Though better known for his treatments of philosophy, history, and politics, the Scottish philosopher David Hume also made several essential contributions to economic thought. His empirical argument against British mercantilism formed a building block for classical economics. His essays on money and international trade published in Political Discourses strongly influenced his friend and fellow countryman adam smith. British mercantilists believed that economic prosperity could be realized by limiting imports and encouraging exports in order to maximize the amount of gold in the home country. The American colonies facilitated this policy by providing raw materials that Britain manufactured into finished goods and reexported back to the colonial consumers in America. Needless to say, the arrangement was short-lived. But even before the American Revolution intervened in mercantilistic pursuits, David Hume showed why net exporting in exchange for gold currency, hoarded by Britain, could not enhance wealth. Hume’s argument was essentially the monetarist quantity theory of money: prices in a country change directly with changes in the money supply. Hume explained that as net exports increased and more gold flowed into a country to pay for them, the prices of goods in that country would rise. Thus, an increased flow of gold into England would not necessarily increase England’s wealth substantially. Hume showed that the increase in domestic prices due to the gold inflow would discourage exports and encourage imports, thus automatically limiting the amount by which exports would exceed imports. This adjustment mechanism is called the price-specie-flow mechanism. Surprisingly, even though Hume’s idea would have bolstered Adam Smith’s attack on mercantilism and argument for free trade, Smith ignored Hume’s argument. Although few economists accept Hume’s view literally, it is still the basis of much thinking on balance-of-payments issues. Considering Hume’s solid grasp of monetary dynamics, his misconceptions about money behavior are all the more noteworthy. Hume erroneously advanced the notion of “creeping inflation”—the idea that a gradual increase in the money supply would lead to economic growth. Hume made two other major lasting contributions to economics. One is his idea, later elaborated by friedrich hayek in The Road to Serfdom, that economic freedom is a necessary condition for political freedom. The second is his assertion that “you cannot deduce ought from is”—that is, value judgments cannot be made purely on the basis of facts. Economists now make the same point by distinguishing between normative (what should be) and positive (what is). Hume died the year The Wealth of Nations was published, and in the presence of its author, Adam Smith. Selected Works   1752. Political Discourses. Edinburgh: A. Kincaid and A. Donaldson. Available online at: http://www.econlib.org/library/LFBooks/Hume/hmMPL24.html 1875. The Philosophical Works of David Hume. 4 vols. Edited and annotated by T. H. Green and T. H. Grose. London: Longmans, Green. 1955. Writings on Economics. Edited by Eugene Rotwein. London: Nelson. 1987. Essays: Moral, Political, and Literary. Edited by Eugene F. Miller. Available online at: http://www.econlib.org/library/LFBooks/Hume/hmMPL.html.   (0 COMMENTS)

If any twentieth-century economist was a Renaissance man, it was Friedrich Hayek. He made fundamental contributions in political theory, psychology, and economics. In a field in which the relevance of ideas often is eclipsed by expansions on an initial theory, many of his contributions are so remarkable that people still read them more than fifty years after they were written. Many graduate economics students today, for example, study his articles from the 1930s and 1940s on economics and knowledge, deriving insights that some of their elders in the economics profession still do not totally understand. It would not be surprising if a substantial minority of economists still read and learn from his articles in the year 2050. In his book Commanding Heights, Daniel Yergin called Hayek the “preeminent” economist of the last half of the twentieth century. Hayek was the best-known advocate of what is now called Austrian economics. He was, in fact, the only major recent member of the Austrian school who was actually born and raised in Austria. After World War I, Hayek earned his doctorates in law and political science at the University of Vienna. Afterward he, together with other young economists Gottfried Haberler, Fritz Machlup, and Oskar Morgenstern, joined Ludwig von Mises’s private seminar—the Austrian equivalent of John Maynard Keynes’s “Cambridge Circus.” In 1927 Hayek became the director of the newly formed Austrian Institute for Business Cycle Research. In the early 1930s, at the invitation of Lionel Robbins, he moved to the faculty of the London School of Economics, where he stayed for eighteen years. He became a British citizen in 1938. Most of Hayek’s work from the 1920s through the 1930s was in the Austrian theory of business cycles, capital theory, and monetary theory. Hayek saw a connection among all three. The major problem for any economy, he argued, is how people’s actions are coordinated. He noticed, as Adam Smith had, that the price system—free markets—did a remarkable job of coordinating people’s actions, even though that coordination was not part of anyone’s intent. The market, said Hayek, was a spontaneous order. By spontaneous Hayek meant unplanned—the market was not designed by anyone but evolved slowly as the result of human actions. But the market does not work perfectly. What causes the market, asked Hayek, to fail to coordinate people’s plans, so that at times large numbers of people are unemployed? One cause, he said, was increases in the money supply by the central bank. Such increases, he argued in Prices and Production, would drive down interest rates, making credit artificially cheap. Businessmen would then make capital investments that they would not have made had they understood that they were getting a distorted price signal from the credit market. But capital investments are not homogeneous. Long-term investments are more sensitive to interest rates than short-term ones, just as long-term bonds are more interest-sensitive than treasury bills. Therefore, he concluded, artificially low interest rates not only cause investment to be artificially high, but also cause “malinvestment”—too much investment in long-term projects relative to short-term ones, and the boom turns into a bust. Hayek saw the bust as a healthy and necessary readjustment. The way to avoid the busts, he argued, is to avoid the booms that cause them. Hayek and Keynes were building their models of the world at the same time. They were familiar with each other’s views and battled over their differences. Most economists believe that Keynes’s General Theory of Employment, Interest and Money (1936) won the war. Hayek, until his dying day, never believed that, and neither do other members of the Austrian school. Hayek believed that Keynesian policies to combat unemployment would inevitably cause inflation, and that to keep unemployment low, the central bank would have to increase the money supply faster and faster, causing inflation to get higher and higher. Hayek’s thought, which he expressed as early as 1958, is now accepted by mainstream economists (see phillips curve). In the late 1930s and early 1940s, Hayek turned to the debate about whether socialist planning could work. He argued that it could not. The reason socialist economists thought central planning could work, argued Hayek, was that they thought planners could take the given economic data and allocate resources accordingly. But Hayek pointed out that the data are not “given.” The data do not exist, and cannot exist, in any one mind or small number of minds. Rather, each individual has knowledge about particular resources and potential opportunities for using these resources that a central planner can never have. The virtue of the free market, argued Hayek, is that it gives the maximum latitude for people to use information that only they have. In short, the market process generates the data. Without markets, data are almost nonexistent. Mainstream economists and even many socialist economists (see socialism) now accept Hayek’s argument. Columbia University economist Jeffrey Sachs noted: “If you ask an economist where’s a good place to invest, which industries are going to grow, where the specialization is going to occur, the track record is pretty miserable. Economists don’t collect the on-the-ground information businessmen do. Every time Poland asks, Well, what are we going to be able to produce? I say I don’t know.”1 In 1944 Hayek also attacked socialism from a very different angle. From his vantage point in Austria, Hayek had observed Germany very closely in the 1920s and early 1930s. After he moved to Britain, he noticed that many British socialists were advocating some of the same policies for government control of people’s lives that he had seen advocated in Germany in the 1920s. He had also seen that the Nazis really were National Socialists; that is, they were nationalists and socialists. So Hayek wrote The Road to Serfdom to warn his fellow British citizens of the dangers of socialism. His basic argument was that government control of our economic lives amounts to totalitarianism. “Economic control is not merely control of a sector of human life which can be separated from the rest,” he wrote, “it is the control of the means for all our ends.” To the surprise of some, John Maynard Keynes praised the book highly. On the book’s cover, Keynes is quoted as saying: “In my opinion it is a grand book…. Morally and philosophically I find myself in agreement with virtually the whole of it; and not only in agreement with it, but in deeply moved agreement.” Although Hayek had intended The Road to Serfdom only for a British audience, it also sold well in the United States. Indeed, Reader’s Digest condensed it. With that book Hayek established himself as the world’s leading classical liberal; today he would be called a libertarian or market liberal. A few years later, along with Milton Friedman, George Stigler, and others, he formed the Mont Pelerin Society so that classical liberals could meet every two years and give each other moral support in what appeared to be a losing cause. In 1950 Hayek became professor of social and moral sciences at the University of Chicago, where he stayed until 1962. During that time he worked on methodology, psychology, and political theory. In methodology Hayek attacked “scientism”—the imitation in social science of the methods of the physical sciences. His argument was that because social science, including economics, studies people and not objects, it can do so only by paying attention to human purposes. The Austrian school in the 1870s had already shown that the value of an item derives from its ability to fulfill human purposes. Hayek was arguing that social scientists more generally should take account of human purposes. His thoughts on the matter are in The Counter-Revolution of Science: Studies in the Abuse of Reason. In psychology Hayek wrote The Sensory Order: An Inquiry into the Foundations of Theoretical Psychology. In political theory Hayek gave his view of the proper role of government in his book The Constitution of Liberty. It is actually a more expansive view of the proper role of government than many of his fellow classical liberals hold. He discussed the principles of freedom and based his policy proposals on those principles. His main objection to progressive taxation, for example, was not that it causes inefficiency but that it violates equality before the law. In the book’s postscript, “Why I Am Not a Conservative,” Hayek distinguished his classical liberalism from conservatism. Among his grounds for rejecting conservatism were that moral and religious ideals are not “proper objects of coercion” and that conservatism is hostile to internationalism and prone to a strident nationalism. In 1962 Hayek returned to Europe as professor of economic policy at the University of Freiburg in Breisgau, West Germany, and stayed there until 1968. He then taught at the University of Salzburg in Austria until his retirement nine years later. His publications slowed substantially in the early 1970s. In 1974 he shared the Nobel Prize with Gunnar Myrdal “for their pioneering work in the theory of money and economic fluctuations and for their penetrating analysis of the interdependence of economic, social and institutional phenomena.” This award seemed to breathe new life into him, and he began publishing again, both in economics and in politics. Many people get more conservative as they age. Hayek became more radical. Although he had favored central banking for most of his life, in the 1970s he began advocating denationalizing money. Private enterprises that issued distinct currencies, he argued, would have an incentive to maintain their currency’s purchasing power. Customers could choose from among competing currencies. Whether they would revert to a gold standard was a question that Hayek was too much of a believer in spontaneous order to predict. With the collapse of communism in Eastern Europe, some economic consultants have considered Hayek’s currency system as a replacement for fixed-rate currencies. Hayek was still publishing at age eighty-nine. In his book The Fatal Conceit, he laid out some profound insights to explain the intellectuals’ attraction to socialism and then refuted the basis for their beliefs. Selected Works   1931. “Richard Cantillon.” Translated by Micheál Ó Súilleabháin in the Journal of Libertarian Studies 7, no. 2 (1985): 217–247. Available online at: http://www.econlib.org/library/Essays/JlibSt/hykCnt1.html. 1935. Prices and Production. 2d ed. Reprint. New York: Augustus M. Kelley, 1975. 1937. “Economics and Knowledge.” Economica, n.s., 4 (February): 33–54. Reprinted in James M. Buchanan and G. F. Thirlby, eds., L.S.E. Essays on Cost. London: Weidenfeld and Nicolson, 1973. Available online at: http://www.econlib.org/library/NPDBooks/Thirlby/bcthLS3.html. 1939. “Price Expectations, Monetary Disturbances, and Malinvestments.” In Hayek, Profits, Interest, and Investment. Reprint. New York: Augustus M. Kelley, 1975. 1944. The Road to Serfdom. Chicago: University of Chicago Press. 1945. “The Use of Knowledge in Society.” American Economic Review 35 (September): 519–530. Available online at: http://www.econlib.org/library/Essays/hykKnw1.html. 1948. Individualism and Economic Order. Chicago: University of Chicago Press. 1952. The Counter-Revolution of Science: Studies on the Abuse of Reason. Glencoe, Ill.: Free Press. 1960. The Constitution of Liberty. Chicago: University of Chicago Press. Reprint. Chicago: Henry Regnery, 1972. 1973. Law, Legislation, and Liberty. Chicago: University of Chicago Press. 1976. Denationalization of Money. London: Institute of Economic Affairs. 1977. Foreword to Economics as a Coordination Problem: The Contributions of Friedrich A. Hayek by Gerald P. O’Driscoll Jr. Kansas City: Sheed, Andrews, and McMeel. 1988. The Fatal Conceit. Chicago: University of Chicago Press. 1995. Introduction to Selected Essays on Political Economy by Frédéric Bastiat. Trans. from the French by Seymour Cain. Edited by George B. de Huszar. Princeton: Van Nostrand, 1995. Available online at: http://www.econlib.org/library/Bastiat/basEss0.html#Introduction,byF.A.Hayek.   Footnotes 1. “Interview: Jeffrey Sachs,” Omni 13, no. 9 (1991) p. 79.   (0 COMMENTS)

  Walter Heller’s claim to fame stems from his years as chairman of the Council of Economic Advisers (CEA) from 1961 to 1964, under presidents John F. Kennedy and Lyndon B. Johnson. Before that, and after, he was an economics professor at the University of Minnesota. As chairman of the CEA, Heller persuaded President Kennedy to cut marginal tax rates. This cut in tax rates, which was passed after Kennedy’s death, helped cause a boom in the U.S. economy. Heller’s CEA also developed the first “voluntary” (i.e., enforced by veiled threats rather than by explicit laws) wage-price guidelines. Heller’s early academic work was on state and local taxation. In 1947 and 1948 he was tax adviser to the U.S. military government in Germany. He was involved in the currency and tax reforms that helped spur the German economic boom (see german economic miracle). In a 1950 article, Heller noted that the reduction in marginal tax rates helped “remove the repressive effect of extremely high rates.” According to tax economist Joseph Pechman, Heller was also one of the first economists to recognize that tax deductions and tax preferences narrow the income tax base, thus requiring, for a given amount of revenue, higher marginal tax rates. Selected Works   1949. “Tax and Monetary Reform in Occupied Germany.” National Tax Journal 2, no. 3: 215–231. 1966. New Dimensions of Political Economy. Cambridge: Harvard University Press. 1969 (with Milton Friedman). Monetary vs. Fiscal Policy. New York: W. W. Norton. 1975. “What’s Right with Economics?” American Economic Review 65, no. 1: 1–26.   (0 COMMENTS)

  Harry Johnson, a Canadian, was one of the most active and prolific economists of all time. His main research was in the area of international trade, international finance, and monetary policy. One of Johnson’s early articles on international trade showed that a country with monopoly power in some good could impose a tariff and be better off, even if other countries retaliated against the tariff. His proof was what is sometimes called a “possibility theorem”; it showed that such a tariff could improve the country’s well-being, not that it was likely to. Johnson, realizing the difference between what could be and what is likely to be, was a strong believer in free trade. Indeed, he often gave lectures in his native Canada excoriating the Canadian government for its protectionist policies and arguing that Canada could eliminate some of the gap between Canadian and U.S. standards of living by implementing free trade. In international finance Johnson’s seminal 1958 paper named the growth in the money supply as one important factor that affects a country’s balance of payments. Before then, economists had tended to focus on nonmonetary factors. Johnson’s article began what is now called the monetary approach to the balance of payments. In the field of monetary economics Johnson made an early attempt to do for Britain what milton friedman and Anna Schwartz were doing for the United States: measure the money supply over time. Although he did not achieve as much in this area as Friedman and Schwartz did, his work led to other, more careful and detailed studies of the British money supply. In 1959, after having been a professor at the University of Manchester in England, Johnson moved to the University of Chicago as the token “Keynesian.” He learned a lot from monetarist Milton Friedman and others at Chicago, just as he had learned from Keynesians in England. Although never a monetarist himself, Johnson became increasingly sympathetic to monetarist views. One of his classic articles, written in his early years at Chicago, is his 1962 survey, “Monetary Theory and Policy.” The article is a graduate student’s delight—tying together apparently disparate insights by other economists, pointing out their pitfalls, and laying out an agenda for future research—all in a clear, readable style that still manages not to sacrifice subtle distinctions. In a relatively short career Johnson wrote 526 professional articles, forty-one books and pamphlets, and more than 150 book reviews. He also gave a prodigious number of speeches. According to paul samuelson, when Johnson died he had eighteen papers in proof. (Commented Samuelson: “That is dying with your boots on!”) Johnson also earned many honors. In 1977, for example, he was named a distinguished fellow of the American Economic Association, and in 1976 the Canadian government named him an officer of the Order of Canada. Johnson graduated from the University of Toronto in 1943 and earned his Ph.D. from Harvard in 1958. Selected Works   1953. “Optimum Tariffs and Retaliation.” Review of Economic Studies 21, no. 2: 142–153. 1959. “British Monetary Statistics.” Economica 26 (February): 1–17. 1961. “The ‘General Theory’ After Twenty-five Years.” American Economic Review 51 (May): 1–17. 1963. The Canadian Quandary: Economic Problems and Policies. Toronto: McGraw-Hill. 1969. Essays in Monetary Economics. 2d ed. Cambridge: Harvard University Press. 1971. “The Keynesian Revolution and the Monetarist Counter-revolution.” American Economic Review 61 (May): 1–14. 1972. Further Essays in Monetary Economics. London: George Allen and Unwin.   (0 COMMENTS)

  In 2002, Daniel Kahneman, along with Vernon Smith, received the Nobel Prize in economics. Kahneman received his prize “for having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty.” Kahneman did most of his important work with Amos Tversky, who died in 1996. Before their work, economists had gotten far in their analyses of decision making under uncertainty by assuming that people correctly estimate probabilities of various outcomes or, at least, do not estimate these probabilities in a biased way (see Rational Expectations). Even if some people place too low a probability on an event relative to what was reasonable, economists argued, others will place too high a probability on that same event and the results would cancel out. But Kahneman and Tversky found that this is not true: the vast majority of people misestimate probabilities in predictable ways. One bias they found is that people tend to believe in “the law of small numbers”; that is, they tend to generalize from small amounts of data. So, for example, if a mutual fund manager has had three above-average years in a row, many people will conclude that the fund manager is better than average, even though this conclusion does not follow from such a small amount of data. Or if the first four tosses of a coin give, say, three heads, many people will believe that the next toss is likely to be tails. Kahneman saw this belief in his own behavior as a young military psychologist in the Israeli army. Tasked with evaluating candidates for officer training, he concluded that a candidate who performed well on the battlefield or in training would be as good a leader later as he showed himself to be during the observation period. As Kahneman explained in his Nobel lecture, “As I understood clearly only when I taught statistics some years later, the idea that predictions should be less extreme than the information on which they are based is deeply counterintuitive.”1 Another bias Kahneman and Tversky found to be common in people’s thinking is “availability,” whereby people judge probabilities based on how available examples are to them. So, for example, people overstate the risk from driving without a seat belt if they personally know someone who was killed while driving without. Also, repetition of various stories in the news media, such as stories about children being killed by guns, causes people to overstate the risk of guns to children (see risk and safety). Kahneman and Tversky also introduced “prospect theory” to explain some systematic choices most people make—choices that contradict the strictly rational model. Kahneman later admitted that their theory’s name was meaningless, but that it was important for getting others to take it seriously, thus giving even more evidence that the framing of an issue matters. (See the next paragraph for an example.) Imagine, for example, that someone is given a chance to bet $40 on some outcome and that he is told, accurately, that his probability of winning $40 is 60 percent, which means that his probability of losing $40 is 40 percent. Most people will refuse such a bet. Kahneman and Tversky called this “loss aversion.” This could be written off as simple risk aversion, which is certainly not irrational. What makes it strange, if not outright irrational, is that people act so differently with bigger gambles. Kahneman and Tversky found, for example, that seven out of ten people prefer a 25 percent probability of losing $6,000 to a 50 percent probability of losing either $4,000 or $2,000, with an equal probability (25 percent) for each. In each case the expected loss—that is, the loss multiplied by its probability, is $1,500. But here they prefer the bigger loss ($6,000) to the smaller one ($2,000 or $4,000). This choice demonstrates what economists calling risk-loving behavior, the opposite of the risk aversion noted for the smaller bets. Kahneman and Tversky also used prospect theory to explain other systematic behavior that departs from the economist’s rationality assumption. Consider the following situation. Many people will drive an extra ten minutes to save $10 on a $50 toy. But they will not drive ten minutes to save $20 on a $20,000 car. The gain from driving the extra ten minutes for the car is twice the gain of driving the extra ten minutes for the toy. So a higher percentage, not a lower one, of people should drive the longer distance for the saving on the car. Why don’t they? Kahneman’s and Tversky’s explanation is that the framing of the issue affects the decision. Instead of comparing the absolute saving in price against the cost of going the extra distance, people compare the percentage saving, and the percentage saving in the case of the car is very small. Kahneman’s and Tversky’s work spurred a great deal of work by economists on systematic departures from rational behavior. See behavioral economics for an introduction to many of the issues. Kahneman was born in Tel Aviv, Israel, and grew up in France. He earned his B.A. in psychology and mathematics at Hebrew University in 1954 and his Ph.D. in psychology from the University of California at Berkeley in 1961. He was a psychology professor at Hebrew University from 1961 to 1978, at the University of British Columbia from 1978 to 1986, at the University of California at Berkeley from 1986 to 1994, and has been a professor at Princeton University since 1993. Selected Works   1972 (with Amos Tversky). “Subjective Probability: A Judgment of Representativeness.” Cognitive Psychology 3: 430–454. 1973 (with Amos Tversky). “On the Psychology of Prediction.” Psychological Review 80: 237–251. 1974 (with Amos Tversky). “Judgment Under Uncertainty: Heuristics and Biases.” Science 185: 1124–1131. 1979 (with Amos Tversky). “Prospect Theory: An Analysis of Decision Under Risk.” Econometrica 47: 263–291. 1986 (with Jack Knetsch and Richard Thaler). “Fairness and the Assumptions of Economics.”Journal of Business 59: S285–S300.   Footnotes 1. See http://nobelprize.org/economics/laureates/2002/kahnemann-lecture.pdf.   (0 COMMENTS)

  Leonid Kantorovich shared the 1975 Nobel Prize with Tjalling Koopmans “for their contributions to the theory of optimum allocation of resources.” Kantarovich was born and died in Russia and did all his professional work there. His first major breakthrough came in 1938 when he was consulting with the Soviet government’s Laboratory of the Plywood Trust. Asked to devise a technique for distributing raw materials to maximize output, Kantorovich saw that the problem was a mathematical one: to maximize a linear function subject to many constraints. The technique he developed is now known as linear programming. In The Mathematical Method of Production Planning and Organization (1939), Kantorovich showed that all problems of economic allocation can be seen as maximizing a function subject to constraints. Across the world, John Hicks in Britain and Paul Samuelson in the United States were reaching the same conclusion at around the same time. Kantorovich, like Samuelson, showed that certain coefficients in the equations could be regarded as the prices of each input. Kantorovich’s best-known book is The Best Uses of Economic Resources, in which he developed some of the points made in his 1939 book. He showed that even centrally planned economies have to be concerned with using prices to allocate resources. He also made the point that socialist economies have to be concerned about trade-offs between present and future—and therefore should use interest rates just as capitalist ones do. Unfortunately, as hayek has shown, the only way to use prices is to have a price system—that is, markets and private property. Besides receiving the Nobel Prize, Kantorovich was awarded the Soviet government’s Lenin Prize in 1965 and the Order of Lenin in 1967. From 1944 to 1960, Kantorovich was a professor at the University of Leningrad. In 1960 he became director of mathematical economic methods at the Siberian Division of the Soviet Academy of Sciences. In 1971 he was appointed laboratory chief of the Institute of National Economic Management in Moscow. Selected Works   1939. Translated as “The Mathematical Method of Production Planning and Organization.” Management Science 6, no. 4 (July 1960): 363–422. 1959. Translated as The Best Uses of Economic Resources. Oxford, N.Y.: Pergamon, 1965.   (0 COMMENTS)

  So influential was John Maynard Keynes in the middle third of the twentieth century that an entire school of modern thought bears his name. Many of his ideas were revolutionary; almost all were controversial. Keynesian economics serves as a sort of yardstick that can define virtually all economists who came after him. Keynes was born in Cambridge and attended King’s College, Cambridge, where he earned his degree in mathematics in 1905. He remained there for another year to study under alfred marshall and arthur pigou, whose scholarship on the quantity theory of money led to Keynes’s Tract on Monetary Reform many years later. After leaving Cambridge, Keynes took a position with the civil service in Britain. While there, he collected the material for his first book in economics, Indian Currency and Finance, in which he described the workings of India’s monetary system. He returned to Cambridge in 1908 as a lecturer, then took a leave of absence to work for the British Treasury. He worked his way up quickly through the bureaucracy and by 1919 was the Treasury’s principal representative at the peace conference at Versailles. He resigned because he thought the Treaty of Versailles was overly burdensome for the Germans. After resigning, he returned to Cambridge to resume teaching. A prominent journalist and speaker, Keynes was one of the famous Bloomsbury Group of literary greats, which also included Virginia Woolf and Bertrand Russell. At the 1944 Bretton Woods Conference, where the International Monetary Fund was established, Keynes was one of the architects of the postwar system of fixed exchange rates (see Foreign Exchange). In 1925 he married the Russian ballet dancer Lydia Lopokova. He was made a lord in 1942. Keynes died on April 21, 1946, survived by his father, John Neville Keynes, also a renowned economist in his day. Keynes became a celebrity before becoming one of the most respected economists of the century when his eloquent book The Economic Consequences of the Peace was published in 1919. Keynes wrote it to object to the punitive reparations payments imposed on Germany by the Allied countries after World War I. The amounts demanded by the Allies were so large, he wrote, that a Germany that tried to pay them would stay perpetually poor and, therefore, politically unstable. We now know that Keynes was right. Besides its excellent economic analysis of reparations, Keynes’s book contains an insightful analysis of the Council of Four (Georges Clemenceau of France, Prime Minister David Lloyd George of Britain, President Woodrow Wilson of the United States, and Vittorio Orlando of Italy).     Keynes wrote: “The Council of Four paid no attention to these issues [which included making Germany and Austro-Hungary into good neighbors], being preoccupied with others—Clemenceau to crush the economic life of his enemy, Lloyd George to do a deal and bring home something which would pass muster for a week, the President to do nothing that was not just and right” (chap. 6, para. 2). In the 1920s Keynes was a believer in the quantity theory of money (today called monetarism). His writings on the topic were essentially built on the principles he had learned from his mentors, Marshall and Pigou. In 1923 he wrote Tract on Monetary Reform, and later he published Treatise on Money, both on monetary policy. His major policy view was that the way to stabilize the economy is to stabilize the price level, and that to do that the government’s central bank must lower interest rates when prices tend to rise and raise them when prices tend to fall. Keynes’s ideas took a dramatic change, however, as unemployment in Britain dragged on during the interwar period, reaching levels as high as 20 percent. Keynes investigated other causes of Britain’s economic woes, and The General Theory of Employment, Interest and Money was the result. Keynes’s General Theory revolutionized the way economists think about economics. It was pathbreaking in several ways, in particular because it introduced the notion of aggregate demand as the sum of consumption, investment, and government spending; and because it showed (or purported to show) that full employment could be maintained only with the help of government spending. Economists still argue about what Keynes thought caused high unemployment. Some think he attributed it to wages that take a long time to fall. But Keynes actually wanted wages not to fall, and in fact advocated in the General Theory that wages be kept stable. A general cut in wages, he argued, would decrease income, consumption, and aggregate demand. This would offset any benefits to output that the lower price of labor might have contributed. Why shouldn’t government, thought Keynes, fill the shoes of business by investing in public works and hiring the unemployed? The General Theory advocated deficit spending during economic downturns to maintain full employment. Keynes’s conclusion initially met with opposition. At the time, balanced budgets were standard practice with the government. But the idea soon took hold and the U.S. government put people back to work on public works projects. Of course, once policymakers had taken deficit spending to heart, they did not let it go. Contrary to some of his critics’ assertions, Keynes was a relatively strong advocate of free markets. It was Keynes, not adam smith, who said, “There is no objection to be raised against the classical analysis of the manner in which private self-interest will determine what in particular is produced, in what proportions the factors of production will be combined to produce it, and how the value of the final product will be distributed between them.”1 Keynes believed that once full employment had been achieved by fiscal policy measures, the market mechanism could then operate freely. “Thus,” continued Keynes, “apart from the necessity of central controls to bring about an adjustment between the propensity to consume and the inducement to invest, there is no more reason to socialise economic life than there was before” (p. 379). Little of Keynes’s original work survives in modern economic theory. His ideas have been endlessly revised, expanded, and critiqued. Keynesian economics today, while having its roots in The General Theory, is chiefly the product of work by subsequent economists including john hicks, james tobin, paul samuelson, Alan Blinder, robert solow, William Nordhaus, Charles Schultze, walter heller, and arthur okun. The study of econometrics was created, in large part, to empirically explain Keynes’s macroeconomic models. Yet the fact that Keynes is the wellspring for so many outstanding economists is testament to the magnitude and influence of his ideas. Selected Works   1913. Indian Currency and Finance. Reprinted in Keynes, Collected Writings. Vol. 1. 1919. The Economic Consequences of the Peace. Reprinted in Keynes, Collected Writings. Vol. 2. 1920. The Economic Consequences of the Peace. New York: Harcourt, Brace, and Howe. Available online at: http://www.econlib.org/library/YPDBooks/Keynes/kynsCP.html. 1923. A Tract on Monetary Reform. Reprinted in Keynes, Collected Writings. Vol. 4. 1925. The Economic Consequences of Mr. Churchill. Reprinted in Keynes, Collected Writings. Vol. 9. 1930. A Treatise on Money. Vol. 1: The Pure Theory of Money. Reprinted in Keynes, Collected Writings. Vol. 5. 1930. A Treatise on Money. Vol. 2: The Applied Theory of Money. Reprinted in Keynes, Collected Writings. Vol. 6. 1936. The General Theory of Employment, Interest and Money. Reprinted in Keynes, Collected Writings. Vol. 7. 1971–88. Collected Writings. London: Macmillan, for the Royal Economic Society.   Footnotes 1. General Theory, pp. 378–397.   (0 COMMENTS)

Lawrence R. Klein received the Nobel Prize in 1980 for “the creation of economic models and their application to the analysis of economic fluctuations and economic policies.” Klein began model building while still a graduate student. After getting his Ph.D. from MIT, he moved on to the Cowles Commission for Research in Economics, which was then at the University of Chicago. While there he built a model of the U.S. economy, using jan tinbergen’s earlier model as a starting point, to forecast economic conditions and to estimate the impact of changes in government spending, taxes, and other policies. In 1946 the conventional wisdom was that the end of World War II would sink the economy into a depression for a few years. Klein used his model to counter the conventional wisdom. The demand for consumer goods that had been left unsatisfied during the war, he argued, plus the purchasing power of returning soldiers, would prevent a depression. Klein was right. Later he predicted correctly that the end of the Korean War would bring only a mild recession. Klein moved to the University of Michigan, where he proceeded to build bigger and more complicated models of the U.S. economy. The Klein-Goldberger model, which he built with then graduate student Arthur Goldberger, dates from that time. But in 1954, after being denied tenure because he had been a member of the Communist Party from 1946 to 1947, Klein went to Oxford University. There he built a model of the British economy. In 1958 Klein joined the Department of Economics at the University of Pennsylvania. He has been a professor of economics and finance at the university’s Wharton School since 1968. During his tenure there he built the famous Wharton model of the U.S. economy, which contains more than a thousand simultaneous equations that are solved by computers. Klein was coordinator of Jimmy Carter’s economic task force in 1976, but he turned down an invitation to join Carter’s new administration. In 1977 he was president of the American Economic Association. Selected Works   1950. Economic Fluctuations in the United States, 1921–1941. Hoboken, N.J.: Wiley. 1955 (with Arthur S. Goldberger). Econometric Model of the United States, 1929–52. Hoboken, N.J.: Wiley. 1966. The Keynesian Revolution. 2d ed. New York: Macmillan. 1975 (with Gary Fromm). The Brookings Model. Hoboken, N.J.: Wiley. 1983. The Economics of Supply and Demand. Baltimore: Johns Hopkins University Press.   (0 COMMENTS)

  The British economist John Hicks is known for four contributions. The first is his introduction of the idea of the elasticity of substitution. While the concept is difficult to explain in a few words, Hicks used it to show, contrary to the marxist allegations, that labor-saving technical progress—the kind we generally have—does not necessarily reduce labor’s share of national income. His second major contribution is his invention of what is called the IS-LM model, a graphical depiction of the argument John Maynard Keynes gave in his General Theory of Employment, Interest and Money (1936) about how an economy could be in equilibrium with less than full employment. Hicks published it in a journal article the year after Keynes’s book was published. It seems safe to say that most economists became familiar with Keynes’s argument by seeing Hicks’s graph. Hicks’s third major contribution is his 1939 book Value and Capital, in which he showed that most of what economists then understood and believed about value theory (the theory about why goods have value) can be derived without having to assume that utility is measurable. His book was also one of the first works on general equilibrium theory, the theory about how all markets fit together and reach equilibrium. Hicks’s fourth contribution is the idea of the compensation test. Before his test, economists were hesitant to say that one particular outcome was preferable to another because even a policy that benefited millions of people could hurt some people. Free trade in cars, for example, helps millions of American consumers at the expense of thousands of American workers and owners of stock in U.S. auto companies. How was an economist to judge whether the help to some outweighed the hurt to others? Hicks asked if those helped could compensate those hurt to the full extent of their hurt and still be better off. If the answer was yes, then the policy passed the “Hicks compensation test,” even if the compensation was never paid, and was judged to be good. In the auto example economists can show that the dollar gains to car buyers far outweigh the dollar losses to workers and stockholders, and therefore, by Hicks’s compensation test, free trade is good. In 1972 John Hicks and kenneth arrow jointly received the Nobel Prize for economics “for their pioneering contributions to general economic equilibrium theory and welfare theory.” Educated at Balliol College, Oxford, John Hicks returned there as the Drummond Professor of Political Economy, a post he held until his retirement in 1965. In 1935 he married the economist Ursula Webb. He was knighted in 1964. Selected Works   1937. “Mr. Keynes and the ‘Classics.’” Econometrica 5 (April): 147–159. 1939. “The Foundations of Welfare Economics.” Economic Journal 49 (December): 696–712. 1939. Value and Capital. Oxford: Clarendon Press. 1940. “The Valuation of the Social Income.” Economica 7 (May): 105–124. 1965. Capital and Growth. Oxford: Clarendon Press. 1973. Capital and Time: A Neo-Austrian Theory. Oxford: Clarendon Press. 1974. The Crisis in Keynesian Economics. Oxford: Basil Blackwell.   (0 COMMENTS)

  Gustav Cassel, a Swedish economist, developed the theory of exchange rates known as purchasing power parity in a series of post-World War I memoranda for the League of Nations. The basic concept can be made clear with an example. If US$4 buys one bushel of wheat in the United States, and if 120 Japanese yen exchange for US$1, then the price of a bushel of wheat in Japan should be 480 yen (4 × 120). In other words, there should be parity between the purchasing power of one U.S. dollar in the United States and the purchasing power of its exchange value in Japan. Cassel believed that if an exchange rate was not at parity, it was in disequilibrium and that either the exchange rate or the purchasing power would adjust until parity was achieved. The reason is arbitrage. If wheat sold for four dollars in the United States and for six hundred yen in Japan, then arbitragers could buy wheat in the United States and sell it in Japan and would do so until the price differential was eliminated. Economists now realize that purchasing power parity would hold if all of a country’s goods were traded internationally. But most goods are not. If a hamburger cost two dollars in the United States and three dollars in Japan, arbitragers would not buy hamburgers in the United States and resell them in Japan. Transportation costs and storage costs would more than wipe out the gain from arbitrage. Nevertheless, economists still take seriously the concept of purchasing power parity. They often use it as a starting point for predicting exchange rate changes. If, for example, Israel’s annual inflation rate is 20 percent and the U.S. inflation rate is 4 percent, chances are high that the Israeli shekel will lose value in exchange for the U.S. dollar. Cassel was a professor of economics at the University of Stockholm from 1903 to 1936. His dying words were, “A world currency!” Selected Works   1921. The World’s Monetary Problems. London: Constable. A collection of two memoranda presented to the International Financial Conference of the League of Nations in Brussels in 1920 and to the Financial Committee of the League of Nations in September 1921.   (0 COMMENTS)