HCJ FOUR: (Economics) Smith to Keynes

History of Economic Theory

18th century:

Adam Smith and free trade:

“Civil government, so far as it is instituted for the security of property, is in reality instituted for the defense of the rich against the poor, or of those who have some property against those who have none at all.”  – Adam Smith.

Smith said the root of human morality was in money. Smith’s great work, The Wealth of Nations, was first published in 1776 and  offers one of the world’s first collected descriptions of what builds nations’ wealth. The book reflects over the economics at the beginning of the Industrial Revolution and touches on topics such as the division of labour, productivity and free markets.

Key points:

Division of labour caused a greater increase in production than any other factor. It arises not from innate wisdom, but from humans’ propensity to barter.  Limited opportunity for exchange discourages division of labour. Because “water-carriage” extends the market, division of labour, with its improvements, comes earliest to cities near waterways. Civilisation began around the highly navigable Mediterranean Sea. Before coinage, people had to weigh and assay with each exchange, or risk “the grossest frauds and impositions.”

Smith gives two conflicting definitions of the relative value of a commodity. He defines the value of commodities by the labour embedded and also by the labour a good commands:

“What every thing really costs to the man who wants to acquire it, is the toil and trouble of acquiring it.”

Smith gives a second definition of value:

“The value of any commodity … is equal to the quantity of labour which it enables him to purchase or command. Labour, therefore, is the real measure of the exchangeable value of all commodities.”

Smith argues that the price of any product reflects wages, rent of land and “…profit of stock,” which compensates the capitalist for risking his resources. When demand exceeds supply, the price goes up. When the supply exceeds demand, the price goes down.

Free trade is a policy in international markets in which governments do not restrict imports or exports.

Smith argued that free trade eventually makes all actors better off. This argument is the modern Free Trade argument. In 1779 Smith was consulted by politicians Henry Dundas and Lord Carlisle on the subject of giving Ireland free trade.

The Radical MP Richard Cobden as a young man studied The Wealth of Nations. Cobden campaigned for free trade in his agitation against the Corn Laws (to protect cereal producers from less expensive foreign imports).

Malthus and the Iron Law of Population:

Thomas Robert Malthus wrote the book, An Essay on the Principle of Population, which was first published in 1798.  Its 6th edition was independently cited as a key influence by Charles Darwin in developing the theory of natural selection. A key portion of the book was dedicated to what is now known as Malthus’ Iron Law of Population (based on the iron law of wages). This theory suggested that growing population rates would contribute to a rising supply of labour that would inevitably lower wages. In essence, Malthus feared that continued population growth would lend itself to poverty.

Engels and Marx argued that what Malthus saw as the problem of the pressure of population on the means of production actually represented the pressure of the means of production on population. Engels called Malthus’s hypothesis “…the crudest, most barbarous theory that ever existed”.

19th century:

Ricardo and The Labour Theory of Value: (contrary to Smith and the Physiocrats)

Classical economist David Ricardo’s labor theory of value holds that the value of a good (how much of another good or service it exchanges for in the market) is proportional to how much labor was required to produce it, including the labor required to produce the raw materials and machinery used in the process.

Ricardo agrees with Smith’s first definition of the value of commodities by the labour embedded. However, Ricardo disagrees with Smith’s second definition of value as he believes that the value of reproducible commodities and services reflects the relative difficulties of production counted in labour units: direct labour plus the dated labour of the past embedded in inputs (capital) and corrected by interests. 

Ricardo’s labor theory of value is not a normative theory, as are some later forms of the labor theory, such as claims that it is immoral for an individual to be paid less for his labor than the total revenue that comes from the sales of all the goods he produces.

Karl Marx and Ricardo shared the (value) theory that the cost of production is relative to the exchange value based on scarcity. However, value theory combined with the Neo-Malthusian doctrine advocating control of population growth created an internal ‘contradiction of capitalism’ thus giving an inability of system to socialise surplus value that resulted crisis and revolution. This was essentially a recurring crisis of over production and under consumption.

After 1848, the crisis was averted with expansion of markets, emigration, new supplies, gigantic efficiency gains of mechanisation, electrification and from the 1890s there was the Golden Age of American economic expansion providing a new source of capital investment. America then saw the appearance of “The Robber Barons” (wealthy and powerful 19th-century American businessmen), Monopoly Capitalism and the success of Pulitzer and Hearst (Citzen Kane).

Wealth then continued to grow due to:

  • The Gold Rush (1849) – (also Australian and South African gold mines – new supplies of gold kept the supply of money sufficient.
  • In 1844, Sir Robert Peel passed the Bank Charter Act which nationalised the money supply and allowed expansion of paper currency.

Gold backed currency was central to classical economic policy – “sound money” – because it allowed the price system to be purely nominal (no “money effect” on the real economy).

The world economic depression the 1880s was attributed by Alfred Marshal (c. 1900) to the drying up of goldmines in California and Australia (and hoarding in India and China).

The Quantity Theory of Money means that too tight money supply will reduce number of transactions and cause unemployment. There was thus a need for government to use its monopoly of banking (in 1844) and interest rates to regulate the quantity of money and keep it in line with the liquidity needs of the real economy.

In terms of fiscal policy (taxation and government spending), the Classical approach is to regulate only the bond market and therefore interest rates. Preference is for the ‘balanced budget’ approach to fiscal policy (government spending/ taxation).


John Maynard Keynes was an influential British modernist thinker and economist. His movement of economics was a rejection of classicism towards subjectivism. In the 1930s, Keynes spearheaded a revolution in economic thinking, overturning the older ideas of neoclassical economics that held that free markets would, in the short to medium term, automatically provide full employment, as long as workers were flexible in their wage demands.

Keynes argued that aggregate demand determined the overall level of economic activity, and that inadequate aggregate demand could lead to prolonged periods of high unemployment.

According to Keynesian economics, state intervention was necessary to moderate “boom and bust” cycles of economic activity. He advocated the use of fiscal and monetary measures to mitigate the adverse effects of economic recessions and depressions.

In summary, for Keynesians as/more important is the use of fiscal policy to regulate AGGREGATE DEMAND – In the budget year there is talk of the PSBR figure (Public Sector Borrowing Requirement).

Theory of utilitarianism is that in trying to optimise your own benefit you think will optimise everyone’s benefit (John Stuart Mill) but Keynes discovered that this isn’t true.


  • More active state (Neomercantilism from 1880s onwards; Protectionism).
  • State spending and social democracy, extended franchise (particularly Germany).
  • Legacy of the National Workshop concept (1848 – Socialism, Social democracy).
  • The political significance of Socialism, Social Democrats, Trade Unions.
  • First socialist party governments are in Germany 1880s; but Bismark also inaugurates “Welfare state” – active state to integrate/subjugate the new German Empire after 1871 (e.g. Alasce Lorraine; East Prussia) – similar story after the American ‘civil war’ – “reconstruction” (ie conquest) of the Southern states. Partly this is political – romantic nationalism, ‘nation building’, imperialism. These things can only be done by the state on a Neo-Mercantilist basis. Especially true of Protectionism movement in England – Chamberlain, Imperial Protection, Imperial Tax tariffs to promote the integration of the British Empire (same thing done now in EU and from Lincoln onward in the USA).
  • North American “State-Capitalism” (later The New Industrial State – the “Military Industrial Complex”) in the conquest of the west – railway companies, later oil companies working with the federal state (the Sod Busters vs the Ranchers and Rail Monolopies – large scale industrial farming, cowboys, John Wayne, etc.
  • Trade wars and competition for colonies and markets – First World War.
  • Origins of the New Industrial State (Galbraith).
  • Sociological aspects, the rise of bureaucracy – Max Weber:
  • Partnership of the economically active state (trend towards fascism, and ‘social fascism’).
  • State spending – manipulation of money supply.
  • Marshal and Fisher (Cambridge School) – the ‘active’ role of money (contrary to classical view of money is purely nominal, with prices finding natural level through the action of free markets for goods and for money itself (banks issuing own currency, linked to gold reserves).

20 century: 

The 1920s:

  • German Hyper-Inflation, resulting from ‘printing money’ (not backed by gold standard).
  • The Roaring 20s – deficit spending for the war led to money supply expanding – the multiplier/accelerator effect – led to speculation and rising prices – “when your cab driver starts giving you share tips, it is time to sell up”.
  • The stock market crash and the great depression.
  • The neo-classical view – “temporary market correction”.

The answer to unemployment is always to reduce the cost of:
1. Wages
2. Money itself (interest rates)

  • Reduce wages must have labour mobility (e.g. migration, education), and no trade unions, no unemployment benefit (Cobbet, Dickens and The Work House, the Poor Law report of 1842. Then all the labour will be re-employed.
  • At same time there is a need to reduce government spending to create downward pressure on the interest rates via the bond market. So ‘cut government waste’ and raise taxes (and tuition fees for example, which is really a ‘stealth tax’). This is the classical economics prescription.

In 1925 Winston Churchill went back on the gold standard saying that the collapse in world trade was due to too cheap money – the exact opposite says Keynes of the reality – ‘deflation’ (gold standard or high interest rates caused by ‘tight’ fiscal policy, was a complete disaster say Keynes) and all modern economists, even most neo-classicists (who would probably favour a free market in money, with banks issuing their own currency – this is a bit like credit cards, and like the way that in third world countries shop will accept dollars, pounds, yen or whatever rather than the local currency, and there will in fact be a ‘black’ (informal) market in money itself.

Keynes says devalue the currency and issue money – this will bring unemployed resources back in to play, companies and consumers will have money in their pockets so people can be employed.


Gross Domestic Product (Y) = Household spending (C) + Private Investment (I)+ Government Spending (G)
Y = C+ I+ G

This is achieved by government spending (issuing bonds); taxation only/mostly to manage demand – to cut off inflationary expenditure (e.g on luxury goods). Taxation is NOT to raise money; but to fine tune the money in pockets of particular groups of people and manipulate behaviour (e.g health and housing policy).

PROBLEMS (of the New Industrial state – identified by both Galbraith (pro-Keynesian; and Hayek and Anti-Keynesian):

1. Inflation and ‘stagflation’ – unemployment returns ‘caused’ by inflation (Chicago School/Austrian School – Hayek and Milton Friedman) – ‘neo-classical’ – also called ‘Monetarism’.
2. Increased role of the state; a decline of freedom (Road to Serfdom)
3. Destruction of profitability in (eg private medicine)
4. Orientation towards arms spending and militarism (‘Military Keynesianism’)
5. Collapse of rational expectations – sticky wages, prolonged unemployment/stagflation
6. Lame ducks, picking losers, protectionism, failure to innovate, scarcity of real investment funds, bureaucracy, racism (The Road to Serfdom)
7. Central government planning undermines democracy, because depends upon a technocratic elite of economists and statisticians – a “new priesthood” policies are not subject to General Will (they are the technically correct) so politics becomes an empty sham about ‘benefit fraud’ and ‘government waste’ (ie – we are going to reduce aggregate demand in order to re-structure interest rates in he bond market) or ‘education, education, education’ or Trident (increasing aggregate demand).
8. Cheap credit, asset inflation leading to ‘credit crunch’ bank failures leading to credit shortage, uniersal bankruptcy, possible currency collapse, possible social collapse (Ireland, Greece)

The Grapes of Wrath by John Steinbeck


First published in April 1939, Steinbeck’s The Grapes of Wrath won the National Book Award and Pulitzer Prize for fiction, and was cited prominently when Steinbeck won the Nobel Prize in 1962. The genre is considered as: epic; realistic fiction; social commentary. The narrator is an anonymous, all-knowing, historically aware consciousness that is deeply sympathetic, not only to the migrants but to workers, the poor, and the dispossessed generally.

The narrative is set in Oklahoma, California around the late 1930s. Tom Joad is the protagonist in the novel and the major conflict surrounds the disastrous drought of the 1930s that forced farmers to migrate westward to California, pitting migrants against locals and property owners against the destitute. Tom Joad’s story dramatises a conflict between the impulse to respond to hardship and disaster by focusing on one’s own needs and the impulse to risk one’s safety by working for a common good.

Themes include man’s inhumanity to man; the saving power of family and fellowship; the dignity of wrath; the multiplying effects of altruism and selfishness.


The bank represents the bureaucracy described by Weber and those working for it don’t necessarily want to take the land but they have to as it is their ‘job’. This reflects a Hobbesian society in which the bank rules and all give everything over to it in order to survive. Marx is mentioned in the book as being the result of Mass Industrialisation. As people group together, their society takes on the form of Communism.

In the struggle for survival, the fittest win out at the expense of their rivals and this is shown  as the Joads survive all of the challenges when many others die (like when the floods come). This is known as Darwinism.

Nietzsche developed one of the first sustained critiques of mass culture and society, the state, and bureaucratic discipline and regimentation. Nietzsche is not a worshipper of the State but a passionate individualist and a believer in the hero. He has no regard for the masses like John Stuart Mill and would therefore have no sympathy for the masses in the novel who are desperately unhappy due to lack of jobs.

Adam Smith believed that:

“Every man is, no doubt, by nature, first and principally recommended to his own care; and as he is fitter to take care of himself than of any other person, it is fit and right that it should be so.”

Despite this, there are still those who value family and help others as is shown at the end of the novel with Rose of Sharon helping the old man who is dying – even though she has just suffered the loss of her stillborn child.

Ricardo talks about supply and demand and here there are too many workers for the jobs. The dust ball at the beginning of the book is a sign of over population described by Malthus as a crisis. It was indeed over population of the land  that forced people to move away to survive.

In combating this crisis, America started to put money back into the economy by means of building infrastructure that employed a lot of people. This is Keynesian philosophy as it is through putting money back into the system and digging holes to fill them again that crisis is averted.

About brackenstockley

Contributor to the JusticeGap and WINOL. Currently studying journalism at the University of Winchester (Year Three).
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