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History of Economic Thought

The original big thinkers of economic theory would be surprised how the landscape history of economic thought has changed over the last 30 years or so. Money has morphed, money has internationalized – and the world’s central bankers have become politicized, leaving their job a far cry from the stability and sobriety and equality sought by their predecessors.

History of Economic Thought

Early history of economic thought was called the “Classical” era. Here gentlemen of leisure speculated about the natural world, and for our purposes, how to understand and explain the Industrial Revolution of the 1800s with its evident successes. Adam Smith’s “Invisible Hand” laid the foundation for all subsequent “laissez faire” concepts of how the economy would work best, suggesting that free markets for goods and labour would send the proper price signals to decision makers, creating the greatest good for the greatest number.

The industrial revolution’s catastrophic working conditions for the exploited masses exposed the rapacious nature of capitalist entrepreneurs. Karl Marx counselled revolution to bring the benefits of economic progress “to each according to his needs”. And so, the history of economic thought became dominated by current discourse: Free Market Capitalism versus Socialism.

Only after the Great Depression of the 1930s did economic theories morph from speculations into something more.

An explanation for the depression was demanded, and “monetarists”, led by the analyses of Milton Friedman, found ready answers: the newly created U.S. Federal Reserve had squeezed the banking system at precisely the wrong time. By denying credit to businesses and commercial banks, the central bank made a bad situation impossibly worse. To this day, monetarists (central bankers are all monetarists) try to get just the right amount of money into the system, but are ruled by the fear of squeezing at the wrong time.

What should have or could have been done? John Meynard Keynes demonstrated that the proper role of government is to spend money and provide jobs when the private economy is in retreat. Sensible Keynsians believed that what is now known as “fiscal policy” must be organized to accumulate a rainy day fund when times are good and use that kitty when times are tough. In this theory, government spending would be “counter-cyclical” – cushioning the effects of the animal spirits that drive economic decisions.

Generally, a pretty decent set of theories. Right? Unfortunately, politics and reality have gotten in the way.

When Keynes developed his theories, the government was a tiny portion of economic activity, and there was virtually no government borrowing. So the government did have the capacity to act as the marginal source of demand. That’s no longer the case.

Predictably, politicians have been happy to spend (gaining favour with voters), and only willing to cut back or raise taxes in times of dire stress. The result is that the sensible advice of Keynsians to accumulate a reserve has never been followed – even when times were very good. Fiscal policy is therefore now hamstrung as a tool of economic management, and macro-economic thought has pretty much stagnated.

Monetarists, on the other hand, have been called upon increasingly to bear the burden of economic management since the U.S. guns and butter policy of the Vietnam era, and former U.S. President Nixon’s 1971 decision to abandon monetary discipline.

Following a decade of stagflation during the 1970s, in which money supply followed and facilitated ever-rising prices, the newly-appointed Chairman of the U.S. Federal Reserve, Paul Volcker, squeezed the system – hard – causing a recession severe enough to eventually cure the inflation problem. Monetarism rocks!?

Wrong! Reality struck in three pernicious ways: money morphed, money internationalized and central bankers became beholden to politicians. For lack of better theories, monetarists cling to the tattered remnants of the tools that Volcker employed, attempting to repair the damage by tacking on ideas such as a Theory of Rational Expectations, which assert that monetary management needs take account of the expectations of financial market participants. This was to no avail.

How did money morph?

Money used to be in your wallet, or in a deposit at the bank, within the jurisdiction of the central bank. Now, you probably use your supermarket credit or debit card, rely on a line of credit, or possibly a money market fund. You borrow against the equity in your house and you pay for a car at Honda Finance. An ever-diminishing proportion of financial transactions take place within the traditional banking system. And anyway, what is money?
Money internationalized?

Cross-border money transactions measure in the trillions daily. Even your government will borrow in the cheapest market, and then hedge back. Economists used to think that national boundaries meant that they could control what went on within their boundaries, but global financial markets now interconnect and arbitrage with the click of a mouse.

Independent central bankers?

Paul Volcker may have been the last independent central banker. These bankers have now accepted responsibility for employment levels, inflation and the health of the financial markets – a set of objectives that economists opining 30 years ago might have judged incompatible, and in any case contemporaneously unattainable given the tools available. It’s a tough job, and intensely political.

And what of Schools of Economic Theory? The current path the history of economic thought has taken can be called “searching” or “chaotic” according to your disposition. In 2015, we see central bankers actively debasing their currencies in the hope of gaining an international advantage that will raise domestic employment. We see central bankers actively pursuing inflation of 2% or more to “grease the wheels” – in the process savaging the purchasing power of those who diligently saved for their retirement. We see central bankers deliberately widening already unconscionable gaps between the wealthy and the rest by driving interest rates toward zero. It’s a far cry from the stability and sobriety and equality sought by their predecessors.

Surely those who fought those great intellectual battles of the past — Smith versus Marx, Keynes versus Friedman — would be united in condemnation of the policies of instability now espoused by their successors.

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