All Terrain Thinking

A Compendium of things I think are Important

Economics: It's not just whats' in your wallet

Alternative Views

Anyone who listened to even a little of the committee hearings on Bill Clinton's impeachment in December of 1998 knows of the power of political parties.  Regardless of one's views on the validity of the charges, there was no question this was a partisan effort where you could identify a person's party from his / her comments.  There is a difference between the way Republicans and Democrats see the world and this is reflected in nearly all that they say and do. 

The same is true to some extent in economics. When you ask an economist the question, which economic system is the "Best," the answer you get will depend very much upon the economist's view the world - on what would be called ideology.  Whereas in politics we have the Democrats and Republicans, in contemporary economic thought, the debate on which is the best economic system is generally between the two ideological groups that would fall within the midrange of the ideological spectrum - Conservatives and Liberals - whose opinions and theories you might expect to see in print on the pages of The Wall Street Journal and The New York Times.  For a brief overview of the alternative perspectives you should check out the History of Economics web site.

Conservatives tend to possess a general distrust of the state and an unending faith in the supremacy of "free enterprise" as a mechanism for allocating resources and promoting growth. The Father of Conservative economists would be Adam Smith who wrote The Wealth of Nations in 1775. The capitalist economic system allows allocation decisions to be made in a decentralized fashion by individuals pursuing their own self interest.  According to Smith, "It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest."  More importantly, this system based on individual choice will tend to operate optimally.  Again in Smith's words: "...by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this...led by an invisible hand to promote an end which was no part of his intention."  For conservatives, a good government is a small government that simply sets the "rules" to govern the competition.  In his book Smith describes the situation as follow: 

All systems either of preference or of restraint, therefore, being thus completely taken away, the obvious and simple system of natural liberty establishes itself of its own accord. Every man, as long as he does not violate the laws of justice, is left perfectly free to pursue his own interest his own way, and to bring both his industry and capital into competition with those of any other man, or order of men. The sovereign is completely discharged from a duty, in the attempting to perform which no human wisdom or knowledge could ever be sufficient; the duty of superintending the industry of private people, and of directing it towards the employments most suitable to the interest of society. (Book 4, Chapter 9):

Liberals, meanwhile, share with the Conservatives a strong faith in the market, but believe there are advantages to be gained by moving to a "compromise" position where the government is able to devise policies to offset some of the "structural flaws" of the system.  Liberal theorists believed they had proven the existence of instances where the capitalist system would behave less than optimally, including a tendency to produce unacceptable and avoidable levels of economic instability. One of the more influential liberals, and the father of modern macroeconomics, is John Maynard Keynes who wrote The General Theory of Employment Interest and Money. In his critique of the prevailing conservative theory, Keynes wrote:

"Now 'in the long run' this is probably true.... But this **long run** is a misleading guide to current affairs. In the long run we are all dead.  Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again." 

As Keynes saw it, the conservative view that emphasized the power of markets to allocate resources may be an adequate explanation of what would happen in the long-run, but we may not have the will to wait that long.

The differences between these two views will be a reoccurring theme in both macroeconomics and microeconomics. In microeconomics one of the issues you would be likely to talk about would be the education industry.  Liberals tend to believe education is too important to be left to the private sector because we can expect the private sector will provide less education than would be best for our society. Their solution is the public provision of education - institutions such as University where the cost of education is subsidized by the general public. Conservatives, meanwhile, tend to believe the market system will provide adequate levels of education and the secret to improving our educational system is privatization. 

In macroeconomics, some of the most heated debates are likely to be about the ability of the government to alter macroeconomic performance with the use of monetary and fiscal policies - printing more money or raising government spending.  The questions you will look into here are: How much money should be in the system and who should control it? How big should the level of government spending be and should we view the level of government spending as a tool to reduce the level of unemployment? Should Japan's government increase government spending to move the country out of a long-running recession? Should the Fed raise interest rates to head off future inflation?  Conservatives tend to push for limited discretionary policies on the part of both monetary and fiscal authorities while liberals tend to believe that discretionary monetary and fiscal policies should be employed to improve the performance of the macro economy. 

This story will be told, to the extent that it is possible, in the third person. Less effort will be spent taking sides and more on describing how economic theory and policy have swung back and forth between these two views over the past sixty years. We will focus our attention on how new ideas develop as the economy changes in ways that old theories find hard to explain - how the new theories become an orthodoxy that eventually becomes incapable of explaining new facts, leading to the rise of yet another set of new ideas. 

As we move forward we will see there is clearly a parallel between economic theory, economic policy, and economic performance.  Economic policies will be grounded in the prevailing economic theories and there will be little pressure to unseat these theories or policies as long as the economy is performing adequately.  It is only in times of economic crises that there is any real movement in public policies and any shift in the balance of power among theorists - a reversal of the ideological pendulum.  Bruno and Easterly (1996) suggest that economic crises, in this case crises triggered by bouts of hyperinflation, can speed the process of economic reform in lower income countries and the return of growth will be faster in those countries that experienced the hyperinflation.  If we follow the logic a bit further we end up where Albert Hirschman (1987) did and conclude that "inflation has acted as the equivalent of war in eliciting change" or Alesina and Drazen (1991) who "model delayed stabilization as a war of attrition." 

Diagram1
Ideological Pendulum

As we work our way through the story you will find there are two dominant themes. One theme is the proper scope of government - a theme that actually pervades all economics courses and discussions.  It is the flip side of the discussion of how well the economy operates on its own - on the adequacy of the economy's self-adjustment mechanisms to deal with the inevitable external shocks such as the Asian financial crises of 1997-98. 

Although our discussions of microeconomics and macroeconomics will be focused on the ideological spectrum spanned by conservatives and liberals, there are important ideas about economics that do not fall in that range.  One would be Marxism, the economic theory attributed to Karl Marx who wrote during the second half of the 19th century.  Where Adam Smith saw Capitalism as possessing a potential for unprecedented economic growth, Marx saw it as possessing a fatal flaw that would eventually bring about its collapse.  Capitalism was simply an intermediate stage in the evolution of economic systems and it would eventually fall under its own weight.    In fact, much of the post WW II era can be viewed as a battle between two economic / political systems - capitalism (market control) in the West vs. communism (command control) in the East.  When the wall between Eastern and Western Europe came down at the beginning of the 1990s, the consensus was that capitalism had proved itself superior to communism and that the ideological debate had been settled.  This is undoubtedly an optimistic view and you can expect that Marxism / communism will be around for quite some time.

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