Living Economics: Yesterday, Today, and Tomorrow

In Praise of Living Economics

"Living Economics is a superb book. Peter Boettke's passion for excellence in teaching and for his subject, mainline economics (the sort of basic economic reasoning that draws on the ideas of a line of thinkers from Adam Smith through the Austrians to people like Jim Buchanan and Elinor Ostrom), shines through on every page. It is vintage Boettke: engaging, witty, and chock full of insight. This book should be put in the hands of every first-year student of economics, if only to show them what they are missing!"

—Bruce Caldwell, Research Professor of Economics and Director, Center for the History of Political Economy, Duke University

"Economics as it should be, Living Economics is a solid book that counters the excessive simulation of modern academic economics while, at the same time, avoiding the temptation to extend application of the logic beyond reasonable limits. Boettke concentrates on the primary purpose of economics, which is to convey an understanding of how, within properly designed institutional constraints, operative markets generate and distribute value without overt conflict."

—James M. Buchanan, Jr., Nobel Laureate in Economic Sciences;

Advisory General Director of the Center for Study of Public Choice and Distinguished Professor Emeritus of Economics, George Mason University

"Peter Boettke's book Living Economics not only is splendidly characterized by broad erudition, solid analysis, shrewd observation, and expositional clarity, it appears at a propitious moment. We are in a presidential election year, with most political spokespersons relying on embarrassingly superficial and bastardized economic diagnosis and rabble-rousing prescription. And the bulk of professional economists persist in putting precious and arid formalism over substantive content. It is high time—but Professor Boettke thinks that it is not too late—to join the impressive and long-persisting caravan of scholars promoting a feel for, sense of, and interest in the contribution which genuine economics can make to a free and increasingly prosperous society."

—William R. Allen, Professor Emeritus of Economics, University of

California, Los Angeles

"Living Economics is in many ways a remarkable book. The volume luminously reflects the amazing breadth of Professor Boettke's reading, and the deep and careful thoughtfulness with which he reads. But the true distinction of this volume consists in more than the profound economic understanding and wealth of deeply perceptive doctrinal-history observations that fill its pages. Its distinction consists in the delightful circumstances that these riches arise from and express Peter Boettke's extraordinary intellectual generosity and unmatched intellectual enthusiasm—rare qualities which have enabled him to discover nuggets of valuable theoretical insight in the work of a wide array of economists, many of whom are generally thought to be far away from the Austrian tradition which Boettke himself splendidly represents. Boettke's prolific pen is dipped, not in the all-too-common ink of professional one-up-manship, but in the inkwell of an earnest, utterly benevolent—and brilliant—scholar, seeking, with all his intellectual integrity, to learn and to understand."

—Israel M. Kirzner, Professor Emeritus of Economics, New York University

"Living Economics is a spirited, passionate, and exciting tour of free-market economics. I enjoyed every page!"

—Andrei Shleifer, Professor of Economics, Harvard University;

Faculty Research Fellow, National Bureau of Economic Research

"Living Economics is inspired by Boettke's students and great teachers, such as Boulding and Kirzner, and the central theme that economics has strayed dangerously from a ‘mainline’ emphasis on process and rules, as opposed to outcomes. The mainline sinew is rooted in Adam Smith's The Theory of Moral Sentiments extending to Hayek, Ostrom and other moderns whom Boettke examines with deep understanding of their relevance for our time."

—Vernon L. Smith, Nobel Laureate in Economic Sciences; George L. Argyros Endowed Chair in Finance and Economics, Chapman University School of Law

"Living Economics is a treasure trove of ideas for anyone interested in communicating economics to students and the broader public. The author's enthusiasm is evident throughout. Professor Peter Boettke shows us what he learned from some of the great figures in economics and what, from their work, he has been able to distill and elaborate as his own teaching message. At the end of the day, this book is about more than teaching economics, it is about Boettke's ‘love affair’ with the subject."

—Mario J. Rizzo, Professor of Economics, New York University

"Boettke's passion for economics and the clarity of his vision make Living Economics a pleasure to read. No reader will fail to benefit from his broad and deep insights."

—Steven E. Landsburg, Professor of Economics, University of Rochester; author, The Armchair Economist

"I am very pleased with Peter Boettke's book Living Economics, which has fully captured the essence of my work and that of others on what good economics is all about and why understanding it is so important."

—Gordon Tullock, University Professor Emeritus of Law and Economics, George Mason University

"Peter Boettke's insightful and wide-ranging book Living Economics is not simply about teaching economics: it is a joyous exercise in teaching us through the great teachers of economics. This volume shows us how the mainline of economic teaching from Smith through Hayek to contemporary thinkers such as Buchanan and Ostrom has analyzed the core features of economic cooperation while recognizing the cognitive limits of economic and political actors, and indeed of economic analysis itself. All students of the moral sciences need to learn Boettke's master lesson: ‘We have to understand man as a fallible yet capable chooser, who lives within an institutional framework that is historically contingent.’"

—Gerald F. Gaus, James E. Rogers Professor of Philosophy,

University of Arizona

"With Living Economics, Peter Boettke cements his reputation not only as one of the leading Austrian economists of our time, but as one of the most compelling and engaging communicators of economic ideas. Teachers will derive inspiration from his essays and policy officials will likely gain a little humility regarding their ability to improve upon undesigned economic processes. All readers of this book will be hard pressed not to come away sharing Boettke's enthusiasm for economics as ‘a deadly serious discipline that tackles vital questions of wealth and poverty, of life and death,’ as well as ‘an amazing framework for thinking about human behavior in the real world, including all human endeavors,…that is entertaining and downright fun.’"

—Susan E. Dudley, Research Professor of Public Policy and Director, Regulatory Studies Center, George Washington University; former Director, Office of Information and Regulatory Affairs, U.S. Office of Management and Budget

"Through his scholarly and entrepreneurial work, Peter Boettke has transformed a sometimes hostile, sometimes neutral, field of economics into a thoroughgoing revival of Austrian ideas in the worlds of thought and action that is in full flower today. Living Economics reveals how Boettke has been the energetic catalyst so pivotal to this transformation. This book provides wonderful insight into how this future has been brought about."

—Richard E. Wagner, Hobart R. Harris Professor of Economics, George Mason University

"Reading the wonderful book Living Economics by Peter Boettke made me start loving economics, and I am sure it will inspire many more readers to do the same. It makes me optimistic for the return of real economics."

—Nassim Nicholas Taleb, Distinguished Professor of Finance and Risk Engineering, New York University Polytechnic Institute; author, The Black Swan: The Impact of the Highly Improbable

"There exist noteworthy works that survey economic thought and others that provide insights into current economic challenges. This highly unusual book does both at once and very successfully. Interpreting and contrasting major contributions to economics in clear prose, it also identifies the policy implications of key economic insights. Insightful, instructive, and also entertaining throughout, Peter Boettke's Living Economics can be read profitably by academics, policy makers, students, and a wide range of other constituencies concerned about our economic institutions."

—Timur Kuran, Professor of Economics and Political Science and the Gorter Family Professor of Islamic Studies, Duke University

"Peter Boettke has spent a career not just as a scholar of economics, but as an educator of both the general public and generations of students. In Living Economics, he reflects on the importance of teaching and of his own teachers in spreading the ideas of the mainline of economic thinking from Smith, Say and Wicksteed to Mises, Hayek, Buchanan, Coase, and Friedman, including his own contemporaries. This book is essential reading, especially in a time when the tradition of sound economics Boettke focuses on is under increasing threat by old fallacies and new politicians. The passion for ideas and economic theory that permeates these pages is exactly the inspiration one gets from a great teacher. Peter Boettke is indeed that."

—Steven G. Horwitz, Charles A. Dana Professor of Economics,

St. Lawrence University

"The truly wonderful book Living Economics shows students and scholars alike why Peter Boettke is one of the most original scholars and teachers of his generation. Boettke's goal is to form minds young and old in the way that his was formed, and thus the lessons of this book come from across the intellectual spectrum. Boettke's masterful ability to deftly meld a variety of approaches to economics into a lens through which to view the world shows the possibilities of economics analysis at a time when its status is much in question and breathes new life into the dismal science."

—Steven G. Medema, Professor of Economics, University of Colorado, Denver

"Living Economics by Peter Boettke is aptly titled. It's all about what he received from his teachers (broadly defined) and what he, in turn, has imparted to his students. Boettke's deep scholarship, serious reflections and passion for economics come through on every page. Accordingly, unlike most economics prose, Living Economics can be safely read before driving. Indeed, Living Economics is full of surprises—like an entire chapter on my former professor, Kenneth Boulding. Boettke's treatment of that great economist hits the nail on the head. The book is well suited for anyone with an interest in economics and finance and should be a required supplemental text for principles of economics courses, as well as courses on the history of economic thought."

—Steve H. Hanke, Professor of Applied Economics, Johns Hopkins

University

"Loaded with content well worth reading and carefully arrayed gems from the history of thought, Peter Boettke's Living Economics is literally his personal statement about living with and living through economics. But be careful as you read. Boettke's love affair with economics is contagious. You will find yourself cheering for more."

—Bruce Yandle, Professor of Economics Emeritus, Clemson University

"Living Economics is a fascinating discussion of the increasingly-acknowledged-as-important field of Austrian economics and its main contributors. But more important is Peter Boettke's lessons not only on the importance of teaching about Austrian economics but on how economics should be taught generally. Living Economics makes a useful tool for both students and their teachers."

—Walter E. Williams, John M. Olin Distinguished Professor of

Economics, George Mason University

"In Living Economics, Peter Boettke has written a compelling book that is part intellectual autobiography and part a discussion on what economics is, and how it should be taught. Professor Boettke's love of economics comes through on every page, and the book is filled with insights on the nature of economics and how it should be presented to students. His sympathy toward free-market ideas and the Austrian school of economics comes through clearly, and much of the book is devoted to discussing the ideas and work of major scholars who have influenced him. The book is delightful to read, and will appeal to both students and teachers of economics."

—Randall G. Holcombe, DeVoe Moore Professor of Economics, Florida State University

"This set of essays is Peter Boettke at his best; they are instructive, learned, entertaining and brilliant. Not only is Living Economics a must read but it is a very enjoyable read for today's economists and social scientists."

—Richard Swedberg, Professor of Sociology, Cornell University

"In Living Economics, Boettke expresses well the ‘joy of economics,’ the expansion of one's own understanding of the process of social coordination we all benefit from, and the pure pleasure in communicating that understanding to students and others. He draws upon a deep well of teaching and guiding both undergraduate and graduate students and his lively advocacy of ‘mainline economics,’ as opposed to ‘mainstream economics,’ makes for an important read for anyone seeking to understand what economics is really all about."

—P. J. Hill, Professor Emeritus of Economics, Wheaton College

"We have here a fascinating reflection that stems from more than a quarter century of Peter Boettke's scholarship and masterful teaching. One cannot close this book without a renewed appreciation of the core insights of economics that run from Adam Smith to F.A. Hayek to James Buchanan and others. On page after page Living Economics bubbles over with enthusiasm, as Boettke shows that our tradition is intellectually rich, robust and exciting to learn. The economic way of thinking, properly understood, studies real people. And Boettke clearly shows that our everyday lives are at stake if the lessons of economics continue to be misunderstood by pundits, politicians and the bulk of a misguided economics profession."

—David L. Prychitko, Professor of Economics, Northern

Michigan University

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Telephone: 510-632-1366 • Facsimile: 510-568-6040 • Email: [email protected] • www.independent.org

PETER J. BOETTKE

Living

ECONOMICS

YESTERDAY, TODAY, AND TOMORROW

Living Economics: Yesterday, Today, and Tomorrow

Copyright © 2012 by The Independent Institute

Published in cooperation with Universidad Francisco Marroquin

All Rights Reserved. No part of this book may be reproduced or transmitted in any form by electronic or mechanical means now known or to be invented, including photocopying, recording, or information storage and retrieval systems, without permission in writing from the publisher, except by a reviewer who may quote brief passages in a review. Nothing herein should be construed as necessarily reflecting the views of the Institute or as an attempt to aid or hinder the passage of any bill before Congress.

The Independent Institute

100 Swan Way, Oakland, CA 94621-1428

Telephone: 510-632-1366

Fax: 510-568-6040

Email: [email protected]

Website: www.independent.org

Cover Design: Keith Criss

Interior Design and Composition by Leigh McLellan Design

Library of Congress Cataloging-in-Publication Data

Boettke, Peter J.

Living Economics : yesterday, today, and tomorrow / Peter J. Boettke.

p. cm.

Includes bibliographical references and index.

ISBN 978-1-59813-075-1 (pbk. : alk. paper)—ISBN 978-1-59813-072-0

(hbk. : alk. paper)

1. Economics—Study and teaching. 2. Economics. 3. Economics—History. I. Title. HB74.5.B64 2012

330—DC23                                                                    2012008378

16  15  14  13  12

5  4  3  2  1

To My Teachers

and to Those I Have Had the Privilege to Teach

Contents

Preface

1  Economics for Yesterday, Today, and Tomorrow

PART I  On Teaching Economics

2  On the Tasks of Economics Education

3  On Teaching Graduate Students in Austrian Economics

4  Teaching Economics, Appreciating Spontaneous Order, and Economics as a Public Science

PART II  On Teachers of Economics

5  Relevance as a Virtue: Hans Sennholz

6  The Forgotten Contribution: Murray Rothbard on Socialism in Theory and in Practice

7  Mr. Boulding and the Austrians

8  Putting the Political Back into Political Economy: Warren Samuels

9  Maximizing Behavior and Market Forces: Gordon Tullock

10  Methodological Individualism, Spontaneous Order, and the Research Program of the Workshop in Political Theory and Policy Analysis: Vincent and Elinor Ostrom

11  Is the Only Form of Reasonable Regulation Self-Regulation? Elinor Ostrom

12  The Matter of Methodology: Don Lavoie

13  Invitation to Political Economy: Peter Berger and the Comedic Drama of Political, Economic, and Social Life

14  Was Mises Right?

15  The Genius of Mises and the Brilliance of Kirzner

16  Hayek and Market Socialism: Science, Ideology, and Public Policy

17  James M. Buchanan and the Rebirth of Political Economy

PART III  On the Practice of Economics

18  Where Did Economics Go Wrong? Modern Economics as a Flight from Reality

19  Man as Machine

20  The Limits of Economic Expertise

21  High Priests and Lowly Philosophers

PART IV  Conclusion

22   A Few Critical Paragraphs That Should Shape What We Teach, and Why We Teach, Economics: Smith, Mises, and Hayek

Bibliography

Acknowledgements

Index

About the Author

Preface

It is no crime to be ignorant of economics, which is, after all, a specialized discipline and one that most people consider to be a dismal science. But it is totally irresponsible to have a loud and vociferous opinion on economic subjects while remaining in this state of ignorance.

—Murray N. Rothbard¹

MY LOVE AFFAIR with economics began in the fall of 1979. The summer prior to that I had experienced the long lines for gasoline, and I was confused and frustrated by the experience for a variety of reasons. Economics erased my confusion and targeted my frustration on the cause of the shortages. I was hooked.

In many ways, the logic of economic reasoning came naturally to me once I started studying. My first readings in the field were Henry Hazlitt's Economics in One Lesson, and Bettina Bien Greaves, ed., Free Market Economics: A Basic Reader (which included Leonard Read's I, Pencil). These were followed by various essays and excerpts from books by Ludwig von Mises related to the problems of socialism and interventionism and the benefits of the free market economy, and then Milton and Rose Friedman's Free to Choose. By the time I finished Free to Choose, I would never think about the world around me the same way. I saw everything through the economic lens—from the most mundane human activities to the most profound. To me, economics is simultaneously the most entertaining discipline in the human sciences and the most important discipline in the policy sciences as it ultimately answers fundamental questions about human life and death.

It is my hope that the following essays capture not only my thirty—plus year love affair with economics as a discipline, but also the sheer joy I get from economic inquiry and inviting my students to join me in that inquiry. I believe that much of modern economics has lost its way, and I am actively engaged in trying to get the teaching and doing of economics back on track. Following one of my teachers—Kenneth Boulding—I use the term mainline economics to describe a set of propositions that were first significantly advanced in economics by Thomas Aquinas in the thirteenth Century and then the Late Scholastics of the fifteenth and sixteenth centuries at the University of Salamanca in Spain (especially the Christian clerics, Francisco de Vitoria, Martin de Azpilcueta, Diego de Covarrubias, Luis de Molina, Domingo de Soto, Leonardo Lessio, Juan de Mariana, and Luis Saravía de la Calle).² These insights were further developed in economics from the Classical School of Economics (both in its Scottish Enlightenment version of Adam Smith and the French Liberal tradition of Jean-Baptiste Say and Frederic Bastiat), to the early Neoclassical School (especially the Austrian version of Carl Menger, Ludwig von Mises, and F.A. Hayek), and finally with the contemporary development of New Institutional Economics (as reflected in the property rights economics of Armen Alchian and Harold Demsetz; the new economic history of Douglass North; the law and economics of Ronald Coase; the public choice economics of James Buchanan and Gordon Tullock; the economics of governance associated with Oliver Williamson and Elinor Ostrom; and the market process economics of Israel Kirzner). The core idea in this approach to economics is that there are two fundamental observations of commercial society: (1) individual pursuit of their self-interest, and (2) complex social order that aligns individual interests with the general interest.

In the mainline of economics, the invisible hand postulate reconciles self-interest with the general interest not by collapsing one to the other or by assuming super-human cognitive capabilities among the actors, but through the reconciliation process of exchange within specific institutional environments. It is the higgling and bargaining within the market economy, as Adam Smith argued, that produces social order. The invisible hand solution does not emerge because the mainline economist postulates a perfectly rational individual interacting with other perfectly rational individuals within a perfectly structured market, as many critics suppose. Such idealizations would be as alien to Adam Smith as they would be to F.A. Hayek. Instead, for those who sit in the seat of Adam Smith man is a very imperfect being operating within a very imperfect world. Sound economic reasoning, by focusing on exchange, and the institutions within which exchange takes place, explains how complex social order emerges through the aid of prices and the entrepreneurial market process.

The mainline of economics, in my narrative, is to be contrasted with the mainstream of economic thought. Mainline is defined by a set of positive propositions about social order that were held in common from Adam Smith onward, but mainstream economics is a sociological concept related to what is currently fashionable among the scientific elite of the profession. Often the mainline and the mainstream dovetail, but at other times they deviate from one another. It is at these moments of deviation that acts of intellectual entrepreneurship are acutely needed by those working within the mainline of economics to recapture the imagination of mainstream economics, getting the discipline back on track.

My research has primarily been in the area of comparative political and economic systems and the consequences with regard to material progress and political freedom. In addressing these questions, I have also had a particular interest in twentieth century economic thought and the methodology of the social sciences because of my judgment that much suffering throughout the socialist and less developed worlds in the twentieth century was caused by bad ideas in economic theory and public policy and that these bad ideas were promulgated because of misguided notions in the philosophy of science as applied to the social sciences. It has become an important part of my research and teaching efforts to explore and tell the tale of this mistaken intellectual path. The Austrian School of Economics, its ideas, its historical figures, and its fate in the economics profession and public policy discourse has been a source of continued intellectual inspiration for me since my undergraduate days, and is no doubt evident throughout all my writings.

A trip I made to Universidad Francisco Marroquin (UFM) with my close colleague and friend, Chris Coyne, in June of 2011 inspired this particular book. UFM is an amazing institution of higher learning in economics. We were both impressed by the commitment of the entire intellectual community at UFM to sound economic reasoning and to high quality teaching of economics. Throughout the campus of UFM, there are images of the great economists throughout the history of the discipline and the core ideas that they sought to communicate in their writings. The various essays in this collection are my attempts to communicate those core ideas of the mainline of economic science from Adam Smith to J.B. Say to Philip Wicksteed to Ludwig Mises to F.A. Hayek to James Buchanan to Vernon Smith to Elinor Ostrom, and many others in-between, and currently practicing economists.

Economics teaches us many things, but to me the most important is how social cooperation under the division of labor is realized. This is what determines whether nations are rich or poor; whether the individuals in these nations live in poverty, ignorance, and squalor or live healthy and wealthy lives full of possibilities. If the institutions promote social cooperation under the division of labor, then the gains from trade and innovation will be realized. But, if the institutions, in effect, hinder social cooperation under the division of labor, then life will devolve into a struggle for daily existence. Economics, in other words, gives us the key intellectual framework for understanding how we can live better together.

This theme of what Mises called the law of association is also what animated the founder of UFM, Manuel Ayau—who in his own books stressed this idea of social cooperation under the division of labor. In the essays in this book, I repeatedly stress the role of property, prices, and profit/loss for providing economic actors with the incentives, information, and the spur for innovation that is required to achieve the complex economic coordination and the social cooperation among anonymous actors that characterizes a peaceful and prosperous society.

It is with this shared vision of the nature and significance of economic science and the commitment to teaching that I am especially thrilled to be publishing this book with the Independent Institute and UFM Press. I want to thank David Theroux, President of the Independent Institute, and Giancarlo Ibarguen, the current President of UFM, for the opportunity to do so. It is an honor to work with these two men who have dedicated their lives to the promotion of sound economic reasoning both inside and outside of the academy. I do hope this book will make a minor contribution to the goal of spreading the economic way of thinking.

I want to thank the staff at my office at GMU and the Mercatus Center for helping in the preparation of this manuscript for publication: Peter Lipsey, Liya Palagashvili, David Currie, Carly Reddig, and Matthew Boettke. I also benefited greatly from editorial suggestions from David Theroux, Roy Carlisle, and Alex Tabarrok. Responsibility for remaining errors are exclusively my own.

I also want to thank the wonderful teachers of economics I have had over the years from Hans Sennholz at Grove City College to James Buchanan, Gordon Tullock, Kenneth Boulding, and Don Lavoie at George Mason. I also was fortunate to have some established figures in the discipline take me under their wing and mentor me at a formative stage of my career: Warren Samuels, Peter Berger, and especially Israel Kirzner, who I worked alongside of for eight years at NYU. It was a dream come true for me to work at NYU (the home of Ludwig von Mises) and to work in close collaboration with Israel Kirzner.

In graduate school, I bonded quickly with two fellow students and they have traveled this entire journey with me—Steve Horwitz and David Prychitko. I don't say thanks to them nearly enough for making me a better teacher and better economist by setting a professional standard early in our careers that we have all tried to maintain. It is my sincere hope that these essays have met that standard even in the areas that they disagree most strongly with me. In one of the essays in this collection, I give the advice to students that they have to choose their teachers wisely because you will teach as you are taught, and that they have to choose whom they read wisely because you will write like those you read. I should add that you must choose your friends wisely because it will be your friends who help set the standard of argument you strive to meet and who will honestly tell you when you are falling short of that standard. Steve and Dave have respectively been those close friends of mine since we entered this profession as teachers and scholars in the 1980s.

And finally, I would like to thank all the wonderful students I have had the privilege to teach throughout my career and especially those I have had the great honor of serving as their dissertation advisor. I don't know if they realize just how much I have learned from them and how much pride I take in their developing careers as first-rate teachers of economics, significant contributors to the development of mainline economics, and to their amazing abilities to communicate sound economic reasoning not only to their students but to the general public as well.

As I write this, we are living through particularly turbulent economic times. It is a time when we need sound economic reasoning more than ever, rather than the sort of emergency room economics that has dominated public policy since 2008. Armed with the truth of the mainline of economic teaching from Adam Smith to F.A. Hayek, and with the great communication skills that these former students of mine have, I am confident that high quality representatives of sound economic reasoning are growing in number and will ultimately beat back economic ignorance and special interest politics, shifting the tide of public opinion in the direction of sound economics. As Milton and Rose Friedman argued in Free to Choose³ (1980, 272): A tide of opinion once it flows strongly tends to sweep over all obstacles, all contrary views.

We all have a lot of work to do to get economics back on track. Let's go to work.

1. Murray Rothbard, Egalitarianism as a Revolt Against Nature (Auburn, AL: Ludwig von Mises Institute, 1974, 2000), 202.

2. Rodney Stark, The Victory of Reason: How Christianity Led to Freedom, Capitalism, and Western Success (New York: Random House, 2005); Alejandro A. Chafuen, Faith and Liberty: The Economic Thought of the Late Scholastics (Lanham, Md.: Lexington Books, 2003); Murray N. Rothbard, Economic Thought before Adam Smith: An Austrian Perspective on the History of Economic Thought, vol. 1 (Brookfield, Vt.: Edward Elgar, 1995), 51-64, 97-133; Marjorie Grice-Hutchinson, The School of Salamanca: Readings in Spanish Monetary Theory, 1544-1605 (Oxford University Press, 1952) and Early Economic Thought in Spain 1177-1740 (London: Allen & Unwin, 1978); Laurence S. Moss, ed., Economic Thought in Spain (Aldershot, England: Edward Elgar, 1993); Raymond de Roover, Business, Banking, and Economic Thought in Late Medieval and Early Modern Europe (Chicago: University of Chicago Press, 1976); and Joseph Schumpeter, History of Economic Analysis (New York: Oxford University Press, 1954).

3. Milton Friedman and Rose Friedman, Free To Choose (New York: Harcourt, Brace & Jovanovich, 1980), 272.

1

Economics for Yesterday, Today, and Tomorrow

The latest new economics, and in my opinion rather the worst for fallacious doctrine and pernicious consequences, is that launched by the late John Maynard (Lord) Keynes, who for a decade succeeded in carrying economic thinking well back to the dark age …. The serious fact is that the bulk of the really important things that economics has to teach are things that people would see for themselves if they were willing to see…. The time has come to take the bull by the tail and look the situation square in the face.

—Frank H. Knight¹

Introduction

AN IMPORTANT UNSUBTLE point should be stressed in every economic conversation with peers, students, policymakers, and the general public concerning the great recession since 2008. John Maynard Keynes was wrong in both his analysis of capitalist instability and reasons for persistent unemployment in 1936, and he was wrong in 2008. The ideas Keynes developed in The General Theory of Employment, Interest, and Money (1936) were as wrongheaded in the nineteenth century as they were in the twentieth century, and as they are in the twenty-first century. Keynesian economics is simply bad economics. And it is vitally important to always remember that in the field of economics, bad economic ideas lead to bad public policies, which in turn result in bad economic outcomes.² The realization of this string of logically connected bads might be long and varied, but it is inevitable. The Keynes of The General Theory was never right when it came to how an economy operates, let alone how to fix it when it teeters during crises. And the resurrection of Keynes among professional economists, public intellectuals, and especially politicians and policymakers in the wake of the global financial crisis of 2008 has been one of the most disappointing developments I have witnessed in my career as an economist.

Keynes was wrong because his analysis was based on a set of flawed premises. The earlier analysis of effective demand failure was first pioneered by Malthus but vehemently opposed by Ricardo and the other classics, and was forced, according to Keynes, to exist below the surface, in the underworlds of Karl Marx, Silvio Gesell or Major Douglas.³ Keynes believes that the complete victory of the classics is a mystery and reflects an unwillingness of professional economists after Malthus to recognize that disconnect between their theory and the basic facts of observation. It may well be that the classical theory, Keynes argued, represents the way in which we should like our Economy to behave. But to assume it actually does so is to assume our difficulties away.⁴

But there are good reasons why economists forced these theories into the underworld of economic opinion. They reflected bad economic analysis. What I mean by that is that these theories implicitly assume away scarcity and believe the fundamental problem of modern society is poverty amidst plenty; they explicitly deny both actor rationality and the coordinating role of prices, as well as the function prices serve in guiding decisions and the feedback and discipline provided by profit and loss.⁵ If you postulate a world of post scarcity, then neither the coordinating role of the price system, nor the incentives of the property rights structure is critical, and if you don't allow the individuals that populate your economy to learn from market signals, and you don't allow those signals to actually work, then of course the economy will not work! This is not mysterious. Without prices and the market process continually guiding economic actors on a path of learning and discovery amid the bewildering throng of economic possibilities,⁶ the economic future will indeed be ensnared by the dark forces of time and ignorance.⁷

It is important to stress, as J.B. Say did in his Letters to Mr. Malthus (1821), that all discussions of overproduction or underconsumption make reference to the price system. The cure to a glut, Say argued, was neither monetary expansion nor fiscal stimulus, but allowing the prices to adjust to clear the market. In response to Malthus's theory of the general glut, Say painstakingly explains how the market process coordinates the production plans of some with the consumption demands of others through market price adjustments. Say simply points out that the slightest excess supply beyond the demand is sufficient to produce a considerable alteration in price.⁸ And this focus on market prices and the role price plays in the self-regulation of the market economy (and not his value theory, as Malthus had argued), Say argues, forms the true cornerstone of Adam Smith's lasting contribution to the science of political economy.⁹

It is this last point raised by Say that I want to emphasize, namely that the cornerstone of Adam Smith's economics is his analysis of the price system and the self-regulating capacity of the market economy. This is where we find what is enduring in economics, whereas what is fleeting is found in that underworld of economic thinking that denies that analysis. Unfortunately, as has been pointed out by thinkers such as F.A. Hayek, James Buchanan,¹⁰ and more recently Luigi Zingales, the Keynesian message appeals to technocrats and politicians.¹¹

This is the economists’ age-old plight, what is fleeting in economics is politically popular, whereas what is enduring in economics is politically unpopular. Hayek describes the economists’ conundrum as consisting of being called upon to consult with politicians on matters of pubic policy more often than any other social scientists, only to have their advice based on the principles of the science dismissed as soon as it is uttered. Not only are the teachings of the discipline dismissed, but public opinion on the matters at hand seems to run in precisely the opposite direction of that of the economist. This position, Hayek argued, was not unique to his time, as it has been the plight of classical economists as well.¹² But what is most fascinating as an issue for a theory of social change is that economists’ ideas in general are not dismissed because public opinion clearly reflects the ideas of economists of the previous generation. Unfortunately, the ideas that dominate are those that Keynes pointed to that had been relegated to the underworld. This is precisely the situation we find ourselves in today. And as economic educators, we must, as the epigraph from Knight argues, stare the situation square in the face, acknowledge the ugly and unpleasant nature of things in our profession and the body politic, and take up the challenge of teaching the principles of economics to those who refuse to learn and in most instances even seriously listen.

What Adam Smith Did Not Say, and What He Did Say

Adam Smith was not the first economic thinker. But Adam Smith synthesized existing knowledge and did so in a way that has captured the imagination of intellectuals ever since. His is one of the towering achievements in the scientific and literary history of Western civilization. Even to this day, Smith's legacy is hotly debated.

A new generation of scholars such as Emma Rothchild and Sam Fleischacker are battling to save Smith's legacy from the Adam Smith tie-wearing conservative policy community.¹³ Stressing the human and egalitarian sides of Smith's theory, they seek to counter the reading of Smith that focuses exclusively on self-interest and market efficiency. This caricature of Smith, as this egalitarian and progressive reading of Smith points out, is false. Smith never said Greed works and that is that. His argument is much different. But the Smith of Rothchild and Fleischacker is also a confused caricature. Smith was not an egalitarian social democrat. He was an analytical egalitarian, but he was also a classical liberal political economist. The Wealth of Nations develops the positive science of political economy, and Book V can be read as an attempt to provide a set of rules that an enlightened statesman who desired to produce the good society could follow on the basis of that positive science.¹⁴ In Smith's work, the scale and scope of government is limited. While not nonexistent, it is limited to basically the night watchman state of classical liberal political philosophy: protections from foreign aggressors, protection of person and property and the administration of justice domestically, and the provision of essential public works. Only a distorted reading of Smith could produce either the institutionally antiseptic self-interest—only interpretation, or the Smith as precursor of the modern social democratic welfare state. The more modern social democratic reading of Smith is a consequence of the caricature prevalent in our culture of the self-interest reading as that of the laissez-faire economists in general. To distance Smith from the economists, they offer an interpretation that is more compassionate to the poor and the dispossessed.

An older literature exists in intellectual history, which also tried to drive a wedge between Smith's Theory of Moral Sentiments (1758) and The Wealth of Nations (1776). Called the Das Adam Smith Problem, it argued that Smith built his theory of moral sentiments on human sympathy, whereas self-interest drove his theory of the economy. In one book we get other-regarding behavior, whereas in the other we get self-regarding behavior—how can we reconcile these works? Many attempts have been made to address this problem, including Vernon Smith's The Two Faces of Adam Smith. The bottom line is that the problem is really not a problem.

The Wealth of Nations is about social order among strangers—a social order in which our span of moral sympathy moves far beyond the realm of the familiar. In civilized society, Smith argued, man stands at all times in need of the co-operation and assistance of great multitudes, while his whole life is scarce sufficient to gain the friendship of a few persons.¹⁵ The market economy is about cooperation in anonymity, cooperation with strangers. In the chapter just before the cited passage, Smith presents the reader with the basic mystery of economic life. The number of exchange relations that must be coordinated to produce even the most common products we take for granted exceeds all computation.¹⁶

The source of the wealth of nations arises from social cooperation under the division of labor, and to realize this social cooperation certain fundamental institutions in society must be in place—the delineation and enforcement of private property, the keeping of promises through contract, and the acceptance of the legitimacy of the transfer of property by consent. Benevolence would not be able to achieve this social cooperation under the division of labor. The relationships exist at the outer bounds of our span of moral sympathy. But when the institutions of property, contract, and consent are in place, then the self-interest of individuals can be marshaled to realize the mutual gains from trade and the benefits of every refined division of labor in society. Our moral sentiments do not disappear as the span of moral sympathy moves from the intimate order to the extended order of the market. They are omnipresent, but we must be mature about them; otherwise, our moral intuitions will be in conflict with the moral demands of the market order. The moral sentiments within a commercial society manifest themselves in more general rules of just conduct (related to the institutions of property, contract, and consent), rather than specific outcomes of just division given a fixed resource endowment. The rules of the intimate order do not transfer to the extended order without sacrificing the gains from social cooperation under the division of labor, in which case we sacrifice the extended order itself.

Smith certainly did not teach that individuals should pursue their self-interest at all costs. But he also didn't even teach the more subtle presentation that the pursuit of self-interest will automatically translate into public benefits. The Wealth of Nations actually has plenty of examples in which the pursuit of self-interest can lead to socially undesirable outcomes. His discussion of the vocation of teaching in Oxford (bad) and in Glasgow (good) provides a classic example.¹⁷ In Glasgow, the teacher had a strong incentive to provide valuable instruction because salary was a function of fees paid by the students, whereas in Oxford, because an endowment guaranteed a teacher's salary, the professors had long ago given up even the pretense of teaching. Smith's work is full of such comparative institutional analysis. The pursuit of self-interest in one case leads to a socially desirable outcome, whereas in the other it leads to an undesirable one. The key point: Smith's analysis does not turn on the behavioral postulate of self-interest but instead on the institutional specifications that are in operation. The institutional specification of a private property market economy guided by price signals and disciplined by profit and loss accounting will steer self-interested behavior in the direction of social cooperation. The vast division of labor is coordinated throughout the world, and the most common products—from a woolen coat in Adam Smith's time to a pencil in Milton Friedman's—are made available to individuals who will never know who played a part in the production of that good, and who if required to produce this product all by themselves wouldn't know where to start.

This is just another way to state Smith's invisible hand proposition. Individuals pursuing their own self-interest within an institutional setting of property, contract, and consent will produce an overall order that, although not of their intention, enhances the public good. Absent that institutional setting, self-interest may very well not produce publicly desirable outcomes and, in fact, may produce the opposite. What matters for Smithian political economy is the institutional filter that individual actors work within, and which produces unique equilibrating processes.¹⁸

J.B. Say in his Letters to Malthus states that he revered Smith: he is my master.¹⁹ As I mentioned before, Say had such a strong affinity to Smith because of his exposition of the fundamental role of prices in coordinating economic activity. As Say argued, exchange and the market prices that emerged in the higgling and bargaining among individuals formed the cornerstone of Smith's political economy. Smith's economics was price theoretic economics, but it was also institutional economics. The link between the abstract function of price and the concrete role of institutions that Smithian political economy provides supplies the foundation for what endures in economics. However, in understanding the full implications of Smith's message about market theory, the price system, and the role of institutions, we also reveal why technocrats and meddlesome politicians find it unpopular.

Hayek has argued that Smith designed his political economy to be robust against both the stupidity and arrogance of actors within the system.²⁰ Smith and his contemporaries (e.g., Hume) sought to discover a system of governance in which bad men can do the least harm and which did not require for its operation that only the best and the brightest be in charge. They sought, in other words, a system of societal governance that treated men as they are—sometimes good, sometimes bad; sometimes intelligent, sometimes not so bright—and that would use their human variety to produce peace and prosperity. The classical political economists of the eighteenth and nineteenth century discovered that the private property market economy provided the basis for just such a system.

Smith had argued in The Theory of Moral Sentiments that the man of systems was wise in his own conceit, but perhaps his most biting passage on the arrogance of the politician is found in The Wealth of Nations. In the paragraph after the famous invisible hand passage, Smith argued the following:

What is the species of domestic industry which his capital can employ, and which the produce is likely to be of the greatest value, every individual, it is evident, can, in his local situation, judge much better than any statesmen or lawgiver can do for him. The statesmen, who should attempt to direct private people in what manner they ought to employ their capitals, would not only load himself with a most unnecessary attention, but assume an authority which could safely be trusted, not only to no single person, but to no council or senate whatever, and which would no-where be so dangerous as in the hands of a man who had folly and presumption enough to fancy himself fit to exercise it.²¹

This passage anticipates the calculation/knowledge argument about government planning associated with Mises and Hayek, as well as the problem of arrogance and power that Hayek identified with the pretense of knowledge or fatal conceit. In other writings I have argued that David Hume's dictum that when we design institutions of government we must assume that all men are knaves implies that we must watch out for both hubristic knavery of the kind that Hayek has emphasized as well as the opportunistic knavery of the kind that Buchanan and Tullock have emphasized in the development of public choice theory. Smith, in this passage, anticipates the core ideas in those modern critiques of government control over economic life and reveals another element of what is enduring in economics.

What Is Enduring and What Is Not

When we teach principles of economics to our students, most teachers of economics introduce the concept of scarcity quickly. Individuals choose within constraints and do not make unconstrained choices. As a result, our choices always involve the assessment of trade-offs, and as such we need some tools to help us make those assessments. The price system provides those tools for us. More importantly, the price system translates our private assessment of trade-offs into publicly useful information for others to utilize in their own private assessment of trade-offs, and thereby establishes the terms of exchange on the market.

Economics explains exchange and the institutions within which exchange takes place. As Frank Knight often stressed, economic analysis must always begin with the recognition of the fundamental point that an exchange is an exchange is an exchange, and exchange is mutually beneficial, otherwise the trade would not have taken place. Economics is elementary, but the persistent and consistent application of the economic way of thinking to all walks of human life requires discipline and creativity. Economics is a deadly serious discipline about deadly serious topics, and economics is a joyous exploration of man in all his