Economics is the study of how individuals, groups, and nations allocate scarce resources. Because nations are populated by citizens possessing unlimited desires but limited means, governments experience intense pressure to allocate their nation’s resources efficiently. This is easier said than done because citizens are not monolithic in their production, saving, spending, and wasting, and citizens don’t really like being told how much they must produce, save, spend or waste; however, this doesn’t stop citizens from demanding the government “fix” the economy whenever it is deemed broken.
To appease the citizenry, governments often call upon economists to advise them in developing policies to control one or more economic outcomes. Unfortunately, economists often disagree on the causes or fixes of stock market declines, rising food prices, or high unemployment. Economists come at their work from a variety of different worldviews, opinions, educations, and temperaments, and this results in multiple competing theories on which policies should be implemented to steer national economies towards outcomes most preferred by the citizenry. It is the purpose of the article to introduce the reader to four of the most common economic theories considered by policymakers today.
Laissez-faire (from the French, meaning to leave alone or to allow to do) economic theory holds that economies function most efficiently when the government doesn’t intervene. Laissez-faire advocates believe policymakers who interfere in the economy with taxes, tariffs, regulations, and other policy tools tend to cause more harm than good. Laissez-faire theorists prefer letting the economy fix itself whenever it is deemed broken.
Laissez-faire was first proposed by Adam Smith in his book Wealth of Nations (1776), and it has been followed several times throughout history. Laissez-faire was practiced during America’s Industrial Revolution in the late 19th Century, and again during the Coolidge administration in what has come to be known as the “Roaring 20’s.”
Keynesian economic theory
Named after John Maynard Keynes, an English economist, Keynesian theory maintains that economic recessions and depressions are the result of a lack of consumer demand for goods and services. When consumers don’t buy, inventories increase, factories then lay off workers, who in turn consume less, continuing the cycle of decreasing demand. Keynes argued governments should increase demand by spending money on goods and services in the marketplace. Keynesians believe governments should spend money (by spending a surplus or simply borrowing it) during recessions to keep people working, earning, and spending. During economic expansions, they advocate reducing spending and paying down government debts.
Franklin Roosevelt implemented Keynesian policies during the Great Depression by hiring millions of displaced workers and spending large amounts of money on government work projects like the Tennessee Valley Authority and the Civil Conservation Corps. Recently, economist and New York Times columnist Paul Krugman has been a strong advocate for Keynesian efforts to increase aggregate demand through government spending; and like other Keynesians, Krugman has little concern for a growing national debt because, in theory, debts will be paid down when the economy is once again booming.
Monetarism is an economic theory which contends that changes in the money supply are the most significant determinants of the rate of economic growth.
In the late 1970s and early 1980s, the United States experienced high inflation and low employment, an odd combination of problems Keynesian economic theory failed to adequately solve. Pioneered by the late nobel prize winning economist Milton Friedman, monetarists advocate using the Federal Reserve to control the amount of money in the economy. When there is too much money in circulation, the “Fed” raises interest rates and sells bonds in the open market to remove excess money, and when there is too little, the Fed lowers interest rates and buys bonds instead. Additionally, the Fed dictates how much money banks must keep in reserve and how much they can lend to customers. In theory, these monetary actions by the Federal Reserve control the amount of inflation and employment in an economy, loosening the money supply when the economy cools down, and tightening the money supply when the economy heats up.
Supply-side economic theory argues that the best way to grow an economy is to lower barriers 1) on producers, who “supply” goods and services, and 2) on investors, who provide the capital necessary for the means of production. According to supply-side theory, when barriers to production or investment are reduced, consumers will benefit from a greater supply of goods and services at lower prices, and the resulting demand for goods and services will increase the number of workers necessary to keep up with the demand, who now have more money to spend, which increases demand even more.
The two main pillars of supply-side economics are lower taxes and reduced government regulation. Supply siders argue if you tax producers less, they will produce more, thus increasing the supply of goods and services in the economy, resulting in lower prices. Additionally, if you tax investment income less, investors will invest more money in the means of production, which will also increase the supply of goods and services and lower prices. Secondly, supply-siders argue that government regulation impedes production and slows down the economy; therefore, it is in the best interest of the economy to reduce any regulations impeding production.
Although less important from an economic standpoint, supply siders also argue that lowering tax rates can actually increase tax revenues collected. This is because the government is able to capture more taxes from greater production and tax compliance.
One of the most vocal proponents of supply-side economic policy was Art Laffer, an advisor to Ronald Reagan. In fact, the Reagan administration adopted so much of supply-side economic theory that in the 1980’s it became known as “Reaganomics.”
It shouldn’t be any secret those advocating for less government intervention into the economy prefer laissez-faire or supply-side policies, whereas those who demand more government intervention prefer Keynesian or monetarist policies. Having studied economic theory for the last three decades, I have come to embrace a fifth principle known as the “Rational Expectations Theory,” which believes citizens are not just pawns on a chessboard that go where government bureaucrats place them, but instead tend to make mostly rational decisions to circumvent any obstacles (or exploit any advantages) the government creates, resulting in economic outcomes never intended by the government policymakers. Whether a government leans Keynesian or supply-side, laissez-faire or monetarist, informed citizens will figure out ways to exploit the benefits inherent in any government economic policy. Unfortunately, history predicts citizens who choose to ignore what the government is doing to control economic outcomes may end up being victimized by any policy a government implements.