A brief history of the disintegration of political economy
In The Wealth of Nations, Adam Smith describes Political Economy as "the science of the legislator or statesman." Political economy was the study of organisation and exchange, and of public policy. Practical public administration required an understanding of political economy. After Smith, economics went through a series of revolutions against, or, more realistically, a series of points of departure from, political economy. Smith’s work was significantly extended by David Ricardo who developed the theory of competitive advantage, explained the origins of benefits from specialisation in production, described by Smith, when combined with trade with remote locations, especially internationally.
The first departure, in the strict tradition of Smith, was explanatory: J.S. Mill's 1834 discussion of method, which grounded political economy squarely among the emerging social sciences, including moral philosophy. Following Mill, political economy developed largely on Mill’s principles until the work of William Stanley Jevons and of Henry Sidgwick, like Smith a moral philosopher, began to call in to question the utilitarian assumptions on which Mill’s work was based.
In the LSE-approved Anglo-Saxon version of events (Hodgson, 2004) in the 1870s, Léon Walras, Carl Menger and Jevons independently applied the logic of Leibniz's and Newton's calculus to economics, the marginalist revolution was underway. The reality (Ekelund & Hebert 2002) is considerably more iterative and complex with various contributions from English, French German and Italian theorists over the nineteenth century culminating in the 'marginalist revolution.' However, it is clear that this "period of restless progress" (Clark, 1891) is the well-spring of the split of economics from political economy.
At the same time, Menger postulated that value was determined subjectively, thus forming the basis of the ensuing logic of residual risk-holding from production decision-making and of entrepreneurial capitalism. Absent the accumulative labour theory of value and the economic (although not the socio-political) foundation of Marx’s theories blows away like sand. In 1923, the major University of Chicago economist Frank Knight subsequently explained this with considerable insight and clarity in his landmark Risk, Uncertainty and Profit.
In the decade following the marginalist insights, Menger engaged in a very public debate with Gustav Schmoller, the leading protagonist of the Hegel-influenced German late Historical School. The debate was known as the Methodenstreit. Within economics, Menger's 'victory' ensured the growth of the Austrian school following Menger. However, especially in the US, where many students of political economy had travelled to study in German universities in the post-bellum period, the German Historical School had a considerable impact on the newly-emerging discipline of political science, notably at Columbia, Chicago and Johns Hopkins universities.
The first US political science department was established at Columbia in 1880, followed by Chicago and Johns Hopkins (Baltimore). Initially, these departments were staffed by scholars taught at or heavily influenced by the German Historical School and L'Institut des Ecoles Politiques in Paris. In London, LSE was established in 1895. These schools consolidated political analysis, annexed political philosophy from metaphysics, and increasingly combined the early influence of the German Historical with the pragmatic philosophy of William James and especially of psychologist John Dewey (most notably his 1927 and 1929 works). These schools incorporated political philosophy and rapidly turned their to elections, public administration and political sociology.
Leon Walras' work was the predecessor of general equilibrium theory. Alfred Marshall picked up both Jevons’ and Walras' work and developed a comprehensive picture of both macroeconomy and microeconomy based on a less stringent equilibrium requirement that became known as partial equilibrium analysis. The 1890 publication of the first ediction of Marshall's landmark Principles of Economics reinforced the separation of economics as from earlier political economy, and developed mathematical expressions of many of the principles he elucidated.
Vilfedo Pareto's 1906 work on preference ordering and subjective utility finally demolished the cardinalist utility theories of J.S. Mill and the English utilitarians. In 1920, in his Economics of Welfare, Marshall's student and successor as chair of Political Economy at Cambridge, A.C Pigou, disputed the premises of Pareto's aggregated social welfare function and the strict conditions for policy change now known as Pareto optimality. Between them, the works of Alfred Marshall and Pigou cemented the separation of economics as a distinct discipline from politics and the political economy that preceded them.
Marshall and Pigou Marshall's work also addressed the velocity of circulation of money in the economy, building on previous work of Locke, Hume and J.S. Mill on money circulation. Marshall's work on velocity was challenged by American economist Irving Fischer, who argued for strict long-run money neutrality and Swede Knut Wicksell who emphasised the impact of exogenous shocks to economies as the source of instability.
In response to the Great Depression triggered by the collapse of the US Stock Exchange in 1929 and to Pigou's work on the relationship between the labour market and the goods market, in 1936 John Maynard Keynes released his General Theory of Employment, Interest & Money. In it, he accepted the possibility of using the money supply to induce economic stimulus against a business cycle — this challenging Irving Fisher's strict approach of money neutrality — but advocated instead for expansionary fiscal policy to induce demand, without the impediment of the empirically-observed wage floor and the resulting effects in the labour market, surges of unemployment. In 1937, LSE economist John Hicks provided a mathematical interpretation of Keynes' work, development IS-LL analysis (later, courtesy of US economist Alvin Hansen, becoming IS-LM, taught to every economics student at undergraduate level).
Then everything changed.
In 1947, Paul Samuelson provided a mathematical formulation of general equilbrium and refined comparative static analysis, offering a pathway to reconcile observed data with economic theory to produce functions of agents' preferences and behaviour at individual and economy-wide levels. Samuelson's method relied on an optimised social welfare function, akin to the generalised logic of Pareto on utility.
After Samuelson's 1947 work, economics was truly divorced from political analysis, separated by organisation within universities, by methodology and by the adoption in academic economics of mathematics as its principal language.
In 1948, Samuelson formulated the 'neo-classical synthesis,' to reconcile the classical economic theory of Marshall, Pigou et al. with Hick's formulation of Keynes' General Theory as extended by Franco Modigliani in 1944. The synthesis essentially acknowledged short-term wage floors implying the utility and viability of Keynesian stimulus while recognising that, in the longer-term, the economy cleared to classical-type equilbrium as described by Marshall.
Demonstrating his versatility, in 1954 Samuelson formulated his definitive theory of a 'pure public good,' which is so often overlooked in public discourse.
In 1970, Samuelson won the Nobel (technically, Sverige Rijksbank) Prize for “for the scientific work through which he has developed static and dynamic economic theory and actively contributed to raising the level of analysis in economic science.”
The divorce from politics and political economy was almost, but not quite, complete.
in 1950, Kenneth Arrow described his impossibility theorem relating to aggregation of individual's welfare preferences through voting; that is, differing original preference sets cannot be resolved to a unique aggregate social preference function as Samuelson had asserted. Nonetheless, in 1951, based on Samuelson's mathematical formulation, Kenneth Arrow and Gerard Debreu separately formulated mathematical solutions for economy in general equilibrium. The Arrow-Debreu formulation bypassed the aggregation problem in social welfare by assuming a Pareto-optimal social welfare function and introduced a range of other simplifying assumptions.
Also in 1951, University of Chicago political scientist Harold Lasswell wrote a highly influential paper titled "The Policy Orientation," in a book he edited with Daniel Lerner. Following Dewey, Lasswell "conceived the social sciences as methods of social problem-solving and thus proposed that they be understood as policy sciences (Torgerson, 2007) . Thereafter, at least in the US, the study of public policy became an increasingly separate discipline from political science, although often studied by political science graduates and political scientists.
Now public policy had separated from political science which had earlier split from political economy and economics, which subsequently developed largely separately. The earlier, seemingly coherent discipline of political economy was in tatters.
Until the stagflation (zero-growth inflation) triggered by the enforcement of the OPEC oil cartel in 1973 and disruptions in Iraqi oil supply in 1979-80, academic macroeconomics concerned the various factors and variables of the neo-classical synthesis. Economics had become a mathematical science, or so it seemed.
Beginning with the insights of Harry Markowitz in 1952 on use of mean-variance analysis and correlation of historic asset prices to construct a portfolio of assets with a given expected risk profile, quantitative finance became an area of exceptional development and creativity in economics. The insights of Franco Modilgliani and of Merton Miller in 1958 on the irrelevance of capital structure to firm value led to a revolution in corporate finance. However, the M-M capital irrelevancy theory was based on some fairly heroic assumptions. Still, it led to a huge growth in leveraged acquisitions and completely overhauled the dynamics of corporate control, imposing a significant discipline on corporate management. This was followed by the capital asset pricing model of William Sharpe (1964) which still dominates both portfolio management and, outside the technology sector, corporate valuation.
The third significant development in financial economics was, in some ways, the most revolutionary. By including the dimension of time in valuation of market securities in 1973, Fisher Black and Myron Scholes simultaneously with Robert Merton solved the mathematics of valuation of options and warrants, providing an explicit basis for valuation in the forward market for securities. The importance of this development was, first, in opening up a previously limited and subjectively-priced market to objective pricing and position-taking within asset portfolios. Secondly, it provided the mathematics of the 'complete' market in the assumptions of general equilibrium theories of Samuelson and Arrow-Debreu. As a result, theory-building and theory-testing became both mathematically tractable and mathematically whole. Time had been included; uncertainty (in the form of estimable risk) had been included. Within the assumptions made, economics was mathematics. So mathematically-minded economists conveniently forgot about the simplifying assumptions of their models and concluded their work was scientific.
This had its ultimate expression in the rational expectations hypotheses of John Muth (1961). Essentially, his approach suggested that economists’ models afforded them no greater predictive ability than a layman. In contrast to Herbert Simons’ important (1954) concept of bounded rationality — that limits on calculative capacity forced the use of essentially heuristic judgment in economic decision-making — Muth believed that “expectations, since they are informed predictions of future events, are essentially the same as the predictions of the relevant economic theory;” that well-informed expectations were, in that limited sense, ‘rational.’
Although largely ignored at the time, in the hands of his near-contemporaries, Robert Lucas and Thomas Sargent, Muth’s hypothesis launched a revolution in economics, combining mathematical economics with econometrics, offering the realisation of Milton Friedman’s objective of a predictive economics (positivist, in Friedman’s term).
Because it offered mathematical tractability and econometric falsification, the ‘success’ of rational expectations further split economics between econometric back-testing to minimise model error as a practical exercise and pure mathematical manipulation. What mattered was not correspondence with causal realities of economic life, but the fit with historic sets of economic data, which, in turn, implied forecast integrity.
Progress within the field of academic economics had clearly become a race for abstract mathematical explication of increasingly obscure phenomena. Major journals were dominated by the thrall of mathematics as evidence of scientific rigour. These debates no longer related to policy (‘to the science of the legislator or statesman’), but to the ability of various mathematical economic models to predict accurately future events.
Within economics departments, mathematical economists gained tenure and seniority. They taught increasingly mathematically-able students to manipulate and back-test the results of their models. They offered PhD supervision based on mathematical literacy in ever-more-refined aspects of the abstract models.
This approach was greatly strengthened by its utility in finance. The view was reinforced by the management of successive crises at the end of the twentieth century — the Russian debt crisis and resulting bail-out in 1998 of hedge fund Long-Term Capital Management, and by the management of the dot com crisis — the collapse in value of technology stocks, principally on NASDAQ, in 2000. The successful management of both gave the appearance of supervisory efficacy in response to crisis, reinforcing the structures of economic belief on which they were founded.
Then, on 15 September 2008, when the efforts of US Treasury Secretary and former Goldman Sachs CEO Henry Paulson to find a buyer for the imperilled investment bank Lehman Brothers failed, forcing it to file for Chapter 11 protection under the US Bankruptcy Code, the full effects of the collapse of the market for mortgage-backed securities and other collateralised debt obligations were unleashed upon global interbank markets, which froze. The global financial crisis, which had begun in April of 2007 with the failure of California-based mortgage originator New Century Financial and accelerated in June with the closure of two Bear Stearns’ hedge funds heavily committed in MBSs and CDOs, now tipped in to a dangerous new phase where total collapse of the world’s financial system appeared imminent. Such a collapse was only prevented by governmental and inter-governmental cooperation and intervention of a nature and scale unprecedented in global finance.
Among many other impacts, the global financial crisis, from which we have not truly recovered, especially in the UK, has forced many economists to reevaluate their understanding of economic phenomena and to question both the epistemic and ontological bases of mathematical economics and econometiics. To date, little has changed. But, to recover from the current economic crises we now face, economics must transform. An essential part of this will be to revisit the split between economics, politics and public policy to ensure that economics or, at least, political economy can serve again as an economically-literate science of the statesman or legislator.
A key aspect of this will be to reappraise the contribution of the Virginia School of political economy, pioneered by James Buchanan (a doctoral student of Frank Knight at Chicago) and Gordon Tullock whose landmark 1962 work The Calculus of Consent: Logical Foundations of Constitutional Democracy launched what has become known as public choice theory and represents the only coherent expression of a new political economy since the marginalist ‘revolution’ of the 1880s. While often derided by progressives and progressive philosophers alike, much of the criticism is as reactive as Buchanan’s detractors (wrongly) assert his views are reactionary. The breadth of his corpus of work reveals an astonishingly original and liberal thinker who, while not given to championing progressive causes, offers a well-structured criticism of pitfalls and dangers state expansionism can present to quotidian freedoms.
Buchanan is not omniscient. There are many other thinkers, liberal, critical or pragmatic, whose contributions to a renewed, synthesised political economy would be vital. But his work is not a bad place to start.