Discussion on the first post in this series went really well, so I’m carrying on. Here’s the proposed introduction.¹ Again, comments, both favorable and critical are very welcome and the best will be rewarded with a copy of Dead Ideas from New Economists (I’m back with the original title at present).

Introduction

The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. JM Keynes

It might be thought, more than 200 years after Adam Smith’s Wealth of Nations set out the classical framework that still guides much economic thought, that economics might have progressed beyond the stage conflict over basic ideas. But economic ideas do not develop in a historical vacuum. Big changes in economic thinking depend on major events such as economic crises, and such events occur only rarely.

The Great Depression of the 1930s was such a crises and it produced a revolution in economic thinking still associated with the name of its originator, John Maynard Keynes. Responding to what he perceived as the absurdity of a classical economic theory proclaiming that a market economy would inevitably return to full employment ‘in the long run’, Keynes observed tartly that ‘in the long run we are all dead’. In his General Theory of Employment, Interest and Money, Keynes developed a model of the economy in which high levels of unemployment could represent a persistent equilibrium. The classical full employment model was reduced to a special case of Keynes ‘General Theory’.

In the hands of Keynes’ successors, such as John Hicks, the Keynesian model of the aggregate economy became the new subject of ‘macroeconomics’, contrasted with the classical model of individual makrets, now christened ‘microeconomics’. Hicks produced a graphical synthesis of Keynesian and classical macroeconomic ideas, taught to generations of students as the IS-LM model after the two curves on which it relied. In the process, Hicks relied heavily on some of Keynes’ ideas, but ignored or discarded others, much to the dismay of more purist Keynesians such as Joan Robinson.

Whether or not it was entirely true to Keynes, the Hicks synthesis produced a theoretical framework to justify policies Keynes had long advocated, of using public works programs and other fiscal policy (that is, changes in tax rates and public expenditure) measures to stimulate demand for goods and services during periods of recession. Conversely, as Keynes argued in How to Pay for the War, the government should use budget surpluses in periods of strong economic growth to restrain demand and reduce the risk of inflation.

The combination of Keynesian macroeconomics and neoclassical microeconomics provided both an ideological justification for the ‘mixed economy’ that emerged after World War II and a set of practical policy tools for its economic managers. The mixed economy was, arguably, the first and most successful example of a ‘Third Way’ between the traditional antagonists of socialism and unrestrained capitalism. The increased macroeconomic role for government went hand in hand with the postwar expansion of the welfare state, already anticipated by such developments as the New Deal in the United States, and the anti-depression policies of social-democratic governments in such far-flung countries as Sweden and New Zealand.

The contrast between the privations of the Depression and war years and the prosperity of the 1950s and 1960s was striking, and transformed the political landscape in the developed world. The laissez-faire doctrines of economic liberalism were discredited, seemingly forever. While conservative parties continued to employ the rhetoric of the free market, the social-democratic reforms adopted in response to the Depression formed the basis of political consensus.
For the next thirty years, the combination of Keynesian macroeconomics and the liberal and social democratic versions of the welfare state were associated, at least in the developed world with strong economic growth, full employment, enhanced equality and improvements in public services of all kinds. It was these developments, and not the posturing of the Reagan era, that guaranteed the defeat of Communism.

During these decades, the victory of the Keynesian revolution was universally recognised and generally perceived as final, despite the grumbling of a relative handful of neoclassical critics, centred on the University of Chicago, and, on the left, an even smaller handful of post-Keynesians and Marxists who derided the new synthesis and its tools as ‘hydraulic Keynesianism’ and ‘a permanent war economy’.

But by the late 1960s, a counter-revolution was brewing. Inflation rates were rising, and the most compelling analysis of the problem was provided by Chicago economists such as Milton Friedman, who argued that expansion of the money supply would inevitably cause inflation, whatever fiscal policy responses Keynesians might propose.

The economic chaos of the early 1970s, including the breakdown of the ‘Bretton Woods’ postwar system of fixed exchange rates, the OPEC oil shock was seen as vindicating Friedman. The biggest blow to Keynesianism was ‘stagflation’, the simultaneous occurrence of high unemployment and high inflation. In the standard Keynesian model of the day, which postulated a trade-off between unemployment and inflation (the famous ‘Phillips curve’), this could not occur. Friedman’s model, which took into account expectations of inflation that were incorporated into wage bargains, appeared to explain stagflation.

In the space of a few years, Friedman’s ‘monetarist’ macroeconomic policies had largely displaced Keynesian demand management. But the counter-revolution did not stop there. In macroeconomic theory, Friedman’s relatively modest (and empirically well-founded) changes to the Keynesian IS-LM model were succeeded by a full-scale return to the orthodoxy of the 19th century, under the banners of ‘rational expectations’ and ‘new classical’ macroeconomics.

Friedman’s macroeconomic success prompted widespread acceptance of the free-market views on microeconomic issues he had long advocated both in academic research and in popular works such as Free to Choose and Capitalism and Freedom. Other advocates of the free market such as FA von Hayek enjoyed a similar vogue. The new version of free market ideology that emerged from the 1970s has been given various (mostly pejorative) names such as neoliberalism, Thatcherism and economic rationalism. I prefer the more neutral term ‘economic liberalism’.

Speculative activity in financial markets had been seen by Keynesians as a crucial source of economic instability. During the Bretton Woods stringent controls were imposed on national financial markets and international capital flows. During and after the monetarist counter-revolution, these controls broke down, ushering in an era of financial deregulation. Over the ensuing decades, the financial sector, a minor and tightly controlled industry during the postwar years, experienced an explosion in the volume and complexity of trade, the profitability of the industry and the lavish rewards to industry participants.

This development called for, and received theoretical support from the economics profession in the form of the efficient markets hypothesis. Building on the relatively innocuous observation that the efforts of stockmarket ‘chartists’ to predict the future movements of stock prices from their past behavior were futile, the efficient markets hypothesis was developed to the point where it was seriously suggested, in the wake of the September 2001 attacks, that the best way to predict terrorist attacks would be to open a futures market.

The general acceptance of the anti-Keynesian counter-revolution was predicated first on the necessity for a way out of the economic chaos of the 1970s and early 1980s and then on the widespread prosperity it delivered from the 1990s onwards. Although problems became steadily more evident, they were ignored as long as profits kept rising and economic growth kept on keeping on.

The economic crisis that began in the US housing market in 2007 and had engulfed global financial markets by late 2008 showed clearly enough that there was something wrong with the dominant economic paradigm. While old-fashioned Keynesians on the left, and advocates of the Austrian School on the right, had pointed to growing economic imbalances as a source of impending disaster, economic liberals continued until well into 2008 to argue that any problems were minor and easily contained.

While it may be satisfying to observe that so many experts got the crisis wrong, it is not really useful. The big question is “What economic doctrines have been refuted by the crisis and what new doctrines (or improved versions of older doctrines) should replace them?”. This book aims to answer the first of these questions, and to provide at least some suggestions on the second.

¹ I’ve been out of order so far, but, after correcting with this post, I plan to offer excepts in the order I want them to appear.