new classical school

The evolution of economic theory and practice up to 2007

Classical economics has been around since the 1700s, with the likes of Adam Smith, David Ricardo, Thomas Malthus, John Stuart Mill and Alfred Marshall (amongst many others). It simply states that the economy works through no other mechanism than self interest, and that Supply ‘creates’ demand (Say’s Law). It works along the basic principle that the market will always adjust to find the equilibrium point between supply and demand, and that there is a natural adjustment to full employment. It is a brutal mechanism, concerned only with the markets and has not affection for the human impact! If the market strays from the equilibrium then the simple answer is to sit back, and wait for the re-adjustment. There is little role for governments, other than to maintain the rules and keep the markets free (ie a very laissez-faire attitude). There are certain roles for governments, such as defence etc, but that a balanced budget should be maintained at all costs (ie after the government spend of WW1, taxes were hiked and spending was cut to redress the balance regardless of human consequence). The belief was that if unemployment was high it was because wages were too high and that people were pricing themselves out of the market and that if there was inflation it was due to too large a money supply, thus fiscal contraction was required to reduce the money base. Market failure was placed very much on the shoulders of the government, and being too involved.

The Fisher Equation 

MV = PT

M = money supply
V = velocity/number of times the money changes hands
P = price
T = number of transactions

Seeing as it was believed that V and T were fairly equal/constant, it could be deduced that there was a positive relationship between the money supply and price (or inflation). Thus an increase in the money supply was seen to increase inflation and vice versa. Then the Great Depression hit, and it all changed.

Keynesian Theory Economics

This was the theory developed by John Maynard Keynes, that took force in the 1950s after the Great Depression. This is concerned with the control of aggregate demand within an economy, and that government should act to control this.

AD = C + (I-S) + (G-T) + (X-M)

for a further breakdown of this please read the following (‘How the Great Depression lead to further spending and fiscal stimulus‘).

Keynes argued that through fiscal stimulus; to include government spending and regulation of taxes; an economy could overcome the usual market cycle of boom and bust and maintain a more regular balance of growth and prosperity. It was a system that was not based on full employment, and was aware that the markets more often than not sat in disequilibrium.

After WWII, it was believed that the only road was that of depression economics. This involved currency devaluations, nationalistic agendas, increased tarifs and taxes for foreign imports. But after WWII both Theodor White and Maynard Keynes offered something new. Fixing the US exchange rate to the Gold Standard of $35 per ounce of gold meant, allowed all other nations to peg their currency to the US dollar which in turn offered the stability markets so craved. The International Monetary Fund was established to manage the currency rate and act as market stabiliser and between 1947-1971 the world’s economic waters returned to calm.

During this period it could be said that mixed market economies existed, where there was a carefully managed relationship between public and private sectors that was tied together with a fixed currency exchange rate. However in the 1980’s the exchange rate was allowed to float due to inflexible markets, and so became a floating exchange rate system.

Through this period it was apparent that the Phillips Curve, a correlation between % inflation and unemployment, existed and so fiscal control was an easy way to control the economic machine. However, in the 1980’s Stagflation set in where both stagnation and high rates of inflation were seen. This gave rise to Monetarist Economics. Monetarism was closely linked to classical economics and was  concerned with the control and supply of money. It was believed that inflation was positively correlated with the money supply, and so to reduce inflation a government should choke the money ‘drip’. However Monetarism was concerned with ‘adaptive expectations’, ie that one could look back over years of behaviour and systematically adjust policies. It blamed government intervention for inflation (going back to Fishers Equation).

There was an evolution of this, called the New Classical Economics theory which did not believe one could predict the behaviour of the people, and instead looked at the ‘instinctive adaptation‘ of leaders and building up a wealth of knowledge. This meant that responses were instant and based on principles, and that systematic errors did not occur. There was a firm belief that government spending resulted in inflation, and was an advocate for reduced government and mass privatisation. It was also called the Rational School of Thought.

Keynesian Economics has had to evolve also, and so as to counteract the forces seen in stagflation, suggested that contracts were vital so as to commit people and businesses to certain rates for a period of time. It aimed at focussing on what policies can work for governments and why.

Supply Side Economics, does just that. It returns to Say’s Law regarding supply before demand and looks at providing incentives to get back into work, promoting hard work and risk/investment. However, i have an issue with this, as i believe demand becomes before supply, and that all incentives in the world can be offered but if there is no work, there are no jobs.

In general this debate has been raging for many years, and will continue to do so for many more as there appears to be no right answer or that the right solution has not been found yet. I have not gone into the recent 2008 collapse, but will aim to get something up soon.