September 12, 2013 columns

Karl Polanyi’s Battle with Economic History

Karl Polanyi’s The Great Transformation provides a foundation for much anti-market rhetoric. The problem is, the book’s claims don’t hold up.

Matt Bruenig at Demos recently criticized libertarian support for free markets by arguing that a market oriented economy and modern economic mentalities are relatively recent inventions. He argues that prior to the eighteenth century economic mentalities like profit and utility maximization, or economic rationality, were absent from human societies. Instead, people were motivated by other goals. Libertarians, Bruenig asserts, are battling with history when they assume constant economic mentalities over the ages.

Bruenig uses “the insights of the famed” Karl Polanyi to demonstrate that libertarians are wrong to suppose that pre-modern humans had modern economic mentalities. Polanyi’s claim that human economic mentalities were recently changed by government edict in the early eighteenth century, the beginning of the modern age, implies that those mentalities can be changed again by an additional edict. The only problem with Polanyi’s thesis is that the specific historical evidence he musters does not withstand even mild historical and economic scrutiny.

Published in 1944, The Great Transformation used to be standard reading for economic historians. By the time I earned my MSc in Economic History from the London School of Economics, however, only 13 pages of Polanyi’s work were included on the recommended reading list. The required reading list, however, was filled with journal articles tearing apart Polanyi’s thesis with historical economic evidence.

Polanyi’s theories are an example of a once-popular economic history that has been systematically dismantled by superior economic historians. In short, his theories are interesting because they are wrong. The Great Transformation is relegated to the role of a foil routinely slayed by economic historians to the great amusement of students. Polanyi’s work does not offer a sound foundation upon which to criticize libertarian understandings of history.

Karl Polanyi

Polanyi’s thesis is that modern economic mentalities like self-interest, utility maximization, and profit maximization are not natural to humans and are the recent creation of strong governments. Polanyi wrote, “[i]n spite of the chorus of academic incantations so persistent in the nineteenth century, gain and profit made on exchange never before played an important part in human economy” (Polanyi, 52). Polanyi continues by writing that Adam Smith’s famous quote about mankind’s “propensity to barter, truck, and exchange one thing for another … yield[ed] the concept of the Economic Man. In retrospect it can be said that no misreading of the past ever proved more prophetic of the future. For while up to Adam Smith’s time that propensity had hardly shown up on a considerable scale in the life of any observed community” [Ibid].

According to Polanyi, pre-modern humans did not behave according to a profit-maximizing model and were very different from the later evolved homo economicus, who supposedly behaves as a rational utility maximizer in all economic circumstances. What were the economic mentalities of pre-modern humans identified by Polanyi? Reciprocity and redistribution—primarily through gifts intended to cement social, familial, and political relationships according to conservative norms of established tradition.

There are numerous historical examples of pre-modern humans who possess modern economic mentalities. Virtually all of the examples Polanyi uses are based on selective or poor historical evidence that, under careful examination, shows humans having consistent modern economic mentalities throughout recorded history. Any modern devotee of Karl Polanyi will have to present serious counter-evidence or concede that Polanyi was wrong.

Douglass North

Douglass North is a famed economic historian, Nobel laureate, left-winger, and proponent of Cliometrics. He has also criticized Polanyi’s conclusions in The Journal of European Economic History. North’s points were: First, Polanyi selectively chose historical events to support his thesis while ignoring others that offered counter-evidence. Second, all economies have elements of reciprocity, redistribution, and markets. To claim that private reciprocity and redistribution play no part in a market economy is simply incorrect. Third, “gifts” are a poor way to describe the economic exchanges detailed by Polanyi. “Bribe” is a more accurate term because they were designed to decrease transaction costs—something that economically rational humans do in the absence of courts and more developed institutions.

North implored his fellow economic historians to investigate Polanyi’s claims and many heeded his call. The following is a small but representative sampling of the results.

Babylon and the Middle East

In The Livelihood of Man, Polanyi claimed that the ancient Middle East had an economy dominated by palaces and temples where prices were not regulated by supply and demand. In international trade, the state dominated through what was called “treaty trade,” where prices were set in advance via treaties and trade was carried out through temple priests who had otherworldly, rather than material, motivations.

As Morris Silver points out in the Journal of Economic History, the ancient Middle East provides great examples of vast markets with variable prices based on supply and demand. Written documents from the period detail market transactions. In one such situation, the price of tin rose 20 percent in a short period—contradicting Polanyi’s fixed-price theory of trade. Other texts in Babylonia from merchants to their agents order them to sell “according to the market”—odd texts in a regime of supposed fixed prices.

Polanyi also asserts that Babylon and other Middle-Eastern governments controlled the price of grain inside their economies as a form of redistribution. In fact, there is no evidence that governments at that time controlled the price of grain, but there is evidence of grain markets with prices changes based on—wait for it—supply and demand. Prices in a “good year” fall and prices in a “bad year” rise, according to the size of the harvest. That behavior is difficult to explain if prices are not determined through the interaction of profit-maximizing buyers and sellers.

Much agricultural land was privately owned, and Silver presents evidence that investments in land improvements were based on expected profits with considerations of opportunity cost and interest. During the dynasty in Ur from 2112-2004 B.C., land was likely owned and operated by organizations similar to firms or larger family units—not as quasi-collective farms as Polanyi implies. Prices for the renting and sale of land are also based on estimated productive capabilities, local interest rates, and the prices of agricultural commodities. Consequently, there is little discernible difference between Babylonian economic mentalities compared to people in other times. Silver provides even more numerous examples in his paper.

Inflation also occurred in the ancient Middle East. Phoenician importations of gold and silver from mines in Spain via tribute stimulated inflation in the Assyrian empire (Aubet 84), which does not make any sense unless traders are profit maximizing. If prices are set and maintained according to tradition, then by what mechanisms does an increase in the quantity of money affect prices? A sticky-price explanation doesn’t explain this result; it might only explain the rate of change.

Wen-Amon’s account of travelling from the Egyptian court to Phoenicia on a trading mission during the end of the Egyptian 20th or beginning of the 21st dynasty records 70 different trading vessels from different city-states or kingdoms owned by hbr (Semitic languages at that time didn’t use vowels). According to etymologists of ancient Middle-Eastern languages, hbr has equivalents in Ugaritic and Hebrew that are translated to mean “syndicate, company, or trading partnership” (Aubet 114-115).

Hbr were a form of public-private partnership. Governments of the time would partner with merchants to gain revenue while the merchants sought government involvement in their enterprises as a means of insurance. Governments were large enough to absorb the risks of long-distance international trade. Before insurance developed, even the wealthiest merchants could be bankrupted by sea disasters, violence, or expropriation of property by states. Public-private partnerships spread the risk of those expeditions and simultaneously decreased the risk of expropriation due to violence.

If merchants in Kingdom X and Kingdom Y are engaged in public-private trading operations between each other then there is a much smaller chance that either Kingdom will expropriate the property of the other Kingdom’s traders when in their port. If Kingdom X expropriates the property partly owned by Kingdom Y, the latter can just take the former’s property next time they arrive in port. Since there are an indeterminately large number of transactions going forward, both sides default to the Folk Theorem and implicitly agree not to steal the other Kingdom’s property. This is similar to how trade between Genoese and Venetian merchants led to the development of modern commercial contract enforcement.

Trading ships were owned by wealthy merchants who sought high profits that they shared with monarchs (Aubet 115-116). Wealthy merchants in Phoenician city-states sat on governing councils to provide a political counter-balance to monarchs, protect their property rights, and consider public-private profit opportunities. This is an example of government-supported cartels and rent-seeking, not laissez-faire capitalism, but profits were the goal and the economic mentalities of all parties involved do not differ from today although some institutional incentives are very different.

Use of money is not recorded in international trade annals back then, but most exchange was local. Money was likely used only in local markets at this time. Lydia is credited with having the first coinage in the 6th century B.C. but that is likely untrue (Aubet 141). There is much evidence of pre-Lydian coinage in Assyria, Babylon, as well as monetary experiments elsewhere (Aubet 141-142). That’s why city-states like the Phoenicians that specialized in international trade adopted coinage later than their neighbors.

Prices in the ancient Middle-East shifted according to supply and demand while an increase in the quantity of money drove prices up over the centuries. Farmers and traders search for profit opportunities and changed their market behavior guided by economic mentalities indistinguishable from our own.

Dahomey

Polanyi wrote another book entitled Dahomey and the Slave Trade: An Analysis of an Archaic Economy that attempted to apply his principles toward analyzing the economic system of the West-African states of Dahomey, Allada, and Whydah from the mid-seventeenth to the late-nineteenth centuries. Central to Polanyi’s thesis was that the kings of Dahomey established fixed prices and exchange ranges into foreign currencies. Polanyi alleges that those prices controls and fixed exchange rates were stable substitutes for prices set by supply and demand. As the theory goes, the inhabitants of those kingdoms and the monarchs were more concerned with maintaining a traditional economy and traditional prices than maximizing profits.

The only problem with Polanyi’s thesis is that it contradicts the historical price fluctuations for Dahomey—evidence that even existed when Polanyi wrote his book. Robin Law wrote in The Journal of African History details the price swings in goods and commodities. Seasonal price variations based around the harvest season—including price falls during gluts and price increases during poor harvests—are recorded and available to economic historians. The slave trade in Dahomey also produced price changes based on supply and demand, with large increases in the supply of slaves lowering the price, a dearth making it spike, and more European purchasers increasing the quantity demanded. In even this horrific market, the rules of supply, demand, and profit maximization seemed to hold.

Law also explained that kings of Dahomey did not enforce fixed exchange rates to maintain tradition—they used them as a source of revenue through debasement. At that time in West Africa, the local currency was a string with 40 cowry shells affixed. The king would take 3 or 6 shells off of the string as a tax, similar to how European monarchs in the Middle Ages debased coins by clipping their edges. Money contained fewer shells and less precious metal, spurring inflation. The price controls and exchange rates of Dahomey failed as Africans and Europeans raised their prices to cover the lower purchasing value of money caused by the debasement—just as rational profit maximizing humans do.

Bohemia

Polanyi was born in Vienna in 1886. Northwest of Polanyi’s birthplace in the province of Bohemia, peasants behaved like the rational profit and utility maximizers they were. As Sheilagh Ogilvie of Cambridge details in The Economic History Review, historians of Polanyi’s persuasion assumed that Eastern European peasants did not have modern economic mentalities and were instead naturally collectivists. According to evidence from peasant behavior on the Bohemian Estate of Frieldland between 1583 and 1692, peasants were highly individualistic, entrepreneurial, and as rational as people in the modern age. The peasants were, however, constrained by the feudal institutions of their day.

Peasant work habits depended upon their opportunity costs while investment and business opportunities changed their behavior in predictable ways. Written records show that peasants travelled long distances to take advantage of arbitrage opportunities, frequently dealt with three different currencies and shifting exchange rates, and understood the monetary value of time and acted to maximize their economic gain from it.

Government created monopolies resulted in laws that imprisoned peasants for illegal trading while government tolls, taxes, and expropriation of private property kept the peasants poor. Peasants reacted to these measures by engaging in illegal trading and shifting productive activity away from high tax activities into low-tax ones. Bohemian peasants behaved as we would expect modern economic actors to behave. The economic mentalities of the Bohemian peasants are recognizable to 21st century people.

Ancient Regime France

Prior to the evolution and adoption of capitalist institutions, creditors found ways to lend money to debtors in Ancient Regime France according to a paper by Phillip Hoffman and others in The American Historical Review. Lending and borrowing money is risky for both parties. For the borrower, the planned use for the borrowed funds may not produce enough extra revenue to pay the interest on the loan. For the creditor, the borrower may skip town with the money.

Rational lenders in Paris thus sought to minimize the risk of lending to dishonest borrowers. Their solution was to involve notaries who were able to match honest borrowers with honest creditors. Notaries were very busy at this time and had specialized knowledge of potential borrowers and creditors who were honest. Since notaries were able to link the two together, this lowered transaction costs, increased the return to savings and accumulating capital, and made loans available to many—mainly for mortgages and business expansion.

A credit market allowed businesses to expand with loans instead of relying upon accumulated profits, meaning the borrowers anticipated their future profits with the investment and compared them to the cost of borrowing. Creditors also compared various lending opportunities and changed interest rates based on the perceived riskiness and anticipated rate of return. In other words, modern economic mentalities were so alive and well in Ancient Regime France that creditors and borrowers helped create institutions to facilitate credit transactions.

Thailand

From 1800 to 1913, Thailand gradually opened its markets to the world economy. A rising standard of living was one good consequence of this policy shift but an even better one was the decline of slavery in Thailand. David Feeny’s paper in The Journal of Economic History describes how reactions to international prices incentivized Thailand’s population to rationally adjust to economic opportunities, injuring the slavery market in the process. Thailand’s government then finally outlawed it.

Thailand was a major rice producer. After liberalization, high international prices drove an expansion in Thai rice exports. The economy shifted from an abundant land and scarce labor economy to a scarce land and abundant labor economy. The high rice prices made farm land more valuable, thus incentivizing the cultivation of new land to grow more rice. The scarcity of land increased relative to labor. The major constraint for increasing rice cultivation was land, not labor.

As a result of the shift in relative factor prices, the complexity of rules governing land ownership increased and the rules governing ownership of slaves decreased over the course of the nineteenth century. As ownership of slaves became less important for the growing rice industry, rules governing their ownership and exchange became less important and gradually simplified.

People make increasingly complex rules to govern the ownership and exchange of scarce goods and factors. Meanwhile, rules that regulate the ownership of abundant factors generally become less complex over time. If the factor is abundant and the price is low, disagreements over ownership are less likely to occur and less likely to lead to severe problems. For example, fewer people would care if a farmer scoops water out of the Mississippi to irrigate crops than if a farmer would take ground water in an arid Western state for the same purpose. Scarcer water means more complex rules that are more stringently enforced. The same process occurred for land and slaves in Thailand.

Thais reacted rationally to Thailand’s changing economy. As Thailand’s exports of rice increased under favorable terms of trade, workers left cities and actually moved to the countryside to work in agriculture, responding to rising rural incomes and the incentives of higher wages. The decline of slavery in the market, the private creation of rules regulating land, increased cultivation, the movement of workers to the country-side, and the decline of slavery were all rational economic reactions to a changing economy. Thais had the modern economic mentality.

A Note About Rationality in Economics

Behavioral economics has certainly shown that humans are not perfectly rational and we have persistent biases that cloud our reason. The works of Richard Thaler, Daniel Kahneman, and Amos Tversky have most influenced me. As Thaler wrote, human economic mentalities behave in a framework of bounded rationality, bounded will power, and bounded self-interest. Rational choice theory explains a lot of economic behavior but also leaves large gaps unexplained that are being plugged by behavioral economists and psychologists. Those caveats and exceptions aside, our modern economic mentalities explain quite a lot of human behavior today and in older civilizations.

Conclusion

The examples here and others not listed discredited Polanyi’s work for the vast majority of economic historians regardless of political persuasion. His work actually lends itself to easy refutation because his thesis is so broad and all-encompassing—namely, that modern economic behavior was essentially invented in the last few centuries. Such a general statement is refuted by a single counter-example but I have instead provided many.

Mr. Bruenig can certainly do better than to cite a discredited work of economic history written in the first half of the twentieth century to argue his point. Libertarians are not the ones battling history. That dubious prize seems to belong to those who still look to The Great Transformation and the other works of Karl Polanyi as sources that accurately describes mankind’s pre-modern economic mentalities.

Culture certainly impacts economics, mainly by creating institutions that incentivize or disincentivize certain types of behavior or create relative inelasticities of demand, but economics also changes cultures and norms of behavior—especially in business. British firms that lost out to better managed Indians firms during colonization is a classic example.

Polanyi likely confused different institutions that lower transaction costs, like the pre-modern credit markets in Paris and the so-called gift economics in primitive societies, or that serve as a substitute for insurance markets like the public-private partnerships of Phoenicia, with an entirely different form of human economic reasoning. Those eras and places developed different institutions that provided incentives to facilitate private profit and utility maximizing economic exchange. Underneath them, the same people with the same profit and utility seeking economic mentalities existed. The peculiar economic mentalities of people seem to be a constant throughout history rather than a result of a relatively recent government edict.

 

References

Aubet, Maria Eugenia.  The Phoenicians and the West: Politics, Colonies, and Trade

Polanyi, Karl.  The Great Transformation: The Political and Economic Origins of Our Time.  First Beacon Paperback edition published in 1957.