Thomas Malthus, the Doomsdayer

At the close of the 18th century, England's food prices were high and population growth was unrelenting, putting pressure on the food supply. There was a recent "apparent" increase in poverty(difficult to verify; perhaps migration from rural areas to urban areas simply made poverty more visible). Utopians asserted that social and political institutions were the cause of poverty and misery and therefore, changes in those institutions could eliminate the resulting evils.

And along comes Thomas Robert Malthus to refute the Utopian beliefs with systematic population studies in his "Essay on the Principle of Population as It Affects the Future Improvement of Society"(1798). His primary thesis was that population tends to increase faster than the food supply. He found that the food supply increased at an arithmetic rate, while the population increases at a geometric rate. There existed, however, some checks to the population. Some are positive population checks, which is to say they increase the mortality rate. These include disease, war, and famine. On the other hand, preventive population checks decrease the fertility rate: moral restraint and vice. Vice, in this instance, refers to birth control and prostitution. Malthus' analysis had flaws: he underestimated the growth of productivity in agriculture and he failed to predict the birth rate would decrease as a result of urbanization, higher incomes, increased education of women, and more modern methods of birth control.

One of Malthus' assertions was that real wages would tend toward subsistence level. Higher incomes (when wages were above subsistence level) lead to a higher fertility rate and by consequence, a larger population, bringing the wage down once again to subsistence level. 

Malthus took a strong stance on England's Poor Laws, claiming that any social welfare program was counterproductive because it would increase the population without also increasing the food supply.

Malthus also developed a theory: the Underconsumptionist theory. He explained that excessive saving and insufficient consumption had created a lack of aggregate demand. His solution, therefore, was unproductive consumption. Unproductive consumers included landlords and those who provide services-these individuals had the capacity to consume without producing and thus, save the economy.

The work and ideas of the father of demography and population studies, Thomas Malthus, continue to affect modern debates on population growth and utilization of resources.

1776: The Debut of Adam Smith

1776 was an important year in history. The Declaration of Independence was enacted in July, establishing political independence for the United States. Months earlier, however, an influential book was published which established economic independence and finally laid out a plan for economic success and substantial wealth accumulation and progress. This book was called An Inquiry into the Nature and Causes of the Wealth of Nations by the world's most famous economist, Adam Smith. Well known for the concept surprisingly hardly mentioned, the "invisible hand," this book was intended to dismantle mercantilism.

Mercantilists believed in protectionism because encouraging exports and heavily restricting imports maximized the nation's specie(wealth, according to mercantilists), but these policies, Smith noted, benefited only the producers and the monopolists and hindered economic progress. Any policies which did not benefit the consumer, Smith deemed anti-growth and shortsighted.

Smith defined wealth, not as gold and silver, as the Mercantilists did, but rather as production and exchange. Wealth encompassed both agricultural goods(which the Physiocrats associated with wealth) and manufactured goods. Money served less as a store of value and more as a medium of exchange. Using this new definition of wealth, Smith proposed no trade restrictions, no wage laws, and an emphasis on saving, investment, and capital accumulation.

Adam Smith introduced the idea of specialization of labor(aka division of labor), which increases microeconomic and macroeconomic productivity in three ways: 1) Division of labor increases the skill of each worker, 2) Workers waste less time in switching from one task to another, and 3) The narrow focus of each worker's attention on his/her task results in the invention of improvements in task technology. The resulting increased productivity from division of labor leads to higher wages and increased output. Greater income means greater consumption and greater savings, both of which spur economic growth. The larger the portion of income that goes into savings, the greater the potential for economic growth(because savings can be invested; investment keeps economic growth going). The ultimate constraint on economic growth, therefore, is the increasing difficulty of finding new and profitable outlets for investment. Cessation of economic growth delivers the economy into what Smith termed a stationary state.

Smith also differentiated between value and utility in his diamond-water paradox. Water has a high value in use but a low value in exchange. Meanwhile, diamonds have a low value in use yet a high value in exchange.

The value in exchange can be described by the market price(short run), which is determined by supply and demand or the natural price(long run), which is determined solely by the cost of production.

The competitive process aids economic growth and is characterized by the following:

• a large number of sellers
• resource owners who are knowledgeable on the wages, rents, and profits within the economy
• freedom of movement of resources between industries 

The Real Bills Doctrine was yet another contribution from Smith.  Operating under the assumption that paper money was convertible into specie, the doctrine stated individual banks should only provide loans when collateral was "real bills." In this manner, banks could not overissue loans.

Smith disagreed with the Mercantilists on many topics-the most important of which was international trade. He viewed international trade as a "positive-sum game," in which all parties benefit. Nations  would specialize in goods they had advantage(s) in producing and exporting. He supported tariffs only in two cases: for national defense and to offset taxes on domestic goods. Some tariffs had been used to protect infant industries but Smith disagreed with this practice because he doubted this protection would be removed once the industry breached maturity. And while in theory, legislators could strategically impose tariffs in retaliation against foreign tariffs, they would be unsuccessful in practice, according to Smith.

Although Smith advocated minimal government intervention, he recognized government was necessary to carry out the following functions:

• national defense
• administration of justice
• provision of public works
• universal public education

Smith's ideas were accepted very slowly for a few reasons. First, he was presenting his ideas to all of Parliament, many of whom were much older. Additionally, France was fighting the Napoleonic Wars at this time, which made the French wary of any change(s). And finally, many people thought Smith's ideas were too speculative and not practical.

Today, we recognize the contributions of Smith, while noting his major omission: Smith did not recognize services as wealth. National wealth is modernly defined as both goods and services.

David Hume

Another contributor to early economic thought was David Hume, philosopher and good friend of Adam Smith. Hume's two most important and lasting contributions to economic thought are the price specie-flow mechanism and the neutrality of money. His main attack was on the Mercantilist belief that wealth could be maximized via specie accumulation(for which they advocated a balance of trade surplus). Hume argued that, under a gold standard system, a balance of trade surplus (or deficit) is self-liquidating. A surplus increases the country's specie, thus increasing the country's domestic money supply. Under an assumption of constant velocity of money, this increase in the money supply increases aggregate demand and thus, the price level. Higher domestic prices mean that the price of exports rise in relation to the price of imports. This price differentiation leads to increased imports and decreased exports until the surplus is liquidated. Neutrality of money refers to the fact that changes in the money supply do not affect real measures of the economy, such as real output and real employment, but rather exclusively affect nominal measures such as prices and wages.
Hume also influenced the ideas of Adam Smith, as they were close friends and colleagues.

New Thinkers Emerge: The Physiocrats

A group of French thinkers, lead by Francois Quesnay, emerged in the mid 18th century to challenge existing Mercantilist ideas and to redefine wealth and economic growth. These were the Physiocrats; they viewed wealth as agricultural goods, introducing the principle that world wealth is not fixed. This extended into the radical idea that in any given exchange, all participating countries benefit, although not always equally.
The Physiocrats opposed Mercantilist trade restrictions because the tariffs hurt agricultural profits and overall, diverted investment from agriculture to manufacturing. In his Tableau Economique, Quesnay describes the key factor for economic growth: the "exclusive productivity of agriculture." The only way to change the total wealth of the nation is to change agricultural productivity. He divided the economy into three distinct sectors: 1) the productive class(farmers, miners, and fisherman, ie individuals who contribute to the total wealth of the nation), 2) the sterile class(merchants, manufacturers, and domestic servants), and 3) the landowner class.
In contrast to the Mercantilists, the Physiocrats waived heavy government intervention in the economy in favor of the "laissez faire" policy. The economy is largely self-regulating and would function better without the controls of the Mercantilist system.
The Physiocrats can be commended for introducing the concepts of a general economic equilibrium, tax shifting and tax incidence, and diminishing marginal product given a fixed input. They attacked the worst ideas of the Mercantilists: the Physiocrats identified national wealth with goods rather than specie, they promoted free international trade, and they argued against manufacturing monopolies.
And yet, the Physiocrats' outlook wasn't perfect either. They maintained the service and manufacturing sectors of the economy were "sterile" and did not contribute to national wealth. We now know that all production(goods and services) add to the wealth of a nation.

The Pioneers of Economic Thought: The Mercantilists

Economic thought has developed over centuries of debate and reform. It can be traced back to the 17th and 18th centuries and a worldwide group called the mercantilists. Mercantilism was a response to a decline in European feudalism, the rise of the modern nation-state, and an increase in both international and domestic trade(aided by improvements in water transportation technology). The mercantilists were the first substantial group to define wealth and devise a plan to increase national prosperity and ensure economic growth. These individuals narrowly defined wealth as specie(gold and silver). This implied a fixed amount of wealth. It also centered around the concept of a zero-sum game of trade: in any exchange, one country always gained only what another lost. The only way for an economy to grow was at the expense of another. The mercantilists advocated a strong central government to impose trade restrictions(quotas, tariffs) and maintain a trade surplus, meaning exports exceeded imports. This ensured a net flow of specie into the country, thereby increasing the nation's wealth, per their definition. They focused on colonization to monopolize markets for their exports and to mine the land for any specie. Mercantilists advocated rapid population growth as a way to maintain low wages. Low wages meant minimal labor costs and minimal price of exports, allowing the country to maximize the quantity of their exports. The resulting trade surplus was maximized along with the country's supply of gold and silver.
However, problems existed with the mercantilists' rudimentary ideas. First, should wealth be limited to specie? Second, is protectionism conducive to economic growth?

Governments

Government is a collective or group decision process where the government has coercive power, the power to force people to do things. Governments exist in a free market economy to carry out the following tasks:

1.  Provide stabilization policies
2.  Provide a stable and acceptable monetary system
3.  Provide an unbiased court and legal system
4.  Provide income redistribution(the tax and transfer system)
5.  Correct for market failures
1. Enact antitrust laws for monopolies
2. Regulate prices for natural monopolies
3. Address externalities, such as pollution, via EPA(Environmental Protection Agency)
6.  Provide public goods
1. These include: national defense, public safety, education, infrastructure, parks and recreation

Though many people disagree on the extent to which governments should interfere with the economy, they largely do not dispute a government's duty to carry out these six tasks.

The Primary Goals of Any Economy

Every economy has 6 key goals: 1) Full Employment of the Factors of Production, 2) Price Stability, 3) Satisfactory Rate of Economic Growth, 4) Freer Trade, 5)"Correct" Distribution of Income, and 6) Efficient Allocation of the Factors of Production. The first four are macroeconomic goals, while the final two are microeconomic goals.

THE MACROECONOMIC GOALS

FULL EMPLOYMENT of Factors of Production

One economic goal is full employment of the factors of production(land, labor, capital, and technology). Full employment allows for maximum economic output and for economic growth. It does not refer to a zero percent unemployment rate, rather it is roughly equal to the frictional unemployment rate. Frictional unemployment is inevitable, as there are always people switching jobs. This number traditionally lies around 4% for the United States and serves as our target rate of unemployment for full employment of the factors of production. Meanwhile, the natural rate of unemployment is that which maintains price levels (zero inflation) and is usually more than the full employment rate of unemployment. The unemployment rate can be changed through fiscal and monetary policy.

PRICE STABILITY (absence of "excessive" inflation)

Inflation is defined as an increase in average prices in an economy, which means that at any given time, some parts of the economy experience inflation lower than that of the nation, possibly deflation(negative inflation, a general decrease in prices), while other parts experience inflation higher than the national rate. Inflation is measured by price indexes such as the Consumer Price Index (CPI), the Producer Price Index (PPI) and the GDP deflator. Though a zero rate of inflation is possible, the United States shoots for mild inflation rates, which are up to 4%. Moderate inflation lies between 4% and 10%, while high inflation exceeds 10%. The unlikely extreme is hyperinflation, a case where inflation exceeds 100%. "Excessive" or high inflation usually causes political changes in a country, hinders positive net economic growth, and is generally avoided.
A small amount of inflation is acceptable and both beneficial and costly. The costs for mild to moderate inflation include the following: fixed income and low income individuals lose out, lenders(holders of financial assets such as stocks and bonds) hurt from inflation, taxpayers in general lose out, and menu costs(costs to a firm resulting from changing its prices). Costs of high inflation include uncertainty costs(firms become reluctant to purchase capital; this reluctance reduces economic growth) and hyperinflation(unlikely). The benefits of inflation, however, are less obvious. They include the following: holders of real assets gain, borrowers gain, government gains(if taxpayers lose, government gains), labor markets function more smoothly, and lastly, moderate inflation means that those below the average inflation rate aren't experiencing deflation.
It is difficult to determine the actual inflation rate because one of the most widely used measures, the CPI, overstates inflation. The CPI is an overestimate because a substitution bias exists(relative price changes affect consumption but may not affect the price basket), because the increase in purchasing power that results from the introduction of new goods is not reflected in the CPI, and because of unmeasured changes in quality. When a firm changes the quality of a good, not all of the good's price change is a result of a change in the cost of living so the CPI rises faster than it should.

SATISFACTORY RATE OF ECONOMIC GROWTH

To assess whether a country is experiencing a "satisfactory" rate of economic growth, we look to the per capita change in real Gross Domestic Product(GDP). The economy must grow faster than the population for this to be positive. Ideally, per capita economic growth is around 1 or 1.5%. In the United States, economic growth is approximately 3%, while population growth is roughly 1%, making per capita growth 2%. For several developing countries, it is difficult to achieve positive per capita economic growth because their economies cannot keep up with their rapidly multiplying population. For more information, see my post on "Economic Growth."

FREER TRADE WITH OTHER NATIONS

Freer trade means importing and exporting goods and services without barriers such as quotas and tariffs. Fewer barriers means increased trade, which is beneficial to consumers because it increases the goods available to them and/or reduces prices of goods already available to them. The amount of trade a country conducts is measured by comparing total GDP to imports and exports. In the United States, the foreign sector is approximately a quarter of the economy. Meanwhile, our largest trading partner, Canada, has ratios of exports and imports to GDP of around 30%, making foreign trade over half their economy. Because exchange rates are flexible, free trade also implies price and wage equalization. As long as prices and wages differ from one country to the next, free trade will not exist. Freer trade has helped maintain a low inflation rate in the U.S.(There may be a slight tradeoff of higher unemployment in the short run associated with the low inflation-see "Phillips Curve" post for most information).

THE MICROECONOMIC GOALS

"CORRECT" DISTRIBUTION OF INCOME

There is a whole spectrum of income distributions with two extremes. The first being perfectly equal income distribution in which every individual has an identical income. The opposite extreme is perfectly unequal income distribution in which one person or family has almost all, if not all, the income, while everyone else has no income or just enough to survive. The United States has an income distribution in between the two extremes, as established by governmental and political action. The "correct" distribution is simply a matter of opinion; the opinion of many economists is that people should be paid according to the value of the work they perform or the value of the output of the assets they own. This concept that people be paid in proportion to their work ethic is known as the productivity principle. Exceptions are established for people unable to do the same work as others-these exceptions form the tax and transfer system. Pell grants, housing assistance, unemployment compensation, food stamps, Social Security, Medicare, and Medicaid are all components of the tax and transfer system in the United States.

EFFICIENT ALLOCATION OF FACTORS OF PRODUCTION

Arguably the most important of the six goals, efficient allocation of the factors of production, or of resources, is otherwise referred to as economic efficiency. It is the best use of labor, capital, natural resources, and technology achieved through two conditions. The first condition is maximum output from a given set of factors of production(called technical efficiency); the second condition is the production of the correct mix of goods and services. A free market system is the best way to achieve these conditions: maximum production of the correct mix of goods and services.