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A Very Brief Introduction to Adam Smith’s Wealth of Nations

Posted by Alex M Thomas on 31st March 2015

The Inquiry into the Nature and Causes of the Wealth of Nations (WoN hereafter) was published on 9th March, 1776. It was advertised in the concluding paragraph of Theory of Moral Sentiments (1759). This blog post is a very brief introduction to Adam Smith’s theory of political economy as presented in the WoN. According to John Rae, the biographer of Smith, the WoN ‘took twelve years to write, and was in contemplation for probably twelve years before that.’ Smith never engaged in any commercial activity unlike his predecessor, Richard Cantillon or his successor, David Ricardo, yet his insights into the working of the competitive economy is intellectually deep and of enduring relevance. His intellectual acquaintances include David Hume, Francois Quesnay, Jacques Turgot and Voltaire.

WoN is divided into 5 books: Book I presents a detailed examination of how labour becomes productive, and contains a theory of supply (of output). On what factors does the annual supply of commodities depend? Book II builds on this and contains a theory of accumulation (of capital stock). The growth policies undertaken by various nations form the content of Book III. The existing theories of political economy are critically appraised in Book IV; this book also includes the policy effects of these theories. Finally, in Book V, a theory of public finance – the theory of the revenue, expenditure and borrowing of the government – is outlined. Given the recurring themes of economic growth and development in this blog, the title of books I and II deserve to be quoted in full.

Book I: Of the Causes of Improvement in the productive Powers of Labour, and of the Order according to which its Produce is naturally distributed among the different Ranks of the People

Book II: Of the Nature, Accumulation, and Employment of Stock

In other words, the first book contains a theory of income distribution and the second contains a theory of economic growth. Recent research has noted the similarities between Smith’s theory of economic growth and neoclassical ‘new economic growth theory’ of Romer; in fact, Smith’s theory clearly emerges as a superior one.

The ‘necessaries and conveniences of life’, according to Smith, are produced by labour. That is, labour produces the annual aggregate supply of commodities and services. The nation is considered better supplied if the proportion between the annual aggregate supply and annual population is high. To expand this definition and adopting modern terminology, we can say that this idea of Smith corresponds to that of output per capita (for example, a high GDP per capita is favoured over a low GDP per capita). Further, Smith asks: what determines the output per capita? According to Smith, there are two factors which determine this proportion. (1) The productivity of labour, and (2) the ratio of workers employed in physical and human capital generation to other workers. Smith uses a different terminology: the ratio of productive to unproductive labour. The number of workers employed in physical and human capital formation is necessarily in proportion to the capital advanced in these sectors. And, labour productivity depends on the capital advanced. But, what is there in Smith’s theory of economic growth which ensures that the growth in aggregate supply is validated by an equivalent growth in aggregate demand?

Smith’s WoN, particularly the first 2 books, is of much contemporary relevance in understanding the socio-cultural idea of ‘subsistence wage’. Also, it contains a rich exposition of productivity unlike the ‘blackbox’ of productivity commonly found in the Solow-type growth theory. Smith’s WoN contains both logical rigour as well as rich prose, and together they vastly enrich our understanding of economic phenomena.

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Posted in Adam Smith, Classical Economics, Classical Political Economy, Economic Thought, Economics, History of Economic Thought, Macroeconomics | No Comments »

Hobson on Underconsumption

Posted by Alex M Thomas on 28th December 2014

Although not in the same tradition, but raising a similar concern as Lauderdale, Malthus and Sismondi, J. A. Hobson (along with Mummery) develops what is known in the literature as the ‘underconsumption theory’. Mummery & Hobson present this in The Physiology of Industry: Being an Exposure of Certain Fallacies in Existing Theories in Economics (1889). These themes are also expressed in other works of Hobson such as The Social Problem (1901) and Problems of Poverty (1905). This blog post completely draws from M. Schneider’s 1996 book titled J. A. Hobson (Macmillan Press; especially chapter 4). A contraction of output can happen through two different routes in a closed economy: (1) underconsumption and (2) underinvestment. The logic of this argument can be explained in the following manner. If planned expenditure – consumption or investment, falls short of the planned output at the aggregate level, output levels will contract in the subsequent period of production. Planned expenditure may be less than planned output either due to planned consumption and/or planned investment falling short of the expenditure necessary to validate the planned output.

Mummery & Hobson take as their focus the first route. As Schneider writes:

‘In the underconsumption theory, a deficiency of consumption, and hence excessive saving, is seen as being accompanied by excessive investment. …underconsumption is simply a case of excess supply in the consumption goods market and excess demand in the investment goods market…’ (Schneider p. 59)

They conceptualize the economy as being made up of two sectors – consumption goods and investment goods sector. Aggregate income can be used for consumption or saving. What is not consumed is saved, and this is assumed to be translated into investment. Therefore, if consumption falls (i.e., there is underconsumption) then saving and investment increases (i.e., there is overinvestment).

Mummery & Hobson assume unchanging technology. A certain amount of ‘capital’ (circulating and fixed) is required to produce the output. [No substitution between labour and ‘capital’ as in marginalist economics.] Given this specification of technology, a decrease in consumption will reduce the quantity of ‘capital’ that can be usefully employed.

…since ‘the profits which form the money incomes of all capitalists concerned in production, the wages of all the labourers concerned…are in a regular condition of commerce, paid out of the prices paid by consumers’ (1889, p. 71), a decrease in consumption would lead to a ‘general reduction in the rate of incomes’ (1889, p. 96) or, in other words, to a ‘depression in trade’, with ‘requisites of production’, including labour, consequently becoming unemployed or only partially employed. (as in Schneider p. 62)

That is, a decrease in consumption ceteris paribus leads to a decrease in aggregate income, since expenditure falls short of output. This also leads to an increase in unemployed labour. This idea of underconsumption has to implicitly assume that investment is ultimately a function of consumption demand. Otherwise, the underconsumption does not pose a problem as it is matched by an equivalent overinvestment. This is why ‘underconsumption leads to the accumulation of excessive capital equipment’ (Schneider p. 71).

The link between aggregate consumption demand, aggregate income and saving is visible in the excerpt from Mummery & Hobson below.

‘it is precisely because they [people] are consuming more that they can save more.’ (1889, p. 126; as in Schneider p. 63).

This excerpt is also suggestive of activity levels being determined by aggregate demand, particularly, consumption demand. A higher income means that the funds to save from are higher. To put the same point differently, saving is a positive function of aggregate income.

Keynes underscored the fact that what is true for an individual need not be true for the aggregate. This is now known as the fallacy of composition.

Every ‘attempt to save more by reducing consumption will so affect incomes that the attempt necessarily defeats itself.’ (Keynes 1936, p. 84; as in Schneider p. 63).

‘Hobson…called this (misleadingly) ‘the distributive fallacy’, which ‘consists in arguing that what is true of each must be true of all’ (1916, p 9; as in Schneider p. 63).

Hobson has made significant contributions to economics. The idea that saving should be favoured over consumption is shown to be false, and this principle is to be found in Kaleckian/Keynesian economics as well. Hobson demonstrated an implicit understanding of the accelerator principle – that investment is dependent of consumption (or that investment is a derived demand). Finally, underconsumption (or a deficiency of aggregate demand) leads to unemployment of labour and underutilized ‘capital’ stock.

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Posted in Economic Thought, Economics, History of Economic Thought, Keynes, Macroeconomics | No Comments »

Robert Torrens: An Introduction

Posted by Alex M Thomas on 30th September 2013

Robert Torrens’s An Essay on the Production of Wealth (1821) is an important contribution to economic theory, in particular, to classical economic theory. Torrens was involved in the founding of the London Political Economy Club along with James Mill, David Ricardo, Thomas Tooke and others. Torrens has written extensively on monetary issues, on colonisation and on price theory. He is also credited with having discovered the comparative costs principle independently of Ricardo. This blog post focuses on his contributions to the theory of value and the possibility of a general glut in his debate with Ricardo.

Torrens is one of the very few (to be precise, nine) economists mentioned by Piero Sraffa in his Production of Commodities by Means of Commodities; Sraffa approvingly cites him for his method of treating fixed capital. Fixed capital is conceptualised as a distinct commodity (a joint product) alongside new commodities which emerge from the production process. Torrens utilises a theory of value based on ‘capital’ as opposed to Ricardo’s labour theory of value. But, how is ‘capital’ to be measured without the knowledge of values/prices? Ricardo recognises that when labour-capital ratios are not uniform across sectors, value will not be proportional to the embodied labour. And, as Carlo Benetti writes in his entry on Torrens in The Elgar Companion to Classical Economics, when the rate of profit is zero, the labour theory of value holds; however, the existence of positive profits does not per se invalidate Ricardo’s labour theory of value. A satisfactory resolution of this problem in value theory is to be found in Sraffa’s simultaneous determination of profits and prices.

The macroeconomics of Torrens, built on his theory of value and distribution, suggests the possibility of a general glut in the economy. On general gluts, Torrens writes: ‘a glut of a particular commodity may occasion a general stagnation, and lead to a suspension of production, not merely of the commodity which first exists in excess, but of all other commodities brought to the market’ (Torrens 1821: 414; as quoted in the Benetti entry on page 473). The underlying reason for this is a disproportion between the different sectors of the economy. Owing to the structural interdependence prevalent in an economy, a disproportion can lead to a fall in ‘effectual demand’. This will lead to a glut in commodities in that particular sector and in other sectors as a consequence of a fall in sales and incomes in that sector. This, evidently, is in direct contrast with Say’s law, loosely understood as – supply creates its own demand.

Other notable commentators on Torrens include Giancarlo DeVivo and Lionel Robbins. The latter published his work in 1958 entitled Robert Torrens and the Evolution of Classical Economics. In 2000, DeVivo edited and put together the Collected Works of Robert Torrens. Studying Torrens will certainly prove invaluable in gaining a deeper understanding of classical economics, and especially his views on general gluts might have contemporary use in relation to the economics of Keynes and Kalecki.

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Posted in Classical Economics, Classical Political Economy, David Ricardo, Economic Thought, Economics, History of Economic Thought, Keynes, Macroeconomics, Michal Kalecki, Sraffa | No Comments »

Thomas Tooke: An Introduction

Posted by Alex M Thomas on 15th June 2013

Thomas Tooke (1774-1858) made important contributions to monetary history, theory and policy. His monetary economics has been viewed in a favourable light by economists such as Ricardo and Marx. Moreover, Tooke’s conception of the rate of interest as a variable determined independently (of the profit rate) bears significant similarities with Keynes’s idea of the rate of interest as a ‘monetary phenomenon’. This post presents Tooke’s monetary theory in brief through his role in the debates between the Currency School (to which Ricardo belonged) and the Banking School (Tooke being the prominent member) in the early 1840s. The reference for this post is mainly the recent research carried out by Matthew Smith.

During Tooke’s time, the dominant view was that the rate of interest is governed by the rate of profit (on capital employed in production) implying that the former is determined by ‘real’ forces. In Smith, it is the competition of capital and for Ricardo, it is the wage rate and production conditions taken together. Tooke argued that the rate of interest is determined by institutional factors in the financial market and is independent of the rate of profit. In his later writings, he stated that it is the rate of interest which regulates the rate of profit with the former entering as a component in the costs of production of commodities.

The Currency School maintained that prices can be controlled by adjusting the quantity of money, as espoused by the quantity theory of money. That is, by altering the bank notes in circulation, it was believed that fluctuations in nominal income could be suppressed. This assumes that there are no time lags and that the velocity of circulation is constant. Tooke contested this policy and stressed the role for a discretionary monetary policy flexible enough to deal with different economic situations. The central principles of the Banking School are as follows: (i) the quantity of money in circulation is endogenously determined by the level of nominal income; (ii) ‘the rate of interest has no systematic influence on the inducement to spend’; and (iii) the rate of interest, being a component of commodity prices, exerts a ‘positive causal influence on the price level’ (Smith 1996: xliv-xlv). Such principles imply that the velocity of circulation is, in fact, a summary measure of the institutional setting of the financial market which can change when activity levels and prices vary.

Tooke’s contributions place a greater responsibility on the central banks. The principles of the Banking School imply that the interest policy of the monetary authorities can have lasting impact on real variables (such as income and employment) by influencing prices and the rate of profit. There is no long-run neutrality of money – monetary variables impact real variables. Moreover, attempts to control the quantity of money solely based on the rate of interest need not be successful since it is endogenously determined. Finally, the causation runs from prices to the quantity of money and not vice versa.

REFERENCE

SMITH, M. (1996), ‘Introduction’, in Variorum of the First and Second Editions of Thomas Tooke’s Considerations on the State of the Currency (1826), edited in collaboration with P. D. GROENEWEGEN, Reprints of Economic Classics, Series 2, Number 8, Sydney, Centre for the History of Economic Thought, The University of Sydney, pp. vi–xlvi.

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Posted in Classical Political Economy, Economic Thought, Economics, History of Economic Thought, Inflation, Macroeconomics, Monetary Economics | 1 Comment »