Classical and Neoclassical Economics

The Origins of Systematic Economics – a Supply-Side School of Thought

An Article in the Compendium of Market-Based Social-Ecological Economics

Key issues in view of the neoliberal crisis:
How can we guarantee employment and fair income?
How can we protect the environment effectively?
How should we shape the economic globalization?
What should the economic sciences contribute?
What must be the vital tasks of economic policy?
How can we legitimize economic policy democratically?

Click here for the list of all articles: Compendium
Click here for the German-language version: Klassische und Neoklassische Lehre

Table of Contents

  1. Abstract
  2. Review and Explanation of Terms
    > Classical and Neoclassical Doctrine are Largely Identical
    > Classical and Neoclassical Doctrine Differ in One Point
  3. The Classical School of Thought
  4. The Neoclassical School of Thought
  5. General Criticism
  6. The Helplessness of Economic Schools of Thought
  7. Outline of a Sustainable Paradigm of Globalization
  8. The Conclusion is Unequivocal

1. Abstract

Economic policy debate is still dominated by economic theories, which have proven to be of limited use even under the former conditions of national autonomy. The backward-looking is determined by classical, neoclassical and Keynesian notions, which, with increasing »market liberalisation«, only provoke fruitless permanent disputes. Nevertheless, dealing with historical theories can help to better classify current developments and point the way to a sustainable economic paradigm that reconciles economic globalization with social welfare.

2. Review and Explanation of Terms

Systematic economics begins with the Scottish moral philosopher and national economist Adam Smith (1723 to 1790). His main work »An Inquiry into the Nature and Causes of the Wealth of Nations« forms the basis for the Classical doctrine, which emerged in the 18th century. In the middle of the 19th century, the classical was replaced by the neoclassical doctrine, which in turn was superseded by keynesianism for a few decades starting in the 1930s, until it was replaced by monetarism in the 1960s, starting with the failure of the post-war economic order (the failure of the Bretton Woods System) and, until it finally experienced a renaissance in the 1970s in the form of modern neoliberalism.

Classical and Neoclassical Doctrine are largely identical:

Firstly, they are both based on an ideal-typical economic player who always has complete information and foresight at his disposal and who makes his decisions selfishly and rationally in order to achieve the greatest possible personal gain or benefit as a producer or consumer. For this fictional player, who does not correspond to today’s perception of human behavior, the term homo oeconomicus is coined in the 19th century.

Secondly, both schools of thought make use of Smith’s metaphor of the invisible hand, which is intended to symbolize the »mysterious« function of free markets, which (supposedly) do not require central control: players produce goods and services for strangers to whom they do not owe any care, or, conversely, acquire goods and services from strangers. They do this because they are guided exclusively by their self-interest in order to achieve the greatest possible personal gain or benefit in competing and exchanging with each other, but at the same time – unintentionally and inevitably – serve the common good. In current neoliberalism this metaphor is often interpreted as if any regulation and control of markets would represent a sin against the principles of the market economy.

However, the market economy is only future-proof if it ensures that players can persue their self-interest and desire for freedom within the framework of politically agreed social and ecological regulations and thus contribute to the well-being of society and the environment.

Thirdly, in that both schools of thought assume completely flexible prices, wages and interest rates, with the consequence that all markets are always cleared (each supply finds its demand), i. e. markets are striving for a new state of equilibrium after every change. Since this assumption also includes the labour market, unemployment is considered by both schools of thought to be a voluntarily chosen condition, i. e. workers voluntarily renounce participation in the labour market because they consider the wage level to be too low. Experience shows, however, that prices, wages and interest rates can be inflexible and that markets are not always cleared and that there can be underemployment and unemployment even when product markets are in equilibrium.

Classical and Neoclassical Doctrine Differ in One Point:

The difference being that the classical school of thought is based on the formation of »natural« prices that result from labour costs and profit, while the neoclassical school of thought highlights market prices determined by supply and demand. However, the neoclassical school of thought is not consistent on this point, because it ignores the strong influence that demand has on production volume in free-market pricing and therefore, like the classical school of thought, assumes constant economic equilibrium. This assumption specifically means that all available factors of production (labour, natural resources and capital) are at all times allocated to the production processes in their entirety and that the growth of the production volume is determined solely by the growth of the productive factors (see also Factors of Production).

Since both schools of thought do not correspond to the current level of knowledge and experience, they cannot be expected to constructively contribute to a sustainable development of our economy. Due to their fixation on production and production growth, both are described as one-sided supply driven. Unfortunately, the overvaluation of the supply side, including the resulting imbalance of the economic policy regime, has reached an unprecedented high point in economic history with modern neoliberalism (the neoliberal globalization). This has come about because the process of globalization is driven by selfish industrial and financial interests, the protagonists of which have established themselves in a transnational sphere, detached from state regulations, and choose to refer to set pieces of the neoclassical doctrine, in order to attain a quasi historically founded scientific coating for their machinations. In the light of the increasingly repressed national or supranational (EU) regulations and the resulting anarchic global competition, including its social and ecological devastations, such backward-looking arguments appear to be of little credibility.

For a better understanding of the current development I recommend the articles Economic Globalization, Neoliberal Vicious Circle, and Neoliberal Economic Doctrine.

Under the prevailing circumstances, it is my concern to present the fundamentals of the classical and neoclassical doctrine in a comprehensible way and to make it clear that, in order to overcome modern neoliberalism, up-to-date economic concepts are necessary that build upon historical experiences. This also includes an understanding of Keynesianism, because the economic discourse and the debate on economic policy have for years been constantly revolving around neoclassical and Keynesian arguments – without the prospect of ever liberating neoliberalism from its inherent contradictions. As a supplement I recommend the article Keynesianism.

3. The Classical School of Thought

Smith had his spiritual and intellectual roots in the age of enlightenment and therefore directed all his power of persuasion against the absolutism of his time: the authoritarian, hierarchically structured state and the economic doctrine known as mercantilism, which aimed at consolidating state power and increasing state wealth. In his main work, he focuses on the self-determined, self-reliant and self-serving human being and concludes that individuals in economic competition with each other serve the common good unintentionally and inevitably simply by seeking to increase their own benefits. Consequently, the state can restrain itself regarding economic policy and confine itself to guaranteeing the freedom and security of its citizens. Smith’s conviction can be reduced to the formula: Self-interest serves public interest.

Smith’s conviction that the human being, who always acts rationally in economic terms and was only later embedded in economic history as homo oeconomicus, forms the basis for the laissez-faire approach of classical liberalism, which combines individual freedom of trade and commerce with the state’s economic restraint. Ferdinand Lassalle, founder of the social-democratic movement in Germany, later derided the model of the reticent state as »night-watchman state«.

In order to safeguard the common good, Smith presupposes a functioning competitive mechanism which, as »invisible hand«, ensures a constant balance between individual and collective interests. For Smith, production and supply take precedence over consumption and demand. Accordingly, he derives the price directly from labour costs and profit and calls it »natural« price, from which the market price determined by supply and demand is never far away. Each supply automatically generates its own demand, because additional production of goods leads to higher incomes and higher purchasing power. Market saturation is categorically excluded, because the market is considered to be unlimitedly receptive. As a result, demand cannot exert an original influence on market developments. Moreover, because of the price mechanism linked to labour costs, wages are settling at a level that guarantees jobs at all times to all those willing to work. Structural unemployment is also excluded because workers are considered to be fully interchangeable and boundlessly mobile. For Smith, unemployment is therefore always a deliberately chosen status.

With his view of strict dependence of demand on the produced supply and the unexceptionally voluntary unemployment, Smith lays the foundation for a supply-side economy that – with slightly altered justifications – continues through the neoclassical doctrine to the present day in the form of modern neoliberalism (the neoliberal globalization). However, in today’s increasingly saturated markets, with cross-border wage competition causing structural distortions, supply-side economics no longer offers a solution for the labour market.

Smith also emphasizes the importance of international specialization and division of labour as well as capital accumulation for the advancement of productivity, for economic growth and for the prosperity of nations. He sees the absolute productivity or cost advantage as the decisive criterion for territorial specialization between trading partners.

DavidRicardoThe Englishman David Ricardo (1772 to 1823), who is also one of the representatives of the classical doctrine, refers with his theorem of »comparative advantage« to the benefits of specialization on the basis of relative productivity or cost advantages: Accordingly, two countries can achieve mutual trade benefits, if each country spezializes in and exports products which have relative cost advantages in comparison to identical products of the trading partner. In this way, countries can achieve mutual trade benefits (profits) even if they have completely different levels of productivity.

Foreign trade theory and foreign trade policy are still, to the present day, irresponsibly and uncritically being influenced by both Smith and Ricardo: The doctrine of neoliberal globalization, which is a product of global industrial expansionism, is dedicated to cut-throat competition à la Smith with absolute price and cost advantages, effectuating a tendency towards complete international specialization and concentration of capital, thus leading to ubiquitous and comprehensive economic desertification (deindustrialization).

If Smith can’t give us any direction, then Ricardo, you’d think. Yes, but Ricardo’s theorem of comparative advantage, of which the protagonists of modern neoliberalism wrongly claim that it is already being applied worldwide, requires a modern adaptation in order to use it profitably under the conditions of today’s complex multi-bilateral trade relations: Firstly, the tendency towards full international specialization and capital concentration, which Ricardo also advocated, would have to be limited by means of economic policy, that is, by repeatedly decentralizing productions and services, and secondly, in order to identify and dynamically exploit comparative advantages, relative prices would have to be calculated by dividing, in local currency, the absolute prices of products by the average price of all trading products. The resulting relative prices can then be compared to the relative prices offered by trading partners. Trade flows can ultimately be determined by products showing the lowest relative price (the greatest comparative advantage). And last but not least: For the mutual benefit from comparative advantages, bilateral exchange rates have to be directly derived from the average price differences of all trading products.

The theoretical foundation and practical examples of the contemporary use of comparative advantages are presented in the following articles: Comparative Advantage – upgraded und Future-Proof Foreign Trade dargestellt.

4. The Neoclassical School of Thought

It arises in the second half of the nineteenth century and adopts the notion of the »invisible hand« and the constant equilibrium of all markets from the classical doctrine, but now takes into account the market price that results from the interplay of supply and demand. Accordingly, the value and price of a product is no longer determined only by the objective production costs and the business profit, but above all by the subjective benefit that the consumer receives from consumption.

Since demand is recognised as an important factor influencing pricing and production, the focus of economic analysis shifts from production volume and its growth to the question of how best to allocate the scarce productive factors in order to ensure the best possible distribution of goods among consumers and, overall, the best possible supply for the general public. Surprisingly, however, as mentioned above, the dependency of production volume on overall demand is not recognized. This omission explains the central internal contradiction of the neoclassical doctrine: that it in fact recognises the market price, but like the classical doctrine assumes that any production volume could be absorbed by the market – now with a flexible price mechanism.
LeonWalrasFinally, the neoclassical equilibrium model is summed up by the French national economist Léon Walras (1834 to 1919): He postulates an ideal market with perfect competition, complete information and complete foresight of all market participants as well as completely flexible prices and wages. In the constantly recurring equilibrium, the productive factors are optimally allocated and every supply finds its demand, also on the labour market. Since, in his imagination, the economy is in a constant state of equilibrium, there is always full employment.

5. General Criticism

Every school of supply side economics, including monetarism and modern neoliberalism, can be criticised from two points of view:

  1. Under the assumption of economically autonomous nation states, it lacks a sense of reality in the face of scarce and increasingly endangered natural resources and the undeniable quantitative saturation of markets, if it seeks unlimited volume growth and also overlooks the fact that innovations and new products only divert stagnating needs into substituted consumption.
  2. Under the existing conditions of the neoliberal globalization, the »invisible hand« loses its steering effect in the face of the dwindling economic influence of national economic policy. Adam Smith’s so emphatically eulogized competition mechanism falls victim to arbitrary price dumping on open global markets, so that the self-interest of economic players no longer serves the common good, but becomes an end in itself, which ultimately turns against its own protagonists.

6. The Helplessness of Economic Schools of Thought

Current neoliberalism, which represents an extreme variant of monetarism and neoclassical doctrine, has so far failed to prove that economic equilibrium is automatic, i. e. self-regulation and self-stabilisation of the economy. The neoclassical doctrine and Keynesianism are to blame, that the controversy between supply- and demand-side theory continues today – though with some new facets. This controversy can be observed most impressively among the members of the Council of Experts of the German Federal Government, the so-called Five Wise Men. Since traditional schools of thought are based on unrealistic assumptions and, moreover, since the exogenous influences of the neoliberal globalization on national economies are historically unprecedented, it cannot be expected that the controversy will lead to a solution of the problems caused by globalization.

7. Outline of a Sustainable Paradigm of Globalization

A predatory competition based on absolute prices (in dollars or euros) on open, nationally unregulated global markets, including the tendency towards complete territorial specialization and capital concentration, has not yet existed in economic history. The inherent contradiction between the doctrine of deregulation of national markets on the one hand and the call for measures to achieve an economic equilibrium with full employment on the other inevitably means that the real chances for equilibrium and full employment are poor. In addition, a sobering experience reminds us that full employment has only been possible to secure for a period of several decades during the extraordinary economic growth following the destructions of the Second World War. One thing only seems certain: In the existing climate of academic economics, a theory is not in sight that would promise full employment under the condition of low growth and stagnation – which for me is the motivation for this compendium.

For additional information see the articles Market and Market Economy and Full Employment.

As any observer can easily see, the doctrinal contradiction is causing a constant wrangling in the day-to-day business of economic policy at all levels between proponents and opponents of »market liberalization«. As long as the proponents pursue their selfish economic goals and the opponents come up with nothing better than to fall back on historically outdated economic theories, there will be no breakthrough on the road to sustainable economic globalization.

8. The Conclusion is Unequivocal

The doctrine of national deregulation with the aim of worldwide liberalization of all economic activities has clearly failed in the face of the social and environmental devastations it has caused. In particular, the consequences of the financial market and economic crisis that began in 2008 only allow the reverse conclusion that sustainable globalization must be built on the foundation of autonomous national or supranational economic policies. This means that national or supranational economic areas must first regulate their international trade in such a way that their cross-border transactions constructively fit into their domestic economy and competition before they can internally focus on sustainable welfare.

A decisive lesson to be learned from historical experience is that neither monetary or fiscal stimulation of the supply side (production) nor that of the demand side (investments and consumption) alone guarantee sustainable full employment. After all, they both aim – directly or indirectly – to increase production without compromising the natural tendency to concentrate production power and capital. Since concentration of capital leads to widespread desertification of economic structures, an increase in production volume without adjustment of production structure cannot lead to employment and equal distribution of income and wealth. However, both structure and volume of production are a prerequisite for sustainable social welfare (see also the article Sustainable Social Welfare).

In plain language, that is:

The key to full employment, prosperity and welfare lies solely in the structure of production!

The priorities must therefore be reversed: instead of uncontrolled concentration of power and capital, regulated decentralization, or rather, regulated subsidiarity of economic structures, must be the priority. This is a prerequisite for decentralized democratic responsibility and for the widespread beneficial participation of all citizens in economic life, i. e. for full employment and living wages, but also for ecological sustainability.

Increases in productivity and production volume, including the associated realization of economies of scale, are then strictly implemented within the given decentralized (subsidiary) structures. This ensures that desirable productivity growth, rather than external costs, such as in the neoliberal system, produce social returns and the lowest ecological costs or even ecological returns.

Only on the basis of autonomously formed subsidiary national or supranational structures can a future-oriented economic globalization be realized. The quality of the interfaces that determine the benefits of trade between autonomous economic areas is measured by the extent to which foreign trade is conducive to the development of the domestic economies of trading partners. International trade and competition can only be profitable if it is performed on the basis of relative instead of absolute price advantages. This is the only way to avoid mutual crowding-out and increasing concentration. The prerequisite for this is an uncompromising return to trade agreements, which must focus on exchange rates that neutralize differences in prices and thus in productivity, accompanied by mutually conceded autonomy to decide on tariffs and trade quotas in such a way that foreign trade stimulates domestic economies in terms of progress and welfare.

I also recommend the following articles: Economic Subsidiarity, and Economic Competition.

Click here for the German-language version: Klassische und Neoklassische Lehre

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