In a market economy the individual user of tin will typically not know whether the increased scarcity of tin is due to the first or the second of these causes; neither is it important for him to know it. What is important is that a higher price of tin sends him a signal that it would be profitable for him to cut back on his own use of tin, and this would also be in society’s interest.
The problem that is solved by the market cannot, Hayek maintains, be solved by a planning process of the type that Lange had in mind. The amount of information that is required for the problem to be solved by central planning is too dispersed and personalized to be made available to a central planning bureau. Economists like Lange and Lerner have been misled by formal analytical models that completely disregard the problem of information.
Many economists in the 1950s and 60s thought that it was obvious that Lange had won the debate with Mises and Hayek. There were at least two reasons for this. One was that Lange had based his arguments on existing economic theories, so that market socialism emerged as a direct application of the theories of welfare economics and general equilibrium. The firmer theoretical foundation lent a degree of scientific legitimacy to his ideas that the less formalized arguments of Mises and Hayek appeared to be lacking. The other main reason was the general planning optimism of the first couple of decades of the post-war period, which was derived both from the successes of war-time planning and from what was perceived as the great economic progress of the Soviet Union under its regime of central planning. More recently, this view of the debate has changed. On the one hand, the collapse of the socialist system in the Soviet Union and Eastern Europe seemed to lend support to Mises’ and Hayek’s views of the inherent weaknesses of central economic planning. On the other hand, modern developments in economic theory have taken a course which is much closer to Hayek’s emphasis on the importance of incentives and information in the market economy.
In the middle of the 2nd World War, while still living in England, Hayek wrote the The Road to Serfdom, which came out in 1944. This book represents a radical extension of the framework for discussion of the issue of alternative economic systems. Hayek maintains that the conditions for economic and political freedom in reality are closely connected, and that the restrictions on economic freedom that would follow from the extension of government control would necessarily also involve a loss of political freedom. From this point of view fascism and communism are no longer polar cases in political terms but closely related systems whose common contrast is the free market system and the liberal political order. Hayek therefore warned against the trend towards expansion of the public sector and central economic planning which he felt was so evident in Britain, and he argued that this development would necessarily imply a weakening of political democracy; this was the road to serfdom.
Schumpeter
Like Mises and Hayek, Joseph Schumpeter (1883-1950) was Austrian by birth, although he was born in a part of the Habsburg Empire which is now a part of the Czech Republic. He studied law and economics at the University of Vienna, where Wieser and Böhm-Bawerk were among his teachers. After completing his doctorate in law, he tried to establish himself in the legal profession, but he also began to write a book about research methods in economics, and on the basis of this book he obtained an academic position first in Czernowitz (a city now in the Ukraine) and later in Graz. In 1912 he published Theorie der Wirtschaftlichen Entwicklung (The Theory of Economic Development) where for the first time he presented his theories of the sources of economic growth. The book was soon translated into English and made Schumpeter an internationally recognized economist. But he had difficulties settling into academic life. He was an active participant in the political life of Austria, where his public image to many was a confusing mixture of conservative and socialist. After the First World War he was appointed Minister of Finance, but after just a few months he was forced to resign. He then became the managing director of a private bank, but this attempt at a new career ended in disaster for both him and the bank. He gradually returned to academic life as professor of economics at the University of Bonn in Germany. In 1932 he moved to the United States where he became a professor at Harvard University, and this became his academic home for the rest of his life. While at Harvard he published two major books, Business Cycles (1939) and Capitalism, Socialism and Democracy (1942). His great work on the history of economic thought was incomplete at the time of his death but appeared as History of Economic Analysis in 1954.
He said that in his youth he had set three goals for himself - to become the greatest lover in Austria, the greatest horseman in Europe and the greatest economist in the world - but that he had only achieved two of them. A witty remark and an interesting glimpse of a personality with ambitions that in part were very modern and in part derived from pre-modern times. In this context we will leave aside his achievements in the first two areas, but there is no doubt that he became a very prominent and important economist. However, it is not easy to define the exact nature of his contribution to economics. Through much of his life he had an unhappy love affair with mathematical economics. He was convinced of the superiority of the mathematical method, but he did not possess the skills that were required to make a contribution to formal economic analysis. What he has left to posterity is above all a particular vision of the economic system as an organism in continuous development. Many have therefore maintained that Schumpeter is the founder of what is sometimes called evolutionary economics; an approach which in their view is neglected by mainstream economics [5].
Schumpeter’s contributions to the great systems debate are closely related to his view of the driving forces in the development of the market economy. The main role in this process is played by the entrepreneur, the agent who introduces innovations in economic activity:
“... the function of entrepreneurs is to reform or revolutionize the pattern of production by exploiting an invention or, more generally, an untried technological possibility for producing a new commodity or producing an old one in a new way, by opening up a new source of supply of materials or a new outlet for products, by reorganizing an industry and so on.” (Schumpeter 1942; 1947, p. 132.)
Inventions and discoveries occur continuously, but their transformation by entrepreneurs into innovations that alter the preconditions for productive activities happens in waves because of the social resistance to change. Innovations break through when the accumulation of inventions and discoveries has reached a critical mass. With a change of technology - in a broad sense - there will be opportunities for new products and new techniques of production; new firms and industries emerge while some of the old ones vanish. This dynamic process Scumpeter called creative destruction. In his book Business Cycles he claimed that the theory was supported by statistical evidence. He found empirical support for the existence of three cycles of unequal length: a short-run cycle of about five years, a medium-run ten years’ cycle and a long-run cycle of approximately sixty years [6].
What kind of market economy is it that provides the best framework for the innovative entrepreneur? In spite of Schumpeter’s admiration for Walras’ general equilibrium theory, he believed that its idealized picture of the nature of competition was quite misleading as a description of an actual market economy, which always finds itself at a particular stage of a dynamic development process. In the real world, the static efficiency of the Walrasian equilibrium was much less significant than the dynamic efficiency that resulted in creative destruction. This process could hardly be imagined without deviations from perfect competition. To an increasing degree, a characteristic feature of a dynamic market economy will be concentration of market power with monopoly and oligopoly as the dominant market forms.
The development of a market economy dominated by large companies will, however, result in an economic system where the role of the entrepreneur becomes bureaucratized. Innovation becomes routine work rather than the outcome of genuine individual creativity:
“... economic progress tends to become depersonalized and automatized. Bureau and committee work tends to replace individual action.” (Schumpeter 1942, p. 133.)
This development will also undermine the social status of the entrepreneur; the mystique and glory that were attached to it in former times will disappear. The great masses of the people will no longer accept the role of the entrepreneurs as social and political leaders, and they no longer feel any emotional attachment to the system that they represent. At the same time there emerges a new class of intellectual idealists - educated at the institutions of learning created by the capitalist system - who are critical to an economic system based on self-interest. Their critical attitudes will encourage a policy which gradually transfers private firms to public ownership and “social control”.
This theory of the eventual victory of socialism is clearly reminiscent of Marx’ analysis of the development and decline of the capitalist system and the rise of the proletariat. The similarity appears above all in the broad sweep through economic, sociological and political causes. But there are also a number of dissimilarities between the two perspectives. Marx predicted a development towards class war and revolution. Schumpeter, on the other hand, foresaw a gradual development whereby bureaucratic socialism would come to take the place of a capitalist system lacking in social legitimacy.
Would the transition to socialism be of benefit to society? In his comparison between socialism and capitalism - the market economy - Schumpeter takes a different viewpoint from that of Mises, Lange and Hayek. The brand of capitalism which is relevant for the comparison is not the perfectly competitive economy of Walras and Pareto. Instead it is the capitalism of oligopolies and monopolistic competition [7]; this is both a more realistic vision and, by force of its dynamic efficiency, a more viable one. This implies that the fear of increasing bureaucracy that would follow the transition to socialism is without foundation:
“I for one cannot visualize, in the conditions of modern society, a socialist organization in any form other than that of a huge and all-embracing bureaucratic apparatus. ... But surely this should not horrify anyone who realizes how far the bureaucratization of economic life ... has gone already and who knows how to cut through the underbrush of phrases that has grown up around the subject.” (Schumpeter 1942; 1947, p. 206.)
Even if Schumpeter’s writing expresses a general scepticism towards bureaucratic decision processes, whether they occur in the public or private sector, he takes the view that the problem of bureaucratization cannot be used as a point against either socialism or capitalism. He believes that a form of decentralized socialism of the Lange type would be feasible in practice. One of his arguments in favour of such a system is that the solution of fundamental economic problems would in some respects actually be easier than in the market economy. He compares the situation facing a manager in either of the two systems. One of the major difficulties of being the manager of a company is how to take account of the uncertainty that surrounds decision-making in a market context. A very important source of uncertainty lies in the lack of knowledge about the behaviour of competitors and about “how general business conditions are going to shape.” This type of uncertainty would be eliminated under decentralized socialism, where the central planning agency, through its responsibility for determining prices, would take on the task of coordinating decisions between companies. Other types of uncertainty would remain and be basically the same as in a system of free markets, but the elimination of the uncertainty about the actions of others would radically reduce the complexity of the manager’s work.
Schumpeter’s analysis of the relationship between socialism and the market economy is complex and difficult to summarize. More than the other participants in the systems debate he emphasizes the importance of non-economic factors, and his view of the inevitable victory of socialism is more reminiscent of Marx than of the Lange-Hayek debate over the price system. While Lange and Hayek discussed the choice between economic systems according to their ability to generate good outcomes for society, Schumpeter took an entirely different approach:
“... value judgments about capitalist performance are of little interest. For mankind is not free to choose. This is not only because the mass of people are not in a position to compare alternatives rationally and always accept what they are being told. There is a much deeper reason for it. Things economic and social move by their own momentum, and the ensuing situations compel individuals and groups to behave in certain ways whatever they may wish to do - not indeed by destroying their freedom of choice but by shaping the choosing mentalities and by narrowing the list of possibilities from which to choose. If this is the quintessence of Marxism then we all of us have got to be Marxists.” (Schumpeter 1942; 1947, p. 129.)
His comparison of his own analysis with that of Marx is obviously to the point. For in this reasoning it is not a question of a choice between systems on the basis of rational scientific discourse and informed political decisions; history has already decided the future course of events [8]. It should be noted that Schumpeter did not look forward to the future that he predicted, for he found his own vision of the transition to socialism to be unattractive. His prognosis for the development of society was quite different from his own wishes, which rather went in the direction of the liberal order in the Austria of his youth. But that was “the world of yesterday”, which could not be restored.
Some words should also be said about Schumpeter as a historian of economic thought. This was an interest that had developed in his youth, and in his later years he worked on an extensive review of the history of economics from antiquity to modern times. He was unable to finish his History of Economic Analysis (1954), but his wife, Elizabeth Boody Schumpeter, who was an economic historian, edited the manuscript on the basis of Schumpeter’s chapter drafts and notes, and the book was published four years after his death. It is a display of the strong sides of Schumpeter’s talent: his wide reading, his personal and colourful style of writing and his ability to draw out the long lines in the history of ideas. It is not a textbook in the usual sense. As his other books describe his visions of economic life, the History offers his vision of the history of economics, and this vision is so strong and personal that it often rises above narrow concerns like chronology. An example of this is the presentation of Cournot’s theory of duopoly (Cournot 1838) in the part of the book entitled “From 1870 to 1914 and after.” We can only guess at his reasons for organizing the material in this way, but a possible explanation is that he thought that Cournot’s work could be seen as a further development of Alfred Marshall’s theories of competition and monopoly. The reader may at times be somewhat frustrated by the difficulties of finding one’s way in the book, but there are also new insights to be gained by the many unexpected connections drawn between topics and authors belonging to different time periods.
Overview of the systems debate
The great systems debate is an interesting episode in the history of economics. The debate about the relative merits of markets and socialism and of decentralization and central planning is naturally not limited to the relatively short time during which this particular debate took place. The systematic investigation of the pros and cons of alternative economic systems has been a central topic in the literature of economics both before and - not least - after. The special urgency that the debate acquired in the 1930s and ‘40s can be explained both by factors internal to the discipline and by external events.
The development of the theories of general equilibrium and welfare economics had led to a much clearer understanding of the efficiency properties of the market mechanism than had been the case before. At the same time, the stylized picture of the market economy which had been drawn by Walras had made many economists realize aware of the contrast between this picture and the real economy in which they lived. Among some of them, like Mises and Hayek, the dissatisfaction with the formalized theory of the market economy created an ambition to formulate a new theory of markets that more realistically captured their true efficiency properties. To economists like Lange and Lerner, on the other hand, the challenge became instead to explore alternative economic systems that could realized the potential for efficiency that was indicated by the theory of perfect competition. The discussions and controversies about the role of prices for efficient resource use, about incentives and information and the relationship between politics and economics led - at least in the long run - to a clearer understanding of the role that economic theory could play in the debate about alternative economic and political systems [9].
In the period between the two world wars the choice between alternative systems was a problem of far more than academic interest. Socialist and communist parties and organizations had acquired considerable political influence, and the Russian revolution of 1917 had convinced many that communist seizure of power had become a real possibility in other countries as well. Communist and socialist ideology was strongly based on economic arguments, and it was natural that many economists should feel the need for a scientific scrutiny of them. But the contributions to the debate were hardly examples of detached evaluations. Without doubt, both Mises and Hayek on their side of the controversy and Lange and Lerner on the other saw their theoretical contributions as being in service to their political convictions. But this should not lead us to brush off their theories as poorly disguised political propaganda. None of them tries to hide the nature of their political sympathies; nevertheless, their theories can be evaluated on a purely scientific basis. We may consider Hayek’s view of prices as carriers of information without having taken a stand in favour of his political libertarianism. We may also study Lange’s theoretical model of decentralized socialism without being disturbed by our knowledge of his political support for a communist dictatorship.
The intensity of the debate was also a reflection of the personal experiences of the main actors. The most prominent among them were all people who left their home countries which they saw as threatened by fascist or communist revolutions. Mises and Hayek emigrated to the United States, which seemed to them to offer the best prospects for a liberal political and economic order. Lange, after his American exile, moved back to his native Poland when its government seemed likely to carry out his ideas for economic reform. They must all have felt that the great systems debate concerned issues that were of central importance in their own lives.
Further reading
The early contributions to the systems debate by Barone and Mises were translated into English and published in Hayek (1935). Mises’ 1920 article is also available at the web site of the American Ludwig von Mises Institute ( http://www.mises.org ). This web site provides much interesting information about Mises, even if the contents have a strong ideological bias.
Oskar Lange’s ideas about market socialism are presented in Lange and Taylor (1938). His life and writings are described in Kowalik’s article about him in The New Palgrave . Abba Lerner’s The Economics of Control can still be read with profit as an introduction to welfare economics. Tibor Scitovsky writes about his life and work in The New Palgrave, and Niehans (1990) reviews his contributions to welfare economics.
Hayek’s book The Road to Serfdom (1944) is well worth reading even today. It contains many important insights into the relationship between economics and politics, even if most modern readers may feel that his dark prophecies concerning the effects of public sector expansion in a market economy are a bit overdone. As a summary of his views on the essential nature of markets and prices, the article on “The use of knowledge in society” (Hayek 1945) can be strongly recommended.
Anyone who is interested in the history of economic thinking must be acquainted with Schumpeter’s History of Economic Analysis (1954); in addition, Capitalism, Socialism and Democracy (1942) is fascinating reading. Richard Swedberg (1991) has written a good biography, and Heilbronner (1999) has a lively and amusing chapter about his contradictory visions. Samuelson (1951), who followed Schumpeter’s lectures as a student at Harvard, gives a vivid impression of his personality.
Among the standard textbooks of the history of economic thought, Ekelund and Hébert (1997) provide the best coverage of the systems debate with extensive references to the literature. The systems debate also continues in more modern forms. Bardhan and Roemer (1992) argue that market socialism should still be taken seriously as an economic system, while counterarguments are presented by Shleifer and Vishny (1994). A wide-ranging modern analysis of the relative merits of markets and socialism is Stiglitz (1994), although the discussion is not closely related to the earlier debate. Gregory and Harrison (2005) provide a fascinating description of actual socialist planning as it was practiced in the Soviet Union in Stalin’s times.
[1] Mises’ further work on socialism versus markets had less influence on the systems debate, and his other economic writings were mostly within monetary theory and policy.
[2] See Kowalik (1987) for a more detailed description of the Lange-Breit model. The organization of industry by means of branchwise trusts bears a striking resemblance to von Stackelberg’s ideas about the rational organization of the corporative fascist economy; see chapter 13. This is hardly a coincidence. It is not surprising that economists who shared a basically sceptical attitude to the free market economy, a strong belief in the power of central plannning and little regard for the dangers of a powerful state, should arrive at similar conclusions.
[3] The problem had also been discussed by Mises, but his view of the causes behind this development was a completely different one. In Mises’ view it was government policy, not the market itself, which was responsible for the trend towards increasing concentration. If only the government would keep away from attempts to regulate private competition, the market mechanism itself would work to eliminate the power of monopolies. Without government support no private monopoly would in the long run be able to protect itself against the forces of competition.
[4] The letter is quoted in Kowalik (1987).
[5] An international Scumpeter Society attempts, through conferences and publications, to keep his vision alive in moderne economic research.
[6] These cycles or “waves” had been suggested earlier, however. Thus, the medium-run cycle is associated with the French statistician Clément Juglar (1819-1905), while the long wave has been supported by references to the work of the Russian economist Nikolai Kondratief (1892-1931?). - Kondratief vanished during Stalin’s purges, and the year of his death is therefore uncertain.
[7] In this connection Schumpeter writes very positively about the work of Chamberlin and Robinson, but his own interpretation of their theories emphasizes the dynamic aspects of competition to a much larger extent than these writers did themselves.
[8] In Schumpeter as well as in Marx there is an unresolved tension between the decisive role that they ascribe to the creative individual - Marx’ capitalist and Schumpeter’s entrepreneur - and their deterministic view of economic and political development.
[9] A Norwegian contribution to this debate was the book by Trygve J. B. Hoff (1949), which was originally published in 1938. Hoff reviews and evaluates the discussion in the international literature; his own views are closely related to those of Mises and Hayek.
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