Reason for a New Age

Schools of Economics

Posted by publius2point0 on 2010/04/03


Economics is still an area of research in its infancy, particularly macro-economics. Besides having a large number of actors influencing the movement of money, and an equally large number influenced first, second, or third-hand by the movement of money, there is also the issue of the cyclical movement of money. The movement of money from point A to point B might occur in a gradual drift that takes many loops through the system to make its way.And to compound all of this, no two nations are the same. Comparing nations when you must also bring in the state of the law in each nation, social values, and the fact that they are ever-changing in ways that you are not, whereas you are changing in ways that they are not. The amount of data to be mined is staggering and there are no control groups.

In essence, this means that for a macro-economist, you’re left dealing in generalities based on simplistic models like mine. There isn’t a lot of room for changing variables in such a model so the fans of any one change tend to clump into any one of a few schools. Of course, there’s also the question of what exactly you are trying to accomplish–which can point you more towards one or another of the options.

Classical Economics

The basic premise of what is now called Classical Economics is that the Free Market can, more-or-less, operate on its own. If something changes, the market will adapt to solve that problem without need of outside intervention. Breaking monopolies, recording patents, creating infrastructure, disallowing false advertising, etc. are all things that are–I believe–considered to be worthwhile and accepted tasks for the government.

Keynesian Economics

John Maynard Keynes (1883-1946), seeing the lengthy period of the Great Depression (lasting on average about 10 years, dependent on nation), suggested that there are cases where an economy can become lodged in a negative equilibrium.

Due to the need for profit in business, all of the laborers of a business must make less in wage than the total value of all products being sold. If demand drops (e.g. due to over-speculation), then the workers must either accept a lower wage to match sales, or go on unemployment. With fewer people employed, demand certainly won’t go back up. A rational actor would accept the lower wage so that he could have at least some income, but people aren’t rational. They tend to refuse to accept a lower wage, and so the high unemployment continues. Everyone sits waiting for wages to come back, but of course they can’t.

Keynes’ suggestion for combating this was for the government to create economic stimuli. One might view it as that the government steps in to replace the missing demand so that workers will come back to work and the economy can then correct. Once this has happened, the government can then gradually sell back whatever it had purchased, making back the money that it went into debt to produce.

One basis for this solution was the historic link between low inflation and unemployment and high inflation and high employment: The Phillips Curve

Monetarism

Milton Friedman and Anna J. Schwartz, in their 1963 work A Monetary History of the United States, 1867-1960, re-examined the Great Depression and argued that its cause was that the Central Bank had been too strict with interest rates. Where the economy would have fixed itself, it couldn’t do so because the businesses couldn’t raise the capital they needed to do so.

Monetarists are principally interested in the actions of the Central Bank and its ability to rein in over-speculation by restricting the money supply (i.e. raising interest rates), or allow growth by expanding it.

Both Keynesian economics and Monetarism, in end result, advocate using inflation as a method of fighting recession, it should be pointed out. One focuses more on direct government intervention, whereas the other focuses on a more indirect method via the Central Bank. And advantage with Monetarism is that it suggests a preventative measure, by restricting money whenever the Central Bank believes it has spotted a growing economic bubble. While this might not destroy the bubble, it does at least lessen the effects when it bursts.

Supply-Side Economics

This theory of economics can be classed as a version of Keynesian economics. Instead of recommending stimulus packages, they advocate lowering tax rates. Since supply-siders tend to not advocate raising those tax rates after the recession has ended, this school of economics is generally placed as being a veneer of economics over political ideology.

Austrian School

The central idea of Austrian economics is that since economics is based on human actions and human actions are unpredictable, one is better to use introspection and deduction to determine policy and the courses of action to be taken than mathematical models.

Of course, on the other hand, this means that Austrian economics can rarely be falsified, can offer little practical advice, and anything they do suggest can fairly accurately be said to have been pulled from their butts.

Editorial

Firstly, it’s worth noting that each of these schools has been shown to be wrong.

Keynesian economics was likely a cause of the stagflation of the 70s. The Phillips curve has also been shown to not accurately describe modifiable reality.

Monetarism, while it may be able to fight recession, may very well exacerbate the situation if they don’t spot an economic bubble. By encouraging growth after the dot-com/9-11 caused recession, all segments of the economy were given encouragement, including the housing market.

That lower taxes produce heightened economic growth hasn’t manifested in empirical studies, and in fact the basis for this idea–the Laffer curve–only theorizes that there is an optimal tax rate, not that a lower one is better. The Laffer curve itself doesn’t appear to manifest in reality.

And the Austrian school’s one testable theory, the Real Business Cycle, hasn’t stood up to empirical study.

Does all of this mean that the classical school was right to begin with? Probably not. It simply means that more revision will be necessary, and that we are possibly on the verge of the third wave of economic thought which will be based on the discoveries that have been made up to this point.

My personal view of these theories is that Keynesianism is bound to fail because it assumes that the government knows how best to fix the market, which runs into the problems of a planned economy. When one inputs a stimulus of money into the economy, the recipients must also feel that the funding will be successful in correcting the problem. Money that has been injected while confidence is still low may accomplish nothing but stagflation. It also seems like you would do just as well to tell people to go back to their old jobs at a lower wage if that’s the problem to begin with.

Monetarism has a similar problem in that it relies on a single organization to know everything and wisely operate to mitigate it. And with no other tool to use than the interest rate, the Central Bank cannot affect anything smaller than the entirety of the market–which is impressively scattershot. Even with some way to pick and choose areas of the economy to stimulate or pull back, you are still reliant on the Central Bank to be consistently wise about this. As a group of professional economists, I would have greater trust in their ability than for the legislative branch of the government to be doing it, but it seems like more would be gained by trying to find ways to make the market not develop speculative bubbles to begin with, and/or ways to make those bubbles be limited in scope, instead of affecting the entire market when they pop. I.e. the creation of economic bulkheads. The goal should be to solve the problem of the free market more than in determining how to kickstart it when it fails.

As for economic schools, I would probably be looking to Complexity Economics to result in the most usable advice in the near future.

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