Regina Burgess
Essay
Question Two
Compare and contrast classical macroeconomic theory with Keynesian Economic theory. Then explain which theory you believe provides a more compelling explanation of how the United States' economy functions and why.
Compare…
Classical macroeconomic theory was best described by Adam Smith in 1776 in his writings The Wealth of Nations calling macroeconomy the “invisible hand of the marketplace”. He had a philosophy of laissez fair which is “leave it alone and it will work itself out”; in other words, equilibrium is the natural state and shifts in supply and demand will bobble the economy but not devastate it. The basic premise is that somebody somewhere will always want to buy something in the right quantity and at the right price. “Self-adjustment was expected in the labor market.” (Shiller, Bradley R. Essentials of Economics. Fifth Edition, 2005 p 254, 2005). Therefore, in the long term, the economy is stable and has steady growth.
Keynesian economic theory has several points in comparison to the “leave them alone and they’ll come home” classical theory.
1. A Keynesian believes that aggregate demand is influenced by a host of economic decisions—both public and private—and sometimes behaves erratically. The public decisions include, most prominently, those on monetary and fiscal (i.e., spending and tax) policy.
2. According to Keynesian theory, changes in aggregate demand, whether anticipated or unanticipated, have their greatest short-run impact on real output and employment, not on prices. Because prices are somewhat rigid, fluctuations in any component of spending—consumption, investment, or government expenditures—cause output to fluctuate. If government spending increases, for example, and all other components of spending remain constant, then output will increase.
3. Keynesians believe that prices and, especially, wages respond slowly to changes in supply and demand, resulting in shortages and surpluses, especially of labor.
4. Keynesians do not think that the typical level of unemployment is ideal—partly because unemployment is subject to the caprice of aggregate demand, and partly because they believe that prices adjust only gradually… Keynesians also feel certain that periods of recession or depression are economic maladies, not efficient market responses to unattractive opportunities.
5. Keynesians advocate activist stabilization policy to reduce the amplitude of the business cycle, which they rank among the most important of all economic problems. Here Keynesians and monetarists (and even some conservative Keynesians) part company by doubting either the efficacy of stabilization policy or the wisdom of attempting it. [Mainly because of lag time from inception to activation of policy.] (Blinder Alan S., The Concise Encyclopedia of Economics, 2002)
Contrast…
It is safe to say that the U.S. economy in its infant stages could be described as Classical. The early presidents and congresses had a hands off, laissez fair attitude. Thomas Jefferson and Alexander Hamilton clashed over just how big government should be and how much power it should have. During the growth years of the United States, after the Revolutionary War, imports and exports, products and services, population and land acquisition all were steadily expanding with only minor spurts and starts like a light foot on the brake peddle. “The cornerstones of classical optimism were flexible prices and flexible wages.” (Shiller, 2005) As the economy breathed, the prices and wages would contract and expand as the “invisible hand of the marketplace” moved across the land and the world. During those years that the infant country called America or The United States was slowly but surely finding its legs to stand on, the economy was a classical ‘invisible hand’ economy. The U.S. government had no teeth, yet and the people were definitely chary of allowing any power build up such as England had dominated her colonies with. Hamilton did an excellent job of designing economic blueprints, but still, it was rolled-up plans compared to today’s economic structure.
In a more grown-up economy, there is a strong parallel with the Roman Empire under Augustus (he was Octavian, the adopted son of Julius Caesar) when he lifted the heavy tax burden off the people. The steep taxation was to pay for the long years of war while the empire was being snatched from Marc Antony’s clutches. According to Roman history, Augustus promoted free trade and private enterprise but it is unclear whether Octavian actually understood the reduction of taxes would promote private expenditures which would help rebuild patrician coffers and in turn would help fill plebian pockets as they produced goods for the Roman marketplace. Because peace reigned in the empire, free trade and commerce abounded. Oertel (1939) describes it this way:
The first century of our era witnessed a definitely high level of economic prosperity, made possible by exceptionally favorable conditions. Within the framework of the Empire, embracing vast territories in which peace was established and communications were secure, it was possible for a bourgeoisie to come into being whose chief interests were economic, which maintained a form of economy resting on the old city culture and characterized by individualism and private enterprise, and which reaped all the benefits inherent in such a system. The State deliberately encouraged this activity of the bourgeoisie, both directly through government protection and its liberal economic policy, which guaranteed freedom of action and an organic growth on the lines of "laissez faire, laissez aller," and directly through measures encouraging economic activity. (Oertel, F. "The Economic Life of the Empire." Cambridge Ancient History 12: 232-81. London: Cambridge University Press 1939).
It was a hands off policy and an equilibrium was established. Except for the freebies in the form of free grain supplied by the Emperor from Egypt the economy of Rome could have stayed in the equilibrium. As a result of the freebies, Rome received over three hundred thousand “poor, tired and hungry”, not to mention all the slaves who were freed so they could qualify for the free grain. (Bartlett, Bruce. CATO Journal, Fall 1994, Vol. 14 Issue 2, p287, 19p). Ownership of a ticket, citizenship and being male over the age of 14 was a requirement to receive the free corn under Augustus. The number of people receiving this handout fluxuated from 120,000 to stabilize around 200,000. (Bartlett, 1994)
Additionally, the steady increase in taxes paying for the cumbersome yet necessary Roman army at an exorbitant cost to maintain, plus the free corn, and later free pork, wine and bread. Then on top of that, the tax collectors added their own hefty fees to pay their fees for the privilege of collecting taxes. This became so burdensome on the provinces they raised a hue and cry and “tax farming” (Bartlett, 1994) was abolished in favor of wealth taxes and population tax under Augustus. It was a pro-growth instead of progressive tax system.
This is because any growth in taxable capacity led to higher taxes under the tax farming system, while under the Augustinian system communities were only liable for a fixed payment. Thus any increase in income accrued entirely to the people and did not have to be shared with Rome. Individuals knew in advance the exact amount of their tax bill and that any income over and above that amount was entirely theirs. This was obviously a great incentive to produce, since the marginal tax rate above the tax assessment was zero. In economic terms, one can say that there was virtually no excess burden (Musgrave, R.A. The Theory of Public Finance. New York: McGraw-Hill 1959.)
Keith Hopkins notes there was an increase in trade because of this growth period, an increase in money supply but also a decrease in interest rates. (Hopkins, K. (1980) "Taxes and Trade in the Roman Empire (200 B.C.-A.D. 400)." Journal of Roman Studies 70: 101-25) “There was probably also an increase in the demand for cash balances to pay taxes and rents, which would further explain why the increased money supply was non-inflationary.” (Bartlett, 1994).
Growth, plenty, economic boom and the State had copious revenue, so much so that Augustus began huge public works programs when he “repaired all the roads of Italy and Rome, restored the temples and built many new ones, and built many aqueducts, baths and other public buildings. Tiberius, however, cut back on the building program and hoarded large sums of cash. This led to a financial crisis in 33 A.D. in which there was a severe shortage of money. This shortage may have been triggered by a usury law which had not been applied for some years but was again enforced by the courts at this time” (Frank, T. "The Financial Crisis of 33 A.D." American Journal of Philology, 1935 56(4): 336-41). “The shortage of money and the curtailment of state expenditures led to a sharp downturn in economic activity which was only relieved when the state made large loans at zero interest in order to provide liquidity” (Thornton, M.K., and Thornton, R.L. (1990) "The Financial Crisis of A.D. 33: A Keynesian Depression?" Journal of Economic History 50(3): 655-62).
Here we have a perfect example of the “invisible hand of the marketplace” being held by big government. The time frame between the boom of Augustus and flop of Tiberius was just a year or two. Did Augustus actually practice hands off policy? Not really, not when there was an abundance of public works underway, and not when the taxes were lowered. In the traditional Keynes philosophy, public works and lower taxes are government tactics used to give the economy a burst of energy. In other words, government induced economic growth. Augustus employed Keynes theory before Keynes was a twinkle in his daddy’s eye.
Did the depression happen because Tiberius hoarded large sums of cash (the economy was based on a cash flow system and credit was not widely used). Was the zero percent interest a shot in the arm in Keynesian style? In contrast to the laissez faire classical macroeconomic theorist point of view, yes. Since the government was not keeping a hands off attitude but was digging deep into public revenues it was the beginning of the fall. The emperors of Rome began to degrade the amount of gold and silver in coins. This debasement of coinage caused inflation which led to the population hoarding the more valuable coins and paying taxes with the less valuable coins. This led to a greater need for revenue by the government so taxes were raised and this resulted in the privately wealthy to be slowly robbed of their wealth. The natural inclination of the patricians to hide their wealth came in the form of tax evasion. The sights of the government were then turned to the middle class. These employed the tactics of the rich by tax evasion in various forms mostly by appearing to be poor or by outright selling themselves as slaves to the larger land owners. (Slaves didn’t have to pay taxes.) The constant drain on the empire’s coffers by the military caused a greater and greater need for more revenue. The emperors put less and less gold and silver in the coinage. It was an economic nightmare.
Keynesian economics is founded on the notion that there are often unused resources in the economy. This notion is usually described as disequilibrium in the market for labor: There is involuntary unemployment; the supply of labor is greater than the demand for labor. The Keynesian economics of the 1950s was notably weak in accounting for the dynamics of inflation. (Hoover, Kevin D. “The rational expectations revolution: An assessment” CATO Journal, Spring/Summer 1992, Vol. 12 Issue 1, p 81).
What happened during Tiberius’ reign proves this. Hoarding monetary resources results in inflation and economic nightmare, but the unused resources are definitely there.
Robert King observes: Keynesian macroeconomics did not begin with the assumption that an economy is made up of individually rational economic suppliers and demanders. Instead of deriving demand from individual choices that are made within specified constraints, for example, the Keynesian procedure was to directly specify a behavioral rule. Keynes claimed that aggregate spending on consumption was governed by a "consumption function" in which consumption depended solely on current income. More generally, Keynesian macroeconomics posited that people followed fixed rules of thumb, with no presumption that firms and households made rational choices. Partly, this grew out of a suspicion on the part of Keynesian modelers that people did not typically act rationally. Partly, it was a pragmatic modeling decision: if people's economic behavior is purposeful, the task of specifying how they will act in various situations is more complicated and, therefore, more difficult to model. (New Classical Macroeconomics, King, Robert. The Concise Encyclopedia of Economics Library of Economics and Liberty. Retrieved April 6, 2005 http://www.econlib.org/library/Enc/NewClassicalMacroeconomics.html It seems to me that the wealthy have acted the same since the first century. Is it irrational to want to save what one owns against unreasonable government demands? I think not.
Keynes had a great grasp of exactly how the powerful government can manipulate economic growth patterns. When the prices were low, raise the interest rates. When prices were high, lower the interest rates. (Keynes, 1923, Tract on Monetary Reform) This would keep the economy stabilized. But Britain’s unemployment sky rocketed after the war which made Keynes do more research and study. Then he wrote General Theory. The Concise Encyclopedia of Economics puts it this way:
Keynes's General Theory of Employment, Interest and Money revolutionized the way economists think about economics. It was path breaking in several ways. The two most important are, first, that it introduced the notion of aggregate demand as the sum of consumption, investment, and government spending. Second, it showed (or purported to show) that full employment could be maintained only with the help of government spending. Economists still argue about what Keynes thought caused high unemployment. Some think that Keynes attributed unemployment to wages that take a long time to fall. But Keynes actually wanted wages not to fall, and advocated in the General Theory that wages be kept stable. A general cut in wages, he argued, would decrease income, consumption, and aggregate demand. This would offset any benefits to output that the lower price of labor might have contributed.
Why shouldn't government, thought Keynes, fill the shoes of business by investing in public works and hiring the unemployed? General Theory advocated deficit spending during economic downturns to maintain full employment. Keynes's conclusion initially met with opposition. At the time, balanced budgets were standard practice with the government. But the idea soon took hold and the United States government put people back to work on public works projects. Of course, once policymakers had taken deficit spending to heart, they could not let it go.
Okay…so what happened in Rome? The problem was that under Tiberius, the government- economic rug was yanked out from under the populace; when government financed programs were shut down many were thrown into unemployed status. Therefore we have not only a lack of government spending, but also a lack of populace spending because of high unemployment. Because the government withdrew from the market, the economy floundered. This illustrates Keynes’ view that government intervention plays a major role in equilibrium of the economy. Lower taxes and government public works programs seemed to be the great economic answer for Augustus. Keynes idea that government intervention spurs the economy and eliminates market failure actually has great merit when viewed through Roman glasses: Tiberius hoarding money and tax evasions of the wealthy led to economic failure which is proof in reverse.
The supply in the market suddenly had huge excesses because the government’s demand for the public project supplies dropped drastically when Tiberius stopped the public works programs. A Keynesian idea that does not fit in this scenario is that those who have the money will not spend it rationally and they will spend immediate income without regard to future income. This idea contrasts with the classical view that those who have the money will spend it rationally and will spend some and save some. This comes from Adam Smith’s philosophy in his Wealth of Nations: individuals will make rational decisions and this will lead to socially acceptable economic outcomes. Not so with the Romans. If they had wealth, they had to hide it and this was perpetuated through the 3rd century because of the over burdensome demand for more revenue in the form of higher taxes and a degraded coinage.
The merchants (plebeians) of the times could not invest in their businesses because this would give them the appearance of affluence which would make the tax dragons breathe fire upon them thus burning up any extra cash they may have accrued. Current cash flow had to be hidden which shoots down another Keynesian pillar of thought. He proposed that people would spend what they have regardless of how little or how much income they might have in the future. Therefore, taxes have a tremendous effect on economic booms and busts.
How our economy functions, and why…
Government cannot control the market effectively because of lag time. It takes months to devise a fiscal policy, then months for the President to promote it and gain support, then months to discuss it in congress then vote on it and then perhaps the judicial system will take a look at it and say it isn’t constitutional and all that time was for naught. This lag time is also reflected in economic boons which transcend presidents in office. Case in point, President Clinton enjoyed quite a bit of economy gains because of the reforms of Reagan and George H.
The only thing that can change instantaneously is interest rate. This was what Keynes first focused on in his economic theory. It has been proven in the past two decades that interest rates play a major role in the economy health as well as world events such 9/11 on the World Trade Center and the war in Iraq. These have an impact on investors who, as a whole, make the stock market go up and down. When it goes up, more people are confident and spend more money. When it goes down, more people spend less and this results in a contraction in the market. With 9/11, there was much less confidence and the stock market plummeted, interest rates were rock bottom and spending was at an all time low during the Christmas splurge season. Now, OPEC decides the cost of a barrel of oil which is the hand in the glove on the handle of prices. The cost of energy effects aggregate demand because it affects all costs of production. Pricing is not an immediate effect, however. Lower prices do stimulate spending but then the labor market suffers if the prices remain too low for too long. Since the government of the U.S. has no strong-arm control over pricing and a modicum control over wages with the minimum wage limit, it would seem that the economy has much more laissez faire with regard to aggregate demand.
However, aggregate demand does include Government spending and our Government does love to spend money with an attitude, “If I don’t spend my budget this year, then next year I lose my money.” The federal government also puts money in people’s pockets in an attempt to redistribute the available money through welfare and other benefits which actually does lend to the aggregate demand because the poorer people now have money to spend not just food stamps. The Roman Caesars found out that once the freebies started flowing, they could not stem the flow because the poorer populace had mob-power. Public officials also feel the pinch of mob-power when voters go to the polls every election day. One false step and the elected official will not be serving another term. The freebies must flow, the taxes must be collected, the government must spend and Greenspan still rules the roost in the economic world.
Since the debate between classical and Keynesians is still raging and there is much on each side of the argument which leaves gaping holes which the other side fills quite nicely, in my opinion, I believe our economy rocks along breathing, growing, contracting, expanding in both the laissez faire and Keynesian processes, but more on the Keynesian side than laissez faire.
Keynesian because of government spending and because the Fed controls the interest rates. Even though the Fed is not controlled by the Government, it must be included in the Keynesian theory because it is a lever used to control the economy which is not what laissez faire is all about. When there is a surplus, more spending and when there is a deficit still more spending; balanced budget does not seem to be the issue. The issue is how much is in a constituent’s pocket, rich, poor doesn’t matter because the poor will get government benefits and the rich will be expected to produce and hire more because they are receiving tax deductions and credits. Because the Executive Branch and the Legislative Branch generally agree on lower taxes because their constituents demand lower taxes, we see a Keynesian-type of control on the marketplace that was illustrated by the Roman economy during Augustus’ time. Our government will continue to spend lavishly on defense, public works and improvements of quality of life while maintaining public servant wages close to the private sector for similar jobs; along with stable tax laws (and for now, lower taxes), this reads as Keynesian. Because of this, our economy does function in a Keynesian style. However…
Laissez faire because the government is a slow and lumbering giant that has three sets of reins, Executive, Legislative and Judicial and those reins do not always pull or tug in the same direction. Since wages and prices are the main economic anchors and these are not manipulated by government strings, the steady economic growth is shown by our steady increase in GDP and in aggregate demand. Since capitalism does reward the ingenious and the hard worker, our economy is as stable as an ocean liner on heavy seas because it is a buoyant as it is heavy.
(c) Copyright 2010 all rights reserved, no reprints or publishing of this without the express written permission of Gina Burgess, author.
References…
Bartlett, Bruce. CATO Journal, Fall 1994, Vol. 14 Issue 2, p287, 19p
Blinder, Alan S. The Concise Encyclopedia of Economics, http://www.econlib.org/library/Enc/KeynesianEconomics.html Retrieved April 18, 2005 Concise Encyclopedia of Economics, http://www.econlib.org/library/Enc/bios/Keynes.html Retrieved April 7, 2005. Frank, T. (1935) "The Financial Crisis of 33 A.D." American Journal of Philology 56(4): 336- 41.
Hoover, Kevin D. “The rational expectations revolution: An assessment” CATO Journal, Spring/Summer 1992, Vol. 12 Issue 1, p 81
Hopkins, K. (1980) "Taxes and Trade in the Roman Empire (200 B.C.-A.D. 400)." Journal of Roman Studies 70: 101-25
King, Robert. New Classical Macroeconomics The Concise Encyclopedia of Economics Library of Economics and Liberty. Retrieved April 6, 2005 http://www.econlib.org/library/Enc/NewClassicalMacroeconomics.html Musgrave, R.A. (1959) The Theory of Public Finance. New York: McGraw-Hill.
Oertel, F. (1939) "The Economic Life of the Empire." Cambridge Ancient History 12: 232-81. London: Cambridge University Press.
Shiller, Bradley R. Essentials of Economics. Fifth Edition, 2005 p 254
Thornton, M.K., and Thornton, R.L. (1990) "The Financial Crisis of A.D. 33: A Keynesian Depression?" Journal of Economic History 50(3): 655-62.
