But in order to learn economics and economic reasoning, there is no shortcut around neoclassical thought. A good illustration of this can be found in the work of John Hicks, one of the major economists of the 20th century.
John Richard Hicks (1904–1989) was born and lived virtually all of his life in England. At a time predating diploma inflation, the B.A. Honors in “Philosophy, Politics and Economics” he earned from Oxford University was sufficient to launch him on an academic career in the most prestigious English universities. He made important contributions to many fields of economics, from microeconomic and macroeconomic theory to welfare economics and labor economics. In 1972, he and Kenneth Arrow were awarded a Nobel Prize in economics “for their contribution to general equilibrium theory and welfare theory.”
Hicks was a master of pure economic theory—that is, the logical development of theorems from the starting point of clearly stated assumptions. He explained his theories mainly in plain English, although he was not afraid to use mathematics when necessary—to extend his results to more than two goods and two persons, for example. His book Value and Capital, which appeared 75 years ago, exemplifies pure economic theorizing. His later book A Theory of Economic History, which appeared 45 years ago, applies economic reasoning to history. Reviewing those two books on their anniversary will allow us to explore Hicks’s development and use of economic theory.
Logic of history / How can one build a theory of economic history? Theory is ahistorical and general; history is made of unique events. Because of particular events and the influence of individuals, history cannot be deterministic. Yet, Hicks explains, economic theory can help understand why, in its general features, history evolved as it did. It also helps the analyst to fill in the blanks when the historical or archeological records are missing or incomplete. Behind the way people act, “there is an economic logic.”
Economic reasoning is the use of logical theories based on individual self-interest, incentives, and related concepts. With economic reasoning, Hicks imagines how the market rose, from prehistoric times to our own. This theoretical reconstruction of history must not, of course, contradict the historical facts we know, but it can make them more intelligible.
The market rose in the interstices of, and against, the custom or command economies that characterized the first ages of mankind. Although humans have exchanged since the earliest of times, the crucial phenomenon in the rise of the market must have been the gradual appearance of specialized middlemen—traders or merchants—who made a living by buying goods only in order to resell them. Middlemen especially thrived in city-states, which from ancient Greece to medieval Italy provided merchant communities with a favorable economic and legal environment. Hicks sees in the rise of the merchant the first phase of the “Mercantile Economy,” a term perhaps not well chosen, which simply means the market economy.
The middle phase of the market economy came when the commercial ways of city-states started penetrating the rest of the world, often after the city-states themselves had been conquered manu militari. Money had been used for a long time, but its character changed in the middle phase. It started to be loaned for interest, even when interest was frowned upon or banned. Financial markets provided an essential tool for commerce, especially in more risky commercial ventures in foreign lands. Banking appeared in Florence in the 14th century. Insurance—against the loss of cargo in transit—developed at roughly the same time.
Many other phenomena strengthened the middle phase. Partly because of the reduction of the labor supply by the Black Death in the 14th century, labor became dearer and peasants escaped servitude and their forced attachment to their lords’ lands. Land slowly became tradable on the market. For the farmers, this commodification was a liberation.
How could the early kings get the revenues they needed? Hicks, prefiguring Mancur Olson, pointed out, “One does not get a regular income by plunder.” Slavery is often not an efficient solution either. So the king will request that his subjects make contributions or pay taxes. He will soon discover that it is more efficient to let his local vassals collect taxes and send him a cut. That leads to a decentralization of power—typical of the Middle Ages—that threatens the king. Hence he will want a bureaucracy at his exclusive service. He will then have to make sure that his civil servants do not usurp his power. Public Choice in historical time, as it were!
Dark side / The third stage of the development of the market—the modern phase—continued the advance of trade. Finance developed further. The Amsterdam Bourse started trading in securities in the early 1630s. The law created limited liability companies. The abolition of the slave trade pushed up the price of slaves, contributing to the growth of a free labor market. In America, the availability of frontier land likewise tilted the balance of power to the laborer by increasing the relative wages of free labor, with dire consequences for black Americans.
But progress was continuing. The Industrial Revolution was made possible not only by technological developments (such as the steam engine), but also by the growth of finance, which reduced the risk of large capital projects. Such projects are, by their nature, sunk and illiquid. If you can’t borrow against your factory in case of need, chances are that you will not build it. Hicks contends that, for a time, labor-saving technologies created a lag between investment and wage increases, but the lag did not last. Wage labor was a liberation. The Industrial Revolution ended the casual and irregular employment of previous times when, at the bottom of the social scale, poor and homeless people drifted in and out of temporary employment.
The modern phase, however, had a dark side. Governments vastly increased their taxing powers through the Administrative Revolution. While the first phase of the Mercantile Economy was “an escape from political authority,” the modern phase made control “immensely easier.” State power grew, especially with World War I. And the process continues: “The contribution of the computer to the mechanization of government,” Hicks wrote perceptively in 1969, “is only beginning to be seen.”
Of course, political authority was not absent before the modern phase. Money had been spontaneously created on the market, but the authorities did not leave it alone. Kings helped the circulation of international coins by stamping them. Those rulers soon yielded to the temptation of debasing money, especially local currencies. Some companies were given trading privileges. Colonization was not always profitable for everybody. Banks were put at the service of public finances.
Celebration of exchange / A Theory of Economic History is a continuous celebration of exchange and its liberating power. “So long as trade is voluntary, it must confer an All-round Advantage,” wrote Hicks. Exchange leads to economic growth, which is what people generally want:
It is easy to be sentimental, or romantic, about the beauties of primitive societies; but it remains true that when people are offered a genuine opportunity for economic growth … they are generally glad to take it.
Trade, especially when combined with technological innovation, can create much disruption. As a welfare economist, Hicks could not ignore that in all big shifts, “there are gains as well as losses,” and that “the gains and losses accrue to different people, so that we cannot easily set one against the other.” Yet, he concluded, “there is a sense, which is recognizable when we look at the matter from a distance…, in which the gains must be dominant.”
Hicks was not blind to the fact that “mercantilism,” as the term is generally used, “marks the discovery that economic growth can be in the national interest,” which he (correctly) viewed as a danger:
The name “mercantilist” is only appropriate when we are looking at history the other way, from the standpoint of the State, from the standpoint of the rulers. They become “mercantilist” when they begin to realize that the merchants can be used as an instrument for their primary non-mercantile purposes.
When, at the end of the book, Hicks expressed his opinion about the problems of underdeveloped countries, he seemed unduly pessimistic of the possibilities of the free market. And he was a bit too optimistic on the positive role that governments can play: “Whatever its motives,” he correctly wrote, “protectionism is an obstacle,” but he accepted (mistakenly, in my opinion) the use of temporary protectionist measures “for the easing of transitions.”
A Theory of Economic History is a delicious book. It is understandable why Hicks later said that it is the book he would most like to be known for, and that he would have preferred that he had received his Nobel Prize for it.
End of marginal utility / As a pure “theory of economic choice,” Value and Capital is a very different book. It is widely recognized as Hicks’s main book and as one of the economics classics of the 20th century. The first part of the book is, in my opinion, the essential one. It proposed what was, at the time, a revolutionary reformulation of the theory of utility and demand, and it rapidly passed into mainstream economics. Hicks showed how the theory could be rebuilt—and refined—without any concept of measurable utility.
Following Alfred Marshall (1842–1924), neoclassical economists had theorized that value comes from the “utility,” or satisfaction, that a good or service provides to individuals. Every individual was supposed to have a certain intensity of desire for goods and services. Although subjective, utility was conceptually measurable, like distances. In other words, it could be represented by cardinal numbers. As one geographical landmark can be, say, twice as far as another one, a certain quantity of a certain good could give an individual twice as much utility as a different quantity of that or another good.
The marginal (or additional) utility that successive units of a good give to a consumer was assumed to be decreasing. In a given period of time, one gets more pleasure from his first glass of wine than from the second, from the first cigar than from the second, and so forth. A consumer maximizes his utility by distributing his budget among goods in such a way that the marginal utility of any good (per dollar spent) is equal to the marginal utility of any other good.
From this, it seemed that interpersonal comparisons of utility were possible. Since the marginal utility of money diminishes (like for any other good), it was argued that income redistribution increases net utility in society.
Many economists, like Carl Menger (1840–1921), one of the founders of the Austrian school of economics, had expressed doubts about this conception of utility. They argued that marginal utility could only be measured (even conceptually) in an ordinal manner, that is, by way of rankings. Ordinal utility was still quantitative utility, and it was not clear how marginal utility could be purely ordinal. If you can carve marginal units out of a total, doesn’t that imply that the total has a cardinal value?
Scale of preferences / In the crucial first chapter of Value and Capital, Hicks shoved away any idea that utility could be measured and cut in tranches.
For that purpose, he borrowed the concept of indifference curves from two economists of his times, Vilfredo Pareto (1848–1923) and Francis Y. Edgeworth (1845–1926). An indifference curve is a geometrical (or algebraic) device showing all bundles of goods that give a certain consumer the same utility, however one cares to measure it. Indifference curves are similar to level contours on a map, but without any significance attached to the distance between them. If we have all the indifference curves of an individual (his “indifference map”), each one corresponding to a certain level of utility, we can theoretically calculate which bundle of goods that consumer will choose, given his budget and the prices of the goods, in order to maximize his utility.
Hicks explained that, in this way, we can totally separate the consumer’s indifference map from any quantitative concept of utility, thereby eliminating any backdoor to cardinal utility. The only necessary assumption is that an individual has a “scale of preferences” on which he subjectively ranks different bundles of goods. Because the quantitative concept of utility is not necessary, “on the principle of Occam’s razor, it is better to do without it.” The scale of preferences replaces the “utility function” (even if the latter’s label is retained).
“If total utility is arbitrary,” Hicks added even more radically, “so is marginal utility.” So marginal utility is gone, too. For example, your second cigar could provide more marginal utility if smoked with the second glass of wine, but it does not matter anyway because there is a better and simpler assumption available than diminishing marginal utility.
Hicks replaced the principle of diminishing marginal utility with a diminishing marginal rate of substitution: at a given level in his scale of preference, a consumer is willing to give up less and less of one good in order to consume more of another; one unit of the new good can be substituted for less and less of the previous one. In order to increase your consumption of cigars, you will be willing to give up less and less wine—otherwise you would fall on your scale of preferences. The condition of equilibrium for a consumer becomes that his marginal rate of substitution of one good for another must be equal to the ratio of the two goods’ prices.
Rabbit in the hat / How do we know that a diminishing marginal rate of substitution is a better assumption than diminishing marginal utility? As Hicks put the question, how did the rabbit get in the hat before the magician released it? The answer is that it is a simpler assumption than diminishing marginal utility, and it allows the development of a richer theory. Hicks’s theory of utility has proven more useful than alternative theories, if only because it decomposes the effect of a price change into a substitution and an income effect.
The marginal rate of substitution can be interpreted as the ratio of the marginal utilities (as some economists continue to do for ease of exposition), but it does not need to be interpreted that way. We can totally dispense with marginal utility to build a theory of consumer behavior.
Theoretical explorations / Part II of Value and Capital extends the partial-equilibrium analysis of Part I into a general-equilibrium system. General-equilibrium analysis connects all markets and follows their indirect effects on each other. Equilibrium means a situation where individual expectations are fulfilled and plans are consistent. Hicks’s analysis incorporated firms and their production functions in a way that still forms the backbone of microeconomics. His conclusion was that a free-market system will likely be in a stable equilibrium.
Part III of the book tries to recast the basics of economic dynamics. Hicks began his dynamic analysis by saying, in typical discovery mode, “Let us proceed to see how it all works out.” The dynamic problem is that the economy does not stay in static equilibrium, partly because lending and money create shifts through time. Another way to look at this is to realize that capital—goods that serve to produce consumer goods and must be financed—changes over the long run. That is the “capital” part in Value and Capital. Hicks readily admitted with Eugen Böhm-Bawerk (1851–1914), a major Austrian precursor in the theory of capital, that the economic system must be conceived as “a process in time,” but he applied the same tools of analysis to a dynamic economy that he used for a static economy.
His dynamic analysis is not satisfactory for today’s economists. Hicks tried to overcome what he saw as the Austrian economists’ shortcomings, such as their neglect of price expectations and their focus on stationary conditions. But his own dynamic theory does not look very dynamic. His conception of interest is also unsatisfactory because it focuses exclusively on risk and excludes time preference (the hypothesis that, other things equal, an individual prefers consuming now rather than later).
Part IV of Value and Capital is also disappointing and has not aged well. The main question was whether the dynamic general equilibrium system is stable, and the stability issue was very important in the wake of the Great Depression. Hicks argued that a free-market system is “imperfectly stable”—that is, generally stable, but not always—once we take into account the accumulation of capital, inflation or deflation, speculation, and self-fulfilling expectations.
Efficient government? / This last part of the book shows how Hicks had already been influenced by Keynes, whose General Theory of Employment, Interest and Money had been published a few years earlier. However, the influence in the other direction was probably greater: Hicks’ “IS–LM” curves, with which any student of economics is familiar, reformulated Keynesian theory—or one version of it—in a more intelligible manner. At any rate, Hicks seemed more optimistic than Keynes on the stability of the economy. And he later distanced himself from Keynes.
Hicks sometimes appears naive toward the efficiency of government intervention and the possibility of central planning, but probably less so than Keynes. In the conclusion of Value and Capital, he suggests that government should use its power of control over investment and its monetary policy to dampen economic fluctuations. “Whether capitalism is less or more efficient than socialism depends very much on the efficiency of socialism,” he wrote. “That is still rather an open question.” He duly recognized, however, how sticky wages (perhaps caused by minimum wage laws) contribute to unemployment.
Other criticisms can be directed at Value and Capital, but Hicks’s formidable logic remains impressive, and his contribution to the development of economic theory (especially in the first two parts of the book) is unquestionable.
Irregular and defective Austrian? / What was Hicks’s philosophy? An analyst must always distinguish facts (what is) from values (what ought to be), the positive from the normative. A nearly parallel distinction runs between the results of economic analysis and the moral judgments brought to bear on them. Hicks was conscious of those distinctions and tried to avoid interjecting value judgments in his analysis. He believed that it is necessary to distinguish mere opinions from “those things which are the fruit of pure logic,” that which we are “compelled to believe.”
Hicks was generally recognized as a classical liberal. His mild classical-liberal values were consistent with his theoretical work, which emphasized the general efficiency of markets but harbored no a priori refusal of government intervention when needed. Yet, his political views changed over his career.
In a September 2013 Econ Journal Watch paper, Daniel Klein and Ryan Daza traced Hicks’s ideological evolution. A temporary appointment in South Africa around 1927–1928 showed him how, contrary to the racist trade unions, a free labor market would advance the progress of blacks. “So I became a free market man,” he wrote. He was then influenced by Hayek: “I fell rather easily into the ultraliberal line which became dominant in the economics section of [the London School of Economics].” By 1935, however, he had lost his “old faith” in the free market, a new ideological period that coincided with his work on Value and Capital. But starting in the 1960s or 1970s, he seemed to have come back to classical liberalism and became more suspicious of government.
In the 1970s, he also seemed to return to his original Austrian influences, claiming to develop a “neo-Austrian” theory of capital. In 1979, paraphrasing poet John Milton who confessed to being an irregular and defective Baptist, Hicks described himself as an “ ‘irregular and defective’ Austrian.”
Critical theorist / That Hicks would not have bought any ideology in bulk, nor sold his soul to any school of economic analysis, that he would always be “irregular and defective,” is not surprising. He was a critical theorist who would follow the logic of his models wherever it would take him. He did not hesitate to criticize his own previous theories.
But he was not blinded by the formal beauty of pure theory. In 1979 he wrote that “theory gives one no right to pronounce on practical problems unless one has been through the labour, so often the formidable labour, of mastering the relevant facts.” He said he “felt little sympathy with the theory for theory’s sake, which has been characteristic of one strand in American economics,” and “had little faith in econometrics, on which [those economists] have so largely relied to make their contact with reality.”
Perhaps he had epistemologically mellowed. Economics, he wrote in 1983, is a discipline, not a science. He warned economists against conceit:
I do think it is a besetting vice of economists to over-play their hands, to claim more for their subject than they should. As will have been seen, I have on occasion fallen into that vice myself; but I think, or hope, that as the years have gone by, I have learned more wisdom.
Yet, he should not have apologized for the beauty of his logic. His conclusions, often surprising and iconoclastic, were always compelling (in the context of his models). He was also an extraordinary writer. Those qualities are obvious in A Theory of Economic History and in Value and Capital, however different those two books are.
