The Rise and Fall of Classical Economics

That able but wrong-headed man, David Ricardo, shunted the

car of economic science on to a wrong line—a line, however, on

which it was further urged toward confusion by his equally able

and wrong-headed admirer, John Stuart Mill.

—William Stanley Jevons (1965, li)

The time between Adam Smith and Karl Marx was marked by the thrill

of victory and the agony of defeat. The French laissez-faire school of

Jean-Baptiste Say and Frédéric Bastiat advanced the Smithian model

to new heights, but it was not to last, as the classical model of Thomas

Robert Malthus, David Ricardo, and John Stuart Mill took economics

down into desperate straits. This chapter tells an ominous story.

Upon the publication of Adam Smith’s Wealth of Nations in 1776,

a new era of optimism swept Europe. Social reformers were hopefully

following the American revolution that promised “life, liberty

and the pursuit of happiness,” and a French revolution that pledged

“liberté, égalité, fraternité.” William Wordsworth described the early

idealism of the French Revolution when he wrote, in The Prelude

(Book 11, lines 108–09):

Bliss was it in that dawn to be alive,

But to be young was very Heaven!

Ever since Sir Thomas More wrote Utopia, philosophers have

dreamed of a world of universal happiness with no wars, no crime,

and no poverty. The genius of Adam Smith was his development of

an economic system of “natural liberty” that could bring about a

peaceful, equitable, and universal opulence.

Smith’s model of universal prosperity was encouraged initially by

disciples from a country that had for centuries been Great Britain’s fiercest

enemy. The French economists Jean-Baptiste Say (1767–1832) and

Frederic Bastiat (1801–50), building upon the sound principles developed

by Cantillon, Montesquieu, Turgot, and Condillac, championed the

boundless possibilities of open trade and a free entrepreneurial society.

They improved upon the classical model of Adam Smith by rejecting the

notions of a labor theory of value and the exploitation of workers under

free-enterprise capitalism. Theirs was the famous school of “laissez faire,

laissez passer” (leave us alone, let goods pass) and “pas trop gouverner”

(not to govern too strictly). Free trade and limited government would

encourage economic performance and entrepreneurial excellence.

Bastiat, a brilliant French journalist, was an indefatigable advocate

of free trade and laissez-faire policies, a passionate opponent

of socialism, and an unrelenting debater and statesman. Bastiat was

unrivaled in exposing fallacies, condemning such popular cliches as

“war is good for the economy” and “free trade destroys jobs.” In his

classic essay, The Law (1850), Bastiat established the proper social

organization best suited for a free people, one that “defends life, liberty,

and property . . . and prevents injustice.” Under this legal system,

“if everyone enjoyed the unrestricted use of his faculties and the free

disposition of the fruits of his labor, social progress would be ceaseless,

uninterrupted, and unfailing” (Bastiat 1998 [1850], 5).

Smith was deeply influenced by Quesnay, Turgot, and Voltaire, and

once The Wealth of Nations was published, the French were successful

in publicizing Smith’s model of free enterprise and liberalized

trade throughout the Western world. They translated Smith’s book,

published the first encyclopedia of economics and the first history of

economic thought, and wrote the first major textbook in economics,

Say’s Treatise on Political Economy, which was the principal textbook

in the United States and Europe during the first half of the nineteenth

century. Many of the Smithian principles were adopted by Alexis de

Tocqueville in his profound study Democracy in America, including

individualism, enlightened self-love, industry, and frugality.

“The French Adam Smith”

J.-B. Say (1767–1832) was called “The French Adam Smith.” Witness

to both the American and French revolutions, he was a cotton

manufacturer who believed that sound economics should be built upon

good theory and models that could be tested by observation lest they

become unrealistic and misleading. He was critical of his colleague

David Ricardo’s labor theory of value and his penchant to abstract

model building, leading economics down a dangerous road. According

to Say, economists like Ricardo who don’t support their theories with

facts are “but idle dreamers, whose theories, at best only gratifying

literary curiosity, were wholly inapplicable in practice” (Say 1971

[1880], xxi, xxxv)

Say introduced several sound principles of economics in his Treatise

on Political Economy, first published in 1805, particularly the essential

role of the entrepreneur and Say’s law of markets, which became the

fundamental principle of classical macroeconomics.

In Chapter 7 of Book II, “On Distribution,” Say introduced the

role of the entrepreneur, the “master-agent” or “adventurer,” as an

economic agent separate from the landlord, worker, or even capitalist.

For Say, the entrepreneur serves as a creator of new products and processes,

and manager of the right combination of resources and labor.

To succeed, the entrepreneur must have “judgment, perseverance, and

knowledge of the world,” Say noted. “He is called upon to estimate,

with tolerable accuracy, the importance of the specific product, the

probable amount of the demand, and the means of production: at one

time he must employ a great number of hands; at another, buy or order

the raw material, collect laborers, find consumers, and give at all

times a rigid attention to order and the economy; in a word, he must

possess the art of superintendence and administration.” He must be

willing to take on “a degree of risk” and there is always a “chance of

failure,” but when successful, “this class of producers . . . accumulates

the largest fortunes” (Say 1971 [1880], 329–32).

Say’s Law: The Classical Model of Macroeconomics

Say is also famous for developing the classical model of macroeconomics,

known as Say’s law of markets—“supply creates its own demand.” It has

been the source of much misunderstanding, especially by Keynes, who

distorted the true meaning of Say’s law (for more on this, see chapter 5

on Keynes). In chapter 15 of his textbook, Say introduced the idea that

production (supply) is the source of consumption (demand). He used an

example in agriculture: “The greater the crop, the larger are the purchases

of the growers. A bad harvest, on the contrary, hurts the sale of commodities

at large” (1971 [1880], 135). In other words, Say’s law is really this:

the supply (sale) of X creates the demand (purchase) for Y. To use an upto-

date example, when Microsoft created Windows software, it created

a boom in jobs and consumer spending in Seattle; when Microsoft was

sued by the federal government for antitrust violations and its stock fell,

Seattle’s economy suffered and consumption declined.

Say’s law is consistent with business-cycle statistics. When a

downturn starts, production is the first to decline, ahead of consumption.

And when the economy begins to recover, production is the first

to make a comeback, followed by consumption. Economic growth

begins with an increase in productivity, a rise in new products and

new markets. Hence, business spending is always a leading indicator

over consumer spending. Say concluded, “Thus, it is the aim of good

government to stimulate production, of bad government to encourage

consumption” (1971 [1880], 139).

A corollary of Say’s law is that savings is beneficial to economic

growth. He denied that frugality and thrift might lead to a decline in

expenditures and output. Savings is simply another form of spending,

and perhaps even a better form of spending than consumption because

savings is used in the production of capital goods and new processes. No

doubt Say was influenced by his reading of Benjamin Franklin’s defense

of thrift as a virtue in the latter’s Autobiography, and in adages such as

“a penny saved is a penny earned” and “money begets money.”

Steven Kates summarizes the conclusions of Say’s law of markets

and classical macroeconomics (Kates 1998, 29):

1. A country cannot have too much capital.

2. Saving and investment form the basis of economic growth.

3. Consumption not only provides no stimulus to wealth creation

but is actually contrary to it.

4. Demand is constituted by production.

5. Demand deficiency (i.e., over-production) is never the cause of

economic disturbance. Economic disturbance arises only if goods

are not produced in the correct proportion to each other.

The Classical Model and the “Dismal Science”

Adam Smith’s optimistic vision was never in more capable hands

than those of the French devotees of laissez-faire. Short of marginal

analysis, they carried the doctrine of the invisible hand and the natural

harmony of the market system to its zenith. Unfortunately, though,

the story of economics suddenly took an unexpected shift from the

upbeat world of Adam Smith to what would be labeled “the dismal

science.” Remarkably, the apostasy away from Smith’s masterpiece

began with the writings of two of his own disciples in his own country,

Thomas Malthus and David Ricardo.

The British economists Thomas Robert Malthus (1766–1834), David

Ricardo (1772–1823), and John Stuart Mill (1806–73) continued the

classical tradition in supporting the virtues of thrift, free trade, limited

government, the gold standard, and Say’s law of markets. In particular,

Ricardo vigorously and effectively advocated an anti-inflation,

gold-backed British pound sterling policy as well as a repeal of both

the Corn Laws, England’s notoriously high tariff wall on wheat and

other agricultural goods, and the Poor Laws, England’s modest welfare

system.

The Diamond-Water Paradox

Yet there was a problem. Classical economics after Adam Smith

suffered from a serious theoretical flaw that provided ammunition

to Marxists, socialists, and other critics of capitalism. Smith himself

supported an optimistic model favoring the harmony of interests and

universal prosperity. He used the making of pins and the woolen coat

to explain how laborers and capitalists work together to create usable

products. But he had no real concept of how prices and the costs of

productive factors were determined in the marketplace to satisfy consumer

wants, a flaw that undermined his harmonic model.

The question Smith and the classical economists tried to answer

was: How are goods and services, and the productive factors, valued in

a growing economy to satisfy consumer wants? They tried to answer

this question by resolving the famous diamond-water paradox. Why is

it that an essential commodity like water is so little valued in the marketplace

while impractical diamonds are so highly prized? To Smith

and his disciples, this paradox was irresolvable. They were baffled

by the observation that some goods were valued more in “exchange”

than in “use.” The failure to resolve this paradox, which remained

unanswered until a generation later by the marginalist revolution (see

chapter 4), led to disastrous results. Marxists and socialists used this

wedge to label commercial society as unjust and immoral, a system

in which profit trumps consumer satisfaction.

Furthermore, Smith’s disciples, especially Malthus, Ricardo, and

Mill, promoted an antagonistic model of income distribution under

capitalism that gave classical economics a bad reputation, leading

English critic Thomas Carlyle to label it “the dismal science.” Instead

of focusing on Smith’s positive view of wealth creation and harmony

of interests, his British disciples emphasized the distribution of wealth,

the conflict of interests, and the labor theory of value.

Malthus Challenges the New Model of Prosperity

The first challenge to Smith’s wonderful world came from an irreverent

young parson, Thomas Robert Malthus. In 1798, at the age of

thirty-two, Malthus published an anonymous work, entitled Essay on

Population, which contended that earth’s resources could not keep

up with the demands of an ever-growing population. His brooding

tract forever changed the landscape of economics and politics, and

quickly cut short the positive outlook of Smith, Say, and other students

of the Enlightenment. Malthus, along with his best friend, David

Ricardo, asserted that pressures on limited resources would always

keep the overwhelming majority of human beings close to the edge

of subsistence. Accordingly, Malthus and Ricardo reversed the course

of cheerful Smithian economics, even though, ironically, they were

stringent followers of Smith’s laissez-faire policies.

Malthus has had a powerful impact on modern-day thinking. He

is considered the founder of demography and population studies. He

is acknowledged to be the mentor of social engineers who advocate

strict population control and limits to economic growth. His essay

on population underlines the gloomy and fatalistic outlook of many

scientists and social reformers who forecast poverty, crime, famine,

war, and environmental degradation due to population pressures

on resources. He even inspired Charles Darwin’s theory of organic

evolution, which explains how limited resources facing unlimited

demands created the power of natural selection and survival of the

fittest. Ultimately, the fatalistic pessimism of Malthus and Ricardo

has given economics its reputation as a “dismal science.”

Malthus’s doomsday thesis was that “the power of population is

indefinitely greater than the power of the earth to produce subsistence

for man,” and therefore the majority of humans were doomed to live

a Hobbesian existence (1985 [1798], 71). His book identified two

basic “laws of nature”: first, population tends to increase geometrically

(1, 2, 4, 8, 16, 32, etc.), and second, food production (resources)

tends to increase only arithmetically (1, 2, 3, 4, 5, etc.). The means

of supporting human life were “limited by the scarcity of land” and

the “constant tendency to diminish” the use of resources, a reference

to the law of diminishing returns. The result would be an inevitable

crisis of “misery and vice” whereby the earth’s resources would not

satisfy the demands of a growing population (Malthus 1985 [1798],

67–80, 225).

Is Malthus right about the first “law of nature,” that human population

grows geometrically? Indeed, since Malthus wrote his essay, the

world’s population has skyrocketed from fewer than 1 billion people

to over 6 billion. However, in looking more deeply at the sharp rise in

world population since 1800, we see that the cause is not Malthusian

in nature. The increase has been due to two factors unforeseen by

Malthus. First, there has been a sharp drop in the infant mortality rate

due to the elimination of many life-threatening diseases and illnesses

through medical technology. Second, there has been a steady rise in

the average human life span due to higher living standards; medical

breakthroughs; improvements in sanitation, health care, and nutrition;

and a decline in the accident rate. As a result, more people are living

to adulthood, and more adults are living longer.

At the same time, there is a good chance that world population will

soon top out, due especially to the sharp slowdown in the birthrate

over the past fifty years in both industrial and developing countries.

This is largely due to the wealth effect: wealthier people tend to have

fewer children (contrary to what Malthus predicted). Over the past

fifty years, the birthrate in developed countries has fallen from 2.8 to

1.9 children per family, and in developing countries from 6.2 to 3.9.

The trend is unmistakable: women are having fewer children, and in

some more developed countries, especially in Europe, the birthrate

is far below replacement.

Malthus’s Sins of Omission

What about Malthus’s second “law of nature,” which says that resources

are limited and restricted by the law of diminishing returns?

Here again, history has not supported Malthus. The law of diminishing

returns only applies if we assume “all other things equal,” that

technology and the quantity of other resources are fixed. But no input

is fixed in the long run—neither land, nor labor, nor capital. The economic

importance of land has in fact dwindled in the modern world,

due to intensive farming techniques and the green revolution. Malthus

ignored the technological advances in agriculture, the constant

discovery of new minerals and other resources in the earth, and the

role of prices in determining how fast or slow resources are used up.

In short, he failed to recognize human ingenuity.1

Malthus proved to be spectacularly wrong about food production,

the advent of farming technology, the use of fertilizers, and

the vast expansion of irrigation. The amount of cultivated land and

the volume of food production have both risen dramatically. In fact,

most famines have been blamed on ill-advised government policies,

not nature.

The story of Thomas Malthus is instructive in developing an

understanding of the dynamics of a growing economy and a rising

population. Granted, Malthus recognized that government intervention

is typically counterproductive in alleviating poverty and controlling

population growth, and thus he joined Adam Smith in adopting a

laissez-faire policy (he was vilified by critics for opposing poverty

programs, birth control, and even vaccines). But he ultimately abandoned

his mentor by disavowing faith in Mother Earth and the free

market’s ability to match the supply of resources with the growing

demands of a rising population. Essentially, he failed to comprehend

the role of prices and property rights as an incentive to ration scarce

resources and as a problem-solving mechanism. Worse, he misunderstood

the dynamics of a growing entrepreneurial economy—how

a larger population creates its own seeds of prosperity through the

creation of new ideas and new technology.

Although Adam Smith did hint at the idea of a subsistence wage,

he firmly believed that wage earners could rise above subsistence

through the adoption of machinery, tools, and equipment. Free-market

capitalism was the escape mechanism from poverty. Malthus, on the

other hand, was gloomy and even fatalistic about man’s ability to

break away from misery and vice. For him, mankind was destined to

be chained to the iron law of wages.

David Ricardo, for Good or Bad

The eminent British economist David Ricardo fell into the same trap

as his friend Malthus. A financial economist who made a fortune in

government securities, Ricardo made many positive contributions to

economic science, especially the law of comparative advantage and

the quantity theory of money. He promoted free trade and hard money,

and his writings influenced the repeal of the Corn Laws, England’s

notorious high tariff wall on agricultural goods in 1846, and England’s

return to the gold standard in 1844. Yet David Ricardo had a dark

side. His analytical modeling is a two-edged sword. It gave us the

quantity theory of money and the law of comparative advantage, but

it also gave us the labor theory of value, the iron law of subsistence

wages, and something economists call the “Ricardian vice,” defined

as either the excessive use of abstract model building or the use of

false and misleading assumptions to “prove” the results one desires

(such as his labor theory of value). Some of the worst ideas picked up

by Karl Marx and the socialists come directly from reading Ricardo’s

textbook On Principles of Political Economy and Taxation (1951

[1817]). Marx hailed Ricardo as his intellectual mentor. A school of

“neo-Ricardian” socialists has developed under the influence of Piero

Sraffa, Ricardo’s official biographer.2

Essentially, Ricardo, for all his love of Smith, took economics down

a very dangerous road, apart from his policy recommendations. He

created a new economic way of thinking, away from the harmonious

“growth” model of Adam Smith and toward an antagonistic “distribution”

model, where workers, landlords, and capitalists fought over

the economy’s desserts. Marx and the socialists exploited Ricardo’s

hostile system to the fullest. Smith’s model focuses on how to make

the economy grow, while Ricardo’s model stresses how the economy

is divided up among various groups or classes. Ricardo emphasized

class conflict rather than Smith’s “natural harmony” of interests.

The Ricardian Device or Vice?

Ricardo is considered the founder of economics as a rigorous science

involving mathematical precision. The financial economist had a

remarkable gift of abstract reasoning, developing a simple analytical

tool involving only a few variables that yielded, after a series of manipulations,

powerful conclusions. This model-building approach has

been adopted by many prominent economists, including John Maynard

Keynes, Paul Samuelson, and Milton Friedman, and has led to the

popularity of econometrics. Mark Blaug comments, “If economics

is essentially an engine of analysis, a method of thinking rather than

a body of substantial results, Ricardo literally invented the technique

of economics” (Blaug 1978, 140).

But “blackboard economics,” as Ronald Coase calls it, has its

drawbacks. It uses unrealistic and sometimes even false assumptions.

Without reference to history, sociology, philosophy, or institutional

framework, Ricardo’s device becomes a Ricardian vice, stripping economics

of its soul. Purely deductive reasoning and high mathematical

formulas divorce theory from history. Take a look at Paul Samuelson’s

Foundations of Economic Analysis (1947) or neo-Ricardian Piero

Sraffa’s Production of Commodities by Means of Commodities (1960).

Samuelson’s book is virtually nothing but differential equations and

assumptions far removed from reality. Sraffa’s work hardly contains a

single sentence that refers to the real world. They are both very much

in the tradition of Ricardo.

“The origin of the misapprehension upon which the whole of

economic theory is based must be traced to David Ricardo,” writes

56 THE BIG THREE IN ECONOMICS

Elton Mayo, a business professor at Harvard (1945, 38). Mayo blames

Ricardo’s unrealistic theorizing on his background as a stockbroker,3

far removed from the realities of the producing economy (1945, 39).

Adam Smith’s Wealth of Nations abounded with theoretical

propositions, but his theories were followed by numerous historical

illustrations. Not so with Ricardo. “His ingenious mind,” writes one

historian, “essentially that of a brilliant theoretician, never displayed

any significant interest in the past” (Snooks 1993, 23). It was this kind

of abstract theorizing that caused J.-B. Say to label economists “idle

dreamers” (1971 [1880], xxxv). Even Paul Samuelson (himself an

abstract thinker) confessed once, “It has sometimes been suggested

that our most advanced students know everything except common

sense” (1960, 1652). Indeed, studies by Arjo Klamer and David

Colander suggest a certain disillusionment with the highly abstract

mathematical modeling that pervades Ph.D. programs in economics.

After surveying the graduate programs at six Ivy League schools,

Klamer and Colander conclude that “economic research was becoming

separate from the real world” (1990, xv). Formalism has an iron

grip on the discipline.

Heuristic model building can be useful in generating best estimates

and decent results, but modeling can easily distort reality and lead to

damaging results. In his classic work, On the Principles of Political

Economy and Taxation, Ricardo carried his theorizing to extreme levels,

whereby he made all kinds of limiting and dubious assumptions

in order to get the results he was looking for. Ricardo’s Principles

was tedious and abstract, full of Euclidian-like deductions with no

historical case studies. Students often called it “Ricardo’s book of

headaches” (St. Clair 1965, xxiii).

Economists are seldom indifferent about Ricardo. They either love

or hate him, and sometimes both. Perhaps John Maynard Keynes best

sums up this attitude: “Ricardo’s mind was the greatest that ever addressed

itself to economics,” Keynes said, and then complained that

“the complete domination of Ricardo’s [economics] for a period of

3. A highly successful speculator who made a fortune as a stockjobber and government

loan contractor during the Napoleon wars. See my article, “How Ricardo

Became the Richest Economist in History,” The Making of Modern Economics

(2001, 96–97).

a hundred years has been a disaster to the progress of economics”

(Keynes 1951 [1931], 117).

Ricardo Focuses on Distribution, Not Growth

How did Ricardo shift away from his mentor, Adam Smith? Smith

recognized that economic freedom and limited government would

create “universal opulence,” but the founder of classical economics

struggled to develop a sound theoretical framework (other than the

division of labor) with which to explain how consumers and producers

work through the profit-and-loss system to achieve this “universal

opulence.” Ricardo and the British disciples took Smith’s parenthetical

statements (such as his labor theory of value in a crude economy, and

his criticism of landlords) and created a model of class struggle rather

than one of harmony of interests—the iron law of subsistence wages

instead of universal economic growth. They viewed the economy as if

it were a large cake, where a larger dessert for capitalists and landlords

could only mean a smaller piece for workers.

In a letter to Malthus, Ricardo explained his primary difference:

“Political economy, you think, is an enquiry into the nature and causes

of wealth [Adam Smith’s view]; I think it should rather be called an

enquiry into the laws which determine the division of the produce

of industry among the classes who concur in its formulation” (in

Rothbard 1995b, 82).

The difference between Adam Smith and Ricardo on this macro

model of the economy can best be illustrated in terms of a pie chart

(see Figure 2.1). For Ricardo’s “class conflict” model, the focal point

is how the fruits of the economy (the pie) should be divided between

workers, landlords, and capitalists. Clearly, if landlords and capitalists

get more of the pie, workers get less. And vice versa. For Adam

Smith’s “harmony of interests” model, the focal point is on making the

economy grow, to make the pie bigger. In this way, there need not be

a conflict of interests. If the pie gets bigger, everyone—the workers,

landlords, and capitalists—gets more.

Ricardo’s antagonistic system was tragic for everyone except the

landlords. In his “corn model,” as it is called, Ricardo’s workers were

machinelike units earning only subsistence wages over the long run.

If wages rose, workers would have more children, which would in

David Ricardo’s

antagonistic model

Adam Smith’s

harmonic model

turn increase the supply of laborers and force wages back down. Thus,

Ricardo’s “iron law of wages” presented a bleak outlook for workers.

Capitalists fared better, but were hardly animated. In Ricardo’s

model, they were a uniform, boring lot mechanically saving and accumulating

capital. Moreover, profits could increase only at the expense

of lower wages, and vice versa. In his Principles, Ricardo called this

inverse relationship between wages and profits the “fundamental

theorem of distribution.” He repeatedly stated, “In proportion then

as wages rose, would profits fall” (Ricardo 1951, I, 111) and “profits

depend on wages” (1951, I, 143, 35).

Worse, profits were also inclined to fall in the long run due to the

“law of diminishing returns.” Under Ricardo’s myopic worldview,

higher wages would stimulate population growth, which in turn meant

farming more land to feed more mouths, and that meant using less productive

land. The price of grain would rise, benefiting landlords’ rents,

but profits would fall because capitalists would have to pay workers

more to keep them from starving (due to higher food prices).

The only beneficiaries in Ricardo’s picture were the landlords.

They earned higher rents as grain prices rose. The tenant farmers did

not benefit from higher grain prices because they had to pay higher

rents. Ricardo vindicated the words of Adam Smith: “landlords love

to reap where they never sowed” (Smith 1965 [1776], 49).

Landlords

(rents)

Capitalists

(profits &

interest)

Workers

(wages)

􀀁

􀀁

􀀁

Landlords

(rents)

Capitalists

(profits &

interest)

Workers

(wages)

􀀂

􀀂

􀀂

Figure 2.1 Two Models of the Economy

According to Ricardo’s fatalistic system, wages tend toward subsistence

levels, profits decline long term, and landlords keep adding to

their share of unjust returns. As Oswald St. Clair comments, landlords,

“though contributing nothing in the way of work or personal sacrifice,

will nevertheless receive an ever-increasing portion of the wealth annually

created by the community” (St. Clair 1965, 3).

What was the flaw in Ricardo’s thinking? His corn model ignored

the benefits that workers accrue from technological advances that

make them more productive. Their wages would tend to rise as companies

became more profitable. (Empirical studies demonstrate that

industries with high profit margins tend to pay workers more.) He

failed to see landlord rents as price signals determining the highest

value or opportunity cost of land. Yet most economists would not

recognize these insights for another generation. Meanwhile, Marx and

the socialists picked up on Ricardo’s attack on the idle landlords and

the exploitive capitalists. In addition, Ricardo’s critique encouraged

Henry George’s land nationalization and single tax movement in the

late nineteenth century.

Ricardo Searches in Vain for Intrinsic Value in Labor

Finally, Ricardo was determined to find an “invariable measure of

value.” Instead of gold, the ultimate unit of account, he focused on

quantity of labor units (not wages!) as the numeraire. In classical

tradition, Ricardo fixed upon a cost-of-production theory of value,

arguing that price was generally determined by costs (supply) rather

than utility (demand). He was aware of exceptions to this cost theory,

such as “rare statues and pictures, scarce books and coins, wines of a

peculiar quantity” (Ricardo 1951, 12), and the impact of machinery.

But machinery and capital were nothing more than “accumulated

labour” (1951, 410). He later wrote, “my proposition that with few

exceptions the quantity of labour employed on commodities determines

the rate at which they will exchange for each other . . . is not

rigidly true, but I say that it is the nearest approximation to truth, as

a rule for measuring relative value, of any I have ever heard” (Vivo

1987, 193).

He struggled with the labor theory of value until the very last days

of his life. About a month before his death he wrote a fellow econo60

mist, “I cannot get over the difficulty of the wine which is kept in a

cellar for 3 or 4 years, or that of the oak tree, which perhaps had not

2/- expended on it in the way of labour, and yet comes to be worth

£100” (Vivo 1987, 193). Even Thomas Malthus disagreed with his

friend, writing, “neither labour nor any other commodity can be an

accurate measure of real value in exchange” (Ricardo 1951, 416).

Economists over the years have had difficulty understanding

Ricardo’s “corn model” and his Principles textbook, especially the

twisted assumptions he required to prove his theories. Ricardo once

remarked that only twenty-five people in the entire country could

understand it. A century later, Chicago economist Frank H. Knight

remarked, “there is much [here] I cannot follow” (1959, 365). Joseph

Schumpeter lambasted Ricardo for making most of the economic

players “frozen and given,” piling “one simplified assumption upon

another,” and developing a theory “that can never be refuted and

lacks nothing save sense” (Schumpeter 1954, 472–73). Just the kind

of theory Marx needed!

Perhaps Keynes had Ricardo in mind when he wrote, “It is astonishing

what foolish things one can temporarily believe if one thinks too

long alone, particularly in economics” (Keynes 1973a [1936], xxiii).

A Defective Classical Model Solidifies Under

John Stuart Mill

Yet David Ricardo was able to convince practically all his contemporaries

of his labor theory of value and his laissez-faire doctrines.

“Ricardo conquered England as completely as the Holy Inquisition

conquered Spain,” said Keynes (1973a [1936], 32). It was principally

through John Stuart Mill that the next generation adopted this classical

model that was more in line with Ricardo’s system of “class conflict”

than Adam Smith’s upbeat “harmony of interests” model.

The year 1848 was especially significant in this regard. It was a

year of rebellion and mass protest in continental Europe. Karl Marx

and Friedrich Engels wrote their revolutionary tract, The Communist

Manifesto. A specter was indeed haunting Europe—not just

communism, but a whole string of isms—Fourierism, Owenism,

Saint-Simonism, and transcendentalism. They all fell under the new

expression “socialism.” There was utopian socialism, revolutionary

socialism, and national socialism. All grew out of a reaction to the

rapid transformation from a rural economy to an industrial world.

The first half of the nineteenth century was an era of discontent—the

Industrial Revolution, the Napoleonic wars, and democratic revolts

throughout Europe. The growth model of Adam Smith was already

undermined by the discouraging works of Malthus and Ricardo. The

revolt of the masses in 1848 reflected the practical difficulties of

adjusting to a new industrial era.

The year 1848 was also significant for John Stuart Mill and his

influence in the world: it was the year of publication of Mill’s textbook,

Principles of Political Economy, a work that would dominate the

Western world for half a century, going through thirty-two editions,

until Alfred Marshall’s landmark textbook took over in 1890.

It was Mill’s textbook that declared that the laws of production were

objectively determined but the laws of distribution were variable. “The

Distribution of Wealth is a matter of human institution solely. They

can place them [goods] at the disposal of whomsoever they please,

and on whatever terms” (Mill 1884 [1848], 155). He added, “If the

choice were to be made between Communism with all its chances

and the present state of society with all its sufferings and injustices,

all the difficulties, great or small, of Communism, would be but as

dust in the balance” (1884 [1851], 159). His book also questioned the

veracity of private property.

Mill was a reflection of his times, enigmatic and lost in an age of

turmoil. In many ways, he was the embodiment of a Greek tragic hero,

a dashing protagonist who ended his career in bewildered misfortune,

including the early death of his beloved wife, Harriet. Here was a

great intellect, a classical liberal, and the last major proponent of the

classical school of economics. Like Ricardo, Mill espoused personal

liberty in his classic libertarian tract On Liberty (1989 [1859]). He

vigorously defended Say’s law of markets, the foundation of classical

macroeconomics, and opposed irredeemable paper money. He

objected to coercive morality, intolerance, and a state religion. And

he was an abolitionist who supported a woman’s right to vote.

Yet Mill was famous for his inconsistencies and contradictions.

He defended free enterprise but insisted he was a socialist. He flirted

with socialism throughout his career, favored revolutionary change

in Victorian culture, railed against overpopulation, and advocated

Ricardo’s distribution theory, separating production entirely from

distribution.4 His love of Benthamite utilitarianism blinded him to

frequent government intervention in the economy. He saw nothing

wrong with heavy taxation of inheritances and nationalization of

land, and questioned the justice of private property. According to

Friedrich Hayek, it was this kind of thinking that led intellectuals to

support all kinds of attacks on property and wealth, and grandiose

tax and confiscation schemes aimed at redistributing wealth and

income, thinking that such radical schemes can be accomplished

without hurting economic growth. Hayek observed, “I am personally

convinced that the reason which led the intellectuals to socialism

was a man who is regarded as a great hero of classical liberalism,

John Stuart Mill” (Boaz 1997, 50).

Mill influenced intellectuals from H.G. Wells to Sidney and Beatrice

Webb toward socialist thinking, so much so that Sir William

Harcourt, chancellor of the exchequer, could say in 1884, “we are

all socialists now” (Stafford 1998, 18). It would be years later before

economists, educated in marginal analysis, would counter the

radical redistributionists, who argued that the theory of distribution

cannot be separated from the theory of production. According to

the marginalist revolution, the producers of goods and services are

paid according to the fruits of their labor, based on their discounted

marginal product, and heavy taxation can only distort their incentive

to produce. Socialist measures to redistribute wealth and income do

indeed affect economic activity. As Hayek states, “if we did do with

that product whatever we pleased, people would never produce those

things again” (Boaz 1997, 50).

Mill was critical of revolutionary socialism, but expressed considerably

sympathy with utopian communitarianism, which operated with

a social conscience and without coercion. It was this kind of socialism

that he identified with. Thus, Mill set the stage “on a downward

slope leading from the eighteenth-century sanity and conservatism

of David Hume to the Fabian socialism and collectivism of Beatrice

Webb” (Stafford 1998, 19).

John Stuart Mill longed for the bliss of a voluntary communitarian

village, but all such communities have suffered from one defect: they

never lasted. New Harmony, Modern Times, United Order—they all

had high-minded names, yet they all eventually disintegrated as a

result of laziness, debt, or fraud.

A Dismal Science?

It was Thomas Carlyle (1795–1881), the English critic, who lashed out

at the classical economics of Malthus, Ricardo, and Mill and labeled

it “the dismal science,” because he thought free competition and utilitarian

democracy would lead to “anarchy plus the constable.” Behold

the pessimism of the iron law of subsistence wages and a miserly

Mother Nature: Carlyle saw a more sinister view of the ubiquitous

marketplace. A romantic conservative and Victorian moralist, Carlyle

complained that supply and demand puts a price on everything, and

“reduces the duty of human governors to that of letting men alone,”

leading to “a dreary, desolate, and indeed quite abject and distressing

. . . dismal science” (Carlyle 1904, IV, 353–54).

Classical economics, as characterized by Carlyle, left the West in

intellectual disequilibrium. Not long after Mill’s time, a new form of

socialism came onto the horizon, the violent revolutionary kind. If

fellow citizens could not be persuaded to cooperate and escape the

ills of raw anarchy and barbaric competition, then they must be forced

to obey through the iron fist and the bayonet. Gradually the eyes of

reformers all turned toward one authority, the second of the “big three”

in economics. Karl Marx is the subject of our next chapter.