Tuesday, July 8

A brief history of economics

Economics aims to determine optimum efficiencies or outcomes from competing wants, which exceed available resources, but overlaps social and political philosophy.

The key determinants for optimum outcomes involve policy assumptions based on the so called laws of supply and demand, the effect of interest rates, aggregates in relation to the circulation of money, the role of exchange rates and how agencies regulate markets.

But policies and theoretical economic models are routinely hijacked by corruptive power and the difficulty of obtaining and interpreting reliable data.
Notwithstanding, the adoption of orthodox economics, supportive of market freedom, but subject to prudential controls and embracing international trading, is suggested by most economists to be an important factor in improved standards of living. But such an advantage may be overstated in lieu of the significant contribution made from the advancement of scientific and technological knowledge.

Early beginnings
Economics was not a word used in indigenous communities, but its application within their non-technological existence was impressive.
Possibly Australian aborigine’s trade between nations represented one of the few really effective free markets. Like indigenous groups elsewhere, they traded ceremonial artefacts, tools, skins, grain and even water rights within respective nations, using interpreters and negotiators to secure trade agreements.
A United Nations approach was employed to ensure optimum outcome from the countries limited resources, so that as crops prospered or game became scarce seasonally in one area it was traded in exchange for goods available in another, just as modern economics champions free trading.

But within the western world complexity was increasing as new scientific discoveries underpinned industrialization, in tandem with the Renaissance, the Protestant Reformation, the age of enlightenment and colonization.

Philosophers reasoned this increased complexity in the management of state affairs could best be served by applying scientific knowledge, based on the assumption markets represented rational outcomes.

The Industrial Revolution
As society became transformed by the mechanised Newtonian world, evident in the mass production of goods and services, philosophers concluded this complexity must conform to laws, yet to be discovered, which, once unearthed would enable optimum policy settings to be determined. 

Scottish philosopher David Hume, who was an influencer of Adam Smith, who wrote “Wealth of Nations”, argued vehemently against the Mercantilists who believed the best way for a nation to gain wealth was to restrict imports and exert total control over exports to maximise gold accumulation in the home country.
Under this system the American colonies were forced to supply all the raw materials for Britain to manufacture into the finished goods which were re-exported to the colonies, at an exchange rate highly favourable to Britain, a significant factor in fuelling a world war.
Wealth of Nations
Adam Smith expanded on Hume’s ideas and introduced the term “invisible hand”, to describe how the market made decisions regarding supply and demand. This led him to a rational theory governing outcomes in respect to aggregates for production, consumption, distribution and their effects on markets.
He concluded people generally acted out of an enlightened self-interest so that the market is mostly able to achieve (by virtue of the “invisible hand”) optimum outcomes. He also championed thrift and saving as a virtue maintaining a national savings pool provided the engine room to support investments which flowed on to improve production and ultimately lead to enhanced living standards.
He concluded there need only be a limited role for government; in defence, education, public works and the operation of the law. He sought to align a nation’s currency with the holdings of precious metals, to ensure the government’s ability to depreciate its currency was curtailed. This was the seeds of the so called “gold standard” where a countries external liabilities were always to be matched by a nations central banks holdings of gold.
Smith was also a moral philosopher, who reasoned his economic theories represented favourable outcomes for the nation and for world trade.

John Stuart Mill
The English philosopher and utilitarian, John Mill made a significant contribution, who supported free markets but was amenable to taxes to be imposed on services and was in favour of a flat tax system for everyone paid the same percentage of taxation. 
His book Principles, which was first published in 1848, and, like “Wealth of Nations” was widely acknowledged and accepted well unto the next century. He concluded that economic democracy arising in the form of worker cooperatives was superior to capitalism.  

The Twentieth Century
A significant contributor in the immediate post World War 2 period was Samuelson, whose ideas became widely accepted in the aftermath of the frightful memories of the Great Depression and war. Samuelson reinforced the earlier work of John Maynard Keyes, whose motivating force was how to avoid a repeat of the horrors of the Great Depression. Keyes had lost his fortune on the stock market and set about determining what measures could be taken to reverse recurring slumps in the trade cycle and mitigate against the over buoyant conditions that preceded the inevitable contraction.
What Keyes and Samuelson concluded was that both monetary theory (supply of money and interest rates) and fiscal policy (taxation and spending measures) could be used as tools to overcome the excesses of the trade cycle; if inflationary pressures persist taxation and interest rates can be increased , whilst stimulatory measures can be employed to reverse contraction. The idea was also for governments to build surpluses in times of stability which could be employed in the event of contraction or external shock.
Keyes recognized the pivotal role of investments, and the effect of the investor multiple which represented a multiple of many times consumption which it sought to satisfy. Keyes was a supporter of government regulation, as a necessary lever in guarding against and offsetting excesses; for regulatory agency bodies to have responsibility to ensure prudential standards were maintained.

However as a result of rising inflationary pressures due to the oil shock of 1973, as a consequence of supply restrictions imposed by the OPEC nations, economies faced soaring unemployment as energy costs escalated and businesses reduced their operations. This situation posed a crisis for Keynesian economics, since his model called for stimulatory measures in the face of a contraction and rising unemployment, but which if implemented at that time would have only aggravated already rising inflation. Of course nations could have simply opted to institute price control subsidies to reduce fuel prices and inflation until the prices of oil stabilized and returned to normal historical trends. Prior to this turning point Keynesian economics had dominated policy in almost all capitalist governments.  

Economic schools of thought
Hence this crisis in Keynesian economic “orthodoxy” fuelled interest in emerging different schools of thought, as the monetarists in the USA gained ascendancy.
It is helpful to examine the effects on both microeconomics and macroeconomics.

Microeconomics is concerned with the choices of individuals who will pay less for a commodity when they have more of it and more when they have abundance; applied to free markets consumer’s choices determine prices, rather than firms.  It is only when firms hold monopolistic powers are they able to exert pricing power over consumers. Of course, the values we hold collectively are unlikely to always coincide with this simplistic economic principle, so that economists now attempt to categorise consumer and business choices into sub groups in a concerted effort to more accurately define aggregated totals.     
Macroeconomics is concerned with the aggregates of production, supply, distribution, money supply and so forth, where we encounter the divergent schools of thought. Along with the diminished Keynesian economics, the Monetarists and others such as the Austrian school placed more emphasis on uncertainty and is critical of many of the modelling theories .
Monetarism, was the brain child of Milton Friedman whose philosophical thrust was stability can be maintained by exercising control just over the supply of money and central banking. Inflation in the seventies dominated economic debate and monetarism simplistically attributed its root cause to an excessive monetary supply by a central bank and for the reverse to be the cause of recessionary cycles. The simplicity of such a new found philosophy was popular with politicians, as it reduced the onus of regulation and policy to just the supply on money, which became popular in the US.
Australia –embracing economic reform within Keynesian economics.
In the earlier post war period the government exercised control over leading economic settings, so that exchange rates were set by the regulatory authorities, who also imposed conditions over lending, setting interest rates, tariff rates and banking.

It was not until the seventies that tariffs were reduced by 25% to open up the nation to overseas competition but the pace of reform increased markedly under the Hawke/ Treasurer Keating labour government of the eighties.
During this period massive changes were instituted, with bipartisan political support, to float the Australian dollar, reduce tariffs, reform the tax system, introduce an enterprise bargaining system for wages outcomes and to privatize previous publically owned companies such as Qantas and the Commonwealth Bank. Later national superannuation was introduced to play a significant role in increasing our national savings pool.

More recently the Howard liberal Government established the GST , and presided over a period of government surpluses arising from the mineral boom, to establish a future Fund once federal government debt was eliminated.

During the global financial crisis the Rudd labour Government employed classical Keynesian investment stimulatory expenditure to counteract any adverse consequences, to ensure the economy remained strong.

 Keynesian philosophy in favour elsewhere
There is a growing realisation that placing all your faith in markets, reducing regulation and having a very loose monetary policy with declining interest rates to discourage savers and fuel reckless lending was a major determinate in the outset of  the Global Financial Crisis.
Furthermore notable economists such as Joseph Stiglitz, James K. Galbraith, Robert Shiller and Paul Krugman have all been critical on monetarism and have argued for a return to Keynesian economics.

Modern day economics – the use of quantitative easing.
Quantitative easing is an unconventional branch of stimulatory monetary policy used when low interest rates has proven to be ineffectual in reigniting sluggish economies, QE has been employed in the US, the UK and the Eurozone, where real risk free interest rates are virtually zero, and in Japan to reflate its economy and reverse deflationary pressures.
QE does not initially involve the printing money, since the volume of cash in circulation is unchanged, as no new financial assets are added to the private sector. How it works is a central bank such as the Federal Reserve in the US, buys a quantity of Treasury notes or bonds ( hence the word quantitative ) from the commercial Banks, who afterwards have a corresponding lesser value of bonds held but more in reserves, to facilitate more lending. Depending on the quantity of different maturing securities bought relative yields can be influenced to make short term commercial interest rates more favourable to longer term or vice versa. After the transactions the central banks holding in government securities increases, according to the quantity purchased, with a corresponding liability to the selling bank. This process is often referred to as expanding its Balance sheet, since it is increasing its assets (securities bought) whilst simultaneously increasing its liability to the banks. No money changes hands as only a credit is registered in the central bank as the amount owing to the commercial banks for the assets purchased.
Banks themselves, have always had the ability to create money through leverage as their lending is always a multiple of capital and reserves, (typically a factor of about 10) so that through quantitative easing they are able to create money once they engage in increased lending.
The ongoing criticism of quantitative easing is that it has continued on for too long, from the early days when it could be argued it was a valid policy response to counter the curtailment of credit before and after the global financial crisis. Then credit was contracting sharply as corporates and individuals deleveraged from the excesses of previous reckless lending that preceded the global financial crisis.
What critics of quantitative easing claim is it is creating distortions with asset inflation and  we need to begin winding back from QEs – the longer we wait the more painful the adjustment. The move to scale back will most likely result in a reduction in the value of many inflated asset classes as interest rates begin to increase to reflect long term mean averages.
Growing inequality.
What is not always acknowledged is that economics originally arose not only as a tool to ensure superior outcomes and improved wellbeing for a nations citizens but more importantly to underpin moral values. In this regard Smith rallied against the unethical stance of the mercantilists, whilst later Keyes and others concluded your cannot legislate against human greed and fear, but you can, with improved regulation, afford control over inevitable excesses, to champion prudential management, under government agencies supervision.

More recently economists, such as Joseph Stiglitz, continue in this tradition to make the case growing inequality in income distribution (evident mostly abroad), is not only an undesirable social objective, but economically is irresponsible. In the US for instance, according to Stiglitz,  one in four people in the US will now be born into a family that will be unable to afford even reasonable nutritional standards or heath care which will substantially impede any future growth. In the US wages are not the problem but a lack of demand emanating from contraction of the middle class and an ineffective tax system. Even in China, which has, in the last 35 years of attempted to emulate a market based economic system under centralist communist oversight, produced inequality which increases the risk the sustainability of past impressive growth.

Inequality increased under coalition’s first budget in Australia
The incoming coalition’s first budget was designed to meet the structural decline in the economy following declines in investments from the mining boom and as a consequence the fiscal challenges from a reduced tax base. But the budget represented a piecemeal approach, with no tax reform but a general notion it was unfair, to overall represent about a negative .3% drag on the economy.
Notwithstanding the latest developments, inequalities have continued to grow, but albeit at a vastly subdued rate compared to most other countries. According to economist Judith Sloan, who recently appearing on Q & A on the ABC, the drift is mitigated by the nations efficient tax and transfer system which redistributes 30% of income to those on lower incomes. The end result is real gains after inflation for the past 23 years for the bottom percentile of  27 % compared to 33% gain for those in the top quartile. The latter increase, might well be explained by enhanced income opportunities arising from higher education.
But Sloan is also critical of the recent first budget to impose a 6 month waiting period for those under 30 to receive unemployment benefits. An alternative would be to provide a relief to employers to employ say the unskilled at a rate below the current minimum wage (about $33,000 pa) but above current unemployment benefits for a period up until they became skilled and are entitled to minimum compensation. In other words, similar to apprenticeships, imaginative solutions need to employed to offer hope to young people and avoid Australia flowing on the folly of accepting the very high rates of evident in much of the world today.

Whilst the US has only just reached the level of employment that existed just before the advent of the GFC, the new jobs are mostly in in the lower paid category and hence they represent people who are unable to save, many of whom are referred to as the working poor, unable to afford basic heath or possibly nutrition, Elsewhere, as in the US, successive governments ran up huge deficits, to exhaust all reserves, so that the last resort was is in the use of quantitative easing.
Making up for decades long of unsustainable spending and failure to ensure sound economics presents a formidable challenge ahead, but accelerated tapering in relation to quantitative easing, with a goal to completion in the next year will help remove the present distortions in asset inflation and restore incentives for savers as rates return to normality.   
A national savings flow is now also essential to sustain future investment and to begin to build up a reservoir to employ against any unexpected further external shocks. Although corporate balance sheets are in much better shape now tax on earnings is hampered by the ease to redirect earnings to low tax regimes, further exasperating respective countries tax collections.
This requires a concerted effort by respective government’s regulatory agencies to ensure multinationals pay a fair share of tax.
Governments also need to revert to more imaginative means pf employment, particularly for the youth and older displaced workers, with the reintroduction of Keynesian style investment expenditures.
But placing more emphasis on savings and investment in expanded resources and people will require a change in policy mix and the prospect of raising taxes of one kind or another likely to be an anathema within current political debate.

The additional investment in both people and facilities to counter downturns or sluggish economies is just as it was first envisaged by Keyes so it remains even more relevant today.


susan said...

This was a very well written explanation of economic thoughts and practices these past few hundred years. One thing none of them are dealing with currently is that we're living in a world whose resources are finite, a fact that makes infinite growth impossible. Would you agree?

Lindsay Byrnes said...

Yes – that is true, but I would also argue good economics was never promulgated on a theory of endless growth, but rather to find the best most economical outcomes. But I can appreciate how one could readily gain that impression from economist’s constant references to growth in GDP etc. That is always predicated on endless growth.
Hence economics aims for smarter outcomes and improved productivity in keeping with a finite earth. Economics is now beginning to put values on our habitat and the environment so that it makes economic sense to ensure we have sustainable economies. As I mentioned in the first post, it also makes sense to put a price on carbon and pollution, which then ensures the most effective market based mechanism to support moral outcomes. Economics as such is only a helpful tool, to enhance optimum outcomes.
Best wishes