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The Keynes view holds that without intervention, the economy will function, but not optimally. Businesses and business leaders can make suboptimal decisions based on incorrect perceptions or lack of information. This leads to underperformance, or in some cases “overperformance,” a boom led by unrealistic expectations. These decisions and overreactions lead to suboptimal demand, loss of output, and unemployment, which of course then serve to make the situation worse. In this view, government policies, including fiscal and monetary stimulus, would be used to increase aggregate demand and economic activity. That stimulus would travel through the economy several times, creating a multiplier effect directly proportional to the velocity with which it traveled.
Monetary stimulus, to resolve the Great Depression at that time, would be accomplished through massive government investments and by lowered interest rates. Both were done, most particularly the government investments through WPA and other programs. Ironically, the theory was really proven effective by the economic boost given by World War II. Keynes also went against the grain in maintaining that deficits were okay, governments didn’t need to balance budgets in the short run, and increased economic activity would fill budgetary gaps later. It should be noted that Keynes did not advocate deficit spending per se, but rather as a necessary investment to smooth economic cycles.
The details of the theory and the effects on wages, prices, and so forth are much more involved and complicated. Over time, U.S. government policy has embraced Keynesian economics, although elements of the Chicago school (or Monetarist school) are also deployed. The Austrian school, favoring little to no government intervention as a way to remove inefficiency more quickly, takes an opposing and intellectually enticing point of view. These are covered in the next two entries.
Why You Should Care
In your normal life you won’t be confronted with having to decide whether you’re a Keynesian, or with the task of implementing Keynesian policy. But it’s helpful to understand the underpi
58. CHICAGO OR MONETARIST SCHOOL
While John Maynard Keynes favored government intervention to smooth supply and demand for goods and services as a way to achieve economic growth and stability (see #57 Keynesian School), another school of thought claimed that stability was a matter of equilibrium between supply and demand of money, not the goods and services themselves. This school of thought, largely held by members of the University of Chicago faculty, most notably Dr. Milton Friedman, is known as the Chicago or Monetarist school.
What You Should Know
Monetarism focuses on the macroeconomic effects of the supply of money, controlled by the central banks. Price stability is the goal, and policies like Keynesianism, which can lead to excessive monetary growth in the interest of stimulating the economy, are inherently inflationary.
Monetarists hold that authorities should focus exclusively on the money supply. Proper money supply policy leads to economic stability in the long run, at the possible expense of some short-term pain. Monetarists are more laissez-faire in their approach—that is, the economy is best left to its own actions and reactions. To the monetarist, money supply is more important than aggregate demand; the pure monetarist would increase money supply (in small, careful increments) to stimulate the economy rather than take more direct measures to stimulate aggregate demand. The Great Depression, in the Chicago school, was caused by a rapid contraction in money supply, brought on in part by the stock market crash, not a contraction in demand per se.
To the monetarists, the more direct approaches to stimulating aggregate demand are considered irrevocable (once the government intervenes, it is difficult to disengage). Worse, they crowd out private enterprise as government thirst for borrowed money to fund stimulus makes it harder and more expensive for the private sector to borrow. Monetarists also suggest that Keynesian stimulation changes only the timing and source but not the total amount of aggregate demand.
The monetarist point of view has always been embraced by policymakers who endorse a tight vigil over money supply in addition to more traditional fiscal stimulus and interest rate intervention. Fed Chairman Paul Volcker, and later Alan Greenspan, were monetarists, although critics are quick to point out that Greenspan got carried away and created too much growth in money supply, which led to strong boom and bust cycles in stocks and later in real estate. It did not lead to the expected inflation, thanks in part to the availability of inexpensive goods from Asia. We got lucky, but this attenuation of inflation may be unsustainable, particularly with the recent growth in money supply used to mitigate the Great Recession.
Why You Should Care
Unless you aspire toward a degree in economics, you don’t need to be too familiar with the details of the Chicago school, nor its many proponents from the Windy City. The greater interest is in knowing where policy comes from and why.
59. AUSTRIAN SCHOOL
The Austrian school, while founded in Vie
What You Should Know
The basic premise of the Austrian school is that human choices are subjective and too complex to model, and thus it makes no sense for a central authority to force economic outcomes. Like monetarism, but to a greater degree, it is a “laissez-faire” economic philosophy.
The Austrian school takes the contrarian view that most business cycles are the inevitable consequence of damaging and ineffective central bank policies. Government policies tend to keep interest rates too low for too long, creating too much credit and resulting in speculative economic bubbles and reduced savings. They upset a natural balance of consumption, saving, and investment, which, if left alone, would make the consequences of business cycles far less damaging.
The money supply expansion during a boom artificially stimulates borrowing, which seeks out diminishing or more far-fetched investment opportunities (like Florida real estate in 1925–1928 and again in 2005–2007), and more recently an outsized interest in high-yield bonds and other riskier fixed-income securities. This boom results in widespread “malinvestments,” or mistakes, where capital is misallocated into areas that would not attract investment had the money supply remained stable.
When the credit creation ca
The recent boom and subsequent Great Recession had many of the footprints of the Austrian scenario. A credit-stimulated overexpansion led to a bust; the government didn’t know what to do about it; bad businesses and business models, like many banks, were propped up. In the Austrian school such businesses should be allowed to fail, for the economy will return to health more quickly, and a patient once on medicine will always require medicine.