Adam Smith & John Maynard Keynes - Literature review Example

Adam Smith & John Maynard Keynes. Adam Smith and John Maynard Keynes are great economists. Their economic theories did not have much in common, however, no one can deny the impressive influence Smith and Keynes had on the policies of their times and even on the theoretical positions of their most vocal opponents. What is more, John Maynard Keynes and Adam Smith offered more than economic theory; they proposed policy solutions to the existing economic problems. These solutions were developed in order to improve macroeconomic performance and national prosperity. As Wesley Mitchell put it, Smith sought to convince people that "the wealth of a nation would be promoted with vastly greater effectiveness by the ‘obvious and simple system of natural liberty’ than by national planning of the mercantilist sort" (Mitchell 48). As for the implementation of Smith’s ideas, his influence on today’s economy is probably greater than it was on his contemporaries or those who lived immediately after his works were published. “An Inquiry into the Nature and Causes of the Wealth of Nations” (or more commonly “The Wealth of Nations”) by Adam Smith, published in 1776 is widely considered to be the first modern work in the field of economics. Up until “The Wealth of Nations” it was generally accepted that in any economic transaction one side always "won". In other words, either the buyer or seller got to "put one over" on his "opponent" — one went home happy, the other went home and eventually got angry at himself for being a dupe. Smith rejected this notion, however, and stated that "a voluntary, informed transaction always benefits both parties": when the buyer gives something of value to the seller in exchange for something else of value, both parties "win". This is because the buyer values what the seller is selling more than what he is giving to the seller in exchange for it. And, for his part, the seller is all too happy to part with what he is selling for the buyers property, because he values that more. In short, each party gets something he wants more in exchange for something he wants less — they both benefit. This book is a clearly written account of political economy at the dawn of the Industrial Revolution. Mercantilism was the ruling economic principle then. “The Wealth of Nations” attacks two fundamental principles of mercantilism: the idea that protectionist tariffs serve the economic interests of a nation; the idea that large reserves of gold bullion or other heavy metals are necessary for a countrys economic success (Smith Vol. I 143-389). Smith proposed something else — the concept of "Invisible Hand" appeared. The idea behind this concept is, on one level, that people benefit the community around them simply by acting solely in their own self-interest, without conscious regard to community service. In other words, self-interest equates with general interest: “It is not from the benevolence of the butcher, the brewer, or the baker, that we can expect our dinner, but from their regard to their own interest” (Smith Vol. I 456). In George Stigler’s judgment, Smith’s greatest achievement was to "put into the center of economics the systematic analysis of the behavior of individuals pursuing their self-interest under conditions of competition" (Stigler 147). What is important: firstly, Smith was not advocating a social policy (that people should act in their own self interest), but rather was describing an observed economic reality (that people do act in their own interest). Secondly, he did not argue that self-interest is always good; he merely argued against the view that self-interest is necessarily bad. On another level, the "invisible hand" refers to the ability of the market to correct for seemingly disastrous situations with no intervention on the part of government or other organizations. For example, Smith says, if a product shortage were to occur, that products price in the market would rise, creating incentive for its production and a reduction in its consumption, eventually curing the shortage. The increased competition among manufacturers and increased supply would also lower the price of the product to its production cost plus a small profit, the "natural price" (Smith Vol. I 403-96). This was later adopted as a universal principle by the laissez-faire economists of the 19th century. Smith himself, however, would not necessarily have been in favor of laissez-faire; he makes no claims to the effect that the free market can always solve economic problems. For example, with regard to regulations, he says, “Whenever the legislature attempts to regulate the differences between masters and their workmen, its counsellors are always the masters. When the regulation, therefore, is in favour of the workmen, it is always just and equitable; but it is sometimes otherwise when in favour of the masters”. (Smith Vol. I 634). However, in “The Wealth of Nations” it is difficult to determine with certainty Smiths actual opinion of government regulation of the private sector. On the one hand, he stated the above, but on the other hand, he also wrote: “The obvious and simple system of natural liberty establishes itself of its own accord... The sovereign is completely discharged from a duty, in the attempting to perform which he must always be exposed to innumerable delusions, and for the proper performance of which no human wisdom or knowledge could ever be sufficient: the duty of superintending the industry of private people” (Smith Vol. II 256). Additionally, Smith harbored a serious distrust of the tradesman class. He felt that the members of this class, especially acting together within the guilds they were wont to form, could constitute a power bloc and manipulate the state into regulating for "special interests" against the general interest: "People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices" (Smith Vol. I 619). Many of these ideas are reflected, developed and criticized in works by John Maynard Keynes, especially “The General Theory of Employment Interest and Money” (or just “The General Theory”). Published in February 1936, it created the terminology of modern macro-economics to a great extent. The book ushered in a revolution, referred to as the "Keynesian Revolution", in the way economists and men in public affairs thought about the economy, and especially how they thought about the feasibility and wisdom of public sector management of the aggregate level of demand in the economy. Briefly, the "General Theory" argued that the level of aggregate demand in a modern economy was determined by a range of factors including the propensity to consume (the percentage of any increase in their income that people chose to spend on goods and services), the propensity to save (the percentage of any increase in their incomes that they chose to save), the attractiveness of fixed capital investment (dependent on anticipated rates of return) and the level of interest rates. Keyness key arguments included that in an economy bedeviled by weak demand (e.g. a depression), where in his terminology there was an ignition problem (a difficulty in getting the economy to move forward more vigorously), then the government (more broadly the public sector) could increase aggregate demand by increasing its expenditures, including by borrowing to finance the expenditures, and that the public-sector borrowing would not increase interest rates sufficiently to undermine the effectiveness of such a policy (Keynes I 13-348). In general, Keynesianism (government attempts to affect demand through tax, expenditure and borrowing and monetary policy) was enormously influential in the post-Second World War period. Keyness ideas influenced Franklin D. Roosevelts view that insufficient buying-power caused the Depression. During his presidency, he adopted some aspects of Keynesian economics, especially after 1937, when, in the depths of the Depression, the United States suffered from recession yet again. But to many the true success of Keynesian policy can be seen at the onset of World War II, which provided a kick to the world economy, removed uncertainty, and forced the rebuilding of destroyed capital. Keynesian ideas became almost official in social-democratic Europe after the war and in the U.S. in the 1960s. (Robbins 217-20). In his article “The End of Laissez-Faire” Keynes writes: “The disposition towards public affairs, which we conveniently sum up as individualism and laissez-faire, drew its sustenance from many different rivulets of thought and springs of feeling. For more than a hundred years our philosophers ruled us because, by a miracle, they nearly all agreed or seem to agree on this one thing. We do not dance even yet to a new tune. But a change is in the air” (Keynes II). Let us remember Adam Smith’s notion of the proper role for state activity. It is said in his writings that there are three areas for legitimate governmental activity in society: defense against external and internal security threats, the formation of laws that prevent individuals from oppressing one another and the provision of public goods that the market would not supply (Smith II 328). Keyness theory suggested that active government policy could be effective in managing the economy. Rather than seeing unbalanced government budgets as wrong, Keynes advocated what has been called counter-cyclical fiscal policies, that is policies which acted against the tide of the business cycle: deficit spending when a nations economy suffers from recession or when recovery is long-delayed and unemployment is persistently high — and the suppression of inflation in boom times by either increasing taxes or cutting back on government outlays. He argued that governments should solve short-term problems rather than waiting for market forces to do it, because "in the long run, we are all dead" (Robbins 204-5). Before Keynes the “classics” (as Keynes himself called all the economists before him) wanted to balance the government budget, through slashing expenditures or (more rarely) raising taxes. To Keynes, this would exacerbate the underlying problem: following either policy would raise saving and thus lower the demand for both products and labor. That is why, Keynesian economics doesn’t mention the principles of taxation laid down by Adam Smith, notwithstanding the enormous importance of taxation in the modern economy, both in Europe and the United States. What is more, Keynesian theory has no answer to the problems of rising unemployment and inflation. It cannot produce these answers because it does not recognize taxation as a factor in the equation, probably because taxation is not a factor of production. Keyness own formulation, that the wage is equal to the marginal product of labor, would be a good starting point if only the marginal product of labor were equal to the wage. This can only occur if it is freed of taxation. The return to capital is simply that part of the marginal product which the employer takes in providing the means of enhancing the marginal product. But it must never be forgotten that labor generates the marginal product and must be allowed to take its full share. Taxation can be met in proportion to the better resources of industries better placed. This needs a concept of taxable capacity, measured by reference to rental values (Mitchell 275). This would satisfy the first of Adam Smiths rules of taxation, that the taxpayers should contribute to the support of the Government as nearly as possible in proportion to their respective abilities (Smith Vol. II 307). Adam Smith spoke in favor of liberal wages. "The liberal reward of labour, therefore," he said, "as it is the effect of increasing wealth, so it is the cause of increasing population. To complain of it is to lament over the necessary effect and cause of the greatest public prosperity" (Smith Vol. II 72). While analyzing the merits and demerits in Smith’s and Keynes’s theories, one has to remember that they lived in very different economic times, with little intellectual overlap during their respective working periods. Capitalism was an evolving phenomenon, but, certainly, it was at different levels of the development. Each economist described the situation to the best of their abilities during their lifetimes. Each economists interpretation was influenced by the channel of information, which was then available, and by the relative development of capitalism itself. The central economic question from the dawn of capitalism in the late 1700s has been over the stability of the relationship between production and consumption. The one constant between the views of scientists seems to have been a common acceptance of the labor theory of value. In short, Smith believed that production could never greatly exceed consumption, while Keynes knew that capitalism could build more capacity than it could absorb. For Smith, economic growth is good and is achieved by the ever-widening application of the division of labor, which is organized within markets and driven by rational self-interest. Those nations that allow market forces to generate such growth will become wealthier, in Smith’s view, than those that follow the mercantile model of managed trade (Robbins 128-29). Adam Smith believed that human labor provided both the production as well as monetary value necessary for consuming the output of others in the village. This labor theory of value simply stated that the number of hours of human labor involved in the production of an article largely determined its market price (Mitchell 106). Once again, writing during the 1930s, British economist John Maynard Keynes believed that overinvestment could lead to excessive productive capacity and that the national inventory could get ahead of total consumption power. The whole economy could almost stop, as was the case during the Great Depression. For Keynes, the weak point of capitalism lay within investment, and serious depressions made further private investment difficult, opening the door to direct federal intervention through the counter-cyclical deficit spending. This type of intervention has become known as fiscal and monetary policy (Leijonhufvud 36-38). Adam Smith observed that "What is prudence in the conduct of every private family, can scarce be folly in that of a great kingdom". Buchanan and Wagner criticize the ideology of Keynesianism, emphasizing the fact that Keynes forgot the teachings of Smith: until the advent of the "Keynesian revolution" in the middle years of the 20th century, the fiscal conduct of the US, for example, was informed by this Smithian principle of fiscal responsibility: Government should not spend without imposing taxes; and government should not place future generations in bondage by deficit financing of public outlays designed to provide temporary and short-lived benefits. The dominant principle expressed clearly by Adam Smith was that resort to debt finance by government provided evidence of public profligacy, and, furthermore, a form of profligacy that imposed fiscal burdens on subsequent taxpayers. Put starkly, debt finance enabled people living currently to enrich themselves at the expense of people living in the future. These notions about debt finance, which were undermined by the Keynesian revolution, reinforced adherence to a balanced-budget principle of fiscal conduct (Buchanan & Wagner 19). Cairncross describes the unforeseen consequences of Keynesianism as follows: “What he could not have foreseen were the many other problems that have arisen, associated not with a failure of demand but with the international flow of capital and rapid structural change affecting the demand for labour of different kinds in a labour market itself undergoing rapid change” (Cairncross 76). Summing up, one can say that Adam Smith is regarded as not merely the father of modern political economy or just a starting point for a history of thought class but a system builder who sought to integrate ethics, morality, political economy and jurisprudence into a coherent whole. We will endlessly debate the extent to which he succeeded in this task — that, in itself, is testimony to his continuing influence and importance. John Maynard Keynes made another revolution by expanding the idea of state interventions into the economic system of the state. Their legacy is a subject of controversy: the fact is testimony to their continuing influence and importance, the fact, which once more emphasizes their grandeur and contribution to the development of modern science. Works cited. 1. Cairncross, Alec. “Sir Alec Cairncross on John Maynard Keynes”. The Economist, April 20-26, 1996. 2. James M. Buchanan and Richard E. Wagner. Democracy in Deficit: The Political Legacy of Lord Keynes. New York: Academic Press, 1977. 3. Keynes, John Maynard (I). General Theory of Employment, Interest and Money. The Collected Writings of John Maynard Keynes, Vol. 7 — The General Theory, edited by Donald Moggridge, London: Macmillan for the Royal Economic Society, 1973. 4. Keynes, John Maynard (II). “The End Of Laissez-Faire (1926)”. 13 Nov. 2001 . 5. Leijonhufvud, Axel. "Effective Demand Failures". Swedish Journal of Economics ‘75, March 1973. 6. Mitchell, Wesley C. Types of Economic Theory. Vol. 1, New York: Augustus Kelley, 1967. 7. Robbins, Lionel. A History of Economic Thought: The LSE Lectures. ed. Steven Medema and Warren Samuels, Princeton, N.J.: Princeton University Press, 1998. 8. Smith, Adam. An Inquiry Into the Nature and Causes of the Wealth of Nations. Vols. I, II. Indianapolis, Ind.: Liberty Classics, 1981. 9. Stigler, George. The Economist as Preacher and Other Essays. Chicago: University of Chicago Press, 1982. Read More