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 influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.
—John Maynard Keynes
Ideas are powerful. They dictate the way we behave. When ideas are acted upon by powerful people they affect all of our lives.
In 2008 the world experienced a financial crisis. In the space of a month, the stock market lost 40 percent of its value and the world entered the worst recession since the 1930s. The US unemployment rate went from 4.5 percent to 10 percent. Between September 2008 and September 2009 the economy lost half a million jobs a month.
Following the 2008 crisis, there was a fierce debate in the press between classical economists like Eugene Fama of the University of Chicago and Robert Barro of Harvard, and Keynesian economists like Paul Krugman of Princeton University and Brad Delong of the University of California at Berkeley. Classical and Keynesian ideas have been actively debated by economists for seventy years. When one side or the other gains more credibility, the effect on all of our lives is substantial.
Policy makers are guided by economic theories. In the 1990s and early 2000s classical economists argued that markets should be given free rein. Their ideas led to deregulation of the financial markets in the late 1990s and the repeal of legislation that had been put in place during the Great Depression. Classical ideas ascended for thirty years, beginning in the 1970s and ending with the onset of the financial crisis in 2008.
In response to the 2008 crisis, the pendulum of economic ideas has swung back towards regulation. Policy makers in the Obama administration are influenced by the ideas of the English economist John Maynard Keynes. Keynes argued that free markets need to be controlled and that government should be held responsible for ensuring that everyone who wants a job has one.
Why is there such disagreement amongst economists, politicians, and journalists about economics? Who are the classical and Keynesian economists and what did they say? Most importantly, how has economic history influenced the development of classical and Keynesian ideas?
Classical and Keynesian Economics
The economic history of the past hundred years can be divided into three periods, each guided by one of two different economic theories: classical and Keynesian economics.
Before 1930, classical economics was dominant. In the period from 1946 to 1976 classical ideas were replaced by a new theory, Keynesian economics. From 1976 through to 2008 classical economics once more gained the upper hand.
The swing from classical to Keynesian economics (1946 to 1976) and back again to classical ideas (1976 to 2008) was driven by historical events. The rise of capitalist free-market economies in the mid-eighteenth century led to dramatically improved living standards and Scottish economist Adam Smith developed classical economics to explain their remarkable success.
During the Great Depression of the 1930s capitalism failed in a spectacular way as the unemployment rate in the United States climbed to 24 percent. This failure of free markets to deliver prosperity led to a rejection of classical economic theory and the development of an alternative set of ideas to explain what had gone wrong: Keynesian economics.
From the end of World War II through the mid-1970s, most economists were Keynesians. But during the 1970s, Keynesian economics itself came under attack when it failed to explain how high inflation and unemployment could coincide as they did at the end of that decade. Economists retreated to classical ideas, which they reformulated using mathematics. By that time, the Great Depression had been forgotten and faith in free markets was once again the dominant view.
All that changed in 2008 when a financial crisis of epic proportions reminded us that market economies could sometimes go spectacularly wrong. The 2008 recession caused economic theorists once again to rethink their positions. Now, we are likely to enter a new era that draws on ideas from both schools of thought.
The Birth of Classical Economics
Capitalism began in sixteenth-century Europe. It was made possible by a new legal institution, the joint stock company, which allowed many people to pool their resources in large-scale ventures while limiting their liability if the venture failed. The first joint stock company in England was the Muscovy Company, created by royal charter in 1555, although it wasn’t until the eighteenth century that capitalism really began to flourish.
Capitalism was accompanied by the rise of political and economic liberalism. Political liberalism is the idea that every adult human being has the right to express his or her opinions freely. Economic liberalism is the idea that the free exchange of goods in markets makes everybody better off.
By the American Revolution in 1776, liberal ideas were in the ascendancy. Political liberalism gave birth to democracy, fostered by the then-radical notion that rulers govern with the consent of the people. Economic liberalism led to our modern system of production whereby individuals are free to buy and sell goods in markets in pursuit of profit.
In 1776, the Scottish philosopher Adam Smith penned An Inquiry into the Nature and Causes of the Wealth of Nations and the science of economics was born. Smith wrote:
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 self-interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.
Or as Gordon Gekko, the fictional character in Oliver Stone’s 1987 movie Wall Street put it; “Greed is good.” What is the evidence for this remarkable claim?
Capitalism and Growth
Before the advent of capitalism, there was very little improvement in living standards. The lifestyle of the average person in Roman times, two thousand years ago, was not very different from that of a peasant in fifteenth-century England. Although the rulers of Rome lived in relative luxury, as did the kings of England, even the poorest person in an advanced society today enjoys many luxuries that would have been inconceivable to Julius Caesar or Henry VIII.
Since the inception of capitalism in sixteenth-century Europe, income per person has grown at a bit less than 2 percent per year, and as a consequence, the standard of living of the average person has doubled every thirty-five years. The power of compound growth is staggering. By fostering this growth, capitalism has been responsible for pulling more human beings on this planet out of misery than any other known form of social organization.