THE THEORY OF RATIONAL EXPECTATIONS: Maintains that people learn from their mistakes. It is illustrated by the story of the economics professor who was walking across the campus with a first-year economics student. “Look,” said the student, pointing at the ground, “a five-dollar bill.” “It can’t be,” responds the professor. “If it were, somebody would have picked it up by now.”
THE THEORY OF REVEALED PREFERENCE: Another of those laws that stipulate how people are supposed to behave. According to this one, people’s choices are always consistent. In other words, once you have revealed your preference for a pepperoni pizza over a Big Mac, you’ll always choose the pizza, provided it’s available. Reduce it to this level, and it’s easy to see the limits of the theory.
ECONOMIES OF SCALE: At the heart of manufacturing strategy since the days of Henry Ford. The principle is a simple one: With big factories using long production runs to make a single commodity, you can reduce manufacturing costs. In addition, the more you repeat the same operation, the cheaper it becomes. Following this principle, American factories have turned out some very cheap goods, indeed.
THE PHILLIPS CURVE: Had everything going for it. Based on data compiled in England between 1861 and 1957, this theory held that when inflation goes down, unemployment goes up, and vice versa. For politicians, it was an invaluable guide: If you had too much unemployment, you let inflation go up and— presto!—down went unemployment. If inflation was raging out of control, you put a few people out of work and down went inflation. All in all, a handy little tool. Then along came stagflation, which combined high unemployment with high inflation, and the Phillips curve turned into the Phillips screw.
EcoPeople ADAM SMITH (1723-1790)
The first economist, this Adam Smith was an actual person, not some contemporary telejournalist’s pseudonym. His historic book, An Inquiry into the Nature and Causes of the Wealth of Nations (1776), propounded the idea that competition acted as the “invisible hand,” serving to regulate the marketplace. His theories, some of them derived from observations he made while visiting a pin factory, would prompt skeptics to ask, “How many economists can dance on the head of a pin?” DAVID RICARDO (1772-1823)
With Malthus (see next page), a leader of the second generation of classical economists. Early on, Ricardo made a fortune in the stock market when he ought to have been going to school. He next gravitated to economics, where his lack of education, naturally, went undetected. In his most famous work, The Principles of Political Economy and Taxation (1817), he advanced two major theories: the modestly named Ricardo Effect, which holds that rising wages favor capital-intensive production over labor-intensive production, and the theory of comparative advantage (see “EcoThink,” page 130). THOMAS MALTHUS (1766-1834)
A clergyman who punctured the utopianism of his day by cheerfully predicting that population growth would always exceed food production, leading, inevitably, to famine, pestilence, and war. This “natural inequality of the two powers” formed, as he put it, “the great difficulty that to me appears insurmountable in the way to perfectability of society.” Malthus’ good news: Periodic catastrophes, human perversity, and general wretchedness, coupled with the possibility of self-imposed restraint in the sexual arena, would prevent us from breeding ourselves into extinction.
A child prodigy, Mill learned Greek when he was three, mastered Plato at seven, Latin and calculus by twelve; at thirteen he digested all that there was of political economy (what they called economics back then), of Smith, Malthus, and Ricardo. For the next twenty years he’d write; in 1848 (noteworthy also for the publication of the Communist Manifesto and a passel of revolutions) he published his Principles of Political Economy, with Some of Their Applications to Social Philosophy. A couple of critics complained that the book was unoriginal—calling it “run-of-the-Mill”—and that Mill’s mildly Socialist leanings (he argued for, among other things, trade unions and inheritance taxes) were antithetical to the Spirit of England. Many more, though, appreciated his making the distinction between the bind of production and the flux of distribution—how, while we can produce wealth only insofar as the soil is fertile and the coal doesn’t run out, we can distribute it as we like, funneling it all toward the king or all toward the almshouse, taxing or hoarding or, for that matter, burning it. Sociopolitical options took a seat next to economics’ abstract—and absolute—laws, and ethics eclipsed inevitability. Mill would be revered as a kind of saint (and Principles serve as the standard economics textbook) for another half century. JOSEPH SCHUMPETER (1883-1950)
An Austrian who came to America in the early Thirties and whose best-known work was published a decade later, Schumpeter is remembered today as the man who argued that government should not try to break up monopolies, that, in fact, a monopoly was likely to call into existence the very forces of competition that would replace it. This dynamic, labeled the “process of creative destruction,” is now much brandished by more conservative political and economic observers, who use it to explain to old industries why it’s OK for them to go out of business. “Don’t think of it as bankruptcy and massive unemployment,” the rationale goes. “Think of it as ‘creative destruction.’” JOHN MAYNARD KEYNES (1883-1946)
The most influential economic thinker of modern times, known to his close friends and intimates as Lord Keynes (remember to pronounce that “kanes”). Pre-Keynesian economists believed that a truly competitive market would run itself and that, in a capitalist system, conditions such as unemployment would be temporary inconveniences at worst. Then along came the Great Depression. In 1936 Keynes published his major work, The General Theory of Employment, Interest, and Money (now known simply as The General Theory) in which he argued that economics had to deal not only with the marketplace but with total spending within an economy (macroeconomics starts here). He argued that government intervention was necessary to stimulate the economy during periods of recession, bringing it into proper, if artificial, equilibrium (the New Deal and deficit spending both start here). Keynes’ system, brilliant for its time, has proved less valuable in dealing with modern inflation, and has been considered officially obsolete ever since Richard Nixon declared himself a Keynesian back in 1971. Later, however, Ronald Reagan’s supply-side economists set Keynes up in order to knock him down again in an uprising known in economics circles as “The Keynes Mutiny.” JOHN KENNETH GALBRAITH (1908-)
One of the first (and certainly one of the tallest) New World economists to give a liberal twist to the field’s dogma. In his The New Industrial State (1967), Galbraith, a Canadian, argued that the rise of the major corporation had short-circuited the old laws of the market. In his view, such corporations now dominated the economy, creating and controlling market demand rather than responding to it, determining even the processes of government, while using their economic clout in their own, rather than society’s, interests. More traditional economic thinkers have agreed that Galbraith is a better writer than he is an economist.