The History of Economics | Basic Economics by Thomas Sowell | Ch. 26

In this entire book about economics, so far, we haven’t really touched on the history of the subject. And that’s just what we’re going to do in this 26th chapter of Thomas Sowell’s Basic Economics.

If you haven’t read my previous summaries and thoughts on this book, please click here. Otherwise, here we go!

Chapter Summary

What most people think of when the history of economics is brought up is Adam Smith and his famous book, The Wealth of Nations. Of course, the millennia of human civilization and existence has produced many different thinkers on the subject, from Xenophon in classical Greece to Thomas Aquinas in the middle ages. What was special about Smith’s philosophy was its legacy and development in the following decades after it was written up until even today. Let’s take a look at the history of this development, and how it has shaped modern day thinking on economics.

The Mercantilists

The mercantilists were a group of 16th and 17th century writers who equated net positive inflow of gold with wealth. This has led to the notion, still popular today, that an export surplus is better than a surplus of imports (though, as discussed in earlier chapters, this is basically circumstantial).

The important thing for the mercantilists, though, was not the movement of resources, but the increase of power of their own nations versus others, and their respective rulers most of all. The government was a primary figure in this process. Thus, things like repressing wages, imperialism and slavery, and other similar things were encouraged to promote the nation, and especially those rulers.

Classical Economics

This was the backdrop in which Adam Smith’s The Wealth of Nations was born in 1776. In it, he did away with many of the mercantilist assumptions, such as economic activity being a zero-sum competition, and focused instead on the creation of wealth through free markets rather than government intervention. On a fundamental level, Smith did not regard the acquisition of gold to be equal to wealth. Instead, he argued that the wealth of a nation consisted of the goods and services it offered, and that imperialism and slavery were both economically inefficient and morally repugnant.

This was in diametric opposition to the mercantilist ideas of the day, and became a foundational text for economics in the the next century, and even afterwards. Of course, that doesn’t mean that Adam Smith’s work was perfect. In countering the equation of gold to wealth, he de-emphasized the role of money, leading to misinterpretations by readers of how money affected production and employment.

Among Smith’s followers was a man named David Ricardo, who wrote his treatise, Principles of Political Economy, as an analysis of economic principles without the social, political, and philosophical emphasis Adam Smith had. Instead, Ricardo envisioned that political economy (which, in his time, meant the economics of a nation, rather than a combination of politics and economics) would be reliant on a system of analysis and rationality. It is to his credit, and a few of his other contemporaries, that the ideas of supply and demand became a dominant means of viewing economics.

Here, we must take a moment to look at a controversial subject in economics known as Say’s Law. It means that the production of output is related to real income which produces that output. In other words, “supply creates its own demand”, and output of growth cannot be so great as to completely outstrip demand, and thus collapse an economy. There was (and still is) controversy about it, as many have argued whether this principle is true. Sowell contends that most of these arguments are semantic, and that the reality is that consumers and investors can certainly choose to not exercise their collective purchasing power, and thus prevent such a catastrophe from happening.

Modern Economics

Historically, economics was regarded as a branch of philosophy. Even Adam Smith was not known as an economist by his contemporaries, since that vocation didn’t really exist. It wasn’t until 1890 that economics became a real profession. In the latter 20th century, it gained rapid advancement as mathematical models and analyses were applied more than purely rational arguments.

Classical economists thought that the amount of labor and similar inputs were essential parts of how the price of a product or service was determined. This was part of the impetus behind Karl Marx’s line of thinking, taking to an extreme the idea that labor was the ultimate source of wealth. This was a cost-of-production theory of value, which stood in contrast to the theory that value was determined by utility of goods to consumers, something Adam Smith rejected with his famous rebuttal in which he offered that, while water had infinitely more utility to people, diamonds were what cost more.

In response, Carl Menger and W. Stanley Jevons proposed a new way to look at utility——namely that it was entirely subjective. Thus, rather than looking at the totality of utility, like Adam Smith was, in which case you would need to have either all diamonds or all water (which would be silly), you need to look at incremental or “marginal” utility. Thus, in the case of water vs. diamonds, the amount paid for water was reflective of how most people were already abundantly inundated with water, and thus having a small diamond (an incremental increase in it) would be a greater value to them. Jevons even showed the actual calculus of how this was determined, and thus set the stage for how mathematical analyses would supersede purely verbal arguments today.

Then, as these supply vs. demand arguments raged, Alfred Marshall published his book, Principles of Economics, in 1890, and argued that it was a combination of supply and demand which determined prices, thus changing the history of economics as we know it. His story is interestingly similar to mine, as explained by Sowell:

Alfred Marshall had been a student of philosophy, and was critical of the economic inequalities in society, until someone told him that he needed to understand economics before making such judgments. After doing so, and seeing circumstances in a very different light, his continuing concern for the poor then led him to change his career and become an economist. He afterwards said that…”the increasing urrgency of economic studies as a means toward human well-being grew upon me.”

The increase in using mathematics to show economic truths gave way to theories of “equilibrium”, in which prices in an industry would no longer rise or fall. Of course, this wasn’t an illustration of the real world, since no equilibrium exists. But just like medical students learn about various body functions in their ideal form (even though they mostly deal with less than ideal bodies), understanding economic equilibrium is really trying to understand why things are currently not in equilibrium.

This kind of analyses can be used in both individual industries and whole economies. In a butterfly effect way, a change in the smallest thing (like the Federal Reserve raising interest rates) can have huge effects on the economy. Thus, even having this simple understanding of equilibrium this can help the average person recognize that solutions offered by politicians can have ramifications outside of what’s intended, and could in fact hurt more than help. No economic activity takes place in a vacuum, even those presented as solutions to problems.

As the Great Depression of the 1930’s and other similar economic calamities happened, economists turned their attention from supply and demand to the boom and recessions of economies. In 1936, John Maynard Keynes produced his now famous book The General Theory of Employment Interest and Money, which proposed a dominant view now known as Keynesian Economics. In it, he argued that government spending could make market adjustment and restoration of employment faster, with few negative side-effects. In this case, inflation would necessarily happen, but would be an acceptable alternative to mass unemployment as seen in the Great Depression. As A.W. Phillips discovered later, government’s intervention would be like choosing from a list of trade-offs, each of which would either cater to unemployment or inflation.

Keynesian economics and its Phillips Curve would be criticized by the Chicago School, made up of economists like Milton Friedman. As mathematical models were studied, it became clear that the market was both more rational and more responsive than Keynes had thought. It also became obvious, especially with the inflation and unemployment levels which rose in the 1970’s, that government intervention was not rational or properly responsive. Yet, parts of Keynesian thought still persist today.

Thus is the back and forth nature of the history of economics. Each era and the individuals making them up contribute something to the field. Then, future writers and thinkers embrace, clarify, repair, or take down the faults of the previous. It’s a very scientific endeavor, in which iteration is more the norm than great leaps and bounds.

The Role of Economics

Like other sciences, economists share a common set of procedures to enable them to do their studies. These procedures allow for exposing or deterring biases, such as that which happened with the Phillips Curve. While economists, like scientists, may not agree on everything, the methods and procedures provide a way for them to test their hypotheses, and see which one is correct. When two ideas are mutually contradictory, only one can prevail. In economics, this is often displayed in the mathematic presentation of arguments, where flaws and incompatible ideas are definitively seen.

Of course, unlike a few other sciences, economics cannot be conducted in a controlled setting. This doesn’t make it any less of a science, however, as many other disciplines, such as astronomy and meteorology, also have similar problems. But understanding root causes (i.e. inflating the money supply will cause an inflation of prices) is similar to how meteorologists understand and predict weather phenomena. Thus, controversies in economics are not about fundamental principles, but how those principles apply in the real world.

In this way, economics becomes evidentially based on the history of economics (or economic study). It’s about how the hypotheses made (i.e. facts) result in particular consequences. Thus the validity of a theory is established. It’s about systemic results rather than opinions or intentions, or how one thinks the results should be. In this way, economists of all kinds of backgrounds can come to the same scientific analyses and conclusions. For example, Adam Smith’s family were not businessmen, which informed his negative view of businessmen. Karl Marx’s social ideology was tempered by his analyses, which sometimes came to conclusions opposite of that ideology.

It is certain that the discipline of economics is based in analyzing historical facts. But it is in the context of these facts that politicians and the general public act. Case in point, Keynesian economics was developed out of the Great Depression. But that doesn’t mean economics is subservient to history. Adam Smith wrote The Wealth of Nations without needing to see free markets. Intellectual insight into supply and demand wasn’t responding to any change in costs or consumer demand. And certainly, the idea of government intervention into the market existed long before Keynes wrote his book.

As a reminder, economics is the study of the allocation of scarce resources that have alternative uses. Understandings in the discipline itself has had difficulty reaching the average person, who would probably never have allowed politicians to do some of the things they’ve done if it had been known. And certainly, there have been cases where economists have risen to prominence, and so become politicians who try to fine tune an economy (like the Keynesians in the 1960’s). But just as economics is a factual discipline free of ideological bias, so have such politicians brought ruin upon societies, almost always and inevitably.

My Thoughts

As I read through this chapter on the history of economics, I couldn’t help but wish this was placed near the beginning of book. I feel like some of the points which Sowell expressed in previous chapters would’ve been better placed in the context of the history of economics, rather than isolated by themselves. But nevertheless, I appreciated reading through this chapter, as it was thought-provoking in many ways.

The Coming Artificial Intelligence Revolution

The recent talks about the rise of artificial intelligence, and its take over of prominent industries, has given rise to a lot of talks about things like Universal Basic Income and government intervention. Not to belabor a point, but we can already see the effects of AI. From things like Tesla and WayMo’s self-driving vehicles to Youtubers using AI to “fix CGI” to even AI being used in apps (which I’ve written about a few times), it’s clear this trend will continue to increase.

The question that should be on everyone’s mind, however, is whether the use of artificial intelligence will produce more unemployment than employment.

The question is a familiar one that touches on a similar point of argument made about the first and second industrial revolution. Namely, that though AI can and perhaps will certainly put some people out of business in certain industries (i.e. long-distance truck driving), it may actually create new businesses and new opportunities of employment, many of which may outstrip the demand for truck drivers.

For example, the proposal for self-driving trucks entails that AI will be the primary drivers, while actual people can monitor the driving from a distance away (to take care of any difficulties). This actually produces more jobs, as businesses would need not only the staff to monitor, but other staff members to report, log, and collate the data. Furthermore, there would need to be staff hired and trained to be ready to assist on the road in the event of failure or accident, and more others hired to assist in the legal and financial ramifications of such accidents.

Would that alone take out the number of truck drivers being unemployed? Perhaps not. And certainly, while the majority of truck drivers may be statistically average in IQ (which actually means they’re within standard intelligence), this doesn’t mean that they are incapable of finding employment in other areas. There are still millions of unfilled jobs in 2019 and 2021 (before and after COVID-19). I think this would be a start.

What we understand from the history of economics is that political or government intervention has resulted in more unemployment and suffering rather than help it. The simple fact is that a singular change in policy can have drastic, unintended consequences that affect the lives of millions, many times in negative ways. So before we look into UBI or the like, I think it’s important to understand that the market corrects for itself more often and better than any single centralized entity ever could.

“Equilibrium” and COVID

Such a realization has provoked me to also wonder what the ramifications of the past year or so of COVID-19 panic and lockdowns will have on people. We already know some of the reports that are coming out. Issues with mental health abound due to isolation and the stress of joblessness are becoming known. More than 60% of small businesses that have closed are now permanently shuttered due to the lockdowns. And the government stimulus promised by the US government have still not been received by millions of Americans.

That last one really shows the ineffectiveness of government to even send out money. Imagine that on a mass scale with UBI. Every month.

There’s very little that I have to add to the conversation, outside of the understanding that government intervention, again like the butterfly effect, has consequences both intended and unintended. But now, we’re on the epilogue of a worldwide shutdown that has happened, something which is perhaps unprecedented in history. Time will tell what is to come in the next few years.