Beyond Economics 101

This post on Economics 101 reminds me yet again how useless modern economic theory is at working through almost any economic issue at all. It’s about the theory of comparative advantage, I think, and the role of free trade in creating a high standard of living. But let me go first to this question at Quora: What are 25 economics books that you would recommend (preferably classical and neoclassical)? My answer:

If you are seriously interested in understanding economics you need to understand classical economic theory, the economics of the period from the publication of Adam Smith’s Wealth of Nations in 1776 until the marginal revolution began about a hundred years later in the 1870s. And if you are interested in understanding classical economic theory, you should read the third edition of my own Free Market Economics: an Introduction for the General Reader.

Modern economic theory has fallen into very hard times since its classical period, and is now incapable of explaining almost anything that matters. My FME third edition is entirely supply-side, explaining how classical economists understood the operation of an economy which is how an economy actually does work.

From the marginal revolution with its focus on marginal utility, through to the Keynesian Revolution of the 1930s with its introduction of aggregate demand, economic theory has looked at economies from the demand side. And while it has a superficial appeal, no economy is driven by demand. All economies are driven from its production side. People buy more where more is produced. If you want to understand what allows people to demand, you first have to understand what makes them capable of producing.

I will just add that if you try to read classical theory without some preparation for the changes in the terminology between economics today and economics then, you will miss the point. This is a paper you can find at SSRN which will help you get past what is a quite formidable barrier.

Classical Economics Explained: Understanding Economic Theory Before Keynes

Steven Kates

Abstract

Since the publication of The General Theory, pre-Keynesian economics has been labelled “classical,” but what that classical economics actually consisted of is now virtually an unknown. There is, instead, a straw-man caricature most economists absorb through a form of academic osmosis but which is never specifically taught, not even as part of a course in the history of economics. The paper outlines the crucial features that differentiate modern macroeconomics from classical theory, with the emphasis on what an economist would have understood as The General Theory was being published. Based on the differences outlined, a model of classical economic theory is presented which explains how pre-Keynesian economists understood the operation of the economy, the causes of recession and why a public-spending stimulus was universally rejected by mainstream economists before 1936. The classical model presented is an amalgam of the final edition of John Stuart Mill’s 1848 Principles of Political Economy published in his lifetime and Henry Clay’s influential 1916 Economics: an Introduction for the General Reader, a text which was itself built from the economics of Mill.

Here’s the link to the paper.

Classical Economics Explained: Understanding Economic Theory Before Keynes

As for comparative advantage and free trade, if you’d like a very good explanation of its classical meaning, you won’t do better than my Free Market Economics, an analysis I have not changed a word of since the first edition. It is naturally taken from the economics of John Stuart Mill who had himself taken it from David Ricardo, who wrote it up in 1817. It’s a great first approximation for all those economic types who are actually addicted to mercantilism, whereby economies are driven from the demand side and economies grow by increasing their level of exports. I know, who could believe such a thing, but let us assume just for now that there really are morons who harbour such views. How did Mill and Ricardo explain what was wrong with such notions? By pointing out that the best way to improve one’s standard of living is to produce what one does best and exchange one’s own forms of supply for the goods and services produced by others. You know, goods buy goods. You know, Say’s Law. You know? Perhaps not.

But you know what was also current then? The gold standard. There are many ways this process of comparative advantage breaks down, but with the abandonment of the gold standard and fixed exchange rates, there are all kinds of ways to cheat in foreign trade relations that are not discussed as part of the basic theory. This is the definition of “currency manipulation” found at Google:

It occurs when a government or central bank buys or sells foreign currency in exchange for their own domestic currency, generally with the intention of influencing the exchange rate and trade policy outcomes.

“Influencing” as in making one’s own situation better at the expense of someone else. It can be done, and is done. And there’s more. For most economies, a devaluation occurs naturally with deficits but not with the $US which is the world’s reserve currency. And let me also add this, that there is no trade war imaginable unless others decide to retaliate. And why would they if the only damage of increased tariffs in the US is to its own economy? Let the US suffer for its actions, right? Why poke yourself in the eye if they want to poke themselves in the eye?

There is so much more that can be said but will leave it to some other time.

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