Objectives, Instruments and the Role of Government
In our historical journey we will see that macroeconomics has experienced
periods of crisis. There is no denying the significant conflicts of opinion that
exist between the different schools of thought, and this was especially evident
during the 1970s and 1980s. However, it should also be noted that economists
tend to disagree more over theoretical issues, empirical evidence and the
choice of policy instruments than they do over the ultimate objectives of
policy. In the opening statement of what turned out to be one of the most
influential articles written in the post-war period, Friedman (1968a) gave
emphasis to this very issue:
There is wide agreement about the major goals of economic policy: high employment,
stable prices, and rapid growth. There is less agreement that these goals are
mutually compatible or, among those who regard them as incompatible, about the
terms at which they can and should be substituted for one another. There is least
agreement about the role that various instruments of policy can and should play in
achieving the several goals.
The choice of appropriate instruments in order to achieve the ‘major goals’ of
economic policy will depend on a detailed analysis of the causes of specific
macroeconomic problems. Here we encounter two main intellectual traditions
in macroeconomics which we can define broadly as the classical and Keynesian
approaches. It is when we examine how policy objectives are interconnected
and how different economists view the role and effectiveness of markets in
coordinating economic activity that we find the fundamental question that
underlies disagreements between economists on matters of policy, namely,
what is the proper role of government in the economy? The extent and form of
government intervention in the economy was a major concern of Adam Smith
(1776) in the Wealth of Nations, and the rejection of uncontrolled laissez-faire
by Keynes is well documented. During the twentieth century the really big
questions in macroeconomics revolved around this issue. Mankiw (1989) identifies
the classical approach as one ‘emphasising the optimization of private
actors’ and ‘the efficiency of unfettered markets’. On the other hand, the
Keynesian school ‘believes that understanding economic fluctuations requires
not just the intricacies of general equilibrium, but also appreciating the possibility
of market failure’. Obviously there is room for a more extensive role for
government in the Keynesian vision. In a radio broadcast in 1934, Keynes
presented a talk entitled ‘Poverty and Plenty: is the economic system selfadjusting?’
In it he distinguished between two warring factions of economists:
On the one side are those that believe that the existing economic system is, in the
long run, a self-adjusting system, though with creaks and groans and jerks and
interrupted by time lags, outside interference and mistakes … On the other side of
the gulf are those that reject the idea that the existing economic system is, in any
significant sense, self-adjusting. The strength of the self-adjusting school depends
on it having behind it almost the whole body of organised economic thinking of
the last hundred years … Thus, if the heretics on the other side of the gulf are to
demolish the forces of nineteenth-century orthodoxy … they must attack them in
their citadel … Now I range myself with the heretics. (Keynes, 1973a, Vol. XIII,
pp. 485–92)
Despite the development of more sophisticated and quantitatively powerful
techniques during the past half-century, these two basic views identified by
Keynes have persisted. Witness the opening comments of Stanley Fischer in a
survey of developments in macroeconomics published in the late 1980s:
One view and school of thought, associated with Keynes, Keynesians and new
Keynesians, is that the private economy is subject to co-ordination failures that
can produce excessive levels of unemployment and excessive fluctuations in real
activity. The other view, attributed to classical economists, and espoused by monetarists
and equilibrium business cycle theorists, is that the private economy
reaches as good an equilibrium as is possible given government policy. (Fischer,
1988, p. 294)
It appears that many contemporary debates bear an uncanny resemblance to
those that took place between Keynes and his critics in the 1930s. Recently,
Kasper (2002) has argued that in the USA, the 1970s witnessed a strong
revival in macroeconomic policy debates of a presumption in favour of laissezfaire,
a clear case of ‘back to the future’.
In this book we are primarily concerned with an examination of the intellectual
influences that have shaped the development of macroeconomic theory
and the conduct of macroeconomic policy in the period since the publication
of Keynes’s (1936) General Theory of Employment, Interest and Money. The
first 25 years following the end of the Second World War were halcyon days
for Keynesian macroeconomics. The new generation of macroeconomists
generally accepted Keynes’s central message that a laissez-faire capitalist
economy could possess equilibria characterized by excessive involuntary
unemployment. The main policy message to come out of the General Theory
was that active government intervention in order to regulate aggregate demand
was necessary, indeed unavoidable, if a satisfactory level of aggregate
output and employment were to be maintained. Although, as Skidelsky (1996a)
points out, Keynes does not deal explicitly with the Great Depression in the
General Theory, it is certain that this major work was written as a direct
response to the cataclysmic events unfolding across the capitalist economies
after 1929.
In our historical journey we will see that macroeconomics has experienced
periods of crisis. There is no denying the significant conflicts of opinion that
exist between the different schools of thought, and this was especially evident
during the 1970s and 1980s. However, it should also be noted that economists
tend to disagree more over theoretical issues, empirical evidence and the
choice of policy instruments than they do over the ultimate objectives of
policy. In the opening statement of what turned out to be one of the most
influential articles written in the post-war period, Friedman (1968a) gave
emphasis to this very issue:
There is wide agreement about the major goals of economic policy: high employment,
stable prices, and rapid growth. There is less agreement that these goals are
mutually compatible or, among those who regard them as incompatible, about the
terms at which they can and should be substituted for one another. There is least
agreement about the role that various instruments of policy can and should play in
achieving the several goals.
The choice of appropriate instruments in order to achieve the ‘major goals’ of
economic policy will depend on a detailed analysis of the causes of specific
macroeconomic problems. Here we encounter two main intellectual traditions
in macroeconomics which we can define broadly as the classical and Keynesian
approaches. It is when we examine how policy objectives are interconnected
and how different economists view the role and effectiveness of markets in
coordinating economic activity that we find the fundamental question that
underlies disagreements between economists on matters of policy, namely,
what is the proper role of government in the economy? The extent and form of
government intervention in the economy was a major concern of Adam Smith
(1776) in the Wealth of Nations, and the rejection of uncontrolled laissez-faire
by Keynes is well documented. During the twentieth century the really big
questions in macroeconomics revolved around this issue. Mankiw (1989) identifies
the classical approach as one ‘emphasising the optimization of private
actors’ and ‘the efficiency of unfettered markets’. On the other hand, the
Keynesian school ‘believes that understanding economic fluctuations requires
not just the intricacies of general equilibrium, but also appreciating the possibility
of market failure’. Obviously there is room for a more extensive role for
government in the Keynesian vision. In a radio broadcast in 1934, Keynes
presented a talk entitled ‘Poverty and Plenty: is the economic system selfadjusting?’
In it he distinguished between two warring factions of economists:
On the one side are those that believe that the existing economic system is, in the
long run, a self-adjusting system, though with creaks and groans and jerks and
interrupted by time lags, outside interference and mistakes … On the other side of
the gulf are those that reject the idea that the existing economic system is, in any
significant sense, self-adjusting. The strength of the self-adjusting school depends
on it having behind it almost the whole body of organised economic thinking of
the last hundred years … Thus, if the heretics on the other side of the gulf are to
demolish the forces of nineteenth-century orthodoxy … they must attack them in
their citadel … Now I range myself with the heretics. (Keynes, 1973a, Vol. XIII,
pp. 485–92)
Despite the development of more sophisticated and quantitatively powerful
techniques during the past half-century, these two basic views identified by
Keynes have persisted. Witness the opening comments of Stanley Fischer in a
survey of developments in macroeconomics published in the late 1980s:
One view and school of thought, associated with Keynes, Keynesians and new
Keynesians, is that the private economy is subject to co-ordination failures that
can produce excessive levels of unemployment and excessive fluctuations in real
activity. The other view, attributed to classical economists, and espoused by monetarists
and equilibrium business cycle theorists, is that the private economy
reaches as good an equilibrium as is possible given government policy. (Fischer,
1988, p. 294)
It appears that many contemporary debates bear an uncanny resemblance to
those that took place between Keynes and his critics in the 1930s. Recently,
Kasper (2002) has argued that in the USA, the 1970s witnessed a strong
revival in macroeconomic policy debates of a presumption in favour of laissezfaire,
a clear case of ‘back to the future’.
In this book we are primarily concerned with an examination of the intellectual
influences that have shaped the development of macroeconomic theory
and the conduct of macroeconomic policy in the period since the publication
of Keynes’s (1936) General Theory of Employment, Interest and Money. The
first 25 years following the end of the Second World War were halcyon days
for Keynesian macroeconomics. The new generation of macroeconomists
generally accepted Keynes’s central message that a laissez-faire capitalist
economy could possess equilibria characterized by excessive involuntary
unemployment. The main policy message to come out of the General Theory
was that active government intervention in order to regulate aggregate demand
was necessary, indeed unavoidable, if a satisfactory level of aggregate
output and employment were to be maintained. Although, as Skidelsky (1996a)
points out, Keynes does not deal explicitly with the Great Depression in the
General Theory, it is certain that this major work was written as a direct
response to the cataclysmic events unfolding across the capitalist economies
after 1929.
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