The Rebirth of Classical Political Economy

The first contribution I want to note among the many made by these classical liberals is that of Friedrich Hayek in the field of the economics of knowledge. The story opens in 1935 with Hayek’s edition of a collection of essays under the title Collectivist Economic Planning, which I mentioned in my last column when discussing Oskar Lange’s market socialism. As I said there, Ludwig von Mises in 1920 had written a seminal article on the impossibility of centralized economic calculation. Hayek decided to republish it, together with studies of central planning by other authors and an introduction and a conclusion from his pen. In a gesture of unwonted fairness he as an appendix added the prime essay of the pro-central planning community, Enrico Barone’s “The Ministry of Production in the Collectivist State” (1908). 2 Nobody believes in a centrally planned economy anymore, but then it was quite a discovery to show that the market was much more efficient than a central board in setting prices, because the dynamic of their movements reflected the knowledge of millions of different people, when a single person, be he planner or individual participant, could only know a minimal fraction of reality. What Mises and Hayek had explained in theory in the 1930s was proven right in fact when the protecting screen of the Berlin Wall was dismantled in 1989 by Germans thirsting for freedom. It was the planned economy, not the market economy that proved to be chaotic.

Hayek retook the central idea of that book in his 1945 essay “The Use of Knowledge in Society”3—since selected as one of the top twenty articles published by the American Economic Review in the hundred years of its existence. Hayek’s object was to amplify his rebuttal of Oskar Lange’s and Enrico Barone’s proposal of a socialist society that would use a replica of the market to facilitate the calculations of the planner. He now widened his criticism by adverting to the dispersed role of all knowledge in an economy.

Hayek not only showed that the economic data needed by a central planner could not be accessed centrally, he rejected the conception of the economic market implicit in “many of the uses made of mathematics” by economists. He did not mention by name Lionel Robbins’s famous definition that “Economics is the science which studies human behavior as a relationship between given ends and scarce means which have alternative uses” (page 16); but he in essence rejected the concept of the economic problem encapsulated in that definition. The ends are not given or generally known and neither are the scarce means and their alternative uses. Both aims and resources will only be discovered through the market process itself.

This led Hayek to distinguish two kinds of knowledge in the functioning of the economy: the scientific knowledge that can be summarized in statistics and the kind of personal and local knowledge that can only be gathered and used individually and practically, like the knowledge of a realtor about the local housing market or that of a speculator about disequilibrium prices. Now, this latter kind of knowledge is difficult to generalize and in perpetual flux and is only made generally available through the price system. One of the conclusions to be drawn from Hayek’s theory of information in society was that the perfect knowledge of perfectly competitive markets could only be assumed as an analytical tool, as an approximation to the study of some markets but not as a full representation of reality. We would have to wait for Ronald Coase to understand that the market itself was far from a costless institution, so that frequently pyramidal organizations such as corporations were substituted for the horizontal dispersion of market processes.

Also important for helping redress the negative view of the free market prevalent during the first half of the 20th century were Hayek’s efforts to retell the economic history of capitalism and of economic thought. This was a necessary condition of the re-founding of liberalism, as he had said at the first meeting of the Mont Pelerin Society in 1947. In 1954 he edited Capitalism and the Historians, where he put together a collection of essays by different authors, with the aim of changing the then accepted picture of the Industrial Revolution. The false picture of an idyllic life of plenty in the countryside and the misery of exploitation in urban factories and dwellings was negated by evidence. 4 Of course, life is hard for the poor at the beginning of industrialization. Even today the harsh realities of urbanization in developing countries seem to tell against capitalist development, though they themselves imply progress: thus in China today, where the miserable masses of inland peasants move to the coast, whose living standards are a step forward for them despite the poor conditions of Chinese workers in Western eyes. Finally, it has become commonplace today to underline the extraordinary transformation of human society wrought by capitalism, of which the recently published Cambridge History of Capitalism (2015) bears witness, but this was certainly not the accepted view during the dark years between the two World Wars.

Milton Friedman (1912-2006)

Milton Friedman’s contribution to the defense of free market economics showed a different emphasis and a less philosophical bent compared with Hayek’s, but it turned out to be just as important in the battle for freedom. As a well-trained statistician, Friedman launched the more empirical way of approaching economic questions that became the hallmark of the Chicago School. He showed special attention to measurable data, both in his macroeconomic and monetary studies, and in his historical research. For him, statistics were not a way to gather comprehensive knowledge about society but, more modestly, a way to show that a theory was mistaken because it was contrary to fact, as Karl Popper had taught.5

It is all very well to show that John Maynard Keynes‘s theories are incompatible with the more correct view of human nature presented by economists of the Austrian School, but such fundamental reflections will not convince dyed-in-the-wool Keynesians. Facts and their interpretation are essential in scientific discussion. Keynes based his claim that the market system could not self-equilibrate on, among other things, his “fundamental law of saving and consumption”, whereby people save more proportionally the larger their income. In 1957 and in A Theory of the Consumption Function Friedman showed that this assumed psychological law was based on deficient statistical work. Individuals did not, as Keynes thought, consume less and less as they became richer and richer, which lead to a perpetual shortfall in aggregate demand. Backed with proper statistical analysis, Friedman showed that individuals made their consumption and saving decisions on the basis of their perceived long term prospects; so their propensity to save stayed proportional to their income: there was no necessary law of growing capitalist under-consumption.

Again, in his work on the quantity theory of money (1971-74), Friedman showed that the demand for money was much more stable than Keynes had assumed and that nominal income and the price level were functionally related to the supply of money. By presenting money as an asset in the portfolio of individuals and showing that people chose the amount of real liquidity they wished to keep as a proportion of their real assets, he was able to show precisely why “inflation is always and everywhere a monetary phenomenon”, with no relation to (real) aggregate demand and supply, as Keynes believed.

Then came his contribution together with Anna Schwartz in A Monetary History of the United States (1963), especially the chapter on the “Great Contraction” of 1931-1940, as they called it. There they showed that, whatever the causes of the recession of 1929 may have been, it was the mistakes of the Federal Reserve that made it much worse. The empirical analysis of monetary policy during the Great Depression allowed them to reject the Keynesian conclusion that the whole dreadful episode was due to a failure of capitalism. So ended the pretense of Keynes to have written a general theory of the macro-economy.

Finally, Milton and his wife Rose proved to have a genius for popularizing the political and economic philosophy of classical liberalism. Their first and widely successful foray into this field was the publication of Capitalism and Freedom in 1962. They also joined forces in producing the films titled Free to Choose and the companion book. In sum, together with his wife Rose, Milton did sterling work to spread the idea that capitalism is the true fount of prosperity.

Gary Becker (1930-2014)

Gary Becker went to the extreme of the Chicago method of doing economics, with extraordinarily fruitful results. “The combined approach of maximizing behavior, market equilibrium, and stable preferences, used relentlessly and unflinchingly, form the heart of the economic approach as I see it”, said Becker (1976). In his view, there need be “no separate theorizing for micro problems, macro problems, non-market decisions, and so on”.6 In other words, by assuming that individuals try to maximize their personal welfare; that their fundamental preferences are part of human nature; that the household functions like a small factory with inputs of goods, market services and time—and outputs of personal services; and that the endeavors of people taken together tend to match out in the market: one can frame predictions of social states that can then be tested with actual statistical data. Especially interesting is the attempt to give some content to the empty concept of changes in tastes that economists tend to overuse.

Education and other environmental variables enter the demand function for goods, not because the tastes change […] but because they change the efficiency of household production. […] Their effects on demand cannot only be described statistically, but can also be predicted.

This approach of Becker’s and his disciples is illuminating for the analysis of a number of economic and social problems. He applied his method to build theories of racial discrimination, of marriage and divorce, of the number of children in different strata of the population, of immigration, of crime rates, of drug and alcohol addiction, or of the wages of university graduates—and checked these models against facts.

James Buchanan (1919-2013)

Another important contribution was the attempt of James Buchanan to solve the often observed incompatibility between individual freedom and democracy. As I have written in a previous column,7Joseph Schumpeter was the advocatus diaboli against the proposition that democracies will be pro-market. He well understood the essence of capitalism but saw it as necessarily bound for self-destruction. In his Theory of Economic Development (1912) he had characterized the free market system as moved by “creative destruction,” where progress is based on new procedures that bring about the obsolescence of existing modes of production. But in his notorious Capitalism, Socialism and Democracy (1943) he arrived at the shocking conclusion that creative destruction would come to a grinding halt in a democracy because the people would not willingly bear its cost. Only a more or less hidden socialist dictatorship could force the people to accept the sacrifices demanded by economic progress.

Instead, Buchanan proposed to solve the conflict between democracy and individual freedom in a thoroughly individualistic way. First, in a democracy,

… each man counts for one, and that is that. […] A situation is judged “good” to the extent that it allows individuals to get what they want to get […], limited only by the principle of mutual agreement.8

To the end that collective decisions were not taken on the basis of protecting losers or shackling innovators, Buchanan laid down that collective decisions be taken in two separate steps: one, in the constitutional mode, when the basic rules of the game should be decided unanimously or nearly so; the other, in the political mode, where decisions can be taken by some form of majority vote. The starting step would be the selection of rules; then came political action within those rules. You do not change the rules of poker during the game, he would say. People would be careful to draft a constitution that guaranteed their basic rights of personal freedom, private property, the rule of law, and the free market, so that they would not suffer oppression if their future situation in society might weaken compared to their present one. The rules would be based on what he (and Hayek) called “the Generality Constraint” 9 or the rule that no social group or individual should be discriminated against in law or by the administration of the state: thus, no progressive income tax or positive discrimination or subsidies to firms or industries.

For Buchanan, markets are institutions born from repeated exchanges between individuals. No outsider observing economic activity from above can adjudicate on the social welfare of these exchanges. It is the people who engage in them who decide to trade because it satisfies them. And if both sides are not wholly satisfied with the outcome they will together try to reform the institutions of that market so that future outcomes are more gratifying for both of them. For Buchanan, political processes cannot be imposed or judged from the outside. He especially directed this prohibition to political philosophers, who should never “play at being God.” Buchanan would not himself presume to tell voters (as social welfare economists do) what they should prefer. In this, he treats the political game as another market where consumers and producers will not be told what to prefer or what to do. It is for people themselves to vote, trade, and decide how to arrange social matters concerning them, as long as they tied their hands against changes in the constitution when they were in a position of power. As in the economic market, he hoped institutions would emerge that better reflect the wishes of voters in the long term. Democracy can be learnt.10

Ronald Coase (1910-2013)

As I said in my last column,11Arthur Pigou’s case against free markets was that they were inefficient due to an endless and growing number of external effects, both positive and negative. This has become the mantra of all orthodox economists, especially those who look askance at the free market. Ronald Coase effectively turned the tables on Pigou with two arguments: that people and firms in the market often corrected externalities by mutual agreement, and that solutions imposed by government often led to a worse outcome than the starting situation.

In a famous 1959 dinner at the home of Aaron Director, where Milton Friedman and George Stigler were present with another seventeen skeptical economists, Coase presented his case that, absent prohibitive transaction costs, the parties confronting a situation beset by external effects would find an optimal agreement with no need for government intervention. He also showed that solutions imposed by authorities as self-evident could often be shown to have little or no justification. Coase had overturned a majority of twenty against his theorem by the end of the dinner. What should be noted by the traducers of neo-liberalism is that Coase did not take it for granted that markets functioned perfectly. High transaction costs made it difficult perhaps to come to effective agreements. After Coase, the case for liberty came to rest on the high probability of government failure—something that is more often than not overlooked in economics textbooks and political discussion.

Coase’s theory has often been misconstrued, however. The way in which such an admirer of Coase as George Stigler involuntarily emasculated the Coasean principle is revealing. Following Stigler, the Coase theory is usually presented in the form of a theorem, as follows: “Given well defined property rights and zero transaction costs, all so-called externalities can be solved by agreement between the affected parties, if one leaves aside changes in distribution resulting from such agreements”. This almost reads like a tautology. It implies that property rights have to be defined before externalities are solved. It makes the questionable assumption that transaction costs can be zero. And it overlooks the difficulty of sharing the benefit obtained by cooperative agreements that move the economy nearer the optimum desired by all the people implicated.12

However, in many cases property rights change during negotiations. Also, any Coasean bargain often overcomes transaction costs of three kinds: (1) information and communication constraints; (2) free-rider costs; and (3) strategic behavior of the parties involved. And the re-distributions of gains can be used to co-opt parties resisting change. Many of these complications disappear under perfect competition, but the last thing we want is to reduce the application of the Coase theorem to situations where all parties are price-takers.13

Fully to understand Coase we need to read the book he published with Ning Wang, How China Became Capitalist (2012) when he was 103 years old. In post-Mao China Coase’s theorem unexpectedly worked in the most fluid of situations. Property rights were in the making while the economy was moving towards capitalism. Information and communication had to overcome huge political obstacles. Negative free riding was transformed into positive imitation. Redistribution often had to take the form of bribes to side-step senseless regulation.14

As Coase and Wang noted, “China did not first delineate property rights and then allowed market forces to allocate rights to the highest bidder”. The state continuously changed and modified those rights under the entrepreneurial pressure of local authorities, firms, and individuals. Agreements were reached and contracts performed under unpropitious legal circumstances. And the resulting prosperity was so great that distributional conflicts, though not inexistent, were minimized mainly with bribes.

The main lesson to be drawn from Coase is that market failure is often corrected by improbable bargains and by the spontaneous emergence of new institutions, such as corporations. The nature of the firm and its role in the reduction of the cost of markets is another great contribution of Case’s: firms appear to substitute partial centralization for impractical horizontal pricing in markets.15 (Coase, 1937)

The experience of Chinese capitalism demands a recasting of the Coase theorem, to make it less static and more dynamic than it appears in misguided reductions such as Stigler’s that are at bottom unfaithful to its spirit.

Classical liberalism and political economy

There is little doubt that a reconstruction of liberalism was needed by the middle of the 20th century. The efforts of these classical liberals of the 20th century have been decisive for this work of repair and restatement. Their fruitful intuition was that liberal philosophy could only be revived by the strict and untiring application to social problems of free market economics.

They are a varied group of thinkers with sometimes widely different approaches to political economy. In my view, however, differences of method among defenders of market economics have been overblown. The essential starting point for us liberal economists is individualism and its defenses—the rule of law, private property economic liberty and the free market. Note that I say ‘individualism’, not ‘methodological individualism’. This latter expression reflects the reductivist method applied by those many welfare economists who construct ‘social welfare functions’ and ‘welfare criteria’ according to their preferences, from which they then deduce to guide economic policy; and then then try to validate these criteria by basing them on assumed individual behavior of the cut and dried sort. Such welfare economists are in fact ethical collectivists, who try to transfigure their aggregate pronouncements on social justice with the wand of factitious individualism. It was Buchanan who most forcefully rejected this kind of alchemy in the pronouncement I quoted above, that we economists ‘should not play at being God’.

I am no eclectic in questions of method nor indeed in matters of economics. I do think that social reality is many-faceted.16 I do not see why studies of aspects of social life by economists such as Gary Becker or Milton Friedman should be excluded on principle by strict followers of the Austrian School. Economists should be free to make the assumption they think most productive to explain social phenomena and see how many miles they can run with them. The basis should be individualistic and the object to find the truth—if possible. The choice I have made of the five rescuers of freedom economics shows that I deny that there is a single orthodox methodology in social questions: philosophical reasoning as in Hayek, statistical criticism and historical revision as in Friedman, microeconomic explanation and prediction as in Becker, democratic individualism in Buchanan, or the new institutional theorizing initiated by Coase should not be ruled out of court just because they do not fit our methodological preconceptions—as long as they hold to strict individualism and give fruitful results.

Barone, Enrico (1908): “The Ministry of Production in the Collectivist State”, in Hayek (1933).

Becker, Gary (1971): Economic Theory. Chicago.

Buchanan, James (1975): The Limits of Liberty. Between Anarchy and Leviathan. Chicago.

Buchanan, James M. (1984): “Rights, Efficiency, and Exchange: The irrelevance of transaction costs”. In The Collected Works of James M. Buchanan, vol. I, The Logical Foundations of Constitutional Liberty, pgs. 260-277.

Buchanan, James, and Congleton, Roger D. (1998): Politics by Principle, not interest. Towards a Non-discriminatory Democracy. Cambridge.

Cardoza, Anthony L. (1982). Agrarian Elites and Italian Fascism. The Province of Bologna, 1901-1926. Princeton.

Coase, Ronald (1937): “The Nature of the Firm”, Economica, 4(16).

Coase, Ronald (1960): “The Problem of Social Cost”, Journal of Law and Economics, vol. III (October).

Coase, R. and Wang, Ning (2012): How China Became Capitalist. Palgrave MacMillan.

Coleman, William (2013): “What Was New About Neo-Liberalism?” Economic Affairs 33(1).

Cooter, Robert (1982): “The Cost of Coase”, Journal of Legal Studies, vol. XI, January, pgs. 1-33. Also in Steven Medema, ed., The Legacy of Ronald Coase, vol II, pgs. 92-128.

Febrero, Ramon, and Schwartz, Pedro (1995): The Essence of Becker. Hoover Institution.

Friedman, Milton (1957): A Theory of the Consumption Function. NBER.

Friedman, Milton (1971-74): Milton Friedman’s Monetary Framework. A debate with his Critics. Chicago.

Friedman, Milton and Rose Friedman (1998): Two Lucky People. Memoirs. Chicago.

Friedman, Milton, and Anna Schwartz (1954): A Monetary History of the United States. Princeton University Press.

Hayek, Friedrich, ed. (1933): Collectivist Economic Planning. Routledge.

Hayek, Friedrich (1944): The Road to Serfdom. Routledge and Chicago.

Hayek, Friedrich (1948): “The Use of Knowledge in Society”,AER, vol. 35, nr. 4, pgs. 519-30.

Medema, Steven G. (1995): “Finding His Own Way: the legacy of Ronald Coase in economic analysis”. Introduction to the two volume collection of articles on Ronald Coase, Elgar, Aldershot.

Samuelson, Paul A. (1947): Foundations of Economic Analysis. Harvard.

Stigler, George J. (1988): Memoirs of an Unregulated Economist. New York: Basic Books.

Williamson, Jeffrey, and Neal, Larry (2014): The Cambridge History of Capitalism. Cambridge University Press.