As a subject, economics is generally focused on producing predictions and assessments of future outcomes. This is highly important; without such forecasts, the economic growth that established our high standard of living would have been very difficult to maintain, let alone initiate. However, the history of these economic ideas – critically the circumstances of their creation – is seldom studied widely. This can be a profound disadvantage when it comes to assess the validity of models and applying economic theories. Such economic-ideas are always the product of their time and location. Applying them blindly and without forethought to a situation can create dire results.
Illustrating the history of economic ideas is perhaps the best evidence one can give. While many consider Adam Smith to be the father of economics, speculation on economic matters long preceded him. Greek and later medieval philosophers, while generally uninterested in economics, did make passing references that would be considered today as the key tenants of economic theory. The Greek poet Xenophon noted the benefits of free trade between Greek city states (including peace and prosperity) while Nicole Oresme of Normandy was arguably an early monetarist (a school of economic thought that focuses on the role of money in an economy). Even the thoughts of the mercantilist era, which Smith spent most of his magnum opus (The Wealth of Nations) relentlessly refuting, introduced interest on loans, stock markets and, in several Dutch writings of the time, rudimentary demand and supply curves (that make up the fundamentals of microeconomics as every first year CBE student will know). It was a time not so economically foreign to our own; there were stock market crashes (several major downturns occurring in London and Paris in the early 1700s), the accumulation of wealth by a new ‘merchant’ class and the rise of significant monopolies such as the East India Companies of the Western colonial powers.
This conceptual lineage heavily shaped Smith’s thinking and beliefs. In late 18th century, the ideas of mercantilism were persisting into an alien industrial world. The impetus was now on the manufacturer of goods rather than those who merely provided the material, as had been since time immemorial. The relics of aristocratic privilege and merchant protection had created inefficient monopolies and obsolesce that stifled growth (such as James I of England’s ‘statues of monopolies’ in 1623). Most egregious of all to Smith was the idea that nations should always maintain a positive balance of trade, importing more than they export, as a sign of economic prosperity. By demolishing these decaying policies, Smith firmly established in their place opposing concepts, including free market competition, free trade and fundamental theories of price and wage determination that set the foundation of modern economics.
The true ramifications of the industrial revolution, which Smith never saw, meant that the large, polluted factory with a huge workforce became the bedrock of the economy over the traditional agricultural sector. Goods were now being produced on a gargantuan scale and prices, wages and labour were new variables for policy makers to consider. Consequently, disciples of Smith updated his ideas. Jean-Baptiste Say, a French industrialist, argued that supply always finds equilibrium on the demand curve, implying that goods in the market will always find buyers (known as Say’s Law). The stockbroker David Ricardo argued, amongst other things, that Smith’s competitive market model was a self-correcting mechanism and that the rational individual pre-empts any government intervention (the Ricardian equivalence). By the end of 19th century, these original economic concepts still permeated throughout economics; forming the foundations of a highly theoretical discipline largely removed from the workings of the everyday economy. Assumptions of the rational consumer and producer formed the basis of models used to predict market outcomes. However, the blind application of these assumptions from another time and place collided violently with the most serious economic crisis of our era: The Great Depression.
Given their classical economics training, policy makers initially advocated no intervention in the economy. Following indirectly from the ideas of Ricardo and other ‘neo-classical’ economists, it was believed that the market regulated itself and this ‘panic’ would soon be over. However, no reaction simply resulted in unbounded mass unemployment, with consumer, producer and bank panic arresting economic activity. By 1937, with the economy seeming to be heading towards another recession, policy makers firmly turned to new ideas. It was in this atmosphere that the ideas of John Maynard Keynes took centre-stage. Showing that (unlike the industrial revolution) it was possible to produce too much and have a shortage of demand, Keynes stated the government’s role in the economy to increase spending and lower taxes to make up for this demand shortfall. Otherwise, the economy was poised to stay in this nightmarish crisis, which could easily become a new equilibrium point (contrary to Ricardo). It was only with this crisis and acceptance of the failure of the prevailing paradigm did economics begin to grow to include Keynesian economics (the birth of macroeconomics), which could tackle the economic depression in a better manner.
This history lesson is still highly relevant today. Economics, like all disciplines, is subject to being stuck in the prevailing thinking long after those ideas have expired. In 2003, Robert Lucas (1995 Nobel Laureate in Economics) claimed that macroeconomics had been perfected and that recessions were now a thing of the past. As it turned out, his classical approach to macroeconomics failed to predict the onset of the Global Financial Crisis (GFC) in 2008 or provide a remedy. One must always attempt to maintain an open mind within economics and look deeper into the ideas being used; namely their origin, history and evolution, to see their predictive power in the modern world.