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5. The History of Capitalism - Evolution of Capitalist Economic Thought - Feudal System to Present
بسم اللَّه الرحمن الرحيم وصلى الله على سيدنا محمد وعلى ءاله وصحبه أجمعين وسلّم
Title: The History of Capitalism - Evolution of Capitalist Economic Thought - Feudal System to Present
Author: Sarfraz Wali
Publication date: 19/10/2014
Assalamu alaykum. Welcome to the Civilisation and Society Programme of the MFAS. This is the fifth of 12 sessions which make up the Question concerning Economics module. The lecture will last approximately 40 minutes during which time you should make a written note of any questions that may occur to you for clarification after the lecture.
Evolution of Capitalist Economic Thought - Feudal System to Present
Sections
2) Major Turning Points in Economic Thought
• Monetarism /Rational Expectations
3) Other schools and contributions
• New and Post Keynesian/New Neo Classical
• Austrian School/Gold Standard
• Reaganomics (Monetarism/Supply Side / Military Keynesianism)
• Neoliberalism and the Washington Consensus
• Return of regulation and Keynesianism post 2008
The aim of this paper is to provide a synopsis of the evolution of Western Economic thought with a particular focus on the circumstances that lead to the various turning points that occurred in the development of such thought.
Each major school or viewpoint will be analysed and discussed according to areas :-
• Timeline
• Context
• Contributors
• Key assumptions
• Policy Recommendation
1) Microeconomics
2) Macroeconomics
3) Neoclassical synthesis
The overall context of this analysis is to understand the current debate over economic thought with a view to present the Islamic alternative to economic management of society. It is thus beneficial to explore the capitalist experience so as to assess whether the issues and problems faced in the West are relevant to our efforts to bring the Islamic system back into implementation.
It also will aid the discussion in the West to debate the subject using the existing terms of reference so as to make the debate were Islamic solutions are presented seem relevant and contemporary.
Note: Marxism has been omitted as the socialist approach is not regarded as credible as far as the mainstream discourse and neither is it part of the sequence of phases which lead to the capitalist tradition.
2. Major Turning Points in Economic Thought
Feudalism was a system of economic organization within Europe that lasted during much of what we refer to as the Middle Ages.
This system started around the 11 Century in England under the rule of King William I and started to unravel around the time the Reformation was in motion throughout Europe by around the 15th Century and lead to the mercantile era.
Feudalism arose in Europe during the Middle-Ages, due to the arrangement between land owners who offered protection to lower servants in exchange for working the land.
The society had a hierarchy starting with Kings, through Lords/Nobles and then their Knights and finally Merchants and Peasants who would work the land. The Church and its interpretation of religion was central to upholding the system which was orientated in favour of the church and clergy along with the Kings who took their legitimacy from the Church.
William I - ‘William the Conqueror’
The system is based on mutual interest. The tradition of serfdom and patronage may have originated from the Roman influence and also the Germanic tribal traditions of patronage and loyalty for hierarchy.
The system was primarily agriculture based with the primary means of production being land and labour. No central planning or government policy intervention was associated with this economic order.
The time period of this system was approximately 1500 to 1800.
The power of the Feudal hierarchy started to unravel during the reformation due to the spreading of knowledge through inventions such as the printing press where books such as the Bible were translated into languages common people could understand and thereby unraveling the power of institutions such as the Church which had underpinned the absolute power of the Monarchies that anchored the Feudal order.
In the new context of a post-Absolute Monarchical order, isolated feudal estates were being replaced by centralized nation states as the focus of power. Technological changes in shipping and the growth of urban centres led to a rapid increase in international trade.
UK: Oliver Cromwell (1599–1658),
France: Jean-Baptiste Colbert (1619–1683).
Mercantilism taught that trade was a ‘zero-sum’ game with one country's gain equivalent to a loss sustained by the trading partner.
This lead to nations seeking to subjugate other nations into colonies and through such colonialism, pursuing a positive balance of trade and the acquisition of precious metals primarily in the form of gold and silver coinage.
Mercantilism promotes governmental regulation of a nation's economy for the purpose of augmenting state power at the expense of rival national powers. This regulation is focused on increasing exports and minimizing imports with a view to capture precious metal in the form of gold and silver.
Mid to late 1700’s.
This school, which was prevalent in France during the height of the enlightenment struggle, was a spearhead for new thinking in the economic thought.
The reason they are considered a key school in the turning points of economic thought is due to their founders, especially Francois Quesnay who was a doctor in applying scientific methods to the field of economics and helping to bring to an end the hegemony of the mercantile era.
They are less important for the importance they attribute to agricultural production which is considered a very weak argument to this day.
Francois Quesnay (1694 – 1774)
Anne-Robert-Jacques Turgot (1727 – 1781)
They argued that land production was the key source of economic value and that agricultural products should as a result be highly priced.
They were one of the first, along with Adam Smith who came later, to argue for a self regulated market approach.
This school arose from the late 18th Century to early 19th Century with the rise of the neoclassical contribution which refined rather than presented a major upheaval.
Astute observers noted that Mercantilism was not a force for increasing the world’s wealth but instead was a system to move the world’s static wealth from the colonies to their respective mother countries.
The other key trigger was the onset of the industrial revolution and the mechanization of industry which opened up huge potential in wealth creation.
Adam Smith (1723 – 1790)
David Ricardo (1772 – 1823)
This school was a major paradigm shift from the schools which preceded it. The key tenet of this school was that wealth creation was not a ‘zero sum’ game and instead a ‘win win’ game.
It was upheld that rational self interest had an overall effect of increasing wealth for all and the key means for manifesting such self interest was through the division of labour whereby everyone would focus on the economic activity for which one was most suited and trade through a free market with others and this through an invisible phenomena (aka Invisible hand) would raise the prosperity of all participants.
The axiom of the classical school is that markets are self regulating and self correcting and the best approach for the state is to leave the market free so that its beneficial effects in wealth creation can be manifested.
It was held that free markets, populated with self interest seeking actors lead to wealth creation via a hidden force, known as ‘the invisible hand’ which benefited all parties much more effectively than if society was full of benevolent actors trying to help each other. It was a major paradigm shift and one that helped raise the standards of living of all those who implemented its policy.
However the rate of wealth creation was disproportionately allocated to those who had more to start with and this led and is leading to its downfall.
1860’s to 1930’s
Adam Smith’s ideas were in fact revolutionary but there were gaps in the Classical school of thought. Most notable was in the field of price theory and the question of how to arrive at value of commodities and services and the correct basis to judge the worth of such goods and services rendered for exchange. The ideas proposed by the Classical theorists were deemed to be inadequate and simplistic.
The school was thus a major contribution in the field of microeconomics and didn’t make its focus the macro economic sphere and neither did it detract from the Classical approach for the state to adopt a laissez faire stance towards the market.
William Jevons (1835 – 1882); Carl Menger (1840 – 1921); Leon Walras (1834 – 1910)
Alfred Marshall (1842 – 1924)
The school rejected the Classical notion that Value was in the quantity of labour spent in the procurement of a good or service and proposed a new perspective. This new stance became known as the marginal revolution and in particular, gave rise to the theory of marginal utility as the basis to compare the value of goods and services.
According to this view, the value of a good or service is assessed at the utility derived from the weakest point of need and not the strongest point of need.
As an example, it would not be sound to assess the value of a meal to a person when he or she was close to death due to starvation as this would not be a normal situation within a market context. Neither would it be generally repeatable to extract from market participants the equivalent in price given by such a person in the situation in question.
What would be extractable would be the equivalent of how market participant view a commodity at the point of the weakest need.
Each unit of consumption, or marginal consumption, renders diminishing utility relative to the previous unit of consumption. It is the utility gained at the weakest point of need that forms the basis of the good or service’s value. It is this value or utility that is then compared with the value of other goods and services when considering the ratio of tradability through the price mechanism.
The marginal school, as stated, did not overhaul the Classical school at the macroeconomic level directly, instead it made a significant contribution towards the field of microeconomics. The insight between the Keynesian school at the macroeconomic level and the neoclassical school at the micro economic level became known as the neoclassical synthesis and governs economics today.
1930s to 1970s
The background to the rise of the Keynesian school was the Great Depression of the 1930s and early to mid 1940s starting in the US and spreading to most of the modern world. The stock market crash in New York in the autumn of 1929 precipitated the longest and deepest global depression the modern world had ever seen.
The economy had deteriorated into a deeply stagnant phase, despite the society not having lost any physical wealth. It was in essence a collapse of the virtual economy that ultimately affected the real economy where wealth is generated.
The thinking of John Maynard Keynes, this school’s founder, was that the Neoclassical macro-economic approach of allowing the market to self correct and reach equilibrium free of any government interference was not working in the context of the Great Depression and that some form of government intervention was needed for assisting the recovery.
John Maynard Keynes (1883 – 1946)
Paul Krugman (1953 -)
A key premise of the Keynesian approach is that markets fail to reach the equilibrium needed to end the bust phase of the business cycle. In essence they disagree with the classical theorists in how efficient self regulated markets are in reaching the optimal resource allocation via pricing.
It notes phenomena such as wage rigidity, also known as ‘sticky wages’ explains the situation where wages tend not to fall and wages flexibility is a necessary condition for the Neo-classical schools recipe for getting an economy out of as recession.
It also asserts that market participants are driven by less than rational criteria when undertaking economic activity. He refereed this erratic behaviour as ‘animal spirits’ and equated it with waves of optimism and pessimism that glance over the collective psyche of people and the resulting collapse in confidence and spending that ensues,
The primary recommendation is at the macroeconomic level and is for the government to intervene by initiating government spending to increase demand in the economy when the private sector is retreating from economic activity. This is usually done with a reduction in taxation intended to increase disposable income and hence demand in the economy. It is due to the fact that demand drives economic growth that it is so keenly sought by policy makers.
The idea is that the excess demand created via government spending or tax rate decrease, often done on deficit spending rather than currency reserves, drives the economic cycle back into the recovery phase.
Monetarism /Rational Expectations
Late 1970s to mid 1980s
The reality of the 1970s saw the demise in the Keynesian analysis and remedy for business cycles. Prior to the emergence of the Monetarist school, there had always been an observable trade off between inflation and unemployment. This inverse relationship was accepted by the economic community since the 1958s publication authored by the New Zealand born economist William Philips and the resulting Philips curve which depicts this trade off.
The 1970’s saw a new phenomenon called Stagflation which equated with the simultaneous rise in unemployment and inflation and this contradicted the models developed by the Keynesian school.
To this conundrum, a highly knowledgeable professor named Milton Friedman proposed the reason for Stagflation and the cure using thorough scientific study which threw into question the Keynesian school place in the debate.
Milton Friedman (1913 to 2006)
Robert Lucas (1937 - )
The key assumption of the Monetarist school is that there is no long term trade-off between inflation and unemployment and the trade-off is very short term and even then, it only works while market participants do not realise the inflating effect of the government policies to help reduce unemployment.
Once market participants realize that the government’s actions to reduce unemployment will cause inflation, they build inflation into their wage expectations resulting in higher wages and thus further inflation and thus nullifying the effects of the government’s actions.
This it was argued would be due to the concept of rational expectations (Robert Lucas 1972), that is the idea that people take into account all available information when making decisions about future economic variables and cannot be all collectively misled as was modeled by the Keynesian modelling were notions such as society having ‘animal spirits’ and acted on waves of optimism and pessimism were understood to be the case.
This notion of rational expectations was a development on the prior model of understanding how economic actors predict the future. Such previous modelling was known as the static and the adaptive expectations modes.
In the former, economic agents were assumed to look at the present value of economic variables such as the inflation rate and use that to interpolate future values and with the adaptive expectations, they were understood to look at the present and recent past to formulate their expectations about the future performance of economic variables.
The other key argument was that the government should not try to reduce unemployment which always comes back to its natural rate, hence the notion of a natural rate of unemployment. The government should instead just work on maintaining the most suitable volume of money in circulation.
The key policy implications of the monetarist school is for the government policy, via the central banks remit, to be for there to be a careful setting of the money supply to be in line with the level of economic activity in the economy.
The Central Banks should ensure that the quantity of money is not short of the requirement so as to prompt a recession or in excess of the requirement so as to prompt inflation. Monetarists believe that there should be no attempt to create full employment as there is a concept of the ‘natural rate of unemployment’ and an economy left free of government meddling will find such a rate.
The Monetarists are also very keen to avoid the use of monetary policy (lowering of interest rates to stimulate the economy) and generally against large government and are very much free market orientated unlike the Keynesian position which sees an active role for government.
3. Other schools and contributions
Behavioural Economics has made contributions within micro economics and seeks to bring insights from other social sciences such as Psychology to understand how individuals make decisions. An example is the concept of ‘anchoring’ where we set our mind on a value, such as a price and then use that to judge the merit of a good or service. For example if you see something in a sale which has been dropped down by 80% in price, you are much more likely to buy it at the lower price than if you had seen it being sold for the lower price. This is because you have ‘anchored’ to the higher price and feel you have a great bargain at the lower price.
Another example is the concept of social belonging. Governments have used this in trying to get people to return questionnaires and other important forms by informing residents that they are amongst the few remaining people on their road that haven’t returned their forms. This leads in the resident a sense of being ostracized from the group which goes against the desire for belonging.
New and Post Keynesian/New NeoClassical
These schools are reinterpretations of the previously discussed school once the idea of rational expectations have been taken into consideration.
Contributors : Steve Keene (1957 -)
This school advocates an extreme form of laisse-faire which goes further than the monetarists in advocating no role for central banking and instead call for the return of the gold standard currency model.
There is much discussion within this school over how the central banks through setting interest rates cause business cycles. This has been aptly labelled the ‘Austrian Business Cycle Theory’ or ABCT.
Carl Menger (1840 – 1921), Murray Rothbard (1926 to 1995), Ludwig Von Mises (1881 – 1973)
Frederich Hayek (1899 – 1992)
Reaganomics (Monetarism/Supply Side / Military Keynesianism)
Reagonomics was a reincarnation of the approach that preceded the Keynesian revolution. It had some variation from the approach however which is why all advocates of the free market were not in agreement in its policy prescriptions. This would explain why it was colloquially referred to by its critics as Voodoo economics.
Central to the departure from the conventional classical free market approach was the idea that drastically lowering the tax rate would create a wider tax base and an ultimate increase in the tax revenue. This supposed phenomenon was described in the economic literature as the Laffer Curve. It suggested that there would be a ‘trickle down’ effect where wealth would filter down to all levels in society if the highest earners were given large tax breaks.
Coupled with this was the idea that the government should bring about recovery by helping the supply side of the economy given that all previous attempts via monetary and fiscal policy were acting on the demand side of the economy. This thinking developed in the 1970s in the post Keynesian era.
Arthur Laffer (1940 -)
Ronald Reagan (1911 – 2004)
Neoliberalism and the Washington Consensus
Neoliberalism is a catchall phrase which describes the era of deregulation and globalization that has been the order of global economic institutions since the early 1980s. This policy has been implemented within the most powerful western states in re-regulating the financial sector and pushed to third world countries under the oversight of the IMF and World Bank.
Return of regulation and Keynesianism post 2008
The neoliberal approach came under intense scrutiny in the aftermath of the global mortgage backed securities financial crash of 2008. Since then there has been a return of the role of governments in creating a more regulated approach, especially in the financial sector along with the return of the Keynesian approach in the US.
That brings us to the end of today’s lecture. There is more material at my blog on the Islamic Economic System: http://breakthrougheconomics.blogspot.com
Thank you for your attention. Assalamu alaykum.