A Short History in Economic Thought...

John Maynard Keynes and Friederich Von Hayek. Remember these two names for they are the fathers of two of the most prominent economic schools of thought. They are also the theorists of two viewpoints that are in direct contrast with each other.

“Why should I care?”

Answer: Understanding their views will help you understand current courses of action (or lack of) by our government in response to the recent financial crisis. I’ll try to keep this simple…

John Maynard Keynes is most well associated with “Keynesian economics”. In the simplest explanation, Keynesian economics would be - “government intervention” in the markets. The argument is that, sometimes the private sector (anything not a part of the government) doesn’t do a good enough job and makes mistakes; therefore, the public sector (the government) has to step in to help stabilize things. This is done through short-term stimulus during the bad times in hope of bolstering long-term growth, then saving surpluses during good times. This sounds relatively simple and not too involved, right? Just like a drug addict; however, you have to wonder if/how such stimulus can be pulled and whether or not governments can actually relinquish their positions of control after having stepped in.

Consider that the economies of the Soviet Union, China, and much of Europe during the 30s, 40s, and 50s were overly involved in the aspects of their respective economies. Setting prices on everything from wages and the price of commodities (grain, oil, metals, etc.) and/or either owned or took control of the major industries of the economy (railroads, steel, oil, coal, telephones, etc.). They took responsibility for the distribution of goods and social welfare (sometimes referred to as “central planning”). During the Great Depression, these European and Asian countries actually flourished while the capitalistic and free market oriented United States floundered. It would not necessarily be fair to say that Keynesian economics results in socialism or communism; however, many of the practices of Keynesian economics can be found in countries with such governmental systems.

For the U.S., Keynesian economics took front and center stage when President Franklin Delano Roosevelt (FDR) took office. FDR initiated massive government intervention during the Great Depression (The New Deal) – employing the unemployed to build highways, bridges, dams, airports, railroads, etc. It was one of the largest expansions of infrastructure in our history. All paid for by the government and via debt. Then World War II occurred and we produced bombers, tanks, bullets, and bombs. Again, all paid for by government debt. See the chart below for a visual on how much government spending went on during that time without the revenue to back it up. Wow!

The Great Depression ended with the advent of WWII. Post-WWII saw the return of economic prosperity. Keynesian economic thought was on the upswing and was held up as the reason for the return to prosperity. Thus, the government continued on instituting Keynesian ideals and practices in the economy until the mid-to-late 1970s. Organizations like the IMF were born out of the Keynesian movement after WWII.

Friedrich Von Hayek could most be identified with “free market” economics – unconstrained from the hand of government meddling. His groundbreaking work, The Road to Serfdom, was a response to much of what he saw wrong with central planning and the European socialist systems around him during the 30s and 40s. If you’ve heard the term “laissez-faire” (meaning “let it be” or “hands off”) regarding economics, his ideas of free market economics support a similar viewpoint. Hayek wasn’t completely government averse, he believed the government did have a role to play with monetary policy and work-hours regulation, but only a small role. The major force of his arguments; however, was that market forces should be unleashed and unhindered. Then, and only then, will we have truly optimal efficiencies and prices in the markets. Similar to the tide of an ocean, unleashed markets are not meant to be controlled, but rather one is to come alongside and flow with the tide of the market forces

However, because of the prominence and seeming success of the Keynesian approach from the 1940s to the 1970s, Hayek was vilified by the economic establishments and his ideas mostly disappeared into obscurity in the economic world. His work did find favor with the London School of Economics and the University of Chicago; however, where he worked during that time and a small but growing underground of free market economists began to emerge. Milton Friedman was a student of his and also helped popularize the ideas of the free markets in the 70s and 80s.

During the 1960s and 1970s, the governments of the United States and the United Kingdom became more and more involved in the affairs of the economy. By the time Richard Nixon was in office, a crisis was growing as inflation and unemployment was a huge problem – known as “stagflation” (ironically, Keynesian economics suggests that inflation and unemployment cannot occur if proper planning and intervention are in place). True to Keynesian economics, the government stepped in and set maximum prices on goods and commodities as well as wages. However, the basic principles of supply and demand overwhelmed the price ceilings and shortages occurred. Farmers, for instance, stopped selling because the prices set for their goods did not cover their costs of producing. The same was true for oil. Shortages were such a constant thing that the government initiated a rationing system for fuel for vehicles.

Similar problems were also occurring in the United Kingdom. However, in 1979, a woman by the name of Margaret Thatcher (an adherent of Hayek’s free market principles) was elected as British Prime Minister. She set out to release many of the government entities, or government supported entities (coal, steel, airlines, railroads, electricity, etc.) to the private sector through deregulation – freeing them to market forces. At almost the same time Ronald Reagan was elected President in the U.S. Reagan, like Thatcher, was a believer in free market economics and begin enacting policies to free up markets to perform on their own without government controls. What we saw was massive deregulation of many markets, privatization, and dismemberment of many monopoly type institutions. Over time, competition and market forces brought about stabilization to prices and the economy began to recover. With the U.K. and U.S. leading the way in prosperity, other nations begin to follow suit in enacting free market policy in the 1980s and 1990s.

History is quite interesting – and not without its irony. We’ve had wild swings in these two viewpoints: From the success of early 1900s free market capitalism to its collapse in the 30s, to the success of socialism and communism beginning in Europe and Asia in the 30s and the success of Keynesian economics from the 40s in the U.S. to its collapse in the late 70s, to the emergence of free market capitalism from the 80s to the 2000s.

Present day? What would you guess? We are seeing a swing back away from free market capitalism and much more governmental involvement. Courtesy of our financial crisis, the government has stepped in and “rescued” many failing organizations with bailouts. It has propped up home owners and banks by taking care of bad mortgages. It has provided money to state governments for spending on infrastructure. We are crossing the dividing line and moving back to Keynesian economic viewpoints. Even in the White House, Lawrence Summers, Assistant to the President for Economic Policy and Director of the National Economic Council; and Christina Romer, Chair of the Council of Economic Advisors (it was actually just announces that Christina Romer is stepping down to return to teaching) are both outspoken Keynesian economists and huge influencers of the President.

So here’s the trillion dollar question (I bet some of you have been thinking it)…it is the question that has been asked a lot as of late: “Are we better off over the past few years having had the government inject stimulus via bailouts and taking an activist role in intervening in the markets?” There is much debate about this. I won’t go into it here. Ultimately, what’s done is done, “it is what it is” as the saying goes.

The greater issue at play is: “how will the embracing of the Keynesian economic viewpoint by our government affect our economy and financial system in the long-run?” Will it spur economic growth or just create more unserviceable national debt? How much longer can we try and spend our way out of a crisis? Can the government stop its spending habits once we get out of our mess or, like a crack addict, will it have an incredible taste for spending that it cannot wean itself from?

Thoughts and questions for your consideration…