That the Obama administration based its policy on the assumption that every dollar of government expenditure has $1.50 worth of impact is a remarkable testimony to Keynes’s observation in that book: “The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.”

So it is that Keynes’s false expenditure-multiplier argument, severely criticized by his contemporaries, can now be invoked in support of massive spending.

The argument is founded on two key assumptions that turn out to be false. First is the notion that savings are not spent but rather are withdrawn from the expenditure stream. That assumption prompts stimulus proponents to believe that taxation or government borrowing expands total spending, while leaving the money in the private sector retards it. The flaw is the equation of saving with hoarding. People save their unconsumed income in bank deposits and mutual funds, purchase bonds (private or government) and stocks, or some combination of all of these. Thus savings are the sources of funds spent by borrowers. And as the classical economist most admired by Keynes declared: “No political economist of the present can by saving mean mere hoarding.”

That was Malthus, who was reaffirming Adam Smith’s explanation in The Wealth of Nations that “What is annually saved is as regularly consumed as what is annually spent, and nearly in the same time too; but it is consumed by a different set of people.” Note that “to consume” does not only mean “to eat.” It also means to “use up.” Thus John Stuart Mill elaborates Smith’s explanation: “The word saving does not imply that what is saved is not consumed, nor even necessarily that its consumption is deferred; but only that, if consumed immediately, it is not consumed by the person who saves it. If merely laid by for future use, it is said to be hoarded; and while hoarded, is not consumed at all.” And when savings are borrowed by businesspeople, they are “all consumed; though not by the capitalist. Part is exchanged for tools or machinery, which are worn out by use; part for seed or materials, which are destroyed as such by being sown or wrought up, and destroyed altogether by the consumption of the ultimate product. The remainder is paid in wages to productive laborers, who consume it for their daily wants; or if they in their turn save any part, this also is not, generally speaking, hoarded, but (through savings banks, benefit clubs, or some channel) re-employed as capital, and consumed.”

Keynes’s lack of formal training in economics, besides his eight weeks of tutorials from Alfred Marshall, may explain his failure to interpret correctly Marshall’s own restatement of the meaning of saving, which Keynes himself quoted: A man “is said to spend when he seeks to obtain present enjoyment from the services and commodities which he purchases. He is said to save when he causes the labor and the commodities which he purchases to be devoted to the production of wealth from which he expects to derive the means of enjoyment in the future.”

The Government Spending Shuffle

The multiplier’s second incorrect premise is that government expenditures are “autonomous”; that is, government spending does not depend on current income. It may be true that politicians pay hardly any attention to the level of income in the economy when they choose how much government should spend. That it planned to spend $787 billion when the economy was in a recession is ample testimony to such an inclination. But the amount the government spends comes primarily from taxes paid out of the public’s current income. Furthermore, government expenditures above tax receipts have to be paid for through the sale of bonds, purchased out of the public’s savings. Thus increased government spending simply shuffles around currently earned incomes and savings without adding anything to total spending. And when government shifts more of current income toward its favored expenditures, the economy’s future functioning is impaired because such spending yields less than would have resulted had the income earners spent the money themselves.

Borrowing from the rest of the world may add to total spending in the United States at the expense of spending in some other countries. But it is hard to conceive of foreign savers eager to send their unspent incomes to the United States when their own economies are experiencing recessions. Besides, the Keynesian multiplier idea is supposed to hold in every country. Thus it is unrealistic to expect that all governments would be able to increase their borrowing from “the rest of the world” in order to increase total world spending.

Borrowing from a central bank (inflation) may increase total spending beyond currently generated incomes. However, the stimulative effect can only be temporary, until nominal wages adjust to the resulting rise of prices and participants in the capital markets have taken measures to hedge against future capital losses. This is the classical forced-saving doctrine that Keynes read but failed to interpret correctly, thinking it applies only to an economy operating at full employment.

Indeed, David Ricardo described as an “absurdity” the belief in the ability of a central bank to promote lasting economic prosperity by issuing paper money. The belief, he said, attributes “a power to the circulating medium which it can never possess.” Keynes encountered a similar warning about the futility of a central bank’s money creation to promote prosperity in Ricardo’s Principles but unwisely dismissed it as having relied on the assumption of full employment. The Federal Reserve evidently has been attempting to prove Ricardo wrong with its reckless money creation, especially since the third quarter of 2008. It has lost so far.

Production Drives Economies

A fundamental flaw of the Keynesian multiplier argument, besides the two faulty premises, is its failure to recognize that consumption spending follows production and the earning of income. It is incorrect to think of spending as one consumer handing over a fraction of her income to another to spend. Rather, individuals engage in production from which they earn incomes by selling what they do not consume. From the incomes thus earned, individuals purchase goods and services they themselves do not produce. The remaining income may be held in cash (hoarding) or turned over to others through purchasing interest- or dividend-earning assets (saving). That is why the classical economists emphasized that production, rather than consumption, drives an economy, another explanation Keynes encountered from Mill but could not interpret correctly:

What constitutes the means of payment for commodities is simply commodities. Each person’s means of paying for the productions of other people consist of those which he himself possesses. All sellers are inevitably, and by the meaning of the word, buyers. Could we suddenly double the productive powers of the country, we should double the supply of commodities in every market; but we should, by the same stroke, double the purchasing power. Everybody would bring a double demand as well as supply; everybody would be able to buy twice as much, because everybody would have twice as much to offer in exchange.

Before Keynes borrowed Richard Kahn’s formulation of the expenditure multiplier, founded on consumption expenditures, other analysts had argued the “multiplying effect” of production, as Mill explains above. The argument is that increased productivity or a surge in production within one sector of an economy stimulates increased production in others as a result of the additional demand or income generated by that sector. Thus the discovery of high-yielding varieties in agriculture or the introduction of more advanced information-processing technologies into computers may have multiplying effects on production in other sectors of an economy. That explanation is a far cry from the Keynesian belief that by taking some of the public’s income to subsidize the arts, pay the unemployed over an extended period, or cover children’s health care, government will stimulate increased production in the rest of the economy. Even necessary expenditures on infrastructure entail forgone production. For a correct analysis, one always has to keep in mind the displacement effect of government spending.

Among Keynes’s contemporaries who criticized his multiplier argument most consistently was R. G. Hawtrey, who declared it variously as “practically untenable, . . . nonsense, . . . [and] fallacious,” and said that it does not represent “a correct account of the sequence of events.” (See more of such criticisms in my “On the Mythology of the Keynesian Multiplier,” American Journal of Economics and Sociology, October 2001.) Evidently, those who recommend massive government spending have paid little heed to previous criticisms of the multiplier argument. They presumably were impressed by its expression in algebra and geometry in modern macroeconomics textbooks. They also have not learned from the failure of former President Bush’s tax cuts of 2008, which were meant to stimulate consumer spending and spare the economy from a downturn. Cutting taxes, only to borrow from the public to fund the increased deficit, could not have increased production. Perhaps the failure of the so-called stimulus to bring economic recovery will finally teach the right lesson on the impotence of increased government spending.

Economic recessions typically are the result of a mismatching of production with consumer demand. Given the incentives of producers to correct their own mistakes to recover profitability, economies sooner or later recover from recessions on their own. But recovery can be forestalled when governments undertake expenditure or regulatory measures that frustrate the corrective actions of private producers and consumers. Massive, diversionary spending by government does not help the recovery process.

Nevertheless, there are some statements about human beings and the social world that can be made with almost as much certainty as those concerning the natural world. One of these is the principle of comparative advantage and the consequent argument that a policy of free trade, even if followed unilaterally, will act to maximize both human cooperation and material well-being. This is one of the few things on which almost all economists agree, however much they differ in their politics and philosophy or position on other economic questions. Moreover, it is a proposition that has overwhelming empirical support: the brute facts of history resoundingly confirm that free trade increases output and leads to closer cooperation and economic integration among people, often those who are widely separated physically.

Despite this, however, the wider public does not share the economists’ confidence in the principle. The case for free trade, which economists regard as overwhelming and as certain as is possible in the social sciences, has to be constantly remade in each generation. The contrary case, for protection and local self-sufficiency, has a continuing appeal and frequently carries the day in politics, often with disastrous results. There are a number of reasons for this, not least that the argument in favor of free trade is counterintuitive for many and that the costs of the policy are concentrated and visible while the benefits are frequently widespread and diffuse. However, there are two other related reasons that go a long way to explaining public thinking about this question: 1) the perception of trade as taking place between groups or political entities rather than individuals, and 2) the misunderstanding of history that follows from this. These date back to the first formulation of the idea of comparative advantage and still obscure what is actually at issue in the continuing argument.

Although earlier authors, such as Adam Smith, had pointed out the benefits of unrestricted trade and commercial intercourse, it was the British economist David Ricardo who first articulated the classical argument for free trade on the basis of comparative advantage in 1812. The idea that a part of the world should specialize in producing those products in which it had an absolute advantage was well established by then. What Ricardo did was to show with a simple mathematical argument that it paid for parts of the world to specialize in particular products even if they did not have an absolute advantage; that is, even if the same goods could be produced more cheaply elsewhere. The critical factor was their comparative cost in terms of alternative products forgone.

Ricardo’s argument was quickly accepted and remains so among economists to this day. However, the way he presented his argument contained a basic flaw, which is the origin of the misunderstanding referred to earlier. He presented trade as taking place between countries rather than individuals. Quite simply, this is false. Countries do not trade with each other. It is individuals and corporate entities, such as firms, that do this. From the economic point of view, trade between persons in Maine and California is no different from trade between persons in California and Japan.

However, most people do not see economic life this way, and that is not how it is reported in much of the media.

Even more important is the way this distorts our understanding of economic history and the lessons to be learned from it. Two common arguments are made by critics of free trade. The first is that Ricardo’s model assumes that capital will not move from one country to another . (Ricardo did indeed make this assumption, which is a consequence of his seeing the world of trade in terms of nations rather than individuals.) The second is that empirical history refutes the theory of free trade. The critics argue that the history of a number of nations , in particular the United States, shows that it is protection rather than free trade that brings about economic development and a rising standard of living while for most countries being integrated into a world of free trade means being condemned to low-value production and low incomes.

At first sight the evidence for the second argument appears strong. The United States moved sharply in the direction of a protectionist tariff policy after the Civil War and continued to follow this policy right up to the aftermath of World War II. During the same period (excluding the Great Depression and war years), the American economy grew rapidly and the United States became the world’s greatest industrial power. How is this compatible with the argument that free trade is the best policy? The answer lies in realizing that trade is a matter of individual exchange rather than exchange between nations. Once you go beyond a society of completely self-sufficient households (if indeed such a thing ever existed) there will always be free trade. The question is not free trade yes or no, but rather how big is the area within which free trade takes place? The degree to which all participants will benefit from trade is a function of the extent of that area in terms of its geographical size and variety and the size and density of its population.

Success Demystified

This makes the success of the nineteenth-century United States easily understandable. The size of its territory and population made it the second largest free trade area on the planet, after the British Empire. Moreover, Britain’s continuing free-trade policy reduced the negative effects of U.S. protectionism on the world economy. Looking at things in this way makes the current debates over globalization easier to understand in as much as we can see more clearly what the real issues are. We can also see that the first objection to Ricardo’s model is invalid. As with trade, there is no meaningful economic distinction between a capital flow from, say, Somerset to Yorkshire and one from Yorkshire to Lisbon. The real question again is what the size and boundaries of the area within which capital flows should be. So what are the real issues at stake in the historical and contemporary arguments about trade? The basic one is: how far the economic and political units should coincide. The logic of economics is that if you want to maximize wealth and economic efficiency, then the unit of trade should be as large as possible, preferably the entire planet. Classical liberals argue that this will also bring social and political benefits, above all greater peace and interconnections between different parts of the world.

The most reasonable counter-argument is that this will lead to change that is too rapid, with consequent social instability and the destruction of settled ways of life, which will derail many people’s expectations. Essentially, there is a tradeoff between greater wealth, comfort, and individual opportunity on the one hand and social stability and cohesion on the other. The choice is obscured, however, by a mistaken view of trade and the misleading perception of the world to which it leads.

In the early months of 1889 a 37-year-old Swedish student named Knut Wicksell was walking through the streets of Berlin in Germany when he happened to notice in the window of a bookstore a recently published volume by the Austrian economist Eugen von Böhm-Bawerk: The Positive Theory of Capital.

Wicksell later wrote to a friend that,

I procured a copy and was soon lost in the book. I understood most of it rather imperfectly, as can be seen from my notes in the margin. . . . Nonetheless the book came to me as a revelation. I had already tried on my own, with little success, to penetrate the phenomenon of interest and the general problem of economic distribution, when complicated by the existence of capital (as well as labor and natural resources). . . . It was as though I now saw with my own eyes the roof being put on a scientific construction, which no economist since the days of Ricardo had managed to raise above its lower floors.¹

This discovery put Knut Wicksell on an intellectual path that led to his becoming one of the great economists of the twentieth century. Through his writings and personal influence Wicksell provided a framework for monetary and business-cycle analysis that has served as the starting point for several generations of Swedish and Austrian economists. Knut Wicksell was born on December 20, 1851, in Stockholm. The sesquicentennial of his birth offers an appropriate occasion for an appreciation of some of his important contributions to economics.

Wicksell was born into a middle-class Swedish family. His father ran a grocery business and wisely invested the profits in real estate. Knut’s mother died when he was seven years old, and his father when he was 15. But he and his four siblings were left financially comfortable enough for them to get through high school and for Knut and his brother to attend the University of Uppsala, not far from Stockholm. He graduated with a bachelor of science degree, cum laude, after only two, instead of the usual four, years, having specialized in mathematics, physics, and astronomy.

But he began having doubts about his future. First, after an intense devotion to his Christian faith following his father’s death, he increasingly came to have doubts, and at the age of 23 became a “free thinker,” a position from which he never wavered for the rest of his life. Second, he doubted whether he could make any meaningful contributions to mathematics, if he chose that direction for his graduate studies.

At the same time, he began to be interested in the social and economic issues of the day, especially the relationship between drunkenness, prostitution, the condition of the poor, and overpopulation. The poor were driven to drink because of the apparent hopelessness of their economic condition. Many men in the lower middle class turned to alcohol and the services of prostitutes because they had no hope of earning a sufficient income that would make early marriage possible.

Wicksell concluded, therefore, that if these vices were to be ameliorated, population growth had to be slowed down so that the rate of capital formation would exceed the rate of increase in population, resulting in a relatively greater scarcity of labor in comparison to capital. This would raise the value of labor and wages relative to the value and price of capital. But Wicksell rejected Thomas Malthus’s famous prescription of “moral restraint” on the part of the members of society. Instead, he made the case for a wide distribution of contraceptives, and in later years advocated the legalization of abortions during the first three months of pregnancy.

For these and other “radical” social views that he put into print in the early 1880s, Wicksell was condemned by the professors at the University of Uppsala, censured by the Uppsala medical association, and warned that he was following a dangerous path in publicly advocating these ideas.

He made his living during these years as a journalist and read economics on his own. But in the mid-1880s and then again late in the decade he was awarded travel grants to study abroad that took him to London, Strasbourg, and Vienna. In Vienna he attended the lectures of Carl Menger, founder of the Austrian school of economics. It was on the second of these travels that Wicksell came across Böhm-Bawerk’s work in a Berlin bookstore.

When he returned to Sweden he applied for a lectureship in economics at the University of Uppsala, but was turned down because of his political and social views. Nevertheless, he was recommended to apply to the university law school, where he was told that he could teach economics only if he had a law degree. So at the age of 45 he did what he had done as an undergraduate and crammed four years of study into two. He passed the law examination in 1899 and was appointed a lecturer in economics at the University of Uppsala the same year. The following year he accepted a professorship at the University of Lund, a position he held until his retirement in 1917 at age 65.

At Lund he continued to make controversial statements. At a May Day demonstration in 1904 he suggested that it was futile to imagine that Sweden could ever successfully defend itself against a determined, more powerful foreign enemy. Instead, he suggested that Sweden should abolish all military spending and invite Imperial Russia to annex the country. Russia would supply all necessary defense against would-be attackers, and the role of the Swedes would be to educate and civilize the rough and backward Russians in the ways of social freedom and democracy. He stepped back from this radical position after the First World War and became a strong proponent of the League of Nations.

Then in 1908 Wicksell took up the cause of an “anarchist agitator” who had “disturbed the religious peace” of the country with remarks declared to be blasphemous for which he was sent to prison. Insistent that this was a blatant and serious violation of freedom of expression and personal liberty, Wicksell delivered a public lecture in which, as an act of peaceful civil disobedience, he satirized the story of the Immaculate Conception. Wicksell was tried and convicted of blasphemy and after several appeals spent two months in prison in 1910.

He wrote widely on the problems of wartime inflation and postwar monetary problems following the First World War and suggested how the negative effects of the war could be minimized in neutral Sweden. He also turned out a string of seminal books on capital, money, interest, and public finance. On May 2, 1926, at the age of 74, he died from a stomach disorder that was complicated by pneumonia.

Major Works

Wicksell’s first major work was Value, Capital and Rent published in 1893.² The classical economists, from Adam Smith through David Ricardo to John Stuart Mill, had attempted to show that the relative prices of goods and the distribution of income among the factors of production (land, labor, and capital) were all ultimately determined by the quantity of labor (along with a few auxiliary assumptions) that was required for the manufacture of goods and the production of food. The “marginalist revolution” of the 1870s had shown that the value of goods and factors of production are ultimately based on the subjective valuations of demanders. Their marginal (or incremental) decisions concerning tradeoffs between units of commodities determine relative prices in the market.

What Wicksell did in his first book was to synthesize the mathematical general equilibrium theory of Léon Walras with Böhm-Bawerk’s theory of capital as a time-consuming, multistaged process of production. He explained how each factor of production received an income equal to its contribution (or marginal product) to the manufacture of a good. He also showed that even in a stationary equilibrium, interest income had to be earned as the incentive for replacing the capital consumed in the processes of production through time.

In his next major work, Studies in the Theory of Public Finance (1896), Wicksell innovatively applied the theory of marginal cost-benefit analysis to the process of government taxing and spending.³ Nobel laureate James Buchanan has emphasized Wicksell’s original and important contribution to political decision-making on fiscal matters:

Among fiscal theorists, Knut Wicksell holds the unique position of having carried his theoretical ideas through to an examination of the political structure within which fiscal decisions must be made and implemented. . . . Wicksell proposed, first of all, that the bridge between tax and expenditure sides of the fiscal account be made explicit. When a specific expenditure project was presented, a whole array of possible distributions of the required tax bill were also to be presented, with each array estimated to produce revenues sufficient to cover the outlay. The expenditure project was then to be voted on in the legislature, along with each one of the tax allocations, and when one such combination secured the unanimous approval of the assembly, it was to be adopted. If no single combination received unanimous support, the expenditure project was not to be undertaken and no tax was to be levied.⁴

Wicksell stepped back from the full unanimity principle to a less restrictive super-majority rule. But Buchanan highlighted that what was crucial to Wicksell’s contribution was his focusing on government fiscal issues in terms of the individual members of society who would either receive the expenditure benefits or bear the taxation costs. The preferences of real people affected by government fiscal policy could no longer be ignored, and economists could not simply view themselves as “proffering advice to nonexistent benevolent despots.”⁵

But the contribution for which Wicksell has received the most international recognition among economists for over a century now is his book Interest and Prices: A Study of the Causes Regulating the Value of Money (1898).⁶ In the first half of the nineteenth century a number of leading classical economists, including David Ricardo, had defended “the quantity theory of money” in understanding the inflation experienced during the Napoleonic Wars. They reasoned that a general rise in prices could not occur unless there was a sustained increase in the quantity of money. And they further argued that the only way to restrain government’s temptation to abuse the printing press was to link the currency to a commodity, such as gold. Thus they advocated the gold standard as an institutional means to prevent government-caused inflations. For a variety of reasons many economists had turned away from the logic of the quantity theory of money by the end of the nineteenth century.

Wicksell set about the task of rehabilitating it.⁷ He used Böhm-Bawerk’s idea of a period of production between the application of inputs and the availability of outputs to serve as the framework for restating his version of the theory. In a nutshell, Wicksell argued that if goods were traded directly in barter, there would be a tendency for market forces to establish an interest rate that balanced the supply and demand for real capital for investment purposes. And this equilibrium rate of interest is what Wicksell called the “natural rate.”⁸

However, in a complex economy goods are traded through a medium of exchange—money. If lenders lent their savings to borrowers in the form of money at a similar equilibrium rate of interest, then money would be “nothing more than a cloak” for the savings and investing of real resources for productive purposes. However, Wicksell says, “Liquid real capital (i.e., goods) are never lent. . . . [I]t is money which is lent, and then the commodity capital is then sold in exchange for this money.”⁹

Depressed Interest Rate

Since it is money that is lent, and not real capital, the monetary authority is able to increase the supply of money available for lending and lower the money rate of interest below the “natural rate” to attract borrowers. Anticipated yields or profits on potential investments will now seem greater than before the fall in the money rate of interest, meaning that at the margin some production projects will now appear attractive that did not seem profitable at the previous higher rate of interest. However, not all types of investments are affected equally by the change in the rate of interest. Those with longer time horizons—longer periods of production before their completion—will be influenced to a greater degree because the lowering of the rate of interest increases the present value of these longer-term investment projects.

Developing several different models using slightly different assumptions, Wicksell presents his theory of how this lowering of the interest rate affects market processes.¹⁰ But the crucial one that served as a springboard for later developments of the theory by other Austrian and Swedish economists is his two-period model.

Suppose, he says, that production processes normally take one year. But with the fall in the rate of interest because of the monetary expansion, two-year investment projects now appear profitable to some entrepreneurs. Using borrowed money, these entrepreneurs purchase and hire factors of production by bidding them away from their present employment in one-year projects. This means that at the end of the first year fewer goods and services will have been produced than would have been, because the required resources were drawn into projects that will not be completed for another year.

This greater scarcity of consumer goods, reflected in higher prices, “forces” society to save—that is, do without consumption goods they normally would have desired to purchase, but which are not available. But according to Wicksell, at the end of the second year, when the longer-term projects have been completed, society will be rewarded for this forced waiting with more and better goods made possible by the longer period of production.

Wicksell argued that if the monetary authority were to keep the money rate of interest constantly below the “natural rate” through continuous monetary expansion, a “cumulative process” of rising prices would be generated. The additions to the money supply would be borrowed by entrepreneurs who bid up the prices of the factors of production to keep or add them to their sectors of the economy. The workers and resource owners receiving those higher money incomes period after period would in turn, and in sequence, bid up the prices for the consumer goods they desire. Only an end to the monetary expansion and a rise in the rate of interest back to its “natural” level could bring the process to an end.

A few years later Wicksell restated his formulation of the Austrian theory of investment and the period of production, as well as his theory of money and how monetary changes influence production processes in his two-volume Lectures on Political Economy.¹¹

Wicksell’s outline of the way in which changes in the money supply modify the market rate of interest and influence the allocation of resources through the processes of production became the starting points for the Austrian and Swedish schools of economics in monetary and business-cycle theory. Ludwig von Mises in The Theory of Money and Credit, Monetary Stabilization and Cyclical Policy, and Human Action, and F.A. Hayek in Monetary Theory and the Trade Cycle and Prices and Production adopted Wicksell’s framework for developing a theory of the business cycle.¹²

Mises’s and Hayek’s innovation was to demonstrate that there were market forces set in motion in Wicksell’s “cumulative process” that would bring it to an end before many of the longer-term investment projects could be brought to completion. Thus the inflationary upturn in investment activity carried with it the seeds for an eventual downturn and correction when these capital projects were shown to be malinvestments resulting from misdirection of resources due to the lack of real savings needed to bring them to, and maintain them after, completion.¹³

In the 1930s Wicksell’s ideas were developed in a slightly different direction by the Stockholm school of economists.¹⁴ Two of the most important contributors from this period were Gunnar Myrdal and Erik Lindahl. Myrdal formulated a theory of “monetary equilibrium,” in which he suggested the conditions that were required for avoiding Wicksell’s cumulative process.¹⁵ Lindahl accepted Wicksell’s basic framework and then analyzed the change in the cumulative process if there were less-than-full employment in either the consumer-goods or investment-goods sectors of the economy or both; Lindahl also developed a “period analysis” of sequential change over time.¹⁶ And in the late 1930s Bertil Ohlin defended the Swedish Wicksellian approach against the emerging Keynesian theory.¹⁷

Both the Austrian and Swedish variations and developments of Wicksell’s seminal ideas on money and the business cycle were submerged in the tidal wave of Keynesian macroeconomics during most of the post-World War II period.¹⁸ But in recent years there has been a renewed interest in Wicksell and his continuing relevance as found in the Austrian and Swedish variations on his themes.¹⁹ And most especially the new generation of Austrian economists has begun a revival of this insightful tradition.²⁰

Thus on the 150th anniversary of Knut Wicksell’s birth, his ideas have as much interest and offer as much insight at the beginning of the 21st century as when he was first penning them at the start of the twentieth.

Notes

1. Torsten Gardlund, The Life of Knut Wicksell (Stockholm: Almqvist & Wiksell, 1958), p. 118. The following account of Wicksell’s life and career are taken from Gardlund’s book and Carl G. Uhr, Economic Doctrines of Knut Wicksell (Berkeley: University of California Press, 1962).
2. Knut Wicksell, Value, Capital and Rent (New York: Augustus M. Kelley, 1970 [1893]).
3. This work has been partly translated as, Knut Wicksell, “A New Principle of Just Taxation” [1896], in R.A. Musgrave and A.T. Peacock, eds., Classics in the Theory of Public Finance (London: Macmillan, 1958), pp. 72–118.
4. James M. Buchanan, Public Finance in Democratic Process: Fiscal Institutions and Individual Choice (Chapel Hill: University of North Carolina Press, 1967), pp. 115–16; see also Duncan Black, “Wicksell’s Principle in the Distribution of Taxation,” in J.K. Eastman, ed., Economic Essays in Commemoration of the Dundee School of Economics, 1931–1955 (London: Economists Bookshop for the LSE), pp. 20–21: “Inside Parliament Wicksell’s principle, by requiring a high majority for an increase of expenditure and a very small minority for a reduction, would make increases of expenditure far more difficult and reductions far easier than with the normal requirement of a simple majority. The bias would be toward curtailment and reduction.”
5. James M. Buchanan, Better than Plowing and Other Personal Essays (Chicago: University of Chicago Press, 1992), p. 6.
6. Knut Wicksell, Interest and Prices: A Study of the Causes Regulating the Value of Money (New York: Augustus M. Kelley, 1965 [1898]). The ideas in this work were also summarized by Wicksell in journal form in “The Influence of the Rate of Interest on Commodity Prices” [1898] in Selected Papers on Economic Theory (New York: Augustus M. Kelley, 1969 [1958]), pp. 67–89, and “The Influence of the Rate of Interest on Prices,” Economic Journal, June 1907, pp. 213–20.
7. See Richard M. Ebeling, “Knut Wicksell and the Classical Economists on Money, Credit, Interest and the Price Level” American Journal of Economics and Sociology, July 1999, pp. 471–79.
8. Wicksell’s use and meaning of the “natural rate” of interest is not without ambiguity. See Arthur W. Marget, The Theory of Prices, Vol. 2 (New York: Augustus M. Kelley, 1966 [1942]), pp. 201–204. Marget discerned at least eight different definitions of the concept in Wicksell’s writings.
9. Wicksell, Interest and Prices, pp. xxvi, 135.
10. A detailed breakdown of Wicksell’s analysis of different “periods” under “stationary” and “cumulative” conditions, as well as some of the inconsistencies to be found in his exposition, is presented in Uhr, pp. 235–45.
11. Knut Wicksell, Lectures on Political Economy, 2 vols. (Fairfield, N.J.: Augustus M. Kelley, 1977 [1901 and 1906]).
12. Ludwig von Mises, The Theory of Money and Credit (Indianapolis, Ind.: Liberty Classics, 1981 [1912; 2nd ed.,1924; 3rd ed., 1953]); “Monetary Stabilization and Cycle Policy” in Percy L. Greaves, ed., Ludwig von Mises, On the Manipulation of Money and Credit (Dobbs Ferry, N.Y.: Free Market Books, 1978 [1928]) pp. 57–171, and in Israel M. Kirzner, ed. Classics in Austrian Economics: Samplings in the History of a Tradition (London: William Pickering, 1994), pp. 33–111; and Human Action: A Treatise on Economics, 4th ed. (Irvington-on-Hudson, N.Y.: Foundation for Economic Education, 1996), pp. 538–86; F.A. Hayek, Monetary Theory and the Trade Cycle (New York: Augustus M. Kelley, 1966 [1929]); and Prices and Production (New York: Augustus M. Kelley, 1967 [1931; 2nd ed., 1935]).
13. For an exposition of the Austrian theory of the business cycle in contrast to the traditional Keynesian theory of the Great Depression, see Richard M. Ebeling, “The Austrian Economists and the Keynesian Revolution: The Great Depression and the Economics of the Short-Run,” in Richard M. Ebeling, ed., Human Action: A 50-Year Tribute (Hillsdale, Mich.: Hillsdale College Press, 2000), pp. 15–110.
14. For an overview of the Swedish economists and their literature, see Richard M. Ebeling, “The Stockholm School of Economics: An Annotated Bibliography,” Austrian Economics Newsletter, Winter 1981, vol. 3, no. 2.
15. Gunnar Myrdal, Monetary Equilibrium (New York: Augustus M. Kelley, 1965 [1933; 1939]).
16. Erik Lindahl, Studies in the Theory of Money and Capital (New York: Augustus M. Kelley, 1970 [1939]).
17. Bertil Ohlin, “Some Notes on the Stockholm Theory of Savings and Investment” [1937], reprinted in Howard S. Ellis, ed., Readings in Business Cycle Theory (London: George Allen & Unwin, 1950), pp. 87–130.
18. For a comparison and contrast of the Swedish and Austrian contributions on the basis of Böhm-Bawerk’s and Wicksell’s theories, see Richard M. Ebeling, “Money, Economic Fluctuations, Expectations and Period Analysis: The Austrian and Swedish Economists in the Interwar Period,” in Willem Keizer, Bert Tieben, and Rudy ven Zijp, eds., Austrian Economics in Debate (London/New York: Routledge, 1997), pp. 42–74.
19. See David Laidler, Fabricating the Keynesian Revolution: Studies of the Inter-war Literature on Money, the Cycle, and Unemployment, Part I on “The Wicksellians,” (Cambridge: Cambridge University Press, 1999), pp. 25–75.
20. Most recently, Steven Horwitz, Microfoundations and Macroeconomics: An Austrian Perspective (London/New York: Routledge, 2000); and Roger W. Garrison, Time and Money: The Macroeonomics of Capital Structure (London/New York: Routledge, 2001).

Ricardo’s insight is in the news these days as talk continues about broadening free-trade agreements to the Americas and as the antitrade forces that raised their heads in Seattle remain in the spotlight.

Or perhaps it is more accurate to say that Ricardo’s insight is not in the news. For it remains misunderstood or underappreciated by almost everyone other than professional economists.

I was recently discussing comparative advantage with a student. She said that the whole concept seemed to miss the point of how trade exploits the poorer nations. In explanation, she told me that when she had lived in Nepal she had done her laundry by hand. She considered hiring a local woman to do it for her. But to pay someone the tragically low prevailing wage would be, in the student’s view, a form of exploitation. She could have chosen to pay more than the prevailing rate—an amount that she would have considered “non-exploiting.” But at that rate, it was worth it for her to do her laundry herself. So rather than “exploit” the washerwoman, the student continued to do her own laundry.

I argued that the washerwoman did not see it as exploitation. She saw it as an opportunity. Surely she would be thrilled to have the job and would be better off from having it.

Ricardo was right: both parties benefit from trade even when there are gross inequalities of skill and productivity. Ironically, the poor may have more to gain than the wealthy. My student saved herself from the indignity of paying someone a pittance in return for cleaner clothes. Her arms and shoulders got a little sore from the novelty of washing her own clothes by hand.

But the washerwoman probably paid a higher price. She may have lost an opportunity to clothe her child. She may have lost an opportunity to keep a child in school instead of sending him off to work. What my student saw as a pittance may have been life-altering for the washerwoman.

The same is true at the national level. If we closed our borders, the impact on Americans would probably be smaller than the impact on our poorer trading partners.

If we closed our borders to avoid “exploiting” the poorer nations of the world, we would face higher prices and have a lower standard of living. There would be less innovation without the spur of foreign competition. The jobs that would be available would be a little less interesting. But if we only bought things made by other Americans the impact would be mitigated by the size and diversity of the U.S. economy.

Malaysia, Indonesia, and many of our other trading partners, however, would pay a heavy price. You can see the difference by imagining more and more severe forms of protectionism in the United States.

“Buy Missourian!”

I live in St. Louis. Suppose I could buy things made only in Missouri. Life would get dramatically less interesting and a lot poorer. Missouri has some car factories, but they would get a lot smaller and be a lot less efficient if the cars had to be sold in-state. As a result, they’d be a lot more expensive. Think about the food in the grocery. If the store couldn’t import produce from California or Florida, oranges and avocados and garlic would either get a lot more expensive or they might not be available at all.

Then think of how poor life would be if I had to buy products made only in St. Louis and no imports were allowed from outside the city. I’d probably lose my job. There wouldn’t be enough students here in town to support the current number of universities here in town. A lot of us would have to become farmers if we wanted to feed our families. Houses would have to be destroyed in order to devote land to farming, pushing people into apartments. A whole string of economic changes would occur and all of them would be impoverishing.

The poorest countries are a lot like St. Louis or Missouri in that their size makes self-sufficiency extremely expensive. Trade lets them avoid that trap. Trading with them doesn’t exploit them—it allows them to escape the poverty of self-sufficiency.

The protesters of free trade would have us believe that Nike and other multinationals exploit their workers by paying low wages and creating an unpleasant work environment. Their claim would be that Nike pays pitiful wages and exploits its workers because it can.

But the workers in those foreign countries are thrilled to see a Nike factory open. They don’t stay away for fear of being exploited. People line up in China and Indonesia and Malaysia when American multinationals open a factory. And that is because even though the wages are low by American standards, the jobs created by those American firms are often some of the best jobs in those economies.

Even with trade, life is not easy for the Nepalese washerwoman or the Nike worker in Malaysia. It may make us uncomfortable at times to trade and interact with people who have such hard lives. But lack of education and marketable skills, not trade, are the cause of that hardship. Trade helps poor nations and their workers accumulate a bit of wealth and comfort. That in turn allows the poorest of the poor a chance to keep their children in school. It allows them the possibility of a brighter future. To deny them the opportunity to trade is the ultimate exploitation.

It would be hard to overstate how important Menger was in the development of economic science and, indirectly, the freedom philosophy. He valiantly defended economic theory per se against those (the socialist German historical school) who insisted there is no such thing. Menger, who died in 1921, patiently demonstrated that indeed there are economic regularities—laws—defiance of which would have undesirable consequences.

Beginning with his Principles of Economics (1871), Menger outlined a new kind of economics, one that, for instance, rejected the labor theory of value. Israel Kirzner, dean of the modern Austrian school, points out that Menger radically undermined the prevailing Ricardian approach to economics. In David Ricardo’s influential system, Kirzner writes, economic phenomena are determined by “objective, physical realities. . . . In the explanation of such determination there is no place for any roles for human resourcefulness, human valuation, human expectations, human discoveries.

“Menger, on the other hand, glimpsed a way to understand economic history in diametrically opposed terms,” Kirzner continued. “[I]t is the impact of the actions of human beings that alone actively determines the course of human events. . . . It was Menger . . . who recognized that it is the consumer valuation of output that tends to be reflected in the market prices of the relevant inputs. . . . Every act of production, every market transaction, is set in motion and wholly governed by consumer preferences.”

Menger’s insight is intimately related to his other contributions: subjective value, methodological individualism, and marginal utility (which he is credited with originating independently, along with two other economists, Léon Walras and William Stanley Jevons).

It was Menger’s vision that inspired the great economists who followed him: Böhm‑Bawerk (see below), Wieser, Mises, Hayek, Kirzner, Rothbard, and the later generations of Austrian economists who are today making their marks.

“What is common to the members of the Austrian School,” wrote F. A. Hayek, “what constitutes their peculiarity and provided the foundations for their later contributions is their acceptance of the teaching of Carl Menger.”

* * *

Politicians make hay out of bashing health maintenance organizations, whose bean counters are said to be issuing life-and-death medical decisions. But political opportunism masks a rather significant fact: the politicians foisted HMOs on the American people in the first place. Twila Brase revisits the recent history.

Hate crimes legislation is being pushed allegedly to protect groups based on race, ethnicity, sex, and sexual orientation. But groups that historically have been the objects of the most virulent hatred are never included in the legislation. Our new contributing editor Lowell Ponte rights this grievous wrong.

Why do certain interests in a community organize to keep Wal-Mart out? They come up with a host of reasons, but as Timothy Terrell shows, they don’t amount to much.

Early in the twentieth century, England had a race of sorts between airships produced by private enterprise and by the government. The outcome is instructive. Frank Laffitte has the details.

What goes by the label “liberalism” today is a far cry from the original political philosophy of that name. Jim Peron journeys to the essence of the freedom philosophy.

Great Britain at last has a written bill of rights. What’s it all mean? Norman Barry sorts it out.

Does Tiger Woods hold any lessons for economics? Raymond Keating sees the young golf phenom as a microcosm of the free market.

One hundred fifty years ago this month, Eugen von Böhm-Bawerk, one of the founding fathers of the Austrian school of economics, was born. Richard Ebeling contributes an appreciation of this giant of an economist and debunker of Marx.

We are constantly being agitated by supposed threats to our privacy from corporations trying to sell us products that may make our lives more pleasant. Far less attention goes to threats originating with the protector of our privacy: the government itself. James Plummer counts the ways we are threatened by our protectors.

Part of the folklore of the Wild West is that bank robberies were common. But according to Larry Schweikart, we shouldn’t confuse the Hollywood back lot with the towns of the American West.

This month’s columns cover a wide range of topics. Donald Boudreaux finds courage in neglected places. Lawrence Reed audits the government’s schools. Doug Bandow tells budget horror stories. Dwight Lee shows how the economy “equates at margin.” Mark Skousen rates economics encyclopedias. Charles Baird sees special privileges for public safety unions. And Andrew Coulson, reading an argument for the merits of a federal takeover of education, responds, “It Just Ain’t So!”

Our book reviewers evaluate volumes on the environment, political monopoly, life under Stalin, maritime power, school reform, and junk health science.

My neighbor is a kindly man with the pink and white complexion of a healthy turnip—and the generosity of a squash plant in dark loam. He has two green thumbs and big hands with long fingers obviously designed to pluck weeds.

Like most southerners, there’s an agricultural limb on his family tree. Even though currently he’s an engineer, every spring he hears the earth calling and he responds with tiller, fertilizer, and eventually seed, resulting in a 300-square-foot reproduction of the Garden of Eden minus the snake and the naked newlyweds. The gentle mist of an automatic sprinkler system substitutes for the Tigris and Euphrates.

I, too, have horticultural ambitions. Or at least I used to. I tried for years to install a garden. But the mineral resources of my backyard were only rusty nails and shingles left by the builder. And my garden skills were minimal. I much preferred puttering around in the kitchen. I’d rather stew a chicken using my secret recipe that features Caffeine-Free Diet Pepsi than pull weeds.

Out of this neighborhood diversity arose my first experience with that anthem of free-trade economists—David Ricardo’s theory of comparative advantage—thereby demonstrating that economic theory has a down-home value to cookers of chicken as well as captains of industry. The comparative advantage theory says that self-sufficiency is a myth. Nations and individuals should specialize in those activities they do best. It’s a good deal for the United States to supply pharmaceutical products to Japan, which sends us TVs that we buy with the yen we receive for our medicines. Likewise with individuals. An accountant doesn’t weave shirts or cobble shoes or raise beef. He spends his accounting wages for those products.

Specialization determined by resources and skills is the watchword. Don’t salinize the Mississippi River so you can grow Nova Scotia Salmon. Have a fried catfish filet instead, and if you still lust for salmon, import it. It’s OK, says the theory, to buy Japanese TVs and sell those big Boeing jets to the Japanese.

My adventure with David Ricardo—the nineteenth-century economist—began one afternoon as I inspected my cement yard—Hell’s Half Acre—after a three-week drought. My jovial neighbor yelled a hearty hello from his suburban Eden—a manicured yard framing a cornucopia of squash, pole beans, and tomatoes that flourished under the mist of his regulated sprinklers.

“Come on over and get ya a couple tomatoes for supper,” he shouted.

And I did, which brought a warm ambience to my home since my wife was a homegrown-tomato addict. She had long complained about my garden shortcomings.

But now, so what if I was a clumsy klutz among the tomato stakes. In some wily way, due to my intra-neighborhood skills, I put fresh sliced tomatoes on the breakfast, lunch, and supper table. Life was good.

One day, while biting into a No. 3 Better Boy, it occurred to me that common decency and the need for a continual flow of tomatoes required some reciprocal generosity on my part. And since my backyard was as barren as Sodom and Gomorrah after the fireworks, and since I couldn’t grow a dandelion in a pile of potting soil, I’d better come up with a creative substitute.

Aha, my famous Stewed Chicken with the secret recipe I would pass on to my children as a rich inheritance and the major part of my estate. The secret is the exotic flavoring of one small turnip. Perfect. I had culinary talent and a freezer full of frozen chicken dating back to the ice age.

So—every week I’d carry a plateful of Spécialité de la Maison to my obliging neighbor and return with my pot full of those scrumptious No. 3 Better Boys. My wife, with an expectant grin (and knife and plate in hand), greeted me at the backdoor with a kiss. Yes, the theory of comparative advantage was everything David Ricardo said it was.

Let me stress that at no time in my pre-tomato days did I ponder my lack of tomatoes and conclude that this nineteenth-century theory was my solution. I was totally innocent of the science of economics. To me, David Ricardo sounded vaguely like a Latin bandleader. Only later, when my son, the University of Chicago-educated economist (and Ideas on Liberty columnist), showed me his recent book on foreign trade did I appreciate my independent discovery. Kids! They think they know everything.

All this time I thought I was swapping stewed chicken for tomatoes, but what was really going on was a classical bubbling of the theory of comparative advantage as described by a nineteenth-century trade theorist.

Hmmm—my neighbor on the other side sure has some nice-looking peaches hanging on his peach trees. Wonder if he likes stewed chicken with a tinge of turnip?

Smith’s conclusions were generally accepted among economists until the twentieth century, when developments in economic theory reversed the conventional wisdom and led economists to advocate central planning and government control as a better way to produce prosperity, especially among less-developed economies. At the end of the twentieth century, economists seem to be turning back to the ideas of Adam Smith. How could they not, especially after the collapse of most centrally planned economies around the world? Yet, driven by abstract economic theory, there still remains a challenge to the idea that laissez-faire policies best promote economic growth.

Adam Smith made the case that prosperity is produced through a competitive market economy. In such a setting, Smith noted in one of his more famous observations, individuals pursuing their own interests are led as if by an invisible hand to do what is best for the whole society. To promote resource allocation in competitive markets, Smith advocated low taxes and government expenditures, the protection of private property rights, and low tariffs to promote international trade. In other words, Smith argued that if a market environment were created and maintained, the economy would grow and prosper.

A few decades later, David Ricardo advocated the lowering of tariffs to promote free trade as a route to prosperity, supporting his arguments with his famous book, Principles of Political Economy, first published in 1817. Ricardo is perhaps best known for showing how everyone ends up better off when people specialize in the activities in which they have a comparative advantage and trade with others. The arguments of Smith, Ricardo, and others brought a reduction in government intervention in Britain and elsewhere, leading to a freer world economy and making the nineteenth century an era of unprecedented economic growth.

Another View on Growth

Although the idea that economic freedom leads to economic growth was not challenged directly, it nonetheless fell by the wayside earlier this century. That was due partly to developments in economic theory and partly to world events. Around the turn of the century, methods in economics began to more closely resemble the hard sciences, especially physics. Economic theory was developed through increasingly complex mathematical models. The economics profession supported those changes, believing that a more scientific understanding of the economy could produce better policies and even more prosperity. In mathematical terms, an economy’s output could be depicted in a production function, where output is a function of inputs such as land, labor, and capital. More inputs produced more output, and the production function was able to show in clear mathematical terms the relationship between inputs and outputs.

When the world was beset by the Great Depression in the 1930s, the development of economics had already traveled far along this path. The National Bureau of Economic Research was established in the 1920s to produce better economic data to allow for more scientific management of the economy. The Keynesian revolution hit economics with the publication of John Maynard Keynes’s The General Theory of Employment, Interest, and Money in 1936. Keynesian economics argued that modern economies need active government policies to manage them and to maintain prosperity. After World War II, those two developments in economics conspired to completely turn around the conventional wisdom on economic growth.

Worried about the possibility of another depression after the war, mainstream economists argued that the government needed to manage the economy in order to maintain prosperity. Economic growth, a significant part of economics since Adam Smith’s day, declined in importance relative to the goal of promoting macroeconomic stability. Growth remained an important issue with regard to less-developed economies, however, and economists believed that they could engineer economic policy to produce growth in those economies in the same way they could do so in the developed world.

The most sophisticated economic models, both then and now, depicted a straightforward mathematical relationship between inputs—land, labor, and capital—and economic output. Thus, economies could grow more rapidly if they increased their inputs. In addition, increased efficiency might allow an economy to produce more output from the same quantity of inputs. Then and now, economists have envisioned increases in efficiency as products of technological advances. The most advanced economies would have to develop better technology through research and development, but less-developed economies may be able to grow simply by adopting the technology of developed economies.

The focus on inputs, coupled with an increasing acceptance of government management of the economy, led economists to recommend government planning as the best way to create growth in less-developed nations. Central planning, they said, could guarantee that economies invested a sufficient share of their incomes, could direct that investment to sectors that would add more value to the economy (for example, away from agriculture and natural resources, and toward manufacturing), and could ensure that the new investment embodied the most advanced technology.

Institutions such as the World Bank and the International Monetary Fund encouraged central planning in less-developed economies and pushed capital investment and adoption of modern technology by offering financial support to less-developed economies headed in that direction. Even in relatively free-market economies like the United States, economic experts supported those types of policies to create economic growth in less-developed nations. Regrettably, the nations that followed such policies did not grow, despite following the advice of the most prominent economists of the time. They would have done better to look back to the advice of Adam Smith.

The Two Views on Growth

Consider in more detail the differences in the two views on growth described above. Both sound plausible, and neither one could really be called wrong, but one view leads to good economic policy and the other leads to bad policy. Why? The twentieth-century approach to growth theory focuses on the inputs of the growth process. If we combine these inputs, it reasons, we will get this output. The Smithian approach looks at the economic environment that is conducive to growth. Following Smith’s line of reasoning, an environment of economic freedom is the key to growth. The problem with the production-function approach is that it ignores the market mechanism that gives people an incentive to combine resources in a way that creates value for others.

Inputs are necessary to produce output, but without the right incentives, it is too easy to combine inputs in a way that makes the final output less valuable than the original inputs. In a market economy we take for granted that production leads to an increase in wealth, because firms that produce output less valuable than their inputs take losses and go out of business. Thus, in a market economy most firms create output more valuable than their inputs. In a centrally planned economy, the government can continue to misdirect inputs into inefficient production arrangements, perhaps not even realizing that resources are being squandered. Policy-makers who designed development policy based on the production-function view of the economy failed to realize that it accurately represented the way that resources were allocated only within the framework of a market economy.

By focusing on the environment conducive to economic growth, the Smithian view pays less attention to inputs. However, Smith also recognized that the invisible hand of the market, if allowed to work within an environment of economic freedom, will do an effective job of allocating resources. Public policy need not be concerned with the production of capital, the incorporation of technology, or the development of a skilled labor force if that conducive environment is created. The economy will attract investment and provide the incentive both for workers to obtain marketable skills and for the adoption of more advanced technology. The right environment will attract the right inputs, but providing the right inputs will not create the right environment. If growth policy focuses on producing an environment of economic freedom, growth will follow. Without the right environment, growth will not occur, period.

Evidence Relating Freedom and Growth

Casual (but persuasive) evidence relating economic freedom and economic growth abounds. After World War II, Korea was divided: South Korea fostered a market-oriented economy, while North Korea maintained a centrally planned economy. As this is being written, many citizens of North Korea are starving because their economy is failing, while South Korea has one of the fastest-growing economies in the world. Similarly, after World War II, Germany was divided into East and West Germany, and again the one with the market economy prospered while the one with the centrally planned economy fell behind. Less than a decade ago, East and West Germany were central players in the cold war that threatened to erupt into World War III. East Germany eventually surrendered to West Germany without a shot being fired, because people in the East wanted to have the advantages offered by West Germany’s economic system.

The former Soviet Union took the production-function model of growth very seriously, so the late empire provides an especially compelling example of the model’s limitations. It invested heavily in physical and human capital, producing a highly trained and educated work force. It also invested heavily in research and development, placing great emphasis on science and engineering. By increasing the quality and quantity of its capital and labor inputs, and creating technological advances, the Soviet Union, according to the production-function approach, should have had one of the world’s fastest-growing economies. Instead, it serves as an example that growth cannot be created by increasing inputs into the production process alone. More inputs lead to an increase in the value of output only when combined within an environment of economic freedom.

In light of their recent prosperity, it is easy to forget that nations like Japan, Taiwan, South Korea, Hong Kong, and Singapore were poor only a few decades ago. Nations that shunned the market system in favor of central economic planning, like the Soviet Union, China, and India, had economies that languished. Now that those formerly socialist countries are moving toward economic freedom, their economies have started to grow. The casual evidence is so clear that there is now a worldwide movement toward more economic freedom. Yet, as compelling as this casual evidence is, it still leaves open the question of what, exactly, the components of economic freedom are, and how much effect they have on economic growth.

A number of recent academic studies have helped shed light on this issue. The most in-depth examination of economic freedom is a study by James Gwartney, Robert Lawson, and Walter Block, Economic Freedom of the World: 1975-1995, published in 1996 by the Fraser Institute. They develop a good numerical measure of economic freedom and show that it is strongly correlated with economic growth. Other academic studies have produced similar results, providing evidence that an environment of economic freedom will attract the inputs necessary to produce economic growth. Those studies examine many other factors, but conclude that the key ingredient is economic freedom. After a century in which the theory of economic growth had moved steadily away from the ideas of Adam Smith, economists are now returning to them to show how economic freedom is vital to prosperity.

Economic Freedom and Political Freedom

After the collapse of the centrally planned economies of eastern Europe in 1989, followed by the demise of the Soviet Union in 1991, most of those nations enthusiastically embraced the principles of Western democracy, hoping political reforms would lead to Western-style prosperity. People in the West offered encouragement, but they supported democratic government more enthusiastically than laissez-faire economic institutions. Thus, it is especially important to understand what is meant by economic freedom as compared to political freedom, and what can be expected from both. While democracy is valuable in its own right, the evidence suggests that democracy by itself makes no contribution to prosperity. Economic freedom produces economic growth; political freedom does not.

This point is especially important in light of the expectations of those in emerging democracies. The citizens of those countries are being set up for a disappointment. If the nations that recently turned to democracy find that their economic conditions are not improving, they may turn their backs on democracy, opening up the opportunity for a return to dictatorship.

The evidence shows that economic freedom leads to economic growth even where countries have limited political freedom. The reverse is not true: political freedom, without economic freedom, does not bring growth. Therefore, it is vitally important that emerging democracies encourage free markets, protect property rights, provide a stable currency, and minimize the government’s role in the economy. There is also evidence that nations with higher incomes tend to be more democratic and more protective of civil liberties and political freedoms. Thus, indirectly, economic freedom leads to political freedom.

The evidence clearly shows that without an environment of economic freedom, growth will not take place. Economic freedom contains a number of components, all of which must be in place for an economy to grow. An economy must have a stable monetary system, secure private property rights, an impartial legal system, low taxes, minimal government, and low barriers to international exchange. If any of these components are missing, an economy will not grow.

—George Reisman^[1]

Adam Smith . . . shunted economics on to a false path. . . . Under Ricardo, this unfortunate shift in focus was intensified and systematized.

—Murray N. Rothbard^[2]

Until the Keynesian revolution in the 1930s, most economists taught the sound principles of classical economics: free trade, balanced budgets, the gold standard, and laissez faire. Adam Smith (1723-1790), the founder of classical economics, has been lionized as the foremost exponent of these principles. David Ricardo, Thomas Malthus, and John Stuart Mill, among others, have played supporting roles.

Many free-market economists congratulate Adam Smith for his profundity and wisdom in The Wealth of Nations, published in 1776. His work almost singlehandedly destroyed the mercantilist arguments for protectionism and other forms of government intervention. George Stigler concludes, It’s all in Adam Smith.

In his monumental new book Capitalism, George Reisman carries on this tradition of extolling the virtues of Adam Smith and David Ricardo (1772-1823). In his judgment, there are four great economists, whom he ranks in the following order: Ludwig von Mises, Adam Smith, David Ricardo, and Eugen von Bohm-Bawerk. Although he does not ignore their weaknesses, Reisman considers Smith and Ricardo great economists who have been much maligned.

Rothbard’s Challenge

But consider Murray Rothbard’s critique of classical economists in his two-volume work Economic Thought Before Adam Smith and Classical Economics, published at the time of his death in January 1995. He lambastes Smith, Ricardo, and Mill, among others, arguing that the classical economists moved away from the sound doctrines and theories previously developed by pre-Adamites such as Richard Cantillon, Anne Robert Turgot, and the Scholastics. According to Rothbard, Adam Smith’s contributions were dubious, he originated nothing that was true, whatever he originated was wrong, and The Wealth of Nations is rife with vagueness, ambiguity, and deep inner contradictions.^[3] He has little better to say of Ricardo and Mill.

How can free-market economists see things so differently? Having read both Reisman and Rothbard, as well as the major works of Smith and Ricardo, I have an answer: Smith and Ricardo were largely right on policy, but often wrong on theory.

A Critique of Classical Economics

If you look at the theories developed by the classical economists, you can easily find fault. Smith advanced an exploitation theory of labor, referred to the work of ministers, physicians, musicians, orators, actors, and other producers of services as unproductive, frivolous occupations, and made a distinction between production for profit and production for use. All of these Smithian concepts gave ammunition to Karl Marx and other socialists.

Ricardo furthered the Marxist cause by implying that profits could only increase at the expense of workers’ wages, which tended toward the subsistence level. As rents earned by idle landlords increased, profits would decline, he predicted. He also invented what economists call the Ricardian Vice, whereby theorists build models based on false and misleading assumptions that lead inexorably to the desired results. Ricardo used this device to prove his labor theory of value. As a result, some commentators have identified Ricardo as the source of today’s highly abstract, mathematical, and ahistorical theoretical model-building.^[4]

Positive Contributions

Despite these theoretical blunders, Smith and Ricardo were consistent defenders of laissez-faire capitalism. Smith ably defended the right to immigrate. He opposed minimum-wage laws, and argued for lower taxes and a simpler tax code. War was bad for the economy, according to Smith. He pleaded for balanced budgets. He spoke favorably about saving and capital investment. His invisible hand doctrine declared that the voluntary self-interest of millions of individuals creates a stable, prosperous society (what Smith called natural harmony) without the need for central direction by the state. Smith viewed free-market capitalism overall as socially humanizing and prosperous, while Marx saw capitalism as dehumanizing and alienating. Smith eloquently promoted the principle of natural liberty, the freedom to do what you wish without interference from the state. His words literally changed the course of politics, dismantling the old mercantilist doctrines of protectionism and human bondage. The Wealth of Nations was the ideal document to accompany the Industrial Revolution.

Despite his pessimism about the future, David Ricardo favored a strict 100 percent gold standard, was opposed to public welfare and the corn laws, and was a firm believer in free trade.

In short, the classical economists had much to offer the world. Their theories weren’t always on target, but they usually proposed the right solution.

1. George Reisman, Capitalism (Ottawa, Ill.: Jameson Books, 1996), p. 2.

2. Murray N. Rothbard, Classical Economics: An Austrian Perspective on the History of Economic Thought (London: Edward Elgar, 1995), p. xi.

3. Rothbard, “The Celebrated Adam Smith,” Economic Thought Before Adam Smith (London: Edward Elgar, 1995), pp. 435-6.

4. For critiques of Ricardo, see Graeme Donald Snooks, Economics Without Time (Ann Arbor, Mich.: University of Michigan Press, 1993) and Elton Mayo, The Social Problems of an Industrial Civilization (Cambridge, Mass.: Harvard University, 1945).