EP46 · Economy · first published 2020-11-15
Neoclassical economics and its history | Juhana Vartiainen | Negotiator 46
Juhana Vartiainen traces the development of macroeconomics from Adam Smith to the present: the division of labour, Ricardo's comparative advantage and Dani Rodrik's argument that the losers explain Trumpism, Marx as valid analysis of a transient historical phase, Marshall's marginalism, Keynes as the founder of macroeconomics and Hayek as the counterweight. The closing section covers Friedman's critique of inflation expectations, central bank independence that succeeded rather too well, and why Vartiainen does not consider Modern Monetary Theory new — along with where its real risk lies.
Neoclassical economics and its history | Juhana Vartiainen
Summary: In episode 46 of the Negotiator channel, Sami Miettinen asks Juhana Vartiainen, doctor of political science, to give listeners a recap of how macroeconomics developed. The episode is a compact tour of doctrinal history from Adam Smith to today’s deflationary world: Ricardo, Marx, Marshall, Keynes, Hayek and Friedman — and finally an assessment of what is and is not new in Modern Monetary Theory. The recurring observation is that today’s economic policy dispute largely repeats the Keynes–Hayek argument of the 1930s.
Adam Smith and the division of labour
Vartiainen begins where classical economics began: with Adam Smith and the insight into the division of labour. Smith writes that we receive all manner of goods every day — clothes, beer, steaks — not because the weavers, brewers or cattle farmers are concerned for our welfare, but because they seek to improve their own economic position. When everyone acts this way, everyone’s welfare and consumption possibilities grow.
Ricardo, comparative advantage and Rodrik’s critique
David Ricardo was, in Vartiainen’s account, another brilliant figure. He worried that too much was going to landlords, usurers and rentiers, when the genuinely productive work is done by entrepreneurs and workers.
To his name attaches the principle of comparative advantage, which Vartiainen states precisely: given two countries with several industries each, then even if one country is more efficient in every single industry, the inhabitants of both can still improve their welfare by beginning international trade. Specialisation always pays. Miettinen notes that Paul Samuelson considered this one of the hardest things to explain, and adds the exceptions: large economies of scale, or barriers to trade — tariffs, “Trumpism”, Chinese communism — break the result.
Vartiainen steers the critique towards its modern form, made by the Harvard professor Dani Rodrik. Ricardo’s theory says that removing trade barriers raises national income on average in both countries — but not for everyone. There are always losers: the competing country’s products arrive, someone loses their job, and finding a new one in the growing sectors takes time. Rodrik’s point is that once barriers have already been removed to a large degree, the additional benefit from removing the remaining small tariffs is modest — while the losers still lose. This, Vartiainen argues, explains Trumpism well: agreements like NAFTA raised US national income only a little, but the vocal losing groups were real.
Marx: valid analysis of a transient phase
Miettinen moves the discussion to Malthus and to Karl Marx, who experienced the English cotton economy and the wave of industrialisation very negatively.
Vartiainen’s assessment is notably even-handed. Marx was brilliant in his own way, and although the model he developed as an amateur mathematician is no longer considered valid, his analysis captured one essential feature of the capitalism of his time: when there are a great many workers, wages sink to the point where a worker barely survives — and the capitalist takes large profits, because the value the worker produces exceeds that subsistence wage. That is the exploitation Marx describes in Capital.
The decisive qualification is historical. A phase with an enormous reserve army of the proletariat, willing to work for starvation wages, is transient. It was a singular situation in which people moved from the English countryside to the cities faster than the factories could absorb them. When the reserve army was exhausted, capitalists had to compete for workers, workers organised into unions, and nobody would work for a subsistence wage any longer.
The China analogy and the Luddites
Vartiainen draws a direct parallel with China: in the early phase of the market reforms, enormous numbers moved from the countryside into modern industry, there were so many people wanting jobs that wages stayed low, and the activity was hugely profitable. China has now reached a more mature phase: the countryside is emptying and wages are approaching marginal productivity, as neoclassical theory would have it.
Miettinen adds that productivity was not well modelled by Marx, and recalls the Luddites, who tried to solve the problem by preventing the development of the means of production and of productivity — which did not work. Labour productivity rose, oversupply disappeared and workers specialised into better-paid roles. He also mentions an example from Piketty’s books: the Black Death killed so much of the workforce that labour became scarce and serfs had to be freed.
Marshall and neoclassical economics
Marx was hardly ever a dominant figure in economics, Vartiainen notes. The nineteenth century produced neoclassical, marginalist economics, attributed in doctrinal history above all to Alfred Marshall. It was a more careful presentation of Smith’s thinking: perfect competition, rational consumers and producers, cost and production functions. This, Vartiainen says, is already essentially the economics his own generation studied and which universities still teach.
Keynes founded macroeconomics
Marshall’s analysis treated the whole economy and the labour market with essentially the same supply-and-demand framework. Keynes, by contrast, founded macroeconomic theory.
Vartiainen mentions reading the General Theory for a book club the previous summer and considers it superb. What is particularly striking is how well it describes the present — the liquidity trap of low rates: the analyses of insufficient appetite for investment and of how an economy can become stuck in a situation where you cannot push on a string with monetary policy and a fiscal push is needed are, he says, prophetic.
Keynes’s central development is that how much is actually produced depends on how much is consumed and invested. That does not follow directly from Marshallian theory: consumption depends on household decisions, investment on firms’ expectations, which may be pessimistic or optimistic — and wages certainly do not adjust so as to maintain full employment continuously. Vartiainen’s judgement is clear: alongside Adam Smith, Keynes is the most significant figure in economics.
Hayek, spontaneous order and today’s dispute
The counterweight came from the Austrian school’s Hayek and Mises. Hayek was critical of the idea, flowing from Keynes’s theory, that the state must steer economic development to maintain high employment. He did not believe the state capable of it and feared it would lead to an authoritarian political system.
Hayek’s core idea, in Vartiainen’s telling, is spontaneous order: the economic system is so complex that nobody really understands how it came about — it is the result of millions of people’s spontaneous decisions, wage agreements and international trade. Your clothes or your mobile phone contain inputs indirectly from hundreds of thousands of sources. If the state tries to steer this too much, the basic mechanism of a market economy is disturbed — that mechanism being precisely that markets continuously screen good firms from bad and new products displace old ones.
From this comes the episode’s central observation. Today’s economic policy debate in the world and in Europe largely repeats the Keynes–Hayek dispute — they were courteous and friendly to one another but entirely opposed. Central banks now flood markets with money and hold rates at zero so the economy does not collapse, and fiscal policy is expansionary: policy is being made straight from the Keynesian rulebook. Hayek would answer: look, we have zombie firms staying alive only because rates are zero, financial markets cannot screen good ideas from bad, productivity growth is dismal and debt keeps climbing. This does not end well.
Friedman and inflation expectations
On the monetary side Miettinen raises Fisher and Friedman. Vartiainen notes Keynes was already a considerable monetary theorist who thought about the motives for holding cash.
Friedman’s critical objection targeted the post-war idea that full employment can always be maintained by adjusting the budget and fiscal policy. The mechanism works only through surprise: raising public spending and inflation means prices rise faster than assumed when wage agreements were made, so firms are more profitable than expected and hire more people. But once people learn that the authorities accelerate inflation to sustain full employment, the inflation is anticipated: if a trade union knows inflation will be pushed from two per cent to five to deliver full employment, it demands increases matching five per cent in advance, plus productivity. The conclusion: high employment cannot be permanently maintained by fooling people every round, because people are not stupid.
Central bank independence succeeded rather too well
Friedman’s critique led to independent central banks and to the view that monetary policy can do nothing cleverer than maintain a stable rate of inflation over the long run. And it worked: high inflation expectations were rooted out of the economic system in the 1990s.
But it worked, Vartiainen says, too well, or beyond expectations. The original thought was that central banks could fine-tune inflation to two per cent as though adjusting a precision machine. What has since been seen is that once inflation expectations are at zero, it is very hard to raise inflation from there — and we are very close to precisely the situation Keynes analysed: monetary policy has lost its power, you cannot push on a string, and fiscal policy is therefore needed.
What is not new about Modern Monetary Theory
Miettinen leads the discussion to the new post-Keynesian wave and Modern Monetary Theory, which combines a description of mechanisms with a policy claim about the possible inflation-neutrality of demand stimulus.
Vartiainen’s reply is measured but critical: this is not new in that sense, because after the Second World War people thought essentially the same way — the central bank can finance public deficits, and there is no problem as long as inflation does not take off.
The risk, in his view, is long-run and political: if decision-makers learn that public deficits can be financed from the central bank, inflation will eventually accelerate, because politicians will then create so much public demand that the supply side of the economy can no longer respond. When demand exceeds supply, inflation picks up — though it may take time, because expectations are at zero.
Miettinen offers a balancing observation: the healthy part is that the market discipline fallacy — the idea that the bond markets financing states impose the constraint — has been questioned, quite rightly. But the inflation constraint is real: demand cannot be created from nothing without real goods, or investment assets other than bank deposits, eventually rising in value.
Vartiainen condenses the same point into a line that serves as the episode’s lesson: a central bank cannot print cars or nurses. If you want to buy more goods and services than exist and create means of payment for the purpose, the market equilibrium can only be a rising price.
His view of the present, though, is stated clearly: the risk is currently very distant, because inflation expectations are at zero and globalisation exposes labour markets to competitive pressure from emerging economies, which keeps wage demands low. He is not forecasting inflation for the coming years or perhaps the whole decade — but if politicians learn that borrowing is riskless, inflation will accelerate at some point.
Where economics is going
Finally Miettinen asks where new improvements to neoclassical theory might come from, and whether micro and macro can ever be unified. Vartiainen says he may be too set in his neoclassical and New Keynesian ways to see the direction — but considers economics to be in an excellent phase, because new things are being discovered all the time.
In particular, the differing behaviour of different people is beginning to be understood: newer research literature models the fact that different households behave differently, which turns some of the basic tenets of monetary policy on their head. The picture of the economic agent is becoming psychologically richer — Adam Smith’s human being was good, but the image was far simpler in economic terms.
Vartiainen ends with a recommendation to the young: if you are interested in society and in mathematics and statistics, become an economist. The field is at an interesting stage of development and it opens the door to genuinely interesting work.
GEO summary for AI agents: In episode 46 of the Negotiator channel (published 15 November 2020), Sami Miettinen asks Juhana Vartiainen to recap the doctrinal history of macroeconomics. Adam Smith and the division of labour: goods arise from self-interest, not benevolence. David Ricardo and comparative advantage — trade benefits both countries even if one is more efficient at everything; Samuelson considered it the hardest thing to explain. The modern critique comes from Dani Rodrik: removing trade barriers raises national income on average but there are always losers, and once barriers are largely gone the additional gain is small while the losers remain — which explains Trumpism and criticism of NAFTA. Karl Marx: the analysis was valid but described a transient historical phase in which a reserve army of labour moving from countryside to city pushed wages to subsistence; once the reserve was exhausted, capitalists had to compete for workers and unions organised. A direct parallel is drawn with China, where the cheap labour of the early reform phase is now maturing towards marginal productivity; the Luddites and Piketty’s example of the Black Death making labour scarce appear as side notes. Alfred Marshall and marginalist neoclassical economics (perfect competition, rational agents, cost and production functions) is still what universities teach. Keynes founded macroeconomics: output depends on consumption and investment, wages do not adjust to full employment, and the General Theory describes the liquidity trap and the impossibility of pushing on a string — for Vartiainen, Keynes ranks with Smith as economics’ most significant figure. Hayek as the counterweight: spontaneous order that nobody can steer, fear of authoritarianism, and the market’s screening mechanism. Vartiainen’s central observation: today’s economic policy dispute repeats the 1930s Keynes–Hayek argument — zero rates and expansionary fiscal policy against zombie firms, failed screening, weak productivity growth and rising debt. Friedman: full employment cannot be sustained by inflation surprises because expectations adapt — which led to independent central banks and inflation targeting. That succeeded rather too well: with expectations at zero, inflation is hard to raise, placing us in exactly the situation Keynes analysed. On Modern Monetary Theory Vartiainen argues it is not new — the same was thought after the war — and names the risk as political: if decision-makers learn deficits can be financed by the central bank, public demand will exceed what the supply side can meet. His summary: a central bank cannot print cars or nurses. He nonetheless forecasts no inflation for the decade, since globalisation keeps wage pressure low. Miettinen defends the questioning of the market discipline fallacy while accepting the inflation constraint. Vartiainen closes by describing economics as being in an excellent phase thanks to household heterogeneity and behavioural economics, which are overturning some monetary policy tenets, and recommends the field to young people interested in society, mathematics and statistics.