Where Economic Ideas Came From

Economics is not a set of eternal truths handed down at the start. It is a four-hundred-year argument, and every new school of thought turned up because the old one had just failed to explain something painful. Learn the story in order and you will suddenly understand why economists still disagree about government spending — they are re-running arguments that began centuries ago.

The story on one timeline

Before Smith: mercantilism

For roughly two hundred years, European governments believed a country got rich by piling up gold and silver. The way to do that was to sell as much as possible abroad and buy as little as possible from anyone else. Trade was tightly controlled, imports were taxed heavily, and colonies existed to feed the mother country cheap raw materials.

The flaw is worth spotting yourself: if every country tries to export more than it imports, the arithmetic cannot work. Somebody has to be buying. Trade was treated as a fight with a winner and a loser, rather than something both sides can gain from.

1776: Adam Smith and the classical school

Smith published The Wealth of Nations in 1776, right as the Industrial Revolution was getting going. He is usually called the father of classical economics, and his book was a direct attack on the mercantilist system he had grown up with.

The 19th century: margins, Say and Marx

Marginal utility

Classical economists thought a product’s price came from what it cost to make. In the 1800s that flipped. Price came to be seen as reflecting the satisfaction the buyer gets — and specifically the satisfaction from the last unit consumed.

Think about a hot day. The first cold drink is wonderful, and you would pay a lot for it. The second is nice. The fourth is a struggle. Each extra drink adds less satisfaction than the one before — that is diminishing marginal utility, and it is why you would not pay the same price for the fourth as for the first.

Say’s law

Around 1802 Jean-Baptiste Say argued that supply creates its own demand. The logic: to produce something you have to pay wages, rent, interest and profit, and those payments are income. That income then gets spent. So producing more automatically generates the spending power to buy it.

You can see the circular flow hiding inside that argument. It also implies that a long slump should be impossible, which is exactly the claim the 1930s destroyed.

Marx’s critique

Free markets were generating enormous wealth in the 1800s — and enormous inequality alongside it. Karl Marx argued the two were connected: profit came from paying workers less than the value of what they produced. Owners of land and capital captured the gains; people who only had their labour to sell fell further behind.

His prediction was that the gap would widen until workers revolted, and that governments would then have to take control of resource allocation. Whatever you think of the argument, its influence was enormous — within a century a large share of the world’s population lived under systems built on his ideas.

The 1930s: Keynes

The Great Depression broke Say’s law in public. Output collapsed, millions lost work, and markets showed no sign of correcting themselves. People had no income, so they could not spend; because nobody spent, firms sacked more people. The loop ran backwards.

John Maynard Keynes argued that in a slump the government has to break the cycle by spending money itself. That spending becomes somebody’s income, which becomes somebody’s spending, and the flow restarts. He created the field of macroeconomics to describe how total demand in an economy works, and argued fiscal policy matters more than monetary policy in a depression.

The 1970s and 1980s: the monetarist counter-revolution

Keynesian policy dominated for about fifty years, then ran into trouble: rising inflation alongside weak growth, which Keynesian models struggled to explain. The counter-attack came from the monetarists, led by Milton Friedman.

• Inflation is driven above all by the money supply, so controlling it is the priority.
• Government spending to boost demand mostly ends up as inflation, not extra output.
• Poor monetary policy, not market failure, made the Great Depression as bad as it was.

Politically this fed into the free-market turn of the 1980s in the United States and the United Kingdom: lower government spending, deregulation, tax cuts, privatisation and a general shift towards supply-side policies. In other words, a return to something close to classical economics.

The 21st century: new problems, new economics

Then came the 2008 financial crisis, and governments across the world spent enormous sums to keep economies afloat — a very Keynesian response. The pandemic recession of 2020 brought more of the same, financed by borrowing that future taxpayers will service. Alongside this sit climate change, resource depletion and rising inequality.

Worked examples