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II. FROM SMITH TO KEYNES AND BACK
The birth of economics as a discipline is usually credited to AdamSmith, who published “The Wealth of Nations” in 1776. Over the next 160years an extensive body of economic theory was developed, whose centralmessage was: Trust the market. Yes, economists admitted that there werecases in which markets might fail, of which the most important was thecase of “externalities” — costs that people impose on others withoutpaying the price, like traffic congestion or pollution. But the basicpresumption of “neoclassical” economics (named after thelate-19th-century theorists who elaborated on the concepts of their“classical” predecessors) was that we should have faith in the marketsystem.
This faith was, however, shattered by the Great Depression.Actually, even in the face of total collapse some economists insistedthat whatever happens in a market economy must be right: “Depressionsare not simply evils,” declared Joseph Schumpeter in 1934 — 1934! Theyare, he added, “forms of something which has to be done.” But many, andeventually most, economists turned to the insights of John Maynard Keynes for both an explanation of what had happened and a solution to future depressions.
Keynes did not, despite what you may have heard, want the governmentto run the economy. He described his analysis in his 1936 masterwork,“The General Theory of Employment, Interest and Money,” as “moderatelyconservative in its implications.” He wanted to fix capitalism, notreplace it. But he did challenge the notion that free-market economiescan function without a minder, expressing particular contempt forfinancial markets, which he viewed as being dominated by short-termspeculation with little regard for fundamentals. And he called foractive government intervention — printing more money and, if necessary,spending heavily on public works — to fight unemployment during slumps.
It’s important to understand that Keynes did much more than makebold assertions. “The General Theory” is a work of profound, deepanalysis — analysis that persuaded the best young economists of theday. Yet the story of economics over the past half century is, to alarge degree, the story of a retreat from Keynesianism and a return toneoclassicism. The neoclassical revival was initially led by Milton Friedmanof the University of Chicago, who asserted as early as 1953 thatneoclassical economics works well enough as a description of the waythe economy actually functions to be “both extremely fruitful anddeserving of much confidence.” But what about depressions?
Friedman’s counterattack against Keynes began with the doctrineknown as monetarism. Monetarists didn’t disagree in principle with theidea that a market economy needs deliberate stabilization. “We are allKeynesians now,” Friedman once said, although he later claimed he wasquoted out of context. Monetarists asserted, however, that a verylimited, circumscribed form of government intervention — namely,instructing central banks to keep the nation’s money supply, the sum ofcash in circulation and bank deposits, growing on a steady path — isall that’s required to prevent depressions. Famously, Friedman and hiscollaborator, Anna Schwartz, argued that if the Federal Reserve haddone its job properly, the Great Depression would not have happened.Later, Friedman made a compelling case against any deliberate effort bygovernment to push unemployment below its “natural” level (currentlythought to be about 4.8 percent in the United States): excessivelyexpansionary policies, he predicted, would lead to a combination ofinflation and high unemployment — a prediction that was borne out bythe stagflation of the 1970s, which greatly advanced the credibility ofthe anti-Keynesian movement.
Eventually, however, the anti-Keynesian counterrevolution went farbeyond Friedman’s position, which came to seem relatively moderatecompared with what his successors were saying. Among financialeconomists, Keynes’s disparaging vision of financial markets as a“casino” was replaced by “efficient market” theory, which asserted thatfinancial markets always get asset prices right given the availableinformation. Meanwhile, many macroeconomists completely rejectedKeynes’s framework for understanding economic slumps. Some returned tothe view of Schumpeter and other apologists for the Great Depression,viewing recessions as a good thing, part of the economy’s adjustment tochange. And even those not willing to go that far argued that anyattempt to fight an economic slump would do more harm than good.
Not all macroeconomists were willing to go down this road: manybecame self-described New Keynesians, who continued to believe in anactive role for the government. Yet even they mostly accepted thenotion that investors and consumers are rational and that marketsgenerally get it right.
Of course, there were exceptions to these trends: a few economistschallenged the assumption of rational behavior, questioned the beliefthat financial markets can be trusted and pointed to the long historyof financial crises that had devastating economic consequences. Butthey were swimming against the tide, unable to make much headwayagainst a pervasive and, in retrospect, foolish complacency.
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