You would often hear economists speak of school of thoughts. There are fundamental premises on which the subject matter of economics has been built, and it is these premises that economists differ on, each difference creating a school of thought. There have been various schools ranging from Monetarism to the Austrian, however two dominated economic study like no other - Classical and Keynesian.
Classical economics emerged at a time when the world was still recovering from monarchy. Most nations followed a top down, command and control approach to the economy. In the atmosphere of rising protectionism, Classical theories emerged as symbols of economic and political freedom.
Founded by Spanish and French scholars and popularized by Adam Smith, the Classical school of thought believes that markets work best when left alone, also called laissez faire. Classicals strongly believe in the efficiency of markets. Naturally, that leaves little room for government intervention. They favor free trade and competition.
Adam Smith’s 1776 release ‘Wealth of Nations' highlights a concept called the invisible hand which means that the competing forces of demand-side and supply-side automatically move the market to equilibrium. Another famous Classical economist, Jean-Baptiste Say, propounded that supply creates its own demand meaning that production of commodities alone would suffice to propel growth.
Classicals held that the economy would adjust to cyclical swings in output by itself. They believed that if demand in the economy fell, the resulting slowdown in production and employment would lead to a decline in prices and wages. This, in turn, would induce employers to make investments and employ more people, restoring employment and growth.
The severity of the Great Depression, however, tested this hypothesis. A British mathematician, John Maynard Keynes posed a challenge to Classical Theory.
Keynes held that free-market economies (classical model) led to underconsumption and underspending. He refuted Say's Law to argue that it was demand that created supply and not vice versa. When aggregate demand rises, to meet that demand, firms produce more output and employ more labor force. Keynes was skeptical of the idea that if left alone free markets will inevitably move towards a full employment equilibrium.
Keynesian Economics proposes the use of active government policy to manage aggregate demand in order to address or prevent economic recessions. Activist fiscal and monetary policy are the primary tools recommended by Keynesian economists to manage the economy and fight unemployment.
These are some points of departure between the two thoughts in terms of the fundamental premises of economics. However, to say that laissez faire implies that there is absolutely no room for policy intervention would be incorrect. Both Classical and Keynesian Economics contain scope of policy action. The kind of policy actions, however, differ.
1. On government spending, the classical model takes a ‘laissez-faire’ approach whereas the Keynesian model makes a case for government intervention, especially in a recession when there is a need for government spending to boost aggregate demand.
2. On fiscal Policy, Classical economics places little emphasis. Classical theory is the basis for Monetarism, which only concentrates on managing the money supply through monetary policy. Keynesian economics suggests that governments need to use fiscal policy, especially in a recession.
3. On government borrowing, a classical would stress the importance of reducing it and balancing the budget because there is no significant benefit from higher government spending, they believe. Lower taxes will increase economic efficiency. The Keynesian view holds that government borrowing is necessary because it helps increase aggregate demand.
4. On supply side policies, the classical view holds that it is crucial to enable the free market to operate. This may involve reducing the power of trade unions to prevent sticky wages.
Keynesians don’t reject supply side policies. They doubt their effectiveness. Say, in a deep recession, supply side policies may not be able to deal with the fundamental problem of a lack of demand. This is not to say that free markets will not bring the economy back to equilibrium, but that the process may be painful for the economy.
Numerous schools of thoughts have yet again departed from these two prominent systems to form new ones. Unlike the sciences, economics does not contain established premises to form a base upon which to build. The interesting challenge in economics is to adopt a base strong enough to sustain various tentacles of a theory.
- Danarya Israel The opinions expressed in this publication are those of the author. They do not purport to reflect the opinions or views of the Achievement Cell or its members.