Front Page Titles (by Subject) III: Political Economy - Literature of Liberty, April/June 1978, vol. 1, No. 2
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III: Political Economy - Leonard P. Liggio, Literature of Liberty, April/June 1978, vol. 1, No. 2 
Literature of Liberty: A Review of Contemporary Liberal Thought was published first by the Cato Institute (1978-1979) and later by the Institute for Humane Studies (1980-1982) under the editorial direction of Leonard P. Liggio.
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In scope and subject matter political economy conceives of its discipline far more ambitiously than does the narrow and fragmented field of modern economics. Conceived of as a broad science of human action, political economy comprises the narrower economic issues, but it also investigates and integrates the ethical, social, and political dimensions of economic activity. It is fitting, therefore, that this group of summaries opens with three reflections on the founder of political economy, Adam Smith.
The coincidence of the recent Bicentennial commemorating both the Declaration of Independence and the publication of Smith's Wealth of Nations suggestively links liberty and its defense in political economy. Smith's concern was to demonstrate how a system of natural liberty was harmonious with justice, moral order, and social harmony. His Wealth of Nations parallels a Newtonian physics of human liberty and unveils how free and voluntary human action as well as self-interest might create a spontaneous economic order.
This theme keynotes the following seven summaries. These summaries, in a vital sense, are the progeny of Smith's concern for finding order in the natural workings of the market. These summaries report how the laws of economic freedom are displayed in the efficient allocation mechanisms of the market, international trade, competitive supply and demand, information, banking, and income distribution.
Adam Smith's Achievements
“The Wealth of Nations.” Economic Inquiry 15 (July 1977): 309–325.
A bicentennial reevaluation of Adam Smith's Wealth of Nations (1776) impresses us with this classic's keen analysis and broad range of economic questions it so admirably discusses. Smith's insight into economics unveiled the importance of the market economy's pricing mechanism as a means of coordinating a complex society which benevolence alone could not coordinate. Reliance on self-interest creates, through the “invisible hand,” an intricate division of labor. In turn, this division achieves “the cooperation and assistance of great multitudes.”
Through self-interest, this remarkable self-regulating market produces the laws of supply and demand, competition, abundance, and prosperity. Indicting the mercantilism of his own age, Smith exposed governmental efforts to improve and regulate the economy as generally perverse:
Every man, as long as he does not violate the laws of justice [should be] perfectly free to pursue his own interest his own way, and to bring both his industry and capital into completion with those of any other man.... The sovereign is completely discharged from a duty, in the attempting to perform which he must always be exposed to innumerable delusions, and for the proper performance of which no human wisdom or knowledge could ever be sufficient; the duty of superintending the industry of private people, and of directing it towards the employments most suitable to the interest of society.
(Wealth of Nations, Modern Library Edition: 1937, p. 651.)
Government tampering with the complexities of the market fails because it lacks both the knowledge and motivation to do a good job in regulating and coordinating the economic system. In addition, governments display a corrupt propensity to be influenced by those whose self-interest stands to gain from advantageous regulation. Smith would limit government to only three duties: to protect society from domestic and foreign aggressors; to establish a legal system of justice defining everyone's rights; and to provide a minimal number of public works and public institutions (e.g., roads, bridges, and canals). Smith might have challenged the need for government construction of such public works in the light of the modern capital market. Yet even within his presuppositions, he argued that such public works should be financed by payments from consumers rather than by subsidies or grants from public revenue.
Smith's view of America and of the contemporaneous American Revolution runs as a minor theme through his Wealth of Nations, accompanying the major theme of the self-regulating pricing system. Smith was both a liberal and a clearsighted realist when he discerned the probable success of the American colonies in breaking away from Great Britain. He viewed the motivation behind the American leaders not so much as a thirst for liberty or democracy, as a quest for position and status. Accordingly, he devised a conciliatory plan that would appeal to the revolutionaries' political ambition: he offered them representation in the British Parliament in proportion to colonial contributions to the revenues of the British Empire. Eventually the Americans could expect two results from their economic power: that the capital of the British Empire would cross the ocean to America, and that an American would be elected Prime Minister. Had his sanguine plan been adopted, America would now rule England and Smith would be celebrated as an American founding father.
“An Adam Smith Renaissance anno 1976? The Bicentenary Output—A Reappraisal of His Scholarship.” Journal of Economic Literature 16, (March 1978): 56–83.
What accounts for the continuing vitality and relevance of Adam Smith's works and ideas? The bicentennial of Smith's Wealth of Nations (1776) is an opportune time for taking stock of the recent vast literature on Smith through a bibliographic essay citing some 175 items of Smithian scholarship.
The new era of Smithian scholarship displays several characteristic demands: (1) We need to interpret Smith's work as an integrated whole, doing justice to its ethics, economics, history, politics, and methodology. Smith, never a narrow economist, can best be appreciated as a far ranging philosopher in the eighteenth century sense. The unified approach to Smith's writings sees no fundamental contradiction between his Wealth of Nations and his Theory of Moral Sentiments. (2) We need to study Smith's social and historical theory as a background for his economics. Both the Theory of Moral Sentiments and the Lectures are required reading to properly interpret The Wealth of Nations. (3) We need to appreciate the logical consistency and realism of Smith's economic theory (such as the circular flow and dynamics of the market). (4) Finally, we need to study again Smith's view of the role of the state and other institutions.
A key area for reassessment is political economy, which Smith described as the “natural system of perfect liberty and justice” or the “liberal plan of equality, liberty, and justice.” Though not a radical advocate of laissez-faire, Smith urged a restricted scope for state functions to achieve his goals of justice and liberty. The state should so restrain itself to enable the people “to provide such a revenue or subsistence for themselves.” From his free market and antimercantilist perspective, Smith appreciated the mechanisms of incentives and disincentives to promote the efficiency of all institutions. The reasons for the state's economic mismanagement, inefficiency, and injustice flow from its in herent lack of such built-in mechanisms.
Linked with such motivations as incentives and disincentives is Smith's concept of self-interest. Unlike Mandeville, he judged self-interest as ethically positive and the engine of economic and social progress. In his own metaphor, self-interest prodded like an “invisible hand” to create a prosperous and amicable society since fellow-feeling and benevolence were weak motives for human action beyond dealings with friends and family.
Probably the best memorial to Adam Smith is the number, range, and variety of scholarly topics that Smith's genius has inspired during the bicentennial. Most noteworthy is the ambitious new series of Glasgow editions of Adam Smith's Works and Correspondence. A brilliant part of the Glasgow series is R.H. Campbell's, Andrew S. Skinner's, and W.B. Todd's new two-volume edition (1976) of The Wealth of Nations. It now replaces Edwin Cannan's 1904 edition as the standard English version.
The overall conclusion of reappraising Adam Smith, the man and author, is that he “was an educated and cultured man, creative and original as a thinker, and unique as an architect of thoughts. The indestructible vitality of his natural system of liberty and justice (i.e, his political economy), rests on his realistic observations and cool assessments of man's nature—the individual's self-interested economic and political activity in society.”
Smith as Political Economist
“The Just Economy: The Moral Basis of The Wealth of Nations.” Review of Social Economy 34 (1976): 295–315.
Adam Smith's The Wealth of Nations is intimately concerned with justice and injustice, with the conflict between private and public interests, and with the antinomy of liberty vs. coercion. Smith's central concern, this problem of a just economy, has been neglected. Political economy for Smith was a subdivision of jurisprudence because he believed the proper administration of justice was a prerequisite for a functioning economy and the accumulation of wealth.
Smith followed the Greek tradition of moral philosophy and was not a Hobbesian. He judged that moral norms make community possible; therefore all human societies are essentially moral communities and are committed to notions of right and wrong. Justice is uniquely important because its norms undergird the social order.
Accenting the central role of justice in his Wealth of Nations, Smith at the end of his Theory of Moral Sentiments inter preted positive law as an “imperfect attempt towards a system of natural jurisprudence, or towards an enumeration of the particular rules of justice.” (This resembles Friedrich Hayek's view of law in Law, Legislation, and Liberty.)
According to Smith, political economy aims at a just economy in a just society. Within this moral society, the well-being of all would advance in the fairest, even though imperfect, manner. Not opulence, but economic advancement for the masses in a just society was Smith's goal. No conflict exists between this economic advancement, motivated by self-love in The Wealth of Nations, and the moral advancement through prudence expounded in Moral Sentiments.
Within Smith's moral framework, justice both preserves and makes society possible. Enforcement of justice alone makes force acceptable. And only the enforcement of justice is the prerogative of the state. Otherwise, individuals must be left free to develop higher virtues, such as beneficence. These virtues are intimately connected with personal choice and freedom, and hence cannot be enforced or commanded.
Government, although necessarily connected with force, is not force. Smith defined the institution of government by its purpose, justice; and not by its means, force. Thus for Smith, government is justice institutionalized: “The liberty, reason, and happiness of mankind ... can only flourish where civil government is able to protect them.” [Wealth, p. 754.]
Adam Smith saw liberty (political, economic, religious) in a just society as the ideal, and portrayed it as the central theme of The Wealth of Nations. In a free society, and under a system of justice, people would have their self-expression protected to develop other virtues and efficiently produce goods. Moreover, liberty presupposes limiting government, which though it exists to insure justice, is itself a source of injustice. Through its sheer size, government is dangerous, since it can then perpetrate grave injustices far worse than the minor misdeeds of individual citizens which may be easily rectified in the social order.
In all this, Adam Smith was dealing not merely with the unique problems of one historical era. “Mercantilism” was the name he gave to manifestations of abuses not unknown today in the twentieth century. Mercantilism, and its zero-sum approach to economic relationships under a variety of guises, seems to be a persistent characteristic of modern states.
Protectionism vs. Free Trade
“An Old Reactionary Free Trader on the New International Economic Order.” Nebraska Journal of Economics and Business 16 (1977): 5–18.
In recent years, Third World nations have demanded that a New International Economic Order (NIEO) replace the current system of international trade. These nations picture themselves as subservient members of a victimized “periphery,” doomed to raw material provision by the economic whims of “core” developed nations.
In order to eliminate the disparity between wealthy and poor countries, NIEO advocates calling for radical change in what they brand as a world of unfair “free” trade. First of all, NIEO would dramatically accelerate the provision of aid, without strings attached, from developed to less developed countries. Secondly, this new order would guarantee preferential treatment for the products of less developed nations in the more developed nations. In addition, it would give the Third World access to patented western technology; the right to expropriate a foreign owned business operating in their lands; and the privilege to contract new longterm debts at bargain interest rates.
Free trade economists, disputing the presuppositions of NIEO, retort that international trade is not free because it is encumbered by quotas, tariffs, exchange controls, and domestic preferences in government purchases. This series of interferences, not free trade, is the culprit causing the widening gap between nations.
Small impoverished countries, in fact, would have more to gain from the introduction of international free trade than would any large country. This is so because free trade would inevitably lead to economies of scale for small participating nations. Also, exports from smaller nations would be less likely to lower world prices, and import demand would also be insufficient to raise prices. Free trade would work to equalize the prices of productive inputs between free trade nations; this would eventually replace either migration of labor or movement of capital.
The overwhelming numbers of unskilled workers in less developed nations may hinder economic progress in these areas. Theoretical and historical evidence confirms, however, that a New International Economic Order would thwart the long-run interest of any participant in world trade. This policy would merely continue the protectionist mentality that has plagued economic growth. The NIEO policy would rest upon the dubious assertion that nonexistent free international trade is a culprit rather than a needed remedy.
Protectionism and Politics
“International Trade, Domestic Coalitions, and Liberty: Comparative Responses to the Crisis of 1873–1896.” Journal of Interdisciplinary History 8 (1977): 281–314.
Public economic policies reveal a variety of motivations as shown in the responses of Germany, France, Great Britain, and the United States to the “Crisis of 1873–1896,” when prices declined and output continued to rise. A major goal of research would be to explain why these countries pursued the tariff policies they did. We need to examine economic explanations, political explanations, general international implications for each country, and the economic ideology involved.
In and of themselves, economic and political explanations do not explain all. The British free-trade Anti-Corn Law Lobby remained in power during this period. In Germany, by contrast, protectionist philosophy opposing free-trade had developed early on; and the Junkers swung quite dramatically from free trade to protection. In America, the Republicans dominated politics after the Civil War; they opposed free trade by favoring high tariffs. It is enlightening that the Free Soil Republicans embraced the slogan of “Free Soil, Free Labor, and Free Men,” but failed to champion free trade.
In each country, the dominant coalitions remained intact. In Germany, for example, the coalition Bismarck welded together endured and, in fact, grew stronger. All four nations pursued some variation of imperialism. In America, the industrialists emerged triumphant, delegated little of their power, and were virtually free of criticism (after 1896) until the 1930s.
In the struggle between the coalition that favored a high tariff and that favoring a low one, the winners fell into three groups: groups whose vested interests for their policy were powerful enough to mobilize for action; groups occupying strategic power positions; and groups occupying strategic economic positions. The word “group” is preferable to “class” both because class is often meaningless (as when representatives of heavy industry and manufacturing square off) and because class analysis is too complex.
Say's Law of Markets
“Say's (at least) Eight Laws, or what Say and James Mill May Really Have Meant.” Economica (U.K.) 44 (May 1977): 145–161.
Say's Law—defending the market's self-regulating mechanisms of supply and demand as well as the superiority or productive investments over idle consumption—went unchallenged in pre-Keynesian analysis. Say's Law has recently been rehabilitated by several authors:
Thomas Sowell, Say's Law: An Historical Analysis (1972); and Classical Economics Reconsidered (1974);
Robert Clower and Axel Leijonhufvud, “Say's Principle, What It Means and What It Does Not Mean.” International Economic Review 4 (Fall 1973); and
William Hutt, A Rehabilitation of Say's Law (1974).
Part of Lord Keynes's misreading of Say's Law came from its unsatisfactory presentation in J.S. Mill's Principles of Political Economy. More accurately formulated, this economic law states that “demands in general” are “supplies in general”; or, the supply of one kind of goods creates the demand for whatever goods the supplier will acquire in exchange for the supplier's goods or their money price.
“Say's Identity” asserts that no one wants to hold money long, so that every offer (supply) of a quantity of goods automatically constitutes a demand for some other goods of equal market value. A general glut (overproduction of goods and services) is logically impossible.
“Say's Equality” holds that periods of disequilibrium where demand falls short of supply are only temporary and soon disappear with reliable equilibrating forces.
Say's Law had conceptual roots in the Physiocrats' writings, as in Mercier de la Rivière's L'Ordre Naturel (1767). [Cf. J.J. Spengler, “The Physiocrats and Say's Law of Markets,” Journal of Political Economy 53 (1945)]. The belief that Say's Law is incomplete in the first edition (1803) of Say's Traité d'économie politique and that James Mill's Commerce Defended (1807) contains a more explicit Say's Law, results from a superficial reading of Say's first edition. In that edition, much of Say's exposition appears further on in the Traité Vol. II, Book 4 and not in his chapter on débouchés Vol. I, Book 1. Also, Donald Winch's James Mill: Selected Economic Writings (1966) p. 34, shows that Mill both explicitly credits Say with the idea and cites him.
Say's chapter “Des Débouchés” should be translated “on outlets for goods” and denotes the availability of effective demand. Say stated that it is “the abundance of other products in general that facilitates sales. This is one of the most important truths of political economy.... When the exchanges have been completed, it will be found that one has paid for products with products.”
Say emphasized that a given investment expenditure stimulated the wealth of an economy far more than an equal amount of consumption. Say held that “the public interest is consequently not served by consumption, but it is served and served prodigiously by saving, ... the labouring class is served by it more than anyone else. [Savings] are consumed; they furnish markets for many producers; but they are consumed reproductively and furnish markets for the useful goods that are capable of engendering still others, instead of being evaporated in frivolous consumption.”
What needed encouragement and incentives, Say stressed, was the habit of savings; however, arbitrary acts against property as well as freely voted tax increases introduced powerful disincentives against savings.
Say in the Traité, Vol. II, Book 4, Chapter 5 (1803), held that the “demand for products in general is therefore always equal to the sum of the products available.... No glut occurs except when too large a quantity of factors of production is devoted to one type of production and not enough to another.... Means of production are consequently lacking for the former to the extent they are superabundant for the latter.... Inability to sell, therefore, arises not from overabundance but from the misallocation of the factors of production.” Say adds that the notes that Germain Garnier included in his translation of Smith (1802) indicated that “over-abundance of the annual product would ‘obstruct trade; if it were not absorbed by proportionate amounts of consumption’.” Say continued: “I realize that trade can be obstructed by the overabundance of particular products. It is an evil that can never be anything but temporary, for participation in the production of goods ... will instead be devoted to the production of goods that are sought after. But I cannot conceive that the products of the labour of an entire nation can ever be overabundant since one good provides the means to purchase the other.”
This statement of Say's Law seems to lack only a rationale. This is supplied first in Say's expanded chapter on débouchés in the second edition (1814): “every product is created only to be consumed ... as quickly as possible, since every value whose realization is delayed causes a loss to the individual who is currently its possessor of the interest earning corresponding to that delay.”
Keynesians have viewed Malthus's opposition to Say's Law as ‘progressive’. But Malthus defended the feudal landholders against the emerging capitalists (Marx saw such writings as “apologetics ..., partly for ‘strong governments’ whose expenditure is heavy, for the increase of State debts, for holders of sinecures, etc.”).
Say and Mill as proponents of saving and investment (productive consumption) opposed government expenditure such as military spending (unproductive consumption). Mill, following Say, insisted (1807): “it is the maintenance of great fleets and armies, which is always the most formidable weight in the scale of consumption.”
“The Political Economy of the ‘Dispersive Revolution.’” Scottish Journal of Political Economy (UK), 23 (1976): 205–219.
Demands for greater political participation in government are often greeted with sneering words recalling Hunt's:
Were you to preach in most parts of the world, that political connexions are founded on voluntary consent or a mutual promise, the magistrate would soon imprison you, as seditious, for loosening the ties of obedience, if your friends did not shut you up as delirious, for advancing such absurdities.
More soberly, we can offer a review of how we might use economic analysis to examine the demand by the individual for more participation in industrial and political decision making.
The conventional ways of formulating the process of choice conjure up the image of human beings reacting like Pavlovian dogs to external stimuli. These are unsatisfactory ways and it is dangerous to base judgments about society's welfare on them. Liam Hudson (Human Beings: The Psychology of Human Experience, 1975), stays more to the point when he says that if we “see the individual as passive—either as the victim of events that lie outside himself, or as a mere knot of sensations ... we strip the individual of his special status as an agent: someone who makes sense of himself and the world around him, and then acts in the light of the sense he makes.” We will find a more useful paradigm of choice, as J. Buchanan argues, in the principle of gains-from-trade as exemplified by Austrian economist Eugen von Bohm-Bawerk's horse traders rather than in the housewife shopping for groceries in the supermarket who exemplifies the passive maximizer.
Increasingly, persons demand greater control over the political environment and the work situation. Such evidence supports this “break-out” theory of individual economic behavior which suggests that the individual has a strong incentive to seek information on alternative political and economic systems.
But in analysing the demand for political decentralization in countries with centralized government we must consider the actual distribution of political power. Predictions based on reality are likely to surpass those based on some principle of the legitimacy of the exercise of political power. The demand for decentralization may emanate not so much from individual citizens as from interest groups. Thus the Report of the Commission on the Constitution (UK) provides evidence that bargains designed to alter the function of government are not between private invididuals and groups whose representatives carry out their decisions. Such bargains actually arise between entrenched political parties, on the one hand, and a wide range of dissident groups of varying size and efficiency on the other. Such groups differ sharply about how the world looks to them and what it is feasible for government to do.
However, the growth of central government may eventually promote a reaction from individual citizens against the government's control over their daily lives. Citizens reacting to this growing impersonality and remoteness of government may also demand political decentralization. It will arise when individuals express their frustration over the government's inefficient goods and services. The degree of this frustration will depend on the disproportion between their tax obligations and the amount and form of service which they really want.
We can draw a stark contrast between the hierarchical order of the workplace and the democratic order to which at least some pay lip-service. But if alienation serves as a function of hierarchical organization, we cannot explain it away by property relations, because collective ownership of the means of production is not synonomous with democratization at the shop floor level. As Ota Sik argues (The 1973 Ernest Bader Common-Ownership Lecture), a centrally planned system perpetuates hierarchies in firms and creates another source of alienation—the gulf between the structure of production and the structure of needs. In any case, we cannot even be certain that workers would prefer nonhierarchical, i.e., self-managed firms.
“The American Express Case: Public Good or Monopoly?” The Journal of Law and Economics 19 (1976): 163–175.
In 1974 the Consumers Union battled the American Express Company and the U.S. Shoe Retail Corporation, appealing to the Sherman Act. “Restraint of trade” was charged along with “restrictive contract” because American Express obliged retail stores not to give discounts to money paying customers in preference to American Express card purchasers. Consumers Union intimated that credit cards were unjustified by any service provided by the cards, and raised prices unfairly. Eventually American Express settled out of court and waived its “restrictive” contract stipulations.
An important theoretical issue raised by the suit is the effect of credit card usage on pricing. One important motive for using credit cards has generally been overlooked. This factor mitigates the effects of credit cards on prices. Credit card companies provide advertising and “brand name” services, which generally reduce search and information costs for both customer and retailer. Other explanations for the use of credit cards focus primarily on the motivation of the customer in using a credit card; they fail to explain the motivation of the retailer in accepting credit cards. In addition, credit cards provide certain benefits not provided by other instruments (e.g., travelers checks). Advertising services provided by credit cards are generally neglected in any study.
In the long-run, economic reasoning suggests that the granting of cash discounts for money purchases (in contrast to credit card purchases) will not be wide-spread.
Free Market Banking
“Thomas Jefferson on Money and Banking: Disciple of David Hume and Forerunner of Some Modern Monetary Views.” History of Political Economy 7 (1975): 156–173.
While Jefferson's monetary views have been criticized on the basis of inconsistency and of his presumed failure to understand banking, they were generally consistent with the views of David Hume. And after allowance for the general substitution of demand deposits for bank notes, they are not greatly different from the views of some leading economists today.
Jefferson's proposals for monetary reform were grounded in the libertarian views of Spinoza, Locke, Montesquieu, Hume, Smith and other seventeenth and eighteenth century writers who espoused the natural rights of the individual within a stable framework of rules for competition and enterprise.
Jefferson studied those writers who had already described a system in which most day-to-day restrictions, such as wage and price fixing, trade barriers, occupational restrictions, and other economic controls handed down from the Middle Ages, could be dispensed with. He shared their view that a community is most thriving when left free to individual enterprise. His opposition to chartering the First Bank of the United States reflected his view that the power of the federal government should be limited.
Jefferson's experience with excessive paper money issues encompassed three periods: (1) the colonial period, (2) the Revolutionary War, and (3) the state-bank emission from 1811 to 1816. The emissions in each period were followed by widely fluctuating prices and sharp changes in debtor-creditor relationships. In consequence, he proposed a banking system that would eliminate the economic instability caused by such issues.
Hume outlined a 100 percent commodity reserve banking system that would rigidly limit the quantity of money to the quantity of specie. Like Hume, Jefferson held that an increase in circulation of paper money did not induce an increase in commerce, manufactures, or capital. Adam Smith missed a point shared by Hume and Jefferson: “that paper money has an impact on the total quantity of money and on prices.” Jefferson, on the basis of his experience with American banking, criticized Smith: “The only advantage which Smith proposes by substituting paper in the room of gold and silver ... is to replace an expensive instrument with one less costly.... But this makes no addition to the stock of capital of the nation.”
Jeffersonian economists, such as Charles Holt Carroll, hold that no gains were added to a nation's wealth by an increase in paper money, and continued Jefferson's criticism of Smith.
Among U.S. writers whose monetary proposals are similar to Hume's and Jefferson's are Irving Fisher, Henry Simons, Lloyd Mints, and Milton Friedman.
Although separated by more than a century, Jefferson and the typical recent proponent of more rigid monetary control share many basic political and economic views. Each supports an institutional framework that would provide for compatibility of individual and social interest. Both believe the function of the state should be limited to the production of public goods and services—the maintenance of law and property rights to prevent coercion of one individual by another, common defense, fire protection, roads, a stable monetary system—and that control of resources and production in the private sector should be determined exclusively by enterprise and competition.
In sum, Jefferson proposed a money and banking system that was consistent with his strong libertarian views. His experience with monetary instability and his studies of leading economists convinced him that only a purely specie currency would meet his criteria for a stable monetary unit.
He saw unstable money producing major price changes, altering debtor-creditor relationship, causing windfall gains and losses in private wealth, disrupting foreign trade, and reducing the efficiency of domestic resource use. He believed that no real gain in wealth or production would result from a rising volume of paper money. Consequently, he proposed that banks should be prohibited from issuing monetary liabilities and should operate in much the same way that savings and loan associations and mutual savings banks operate today.
Income and Motivations
“Theories of Personal Income Distribution: A Survey.” Journal of Economic Literature 16 (1978): 1–55.
Why does one individual earn a larger income than another? More sophisticated versions of this question raise moral issues of fairness and distributive justice as well as economic problems.
Economists, through empirical and theoretical studies, are waging a “great debate” to explain general inequalities and equalities of income earned by various income classes or individuals. They advance many separate reasons for such income differences: inherited abilities (I.Q.), opportunity, family environment, educational training, voluntary individual choices and efforts, or investments which individuals make in their own “human capital” to maximize their opportunities.
Some of these proposed reasons are used to support government redistributions (inheritance and other taxes) or social engineering (public education, etc.) in the hope of increasing equality. Others of these reasons favor the voluntary, spontaneous order of the marketplace and a tolerance for whatever income distributions or inequalities the market produces without government intervention. The unanswered ethical questions are whether or not economic inequalities are unfair in themselves and, if so, why? One of the unanswered economic questions is how can one measure psychic and subjective “income” (beauty, love, admiration, etc.) or hidden sources of material income.
Ability as the cause of personal income distribution has been among the oldest theories. Vilfredo Pareto showed that incomes were distributed not normally but lognormally (skewed towards inequality). The Cambridge School (England), and more recently American Cambridge (Harvard-MIT), have sought explanations in inheritance and institutional organization. With roots in Ricardo and Marx through A. C. Pigou and J. M. Keynes, the Cambridge Theory (expounded by Lord Kaldor, and by Luigi Pasinetti) distinguishes between different savings propensities among social classes and income sources. Kaldor's model of substantial differences in long-run propensities to save by different income classes was refuted in Milton Friedman's A Theory of the Consumption Function (1957).
Public Income Distribution theories seek to find what are the effects of taxation or coercive distribution of incomes. Empirical studies suggest redistribution comes either from upper to lower income classes, or from lower to upper classes. However, Director's Law as stated by George Stigler [Journal of Law and Economics 13 (April 1970)], is based on the fact that the state is used to redistribute income to those who control the state. Stigler concludes that in democracies the middle classes control the state and are therefore the beneficiaries of coercive redistribution.
Based on Pareto's lognormal or skewed income distribution conclusion, some economists have explained that additional talents or abilities tend to multiply a person's productivity (a lognormal rather than additive effect). Some have found relationships between ability and education, ability and responsibility, as well as ability and the future-oriented aptitude for saving or capital accumulation. Harold Lydall has emphasized “the D-factor'—drive, doggedness, determination—as having a multiplicative effect on income.
One interesting fact (A.R. Thatcher's study) is that income distribution among homogeneous manual workers is an unequal as that of the whole population—and has remained so since 1886. In the end, therefore, the ability theory—which sees a person's abilities as the cause of income differences—remains a strong competitor with modern, sophisticated theories, such as the human capital theory.
Milton Friedman's individual choice theory is rooted in the differences among people in their attitudes toward risk—risk preferences. In Friedman's analysis, dynamic societies are characterized by very few high risk-takers and large majorities of the risk-indifferent or risk-averters. Mounting poverty occurs in societies that increasingly tend to prefer the risks of less income (or savings) and the higher utility of nonmonetary advantages. Such choices are influenced by the costs or rewards introduced by coercion, taxation, subsidies, and public transfers of income.
Taking off from Friedman, the Chicago School has developed a more refined Human Capital Theory of income distribution. Human Capital Theory emphasizes that investment in oneself is the result of rational, optimizing decisions (by individuals or their parents). Such decisions are made on the basis of estimates of the probable present value of alternative life style income streams, discounted at some appropriate rate. People with higher ability invest more in themselves, do so at younger ages, and earn higher rates of return on their human capital. The Human Capital Theory has been attacked by the “screening theories” of the Cambridge School: schooling does not teach but merely “screens” those with desirable traits, making schooling an elitist rather than an equalizing device.
Ideological values lie behind the whole issue of income distribution: should society by pass the market's voluntary patterns of production and distribution and allow government to coercively determine the “laws” of distribution at will?