[From the Austrian Economics Newsletter, Spring 1987]
The Austrian School of economics did not develop out of thin air. It built upon the work of a number of other economists and philosophers going back as far as Aristotle. Among the precursors of the Austrian School were a number of Spanish and Italian scholastic economists.
Several early Italian economists influenced the development of continental European economic thought in the centuries before Carl Menger.
Gian Francesco Lottini (1512–1572) had a rough idea that people value present wants higher than future wants — the basis of time-preference theory. Bernardo Davanzati (1529–1606) applied subjective-value theory to money, and solved the “paradox of value.” He also pointed out that the price increases of his time were caused by the influx of gold from America, thus anticipating the quantity theory of money. Geminiano Montanari (1633–1687) had a fairly well developed quantity theory of money, and realized that there is a subjective factor involved in the valuation of money.
The Italian economist who had perhaps the most influence on the Austrian School was Ferdinando Galiani (1728–1787). Born in Chieti, he became a leader of the Italian Neopolitan School. His economic thinking was influenced by Aristotle, Davanzati, Locke, and Montanari, among others.
Galiani is most noted for his contributions to value theory, interest theory, and economic policy, topics that were explored a century later by Menger, Böhm-Bawerk, Jevons, Walras, Marshall and the German Historical School.
He recognized that there was a dichotomy between utility and scarcity, a concept that had been kicked around by philosophers since Aristotle. His most notable work, On Money, was written when he was in his early 20s, but was not widely read then because it was available only in Italian. It is in that treatise that his interest and subjective-value theories were included.
In the mid-19th century, Francesco Ferrara, another Italian, expanded on the subjective value theory and, according to Buchanan, surpassed the subjective-value theorists in some respects.
Galiani observed that a commodity’s price regulates consumption, and consumption regulates price. As the price of a commodity falls, the demand for it increases, and vice versa. If a country producing and consuming 50,000 barrels of wine is suddenly invaded by a foreign army, the price of wine will go up because there are now more people to drink it.
The value of a good is not intrinsic; it is a calculation or ratio between goods that people make in relation to other goods. Men compare one good to another, and make an exchange only when their level of satisfaction will be equal as a result of the exchange. (Adam Smith and others have improved on this view, by observing that an exchange takes place when the value given up is subjectively less than the value received.) These views seem elementary now, but they were not so elementary when Galiani made them two centuries ago.
He also recognized the existence of the elasticity of demand. If the price of shoes increases, consumers can delay purchasing a pair and continue to wear the shoes they already have until the price comes down. But if the price of grain rises, consumers will continue to buy bread anyway. Otherwise, they would starve. The demand for shoes is highly elastic, whereas the demand for grain is inelastic. Marshall made a similar observation a century later.
Galiani also recognized the existence of a relationship between the price of a good and the demand for it. Rich people can afford a good that poorer people cannot. As the price of a good decreases, people from the less-affluent income categories begin to purchase it, thus increasing total demand. If the price rises, some of these people will stop buying it.
The rich make some purchases because it is fashionable to do so, even though the good purchased has little or no utility. It is fashionable to purchase diamonds, and unfashionable to purchase water or air. That is one reason why diamonds have a high price and water and air have a low price (or no price). This example also shows that there is a difference between value and utility. He realized that value is not intrinsic but subjective. A good’s price varies with the taste and purchasing power of each individual.
Galiani was also aware of the law of diminishing marginal utility. When Davanzati stated that a living calf is both nobler and cheaper than a golden calf, and that a pound of bread is more useful than a pound of gold, Galiani replied that “useful” and “less useful” are relative concepts, and depend on individual circumstances.
For someone who is in need of both gold and bread, bread is more useful. Choosing gold over bread in this case would lead to starvation. But once the individual has eaten his fill of bread, gold would be chosen over more bread. A single egg would be valued more highly by a starving man than all the gold in the world, and would be valued much less by the same man who had just finished eating. Thus, Galiani was aware of the ranking of goods, substitution of goods, and diminishing marginal utility, topics discussed by Gossen, Walras, Jevons, and Menger one hundred years later. Menger was aware of Galiani’s views, as evidenced by his citation of Galiani in his Principles of Economics.
Böhm-Bawerk pointed out that Galiani was the first to see that interest was not a surplus, but is instead a supplement that is needed to equalize service and counterservice. According to Galiani, interest equalizes present and future money. It is a means to compensate for the palpitations of the heart that a creditor must endure until the money is returned. It is a just payment to a creditor for the risk taken. This payment is for the convenience of the debtor, and compensates the creditor for the inconvenience that is incurred by not having the money for a certain period of time. The values are subjectively equal, but numerically different because they are separated by time.
Böhm-Bawerk criticized Galiani’s theory because Galiani viewed interest only as the price of palpitations or the price of insurance. Böhm-Bawerk expounded on the time-preference aspect of interest, an area Galiani neglected.
Galiani believed that government generally should not interfere in the natural workings of the economy. A government that attempts to stimulate all sectors of the economy, agricultural and industrial, stimulates nothing. Stimulation means that a particular sector is given preference over the other sectors, and how can one sector be given preference over another if all sectors are stimulated?
Another aspect of his economic-policy theory is that an economic policy must be formulated by taking time and place into account; an economic policy that may be appropriate in one country or at one time may be inappropriate in another.
Unlike the physiocrats, Galiani argued that agriculture need not always be viewed as supreme. The view that economic models must be adjusted for time and place later became a basic principle of the German Historical School, the school that later debated the validity of Carl Menger’s methodology. But, unlike the German Historical School, Galiani did not reject abstract theory.