Transformation of Economic Theory

This post is a continuation of our series on the history of Central Banking. The previous post was:  Monetary Policy from 1914 to 1980. Before going on to discuss the transition from Keynesian goals to inflation targeting, we need to step back and provide some background information on the ideological battles which were crucial to this transition. Whereas Mercantilist economics was focused on acquiring gold to finance wars, the Hundred Years of Peace between the European powers (accompanied by brutal and ruthless wars of conquest and colonization elsewhere) led to fundamental change in the economic theories. This transition is described below.

In the first post in this sequence (Origins of Central Banking), we discussed how the Bank of England was created in 1694 to provide funding for a war with France. The success of this institution was noted, and it was replicated across Europe, so that Central Banks came into existence to finance the nearly continuous wars between European powers that characterized the 18th Century. The 19th Century was unusual in that European powers set aside differences to create a Hundred Years of Peace (1814 to 1914), in order to go on a spree of global colonization and conquest. The transition from war to peace also created a transformation in economic theories from Mercantilism to Free Trade. Some aspects of this transition are discussed below.

The Root of All Evil

An essential aspect of the Great Transformation from traditional, paternalistic societies to market societies involves re-engineering human motivations. The lust for money does not normally rank high as a driver of human behavior. When a capitalist society makes markets the central mechanism for production and distribution of essential commodities to the society, then the money motive must be strengthened. Capitalism cannot risk the baker taking a day off for fishing, or laborers deciding to take a break from monotony, disturbing the supply of essential commodities to the populace. Many mechanisms are used by capitalist societies to make the love of money enter the hearts of all members of the society. Max Weber noted that “In fact, the summum bonum of this ethic, the strict earning of more and more money, combined with the strict avoidance of all spontaneous enjoyment of life, … is thought of … purely as an end in itself,  … .  Man is dominated by the making of money, by acquisition as the ultimate purpose of his life. Economic acquisition is no longer subordinated to man as the means for the satisfaction of his material needs.  This reversal of what we should call the natural relationship, so irrational from a naïve point of view, is evidently as definitely a leading principle of capitalism as it is foreign to all peoples not under capitalistic influence.” The Great Transformation changes the Biblical “Love of money” to the Shavian “Lack of money” as the root of all evil. These changes are reflected in politics, trade, and in economic theories, as we discuss below.

Finance for Wars:

There is a close connection between wars and finance. Central Banks were created for the purpose of financing wars, and for most of 18th Century, the main function of Central Bank was to provide financing for wars. The evolution towards modern monetary functions occurred in the 19th Century, where European powers avoided wars with each other, and concentrated on colonizing the globe. During this century, arranging finance for investment for ventures in the colonies across the globe became the main function of finance. Wars on European continent were avoided because of the influence of haute finance on political decisions. Similarly, the evolution of money in the 20th Century has been strongly influenced by War. The gold standard collapsed due to World War 1. Attempts to re-instate the gold standard failed due to World War 2, at which point the Bretton-Woods agreement of 1944 created an alternative. This was a dollar-based system of international trade, called a gold-exchange standard since dollars could be exchanged for gold, at least theoretically. When all currencies are tied to gold through dollars, even notionally, this leads naturally to fixed exchange rates based on gold-equivalence. Financing expenses of the Vietnam War led to massive overprinting of dollars, making it impossible for the USA to redeem them in gold. In 1971, Nixon announced that dollars would no longer be redeemable for gold. This “Nixon shock” removed the anchor which had tied all currencies to a fixed gold value, and set them all adrift. The natural consequence was the world of floating exchange rates which we now live in.

The Unusual Nineteenth Century

Given the close connection between finance and war, Mercantilism is based on the acquisition of gold from foreigners to enhance domestic ability to make war, and also to weaken foreigners’ ability to finance their war efforts. This is perfectly natural in a world of constant warfare. The exceptional 19th Century occurred because the process of colonization of the globe temporarily made available vast resources of the entire globe to the colonizing European powers. The conquest of colonies raised standards of living among peoples of European descent at an astonishingly rapid pace, while impoverishing the colonies and the entire planet to a far greater extent. Vast numbers of books have been written to explain the MYSTERY of the ascent of Europe, and the corresponding failure of the rest of the globe. James Blaut in “Eight Eurocentric Historians“ and “The Colonizers Model of the World” has listed and debunked over thirty of these myths. Meanwhile, no one has mentioned the elephant in room (except to dismiss it): massive expropriation of global resources created by conquest of 85% of the planet enriched Europe and impoverished the globe. In fact, Lefken Stavrianos in “Global Rift: the Third World Comes of Age“ has put forth and documented precisely this thesis. Unfortunately, this book has been out of print for some time. The 19th Century was unusual in that vast non-monetary resources available in the colonies – men and minerals – were exploited, so that trade was carried out for enrichment of mother countries in terms of commodities, as well as gold and silver. This change in orientation from Mercantilism was reflected in classical economic theories of the 19th Century.

General Equilibrium (C-M-C’) Versus Karl Marx (M-C-M’)

The transition from constant warfare in the 18th Century to the Hundred Years Peace in the 19th was accompanied by the transition from Mercantilism to the free trade theories of Adam Smith and Ricardo. To understand the difference, we must look at the purpose of trade. When trade is carried out for the purpose of making money, the M-C-M’ paradigm applies. That is, traders use money to produce commodities, and sell them to make more money. Trade is adversarial in this paradigm – either I will make money or you will make money, both parties cannot get more money given a fixed and finite supply of gold. Using unbacked currencies, MMT accounting identities show that if exports are greater than imports, domestic profits and savings must increase by the amount of the difference. Conversely, if imports are greater in value than exports the difference reduces net profits and savings in domestic economy. Thus, trade is a zero-sum game when played for money. The win-win solution at the heart of General Equilibrium models of trade is based on trade for commodities, or the C-M-C’ model, as explained below.

Modern economic theory has its roots in the peace of the 19th Century, where economic activity produced commodities to raise standards of living, and money was an intermediate good; the C-M-C’ paradigm. The theory of comparative advantage argues that both nations can get both of more goods if the colonies specialize in raw materials while the center specialize in manufacture and industry. The theory assumes that the goal of trade is to get more commodities C-M-C’, and not to earn more money. Similarly, general equilibrium theory of Walras is also focused on the acquisition of commodities as the final outcome of trade. These theories are not compatible with a world where trade is for the purpose of acquiring gold and the financial power to make wars. They emerged and became powerful and widely accepted because of sudden change in the interests of haute finance, represented by Central Banks, from war to peace.

Finance for Peace:

Karl Polanyi writes about the sudden shift from war to peace that occurred at the beginning of the 19th Century as follows – (parenthetical expressions are mine; for full original quote, see Polanyi Quote)

The “balance of power” ensures that three or more units capable of exerting power will always behave in such a way as to combine the power of the weaker units against any increase in power of the strongest.  (BOP) attained this end only by continuous war between changing partners. The fact that in the nineteenth century the same mechanism resulted in peace rather than war is a problem to challenge the historian. The entirely new factor (which explains how BOP produced peace instead of war) was the emergence of an acute peace interest. (The State, the Church and the Public were strong advocates of war as a means of protecting the national interest.) Few things were regarded as more detrimental to a community than the existence of an organized peace interest in its midst. As late as the second half of the eighteenth century, J. J. Rousseau arraigned trades people for their lack of patriotism because they were suspected of pre­ferring peace to liberty.

After 1815 the change is sudden and complete. The backwash of the French Revolution reinforced the rising tide of the Industrial Revolution in establishing peaceful business as a universal interest. Metternich proclaimed that what the people of Europe wanted was not liberty but peace. Gentz called patriots the new barbarians. Church and throne started out on the denationalization of Europe. Their argu­ments found support both in the ferocity of the recent popular forms of warfare and in the tremendously enhanced value of peace under the nascent economies.

When the interests of haute finance (central banks, and the transnational financiers behind these banks) became aligned with peace, then the public minds were aligned with peace, instead of war. The vast proportion of Colonial trade in the early 19th Century was between mother country and colonies, and not across colonies. The colonies were generally poor in gold but rich in resources. So, the Mercantilist model of acquiring gold for making war became obsolete. Instead, theories were developed which were aligned with acquiring resources for the mother country by exploiting the colonies. This process was hugely successful as massive amounts of global resources were transferred to nations of European origin, enriching them while impoverishing the rest of world. Stavrianos provides historical details in “Global Rift: The Third World Comes of Age“.

Power and Knowledge

The popular picture of economic theory as a body of knowledge created by neutral searchers for truth is dramatically wrong. From Adam Smith onwards, the ascendant economic theories have been closely linked to the interests of the wealthy capitalists. Free trade suited the interests of England, which had a fifty-year lead over Europe in the Industrial Revolution. It is no coincidence that free trade theories were strongly advocated by England. At the same time, theories of protection were developed by  German economist Friedrich List, and other European and US economists in the early 19th Century. After the US and Europe caught up to England using protectionist policies, the West collectively imposed free trade on the rest of the world. Wars with China and Japan were carried out with the only objective of opening these economies up to free traders of the West. For this history see Ahmad & Zaman “Free Trade and Development“. For a more general view of how economic theories are devised to favor the rich and powerful, see ET1%: Blindfolds Created by Economic Theory of the top 1%. Analysing the links between power and knowledge opens the door to deep insights. As Foucault said, “My job is making windows where there were once walls”.  More transparently, “The history of the struggle for power, and consequently the real conditions of its exercise and maintenance, is still almost totally hidden. Knowledge is not a part of this: that should not be known.”   In order to create people who are ready to die for their country, the truth that the war is about control of resources like oil, must be concealed — see “The Business of War” for a detailed discussion. Even more important, our entire educational system is designed to create human resources for the labor market essential to the survival of capitalism. Knowledge about the potential for excellence contained within every human being must be concealed for this purpose. The journey of life begins when we remove the blindfolds created by our education, and make the strenuous efforts required to discover our true identities — see “Learn Who You Are!

POSTSCRIPT: Links to this post on: Medium, WEA Pedagogy Blog,

Date posted: November 1, 2019
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