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In previous post on the founding of the Bank of England, we have explained that Central Banks were created to provide financing for wars. In fulfilling this role, they had several advantages over the state, enabling them to get credit, and get it at low interest rates. For a number of reasons, this was not possible for sovereign states. See  Origins of Central Banking  for historical details about the creation of the Bank of England. Accompanying post on  Monetization, Maturity Transformation, and MMT  explains the dramatic differences between appearances and reality about exactly how banks function.  That the main function of Central Banks was financing of wars, and that they succeeded at this function very well, is empirically established by Paul Poast in “ Central Banks at War ”. One of the unique features of this virtually constant fighting between the “great powers” of Europe was that no one party could dominate the others, although many attempts were made. This was due to the Balance of Power mechanism, whereby when any one power seemed to be acquiring too much control, the others would combine against it, to prevent this from happening. A consequence of this continuous fighting with no single victor was a “Military Revolution”, which was not just in weapons and battle tactics, but in finding ways of financing the enormously expensive methods of modern warfare that were invented in the process. For a detailed historical discussion, see Paul Kennedy “ Rise and Fall of Great Powers ”.  Central Banks are an important part of this story, in terms of creation of modern methods of financing warfare. This post provides a detailed explanation of concepts covered briefly in the 15m video lecture:

The last of the major wars between the Great Powers ended in 1814 with the defeat of Napolean at Waterloo. After this, a century of peace between the Great Powers ensued, until the outbreak of the first World War in 1914. See  Hundred Years’ Peace . Karl Polanyi writes that this was due to the emergence of a peace interest – haute finance. The Central Banks, established to give loans to states to fund wars, were globally connected. They found it more profitable to maintain peace, and benefit from global trade and investment, rather than provide funding for wars. In particular, avoidance of direct conflicts, and investments in the colonies became a larger priority. Over the hundred years of peace, the functions of Central Banks evolved and changed. As this happened, the theory of Central Banking was also developed in the light of accumulating experience.      Read More

This post is the third part of lecture 8 of Advanced Macro L08C: Fisher’s Debt-Deflation Theory of the Great Depression. In previous segments of this lecture L08A: Micro-Foundations for Keynesian Economics, and L08B: Keynesian Explanation for Great Depression: Seriously Incomplete, we examined the Keynesian explanation for the Great Depression, and found serious deficiencies in it. L08A explains that many different kinds of outcomes, with and without unemployment, are possible depending on how we specify details of the micro-structure that Keynes failed to specify. L08B explains that a simple deficiency in aggregate demand created by savings does not suffice to create unemployment because savings of current period is income/wealth of the next. It is necessary to look at abnormal savings, together with fixed prices, to create surplus production which signals shortfall in aggregate demand to the producers. Thus, many elements – micro-structure, role of debt, and different sectors of the economy – must be added to the Keynesian model to achieve the outcome of unemployment due to shortfall in aggregate demand that is at the center of Keynesian analysis.

This post deals with the last segment of the lecture, which explains Fisher’s Debt-Deflation theory of inflation. The lecture goes through and explains the article: Fisher, Irving (1933), “The Debt-Deflation Theory of Great Depressions”, Econometrica – making only minor commentaries. The goal is to understand what Fisher was saying, before attempting analysis, critique, and extensions. Many elements of this explanation are crucial to understanding the Great Depression, but are not available in the standard Keynesian analysis. Recently, elements of this theory have been picked up and presented as “Fisher-Minsky-Koo approach: Debt, Deleveraging, And The Liquidity Trap: A Fisher-Minsky-Koo Approach”  Gauti B. Eggertsson and Paul Krugman: The Quarterly Journal of Economics,Vol. 127, No. 3 (August 2012), pp. 1469-1513. In this lecture, we only present Fisher’s original paper. Post covers portion of lecture from 37m to 1:15m.

Summary of Fisher’s Econometrica paper on Debt-Deflation.
Fisher starts with an insight which comes straight from the experience of living through the Great Depression. An economic system is complex, subject to numerous conflicting forces acting simultaneously and repeatedly through time. It is unlikely to ever be in equilibrium. It is unfortunate the modern economics rejects this fundamental insight.

Fisher starts by asking how we can study disequilibria? In theoretical terms, the answer is to look at the forces which are acting in a given economic situation. Instead of looking at the long run outcome of how these forces would be resolved to arrive at equilibrium, we should use historical experience to judge the relative speed and strength of these forces. This would be a radically different methodology from the one currently in use in economics today.

By using this methodology, Fisher comes to the conclusion that the Business Cycle is a myth. There are many different kinds of economic forces which create multiple cycles. The complex of of forces can acting in tandem or at cross purposes. There are three types of tendencies (forces) – both cyclical and non-cyclical: (1) Those which create growth; (2) Those which create random fluctuations; and (3) Those which create cycles – these cycles can be stable and unstable, and they can be due to  (or interact with) internal factors, or external shocks to the economy.

He compares the economic system to a boat, which can resist small waves, but will capsize in a major storm. The system can accommodate small cycles, but may fall into crisis in big ones. There are some economic variables which can systematically deviate from equilibrium values. He names Capital Stocks, Real Income, Prices. In particular, Say’s Law is regularly violated. The production of goods can be in excess, or deficient, both in stocks and in flows. Forces in temporary disequilibrium will determine what happens next. Overshooting or Undershooting targets for production is common. BUT – this is NOT the cause of BIG disequilibria. The CENTRAL diagnosis of Fisher is the following:

The biggest cause of economic crises is: Too little money (too high price) mistaken for excess of goods!!

NOTE: This resonates with Friedman’s insufficient money supply explanation. Also, the Keynesian explanation, both of which work with short run fixity of prices.

In arriving at this diagnosis, Fisher lists and considers many common factors which lead to disequilibrium, and rejects them as sources of major crises. He then focuses attention on the Big Bad Actors – Debts and Deflation – as the cause of crisis. H says that the Apparent Causes are Over-Investment & Over-Speculation – this was obvious to all in the aftermath of the Great Depression. But Fisher thinks that the real Harm is caused by UNDERLYING debt which is used to finance this activity.

The mechanism which Fisher outlines starts with excess debt taken in a booming economy. Since assets like land, stocks are booming, people are happy to take debt at low interest, planning repay from the gains they make due to rapidly rising prices of stocks and real estate. Banks are happy to lend because they have the valuable asset as collateral for the loan, so even if the lender cannot repay, they will be able to cover their costs by selling the asset. Since banks create the money they lend, there is no check on the process, and loans increase geometrically leading to a situation with excess debt.

At some point, the bubble bursts. This is generally caused by failure of nerve of some party – either the banks, or the lenders. As indebtedness increases, people take loans to repay interest on past loans, and eventually, a steady stream of failures to repay emerges to public notice. At this point some people panic and start selling their assets, which sets off a chain reaction. As people sell to pay off loans, money supply contracts, and loans become less available. Now people who were relying on borrowing to repay previous loans start defaulting, or start to sell assets to cover loans. As more and more people sell assets, asset prices collapse. The collapse of prices leads to DEFLATION. Deflation increases the value of money, so that the debt burden becomes heavier. Paradoxically, the attempt to pay off debt puts people deeper into debt.

Balance sheets of banks, and firms, contain assets which are priced according to their market prices (This is called Mark-to-Market in accounting terminology). When stock and real estate prices collapse, the net worth of banks and businesses can become negative. Similarly, mortgage loans go under-water; they have negative equity. In simpler terms, this means that the value of house you own is less than the amount of loan you must pay to the bank to get ownership of the house. In this situation, it pays for the homeowner to declare bankruptcy and walk away from the loan and the house. Similarly, businesses whose net worth has become negative can collapse. This leads to panic and loss of confidence about the future in the general public. As expectations about the future become negative, people stop investing, business stop producing and lay-off employees. Heavily indebted people lose incomes and ability to pay off loans. Negative expectations about the future become self-fulfilling prophecies.

In the “Fisher” Sequence of events which leads to major crisis, Fisher says that two diseases – excessive debt, and price deflation – act together to create crisis.The effort to pay off debt leads to falling asset prices, which leads to further increase in real debt, and decrease in ability to pay. This is a vicious cycle which leads to collapse. Either one of the two forces acting individually would tend to return the system to equilibrium. The system can take small shocks and return to equilibrium, but large shocks, acting in tandem, lead to collapse.

Some Comments on Fisher’s Debt-Deflation paper

Fisher attempts to define “over-indebtness” which would lead to crisis, but failed to do so satisfactorily. Here Hyman Minsky made a major contribution. Minsky identifies three stages of debt in the business cycle. In the first stage, people & firms borrow to invest, and their stream of earnings is enough to pay off the interest and the principal. In the second stage, earnings are not sufficient to pay the principal, but enough to pay interest. Now loans are re-financed when the principal is due. In the third stage, earnings streams are not even sufficient to repay interest, and borrowing is done to pay interest on the loan. This last stage is what Fisher wanted to define as “over-indebtedness”, but failed to do.

He attempts to quantify the size of loans relative to assets/income available to repay. He writes that debts in 1929 were at historically highest known levels. By 1933, debts reduced by 20%, Prices decreased by 55%. Value of dollar increased by 75% — real debt increase 40%. This provides support for his key hypothesis: As you pay off debt, you go deeper into debt

Fisher offers the solution as price reflation, breaking one of the two components of the vicious cycle. He thought that if we could take policy actions to prevent prices from falling, or to put them back up to pre-crisis levels, then the economic system would find its way back to equilibrium. However, subsequent authors have cast doubts on this, suggesting that the levels of debt are so high that they cannot be repaid, even if assets do not lose their value. Thus the only solution would be to require debt-forgiveness.

The Wikipedia entry on Debt-Deflation provides a good summary of key points of Fisher’s thesis, and also its influence on subsequent work, and later developments. In fact, Fisher’s theories were ignored and neglected in favor of Keynes for a long time, prior to revival of interest in the 1980s. One of the reasons for this neglect was the idea that debt did not matter. What is a debt of one person is an asset of the other, so debts cancel. This mirage – that debts do not matter – continues to mislead economists. It is the large-scale inability to repay debts which is ignored in this picture.

As debts mounted up, Fisher’s Debt-Deflation theory has enjoyed a resurgence in popularity. It seems clear from a lot of research that levels of debt play a very important role in leading to financial and economic crises. For example, Atif Mian and Amir Sufi in House of Debt, highlight the role of leveraged debt as a key factor in the Global Financial Crisis. “Deflation”, or a dramatic fall in inflated asset prices, also plays a major role, and when combined with leveraged debt, this creates the catastrophic combination that Fisher identified. In retrospect, it seems that the widely accepted Keynesian explanation for the Great Depression was seriously incomplete, and Fisher identified some key elements missing from Keynes. For an update on Fisher, see:   DEBT, DELEVERAGING, AND THE LIQUIDITY TRAP: A FISHER-MINSKY-KOO APPROACH  by Gauti B. Eggertsson and Paul Krugman, in The Quarterly Journal of Economics,Vol. 127, No. 3 (August 2012), pp. 1469-1513

Last Portion of Lecture 8 – from 1hr 15m onwards

The last portion of the lecture  L08D Friedman-Schwartz   discusses the Friedman-Schwartz book on the Monetary History of the United States, which puts forth yet another diagnosis for the reasons of the Great Depression. They argued that it was the sharp contraction in the money supply that was responsible. This diagnosis was the one that was actually followed by Bernanke during the Global Financial Crisis, who massively increased money supply via Quantitative Easing programs. This did prevent financial collapse, but could not prevent the Great Recession, invalidating the Friedman-Schwartz hypothesis about the causes of the Great Depression. Furthermore, as a result of Quantitative Easing, reflation of asset prices has also occurred, which was Fisher’s proposed remedy. This has not proven very satisfactory, in many different ways. Of the two problems, Fisher thought that taking care of Deflation would suffice, but it seems to be only half of the remedy. The other half is the “Debt”, which can be removed by various methods, such as debt-forgiveness.

This post is a continuation of ET1%: Blindfolds Created by Economic Theory, We show how the Invisible Hand theory appears to be neutral but actually favors the top 1%.

As quoted and refuted in my earlier post on “Failures of the Invisible Hand“, Mankiw writes that: “The reason for excellent functioning of decentralized market economies is that all participants are motivated by self-interest. This self-interest works better than love and kindness in terms of promoting social welfare.”  

What a monstrous statement! How can any human being think such thoughts? This is what comes from cutting off human experience as a source of knowledge, removing hearts from bodies, and leaving only brains floating in vats as a the sole source of knowledge.

Our hearts — in their pure states –would revolt at the oxymoron of a society based on selfishness. However, contamination by the poisons of economic theory and positivism leads to the blindness to sources of human welfare displayed in the Mankiw quote. In earlier times, A Christmas Carol of Dickens was sufficient as a reminder the wealth is not a measure of welfare. However, modern times reflect modern mindsets, which convert greed and wealth to desirable virtues, as reflected in the Disney version of Uncle Scrooge. So, sadly, it becomes necessary to argue on logical grounds, appealing to brains in vats, instead of appealing to the heart.

First, let us note that “excellent functioning” just means maximization of wealth, and “social welfare” is also measured by the amount of wealth owned by society. At the individual level, the end-of-life psychiatric disorders of Howard Hughes have been the subject of numerous books and articles. Would anyone consider that the billions he made pursuing profits in a market economy created greater social welfare for him than love and kindness would have? What is true at an individual level is also true at a social level — The Easterlin Paradox shows that massive gains in wealth in societies have not caused corresponding increases in happiness. This is true both in time series for single countries, and for cross sectional studies across countries. As detailed and careful studies show — there is no long run relationship between happiness and increases in GNP per capita. Because this finding threatens the foundations of economic theory, economists have challenged it on many different grounds. In a review of these critiques which re-affirms their original findings, Easterlin et. al. have shown that, they do not differentiate between short and long run. The Easterlin Paradox is more accurately stated as – money does buy happiness in the short run, but not in the long run. This is exactly in accordance with my post on “The Coca-Cola Theory of Happiness” — Coca-Cola does buy happiness in the short run, but is not the formula for long run happiness.

Evolutionary biology has now discredited that idea that the survival of the fittest requires selfishness and competition; see Cooperation and Generosity leads to Evolutionary Success. It is almost obvious that groups would be strengthened by coooperation and generosity. There is no question that we would all prefer to live in a society based on love and kindness, instead of living in jungle ruled by survival of the fittest.  If “social welfare” is understand properly, instead of being reduced to a quantity of money in the bank, it is clear that love and kindness would work much better at promoting social welfare.

Why then have economists in the twentieth century insisted on attributing a mis-interpretation of the invisible hand to Adam Smith (see “Adam Smith & the Invisible Hand“) and have made this the central pillar of modern economic theory? The answer lies in ET1%: the necessity for the top 1%  in democratic societies, to invent theories which appeal to the bottom 90%, while actually favoring the rich and powerful. The Invisible Hand asks us to let everyone do whatever they want, since it will all work out to the best for the entire society. Even if the rich and wealthy appear to be exploiting others, the invisible hand will make sure that their greed is harnessed for the welfare of the society. The only way to make sense of this nonsensical message is to understand it as a clever piece of propaganda which supports the interests of the rich and the powerful, by identifying these interests with those of the society as a whole. This is very similar to the “trickle-down” theory, according to which enriching the wealthy will (eventually) bring benefit to the entire society. Even though it is easy to demonstrate “The Failures of the Invisible Hand” both empirically and theoretically, this theory dominates the pages of the modern economics textbooks. This demonstrates the main theme of my post on ET1%: Blindfolds created by Economic Theory;  modern economic theory is meant to blindfold students to the tremendous advantages the capitalist system confers on the tiny minority of the rich and wealthy, the 1%. It systematically distorts our vision and mindset to cause the tremendous inequities of the system disappear. See my paper on “The Invisible Hand: Death of a Metaphor“, for further explanation for how, with repeated use, a metaphorical usage becomes conflated with reality in the public mind. This is extremely beneficial for the 1% as it allows them to create myths which protect their interests, and have them accepted as truths in the form of modern economics. This illustrates the Power/Knowledge thesis of Foucault.

This is the second lecture on Understanding the Rise and Fall of the Gold Standard — shortlink: bit.do/azifa2 — we start with a  Summary of First Lecture 

The first lecture discusses the Keynesian theory that the exact level of money in an economy is critically important – too little leads to recessions, while too much leads to inflations. Furthermore, domestic business cycles, and international financial crises are caused by pro-cyclical behavior of current artificial systems of money creation and international trade. Standard macro theories make it impossible to understand the economy because they assert that money is neutral, and does not affect the real economy – exactly the opposite of the Keynesian idea that the quantity of money is all important. Standard macro model currently in use throughout the world have no explicit role of money, banks, and credit, even though these factors are of central importance in understanding the world. Once we understand the vital role and function of money within an economy, it becomes possible to understand historical events of the twentieth century – whereas this is impossible using conventional macro theories. The first lecture summarizes how the colonial system came into being, and the monetary arrangement for a hard currency at the core and soft currencies in the periphery. This system of fiat currencies works fine within one system of colonies, where the value of money is decreed by sovereign fiat. For trading between different countries, the gold backed currencies were used. As European countries prospered by exploiting resources throughout the globe within their colonies, inter-European trade increased. The optimal quantity of money required for the domestic economy is not the same as that required for stable international exchange rates. The pro-cyclical money creation which is characteristic of the system creates cycles, and large cycles lead to crises on a routine basis. World War I was partly caused by the breakdown of the colonial trading system due to the end of expansion possibilities after the completion of the conquest of the globe. Efforts to restore the gold standard after World War I failed. The second part of the lecture discusses the post World War I history, with reference to the international financial architecture that emerged in the post-Gold era after World War I.

3100 Word Summary of Second Lecture on Global Financial Architecture

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In previous parts of this article (Understanding Macro I & Understanding Macro II), we have described how strict financial regulation and Keynesian prescriptions for full employment brought prosperity for the masses, but reduced corporate profits. This last part describes the successful counter-attack by corporations which reversed this state of affairs, causing a massive rise in the income shares of the wealthy 1% and a decline in the fortunes of the bottom 90%.

In the mid 70’s, when I was studying for my Ph.D. in Economics from Stanford, Keynesian economics ruled the roost; pre-Keynesian free market economics was confined to the Chicago School, and not considered intellectually respectable. This situation was reversed in the 90’s, when the Chicago School became dominant, while Keynesian economics was no longer considered respectable. The multi-dimensional strategy used to create this revolution on the academic front is described by Alkire and Ritchie inWinning Ideas”, while the global strategy to transform socialistic economies into capitalistic free markets is described by Naomi Klein in The Shock Doctrine: The Rise of Disaster Capitalism. A common thread between the two is the patient preparation of detailed plans, while waiting for a crisis, which provides an opportunity to implement these plans.

The intellectual crisis that Chicago had been waiting for occurred in the early 70’s when the Arab Oil embargo, in retaliation for US support of Israel, led to stagflation in the USA. The simultaneous occurrence of high inflation and high unemployment was said to be in conflict with Keynesian theories, while the Chicago School theory of Milton Friedman was said to provide an explanation for the unexpected phenomena. This became widely accepted, and led to a substantial rise in the prestige of the Chicago School, and a blow to the Keynesians. The 1% capitalized on this by providing funds to Sveriges Riksbank, the Central Bank of Sweden, to create a simulated Nobel Prize for Economics, named the Sveriges Riksbank prize in honor of Alfred Nobel. The Nobel family protests against this appropriation of the prestige of the Nobel Prize were ignored, and the public was fooled into accepting this just like the genuine Nobels. In quick succession, roughly half of all the Nobel prizes were awarded to Chicago economists, interspersed with 50% going to randomly chosen others to create a semblance of neutrality. This led to a rapid rise in the academic prestige of the Chicago school.

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[bit.do/azifa] Lecture 1 on Rise and Fall of the Gold Standard, on Friday 4th May 2018 in AR Kemal Rm at PIDE, by Dr. Asad Zaman, VC PIDE. 1hr 20m Video Lecture. Shortlink for Lecture 2: bit.do/azifa3

3100 word summary of lecture:

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My article about the Battle of Methodologies, published in March 2018 issue of NewsLine Magazine:

Because of the universal spread and impact of Western educational systems, necessary for survival in the modern world, we have all learned to view the world through glasses manufactured in Europe. Just as a fish is unaware of the waters in which it swims, so we are unaware of the currents of history which have shaped European thought. Yet to understand the world we live in, and how our perceptions have been shaped by the dominance of West, it is essential to acquire an understanding of how the Western worldview has been radically transformed over the past few centuries. In this brief essay, we will discuss the “Methodenstreit”, the battle of methodologies, which took place in the late nineteenth century. While this is only one piece of the complex and multi-dimensional historical experiences of Europeans, the methodenstreit had a decisive impact on modern social science, which shapes our current understanding of human beings and their social, political and economic lives. The title of the book “How Economics Forgot History” about the methodenstreit by Geoffrey Hodgson accurately describes the impact of this battle on the discipline of Economics. In this battle, the German Historical School, championed by Schmoller and his colleagues, lost to the Austrian School of Menger, who favored a scientific and quantitative approach to economics.

But what is wrong with taking a scientific approach to the formulation and solution of economic problems, the reader might ask. This essay provides an answer to this question. The idea that economics is a “science” is firmly embedded in the foundations of modern economics. This means that economics provides us with a set of laws which have universal applicability across time and space, independent of social, political, geographic, and historic context. In fact, there are no such economic laws. How we organize our economic affairs differs in different societies, and also varies across time. The attempt to create a “scientific” economics resulted in forcing mathematical laws upon human behavior. Over the past few decades, psychologists who study actual human behavior have established that humans do not behave according to these laws. This has resulted in the creation of field of “Behavioral Economics,” and many researchers working in this area have been awarded Nobel Prizes (most recently, Richard Thaler) for discoveries which contradict the laws of behavior still being taught across the globe to students of economic theory. Despite discoveries that human beings are temperamental, driven by diverse and conflicting emotions, and free to make sudden changes in behavior, the scientific methodology of modern economics currently being taught to students across the globe continues to describe human beings as predictable robots subject to mathematical laws. The insights from behavioral economics are so radically in conflict with economic theory, that economists have not been able to assimilate them into the mainstream curriculum.

Similarly, the scientific method leads economists to ignore specific historical events in their vain quest for universal laws which describe economic systems. Essential insights about economics are lost due to this disregard of history.  For example, the two world wars, The Great Depression, The Bretton-Woods agreement, and Nixon’s revocation of gold backing for the dollar are events of central importance for understanding the economics of the twentieth century. However, economists do not study these events since they are particular and specific historical events, which cannot be described using universal scientific laws. On a larger scale, the birth of modern market society can be traced to the industrial revolution, which created possibilities of massive overproduction of goods in 18th century England. This overproduction concentrated a massive amount of wealth and power in the hands of a small group of people, who were able to use favorable historical circumstances to increase their wealth and power by expanding the role and influence of markets to the point that they came to dominate and destroy traditional societies all over the world. The deep insights which emerge upon connecting the historical context with economic theory have been brought out by Karl Polanyi in his magnum opus: “The Great Transformation: The Political and Economic Origins of Our Times.” One of the central themes of Polanyi is the dramatic contrast and opposition between values of traditional societies and the emerging modern market society. Traditional societies organize their economies on principles of redistribution and reciprocity, cooperatively taking care of all members. Furthermore, traditional societies value many characteristics like heroism, generosity, knowledge, spirituality, literature, arts, sports, etc. over and above the possession of wealth. In contrast, wealth becomes the primary marker of status in market societies, and becomes the main object of personal and collective endeavor. Studying the evolution of economic system and the co-evolution of economic theories adapted to the study of these systems in historical context yield deep insights not available using the currently dominant ‘scientific’ methodology.

An important consequence of the opposition between market values and social values is that traditional societies do not and cannot evolve into becoming market societies – this change is always brought about by a revolution, which destroys traditional values and replaces them by anti-thetical values of a market society. This revolution occurs on both the physical and material dimension, and, more importantly for our present essay, it also occurs on the ideological dimension. As Marx realized, capitalism produces laborers conditioned by education, tradition, and habits into thinking of the economy as subject to natural laws, and accepting their own exploitation as a necessary, fair, and just part of the system. Similarly, even though the market society provides enormous amounts of wealth and power for a few select members, expansion of the market into all human affairs requires this minority to create and popularize market ideologies. At the core of market ideologies is the idea that markets are governed by natural laws which provide equitable outcomes to all participants and create maximum wealth for all. This ideology runs counter to traditional ideas about social responsibility for the poor and disadvantaged, and suggests that interfering with market mechanisms will cause harm to everyone.

To understand the “origins of our times,” it is necessary to understand the parallel growth of market institutions which expand the scope and power of the marketplace, and the accompanying market ideologies which counter and negate traditional ideas about social norms. For example, exploiting the possibilities of massive overproduction created by the industrial revolution required the creation of consumers for these products. The globe was occupied by traditional societies which prized self-sufficiency as a virtue, and did not have markets for British goods. The productive capacities of the industrial society created the power to physically take over and colonize weaker societies all over the world. The destruction of local institutions for provision of social welfare, and the harnessing of all factors – labor, land, natural resources – to the global production of capitalist wealth was also accompanied by ideologies promoting the idea that this was the best path for all concerned. In particular, the economic theory of “comparative advantage” was invented to justify the absurd idea that it was in best interest of the colonies to remain engaged in the production of raw materials, leaving England to specialize in the production of industrial manufactures. Since it is easily refuted by empirical evidence, comparative advantage cannot be understood as a “scientific theory”. It can only be understood as a product of historical circumstances, as a part of a collection of theories required to justify the brutal processes of colonization and the accompanying destruction of local economies.

Since ‘comparative advantage’ was a manifestation of political power, effective counters also required political power. In Germany,  Friedrich List created the ‘infant industry argument” to support protectionist policies in Germany and Europe, which allowed European industries to catch up to England. Similarly, the American Revolution allowed the USA to implement protectionist policies which developed strong industries in North America. Colonies which did not have the political power to resist the ideology of comparative advantage remain agricultural economies providing raw materials to advanced economies to this day.  Like all major modern economic theories, comparative advantage can only be understood within its historical context, by seeing how the interests of the powerful imperialists were protected and advanced by the spread of this theory. The theory of free trade, which remains popular and widely believed by economists, is very similar. Wars by European powers against China and Japan were concluding by signing treaties which opened these countries to European goods, creating a market for industrialized European economies. Not only was free trade forced upon them by war, but the ‘theory of free trade’, which says that this was in their best interest, was forced upon them by the corresponding ideological war. It was the ability of China and Japan to resist this ideological war that has led to their economic success today. Similarly, it has been our failure to resist the invasion of ideologies and theories of the economic hit-men that has led to our poor economic performance for several decades.

The most important insight which emerges from studying history, politics, geography, and society in conjunction with economics is the deep inter-connections between all these spheres of human lives, and the impossibility of studying them in isolation. Like all of social science, modern economic theory derives directly from the analysis of economic systems of Western capitalist societies. The victory of the scientific and quantitative school over the German historical school in the battle of the methodologies created the misconception that this analysis is a “science” which is universally valid across time and space, for all societies. This has led to the current situation, where we teach and study capitalist economics relevant to modern European and USA economies but largely irrelevant to our economy, which is structured along different lines. At the same time, we do not study the success stories in patterns of the miraculous growth achieved by China and East Asian economies, which followed radically different policies. Discarding the blinders created by “scientific” pretensions of Western economics would create much-needed skepticism about the applicability of Western economic  theories to our radically different historical and cultural context, and also open our eyes to non-European models for prosperity which offer us substantially greater chances of success.

PostScript: For a more detailed discussion, see Origins of Western Social Sciences