APPLIED ECONOMICS A Brief History of Economic Thought Leading to The Main Competing Economic, Philosophical and Political Theories of Our Time

JOHN MAYNARD KEYNES VS. F.A. HAYEK

IN THE BATTLE FOR YOUR MIND AND YOUR LIFE! Economics Science of Economics Marshall High School Mr. Cline Unit One- DB *

• In London, Karl Marx castigated the capitalist system, which he described as exploitative and alienating.

• As a result of Marx concern with class exploitation, from about 1870, attempted to erect a positive, mathematical, and scientifically grounded field objective, and above normative politics.

• After the two world wars of the early twentieth century, John Maynard Keynes led a reaction against governmental abstention from economic affairs, advocating interventionist fiscal policy to stimulate economic demand and growth.

• With a world divided between the capitalist first world, the communist second world, and the poor of the Third World, the post-war consensus broke down.

• Others like Milton Friedman and Friedrich Hayek warned of The Road to Serfdom and the unworkability of socialism, focusing their theories on what could be achieved through better monetary policy and deregulation. * Classical Economics

• Prior to Keynes and Hayek, Economics was viewed in what we refer to today as the classical model, of which you have just seen and heard about.

• This view stated that the economy existed in a state of general equilibrium, meaning that the economy naturally consumes whatever it produces because the needs of consumers are always greater than the capacity of the economy to satisfy those needs.

• And, that individuals produce so that they can either consume what they have manufactured or sell their output so that they can buy someone else's output. This perception rests upon the assumption that if a surplus of goods or services exists, they would naturally drop in price to the point where they would be consumed (Say’s Law, in effect)

• Keynes's theory was significant because it overturned the mainstream thought of the time and brought about a greater awareness that problems such as are not a product of laziness, but the result of a structural inadequacy in the economic system.

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• He argued that because there was no guarantee that the goods that individuals produce would be met with demand, unemployment was a natural consequence.

• He saw the economy as unable to maintain itself at full employment and believed that it was necessary for the government to step in and put under- utilized to work through government spending.

• This access to those savings was done through either;

• Borrowing, or

• Taxing those savings

• Thus, according to Keynesian theory, some individually rational microeconomic-level actions such as not investing savings in the goods and services produced by the economy, if taken collectively by a large proportion of individuals and firms, can lead to outcomes wherein the economy operates below its potential output and growth rate.

* Keynesian Economics

• Prior to Keynes, a situation in which aggregate demand for goods and services did not meet supply was referred to by classical economists as a general glut, although there was disagreement among them as to whether a general glut was possible (Say’s Law)

• Keynes General Theory could be quantified in the following equation:

C+I+G+(X-M)=Y

• C= Consumer Spending • I= Investment • G= Government Spending • X= Total Exports • M= Total Imports • Y= Aggregate Demand

• Keynes argued that when a glut occurred, it was the over-reaction of producers and the laying off of workers that led to a fall in demand and perpetuated the problem. * Keynesian Economics

• Keynesians therefore advocate an active stabilization policy to reduce the amplitude of the , which they rank among the most serious of economic problems.

• The business cycle is the periodic but irregular up-and-down movements in economic activity, measured by fluctuations in real GDP and other macroeconomic variables.

• a branch of economics dealing with the performance, structure, behavior, and decision-making of an economy as a whole, rather than individual markets.

• According to the theory, government spending can be used to increase aggregate demand, thus increasing economic activity, reducing unemployment and .

• Deflation is when the value of currency increases to a point where most people cannot afford it, and there are cash shortages.

• President Franklin D. Roosevelt was heavily influenced by this Keynesian viewpoint, and based most of his economic viewpoints on this philosophy as he tried to deal with the .

* Keynesian Economics

• Keynes argued that the solution to the Great Depression was to stimulate the economy ("inducement to invest") through some combination of two approaches:

1. A reduction in interest rates (monetary policy), and

2. Government investment in infrastructure (fiscal policy).

• By reducing the interest rate at which the central bank lends money to commercial banks, the government sends a signal to commercial banks that they should do the same for their customers.

• Investment by government in infrastructure injects income into the economy by creating business opportunity, employment and demand and reversing the effects of the aforementioned imbalance.

• Governments source the funding for this expenditure by borrowing funds from the economy through the issue of government bonds, and because government spending exceeds the amount of tax income that the government receives, this creates a fiscal deficit.

* Keynesian Economics

• This central planning of the economy, when and how much to borrow, and when and where to spend government money, means that a highly trained intelligentsia has to be in charge of the government.

• Summary of Keynesian Economics (as seen in the video “Fear the Boom and the Bust”)

• In a theoretical ideal economy wages would go up and down with supply and demand and should lead to optimized employment.

• In reality wages tend not to go down much (sometimes they do, but generally people are laid off instead), and pay raises are often only annual and even then they tend to move slowly. This is stickiness.

• It then follows that by wages not reacting to market forces, employment will be less optimized.

• When times are good, staff may not be paid as much as they are "worth", which may prevent people who do not need to work being tempted back into employment. * Keynesian Economics

• Summary of Keynesian Economics (as seen in the video “Fear the Boom and the Bust”)

• Also, because employers know wages are hard to drop they will be resistant to hiring large numbers of people on "high" salaries.

• When times are bad the salaries are overvalued and less people are employed than possible.

• If I can only afford to pay a worker 5 dollars an hour, but they demand 6, what do I do? Employ less. If wages were not sticky, then I would drop rates and hire more people.

• Traditional economists would recommend that the central bank (the Federal Reserve in the United States) drop interest rates in order to encourage the banks that borrow money from it to do the same, thus lowering the cost of borrowing money to the consumer, so that businesses will borrow more money to finance expansion and start up, and thus hire more people.

* Keynesian Economics

• Summary of Keynesian Economics (as seen in the video “Fear the Boom and the Bust”)

• Keynes argues that if this backfires, and businesses are still leery about the economy, then they will not borrow the money still, and now it is stuck in the banks in what he referred to as a liquidity trap.

• Liquidity is the ability to quickly convert investment to immediately spendable cash.

• So, how does Keynes suggest we get around this?

• For one, we don’t just sit around and wait for the natural business cycles to equilibrate.

• People are suffering, and we need to do something in the short term, and while this may be bad economics in the long term, “In the long term, we are all dead.”

• If the economy needs an influx of cash in order to spark it, then hoping businesses want to borrow money is neither the quick way to do this, nor a reliable way. * Keynesian Economics

• Summary of Keynesian Economics (as seen in the video “Fear the Boom and the Bust”)

• What we can do right now is have the government infuse cash into the system through money and increased spending on public works (digging ditches, building bridges, shovel ready projects)

• This will increase employment as we need people to do these jobs, and will give them money to purchase products, thereby increasing aggregate demand, and causing businesses to increase output and hire more workers to assist them in doing so.

• Now, if it so happens that government spending exceeds tax revenue, then the government can borrow money with which to do this.

• Yes, this will lead to and increased national debt, but these need only be short term if the economy improves. * Keynesian Economics

• Summary of Keynesian Economics (as seen in the video “Fear the Boom and the Bust”)

• If it is not, then that is also OK because we can gradually pay it back in small increments in the future, and

• No debtor expects the entire debt to be paid off at once, and the more they loan to you, the more they will have to loan in the future in order to make sure that you can pay back what you have already borrowed, so borrowing can be limitless.

• Spending is the key, however, in whatever form, because it creates a circular flow that keeps the economy going, avoiding the peaks and valleys of the “natural” ups and downs of the business cycle.

• Keynes referred to this as the “animal spirits” in reference to the nicknames of an up and down market, “Bull” and “Bear”, respectively. * Keynesian Economics

• Summary of Keynesian Economics (as seen in the video “Fear the Boom and the Bust”)

• When people feel that the economy might be bad, their natural inclination is to “save” their money, and not spend it.

• Keynes referred to this as “the ” because when people save, they think they are being smart, but in the aggregate, this hoarding of wealth is not helpful because they are not spending it.

• As a result, the government is forced to tax at high rates, and create welfare stimulus programs in order to redistribute the wealth to cash poor individuals so they have money to spend.

• As the absolute proof of the veracity of his “General Theory,” Keynes said one need only look at how the United States got out of the Great Depression….World War II, where the government injected huge amounts of money into the economy to successfully manage the war. * Austrian and Chicago School Economics

• The Chicago School actually began with the when Austrian economist F.A. Hayek came to the Department of Economics at the University of Chicago.

• The Austrian and Chicago schools can be considered neo (new) classical economics.

• F.A. Hayek is the polar opposite of John Keynes, in that Keynes focus was on the “bust”, or when times were bad, while Hayek’s focus was on the “boom” or when times were good.

• Hayek stated, in response to Keynes, that government spending does not spark the economy because it does not reach its marginal utility.

• the marginal utility of a good or service is the gain from an increase or loss from a decrease in the consumption of that good or service.

• As the government collects more money, and completes more projects, more is needed to spend money on, and so waste and cronyism, or the funneling of government monies to friends and supporters of the politicians controlling its use, reduces the amount that actually goes in to the economy.

* Austrian and Chicago School Economics

• As such, for every dollar that the government collects, the spending by the government only returns a portion of every dollar to the public in terms of economic stimulus.

• Thus, when times are good under the Keynesian model, the “boom”, it is an illusion perpetrated by the belief of people that there is plenty of money to be had, when in fact, the money does not exist at all, but has been borrowed, or taken out of the economy through taxation.

• The government’s continued insistence on spending then, forces the printing of more money backed by nothing but IOU’s, that in turn causes and will lead not to just an ordinary cyclical “bust”, but a large scale depression or .

• To Hayek, the Great Depression was not a matter of the “bust” as it was to Keynes, but the “boom” of the 1920’s when governments did not have the financial resources needed, and therefore printed excess money in order to stimulate their economies.

• Also to Hayek, full employment was not necessary, nor as important as the individual choice that ran the economy. To Hayek, the government could employ everyone, but then there would not be enough tax revenue to pay them all, nor enough of other needs such as food. * Austrian and Chicago School Economics

• It is not the “top down” management of the economy that is needed then, as it causes more serious problems

• The economy is “organic” and not a machine that needs “fixed”

• People should be allowed to guide their own spending and , and that in the end, the market will fix itself without heavy handed guidance, which would lead to prolonged suffering despite the good intentions of those doing the spending.

• Summary of Austrian and Chicago School (Neo-Classical) Economics (as seen in the video “Fear the Boom and the Bust”)

• All of the Keynesian planning, and interference in the organic, and natural cycle of the economy, for whatever reason or good intention, only causes misery in the long term.

• It requires the loss of too much freedom, and does not recognize the individual’s significant role in the economy, viz a viz the “invisible hand” * Austrian and Chicago School Economics

• Summary of Austrian and Chicago School (Neo-Classical) Economics (as seen in the video “Fear the Boom and the Bust”)

• The economy is too complex, and there are innumerable unintended consequences that result from meddling in the economy, because central planning of it requires ignoring individual motivations and actions.

• In order for the government to continue to tax and redistribute wealth, it must promise to the people a “free lunch” in the form of some program that the money will be going towards.

• However, there is no such thing as a “free lunch,” someone, somewhere has to pay for it, and in terms of governmental spending it is future taxpayers.

• So, in essence, we are just handing the bill to future generations, our children and grandchildren, to handle.

• When the government borrows to fund its spending, it is not “real” money, because it has to be paid back at some point, with interest, meaning it is costing more to have this credit than it is to spend it. * Austrian and Chicago School Economics

• Summary of Austrian and Chicago School (Neo-Classical) Economics (as seen in the video “Fear the Boom and the Bust”)

• Not to mention that if the spending does not work, the Keynesian model’s solution is to call for increased, and even more, spending to rectify it.

• This is akin to becoming intoxicated one night, having a bad hangover the next day, and trying to cure it by drinking some more, or figuratively, “taking some of the hair of the dog that bit you.”

• The only way to inject cash into an economy is through real savings, because the market gives individuals clues about when it is doing poorly and they should save, and when it is doing well and they should spend, through the organic forces that coordinate the time to spend with the interest rate available.

• In other words, when interest rates are lower, people will be more likely to spend, and when interest rates are higher, they will be more likely to save. * Austrian and Chicago School Economics

• Summary of Austrian and Chicago School (Neo-Classical) Economics (as seen in the video “Fear the Boom and the Bust”)

• The so called liquidity trap is not a credit crunch, but rather a signal that there is too much intervention in the banking system by the central bank.

• While Keynes worries about helping people when there is a bust, Hayek is more worried about helping to prevent the bust, when there is a boom.

• An economic boom to Hayek is a signal that credit has been overextended, and people are playing with “phony” borrowed money

• When “real” money becomes due to pay back these loans, there is not enough of it to go around, and the economy takes a downward turn into a bust.

• And, if the government continues this illusion by infusing even more borrowed money into the economy, it can make the bust even worse, causing a recession, and even a depression. * Austrian and Chicago School Economics

• Summary of Austrian and Chicago School (Neo-Classical) Economics (as seen in the video “Fear the Boom and the Bust”)

• A recession is when there is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.

• A recession begins just after the economy reaches a peak of activity and ends as the economy reaches its trough.

• Between trough and peak, the economy is in an expansion. Expansion is the normal state of the economy; most are brief and they have been rare in recent decades.

• A depression, on the other hand, is repeated periods during which real GDP falls, the most dramatic instance being the early 1930s. Such periods are called recessions if they are mild and depressions if they are more severe. * Austrian and Chicago School Economics

• Summary of Austrian and Chicago School (Neo-Classical) Economics (as seen in the video “Fear the Boom and the Bust”)

• In other words, economists do not have clear definitions, and it is only long after they have occurred that economists reach consensus on whether it was a recession or a depression .

• To illustrate this uncertainty, there is an old joke told by economists; “A recession is when your neighbor loses his job, a depression is when you lose yours.”