How to turn old-school economic theories into forward-thinking economic strategies

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16 January 2024

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What is economics?

UK Prime Minister Margaret Thatcher once defended her economic policies by saying “there is no alternative”. And in a field as enigmatic as economics, a lot of people simply accepted that as fact. But the Iron Lady’s understanding was perhaps a tad rusty – there are in fact loads of alternative ways to interpret economics. It’s a field that’s been filled with lively debate from the beginning and – luckily for us – there’s no signs of that slowing down anytime soon. Let’s enter the ring.

What is economics? Economists love debating what economics is almost as much as they love debating economics itself – they just really, really love talking... Some will tell you that it’s the study of rational choice, i.e., how individuals make decisions. But that’s a bit broad. We prefer the definition from economist Ha-Joon Chang: economics is the study of the economy (lesson #1: a lot of economics is stating the obvious).

That still covers a lot of bases. The money in your pocket, the jobs you apply for, the complex web of international trade that resulted in you reading this on your smartphone… all these fall under the economic umbrella.

Governments and central banks have control over these things through policies like minimum wages, taxation, and spending. And depending on their preferred economic theories, they might implement different policies. Examples include hands-off conservative approaches, or full-on communism that abolishes private property.

Why do I need to know this? The decisions made by people in power directly affect you. Economics seeps into every aspect of your daily life: from the price you pay for groceries to how easy it is for you to find a job. And seeing as there are multiple ways to skin an economic cat, each way will impact you differently.

If you live in a democratic country, you probably have some kind of say in its economic policies. Different political candidates may support different economic theories. By understanding the different theories, you can make an informed decision when you vote – picking the candidate and theory that appeal to you the most.

In this article, we’ll take a look at the big economic theories you need to know about, ranging from Milton Friedman’s hands-off economy all the way to MMT. But first, hold onto your kilts – let’s take a trip to 18th-century Scotland.

Adam Smith: Classical economics

Who was the “Father of Economics”? He went from being kidnapped aged three to founding the field of economics aged 53 – Scotsman Adam Smith was kind of a big deal. His 1776 book, The Wealth of Nations, laid the groundwork for economics (which was known as “political economy” back then). He established the school of thought known as “classical economics”.

Smith’s big idea was that individuals acting in their own self-interest would help society as a whole to generate wealth. According to Smith, people want to buy the best things they can at the lowest possible price – and in a competitive environment, that means manufacturers will try as hard as possible to reduce their costs. Production is therefore as efficient as it can be, meaning more resources for everyone. This idea is known as the invisible hand – the way in which a series of individual actions coalesce into a big movement in the right direction.

The other big idea in classical economics is Say’s Law: “supply creates its own demand”. When something is sold (i.e., supplied), workers and suppliers are paid, and profits are taken. Those workers can then use their money to buy other goods – meaning demand increases for them.

Classical economics also has lots to say about international trade. David Ricardo developed the idea of comparative advantage: that free trade makes everyone better off by getting countries to focus on the things they can produce most efficiently.

In practice, this led to a laissez-faire approach: one where government intervention was the bogeyman, and where the notion of reduced demand shrinking an economy was outright rejected. But over time this thinking relaxed slightly, eventually morphing into the now-popular “neoclassical” approach.

With more of a focus on consumers than producers, neoclassical economics is all about maximising people’s happiness and minimising their suffering. It views the world as being made up of rational, selfish individuals who will somehow produce a good societal outcome for everyone. It’s still a pretty hands-off approach, but it understands that markets can sometimes mess up – especially in the branch known as “welfare economics”. Arthur Pigou pointed out that markets fail to value some things, like the negative effects of air pollution and that some intervention was necessary to force markets to consider these externalities.

The anti-intervention stance of classical and neoclassical economics was popular for a while, but the Great Depression put a bit of a stop to that. Let's find out what came next...

Keynesian economics

What changed in the Great Depression? In 1929, the American economy started to collapse and by 1933, when things reached rock bottom, it had shrunk by 30%. Millions of people lost their jobs, a quarter of the US population was unemployed, and it was pure chaos.

Classical economists who thought employment would always remain around a “natural” level were shocked. While they argued that in the long run employment would recover, not everyone accepted this response. Enter John Maynard Keynes with his famous quote: “In the long run we are all dead.”

Keynesian economics says there’s no guarantee that any left-over money will be reinvested into the economy. And when people start to panic as they did in 1929, investment might be seriously reduced. Reduced investment means people are paid less, which means they spend even less, which reduces investment even more… you get the idea. To break out of this cycle, Keynes argued that governments could stimulate the economy with spending.

If a government borrows money to spend on a new infrastructure project, all the people working on said project will have money in their pockets. They’ll probably spend some of that new income and it becomes part of the economic cycle. If they spend some at their local bar, the bar owner now has a bit more cash which she can spend… and the cycle continues. In jargon-y terms, the “fiscal multiplier” turns a bit of government spending into a lot of good for the economy.

During World War II, huge US government spending on the military helped boost growth – seemingly proving Keynes right. And after the war, Keynesian economics became mainstream, pushing countries down the road to recovery.

But by the ‘70s, the ideology had fallen out of favour. People worried about governments crowding out private investment, whether government spending would always trickle down to increased economic growth, or whether it would just lead to people hoarding even more cash. The biggest worry was inflation: whether too much money in the economy would drive prices up and cause more problems than it solved.

Keynesian economics wasn’t fully discredited – it played a key role in government responses to the 2008 financial crisis, when they boosted spending to stabilise their economies. But the ‘70s brought more than just disco music with it – a new breed of economics boogied along too. Greed is good, right?

Friedman and monetarism

The main man of the 1970s and ‘80s was American economist Milton Friedman. An advisor to both Ronald Reagan and Margaret Thatcher, he was a key figure in what’s now known as the Chicago school of economics and the theory known as monetarism.

Friedman was not a fan of Keynesian economics. While Keynes’s concerns lay in government spending (fiscal policy), Friedman was much more concerned with cold, hard cash (monetary policy). His big worry was inflation – particularly because by the end of the ‘70s, Keynes’s ideas had led to “stagflation”: high inflation, high unemployment, and low growth.

Friedman blamed Keynesian policies for printing too much money, which caused this inflation. He thought inflation could always be dealt with by shrinking the “money supply”: reducing government spending and increasing interest rates, which would in turn make it more expensive to borrow cash. Less money in the economy means less spending, and that decreased demand should bring prices down – reducing inflation. That worked: when the US Federal Reserve restricted money supply in 1979, inflation finally decreased. However, that did also cause a recession.

Rather than encouraging governments to spend more, Friedman advocated a smaller government – one that deregulated industries and let markets operate freely. He thought individual people could always spend money more efficiently than a government could, and so the economy would be better off with lower taxes and reduced government spending. The wider Chicago school came to be known for its libertarian views, which remained very popular during decades of deregulation and booming growth.

One offshoot of Chicago economics was Eugene Fama’s efficient market hypothesis. According to Fama, markets are always perfectly efficient. Basically, all available information about a company is already reflected in its share price, and stock markets reflect new information instantly. This means assets can never be overpriced, and market bubbles can never exist.

History kind of disproved that, though... Some people might have put too much faith in this theory back in 2008 when it became clear that markets weren’t as great at accurately assessing risk as everyone had thought. As millions of people were affected by the worst economic crisis since the ‘30s, people reconsidered their love for Chicago and its economists.

That brings us to now. Current economic thinking is a mix of all the above: a bit of Keynesian economics to deal with recessions, a bit of monetarism to keep everything in check, and a mostly hands-off approach to markets (known as the “new neoclassical synthesis”). But that consensus could be about to shatter. There’s a new kid on the block: meet MMT.

Modern Monetary Theory

Modern Monetary Theory (a.k.a., MMT) is a pretty radical departure from other economic theories. It takes Keynesian theory to the next level, arguing that a government can borrow as much as it likes to pay for its spending.

Unlike Friedman, MMT doesn’t care much about monetary policy or interest rates. In fact, it thinks the natural interest rate should be zero and anything above that is just a nice bonus for investors. Instead, MMT is concerned with government spending: whenever something needs to be paid for, the central bank should just print more money, use it to pay for the projects, et voilà: unlimited money.

Really? Well, not quite. When people hear about MMT they often freak out about spiralling, Venezuela-style price rises. Borrowing more money only leads to more economic activity if it’s put to productive use. Otherwise, extra cash chasing the same goods and services could spark inflation.

But MMT fans have a potential solution: a guaranteed job programme. Anyone that needs a job would have one, which should mean enough workers are in the labour force to deal with the increased demand created by more money in the economy. Plus, MMT can reduce most taxes because government spending will now be funded by borrowing, not taxation. This would allow the government to use the taxes that are left to stop inflation from ever getting too carried away – a simple tax hike should slow price rises by reducing people’s take-home pay.

MMT is a brave new frontier for economics – it’s never really been put into practice. The closest example would probably be Japan, where national debt has at times been 250% of the economy. Japan’s got problems with slow growth, but inflation is the least of its worries – in fact deflation (decreasing prices) is common there.

Anything as tradition-smashing as MMT will attract detractors, and there are some pretty vocal ones against this radical economic theory. Critics say governments can’t be trusted to go through the politically unpopular process of raising taxes to control inflation, and worry that reckless spending might become a new normal. But with people increasingly sick of the economic status quo, MMT offers a new alternative.

The history of economics has been one of constant change – theories come into vogue, something goes wrong, and then we move on to the next one. Who knows: maybe MMT is just another in a long line of these theories… or maybe we’ll finally find the one that works?

In this article you learned:

🔹There’s more than one way of interpreting economics, and debates about which way is “right” have raged for centuries

🔹Classical economics argues for the power of the invisible hand, advocating for free markets

🔹Keynesian economics is more keen on government intervention, wanting them to spend their way out of recessions

🔹Monetarism thinks we’ve got to use interest rates to control the money supply and inflation

🔹Modern Monetary Theory is a new way of thinking that suggests we can fund government spending by printing more cash