In studying economics, we encounter different schools of
thought regarding phenomena such as business cycles, national
income, markets, and international trade. Students will also
encounter their names and theories. It is therefore worth while to
see what these schools teach and how they are different.
During the 1500s through the 1700s, the mercantilist school
predominated in Europe. The main object of trade was said to be
the acquisition of bullion - gold and silver - for the national
treasury. Such riches would enable a country to have a strong
military and also use this wealth for domestic investment.
Mercantilists also promoted domestic industry with government
protection and aid. To acquire precious metals, a country needed
to either possess mines, as did Spain in its Latin American
colonies, or to have an export surplus which would be balanced out
with an importation of metals.
One problem with such a mercantilist policy is that one
country's trade surplus implies deficits in other countries, so all
countries cannot together succeed. As Adam Smith was to argue in
his Wealth of Nations, when all countries restrict trade, the
result is less wealth overall.
In reaction to mercantilist policy, a school of though arose
in France during the 1700s, the first to call themselves
"economists." They called their school "physiocracy," which means
"the rule of natural law." The most prominent of the Physiocratic
economists was Francoise Quesnay. Physiocratic theory emphasizes
free trade as removing barriers which harm consumers.
In physiocratic theory, nature provides a "net product" which
is a surplus beyond the payment to labor and the provides of
capital. This is equivalent to what we now recognize as land rent.
Instead of taxing industry, the physiocrats theorized that the net
product could be an "impot unique" or "single tax" that could
provide for all government revenue. Much of this revenue could
then be invested in infrastructure and other capital investments,
which would further increase productivity, increasing rent or the
net product even more, thus putting into effect an upward spiral of
economic development. The Physiocrats thus had the first model of
the circular flow of an economy and a model of economic development
which was to be successfully applied by Japan and Taiwan.
3. The classical school
Also in reaction to mercantilist economics, and influenced by
the physiocrats, Adam Smith in 1776 began the school which was to
be called the "classical." As noted above, Smith showed how free
trade would increase the "wealth of nations." His book, a major
systematic treatise on economics, showed how the general welfare
was increased by persons acting out of self-interest in a free
market. Smith emphasized the productivity caused by a division of
labor. Classical economists believed in the "labor theory of
value," that the value of goods comes from the labor used to
produce it, a view refuted by later economists. Also a moral
philosopher, Smith's book, The Theory of Moral Sentiments, showed
how people are not just self-interested but also can act out of
sympathy with others or some cause.
David Ricardo in the early 1800s expanded the though of Smith
to analyze the effects of growth on land rent. Population growth
would push production to less productive land, thus increasing land
rent while keeping wages at a subsistence level. Ricardo also
furthered the theory of international trade with the concept of
comparative advantage, showing how trade was mutually advantageous.
John Stuart Mill was another major classical economist as well
as philosopher and the author of the famous essay On Liberty.
Writing in the mid 1800s, his text was a widely used benchmark in
economics. The classical school theorized that free markets
provide for maximum prosperity, and that land rent is an especially
suitable source of taxation. However, social problems, labor
unrest, and continuing poverty raised doubts among some about the
virtues of markets. Some economists, including Mill, turned to
various degrees and types of socialism for remedies.
4. Socialist economics and Marxism
Karl Marx was a German philosopher and economist who settled
in Great Britain and collaborated with Friedrich Engels in much of
their work, including The Communist Manifesto. Marx's main book,
Das Kapital or Capital, in three volumes, was as much a critique of
so-called "capitalism" or market economies as a treatise on the
socialist alternative, which was not described in much detail.
Marx divided society into two main classes, capitalists who owned
property and the proletariat workers.
Basing his analysis on the labor theory of value, Marx held
that revenues of production belonged to labor, and the surplus
value, or profits, properly belonged to workers. For that reason,
and due to an army of unemployed workers which keeps wages low,
capitalists exploit workers. Eventually, however, as capital goods
accumulate, the rate of profit will fall, and industry will become
more concentrated in ownership. Eventually, the proletariat would
revolt and own the means of production, sharing the product
according to need.
Modern Marxist economists follow Marx's general line of
thought, with various modifications. Despite the failure of
socialist systems and the theoretical criticism of Marxist thought,
Marxists continue to believe that the market process is inherently
flawed and needs much fixing.
5. Geo-classical economics
Henry George was an American classical economist, but was also
very critical of much of classical thought and presented
alternative theories. His major work was Progress and Poverty,
written in 1879. Thus he and his Georgist followers form a school
of their own, which I call "geoclassical," the term "geo" standing
for both George and for land. It has elements in common with both
the Physiocrat and the classical school. But George rejected the
classical notion of Malthus that population will tend to outrun
production, and he also argued against the classical "wages fund"
theory that wages are paid from some fixed amount of capital fund.
Instead, George theorized that wages are set at the margin of
production, where the best free land is available, and production
of better land, after paying wages and capital yields, constitutes
land rent. Land rent is increased and wages lowered by land
speculation, which pushes the margin to less productive land. The
remedy for the resulting poverty is the collection of land rent for
public revenue and the abolition of the taxation of labor and
capital. This will not only increase the margin to more productive
land, but also remove the stifling effects of taxing and
restricting labor. George also advocated free trade just as the
classicals and physiocrats did.
Hence, while socialists advocate the replacement of markets
with central planning and redistribution, the geoclassical school
recognizes that markets are not truly free if restricted and taxed,
and it is these interventions that cause unemployment and poverty.
Prosperity can be attained by removing these barriers, not erecting
6. The Austrian school
In 1871, Carl Menger, an economist in Vienna, Austria, wrote
The Principles of Economics in reaction to German economists who
based their though on historical studies, without the need for any
general abstract theory and also in reaction to some classical
concepts. In contrast to the classical labor theory of value,
Menger recognized that value and utility are entirely subjective,
independent of labor and other inputs. The value of land, labor,
and capital goods are base on the values and utility people place
on consumer goods.
Besides subjectivism, Menger's theory included marginal
analysis, in which the value and market price of a good is based on
the utility of the marginal or extra increment of the good
obtained. This marginal utility diminishes with increasing amounts
of the good. Trade is beneficial because people exchange goods of
lower marginal utility for those of higher marginal utility.
Menger also developed a theory of money based on its origin in
This analysis began a new school of thought, called the
Austrian. Other economists in the school included Boehm Bawerk,
who worked out a theory of capital and interest. Ludwig von Mises
also wrote on this theme, recognizing that interest rates depend on
time preference (see Chapter 5). Mises' main treatise, Human
Action, written in 1949, is a staunch defense of the market
process. Mises and another Austrian, Friedrich von Hayek, argued
against socialism, saying that economic calculation required the
competitive enterprise of markets, so socialism would be
Austrian thought emphasizes the importance of basing theory on
individuals and their subjective values. Besides marginal
analysis, Austrian theory emphasizes the spontaneous order of
market processes, the uncertainty of the future, the importance of
the heterogenous aspects of capital and money creation, and the
decentralized nature of knowledge. Austrians such as Hayek have
further developed the theory of capital, and modern Austrians have
pioneered the theory and study of the history of free banking.
Austrians also have a theory of the business cycle emphasizing the
role of money creation and interest rates. Contemporary Austrians
are now world-wide.
7. The neoclassical school
Besides Menger, two other economists, Stanley Jevons in Great
Britain and Leon Walras in France pioneered marginal utility theory
and thus sparked a revolution in economic thought that converted
most economists from classical to neoclassical analysis. In
neoclassical thought, the value of goods derives not from labor but
from their marginal utility. The classical differentiation of land
and capital became blurred, as neoclassical theory became described
in mathematical terms. Land became treated as part of capital.
Walras pioneered the theory of general equilibrium, with a
model of an entire economy where all production is interrelated in
an equilibrium setting all prices and quantities. Alfred Marshall
in Great Britain developed the theory of supply and demand,
including the geometrical conventions of the curves. In Sweden,
Knut Wicksell, influenced also by Austrians, further developed
theories of capital, interest, and public finance. Favorable to
taxing land, Wicksell originated the concept of the natural rate of
interest in a free market.
8. The institutional school
While most economic theory is based on abstract supply and
demand, factors, and expenditure, the institutional school points
out that organizations also influence economic activity. The
American economist Thorstein Veblen was a key theorist in this
approach. Government, large corporations, banks, labor unions, and
social organizations certainly affect the outcomes of economies,
and institutionalist economics is important in the understanding of
economic history and current economic life. The theory of
institutions is also part of basic economic theory. Both the
Austrian and geoclassical schools have included institutional
concepts in their theories, including the role of central banks in
Austrian monetary theory and the role of land tenure in
9. The interventionist school and Keynesianism
During the great world-wide depression of the 1930s, many
neo-classical economists came to doubt the full-employment claims
of neo-classical macroeconomic theory, although Austrians and
geoclassical economists recognized that the economies of the early
20th century had many interventions which had led to the
depression. John Maynard Keynes in Great Britain published the
book The General Theory of Employment, Interest and Money in 1936,
claiming to overturn many neo-classical concepts, although
microeconomic neoclassical theory was not questioned.
Keynes argued that wages would not automatically or swiftly
adjust to a lower supply/demand juncture, but can remain stuck at
a high level, reducing the demand for labor and creating
unemployment. Also, Keynes disagreed with the classical and
neoclassical concept that investment increases with lower interest
rates. To Keynesians, markets do not necessarily work well, and
they are not always self-correcting when unemployment rises and
output declines. Government intervention is needed to boost
demand. Whereas classical theory states that the supply side
determines output, since factors are paid the full amount of the
product, and since prices adjust to equilibrate supply and demand,
Keynesian interventionists claim that prices and wages don't in
fact adjust, and that in a money economy, the total demand for
products can be insufficient, since people don't necessarily spend
Keynesian policy thus emphasizes increasing demand during a
depression by increasing the money supply, by increasing government
spending, raising the money supply, and reducing taxes to increase
private spending. During a boom, the government can reverse these
policies to reduce inflation. Interventionists have restored some
mercantilist policies, some arguing for protectionist measures.
Critics of such interventionist policies point out that the
interventions, first of all, do not necessarily work in the long
run. Inflating the money supply eventually raises prices and stops
raising output, aside from distorting prices and production. Also,
these policies attempt to treat the effects of economic problems
without analyzing the root causes, which turn out to be
interventions rather than the market process itself.
In response to these critiques, a New-Keynesian school has
developed, with more sophisticated theories of how markets fail and
how intervention can correct them, so the debate continues.
10. The new-classical macroeconomic school
In reaction to interventionists, especially in money and
banking, the monetarist school restored the classical theory of
money that emphasizes the role of the quantity of money. High
money expansion in the long run leads to inflation rather than
increasing output. A key monetarist has been Milton Friedman in
the United States. Monetarists point out that government does not
have the knowledge to respond to every twist and turn in the
economy, so instead of discretionary policy, it is better to have
some rule that will be followed by central banks. Monetarism is not
a complete macroeconomic theory, but is a school within
macroeconomics, especially for monetary economics.
More comprehensively, some economists have argued against
intervention as the "new classical" school. A key concept in this
school is that of "rational expectations," which states that people
create judgements about future economic variables such as inflation
using past information and some model or theory of the economy, by
which they will avoid systematic mistakes. The New-Keynesian
school has accepted rational expectations, so it is not an
exclusively new-classical principle, but it is used to rebut some
interventionist policies, since the new-classicalists state that
people will recognize and respond to expected policy.
11. The post-Keynesian school
A new macroeconomic school of thought based on Keynesian
thought, expanded by the work of the Polish economist Michael
Kalecki, has been called "post Keynesian." They follow Keynesians
in believing that markets don't always clear and that individuals
don't always perceive the correct market signals. They also have
adopted some institutionalist thought and a Marxist emphasis on the
different economic classes, the workers and capitalists.
Post-Keynesian thought has also been influenced by the work of the
Italian-British economist, Piero Sraffa, who restored some
Ricardian classical theory, where prices are determined by the
costs of production.
12. Foundational economics
The foundational school of economics encompasses all economic
theory, micro, macro, and institutional. It seeks a comprehensive
theory of economics, synthesizing the thought of all other schools
in an integrated, systematic way, with a foundational based on a
set of axiomatic propositions that apply to all people, times, and
places. Pure theory is derived from these propositions using
deductive logic. Specific theory about particular events,
cultures, and economies is based on pure theory and the
institutions and facts about the particular phenomena, derived
using hypotheses tested by data as well as deductively. The
foundational school integrates moral and economic concepts, since
it recognizes that pure markets follow moral rules.
The macroeconomic model is that of a pure market economy on
which interventions are imposed. Pure markets work well, providing
for prosperity and full employment. In accord with the
physiocratic and geoclassical schools, foundational economics
agrees that land rent is the efficient source of revenue for public
goods and services. In accord with classical theory, it agrees
with the principles of free trade. Its trade theory combines
geoclassical and Austrian elements for an integrated theory with
real and monetary aspects. It also accepts the Austrian theory of
interest rates based on time preference and its theory of banking.
Foundational theory encompasses neoclassical marginal analysis
and price theory, but retains the classical differentiation of the
three factors of production. Socialist and interventionist views
are not accepted, since these are flawed or lacking axiomatic
Foundational economics is open to theory from any school or
approach so long as its pure theory can be derived from the
axiomatic propositions or has specific theory founded on pure
theory. It can therefore potentially create a synthesis from the
other schools as a comprehensive and unified theory of economics.
Most economists today are neoclassical in micro-economics and interventionist or monetarist/new-classical in macroeconomics. This author and text are foundational, drawing much from geoclassical, Austrian, and neoclassical theory. Which school do you find makes the most sense?