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November 2012 Brief: Volume 19, Number 32

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A Short History of Economic Theory


by Adam Wachholz



Economic theories have dominated the last three centuries of world history, and it is imperative that we understand their development and implications for the future. Starting in 1776 with Adam Smith and his seminal work The Wealth of Nations, early economic theory championed the free market and individual liberty. Smith identified the division of labor, money, and the invisible hand as crucial components to a functioning economy, formalizing many basic economic tenets. At the core of Smith’s ideas was a belief in the power of individuals to make correct choices about production and consumption, rather than an ubiquitous central authority. The principles of limited government espoused by Smith were a sharp contrast to the view of monarchy that persisted throughout the 18th century. In the infant United States, Smith’s theory found purchase, driving a century of rapid industrialization and expansion.


For all of Smith’s genius, he lacked understanding when it came to a vital part of dynamic economies: entrepreneurism. Into this gap stepped Jean-Baptiste Say, the foremost political economist of the early 1800s. In the chaotic world of the Napoleonic Wars, Say became a quintessential entrepreneur, starting a successful textile business in France before developing his famous Law of Markets. Say’s experience as a doer in the free market allowed him to see the importance of innovative entrepreneurs who make the economy function. By adding the entrepreneur into Smith’s theory, Say brought the capitalistic model to completion.


The collectivist answer to Smith and Say’s free market came from Karl Marx in his 1867 work Das Capital. Marx viewed the laissez-faire free market as an exploitative function of business owners’ greed, ignoring the Industrial Revolution’s beneficial impact on all levels of society. Taking a stand in staunch opposition to profits, Marx argued that the real value of a product was determined by the amount of labor expended in its production, ergo, anything paid for the product above the laborer’s wages was tantamount to theft. Das Capital radically altered the framing of economic debates, moving to a “dialectic materialism” model based on class warfare. Although his stated goal was to free the common man from the oppression of capitalism, Marx’s introduction of communism into economic theory established some of the most oppressive regimes in history.


While the war between supporters of centralized economic control and free markets raged, John Maynard Keynes shaped modern macroeconomic theory in his 1936 book The General Theory of Employment, Interest, and Money. Adopting a distanced tone from the early concepts of capitalism, Keynes worked to establish the government as an arbiter of the economy, utilizing fiscal policy to “smooth” the business cycle. Keynes believed that government spending had tremendous simulative effects and advocated an interventionist mindset based on his theories about the marginal propensity to consume and the multiplier effect. His writings had broad policy implications, such as President Franklin D. Roosevelt’s New Deal, which shaped much of the 20th century’s understanding of the relationship between government and the economy. At best, Keynes’ work represented a misguided attempt to fuse the best of Marx and Smith together, and at the worst provided justification for highly restrictive government control over an economy in crisis.


In response to Keynes’s dismissive attitude towards Smith and Say’s theories, Milton Friedman led an explosive rebirth of economic liberty in his 1964 book Capitalism and Freedom. This concise work clearly articulated the values of small government and economic freedom, while critiquing Keynes’s fiscal policy suggestions. In addition, Friedman introduced the concept of monetary policy and its connection to economic growth, founding the Monetarist school of thought. He also examined the effects of government welfare on society, contrasting it with the benefits of an unbridled free market and detailing the consequences of redistributionist policies. Friedman successfully rebutted the forces of economic collectivism and centralized power, epitomized by Marx and Keynes, and revitalized the faltering forces of advocates for liberty.


Without a doubt, one of the most controversial aspects of applied economic theory is the value of a gold standard. Smith and Friedman both acknowledged the benefits of a gold standard; Smith for its use as a currency, and Friedman for its ability to protect against an intrusive government. However, the supply of gold expands much more slowly than the economy, leading to constant deflation when a currency is tied to gold. Additionally, gold has high resource costs and can consume a significant portion of the economy simply to provide a currency. Ultimately, Friedman advocated a fiat currency administered automatically, which would prevent abuses of federal power and avoid the disadvantages of a pure gold standard.


Using economic stabilization policy to promote growth has divided economists into three warring camps: the Keynesians, the Monetarists, and the Neoclassicists. The Keynesians believe that business cycles should be stabilized by government intervention, raising taxes and cutting spending during an expansion, while doing the opposite during a recession. Monetarists hold that fluctuations in the money supply lead to booms and busts, calling for an end to the discretionary policy of the Federal Reserve and the implementation of an automatic system to give the economy a reliable currency. Followers of Smith, the Neoclassicists seek renewed laissez-faire policies that allow business cycles to “work themselves out” and believe that the economy is naturally self-correcting without government interference.


Public Interest Institute’s POLICY STUDY, A Short History of Economic Theory, can be viewed at ps-12-9.html.


Adam Wachholz is from Ottosen, Iowa, and is obtaining a B.A. in economics from Thomas Edison State College. Contact him at


Permission to reprint or copy in whole or part is granted, provided a version of this credit line is used:"Reprinted by permission from INSTITUTE BRIEF, a publication of Public Interest Institute." The views expressed in this publication are those of the author and not necessarily those of Public Interest Institute. They are brought to you in the interest of a better-informed citizenry.




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