THE CONTINUING DEBATE

THE CONTINUING DEBATE

So, is the market economy a fully automatic, self-regulating
system capable of securing general equilibrium for a country as
a whole? The Keynesian critique, in the previous section, says no.
Unemployment at one extreme or inflation at the other are the
inescapable consequences of an economy where aggregate demand
adds up to either insufficient, or too much, spending to balance
aggregate supply. Any self-righting market forces within the
economy working to restore balance are said to be too weak to be
effective.
This is a major, positive-economic criticism of the market system
and, since its first articulation way back in 1936 (in Keynes’ masterpiece,
The General Theory of Employment, Interest and Money) it
has provoked an ongoing controversy.
That all economies experience periods of inflation and unemployment
is self-evident. What accounts for these unwelcome
phenomena is something much more contestable.
The Keynesian argument is clear – that variations in unregulated
aggregate demand (particularly caused by the instability of private
investment) are the prime culprit. Note that the important twentiethcentury
policy recommendation derived from this thinking was that
if private markets were too volatile to keep injections equal to leakages
at the full-employment level of national income required, then
governments had to intervene. Governments should increase their
own spending when aggregate demand was otherwise too low and
decrease their spending when aggregate demand was so high as to
be inflationary. Such a policy recommendation was known as
DEMAND MANAGEMENT (see Box 4.4).
© 2004 Tony Cleaver
Box 4.4 Demand management and government budgets
Governments spend money on education, health, transport,
defence and a whole range of services to the nation which must
be paid for – if not by direct pricing – by levying taxes. The
balance of public sector spending on one side, against tax
revenues on the other, is recorded in the government’s BUDGET.
Note that government expenditure acts as an exogenous injection
into the domestic economy whereas taxes act as a leakage
to reduce people’s incomes and spending. This fact enables
governments to use their budgets in an active FISCAL POLICY to
directly influence the circular flow of national income.
Suppose business expectations are pessimistic, investment is
less than aggregate savings and financial markets cannot induce
further investment, even though interest rates are rock bottom.
National income will fall as recession grips the economy. In such
circumstances, Keynesian economic policy is for governments to
spend more than they tax. If the government’s budget is in
DEFICIT then the domestic economy must be receiving the money
the government is losing (assuming no outflow of international
funds). Private sector investment may be low but net injections
will rise if public sector investment compensates to build more
roads and hospitals, employ more people and pay them wages.
An economy in recession can thus be stimulated if the government
makes the injections which the private sector is unwilling
to provide. Notice in this example that savings outweigh private
investment so therefore the government can finance a budget
deficit by borrowing from the financial markets which are flush
with funds that no one else wishes to employ. As the economy
recovers due to the fiscal stimulus, incomes will grow and along
with them tax revenues will rise to pay off the (low-cost) loans
the government originally borrowed.
The converse of all this also applies. If investment is greater
than savings, injections exceed leakages and inflation threatens,
then governments can aim to increase taxes and make a budget
surplus to take the heat out of the economy and ensure that
aggregate demand attains equilibrium at full employment level
and not higher.
© 2004 Tony Cleaver
In his time, Keynes’ writings were so revolutionary that he
became the world’s most famous economist and his legacy on the
subject as we know it today is immense. His theories and the policy
implications that flowed from them changed the accepted paradigm
such that the post-Second World War international economy was
dominated by governments, think tanks and policy makers of all
stripes all advocating demand management policies.
But just as he challenged the orthodoxy of classical economics
which preceded him, so other economists have since had to overcome
the intellectual stranglehold that the Keynesian paradigm
exerted in the post war years.
The most famous economist living today, Milton Friedman, is
one who has been in the forefront of re-establishing neoclassical
economics and in challenging both the Keynesian notions that
market economies are not self stabilising and that they therefore
need government macroeconomic regulation.
Friedman, and other neoclassical economists, do not dispute
there is a role for government intervention in MICROECONOMICS
(e.g. to break up monopolies and promote competition amongst
suppliers, as discussed in the last chapter). But they say there is
more likelihood that government spending at macroeconomic level
will be actually destabilising and lead to more problems of unemployment
and inflation, rather than the opposite.
This neoclassical position, at its extreme, asserts that Keynesian
theory gives governments the excuse to increase spending beyond
budgets and, once you let this particular genie out of the bottle you
will never get it back in. Government spending increases year on
year as public officials find more and more reasons to overshoot
budgets; budgets are thus revised and yet again they are overspent.
The end result is an increasingly bureaucratic public sector that
grows with a mind of its own and crowds out the private sector –
which loses revenues, dynamism and the potential for supporting
the national economy in the long term.
Inflation, Friedman argued, was and is the result of central authorities
allowing excessive monetary growth. Cut back the money supplies
and you cure the problem. The opposite extreme experienced by the
US in the Great Depression of the 1930s was caused by a sudden and
severe collapse in money supplies due to a chain reaction of commercial
bank failures. Remedy? Governments should set a steady course with
© 2004 Tony Cleaver
money supplies growing at a rate just equal to the rate of growth of
all goods and services in the economy and then they should leave the
market well enough alone. Markets may not be perfect but they are
better than the alternative – ham-fisted attempts by governments to
‘stabilise’ the macroeconomy.