International Political Economy

History of economic thought

We normally distinguish classical economists (Smith, Ricardo, Marx) from marginalist or neoclassical economists and Keynesian economics. Classical were both economists and philosophers, because they kept the economic, social and political aspects together. The economic aspect was the center, but they believed that the three things cannot be separated: how you structure an economy has implications on how the society is structured and is strictly linked in how politics worked.

Some important books

• Adam Smith, industrial revolution and Political Economy: “The theory of moral sentiments” (1759) and “An inquiry into the nature and the causes of the wealth of nations” (1776).
• David Ricardo, “On the principles of Political Economy and Taxation” (1817),
• Karl Marx, Das Kapital. A Critique to Political Economy (1867).
• Alfred Marshall from Political Economy to Economics: “Principles of Economics” (1890) and “Industry and Trade” (1919).
• John Maynard Keynes “The economic consequences of the peace” (1919) and “The General theory of employment, interest and money” (1936). “The economic consequences of the peace” he discussed about how countries should deal with the peace process after WWI.

Adam Smith (1723-1790)

When we think about Adam Smith, we’re referring to political economy as a discipline that originates within moral philosophy. Smith used to teach moral philosophy and from that he moved towards trying to understand capitalism as an economic and social system. He lived at the time of the industrial revolution and he used to study Newton, trying to grasp the scientific method of inquiry into phenomena. He saw big changes in the way goods and services were produced and he was trying to understand the implication of these changes, if work in a factory is reorganized and the implications for the factory and for society.

If we look at this in the long term perspective, he was observing the shift from a feudal system to a capitalist market economy system and the birth of market economy (market seen as institution, the set of rules that govern changes of goods and services between equal individuals because they have property). He put at the center of his studies both the organization of production within companies and the social organization of production. The position of each individual in society depends on one’s ability, it is not a matter of where you were born or who you are the son of. Based on your ability you can start a new business and your position in the society can change.

Wealth of nations depends on the division of labor and the extent of the market, so it depends on the ability to organize labor in such a way that can improve the productive power of labor. Smith was observing pin factories where labor was organized in several phases, and instead of devoting one person from the beginning to the end, each one had his own task and would specialize in one part of the production process. On top of this, they used machines that can help a person to the simple task. This brings along an improvement in terms of productivity: from producing 20 pins per day for each worker to 4000 pins for each worker in a day.

There is another side of the story which is the one related to the extent of the market. If the market is a town in middle of the Scottish island, there’s no way you’re going to sell those 4000 pins. If you have a wider market, than the possibility of selling those goods and services is wider. You can think about the extent of the market in a geographical extent, in which there are immediate implications in the international trade. If you sell goods in UK you’re not exploiting them. If you sell in the colonies, you gain from the improvement in productivity. You can also think about the extent of the market in power of exchanges: more people are able to demand goods. The immediate implication for international exchanges is free trade as a policy implication, promoting free trade so you can have places in the world specializing and selling to the rest of the world.

Smith's intuition is still useful because they can explain what happens for instance when China entered the WTO and are able to demand goods and services in the international market. That’s a big increase in the extent in the market, which means that you have the possibility to improve productivity elsewhere. The extent of the market can also be called the demand. Smith was insisting that the limitations to the improvement in the productive power of labor is the demand.

The invisible hand in the historical context he was using it wanted to justify freedom of exchanges in a world that was changing. Suggesting shifting economic systems would mean the collapse of the system because you could let people free to exchange goods and services and this would be beneficial in terms of improvement of productivity. However, in the theory of moral sentiments he was discussing the sentiment that make people live together in the society peacefully and empathy. Those sentiments were important to guarantee social stability and cohesion and guarantee peaceful lives in society. If there are equal rules and rights and a shared system of values, the market can work and bring improvements for everyone.

David Ricardo (1772-1823)

Ricardo suggested the idea of the comparative advantage: he suggests that it is possible for all countries to engage in international exchanges of goods and services and the situation would be a win-win, providing that each one specializes in the production of goods and services where they have a comparative advantage. Most of the theories in international economics such as the Heckscher-Ohlin Model or most of the trade theories that are used in mainstream economy are based upon the idea of comparative advantage. It’s a very influential concept and one of the more criticized because there have been other theories particularly within development economics.

There is a theory called the Prebisch–Singer hypothesis: the economists Prebisch and Singer were not satisfied with the idea of comparative advantage and said that over the long run they expected a price of the manufactured goods and services to go up because of technology and researches, whereas the prices of natural resources or primary commodities go down, and those who are specialized in exporting primary goods and services on natural resources will have a disadvantage in the long run.

Karl Marx

Marx has in common with other classical economists the approach of political economy. He was questioning the idea that in a capitalist system the position of each one is determined by each person's own ability to organize labor or to engage in a new business. Just as Adam Smith was observing that a new capitalist, noble class was emerging, Marx was observing that there was another, working class that also wanted to have more voice and power against the capitalist class.

The capitalist systems would be based on a conflict between these two classes and this conflict would be the defining feature of capitalism, where the only way to manage this conflict would be to guarantee perpetual growth on a global scale. The conflict would be internal to any country between the working class and the capitalist class, and at the global scale you would have conflict between the first comers and the latecomers. According to Marx's perspective, there is little room for latecomers to actually improve their situation because they are dependent on the first comers, and even if a country can manage to develop its own industrial base, it is still going to be dependent on foreign technology. Unless you engage in a changing of the whole system shifting away from capitalism, there's no chance to gain the same one of first industrialized economies.

Alfred Marshall

The major question of Smith, Marx, and Ricardo, was “what determines the value of goods and services?”. They believed that this was dependent on the quantity of labor needed to produce those goods and services, and any entrepreneur would take into account the costs of production, a markup which would guarantee a margin of profit to himself and that would be the final price.

As the history of economic thought and industrialization were evolving, scholars suggested that consumers had also a role, and introduced the concept of marginal utility. Consumers make their choice based on this concept of marginal utility, the utility you gain from the last quantity of goods and services that you're consuming. They also introduced this idea of diminishing marginal utility: what consumers are willing to pay determines the price. According to the different schools of thought, that was the main point in terms of the price of goods and services, you need to consider marginal utility and what consumers are willing to pay. It's the demand that matters in determining the price of goods and services.

Alfred Marshall puts the two together. He suggests that the price is determined by a sort of equilibrium between the demand and the supply. To understand the price of a specific good you need to consider their cost of production and their markup. On the other side, you need to take into account consumers and their marginal utility. Marshall tried to find analytical tools to explain this, and he derived the very well-known graphs of demand and supply.

It's an analytical tool which suggests that price is a coordinating mechanism. Price is the mechanism through which markets coordinate themselves: if prices are going up for specific goods, it's a signal to producers to enter that market and to consumers to be careful with prices. You can apply the same tool to different types of exchanges. That analytical tool has the distinctive feature of being universal. Marshall was engaged in this effort of finding universal analytical tools because he had the ambition of moving economics towards sciences.

On the other hand, it takes away the political aspect. Economics becomes the understanding of markets through the loss of demand and supply, and the science studying the choice of a different option of a representative agent, that, in a rational way, maximizes its utility, at the margin. However, Marshall said that mathematics should not be the main language to explain economics, because it was important to be able to communicate to everyone.

He gave a great contribution in going in the direction of finding universal analytical tools. It's not to say that he was only interested in the abstract aspect, but he gave a great contribution to the marginalist revolution. It’s called marginalist revolution because from that moment onwards one part of economics goes in the direction of deepening these kinds of marginalist thinking, analytical tools, and use of mathematics.

According to some, the ambition was that he should separate the positive analysis from the normative one and then the economics should be interested in the positive analysis and be free from value judgments. The positive analysis is the realistic description of a phenomenon. Normative analysis is very much based on value judgments. According to some, it is difficult to have purely positive analysis because even the choice of how you describe the phenomenon can be influenced by your value judgments.

Here we are at the beginning of the 20th century, where that marginalist school, also called neoclassical economics, became mainstream. It was rooted in this idea of rational representative agents and also that perfect competition would be markets in which you have many producers that compete with one another and consumers have a lot of choices, producers cannot fix a price that is too high. The opposite situation to perfect competition is monopoly.

Keynesian revolution of the first half of the 20th century

Keynes was very influential for several reasons. First of all, he wrote “The Economic Consequences of the Peace” after WW1, where he was suggesting helping Europe, and in particular Germany to recover from war. For economists, one of the most important contributions of Keynes is “General Theory of Employment, Interest and Money”. According to Keynes, the neoclassicals were focusing on the exception (perfect competition). Most of the time we observe markets that are closer to monopolies or oligopolies, which is most consumer goods that we have today (PC, mobile phones).

That’s why many markets do not function as well as we expect, he thought so because he was living at the time of the Great Depression. It was characterized by long-term unemployment. For Keynes there are situations in which markets fail, and in those cases with prolonged crisis, you need to fix those failures through public interventions to provide with positive expectations to economic agents, so that they begin investing again. GDP is made of investments, exports, consumption, and government spending: during the crisis, investments and consumption go down because you have no positive expectations about the future, so companies prefer to save. For example, in Roosevelt’s New Deal public investments create labor, and then people can start spending again. As for trade, he had a very pragmatic approach: he didn’t defend free trade at all levels. He was aware that you can have trade imbalances.

Graph: “Globalization over 5 centuries”, but it touches one aspect of globalization: trade openness. It shows an index that measures the amount of trade in terms of import and exports as a percentage of world GDP. So, of the total value of goods and services produced, it shows that there is quite a precise trend over time, particularly after WW2: increasing trend in trade openness index.

If we go back in time, during the time of industrial revolution there was very little compared to what we have today. In 2008, 60% of world GDP is made of imports and exports: absolutely new in human history. And much more people are involved. The type of coordination that it requires living in this world is much higher than it has ever been. And it’s not only about exchanging goods and services, but also about producing them through different places (designing a product and then building it in an opposite side of the world): this creates connection and interdependency between places which require some coordination. Of course, we have encountered difficulties, such as global financial crisis, or the current health emergency.

For some, there is a trend that reverts somehow this long-term trend of increasing globalization: they think that we’ve come to a point in which globalization is too extended. According to others, globalization has also had advantages, because interdependency guarantees that countries need to coordinate their efforts. Therefore, the conclusion is to try to manage it in a better way, increasing coordination mechanisms, providing more power to international institutions. A third vision says that probably from now onwards, (2008: slowdown in international trade but then it went back, but it doesn’t seem to be an increasing trend) exchanges will be much more regional, instead of being across the globe.

In terms of exchange of goods and services: war economies are typically closed, they tend to close, to protect themselves. At the end of WW2 we see a rise. The Bretton Woods conference was precisely dedicated to define the rules of the global economy, that would help preventing other wars. And on a separate level, countries would engage in the UN. And the Marshall Plan, based on the idea of the USA helping Europe.

Bretton Woods and its pillars

• A system of fixed exchange rates: currencies had value that was fixed to remain, it didn’t change. Today the reality is different: values change every day (flexible exchange rate system).
• Funding of the international monetary fund: the IMF was meant to be the economic institution helping countries facing short-term crisis, mainly due to inflation. (They didn’t want to make the same mistake of the end of WW1 with hyperinflation in Germany).
• World Bank: its aim was to lend money long-term. To help lower income countries to their process of economic development. The idea was to try to be inclusive.
• The General Agreement on Trade and Tariffs: it was the first step towards the WTO. The idea was that countries increasingly engage with free trade. Globalization in terms of goods begins. It’s an increase: there was a stop because previous colonies engaged into policies which didn’t really free trade remained protected.

But capital movements were not free: so, not free of investing capitals, there were controls. USA, UK had power to have a strong say in this set of rules. They had competing views: the delegate for the UK who took part in the Bretton Woods conference was Keynes. They wanted to prevent new world wars. They had competing views: Keynes believed that, about the fixed rate exchange system, each country had to find a system of exchange rate where each currency of each country would be fixed against a virtual currency basically made out of the average currency.

On the other hand, the US had a position in which the dollar would be the reference currency, and all other currencies would be fixed against the dollar. Keynes was worried about that because if the USA got into trouble with its own macroeconomics variables, then the whole system would collapse. In fact, this happened in the 1970s: the USA entered into macroeconomics troubles because they printed many dollars for war purposes, those dollars that were around could not be guaranteed by gold reserves, so the USA had to say that the dollar was no longer convertible into gold and they had to devalue it. So, the Bretton Woods system changed from the 1970s onwards, and it gradually shifted towards a flexible exchange rate system, based upon the demand and supply. Gradually capital movements were allowed, and the function of IMF and World Bank changed a bit.

From the Great Depression to the 1970s Keynes ideas were the mainstream in economics. Things started to change around the 1970s because with the first oil shock from the economic point of view, 2 things happened at the same time: countries found themselves dealing with inflation and high unemployment at the same time. The crisis originated in the supply side, it had to do with the cost of production, so companies willing to supply less goods and services, and so to employ fewer workers.