Where Economic Ideas Came From

Nobody sat down and invented economics in one go. Every major school of thought was a response to a crisis the previous one could not explain — and understanding that pattern tells you far more than memorising a list of names ever will.

The pattern to look for

Understanding how economic thought evolved over the past four hundred years helps you see the strengths and weaknesses of the policies used today. Every economic revolution was created in response to the challenges of its own moment, and there is a live debate right now about whether societies need a new economics built for twenty-first century problems.

The 18th century: Adam Smith

Adam Smith published The Wealth of Nations in 1776 and is widely regarded as the father of classical economics. Written at the start of the Industrial Revolution, it set out how markets could coordinate themselves through demand and supply.

It was also a direct response to the previous century of heavy government interference in European markets, known as mercantilism.

The 19th century: utility, the margin and Marx

Three big ideas emerged, plus one powerful attack on all of them.

Utility and the margin

Classical economists had priced goods according to what it cost to produce them. Utility turned that on its head: price came to be seen as a function of the satisfaction gained from consuming something. If consumers get high utility from a good, producers should make more of it.

Marginal utility is the extra satisfaction from consuming one more unit. It usually falls as you consume more.

Say’s law

Developed in the early 1800s by the classical, laissez-faire economist Jean-Baptiste Say, it is usually summed up as “supply creates its own demand”. By supplying goods to the market, a producer generates income from sales, and that income is then used to buy other products. The implication is that raising national output is what matters most, so governments should focus on production rather than worrying about consumption.

Marx’s critique

Free markets had generated extraordinary wealth in the Western world. Karl Marx, a German philosopher, argued that this wealth came from worker exploitation — a natural consequence of firms maximising profit — and that inequality was deepening as a result.

• Exploitation showed up as low wages and poor working conditions.
• The owners of the factors of production, the capitalists, took the largest share of income.
• If all a person had to sell was their labour, and wages were held down, inequality could only widen.

Marx argued that capitalism would eventually push workers to revolt, and that periods of exploitation would be followed by revolutions. Restoring stability and equality would then require government intervention, with the state directing the allocation of resources — a command economy — to stop the pattern repeating. His ideas spread fast: within a relatively short period, more than a third of the world’s population lived in economies shaped by them.

The 20th century: Keynes, then the counter-revolution

The first half of the century was dominated by two world wars and the Great Depression, and the ideas of the previous century stopped working. In a severe recession Say’s law became obsolete: households could not buy goods at all, because they had no income to buy them with. Supply was plainly not creating its own demand.

John Maynard Keynes, a British economist at Cambridge, argued that new thinking was needed. His ideas were adopted quickly, and the next fifty years saw a widespread Keynesian revolution.

The monetarist counter-revolution

Monetarism is a school of thought emphasising the use of monetary policy to influence an economy. Monetarists argued that poor monetary policy caused the Great Depression in the first place, and that using fiscal policy causes inflation, because government spending pushes up aggregate demand.

Milton Friedman was among the leading monetarists of the late twentieth century. His ideas influenced Ronald Reagan in the USA and Margaret Thatcher in the UK, and both governments moved away from Keynesian economics. From the early 1980s there was a resurgence of belief in classical economics and laissez-faire markets: government spending was cut back and the focus shifted to supply-side policies, of which privatisation was the most prominent.

The 21st century

The early part of this century has thrown up a set of challenges that neither of the twentieth-century schools was designed for: climate change, ongoing wars and displacement, a global population that has grown by roughly six billion people in a century, the Global Financial Crisis of 2008 and the Covid recession of 2020.

Keynesian thinking returned with the 2008 crisis, as governments chose to spend their way out of trouble. Government spending rose to levels never seen before and stayed high for more than a decade, financed by increased borrowing — which creates a larger tax burden for future generations. Even with spending extraordinarily high, expansionary monetary policy had to be used widely as well to bring stability.

That pattern prompted calls to rethink economics: for an economic philosophy no longer rooted in old thinking, and for ideas built for a twenty-first century world.

Worked examples