Tag: Adam Smith

Is there anything natural about prices?

This blog post is motivated by Ashish Kulkarni’s post, which is a response to Samrudha Surana’s substack entry, which in turn is a response to a question I had posed at the recently concluded HET conference organized at Azim Premji University, Bengaluru. And perhaps the process of reading and writing for this post will motivate me enough to get back to systematic blogging. 

According to the Oxford Dictionary, ‘natural’ means “not made or caused by humans”. Viewed this way, there is nothing natural about markets or governments. Both have been created/designed by humans. Consequently, the prices set in markets and the prices set by governments are in no way natural. Yet, marginalist economists (and adherents of the Austrian school) suggest that there is something natural or spontaneous about the prices that emerge in markets vis-à-vis those that are set or administered by governments. This is the mainstream view—propagated via introductory textbooks. 

This post critically engages with James Buchanan’s 1964 article ‘What Should Economists Do?’ published in the Southern Economic Journal as this forms the basis of the posts by Samrudha and Ashish.  The critical appraisal of Buchanan’s article is restricted to his misunderstanding of Adam Smith.

Buchanan’s misunderstanding of Smith

In the very first page of his article, Buchanan calls our attention “to a much-neglected principle enunciated by Adam Smith” (p. 213). The “principle which gives rise to the division of labor” is, quoting Smith, “the propensity to truck, barter, and exchange one thing for another”. And that its significance “has been overlooked in most of the exegetical treatments of Smith’s work.” 

Buchanan wants economics to be “the theory of markets” and not the “theory of resource allocation” (p. 214). As he writes,

Man’s behavior in the market relationship, reflecting the propensity to truck and to barter, and the manifold variations in structure that this relationship can take; these are the proper subjects for the economist’s study. 

Later in the essay, there is an inaccurate reference to Smith’s invisible hand (p. 217; see my moneycontrol article on Smith here). What Buchanan perhaps ignores or is unaware of is that Smith’s economics is one that emphasizes production, economic growth and development. Contrast Buchanan’s definition of economics provided above with that of Smith. 

Political oeconomy, considered as a branch of the science of a statesman or legislator, proposes two distinct objects: first, to provide a plentiful revenue or subsistence for the people, or more properly to enable them to provide such a revenue or subsistence for themselves; and secondly, to supply the state or commonwealth with a revenue sufficient for the public services. It proposes to enrich both the people and the sovereign. (Smith 1776, IV.1)

And to make sense of economic development, a theory of price is essential (for an elaborate account, see Section 2 of my chapter in The Anthem Companion to David Ricardo—available here).

In the tradition of Petty, Cantillon and Quesnay, Smith distinguishes between “natural prices” and “market prices”. In Cantillon, the corresponding terms are “intrinsic value” and “market prices”. It is important to keep in mind that both “natural prices” and “market prices” are theoretical in nature, with the former at a higher level of abstraction than the latter. If market prices were empirical in nature, there would not be a single market price but a spectrum of prices that vary according to the nature and quality of the commodity as well as the time and location of the market. 

Be it the market or the government, both have been created and designed by humans and will continue to be re-created and re-designed. This, Buchanan recognizes. As he writes, “A market becomes competitive, and competitive rules come to be established as institutions emerge to place limits on individual behavior patterns” (p. 218; emphases in the original). For him, the market is “the institutional embodiment of the voluntary exchange processes that are entered into by individuals in their several capacities. This is all that there is to it” (p. 219). This is where Buchanan goes astray. 

I ask: how voluntary is the process of exchange under capitalism? How voluntary is the process of exchange under patriarchy? How voluntary is the process of exchange under the caste system? Smith is very cognizant of the fact that employers have more power than workers in capitalist societies. Smith is aware that big corporations (with/without support from the government) have more power than small entrepreneurs. Buchanan is unable to view power as a structural feature of our economic system—unlike Smith. One reason for the inability could be his adherence to an extreme version of methodological individualism. 

Conclusion

To conclude, the spaces wherein exchanges are truly voluntary for all parties, I think, are very less. Household? Firm? Village? City? International trade?

Political economy, in the work of Adam Smith, recognizes social classes and social power. And it is this recognition that will enable us to design better markets and governments. And this means better designs for pricing commodities, determining wages, setting interest rates, improving employment levels, and recharging our environment.  

Economic Survey 2019-20 and the Missing Role of the Government

According to the Economic Survey 2020 (ES hereafter), wealth is created by the ‘invisible hand supported by the hand of trust’. This is another way of saying that economic prosperity can be achieved by free markets with the government playing the role of an enabler (primarily to enforce private property rights). The introductory paragraphs of the first chapter states the following: ‘During much of India’s economic dominance [in the past], the economy relied on the invisible hand of the market for wealth creation’; ‘the evidence across various sectors of the economy illustrates the enormous benefits that accrue from enabling the invisible hand of the market’; and that the ‘invisible hand needs to be strengthened by promoting pro-business policies’ (p. 1). In the chapter, there are quotes from old texts from the ‘Indian’ subcontinent such as Arthashastra and Thirukural to point out that wealth creation was strongly encouraged. Subsequently, as empirical evidence, they show India’s (historical) contribution to world GDP.

It is surprising to notice that our Chief Economic Advisor (CEA), Krishnamurthy Subramanian, the person responsible for the writing of the Economic Survey, did not object to the following mistake: ‘The ultimate measure of wealth in a country is the GDP of the country’ (p. 14). ‘While GDP or income is a flow concept (measured over a period of time), wealth is a stock concept (measured at a point in time); however, let us try to believe that the chief economic advisor meant income when he wrote wealth. Otherwise, it is an elementary mistake.’

The ES misunderstands Adam Smith’s political economy when it talks about ‘invisible hand’. It is stated that ‘wealth creation and economic development in several advanced economies has been guided by Adam Smith’s philosophy of the invisible hand’ and ‘During much of India’s economic dominance, the economy relied on the invisible hand of the market’ (p. 6). What is the meaning of invisible hand in Smith’ Smith used ‘invisible hand’ as a metaphor to indicate that there are unintended consequences to individual actions and it figures only once in his Wealth of Nations. However, it is true that this term has been appropriated subsequently to paint the image of Smith as a free market economist, which he unarguably was not. As a counter to the view of Smith as a free-market apologist, it is important to note that Smith believed that education should be provided by the government to offset the cognitive ill-effects from division of labour and that it should be affordable to the worker who earns the lowest wage (for more on this, see Thomas 2019).’

According to the dominant economic theory (popularly termed neoclassical but marginalist more accurately), given preferences, technology, and endowments, under conditions of perfect competition, equilibrium prices (of commodities as well as labour) are (Pareto) efficient. [Pareto efficiency means that no one can be made better off without making someone else worse off.] Of course, mainstream economists recognise that an outcome might be efficient but it need not be fair. The ES reduces this formal idea to the following: ‘the market economy is based on the principles that optimal allocation of resources occurs when citizens are able to exercise free choice in the products or services they want’ (p. 6). Leaving aside the conceptual issues with the marginalist theory of value and distribution, how can the market economy in reality not just reproduce but also exacerbate the inequalities of wealth (or endowments), income, caste, and gender”

The ES appears to grossly misunderstand both the historical position and conceptual basis of Smith’s ‘invisible hand’. But was the market economy dominant during the time of Arthashastra as claimed by the ES’ Here are two excerpts from Thomas Trautmann’s 2012 book Arthashastra: The Science of Wealth (for my critical assessment, see Thomas 2016).’

‘As regards the quantity of rations to be issues to inmates in the king’s household: for upper-caste (Arya) males, the measure is one prastha of rice, one-fourth prastha curry (supa), salt one-sixteenth of the curry and butter or oil one-fourth of the curry. For lower castes, the measures are less. It is one sixth prastha of curry, and half the butter or oil. For women the measure is less by one quarter, and for children, it is less by one half. Thus ration units are proportionate to the status of the person and the body size.”(pp. 57-58)

 

‘In the case of commodities distant in place and time, the Overseer of Trade, expert in determining prices, shall fix the price after calculating the investment, the production of goods, duty, interest, rent and other expenses.’ (as quoted on p. 130)

The above two passages dispel the myth propagated in the ES that market forces had a ‘free’ reign in the past. In fact, it was exactly the opposite. There was a ‘division of labourers’, to use BR Ambedkar’s phrase, and food rations were provided on the basis of caste. Therefore, there existed no mobility of labour, and this is hardly surprising in a caste-based society. Moreover, prices were controlled because they believed in the concept of a ‘fair price’ which the market would not be able to set.’

ES also believes that the growth in incomes will trickle down to all: ‘Greater wealth creation in a market economy enhances welfare for all citizens’ (p. 11; emphasis added). ‘Wealth creation in the economy must ultimately enhance the livelihood of the common person by providing him/her greater purchasing power to buy goods and services’ (p. 14). How’ This happens in theory only if you make strong assumptions and neither is there strong empirical evidence to back this claim. On the same page, it is mentioned that the ‘freedom to choose is best expressed in an economy through the market where buyers and sellers come together and strike a bargain via a price mechanism’ and the reason is the following. ‘Where scarcity prevails and choice between one use of scarce resources [sic] another must be made, the market offers the best mechanism to resolve the choice among competing opportunities’ (p. 11). This is indeed the mainstream teaching of marginalist economics. It is true that marginalist economics views economics as a science of choice (under conditions of scarcity). However, what we require is a theory of production–available in the political economy of Adam Smith, David Ricardo, Karl Marx, and JM Keynes. In India, there is neither scarcity of labour nor of capital. Ipso facto there can be no scarcity of commodities. What we are faced with is surplus labour and capital; the former is manifested in high labour unemployment and the latter in high excess capacity. The macroeconomic problem is thus one of aggregate demand deficiency.’

The current economic survey applies a (marginalist) microeconomic analysis to our central macroeconomic problem–unemployment (this is not particular to this year; for another such attempt when Kaushik Basu was the CEA, see Thomas 2012). Thus, it argues ‘that government intervention hurts more than it helps in the efficient functioning of markets’ (p. 12). Within the marginalist paradigm, government intervention reduces ‘economic efficiency’ and therefore is discouraged. However, for the most important macroeconomic problem of unemployment, the government ought to play a key role in the economy. This is necessary because domestic private investment is volatile and foreign private investment even more so. It is extremely unjust for any government to transfer its core macroeconomic responsibility of full employment to the private sector.’

[This is a revised version of my talk delivered at a public discussion on the Union Budget on 16 February 2020 organised by Bengaluru Collective, Centre for Social Concern, Ashirvad, and St. Joseph’s College. The link to the video is:’https://www.youtube.com/watch’v=8VA6OmzDp6A]

 

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

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.

On Economics and Ethics

Ever since political economy became economics, the role of ethics has continually diminished in the learning of economics. This is because economists want(ed) their discipline to be scientific. To serve this purpose, economics has been divided into normative economic and positive economics. Normative economics deals with questions such as ‘what ought to be the price configuration’ whereas positive economics deals with questions such as ‘what is the configuration of process’. In other words, there is no room for debate in positive economics; at least, that is the impression one gets from reading the mainstream textbooks. Amartya Sen tried to remedy this situation by strengthening the area of welfare economics; however, methodologically, it still adopts a ‘positive economics’ framework. In any case, this development motivated economists to ask humane and ethical questions. This post raises some issues concerning the role of ethics in economics.

Adam Smith, the father of economics, did not only write Wealth of Nations; being a moral philosopher and an acute observer of society also published a book titled Theory of Moral Sentiments. This book talks of sympathy, passion, ambition, justice, duty, utility, custom, virtue, self-command, etc. Often, proponents who favour utility maximization cite Adam Smith as the first one to do so effectively. As much as one glance at the table of contents of Theory of Moral Sentiments will say otherwise.

This brings us to the following pertinent, yet very difficult questions. What is the objective of economic policies or economic engineering’ What role does economic theory play in policy making’ Does economic theory provide tools, methods and concepts that aid policy formulation’ The final objectives of economic policy invariably happen to be poverty elimination, reduction of unemployment, inflation control and provision of a good standard of living to all the inhabitants. Hence, various kinds of policies are undertaken to achieve these broad objectives. Very often, economic theory aids such policy making exercise in a significant manner. Now, we come to a very startling observation. Economic theory (which is positive in nature) has no room for conflicts, ethics or values. Instead, the major criterion which dominates most economic theorization is that of economic efficiency ‘ free markets achieve efficiency. So what’ The goals of economic policies are not to make markets efficient or free; instead, it is to provide the inhabitants with a good standard of living. In India, how can markets take care of the diversity in caste, language, region, income, etc’ Economists must do away with their arrogance and admit that policy making is a serious and complex matter, which cannot be solely guided by macroeconomic models of the general equilibrium variety!

For instance, the variables which the government tries to engineer affect people in different and often opposite ways. Alterations in interest rates affect lenders and borrowers differently. Also, movements in exchange rates affect exporters and importers in exactly opposite ways. More importantly, changes in prices of goods and services affect those who cannot afford it very adversely. Given such differential effects of policy variables, economics must incorporate ethical discussions into its fold. Perhaps, a reading of Theory of Moral Sentiments will be of great help!