ECS3705 STUDY NOTES SUMMARY AND EXAM PREP 2021.

ECS3705 STUDY NOTES SUMMARY. History Of Economic Thought. French mercantilism differed from its English counterpart in two main ways. First, it had a stronger feudal flavour, meaning that its policies and regulations were also aimed at protecting the interests of the landed nobility in addition to the interests of the merchants. That is why tolls and other restrictions on intranational trade were part of mercantilist state regulation in France too. Second, French mercantilism was probably stricter, more elaborate, more intrusive and more crippling than anywhere else in Europe. Add to that the exceptional corruptness of French state officialdom as well as the court extravagance and wasteful warring of its Bourbon kings, and one can understand why France had become desperately poor at the time (second half of the 1700s, 2007:33-34). The physiocracy was the first anti-mercantilist movement in Europe, which sought to rebuild France, primarily by liberating its agriculture from mercantilist restrictions and tax burdens, but also by making government less corrupt and wasteful. Physiocracy means “rule of nature”, as its advocates believed in the existence of natural laws which, when given the chance, would spontaneously steer the economy towards harmony and prosperity – a philosophical idea which also underlied Smith’s economics as we will see shortly. The detailed direction of economic life by a coercive government was therefore considered unnecessary as well as harmful, which one can understand given the particularly stifling nature of French mercantilism. And remember that government intervention was, at the time, used primarily to favour the interests of the rich and powerful rather than the poor, which is indeed not uncommon even in modern times! For a more detailed examination of the policies and ideas of the Physiocrats, the textbook’s “Overview of the physiocrats” (2007:33-37) is once again comprehensive as well as fairly easy 20 to follow. Only Quesnay’s tableau economique (economic table) may be a bit more challenging, for which we will, therefore, provide some additional explanation. Otherwise, just a few remarks as “asides” will suffice. The physiocrats overcame mercantilist bullionism by acknowledging that wealth consists of useful goods rather than precious metals. But they added to this sound idea the odd idea that only those goods produced in the primary sector (mainly agriculture, but also mining and fisheries) contributed to the national product. Manufacturing, trade, finance and the professions were considered sterile, meaning that the value of their output was merely equal to the cost of production, no extra value being added. The potentially tremendous contribution to national wealth of manufacturing, especially when industrialised, was thus insufficiently appreciated by the physiocrats, although their emphasis on laissez-faire and their proposed freedom of taxation for all non-landowners unwittingly gave scope for industrialisation. Nonetheless, when an economy lies in complete ruins, it is not a bad idea to start rebuilding it by focusing on its agriculture - then, at least, people have food to eat and a surplus is created to feed people involved in non-agricultural pursuits, like manufacturing and trade. The mistaken idea that only production in the primary sector adds value seems to be based on the erroneous view that only tangible, material goods are useful and that intangible, immaterial goods (services), therefore, have no value. After all, the secondary sector (manufacturing) merely reshapes the tangible raw material obtained from the primary sector and, as such, adds no matter and thus seemingly no value to its end products, while the tertiary sector (trade and services) produces intangible, immaterial goods. The textbook (2007:35) argues that the physiocratic preference for taxing the rent received by landlords is based on the mistaken notion that “only agriculture ... produced a surplus”. But this seems just a part of the story. While the physiocrats did not question the right of landlords to receive rent as a reward for the capital expended to originally acquire the land (see 2007:40- 42), they also regarded rent as partially unearned income, which is part of the reason why they wanted to tax it as well. And the physiocrats would be correct to a degree. Landlords did run a risk on the capital invested when originally obtaining the land: the risk that land values drop (if land is held speculatively) and the risk that land is farmed irresponsibly by tenants, leading to soil erosion or other forms of permanent land degradation. Landlords obviously also ran a risk on the capital invested in land improvements such as fencing, irrigation, fertilisation and the built-up structures like farmhouses and barns. Rent rightly compensated landlords for these kinds of risk. But rent clearly compensates for more than only these risks. It is also a reward for contributing the original productive powers of the soil, which, in so far as the land is farmed responsibly, are everlasting and therefore not subject to depreciation. When there is no depreciation, nothing is given up to merit a reward. The portion of rent which is a reward for contributing these original productive powers of the soil (and the sun), therefore, does seem to constitute unearned income, as also indicated by the simple fact that human beings do not cause the plants to grow or the animals to increase. It is this unearned portion of the rent that the physiocrats wanted to tax away. Adam Smith, who had been influenced by the physiocrats, significantly remarked in this regard that “landlords, like all other men, loved to reap where they did not sow and demand a rent even for [land’s] ... natural produce”. One should, of course, be cautious about saying the same of modern farmers, like farmers in South Africa, who cultivate their own land - by contrast, the landlords of physiocratic times were not cultivators of their land. They merely owned and rented it out to tenants who did the real farming. Even so modern farmers’ incomes do also contain, according to the physiocratic logic, a portion of unearned income, although it may be argued that farmers anyhow lose that unearned income in the form of taxes paid on earned income. 21 ECS3705/1 RELEVANCE FOR TODAY The 19th century American economist Henry George (mentioned and criticised by the textbook, 2007: 36, 270) proposed to tax away the value of unimproved land (the pure site value of land expressed as an annual rent) for redistribution and social spending, while scrapping all other forms of taxation. Apart from whether George’s proposal is practicable, which is open to debate, he does tackle an issue of potentially great relevance to our region. Henry George’s classic work is entitled Progress and Poverty, and is still worth a read for those who are interested (although some of the analysis is flawed). Very briefly, George advocated that land be privately owned but that private land owners compensate all other citizens for the right to exclude them from their parcel of land by paying an annual rent representing the naked site-value of land (the value of land net of man-made improvements). The pool of funds thus collected could then be used for social spending or evenly distributed over all citizens as some kind of a basic income grant. Land does seem unique in that, unlike any other good, it is not man-made (it is a gift of nature), is fixed in supply and its site-value is, in part, socially determined by the spill-over effects from how others use the surrounding land parcels and from the public infrastructure available on surrounding land parcels. Your lecturer is not yet fully convinced that George’s ideas are practicable, but it does seem worthy of closer investigation, especially since land ownership is such a hot and divisive issue in South Africa with the potential of creating major and very damaging social strife. It is interesting that a free-market advocate like Friedrich Hayek is surprisingly complementary about Henry George’s ideas: “[George’s proposals] seems to me to the present day the most defensible of all socialist proposals and impractical only because of the de facto impossibility of distinguishing between the original and permanent power of the soil and the different kinds of improvements.”2 The textbook (2007:36,270) criticises George’s policy proposal on the grounds that it reduces the market price of the site value of land to virtually zero which would cause major losses to people who had just bought land for large sums of money. The criticism could, however, be overcome by giving people tax credits up to the value of the price they originally paid for the land as an interim measure. The textbook (2007:35) mentions how the physiocrats sought to replace the complex indirect tax system of the mercantilists with a simpler system of direct taxation on rent. We take it you understand the difference between direct and indirect taxation. Direct tax is tax on income (in the form of profit, rent, wage or interest), while indirect tax is a tax on goods, like our modern VAT, import duties or excise tax on alcohol and tobacco. We provide some additional explanation of Quesnay’s tableau economique (see 2007:37-40), not only because Figure 3-1 may be somewhat confusing but also because the figure nicely sums up some of the main ideas of the physiocrats. For that purpose, we introduce three income-spending statements, for tenant farmers (productive class), landlords (proprietor class) and manufacturers/traders (sterile class) respectively. The numbers used in these statements correspond with those used in Figure 3-1. 2 Hayek, F.A. (1994). Hayek on Hayek; An Autobiographical Dialogue, edited by S. Kresge and L. Wenar. Chicago: University of Chicago Press, p.63. 22 Tenant Farmers (productive class) Income: Spending: Sales of agricultural goods to landlords 1 billion livre Purchases of manufactured goods from manufacturers/ traders 1 billion livre Sales of agricultural goods to manufacturers/traders 2 billion livre Surplus (=rent) paid to landlords in this period 2 billion livre Total 3 billion livre Total 3 billion livre This period’s total agricultural production is 5 billion livre (the livre was the pre-Revolution French money unit), of which 2 billion is cost of production in the form of seeds and food needed by the tenant farmers themselves. So tenant farmers sell only 3 billion worth of agricultural produce, as can be seen from the total on the left-hand side of the statement. Of that 3 billion, they sell 1 billion to landlords and 2 billion to manufacturers and traders, as can also be seen from the left-hand side of the statement. Tenant farmers used their 3 billion income to buy 1 billion worth of manufactured goods from manufacturers/traders, while the remaining 2 billion is rent, which they pay to the landlords. See right-hand side of the statement. The next income-spending statement is that of the landlords (proprietary class). Landlords (proprietary class) Income: Spending: Previous period’s rent from tenant farmers 2 billion livre Purchases of manufactured goods from manufacturers/ traders 1 billion livre Purchases of agricultural goods from tenant farmers 1 billion livre Total 2 billion livre Total 2 billion livre Their rent income (see right-hand side of the statement) of 2 billion corresponds with the 2 billion rent which tenant farmers pay to landlords, except that this 2 billion is rent paid during the previous period, while the 2 billion rent paid by tenant farmers during this period is only income for landlords during the next period. Note that periods repeat themselves in a uniform manner. Landlords spend their 2 billion rent income on 1 billion worth of manufactured goods from manufacturers/traders, and 1 billion worth of agricultural goods from tenant farmers, which is also recorded on the income side of the tenant farmers. As you can see from this incomespending statements, landlords do not generate a surplus. In accordance with physiocratic ideas, only tenant farmers do. Lastly, the income-spending statement of manufacturers/traders (the sterile class): Manufacturers/traders (sterile class) Income: Spending: Sales of manufactured goods to landlords 1 billion livre Purchases of agricultural goods (including raw material) from tenant farmers 2 billion livre Sales of manufactured goods to tenant farmers 1 billion livre Total 2 billion livre Total 2 billion livre Their income from selling manufactured goods to landlords and tenant farmers also appears as spending categories in their income-spending statements. Manufacturers’ spending on agricultural goods, which comprises food for the manufacturer and raw material for his production, are also recorded as income for tenant farmers above. You notice that the cost and the sales value of their production are equal (2 billion livre), which illustrates how the 23 ECS3705/1 manufacturing sector is supposed to be “sterile” in the sense of not producing a surplus. Again, only the tenant farmers produce a surplus in physiocratic thought. Of course, it is easy to shoot holes in the Tableau. For instance, how would any manufacturer be able to accumulate capital to finance implements and tools, if he or she cannot make a genuine profit. Why would one want to expend the extraordinary effort of running a business if there is hardly any profit incentive? Even so, Quesnay’s Tableau is important in that it was the first attempt to highlight the interconnection between economic sectors. As such it is a rudimentary form of national-income accounting and input-output analysis. The Tableau also expressed physiocratic concerns about the non-interruption of the circular flow of the net product, which they believed was achieved when the investments made by tenant-cultivators got back to them so that the same amount of investment could be repeated and agricultural production could expand to the benefit of society at large. These are foreshadowings of modern Keynesian concerns about leakages from the circular flow of money, which could lead to a contraction of aggregate investment or aggregate demand in general. We pay more detailed attention to the income-spending circulatory stream at the macro level in our discussion of Say’s Law and of Keynes below. The physiocrats were also modern, in that they already recognised the phenomenon of tax shifting (see 2007:37, 42-43). Tax shifting occurs, for example, when a manager of a big corporation makes his salary demands in after-tax terms, which means that the income tax is effectively borne by the firm rather than the manager on whom it is levied. The physiocrats argued that all taxes were eventually borne by the landowners because of tax shifting, so that one might as well tax their income directly. Their reasoning was based on the idea that everybody apart from landowners more or less operated on a subsistence income and so already paid the maximum they could afford - any income losses would mean starvation. Price increases due to taxation would, therefore, eventually reduce rent paid by the tenant-cultivators to their landowners. In general, the degree of tax shifting, as with the passing on of any cost increase, depends on the relative market power of those on whom it is levied. For example, when management skills are scarce, managers may have the market power to shift their tax payments onto firms and negotiate their salary in after-tax terms. Similarly, continually living on a minimum salary awkwardly gives one bargaining power to shift one’s increased taxes forward, assuming that others, eventually landlords, do not wish you to starve. Take note of Hume’s disagreement with this argument (see 2007:57). Instead, Hume believed that wages are determined by demand and supply and that competitive relations in the labour market are not always such that workers live on the bread line or have no bargaining power whatsoever other than the threat of starvation. The fact that the physiocrats wished to tax only landlords but not craftsmen or merchants should obviously not be taken to mean that they were somehow pro-craftsman and pro-merchant and anti-landlord, although some landlords of the time would undoubtedly have accused them of exactly that. If anything, the physiocrats looked rather askance at merchants in particular, questioning whether trade adds any value to goods. The physiocrats argued that, because of tax shifting, all the tax would anyhow be carried by the landlord, and that using the landlord’s rent income as the tax base would simply be a more convenient way of collecting tax plus a way of keeping the price of agricultural products low, which was in the interest of all classes of society (see 2007: 42-43). The section on Turgot (2007:40-43) makes interesting reading, even if it does not have a great deal of extra information about physiocratic ideas. The textbook (2007:37) speaks of the “dauphin of France”; the “dauphin” is another name which the French used for their crown prince, the heir to the French throne. 24 RELEVANCE FOR TODAY: It is interesting to note that the main leaders of the physiocratic movement, Quesnay and Turgot, came from the class of aristocratic landowners themselves. Apparently they were able to overlook the narrow interests of the class into which they were born for the sake of justice and the broader interest of France as a whole, which is to be admired indeed. South Africa could do with a few more politicians and business leaders like that. ECONOMICS IN ACTION: LOOKING BACK Have Tom and Sipho stopped arguing already? THE CLASSICAL SCHOOL AND CLASSICAL FORERUNNERS • Chapter 4: Only the sections "Overview of classical school" (pp 45-49) and "David Hume" (pp .54-57). ECONOMICS IN ACTION Classical liberalism is now regarded as a conservative ideology. But at its inception it was seen as very progressive and even subversive to the status quo as dominated by mercantilist ideas. As an introduction to the classical school, consider the following imaginary reflections of a typical mercantilist government official who notices, with alarm, the increasing popularity of classical liberal ideas. “These liberals, these rascals! They think they do our Kingdom a favour by removing all proper government controls on entry into the crafts, do away with all controls on the price and quality of the goods produced and cancel all controls on trade between nations. Every Tom, Dick and Harry can now become a candlestick maker and sell his candlesticks at any price he wants. How will the public know that the candlesticks are of the required quality? And how will existing candlestick makers be able to make a living if anybody with half an idea of how to make a proper candle can sell his rubbish at any price to the unsuspecting public? And how can it serve the interest of our country if foreigners are allowed freely to sell their products in our country and so take the jobs and incomes away from our own people? It is ridiculous! This newfangled idea of giving the uneducated masses the freedom to do what they want is a recipe for disaster. How can there be order in the chaos of freedom? We, of the old school, brought peace and order to this country. We made sure that things were done properly, with a proper price for a properly produced good. Liberty is fine as far as it goes, but surely you can’t give unrestricted liberty to the uncivilised masses, the majority of which do not know what to do with it anyway. It will be chaos, I am telling you! The vices of greed and licentiousness will go rampant! And now the liberals want to grant people the liberty to practice their own self-invented religion too. What is next? There should be one religion, the True Religion, and the King should make sure that everybody practices it in the proper way. Imagine all the nonsense that people will start to believe in if you allow them to believe what they want? Chaos, I’m telling you! Just now they want to follow that mischievous new country, the United States of America, and give the rabble the right to elect the government of their choice! Sedition, that is what it is! What will happen to our beloved King?! What has become of the world? Where will I find another job at my age ...?” Question: After having studied the “Overview of the classical school”, how would you evaluate the ideas of this conservative mercantilist? To what extent should the government curtail freedoms in an effort to protect its citizens against their own ignorance or folly, and to what extent should the government allow people to make their own decisions with the implication that they may need to suffer the negative consequences of these decisions? What alternative, non- 25 ECS3705/1 governmental controls on economic life are possible? CONTENT As mentioned in the introduction, the classical school began with the publication of Adam Smith’s The wealth of nations, which was published in 1776 and dealt a death blow to mercantilism. Nonetheless, as is often the case with scientific breakthroughs, many of the central ideas were already formulated by others in partial or rudimentary forms. Once more, Grant and Brue’s (2007:45-49) “Overview of the classical school” is clear enough so we do not need to add much by way of additional explanation; also, much of its content is repeated and elaborated on when the textbook discusses the classical economists themselves, like Smith, Ricardo and Mill. This is not to say these sections are less worthy of careful study. Grant and Brue’s (2007: 45-47) discussion of the two “revolutions” that contributed to classical liberal thought – the scientific revolution and the industrial revolution – is particularly interesting and revealing. A careful reading of these sections will give you an appreciation for the fact that both were real revolutions: they dramatically changed the way people thought (scientific revolution) and lived (industrial revolution) at the time. The industrial revolution, among other things, caused the demise of traditional handicraft production in favour of factory production, which has a major impact on social life; it further shifted economic power and wealth away from agriculture towards industry and trade; and it dramatically increased urbanisation and stimulated large-scale agriculture. We will just clarify a few terms here. Just as the concept of monopoly refers to a market form where there is only one supplier, so the concept of monopsony (2007:49) refers to a market in which there is only one demander. Both monopolists and monopsonists would have almost total power to set the price in their markets. The textbook (2007:49) refers to public goods being “indivisible”, which is an unusual way of describing them. Public goods are more commonly described as non-excludable and non-rival. Non-excludability means that non-payers cannot be excluded from the benefits of these goods when they are provided, like the benefit of defence against foreign aggression by an army. Nonexcludability thus implies the problem free-riding. Goods are non-rival when their increased consumption by some does not diminish their availability to others. The general idea is that unless public goods are provided by the state, they tend not to be provided at all. Hence there is an argument that such goods should be provided by the state and financed out of taxation. The services of military defence and lighthouses are often used examples. Of the classical forerunners, you only need to study Hume (2007:54-57). Pay particular attention to Hume’s price specie-flow mechanism, with which you should already be familiar if you have taken a course in international trade. The price specie-flow mechanism suggests how surpluses and deficits on the balance of payments trigger forces which will cause the balance of payment to spontaneously revert back to equilibrium. The basic presupposition of this mechanism is that the exchange rate between local and foreign currencies remains more or less unchanged, which is to be expected if local and foreign money units (say, the pound, euro, or dollar) reflect given amounts of precious metal, as they did at the time. If we then assume, for example, a surplus on the balance of payments, the resultant increase in the local money stock will cause local prices to rise, which will make exports less and imports more competitive, which, in turn, will eventually cause the surplus to dwindle and equilibrium on the balance of payments to be restored again. When exchange rates are flexible (as they are in modern times), an important part of the necessary adjustment in import and export prices is brought about by changes in the exchange rate, which may cause the balance of payment to revert back to equilibrium quicker and with less impact on the local money supply, and hence on local prices. Hume, of course, used the 26 specie-flow mechanism to show how surpluses on the balances of payments cannot be maintained indefinitely, so that mercantilist policies to stimulate the inflow of bullion (monetary gold and silver) by way of the stimulation of exports and the discouragement of imports are unsustainable and self-defeating. Hume’s controversial assertion that the difference between rich and poor nations would eventually even out is interesting. As Grant and Brue (2007: 56) correctly emphasise, there is a kind of self-reinforcing tendency according to which rich nations get richer and poor nations poorer. Because rich nations accumulate more capital, they can grow faster. This growth, in turn, expands the size of their market, which creates scope for further investment, innovation and growth. Moreover, rich nations are able to lure away the best talent from other, poorer nations, which adds impetus to their wealth-creating ability. But, as Hume already noted, there are also contrary forces. For one, prices and labour cost tend to be higher in richer nations, which creates an opportunity for poorer nations to supply technologically unsophisticated, labour-intensively produced goods at a price which is competitive and attractive in the richer nations’ markets. The profits generated in this way can then be used to accumulate capital, which enables poor nations steadily to move into more capital-intensive, more technologically sophisticated production. Taiwan, South Korea and China have successfully applied this very strategy over the last couple of decades – a strategy which was already identified by Hume. However, it presupposes a deliberate low-wage policy (at least at the initial stages), which may not be feasible in South Africa where the difference between rich and poor is already so stark. Ironically, China could enforce a low-wage policy, because its government was, and still is, communist and in that sense completely authoritarian. ECONOMICS IN ACTION: LOOKING BACK Classical liberalism, with its emphasis on individual freedom, private property and minimal government, is alive and well today. Yet it is also under stress. Societies are struggling to strike a balance between individual rights and individual responsibilities, between “society owes me” and “I owe society”, between allowing people make their own decisions and not allowing them to hurt the common good, and between the wealth of the few and the poverty of the many. Somehow it seems increasingly difficult to strike such a balance, mainly because the irresponsibility of some (say, a few Wall Street bankers) tend to have increasingly large negative spillovers for many. 27 ECS3705/1 STUDY UNIT 2 Adam Smith Study the following prescribed material in the textbook: Chapter 4: only the “Overview of classical school” (pp. 45-49), again All of chapter 5, excluding “5-1 Past as prologue” (pp. 75-76) STUDY OUTCOMES When studying this unit, you should aim at gaining knowledge and understanding of the following: • The main tenets of the Enlightenment worldview. • How both the Theory of Moral Sentiments and the Wealth of Nations suggest different ways of reconciling individual freedom with the achievement of the common good. • How the division of labour enhances productivity and ultimately leads to mechanisation and industrialisation. • How the size of the market limits the division of labour. • The meaning of Smith’s concept of self-interest and how that concept may be differentiated from pure selfishness or greed. • Why in modern capitalism competition is less likely to guide private interests towards the common good than in Smith’s time. • The two main reasons why, according to Smith, state interference is likely to be ineffective in furthering the common good. • The forms of state interference which Smith, nonetheless, advocates. • Smith’s argument in favour of free international trade. • Smith’s distinction between value in use and value in exchange. • The meaning of the water-diamond paradox, why it caused Smith to focus on value in exchange and ignore value in use (utility). • The distinction between relative price and absolute nominal price, and the role it plays in Smith’s labour theory of exchange value. • The distinction between short-term market price and long-term natural price, and the role it plays in Smith’s labour theory of exchange value. • The sense in which Smith’s labour theory of exchange value is applicable to an “early and rude state of society”. • How, according to Smith (and Hume), the general price level is determined by the quantity of money in circulation. • The wages-fund theory, and why it is more applicable to an agricultural society than to a modern industrial society. • On what grounds Smith disagreed with the low wage doctrine of the mercantilists, and the “iron law of wages” of later classical authors. • Smith’s determinants of the wage structure in a free society. • Smith’s view of profit as the reward for risk-taking. • How the classical authors in general insufficiently distinguished between profit and interest. • Why profit rates, according to Smith, tend to be lower in rapidly advancing nations than in poor stagnating nations, which can be more than offset by the lower wages paid in poor nations. 28 • After having studied Ricardo: how Smith’s theory of rent is similar to Ricardo’s. • How Smith’s anti-bullionist stance caused him to underestimate the contribution of money to wealth creation. • The grounds on which Smith opposed the rising national debt of his day. • The virtuous circle implicit in Smith’s ideas, according to which increased productivity and wealth creation leads to even greater increases in productivity and wealth creation. • Smith’s distinction between productive and unproductive labour