The rediscovery of classical economics adaptation complexity and growth

The Rediscovery of Classical Economics


NEW THINKING IN POLITICAL ECONOMY
Series Editor: Peter J. Boettke, George Mason University, USA
New Thinking in Political Economy aims to encourage scholarship in the intersection of the disciplines of politics, philosophy and economics. It has the ambitious
purpose of reinvigorating political economy as a progressive force for understanding social and economic change.
The series is an important forum for the publication of new work analysing the
social world from a multidisciplinary perspective. With increased specialisation
(and professionalisation) within universities, interdisciplinary work has become
increasingly uncommon. Indeed, during the twentieth century, the process of
disciplinary specialisation reduced the intersection between economics, philosophy
and politics and impoverished our understanding of society. Modern economics
in particular has become increasingly mathematical and largely ignores the role of
institutions and the contribution of moral philosophy and politics.
New Thinking in Political Economy will stimulate new work that combines
technical knowledge provided by the ‘dismal science’ and the wisdom gleaned
from the serious study of the ‘worldly philosophy’. The series will reinvigorate our
understanding of the social world by encouraging a multidisciplinary approach to
the challenges confronting society in the new century.
Recent titles in the series include:
Socialism, Economic Calculation and Entrepreneurship
Jesús Huerta de Soto
The Political Economy of Hurricane Katrina and Community Rebound
Edited by Emily Chamlee-Wright and Virgil Henry Storr
Robust Political Economy
Classical Liberalism and the Future of Public Policy
Mark Pennington
Good Governance in the 21st Century
Conflict, Institutional Change, and Development in the Era of Globalization

Edited by Joachim Ahrens, Rolf Caspers and Janina Weingarth
Institutions in Crisis
European Perspectives on the Recession
Edited by David Howden
Constitutional Economics and Public Institutions
Edited by Francisco Cabrillo and Miguel A. Puchades-Navarro
International Aid and Private Schools for the Poor
Smiles, Miracles and Markets
Pauline Dixon
The Rediscovery of Classical Economics
Adaptation, Complexity and Growth
David Simpson


The Rediscovery of
Classical Economics
Adaptation, Complexity and Growth

David Simpson
Formerly Professor of Economics, University of Strathclyde,
Scotland, UK

NEW THINKING IN POLITICAL ECONOMY

In Association with the Institute of Economic Affairs

Edward Elgar
Cheltenham, UK • Northampton, MA, USA

© David Simpson 2013
All rights reserved. No part of this publication may be reproduced, stored
in a retrieval system or transmitted in any form or by any means, electronic,
mechanical or photocopying, recording, or otherwise without the prior
permission of the publisher.
Published by
Edward Elgar Publishing Limited
The Lypiatts
15 Lansdown Road
Cheltenham
Glos GL50 2JA
UK
Edward Elgar Publishing, Inc.
William Pratt House
9 Dewey Court
Northampton
Massachusetts 01060
USA

A catalogue record for this book
is available from the British Library
Library of Congress Control Number: 2012952657
This book is available electronically in the ElgarOnline.com
Economics Subject Collection, E-ISBN 978 1 78195 197 2

ISBN 978 1 78195 196 5 (cased)
978 1 78254 508 8 (paperback)

03

Typeset by Servis Filmsetting Ltd, Stockport, Cheshire
Printed by MPG PRINTGROUP, UK


Contents
Preface
1
2
3
4
5
6
7
8
9
10

vi

Introduction
Human behaviour
Qualitative change and quantitative growth
Adaptation, emergence and evolution
Self-organisation and complexity
Markets, competition and entrepreneurship
Specialisation and growth
Prosperity and recession
Government
The rediscovery of classical economics

Bibliography
Index

1
13
28
51
71
86
105
131
160
179
195
206

v


Preface
A book so long in the making generates many debts of gratitude. Among
those who have provided me with help and encouragement at various
stages of its writing are Fessal Bouaziz, Asa Briggs, Ian Byatt, Phoebe
Clapham, Michael Fry, Gavin Kennedy, Brian Loasby, Alan Peacock,
Colin Robinson, Jim Stretton and John Thomson, as well as an anonymous researcher at the Royal Economic Society. There are many others
whom I may have overlooked. I thank them all most warmly for their
individual contributions, moral as well as intellectual. I should also like
to thank my editors, Matt Pitman, Jo Betteridge, Sarah Cook and Jane
Bayliss, as well as the staff of the Reading Room at the National Library
of Scotland.

A special word of thanks must go to Neil Menzies who read some early
drafts and tirelessly prodded me whenever my concentration wavered. I
am particularly grateful to Jim Walker, once my student, now my teacher.
He is living evidence that classical economics really works. Above all, I
am deeply indebted to my wife Judy for her forbearance during so many
absences of mind and for her active support at critical times. Without that
support, this book could not have been written.
Tyninghame, East Lothian
January 2013

vi


This book is for Judy, who made it possible.

Two roads diverged in a wood, and I,
I took the one less traveled by,
And that has made all the difference.
Robert Frost The Road Not Taken



1.

Introduction
The main concern of economics is thus with human beings who are
impelled, for good and evil, to change and progress . . . [T]he central idea of
economics . . . must be that of living force and movement.
Alfred Marshall1

The purpose of this book is to put forward an alternative to equilibrium
economics, the paradigm that has dominated the mainstream of economic
thought for the best part of a century.2 That alternative is what may be
called classical economics, namely the intellectual tradition that began
with Adam Smith, evolved in the nineteenth century, was continued in the
twentieth century by Marshall and the Austrians amongst others, and is
today represented by theorists of complexity.
The hallmarks of the classical tradition are principally three. The first
is the belief that the growth of the economy, rather than relative prices,
should be the principal object of analysis. Coupled with that belief is
an understanding of the market economy as a collection of processes of
continuing change rather than as a structure, and that the nature of this
change is self-organising and evolutionary. Finally there is a conviction
that economic activity is rooted in human nature and the interaction of
individual human beings. Many people might suppose from the similarity
of the terms ‘classical’ and ‘neoclassical’ that the one school of economic
thought is closely related to the other. In fact, as this book will try to show,
they are more nearly exact opposites.3
We need an alternative to conventional equilibrium economics because
it does not provide us with a good understanding of how the economy
works. Equilibrium theory is essentially a mechanistic metaphor.4 The
progressive refinement of the theory during the twentieth century was
intended to deliver determinacy of solutions together with simplicity of
structural form. This has been achieved in principle, but at the cost of
such drastic simplification of assumptions and the exclusion of so many
important elements of economic activity that the resulting theory has little
correspondence with reality. It is not surprising therefore that it has been
useful neither for prediction nor for explanation.
This is particularly harmful for policy makers. The importance of real
world phenomena that cannot be accommodated within the structure of

1


2

The rediscovery of classical economics

static equilibrium analysis is frequently overlooked or downplayed. The
arrival of the recession of 2008‒2010 took Treasury officials and central
bankers on both sides of the Atlantic by surprise. They had been almost
unanimously agreed that, thanks to their policies, from around 2000
onwards the Western world had entered a new era of stability and growth
that would last indefinitely. Furthermore, recovery from the recession has
proved unexpectedly resistant to orthodox policy measures. It is difficult
to separate these policy failures from the conventional equilibrium theory
on which they were based.5 Surely it cannot be a coincidence that the
study of business cycles was displaced from the academic curriculum by a
version of static equilibrium theory called macroeconomics? Although a
return to sustained economic growth is desperately sought by politicians
throughout the Western world as they struggle to balance their books and
provide their voters with jobs, little is heard about the contribution that
capturing increasing returns might make to this objective, perhaps because
increasing returns do not fit easily into the static equilibrium model.
Such basic issues as free trade and protection and the market versus state
management appear to divide opinion in the profession as much as ever.
Competing solutions to these and other policy questions remain intellectually not much further advanced than Adam Smith left them (Kennedy
2008: 2). Many other examples can be cited. The point is that conventional
equilibrium theory provides policy makers with a poor understanding of
how a market economy actually works.
Equilibrium theory has focused the attention of academic economists

on issues surrounding the efficient allocation of a given set of resources
amongst a number of competing uses at a single moment of time. While
such questions have engaged the best brains of at least two generations in a
number of intellectual conundrums,6 it has diverted them from an analysis
of those features of a market economy that have impressed themselves on
human history.
There is first of all the ability to sustain growth in aggregate productivity over long periods of time. This is a unique feature of the market
economy: no other form of economic organisation has been able to deliver
sustained increases in living standards for masses of people. The poorest
citizens of a rich country today are materially better off than their wealthiest compatriots of a hundred years ago, and immeasurably better off than
mediaeval kings and princes.
Another characteristic feature of market economies is the periodic fluctuations in total output and employment that have been apparent since
at least the beginnings of industrialisation. A third feature is the system
of markets itself, with its associated sets of prices. But perhaps the most
striking feature of the market economy, distinguishing it from other forms


Introduction

3

of economic organisation, is the fact of incessant change. New goods in a
bewildering variety are added every week to the shelves of our supermarkets. We have come to expect continuous improvement in the quality and
technical specification of both producer and consumer goods. We take for
granted constant novelty in the various forms of communication, computing and entertainment services that we are offered.
For economists, it should be important to be able to explain these
phenomena: the process of growth in productivity that has brought about
our rising living standards, the origins and development of the business
cycle, the nature of markets and the processes of change. But on all these
questions, equilibrium theory is silent.7 It is difficult to exaggerate the

inappropriateness of using the concept of ‘equilibrium’ to try to analyse
a market economy.8 Equilibrium means being at a state of rest. A market
economy is never at a state of rest. It is essentially restless, as Marshall
understood (Metcalfe 2006: 651).
As we shall see in Chapter 10, the present state of equilibrium theory is
the culmination of a century long digression in the academic teaching of
economics from the classical tradition, using linear algebra in pursuit of
the illusion of becoming a ‘hard science’ (Mirowski 1989), accompanied
by the marginalisation of important cognate disciplines like economic
history and the history of economic thought. Equilibrium theory has difficulty in either explaining or predicting movements in a market economy.
These difficulties arise from the limitations imposed by its assumptions
and omissions, limitations that make equilibrium theory ‘difficult, if not
impossible, to relate to empirical reality’ (Colander 2009: 416). There are
three critical assumptions.
The first assumption made by equilibrium theory is that the economy is
static. The configuration of the economy is analysed at a single moment
in time. If change is to be investigated the most that can be hoped for
is a comparison between two static equilibria A and B, before and after
the notional change. The path by which the economy moves from A to
B cannot be analysed. The implication is that adjustment is instantaneous and costless. To put it another way, the question of how resources
became allocated the way they are is resolved before the analysis begins.
Equilibrium theory ignores the market process by which the state of affairs
is brought about that it simply assumes to exist.
The logic of choice may be appropriate for the analysis of individual
action. The preferences of one individual together with their knowledge
of the relevant facts determine a unique solution. But the analysis of
individual choice cannot legitimately be extended to a market process
in which the decisions of several individuals influence one another, their
actions and reactions succeeding each other in time. Once we allow for the

4

The rediscovery of classical economics

behavioural interdependence of individual consumers and producers, the
inadequacy of the static equilibrium model of the market process becomes
clear (Samuelson 2006: 244). The problem then becomes one of how the
data for each individual, on which they base their different plans, are
adjusted to the actions of other people. It is precisely this process of adjustment on which complexity analysis focuses its attention. It is a dynamic
self-organising process whose nature and characteristics are assumed away
by static analysis. Market equilibrium assumes that the data for different
participating individuals have been fully adjusted to one another, but does
not tell us how this was brought about (Hayek [1948] 1980: 93‒94).
From the perspective of equilibrium theory, the essential economic
problem consists in allocating the scarce resources of society amongst
consumers as efficiently as possible, given everyone’s preferences and the
available technologies and resources. To make possible a determinate
solution to this problem, it is assumed that there is a single global stock of
knowledge that is freely accessible to all participants in the economy. This
stock includes knowledge of all prices, future as well as present, of all technologies, and of all possible investment opportunities and their outcomes.
The prior problem of how all this knowledge can be known to one mind or
can somehow be collected in one place is simply assumed way. This is the
second critical assumption of equilibrium theory.
In practice, the knowledge that is put to work in a market economy
is widely dispersed. Different people know different things, and what
they know is largely subjective and incomplete, and often tacit or contradictory.9 The progress of the economy means that new commercial
knowledge is constantly being discovered. The real economic problem
is therefore this: how can all this dispersed knowledge, new as well as
existing, be discovered and communicated to all the different participants

in an economy? To put it another way, how can the range of diverse and
specialised economic activities that make up a market economy be coordinated in a tolerably effective manner? The actions of every participant
in a market economy are guided by a common set of prices, prices being
signals that abridge knowledge of what is happening in different markets.
If they are to be reliable guides to action, prices must be generated by
markets.10
There is a fundamental difference between the way prices are determined
in equilibrium theory and in classical theory. In equilibrium theory producers and buyers are assumed to know in advance the lowest cost at which
a commodity can be produced. Classical theory believes this information
will only be discovered by a market process of competition. Likewise, in
equilibrium theory producers are assumed to be fully informed about the
preferences of consumers, including the kinds of goods they would like


Introduction

5

and the prices they would be willing to pay for them. Classical economists
would regard this kind of knowledge not as given data, but as facts that
can only be ascertained through competition (Hayek 1948: 95).
The distinction between the two approaches to the nature of knowledge
in a market economy is more than academic. It came to have immediate
practical importance with the establishment of a planned economy in the
Soviet Union in the 1920s. Marx and his immediate followers had shied
away from the question of how economic activity in a socialist state would
be coordinated. Early critics argued that without market prices it would
be impossible to achieve any remotely rational allocation of resources.
Socialist economists like Oskar Lange argued to the contrary that a central
planning authority could gather enough information to compute prices

centrally for handing down to factory managers, and that once sufficiently
powerful computers became available the problem would be solved. This
was disputed by Hayek, Mises and others who argued that the dispersed,
subjective and fragmentary nature of economic knowledge meant that the
problems of acquiring, centralising and communicating it in a command
economy could not be overcome. A vigorous debate, now known as the
socialist calculation debate, ensued in the academic journals in the 1930s
(Hayek [1948] 1980: 119‒209). The debate was definitively resolved by the
collapse of the Soviet Union in 1989, the political system being brought
down by the inability of the planned economy to deliver either the increasingly sophisticated range of goods desired by consumers or the advanced
defence equipment required by the military. Given the similarity of the
assumptions made about the nature of economic knowledge by equilibrium theorists and by the proponents of central planning, the implications
of this episode are significant.
The third critical assumption of equilibrium theory is that of rational
behaviour. It is assumed that consumers and businessmen use the perfect
knowledge that is believed to be at their disposal in a consistent and
calculating manner to make optimising choices. It is implicitly assumed
that their brains have the power to absorb and process all the available
information, unclouded by cognitive biases. Even stronger assumptions
are required to justify the so-called ‘rational expectations’ approach that
dominates equilibrium macroeconomics. Here, it is additionally required
that every market participant shares a ‘true’ model of how the economy
works and is able to use that model to form identical expectations about
the future path of the economy. All other participants have identical
beliefs and information and therefore share the same view of the future.
It is self-evident that such assumptions do not reflect the reality of a
world of conflicting opinions. The assumptions need to be relaxed in one
or both of two directions. One is to allow different agents to form different

6

The rediscovery of classical economics

expectations, and the other is to allow agents to form their expectations
over time in the light of experience. It seems plausible that people form
their own understanding of how an economy works through a learning process involving the social transmission of information and ideas.
However, the most casual observation suggests that people do not share a
common view of the working of the economy, whether that is a true one
or not. We live in a world of conflicting opinions and forecasts, where
individuals act differently. Only after actions have been taken do we learn
who was (more nearly) right, and who was (more nearly) wrong. Despite
this, ‘rational expectations’ remains the predominant assumption about
expectations formation in the contemporary literature of equilibrium
theory. Why is this so? Presumably for reasons of analytical convenience.
Choosing assumptions to fit a model rather than the facts does not seem
to be a scientifically satisfactory procedure.11
Many other restrictive assumptions are commonly made by equilibrium
theory in order to achieve determinacy, an important one being the convexity assumption that effectively rules out increasing returns, but these
three are the important ones.
Also important in understanding the limitations of equilibrium theory is
an awareness of what is left out. Institutional, social and political factors
are generally excluded. The result is that those who interpret economic
events from the perspective of equilibrium theory will typically give undue
weight to those factors that are quantifiable, and underestimate the influence of unquantifiable ones. The historical context of events is likewise
frequently discounted in equilibrium analysis, general influences being
emphasised at the expense of the particular.
Even more damaging than the omission of institutional factors is the
omission of the human factor. The absence of change and uncertainty in
equilibrium economics means that there is no scope for entrepreneurship.

Likewise, there is no place for human emotions like fear and greed that
play their part in forming expectations and levels of confidence. Nor for
the emotions that drive economic growth like ambition, curiosity, or an
altruistic desire to serve humanity (Mokyr 2006: 311).
Many economists recognise that equilibrium theory is remote from the
practical issues that confront them, but they are reluctant to let go of it
because they value its logical rigour, and cling to the principle of determinacy. Their standard defence is familiar:
1.
2.

A market economy behaves ‘as if’ the assumptions of equilibrium
theory were true.
Only predictions matter, not explanations. Therefore it doesn’t matter
if assumptions are unrealistic.


Introduction

3.

7

Evolutionary selection will eventually drive outcomes to the optimal
equilibrium, because good outcomes will drive out bad ones.

The rejoinder to these points is straightforward. (1) There is no persuasive
evidence in favour of this proposition. On the contrary, most markets are
evidently out of equilibrium most of the time. (2) The purpose of theories
should be to explain, rather than to predict. Even if we were to accept the
criterion of prediction, economic forecasts based on equilibrium models

have invariably performed badly. (3) Simulations show that only with
certain parameter values do complex systems converge to equilibrium.
There is no guarantee that that equilibrium will be an optimum. The conclusion must be that equilibrium theory is irrelevant to an understanding
of how a market economy works (Kaldor 1972).
The story of the development of economic theory since Adam Smith is
seen by equilibrium theorists as a search for an ever more formal structure.
The search was so keenly pursued that the formal structure became an
end in itself, and its ultimate purpose was lost sight of. The story has two
aspects. In the first, society looking for a theory of growth was fobbed off
with a theory of value (Robinson 1966). In the second, the achievement of
formality, simplicity and elegance of theoretical structure was bought at
the cost of making such drastic omissions and such simplistic assumptions
that all connection with empirical reality, that which is to be explained,
has been lost. The theory cannot explain anything of importance about the
contemporary market economy, nor does it contribute to an understanding of how that economy works.
Equilibrium theory has got away with this because, until quite recently,
there was no other competing theory of comparable formality and simplicity. Now there is. The rival theory has greater explanatory power,
and offers new insights into how the economy works. It has the great
advantage that it is not a static theory but a dynamic theory, it deals with
processes not structures, and it is does not require assumptions about
states of equilibrium. It is therefore well-suited to addressing questions of
growth and fluctuation, the big questions of a market economy.
None of the foregoing criticisms of equilibrium theory is original. It has
been necessary to rehearse them in this introductory chapter in order to
clear the ground for the alternative that is expounded in the main part of the
book. If the present work has any originality it lies in emphasising the congruence of the economic applications of complexity theory with many of
the strands of thinking represented by the Austrian school, itself a continuation in the twentieth century of the older classical tradition in economic
thought. Taken together, these three apparently disparate schools form a
single continuous line of thought that can justly be termed ‘classical’.12

8

The rediscovery of classical economics

While the earlier Classical School is usually said to have ended with
J.S. Mill, I shall apply the term ‘classical’ to an intellectual tradition that
has been continued up to the present day by a number of economists of
whom I shall single out Marx, Menger, Marshall and Allyn Young as
well as Schumpeter and Hayek. More recently, the classical tradition has
been continued in the writings of Boulding, Kaldor, Shackle and Loasby,
amongst others. Let me repeat the three principles that can be said to
characterise this tradition:
The first is that classical economists believe that economic growth, not
the theory of value, is the primary issue with which economic analysis
should be concerned. Since growth means change, classical economics
analyses processes of change, not structures or end states.
The second principle of the classical tradition is recognition that the
nature of change in a market economy is self-organising and evolutionary.
Change is seen as beginning with individuals adapting their behaviour,
then spreading throughout the economy from the bottom up as a result
of further adaptation on the part of other individuals and businesses. A
self-organising process is one where the interactions among the individual
elements of a group lead to patterns of behaviour at the aggregate level of
the group as a whole that are different from, and cannot be predicted by,
the behaviour of the elements themselves. Self-organising processes are
pervasive in market economies. In the classical view, economic activity
is an irreversible process that takes place in historical time: it involves
qualitative as much as quantitative change. Change is determined largely
by factors occurring within rather than outside the economy, so a market

economy is also an evolutionary process.
Thirdly, classical economists recognise that a market economy is an ever
changing assembly of relationships among individual human beings. An
understanding of human motivations and beliefs must therefore be central
to any economic analysis.
The differences between classical theory and equilibrium theory can be
summarised in the following terms. Classical theory focuses on change and
growth within open, dynamic nonlinear systems that are normally far from
equilibrium. Equilibrium theory, on the other hand, analyses the theory of
value13 within closed, static linear systems that are always in equilibrium.
As to the essential nature of economic activity, classical economics makes
no distinction between micro- and macroeconomics. Patterns of activity at
the macro level emerge from interactions at the micro level. Evolutionary
processes provide the economy with novelty, and are responsible for its
growth in complexity. In equilibrium theory micro-and macroeconomics
remain separate disciplines; there is no endogenous mechanism for the
creation of novelty or growth.


Introduction

9

The behaviour of human beings in classical theory is analysed individually. People typically have incomplete information that is subject to errors
and biases, and they use inductive rules of thumb to make decisions and
to adapt over time. Their interactions also change over time as they learn
from experience. In equilibrium theory, individual behaviour is assumed
to be homogeneous and can be modelled collectively. It is assumed that
humans are able to make decisions using difficult deductive calculations,
that they have complete information about the present and the future, that

they make no mistakes and have no biases, and therefore have no need for
adaptation or learning (Beinhocker 2006: 97).
In the following chapters we shall try to show that the classical perspective provides a better understanding of how market economies work than
does equilibrium theory. We begin with human behaviour in Chapter
2. It is sometimes forgotten that all economic activity is the result of
human actions that depend in turn on the different and variable motives
and beliefs of millions of individual human beings. Human knowledge
is at the root of the growth of output. Human qualities like judgment,
perseverance and leadership lie behind every successful business, while
human weaknesses have brought about some spectacular market failures.
Markets are moved by changes in expectations, while human emotions
like greed and fear drive cycles of prosperity and recession. The way
humans interact with one another is different from the behaviour of other
animals and even more different than the behaviour of physical particles
when they collide with each other. Human behaviour therefore needs
to be modelled differently from natural phenomena. Within the broad
class of complex adaptive systems, there is a hierarchy of behaviours of
increasing complexity. Biological phenomena are more complex than
physical phenomena, and human behaviour is more complex still. A
market economy therefore needs to be distinguished from other types
of complex systems and treated as a separate class, namely as a human
complex adaptive system.
It is the restless nature of human beings that is chiefly responsible for the
relentless and incessant change that we see manifested in every developed
market economy. Novelty and continuous improvement in technology
and in the quality of consumer and capital goods is one of the distinguishing features of a market economy, and it requires explanation. This is the
subject of Chapter 3.
Changes in economic activity originate from initiatives by individuals. The changes their actions set in motion compel responsive changes
on the part of other people. In other words, they adapt their behaviour.
Individuals and businesses in market economies learn to adapt their behaviour largely by processes of trial-and-error; they learn from experience.

10

The rediscovery of classical economics

They do this for the simple reason that they lack the knowledge to do otherwise. An important part of the changing environment to which they are
responding is simply the changing behaviour of other market participants.
Adaptation leads to the emergence of new patterns of behaviour that
eventually permit a growth in total productivity. From this perspective,
the benefit of a market economy may not be so much its efficacy in the
allocation of resources at a moment in time, or even their efficient allocation over time, but rather that, more than other forms of organisation, it
facilitates adaptability or adjustment to change. Adaptation, emergence
and evolution are discussed in Chapter 4.
The adjustments that take place in a market economy are mutual
and voluntary. There is no control exercised from the top down either
from within or from outside the economy. From mutual adjustments
in behaviour at the micro level, there emerge, through intermediate
layers of similar actions, discernible patterns of activity, irregular but
persistent, at the level of the economy as a whole. Those relatively stable
patterns, those  modest but apparently steady changes that we observe
on the surface of most economies are the outcome of incessant and
frequently disruptive, interactions taking place below the surface. This
fits the description of a self-organising system, or, in modern parlance, a
complex adaptive system. The vision of an economy as a self-organising
system can be traced back to the classical economists of the eighteenth
century, and even earlier.14 But it has been substantiated by some recent
advances in applications of nonlinear mathematics. Chapter 5 reviews the
properties of self-organising systems and their implications for economic
analysis.

In the next four chapters we use the concept of self-organisation to
understand some of the characteristic features of a market economy. In
Chapter 6, we show how markets themselves are best understood as selforganising processes that perform the vital functions of price discovery
and product selection. Only when markets are treated as processes can we
make sense of competition and entrepreneurship. Markets have evolved
over a long period of time, and are still evolving.
The sustained annual increments in total output per head that we
associate with market economies are the result of another self-organising
process, the process of economic growth. In Chapter 7 we show how trade,
a distinctly human characteristic, sets in motion a process of increasing
specialisation of economic activities that results in sustained increases in
productivity. When the higher profits and wages accruing from those productivity gains are spent they lead to an expansion of purchasing power
in the economy as a whole. This increases demand somewhere which
will justify a further degree of specialisation in that part of the economy,


Introduction

11

raising total productivity still further, and so on in a cumulative spiral of
growing productivity and incomes.
Another distinctive pattern to be seen in industrialised market economies is that periodic fluctuation in total output and employment known
as the business cycle. A recent study identified no fewer than 148 occasions since 1870 where a country experienced a cumulative fall in output
of at least 10 per cent (Barro and Usua 2008). Each of these episodes
differs from one another in several ways. They are triggered by different
events, and the industries principally affected may be different. Nor can
any statistical regularity be detected in the frequency, amplitude or duration of each cycle. It may therefore be more appropriate to think of such
fluctuations as having a recurring pattern, rather than forming a cycle, a
term that perhaps implies too great a degree of regularity. In Chapter 8 we

analyse the common pattern that is discernible in most economic fluctuations. It, too, has the characteristics of a self-organising process.
Market economies, like the societies of which they are part, are often said
to operate within a ‘framework’ of institutions. But the rules of behaviour
of societies including formal laws as well as social norms, together with the
organisations that embody them such as markets and governments, evolve
gradually over time. Most of today’s business practices are the outcome
of a long and continuing process of cultural evolution. The classical
economists were well aware that most of the important institutions of their
society were the product of evolution rather than design. It might seem,
on the other hand, that contemporary institutions, such as banking laws,
owe their existence to acts of deliberate collective decision making. Surely
they cannot be said to have evolved? On closer examination, however, it
turns out that legislation also evolves. Like individuals and businesses,
governments progress by trial-and-error. The functions of government are
the subject of Chapter 9.
Chapter 10 traces the continuity of classical thought from the older
classical school through the work of Menger and his twentieth century
followers to contemporary theories of self-organisation as reflected in
the analysis of complex systems. It is widely supposed that the analysis
of dynamic nonlinear systems originated quite recently in the natural
sciences, and in the mathematical sense that may be correct. However,
the principles of self-organisation to which the mathematics gives expression were identified much earlier by social scientists. When the results of
the first applications of the methods of complexity to economics became
available, it was recognised that they represented a rediscovery of classical economics. For most of the twentieth century classical economics has
been marginalised, the mainstream of economic thought being occupied
by equilibrium theory in its neoclassical version. Neoclassical economics


12

The rediscovery of classical economics

is now revealed to be not the mainstream but a backwater, a dead end in
the history of economic thought. It is the Austrian economists and their
successors, the theorists of complexity, who are the true inheritors of the
classical tradition in economic thought.

NOTES
1.
2.
3.
4.

5.

6.
7.

8.
9.
10.

11.
12.
13.
14.

Marshall ([1920] 1962: xiii).
Within the term ‘equilibrium economics’ I include neoclassical and neo-Keynesian
theories, and any others that use the static equilibrium framework of analysis.

‘Hardly an author can be found, not even Keynes himself, who is so much the exact
antipode of Milton Friedman in every part of the economist’s theoretical vision as Carl
Menger’ (Streissler and Weber 1973: 165).
Mirowski (1989). The term ‘equilibrium’ seems first to have been used in the context
of economic theory by Sir James Steuart. It was never used by either Smith or Hume.
Its modern usage appears to have originated with Cournot in 1838, gaining currency in
the English-speaking world with Mill ten years later (Milgate 2008: 22). The term has
two broad meanings. First, a point at which there is no incentive within a system to
change behaviour, e.g. a steady or stationary state, and second, a stationary position in
a dynamic process. The former interpretation is commonly associated with economics,
whereas the latter is the sense in which the term is most often used in the natural sciences
(Winter 2008: 57).
‘The typical graduate macroeconomics and monetary economics training received
at Anglo-American universities during the past 30 years or so may have set back by
decades serious investigations of aggregate economic behaviour and economic policyrelevant understanding.’ Willem Buiter, ‘The Unfortunate Uselessness of most “State
of the Art” Academic Monetary Economics’, Financial Times blog 3 March 2009, available at www.ft.com/maverecon.
See, for example, Harcourt (1972).
It might be thought that the equilibrium theory of value would be able to explain at
least the workings of markets. But so restricted is its construct of ‘perfect’ competition,
that it excludes almost all the activities that the verb ‘to compete’ describes (Hayek
1948: 92).
‘[T]he limitations of the concept [of equilibrium] in dealing with conditions of persistent
and imperfectly predicted change will not be removed until economics possesses a
developed theory of change’ (Stigler 2008: 57).
The extraordinary volumes of trading observed in financial markets arise in large part
from the fact that different people know, or think they know, different things.
Classical economists believe that market economies have evolved over time to meet
the need to coordinate dispersed commercial knowledge, in much the same way that
language has evolved to meet human needs to communicate with one another, and law
has evolved to meet society’s need to resolve disputes.

It may not be surprising to find that economic models based on rational expectations
have difficulty in explaining such robust stylised facts as the trade-off between inflation
and unemployment (Carroll 2006, p.6).
See Chapter 10.
Macroeconomic theory has extended the theory of value into the topics of growth
and fluctuations, but, as we shall see in Chapter 10, such extensions are fraught with
difficulties.
For example, Mandeville ([1732] 1988).


2.

Human behaviour
Economics is a study of men as they live and move
and think in the ordinary business of life.
Alfred Marshall1

We have become so accustomed to economies being described by statistics
of output, exports, stocks of capital and so on, that we often forget that all
these things are simply the outcome of human activity, and that a market
economy is a collection of relationships between human beings. That
being the case, we should not be surprised to discover that the way that
economies work is determined by human behaviour. Human behaviour
is rooted in individual human values, and individual human values are
subjective, heterogeneous and changing.
Classical economists from Smith to Marshall and Schumpeter have put
human beings at the centre of their vision of economic activity. Marshall
defined Economics as being a study of humans in the ordinary business of
life. Schumpeter noted that the essence of the economy lay not in paper
securities or production equipment but in the psychological relations

between people and in the mental state of the individual. For Smith, the
three great drivers of economic activity, the psychological constants of
his model of the economy, were ‘the [human] propensity to truck, barter
and exchange one thing for another’, ambition, and the urge to procreate.
Another basic human motive to which he drew attention is the individual’s
need for the approval of others (Kennedy 2008).

TRADING
From the point of view of an economy perhaps the most important human
trait is the disposition to exchange goods and services with one another.
The significance of trading is that it leads to specialisation, a form of
cooperation that is the key to economic growth. Adam Smith asserted that
what he called ‘the propensity to truck and barter’ was a uniquely human
activity, remarking that ‘No man ever saw a dog make fair and deliberate
exchange of a bone with another dog’2 (Smith [1776] 1937: 13). Was Smith
right in thinking that cooperation through trade is uniquely human? There
13


14

The rediscovery of classical economics

are some species, like ants, where individuals live together in colonies with
specialisation of tasks and trade. But this tends to take place among relatives. In other species, there is evidence of limited cooperation between
nonrelatives around specific tasks, within very small groups and for short
periods. Extensive cooperation among large numbers of nonrelatives
persisting over long periods of time does indeed appear to be unique to
human beings (Beinhocker 2006: 7; Seabright 2004).

AMBITION
Ambition, ‘the desire of bettering our condition’ (Smith [1776]1937: 341)
or ‘[the] universal, continual and uninterrupted effort [of men] to better
their own condition’ (ibid: 345) has been a key driving force for change
and growth in the economy throughout history:
it is this effort, protected by law and allowed by liberty to exert itself in the
manner that is most advantageous, which has maintained the progress of
England towards opulence and improvement in all former times, and which, it
is to be hoped will do so in all future times. (Ibid.)

Most of us have come across the ultra-ambitious type, the workaholic to
be found in all occupations. According to Smith, those individuals who
are driven by the prospect of fame and fortune deceive themselves. Even
when they realised their ambitions, this did not bring them personal happiness or peace of mind; they ended their lives exhausted and unhappy.
Although ambition may be damaging to the individuals afflicted by it, it
is a human motive of great, albeit unintentional, social benefit. Smith puts
the argument eloquently:
The poor man’s son, whom heaven in its anger has visited with ambition, when
he begins to look around him, admires the condition of the rich. . . . With the
most unrelenting industry he labours night and day to acquire talents superior
to all his competitors. . . . Through the whole of his life he pursues the idea of a
certain artificial and elegant repose which he may never arrive at, for which he
sacrifices a real tranquillity that is at all times within his power. . . . It is . . . in
the last dregs of his life, his body wasted with toil and diseases, his mind galled
and ruffled by the memory of a thousand injuries and disappointments which
he imagines he has met with . . . that he begins at last to find that wealth and
greatness are mere trinkets of frivolous utility . . .
And it is well that nature imposes upon us in this manner. It is this deception
which rouses and keeps in continual motion the industry of mankind. It is this
which first prompted them to cultivate the ground, to build houses, to found

cities and commonwealths, and to invent and improve all the sciences and
arts, which ennoble and embellish human life; which have entirely changed the


Human behaviour

15

whole face of the globe, have turned the rude forests of nature into agreeable
and fertile plains, and made the trackless and barren ocean a new fund of subsistence, and the great high road of communication to the different nations of
the earth. The earth by these labours of mankind has been obliged to redouble
her natural fertility, and to maintain a greater multitude of inhabitants. (Smith
[1759]1976: 181)

PROCREATION
The universal urge to procreation meant, according to Smith, a constant
tendency for population in every society to increase. The resulting pressure
of population growth on resources was responsible for driving societies
through successive stages of development, as each sought new ways to
relieve the pressure. Increased food supplies might temporarily allow
income per head to rise, but sooner or later population would catch up
through reduced infant mortality or extended longevity (Kennedy 2008:
65). This theme was taken up by Malthus, but it dropped out of mainstream academic discourse once equilibrium theory had replaced the old
classical factor supply functions with the simplifying assumption of fixed
supplies of resources (Blaug 1997).

SOCIAL NORMS
When the human need for approval is combined with another human trait,
a concern for the well-being of others, together they give rise to a social
convention or norm in society that limits the tendency for an individual to

act in a purely self-regarding way.3 In other words, in developed market
economies there exists a social norm of what we might call ‘fairness’ that
makes certain kinds of selfish behaviour unacceptable.
Generally speaking, individual human behaviour is shaped by the
norms and values, customs and habits of the society in which it takes
place. Different norms can produce very different outcomes. The ‘wrong’
norms can provide insuperable obstacles to economic progress, or at least
dampen its prospects. Even in the most advanced economies examples can
be found of communities where personal achievement is frowned upon,
and those who want to ‘get on’ have to leave. In the absence of a norm
like trust, trading activity becomes impossible or very difficult, so that it is
hard to imagine a market economy developing without it.
When managers of large corporations are discovered to have been
acting in bad faith in the conduct of their businesses, they are punished
by society. If such wrongdoing is suspected, rightly or wrongly, to be


16

The rediscovery of classical economics

widespread, then trust in the whole economy is shaken (Akerlof and
Shiller 2009: 26). When the major US banks stopped trusting each other
in late 2008, they became unwilling to lend to each other and the supply of
inter-bank credit dried up.4
Some cultural norms are conducive to change and growth. They include
a spirit of enterprise – the ‘can-do’ attitude – a sense of identity, a commitment to the common good, a willingness to work hard, thrift, honesty,
patience and tenacity together with an ability to transmit these values
from one generation to another (Landes 1998: 217‒18). Bowles and Gintis
(2006) suggest that adherence to social norms is underwritten not just by

the expectation of future reciprocity, but by such emotions as shame, guilt,
pride, regret and joy. They believe that these feelings play an important
role in sustaining cooperative relations within societies.
Other human emotions have varying influences on economic activity. Self-confidence, a willingness to take risks and a desire to ‘keep up
with the Jones’s’ all work in favour of change and growth. On the other
hand, states of mind coloured by unwarranted feelings of optimism or
pessimism, envy, resentment and temptation can amplify fluctuations
in economic activity. As Kindleberger observed, ‘There is nothing so
disturbing to one’s well-being and judgment as to see a friend get rich’
(Kindleberger 1996: 13). At certain times, people allow their normal judgment to be unbalanced by greed. How else can one explain in the run-up to
the financial crisis of 2008 the spectacle of bankers eagerly buying bundles
of securities whose value they did not know.
Human weaknesses of a slightly different kind are at work in the public
sector. If we were all saints, there might be no need for government at
all. But the fact that it is notoriously difficult to get publicly controlled
organisations to operate efficiently may be attributable to the fact that
their employees, like the rest of us, can’t resist pursuing their own private
agenda.5

‘RATIONAL’ ECONOMIC BEHAVIOUR
In the Preface to the First Edition of Principles of Economics Marshall
wrote: ‘Attempts have indeed been made to construct an abstract science
with regard to the actions of an “economic man”, who is under no ethical
influences and who pursues pecuniary gain warily and energetically, but
mechanically and selfishly. But they have not been successful’ (Marshall,
[1920] 1962: v). Sadly, this judgment turned out to be incorrect. In the following hundred years equilibrium theorists were singularly successful in
capturing the mainstream of economic thought.