From a mechanical study of static equilibria to a science of human behavior?

1914 2014To mark the centenary of The First World War, we will be publishing a series of articles looking at what has changed over the last century in a number of domains. In today’s post, Professor K. Vela Velupillai of Trento University and The New School, New York, discusses economic theory.

When Archduke Ferdinand was assassinated on 28th June, 1914, economic theory was very much a European “monopoly” – with only a few isolated contributions by great American economists – notably Irving Fisher – to the lasting development of the subject, none of whom would reach the pioneering status of a Walras, Pareto or the young Schumpeter. So this is very much a Eurocentric narrative, for that was the way the story of economic theory in 1914 seemed, even at that time, to the pioneers of the field. It was to Vienna, Lausanne and Cambridge that the narrator of the origins of neoclassical economic theory turned, or to France, England and Scotland, for the pioneering work of the classical economists.

That being said, the most important event on the eve of August 1914 from the point of view of monetary theory and policy, was the establishment of the US Federal Reserve system, with the Federal Reserve Act of 23rd December, 1913. It far exceeds in significance the creation of the European Central Bank and the Euro Currency area, from every point of view, but particularly in the monetary policy ramifications in this era of so-called globalization of currency markets (even if not of labour markets and, to a lesser extent, commodity markets).

The Federal Reserve Act of December, 1913 and the birth of modern macroeconomics – especially at the hands of Knut Wicksell, were the result of the bimetallist controversy in the US in 19th century (using both silver and gold in the monetary standard), and the 20-year period of deflation from 1873 to 1893. Thus, the golden era of the gold standard – with its close ‘cousin’, the gold exchange standard – came to occupy the seemingly impregnable institutional framework for the conduct of monetary policy in almost all the (then) advanced industrial countries. It was to take the monetary dislocation and disorientation caused first by the hyperinflation in the immediate post WWI years and then the Great Depression before these golden fetters were discarded. But they would always hover in the wings of orthodoxy and its eternal extolling of the virtues of monetary neutrality.

Back to the one or two of the broader arenas of theory, in those halcyon, pre-WWI years. A.N. Whitehead and Bertrand Russell’s monumental Principia Mathematica had been completed in 1913, the same year, Diederik Korteweg vacated the Chair of Mathematics at the University of Amsterdam in favour of Luitzen Brouwer, whose inaugural lecture on Intuitionism and Formalism was to throw down the gauntlet to the Logicism of Principia Mathematica (the view that some or all of mathematics can be reduced to formal logic) and the Formalism David Hilbert. In April of the following year Wittgenstein began writing what eventually came to be the Tractatus Logico-Philosophicus, working on it all through the war while on active service and a prisoner.

Just as the hostilities started, Dennis Robertson submitted A Study of Industrial Fluctuation (note: Fluctuation – not Fluctuations!) for a Fellowship election at Trinity College Cambridge. There is not a single mathematical equation or formula in this wonderfully “modern” book, with a message that is still relevant – although there are graphs, charts and tables galore. The one graph was prefaced with the characteristic Robertsonian wit: “Diagrammatic representation, though not completely satisfactory, will perhaps be found useful by some.”

There are no mathematical equations in Keynes’ first published book either, Indian Currency and Finance, published in 1913[1], and there is no evidence whatsoever in the 600 or so pages of Wesley C. Mitchell’s Business Cycles that such a thing was even envisaged by that great founding father of the NBER (and of my own New School University!). What, alas, many at the so-called frontiers of research in economic theory and behavioural economics missed was the exceptionally prescient Human Behavior and Economics: A Survey of Recent Literature by Mitchell a year later in (1914) that ends by saying: “[I]n embracing this opportunity [to profit by and to share in the work of contemporary psychologists] economics will assume a new character. It will cease to be a system of pecuniary logic, a mechanical study of static equilibria under non-existent conditions, and become a science of human behavior.”

It is particularly pleasing to remember that this classic by Mitchell is succeeded in the same issue of the Quarterly Journal of Economics, by Maynard Keynes’s own nascent contribution to a field in which he was to stride like a colossus, in the interwar period: an institutional analysis of monetary experiences.

Mitchell’s plea for an economic theory, underpinned by a theoretically sound psychology, seems to have been answered by the practitioners – and claims – of a version of behavioural economics, without sacrificing their homage to the altar of the neoclassical triptych: preferences, endowments and technology. Thorstein Veblen’s passionate advocacy of an evolutionary approach to economic theory – to which Marshall was not unsympathetic – has become a new orthodoxy at the hands of evolutionary game theory.

The supreme dominance of the so-called fundamental theorems of welfare economics would, I am sure, induce discomfort in Marshall and Pigou. The “old” welfare economics they carefully (even lovingly) developed, so that the economic theory they fashioned as a development of Ricardian equilibrium economics could serve as a basis for enlightened policy, became the “new” welfare economics at the hands of Kaldor and Hicks. This was basis for the development of the fundamental theorems of welfare economics – although the mathematical framework in which it was encapsulated, primarily by Arrow and Debreu (but not in their fundamental joint paper of 1954) – which is the basis for the nihilistic policy frameworks of every kind of orthodoxy, from Hayek to Lucas, via Friedman.

How much of the economic theory that is being taught, and practiced, via an underpinning of economic policy – both monetary and real – couched in monumentally irrelevant mathematics, would be strange and unfamiliar to our neoclassical masters? To Jevons and Marshall, to Walras and Pareto, to Menger and Wicksell, to Edgeworth and Pigou? None of them may well be sure-footed in the non-computational, uncomputable, undecidable, unsolvable mathematics that encapsulates the formal economic theory they fashioned, in the golden decade culminating in the tragic year of 1914.

But they would be eminently comfortable in the safely ensconced orthodox economic theory of today – although Marshall may be an outlier and Wicksell a dissenter!

Useful links

If you’d like to find out which famous painter was interested in the non-Euclidean geometry of relativity in Einstein’s physics, or who invented purchasing power parity, download the pdf of the unabridged version of Vela’s article here.

OECD work on economics


[1] Any serious understanding of the changing monetary stances adopted by Keynes, both in the foundations of the monetary theory he continued to fashion, and re-fashion, and – more importantly – on the monetary policy frameworks he developed, with imaginative flair and theoretical audacity, in the whole interwar period, can best be understood via his intensive work, in the two years in the India Office.

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  1. Philip Hodkinson - 09/09/2014 Reply

    Interesting paper, although seemingly neutral in analysis. The interesting part for me was the references to human nature in the equation. Whatever economic stance you take, successive governments around the world, have introduced social welfare programmes year on year, but never the means to fully support them. (first pensions in UK were 1927 I believe.)
    This alone has mushroomed into serious national debt. This coupled with the earlier circumvention of the gold standard and the manipulation of the monetary systems thereby, has allowed the printing of money ( sorry quantitative easing) to exacerbate the situation to levels we have today, where whole countries are becoming bankrupt. Theories are all well and good, but a practical solution must be developed to stabilise the situation.
    If the have nots become the have even lesses a situation that led to WW1, could re occur.

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