I have asked three questions with my textbook chapter in which they come from. it would be greatly appreciated if you could help me answer these three questions. Thanks so much. :)

1. What is the difference between making goods and making money? Can problems arise when there is a conflict between the two, give an example.

2. What is the Keynesian Revolution and how did it reshape the way economist thought about the economy?

3. Explain the concept of creative destruction and give a contemporary example (use an example other than the textbook)?

130 EVOLUTION OF ECONOMIC IDEAS AND SYSTEMS III Dollar flow Banks Investment $ Real flow Savings $ sumer spending $ Goods & services markets Consumers buy goods & businesses buy capital goods (Investment) from firms Households Businesses $ Wage, rent, profit S Labor, resource, & capital markets Firms hire workers, rent buildings, pay shareholders FIGURE 7.1 The circular flow model of the economy, with savings and investment. According to Say's law, all of the money that is taken out of the economy in the form of savings is put back into the economy in the form of investment. 7.2 THE MACROECONOMIC REVOLUTION OF JOHN MAYNARD KEYNES John Maynard Keynes (1883-1946), pictured in Figure 7.2,' was born in Cambridge, England. His father was a well-known economist, and he studied with the famous neoclassical economist Alfred Marshall at Cambridge. Even early in his career, he demonstrated extraordinary sophistication and foresight in his analysis. In his famous book, The Economic Consequences of the Peace (1919), he predicted that the harsh financial conditions imposed on Germany after World War I, requiring it to pay more than 80% of gross domestic product (GDP) in reparations, would cause impoverishment and starvation and would eventually lead to another war even worse than World War I. The German hyperinflation and crisis of the 1920s, fol- lowed by the rise of Adolf Hitler and Nazi Germany, and the advent of World WarKEYNES AND MIXED MARKET CAPITALISM 131 FIGURE 7.2 J. M. Keynes (1883-1946). II in 1939, showed just how accurate Keynes' predictions were. He was also able to use his knowledge of the economy to make a fortune for himself and for King's College in financial markets. Rather than depending on abstract, deductive theory based on questionable assumptions, Keynes based his ideas on-observations of actual investor and worker behavior. What he saw was a picture very different from the one described in the- neoclassical theories of the day. The first major flaw in neoclassical analysis, according to Keynes, was with Say's law. As you can see with the circular flow model above, Say's law only holds if savings and other leakages out of the economy are equal to investment and other It injections into the economy. (Later, we will include additional leakages such as export spending and taxes, and additional injections such as import spending and I Or government spending.) However, Keynes observed that when a crisis hits, sav- ings increases but investment falls as businesses lose confidence, leakages then mentey exceed injections, and the economy spirals into a recession. Thus, the first pillar of har Keynesian analysis is the inherent volatility of investment. 1. Volatility of investment: The Keynesian theory that business pur- physical chases of capital goods (investment) depend primarily on expected future profits, which are driven largely by expected sales, and expec- tations can vary dramatically. When businesses' expectations change, we Depend on capital in the future.132 EVOLUTION OF ECONOMIC IDEAS AND SYSTEMS can anticipate large changes in investment, resulting in the booms and busts of the business cycle. Say's law fails precisely because it does not incorporate this fundamental driver of investor behavior. The stock market crash of 1929 and failures of banks under- mined business confidence and reduced consumer spending as people saw their wealth decline. According to Say's law, the decrease in spending meant that people were saving more, and more money in banks should have led to lower interest rates, which should have prompted more investment. But few businesses were investing despite lower interest rates. Why? Because expected sales were very low. With consumer spending down and unemployment spiraling out of control, no sane businessperson would see 1932 as a good time to increase investment Recall that investment, the purchase of capital goods, usually increases the size and scale of business operations. Businesses will not invest unless they expect to sell more goods in the future. The main reason for this is that it can take a long time, often more than a year, for a business investment to start earning profits. A business that builds a new factory must lay out large sums of money now for a plant that could take two years before it has been built, staffed, and become operational When it invests, the business is making a bet that it can sell more goods in two years than it does now. The only conditions under which the business will make the investment in the new factory is if it expects sales to be very good in two years. A pessimistic sales forecast would likely mean that the business will not undertake the investment. This is why business expectations are such an important driver of investment, which is an important driver of the business cycle. In the Great Depression, as unemployment increased and consumer spending fell, businesses cut their investment even though interest rates were low. Thus, there was no increase in investment forthcoming, as Say's law had predicted, and the economy languished in the Great Depression for years. Savings continued to exceed investment. This problem was exacerbated when banks failed, reducing the money supply and causing interest rates to increase. Furthermore, the unemploy- ment rate failed to decrease, as the neoclassical economists had predicted. One of the main causes of this was sticky wages. people Saved 2. Sticky wages and prices: Keynes' observed that, in a recession, wages and prices do not fall fast enough to encourage businesses to hire more workers and consumers to buy more goods What Keynes found was that it took a very long time after the start of a recession for wages to fall. Workers and their unions fought any wage cuts vigorously and angrily, so slashing wages often meant strikes and lower productivity, which were bad for profits. However, employers have found that if they keep wages the same and lay off some of their workforce, the results are different. Workers who keep their jobs in the face of layoffs are very happy to have them. They will work harderKEYNES AND MIXED MARKET CAPITALISM 133 and more productively to keep their jobs so that they do not get laid off in the future. In this sense, wages are "sticky downward": They tend to increase in booms when the unemployment rate falls and workers are in demand, but wages tend to stay the same for a long time in recessions before falling eventually if the recession persists for several years. For example, Leo Wolman of the National Bureau of Economic Research reported that after the stock market crash in 1929, real wages fell very little in 1930 and 1931 and only fell in 1932 in non-union and non-utilities industries.' Meanwhile, unemployment surged. So three years after the crash, the Great Depression persisted with large increases in layoffs but only small declines in wages in some sectors. Wages did not fall far enough and fast enough to spark a rise in employment that would have helped to end the Great Depression, as neoclassical economic theory implied. But even where wages did fall, there was not the desired increase in employment that neoclassical economic theory had predicted, as we will see below. The story with prices is a bit different. Prices of goods did not fall significantly for the first six months after the stock market crash, but then they began to fall quickly. As the economy crashed, surpluses of goods began to pile up because no one was buying them, and that caused prices to fall in one market after another. Prices fell by more than 20% from 1930 to 1933. According to the neoclassical theory of the day, that decline in prices should have sparked an increase in con- sumer purchases, helping to solve the Depression. Instead, deflation and declines in wages proved to be ruinous. Lower prices did not 3. Macroeconomic problems created by wage and price deflation: solve Declines in wages undermine aggregate demand and declines in the goods' prices undermine business profitability, both of which harm problem . the economy in particular ways One of the important economic facts that Keynes established was that, in gen- eral, wage declines are bad for economic growth. Neoclassical economic theory of the time predicted that a decline in wages, by reducing the cost of hiring, would cause employers to hire more workers and boost the economy. However, neoclas sical economists were only focusing on the cost, or supply, side of the wage issue, ignoring the demand side. When wages fall, workers have less money to spend. When workers spend less, sales fall at businesses, which then lay off workers due to poor sales. Thus, when wages decline, the total demand for goods and services (aggregate demand) falls, which prevents employment from increasing (despite the decrease in wage costs) and harms real GDP growth. Declines in prices are also destructive to economic growth. In fact, deflation is one of the worst things that can happen to a business. Imagine Henry Ford produc- ing 1 million basic Model A cars for an average cost of $450 in 1930 and being able to sell them for $500 to make a reasonable profit. But with deflation, if the price at which he can sell the Model A car falls 11%, to $445, then he takes a loss on every134 EVOLUTION OF ECONOMIC IDEAS AND SYSTEMS car he sells. Losses, if they continue, will result eventually in bankruptcy. By reduc- ing the prices that businesses can sell their goods to below what it costs to produce, deflation can be ruinous to producers. As a classic example from the Depression, the price of milk fell so low that farmers lost money on each gallon they sold. In desperation, the farmers went on strike, dumping their milk and blocking milk shipments of nonstriking farmers to try to boost prices and call attention to their plight. Similar dumping and destruct tion of food happened with oranges, potatoes, pigs, and other farm products. It is remarkable to think of children dying of malnutrition at the same time that food was being destroyed due to low prices, something John Steinbeck called "a crime ... that goes beyond denunciation" in his famous novel about the Depression, The Grapes of Wrath. Deflation was one of the most devastating aspects of the Depression, and it remains a significant problem for economies in recessions. It also is important to understand how the contagion of a downturn spreads from one sector to another via the multiplier process. 4. Multiplier process: A respending process whereby a dollar in spend- ing becomes income for someone else, which they then spend, which becomes additional income, and so on, so that a dollar of spending is respent multiple times. Similarly, when a firm lays off workers and incomes decline, those workers spend less, which reduces incomes at the businesses they usually patronize, which lowers revenues of those businesses, which causes them to lay off workers, who then spend less, which lowers incomes more, which lowers spending more, and so on. The stock market crash of 1929 caused businesses to cancel investment projects such as the building of new factories, and it caused consumers to cut their spending on expensive, durable goods such as houses, cars, and appliances. These declines in spending reduced the incomes of firms in the construction and durable goods sectors. Those firms, in turn, laid off workers and cut their investment spending. When the workers in construction and durable goods lost their jobs, they too cut their spending, buying fewer goods of all types, which hurt those businesses that they usually patronized. And on and on it went. Thus, one major macroeconomic event, like a stock market crash, can spread like a contagion to other parts of the economy. Fortunately, Keynes observed, crashes can be reversed if the government will engage in appropriate stabilization policy. Taken together, these key Keynesian insights tell us that there is no reason to expect recessions to fix themselves. Given that the economy can linger in a recession for long periods of time, as it did in the Great Depression, Keynes argued that in recessions, the government should use all of the tools at their dis- posal to stimulate the economy. This "stabilization policy" meant abandoning the laissez-faire approach and actively using government policy to improve the economy.KEYNES AND MIXED MARKET CAPITALISM 135 7.3 MACROECONOMIC STABILIZATION POLICY As we noted in the previous chapter, Keynes thought it was ridiculous to wait for the economy to eventually improve, stating sarcastically, "In the long run we are all dead." Instead, he advocated taking concrete, immediate government action to stimulate the economy. He thought the government should engage in macrocco- nomic stabilization policy: (1) Increase government spending, (2) reduce taxes, and (3) reduce interest rates in recessions, while doing the opposite when the economy is growing too quickly. Increasing government spending was the surest way to improve economic conditions in a recession. The biggest problem in a recession was that there was too little spending (a shortage of aggregate demand): Investors and consumers weren't buying enough goods to keep the economy going at its normal rate Therefore, the best way to correct the economy was for the government to increase spending because this would directly increase incomes and then, via the multiplier, spark additional rounds of spending. If the government were to spend billions of dollars building roads, bridges, parks, and schools, it would create jobs and income for millions of workers necessary to build those things. Those workers would then spend the income they received, further stimulating the economy. The government could also cut taxes, giving consumers and businesses more money to spend. As they spend more, this will stimulate income and job growth. Tax cuts should be targeted at poor and middle-class families, who will spend the largest percentage of their tax cut and therefore stimulate spending the most. However, tax cuts tend to be less effective than government spending in recessions because of poor consumer and business confidence. If consumers are pessimistic about the future, worrying that they might lose their job or fall on hard times, then they will likely save the tax cut instead of spending it. Similarly, businesses that get Governor a tax cut in a recession might use that money to invest in new plants and equip- ment, but if they expect slow sales to continue, they too might save the money from the tax cut instead of spending it. Tax cuts tend to be less effective than government-) - ouranked spending in a recession because some (and possibly a lot of the tax cut will be saved. whereas all of the government project money is spent The government should also increase the money supply in order to reduce interest rates in a recession. As the government floods the banking system with money, banks will seek to loan out the new money to new borrowers, which will require them to lower interest rates to entice new borrowers. One of the major More problems in the Great Depression was that when banks failed, this significantly reduced the money supply and increased real interest rates, which made businesses and consumers reluctant to borrow for spending on investment and consumer durable goods. Increasing the money supply would help to reverse that problem. Unfortunately, like tax cuts, declines in interest rates can have limited effect tiveness in a recession due to pessimism. Consumers might not be willing to borrow136 EVOLUTION OF ECONOMIC IDEAS AND SYSTEMS more money for new houses and cars if they are worried about keeping their job in the future. And employers might not be willing to borrow money to finance new investment purchases of plants and equipment if they expected slow sales to continue in the future. There is no guarantee that lowering interest rates will spark significant increases in investment and consumer spending. The best possible way to combat a recession would be to enact all three poli- cies, increasing spending, reducing taxes, and reducing interest rates so that every possible lever is used to stimulate the economy. In fact, the government did all of these things to combat the recessions of 2008-2009 and 2020. Note that enacting stabilization policy not only requires the government to intervene in the economy, but it also requires that the government run a deficit and borrow money in a reces- sion. Running deficits, however, was the opposite of the policy of austerity recom- mended by most neoclassical economists of the day. As we noted in Chapter 1, government deficits tend to increase automati- cally in recessions, and this was particularly true during the Great Depression. As incomes and spending fell after the stock market crash, tax revenues fell as well, creating budget deficits for the government now that tax revenues were below spending. Neoclassical economists argued that the government should increase taxes and cut government spending to balance the budget. But in cases where the government did this, the recession worsened. Increases in taxes reduced spending. as did cuts in government programs. Keynes suggested the opposite. Even though the budget deficit has increased in a recession, the government should run even larger deficits by cutting taxes and increasing spending. Those policies will increase income and stimulate economic growth, which will then increase tax revenues in the future. In essence, running government deficits during recessions pays for itself once economic growth returns. Here, Keynes argued for a revolution in thinking about government interven- tion and government budgets. Instead of running a balanced budget each and every year, governments should run deficits in recessions, which could then be paid off by surpluses that are run during expansions when economic growth is more rapid and incomes (and tax revenues) are higher. The government budget should be balanced over the entire business cycle, not each year. Governments must have the flexibility to run deficits when conditions are bad and to slow down the economy by run- ning a surplus when they see the economy growing too quickly-an overheated economy-which can lead to a bubble and a crash. 7.4 THE NEW DEAL AND THE RISE OF THE MIXED ECONOMY In the 1932 U.S. campaign for President, Franklin Delano Roosevelt promised to stop following a laissez-faire approach and to take direct government action to end the Great Depression, adopting a philosophy similar to Keynes' called the "NewKEYNES AND MIXED MARKET CAPITALISM 137 Deal." He won the election in a landslide over Herbert Hoover, winning by 18 percentage points and bringing a Democratic Congress into office with him. After inauguration in 1933, Roosevelt and Congress enacted 15 major bills in the first 100 days to begin to transform the United States into a mixed market economy. Over the next two years, even more changes were made. The major areas of reform were (1) regulation of banking, financial markets, and the money supply; (2) the creation of a safety net for people who had fallen on hard times; (3) the direct provision of jobs for the unemployed; (4) the establishment of the Social Security retirement program for the elderly; and (5) the creation of an agricultural price support system. 7.4.1 Regulation of banking, money, and financial markets One of the major problems after the stock market crash had been bank failures. Consumers and businesses lost their savings when the banks failed, which made everyone reluctant to put their money into banks once they had some. Many people hid cash under their mattresses rather than entrust their money to a bank! But the lack of savings in banks was very bad for the economy. There was little money for businesses and consumers to borrow, which stifled business investment and con- sumer purchases of houses, cars, and appliances. To solve this problem, the Roosevelt administration created Federal Deposit Insurance, where the government would guarantee deposits of up to $5000 per individual in banks (that amount has grown to $250,000 per individual today). This means that if the bank fails, the government would reimburse depositors for any money the bank lost. In exchange for providing this insurance, the gover- ment imposed strict regulations on banks. Insured banks were prohibited from engaging in speculative investments in the stock market, they had to agree to keep a certain amount of cash on hand (reserves) to prevent runs on the bank, and they were required to submit to regular inspections from bank regulators. The govern- ment split the banking sector into safe, insured mortgage banks and riskier, non- insured investment banks. The government also established itself as the "lender of last resort," meaning that if a bank ran short of cash, it could borrow from the Fed. And it established the possibility of the federal government seizing insolvent banks and bailing out banks experiencing financial difficulty. Investment banks and stock markets were now to be regulated by the newly created Securities and Exchange Commission. The SEC established rules and guidelines for financial markets, mandated transparency, and outlawed insider trad- ing and other unethical market manipulations. The government also took greater control of the money supply-which at the time meant controlling the supply of gold and the issuance of Federal Bank notes backed by gold. By devaluing the dollar relative to gold (and also relative, to other currencies backed by gold), the money supply increased. By flooding banks with money, real interest rates dropped as banks sought to find new borrowers, stimulating investment and consumer spending. Devaluing the dollar relative to138 EVOLUTION OF ECONOMIC IDEAS AND SYSTEMS other currencies also increased U.S. exports because it made U.S. goods cheaper to foreign consumers. Together, the banking, financial market, and money supply reforms restored faith in the financial system. People began putting their savings in banks and stock markets once again, the money supply expanded significantly, real interest rates fell, and consumer spending and business investment started to increase. Ironically, although many of these reforms were looked at as "socialism" by those opposing government intervention, they were proposed and enacted by conservative bankers who saw these changes as the only way to save capitalism. 7.4.2 The safety net: Social Security, unemployment insurance, and welfare In addition to its pathbreaking regulation of banks. financial markets, and the money supply, the New Deal established a "safety net" for those who fell on hard times with the Social Security Act. This too was a revolutionary change in philoso- phy, with the government for the first time taking on the role of insuring that its citizens "fared well," in what came to be termed the "welfare state." The first key component of the new welfare state was the Social Security program. In the 1930s, the elderly were among the poorest segments of the population. Most workers in that era did not receive pensions, there was no government-pro- vided old age insurance, the jobs that did exist in the Depression went to younger workers, and many of the elderly had lost their life savings in the bank failures of the early 1930s. To rectify this situation, the Roosevelt administration established the Social Security program as a national system of old age insurance. Once work- ers reached age 65, they would receive a payment from the government based on the amount they had earned during their lifetime, up to a limit. In order to start the program immediately to address the poverty of the elderly, the Social Security program was established as a pay-as-you-go system: Workers and employers in the 1930s would pay a Social Security tax that would go directly to existing retirees. When those workers and employers retired, say, in the 1950s, their Social Security benefits would be paid out of taxes from new workers and employers. There are no retirement accounts within the U.S. Social Security system. Rather, by working in the United States, you acquire the right to a certain amount of Social Security retirement benefits, which will be paid as long as there are enough workers and employers paying Social Security taxes to support you and other retirees. Another major innovation of the Social Security Act was the establishment of unemployment insurance. This program provides temporary assistance, usually for up to six months, to a worker after she or he loses their job. (In recent recessions, the government has regularly extended unemployment benefits beyond six months when conditions are such that unemployed workers have little chance of finding a job.) Workers who were unable to find jobs or generate income for prolonged peri- ods of time and who became destitute would qualify for welfare programs, designedKEYNES AND MIXED MARKET CAPITALISM 139 to help the poorest, most desperate people in society. These programs also helped to support single mothers and their children and the disabled. During the Depression. because many families were no longer able to support their relatives who had fallen on hard times, the government increasingly took on this role. 7.4.3 Intervention in the labor market: Job creation and labor laws Due to the massive nature of the unemployment problem, Roosevelt also created new programs to put people back to work directly. The Civilian Conservation Corps employed hundreds of thousands of unemployed, unmarried men between the ages of 17 and 27. These men planted more than 3 billion trees to stop land cro- sion and beautify towns. The Civil Works Administration, the National Industrial Recovery Act, and the Works Progress Administration employed people to build roads, schools, national parks, and airports or to serve as teachers. Until the United States entered World War II, these programs employed more than 15 million peo- ple at various times on a variety of public works projects. The efforts were so successful at job creation and achieved so many useful things in communities that some reformers began to consider the idea that the government should be the "employer of last resort" in recessions, employing people who wanted to work but could not find a job. Other dramatic actions were taken in labor markets as well. The government legalized the right of workers to unionize and the right of unions to collectively bargain with employers. Collective bargaining occurs when workers bargain (OR as a group (union) with employers instead of each worker bargaining sep- arately with an employer. This significantly strengthens the bargaining powerI with of employees, allowing them to get better wages and benefits and greater job secu- anagreement rity. When employees bargain on their own with their employer, they have little power in negotiations. When the workers bargain as a group, they can threaten Together . to go on strike and shut down the entire company if their demands are not met, giving them much more say in pay and working conditions. The government also established minimum wages in many industries, reduced the standard work week to 40 hours, and abolished child labor. In addition to these interventions in labor markets, the government began regulating agricultural markets. 7.4.4 Agricultural price supports Farmers were among the groups hardest hit by the Depression, when agricultural prices plummeted in the early 1930s. To alleviate the farmers' plight, Roosevelt paid them to produce less, reducing the supply of agricultural products so that prices would increase and farmers would make more money. Although this policy was condemned by many given that there were a lot of hungry people in the United States at the time, it succeeded in stabilizing agricultural markets.140 EVOLUTION OF ECONOMIC IDEAS AND SYSTEMS 7.4.5 The success of the New Deal The New Deal reforms had a very positive effect on the economy, finally ending the freefall that began in 1929. Financial markets and banks were stabilized by the reforms. Unemployment insurance, welfare, job creation, and Social Security programs directly put money into the hands of poor households, and they spent it, stimulating aggregate demand, increasing businesses' sales, and sparking even more hiring. From 1933 to 1937, business investment increased by more than 1200%, consumer spending increased by more than 46%, and real GDP had returned to its 1929 level. In general, the New Deal was pragmatic and modest in scope, intending to stabilize markets and to correct market failures where they were most glaring- especially in labor, finance, banking, and agriculture. Despite these modest goals, it ushered in a new era of government intervention in the economy, with the state assuming the role of stabilizer of markets and insurer of the welfare of its citizens. Nonetheless, many people were worried about this unprecedented increase in the government's role and especially the 83% increase in government spending 7.4.6 The Recession of 1937-1938 Despite all the successes of the New Deal and the positive growth that had been achieved, the Roosevelt administration still had not completely embraced Keynesian economics and the need to run substantial deficits and engage in expansionary monetary policy until the economy had fully recovered. Business investment was still 27% lower in 1937 than it had been in 1929, despite Roosevelt's efforts. Even with the fragility of the recovery. the Roosevelt administration decided to raise taxes, slash spending by $1 billion, and reduce the money supply. This produced another devastating recession. with real GDP falling by $5 billion (another exam- ple of the multiplier in action). This experience produced an important lesson for economists: When the economy is still in fragile condition from a major recession, it is a mistake to cut spending. raise taxes, or raise interest rates because these can derail the expansion by undermining business and consumer confidence just as they are beginning to rebound. Fortunately, after the financial crisis of 2008-2009, the government heeded that lesson and continued to stimulate the economy until 2017, when the economy had returned to full strength. 7.4.7 World War II proves Keynes right After 1938, the economy made a sluggish recovery, and it was not until the United States entered World War II and engaged in a massive increase in military spend- ing that the Great Depression finally ended. But World War II did demonstrate conclusively that the government can end any recession, no matter how severe, if it is willing to spend enough money. The wartime spending also proved another of Keynes' ideas true: Running budget deficits for short periods of time does notKEYNES AND MIXED MARKET CAPITALISM 141 necessarily create macroeconomic problems. The U.S. government ran huge defi- cits to finance war spending. but rather than constrain economic development, business investment surged along with government spending. The U.S. public national debt reached 106% of GDP in 1946-the government owed more money than the value of all goods and services produced in a year! Yet. not only did the economy remain strong but this set the stage for one of the most rapid periods of economic growth that the United States has ever seen. 7.5 HAYEK'S CRITIQUE OF GOVERNMENT INTERVENTION Following the success of Keynesian policy in the United States and other countries where it was used, economists became more and more comfortable with the idea of government intervention in the economy to fix market failures. However, one group of economists, the Austrian school, led by Ludwig von Mises and Friedrich Hayek, found this approach to be deeply problematic." The Austrian economists had much in common with neoclassical economic S actual theory, believing that the individual (not groups or institutions) should be the focus of economic analysis. However, they tended to avoid the use of the mathematical not good models that neoclassical economists favored. Austrian economists also harbored a deep suspicion of government intervention. With the rise of authoritarian regimes on either side of Austria-Nazi Germany and the Soviet Union-this revulsion of government grew even stronger with time. Hayek was an insightful economist in several key areas, and his ideas had substantial influence on conservative politicians in the United States and England. Both Ronald Reagan and Margaret Thatcher cited him as a major influence and inspiration. His often-controversial ideas on the business cycle, central planning. freedom, and the efficiency and effectiveness of markets provide an important potential counterargument to Keynesian approaches. 7.5.1 The business cycle One of Hayek's major disagreements with Keynes was on the business cycle. Hayek believed that periods of overinvestment create a boom and an imbalance between savings and investment. A shortage of savings causes interest rates to-rice, which- halts investment and leads to a crash. He thought that after a crash, financial mar- kets would return to equilibrium, and he believed that there were no major conse- quences to recessions. In fact, recessions could be useful in his view by weeding out inefficient firms. so recessions should not necessarily be avoided. However, most economists today reject the idea that the government should do nothing to allevi- ate extraordinarily high levels of bank and business failures and unemployment, believing that the costs of recessions are too high.142 EVOLUTION OF ECONOMIC IDEAS AND SYSTEMS 7.5.2 Central planning and freedom Hayek also disagreed with the idea that government should become a welfare state or intervene extensively in industrial development. He saw the New Deal moving the United States closer to command communism, and he believed this increased level of government intervention was a threat to freedom, which he defined as free- dom from government interference. He argued in The Road to Serfdom that "plan- ning leads to dictatorship because dictatorship is the most effective instrument of coercion and the enforcement of ideals and, as such, essential if central planning on a large scale is to be possible." He worried that any government venture into plan- ning would ultimately lead to dictatorships, so he resisted public health care, public education, and government economic development programs. In contrast, Karl Polanyi, who wrote The Great Transformation during the same time when Hayek was active, thought that Hayek's definition of freedom would result in freedom being available only for the rich and powerful. Polanyi believed that workers and the nonelites needed government intervention to protect them from market outcomes, arguing that unemployment and destitution are "brutal restrictions of freedom." To Polanyi, truc freedom, the freedom to live a good life and make choices, comes from having security, a decent income, and job opportu nities. He saw government intervention as a crucial part of creating an economy in which everyone, including working people, has significant freedoms. In Hayek and Polanyi, we see two sides to economic freedom. In philosophy. negative freedom is the absence of barriers or constraints, whereas positive freedom is the ability to have opportunities and to control one's life. Hayek's (negative) definition of freedom emphasizes the right of individuals to do as they will with their person and their property, free from government interference. This view supports a laissez-faire approach in which government plays as little a role as pos- sible. Polanyi's (positive) definition of freedom focuses on the factors that enable most people to live a good life free from the threat of starvation, poverty, and exploitation. This view supports the use of government intervention to regulate the functioning of the economy so that all citizens can live a good life. When we study modern economic systems, we will see this ongoing tension between "free- dom from" government, which is the hallmark of most market-dominated (laissez- faire) economies, and "freedom to" have a good life, which is the hallmark of most government-centered economies. 7.5.3 Markets and information One of Hayek's most important insights was his understanding of markets as superb gatherers and disseminators of information. Hayek pointed out that markets and prices are perfect vehicles for transmitting massive amounts of information to coor- dinate an economic system. Consumers transmit exactly how much they value goods and how many they want via their purchases. Manufacturers respond to consumer demand by making goods that consumers want in the right quantities.KEYNES AND MIXED MARKET CAPITALISM 143 In the process, manufacturers send signals to input markets about what materials they need-how much machinery, raw materials, and labor are required to build their goods. The suppliers of inputs then know how many people they need to hire and they can figure out what materials they need to obtain for their production. And so on. One of Hayek's most astute insights was the prediction that the central plan- ning of the Soviet Union could never compete with the efficiency of markets. Planners, he thought, could never duplicate the sophisticated signaling inherent to markets in order to coordinate an entire economy and were doomed to produce inefficiently. Certainly the Soviet Union did run into numerous problems deriv- ing from central planning. Despite developing sophisticated measures of the input requirements for each industry, it regularly experienced gluts or shortages of a huge magnitude that resulted in delays and inefficiencies. 7.5.4 Joseph Schumpeter and creative destruction In addition to production inefficiencies, the Soviet Union lagged behind the United States in innovation. A key reason was what another Austrian economist, Joseph Schumpeter, called the "creative destruction" of capitalism. Building on Marx's ideas but coming from a very different perspective, Schumpeter noted that one of the keys to understanding capitalism was the constant innovation and remaking of industries. As he put it in his 1942 book, Capitalism, Socialism and Democracy, The opening up of new markets, foreign or domestic, and the organiza- tional development from the craft shop and factory to such concerns as U.S. Steel illustrate the same process of industrial mutation ... that inces- santly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism. Creative destruction is the process by which businesses are forced to invent constantly to stay one step ahead of the competition and where creative new industries inevitably destroy and replace older ones. Certainly capital- ism in the United States was much more innovative than the command economy of the Soviet Union. Whereas Russia faced a stifling bureaucracy, firms in competi- you tive U.S. capitalist markets were constantly investing and innovating, although this Man was less true during the Great Depression than it had been previously. products Schumpeter thought that the process of creative destruction would be too destabilizing for markets, as was the case when entire communities were devastated by the loss of an outmoded industry. Ironically, an adequate safety net can help communities recover from creative destruction and prevent the destabilizing prop- erties of markets from manifesting. So, although Hayek and Schumpeter might not 1 eef approve given their preference for laissez-faire approaches, modern economies have found a certain amount of government intervention crucial to stabilizing markets, prices nish .144 EVOLUTION OF ECONOMIC IDEAS AND SYSTEMS thereby reducing the pressures to rein in markets when communities are suffering from creative destruction, which in turn allows the process of creative destruction to continue. 7.5.5 Market institutions Hayek also understood that capitalism depends on an important set of supporting institutions in order to function properly. These include the sanctity of private (Jorme ht property so that businesses will invest in their enterprises. There also need to be social norms of trust facilitated by systematic and fair laws so that people freely and snovid willingly enter into exchanges and bargains. No one will invest and start a business if they think it will be seized by others once it is successful. Markets also must be e. forcontestable-open to the entry of new firms. The government's role, according to Hayek, was to enforce contracts and laws fairly rather than discriminating arbitrar- basic aly among individuals. Where market-supporting institutions are absent, markets will not perform effectively, as we see in many cases in less developed countries. rules Hayek has had an important influence on economic systems, especially in the one jesu ed States and the United Kingdom, where conservative politicians regularly cite him as a major influence. Even though most economies today utilize more gov- Purposes crnment intervention than Hayek preferred. his cautions about the need to avoid authoritarianism and the inefficiencies of central planning have played a major role in spurring most democracies to impose checks on government behavior. Next, we turn to the U.S. economy in the post-World War II era. We will only cover this period briefly to give you a flavor of the broad sweep of U.S. history and the most important trends. 7.6 THE MIXED ECONOMY AND THE GOLDEN AGE OF U.S. CAPITALISM, 1945-1973 The establishment of a mixed economy in the United States after the Great Depression and the global dominance of U.S. manufacturing created the perfect combination for a period of unprecedented growth and stability. By the early 1950s. the United States was producing 80% of the world's manufacturing output due to its advanced technology and the devastation that other manufacturing industries in Europe and Japan had experienced during World War II. This era is sometimes termed the "capital-labor accord" in that workers and management got along very well for the most part. Manufacturers could afford to pay their workers well due to their domination of industries, and they had to pay their workers well because unions had become quite powerful now that they were legal. The unionization rate peaked in 1954 with 35% of the workforce being represented by a union, and unions were heavily concentrated in manufacturing. Workers experienced rising wages and were able to afford a middle-class lifestyleKEYNES AND MIXED MARKET CAPITALISM 145 with a car, a house, and all the appliances and accoutrements that go with a house purchase. The creation of a large middle class in the United States stems from this era, and the spending by the middle class proved to be very good for businesses. sparking growth in one consumer industry after another. The economy grew rapidly and experienced only short recessions in this era, with per capita real GDP growth averaging 2.49% per year from 1948 to 1973. This was much faster than the per capita real GDP growth rate during the monop- oly capitalism cra of 1890-1929, when growth averaged 1.92%. It was also faster than growth during the global capitalism era of 1974-2015, which averaged 1.65%. The increase in incomes during the "golden age" was also very equally distrib uted. Rich, middle-class, and poor citizens all experienced significant increases in income. Rapid economic growth and strong unions meant that workers received a substantial share of the wealth that was being generated. But firms still benefited significantly as record consumer spending expanded sales and profits. The wealth injected at the bottom to workers trickled up to the owners of businesses. Despite the rapid growth of the era, African Americans and women were still excluded from the best positions. Overt racial discrimination, separate but une- qual education and facilities, and lynchings combined to provoke the Civil Rights Movement, led by Rev. Martin Luther King, Jr.. It achieved some major victories, with new laws enacted in the 1960s prohibiting discrimination in employment and preserving voting rights. Women and minorities were assisted by affirmative action laws, which man- dated that, in cases where two applicants for a position had equal qualifications but differed by race or gender, the job should go to the person from the underrepre- sented group (women or minorities). This helped pry open jobs in law and business that had previously been the purview of white males. The government also began intervening more directly in helping the poor. As part of the "War on Poverty." President Lyndon Johnson and Congress estab- lished Medicare and Medicaid to provide health care for the elderly and the poor. respectively. The Food Stamps program was established, as well as the Head Start program to provide subsidized preschool for poor children. The government also made its first major attempts to regulate environmental damage. By the end of the 1960s, the government was firmly established in the United States as a major factor in markets. However, the stagflation of the 1970s and the deindustrialization asso- ciated with globalization that began at the same time would set the stage for a new effort to bring back rapid growth by deregulating the economy. 7.7 THE ERA OF NEOLIBERALISM AND GLOBALIZATION, 1974-2021 In 1973, the Organization of the Petroleum Exporting Countries (OPEC) cut pro- duction and imposed an embargo on selling oil to the United States due to U.S.146 _ EVOLUTION OF ECONOMIC IDEAS AND SYSTEMS ..._....s.s....-..a.mu.u..su-u_. .. , support For Israel. Oil prices surged from $3 per barrel to $12 a barrel internation- all}I (a 300% intreasell. and prices were even higher in the United States because of the embargo. This devastated the U.S. economy. which had become completely dependent on oil to run its cars and factories. The explosion in the price ofenergy caused businesses' costs to rise and profits to fall. so they laid of workers. The result was stagnationstagnation and ination It the some timeas businesses laid of! workers to cut costs and raised prices to try to recoup the higher cost of energy. A major recession resulted. A second oil crisis occurred in 1979. when oil supplies were disrupted by the Iranian Revolution. This time oil prices doubled. once again spurring a major recession in the United States and other oildependent economies. Meanwhile. in a decade that saw two major recessions, there was also a study erosion of manufacturing jobs due to mechanization and overseas competition from japan and Europe. Wages for workers stagnated while unemployment and ination stayed disturbingly high. Ronald Reagan was elected President in 1980. running on a platform of reducing government and its scope of intervention in the economya return to iaisser-faire principles. This was known as the era of neoliberalism. in that it sought a return to the liberalism ofAdam Smith. Many countries followed the lead ofReagan' in the United States and Thatcher in England W W Reagan was able to enact la tax cuts for businesses and the wealthy. known as supply-side tart cuts because the money went to suppliers (rms and entrepre- neurs} rather than demanders (consumers). The Reagan administration also reduced spending on social programs while increasing spending on the military. The U.S. economy did recover by 1984: however. growth in the 1980s was less robust than in previous decades. and the federal decit quadrupled in size from 1980 to 1990. The tart cuts did not generate suicient growth to pay for themselves. as supply-side supporters had hoped. Similar policies emphasizing deregulation and sealing bad: of government programs were pursued by subsequent Presidents George Bush. Bill Clinton. and George W. Bush. Nonetheless. these administrations did follow basic Keynesian stabilization policy. stimulating the economy whenever it hit a reces sion. so these aetions were not a complete reversal of Keynesian policy. A recession in 1991 was followed by the tech boom of the 19905 under President Clinton. However. a stock market bubble formed toward the end of the 1990s as investors clamored for the latest internet stock o'erings. even from companies that had never made a prot. That bubble burst in 2000. with tech stocks plummeting by rm and the economy lling into a recession. After a period of modest growth. another bubble formed in the mid-20005. this time in real estate. From 2004 to 2007 a huge speculative bubble. seled by massive debt and unsound loans in the sub-prime housing market. formed. Deregulation of nancial markets pursued by Reagan. Bush. Clinton. and W Bush allowed banks to invest in very risky and volatile nancial instruments. When these investments crashed. KEYNES AND MIXED MARKET CAPITALISM 147 they brought the stock market and the entire banking system with them, sparking the worst recession since the Great Depression. Fortunately, the George W. Bush administration and, after 2008, the Obama administration, engaged in a massive bailout of the banking system and a significant increase in government spending. Rather than repeat the errors of 1937 and the Great Depression, the Fed kept stim- ulating the economy by injecting money into financial markets for years after the worst part of the recession was over. Obama also signed the Affordable Care Act, making the United States the last developed country to install a national health care system of some kind. Keynesian policy had returned to the United States, and it reduced the length of the recession significantly. As conclusive evidence of how useful Keynesian policy is, the European Union, which imposed austerity programs on the economies of Greece, Spain, and other poorly performing econo- mies, fared very poorly compared to the United States, which instead injected large amounts of money into the economy. The recovery from the Great Recession was slow, as is often the case after a major financial crisis. Hoping for a change in policies that would reinvigorate economic growth, U.S. voters elected Donald Trump President in 2016. Trump promised to bring back jobs to the United States from abroad by renegotiating trade deals and by cutting taxes and regulations on businesses. In essence, Trump was promising more government intervention in some areas (trade) and less in others (deregulation). The unrest that propelled Trump to the presidency was also present in other developed economies where workers' wages stagnated and com- munities experienced deindustrialization as jobs shifted to China and other inex- pensive manufacturing locations. Trump's tax cuts and deregulation efforts had no measurable impact on eco- nomic growth. With the advent of the devastating coronavirus recession of 2020, the U.S. adopted Keynesian policy, spending trillions of dollars on stimulus pro- grams to reduce the severity of the downturn. Joseph Biden was elected to replace Trump in 2020, promising to restore the government programs Trump cut and invest more significantly in health care and environmental programs. Around the world, the pandemic and the accompanying recession prompted a return to Keynesian policy to deal with the crisis. Whether this will lead to a significant move away from neoliberalism remains to be seen. 7.8 CONCLUSION: THE MIXED ECONOMY OF THE UNITED STATES In general, there has been a trend toward greater deregulation in the United States since 1980, but the country continues to use government policy and programs to fix market failures. The United States is a laissez-faire-leaning mixed economy, with less government intervention than most other developed countries but much more government intervention than was the case in the United States prior to the Great148 EVOLUTION OF ECONOMIC IDEAS AND SYSTEMS Depression. Keynesian economic policy has been very good for the U.S. economy in general. As you can see from Figure 7.3, prior to 1950, the U.S. economy expe rienced dramatic fluctuations in economic growth. After 1950, the United States experienced more rapid and steady growth. which was achieved with the help of government efforts to stabilize the economy. A stable business environment makes firms more likely to invest. which drives growth and prosperity. This type of economic system is called "regulated capitalism" or a mixed economy: Where markets are seen as worth preserving due to the effi- ciency and innovation they promote, but sound government policy can improve the functioning of the capitalist market system by reducing or eliminating market failures such as recessions. A mixed economy relying on markets and government is seen by most economists as preferable to a laissez-faire or a state-dominated economy. Keynes can be thought of as wanting to save capitalism from itself. In its unregulated state, capitalism can result in lengthy recessions, as well as bad out- comes for workers and the environment. Appropriate government policy can solve those problems. In a recession, the government can spend money, cut taxes, and increase the money supply to pump money back into the economy and, via the multiplier, increase spending significantly to end the recession. If banks are prone to speculative bubbles and risky behavior, the government can regulate them to make sure they behave in a financially sound manner. Where markets fail to safe- guard workers or the environment, the government can impose laws or regulations to force markets to address these shortcomings. As we will see in the next chapter, which looks at modern economic systems, other economies strive for a different balance of state and markets than the United ID 10 -15 1900 1910 1920 19 30 1950 1960 1970 1980 1790 2000 2010 2020 FIGURE 7.3 Economic instability in the U.S. economy: Real GDP growth per capita, 1890-2020. Sources: Our World in Data, https://ourworldindata.org/ grapher/gap-per-capita-over-the-long-run-Maddison, World Bank, and Federal Reserve Economic Data (FRED).KEYNES AND MIXED MARKET CAPITALISM 149 States. The United States is a market-dominated economy, striving for the least amount of government intervention possible to keep markets functioning effect tively. Even though our government is large, it controls only about 30% of the economy while the rest of the economy is controlled by private sector firms. In other countries, such as most of Europe and Japan, we find social market econo- mies where the government controls a much larger share (sometimes over 50%) and strives to manage the economy in accordance with domestic social values. Meanwhile, in state-dominated economies like China, the government plays an even larger role in controlling the economic system. All of these economic sys- tems use some degree of markets and some amount of government intervention, so they are all considered mixed market economies, but the mix of market and government can be quite different. . . ...... QUESTIONS FOR REVIEW Explain how the neoclassical concepts (a) marginal productivity theory of dis- tribution. (b) markets always clear, and (c) Say's law combine to result in a conclusion that no government intervention is necessary in a capitalist market system. 2. Describe the nature of the Keynesian "revolution" in economics. How did Keynes reshape the way economists thought about the economy? How did he address the major flaws in the neoclassical economics of his time? 3 Why do many economists see the volatility of investment along with the mul- tiplier as the key to understanding the business cycle (the cycle of booms and busts that characterize our economic system)? How do sticky wages and prices prevent the economy from adjusting in a recession? 5. In what areas of the economy do we tend to see the market fail to work well? What government programs have been designed to address those market failures? How would you explain to someone with no economics background why deflation can be a major macroeconomic problem? 7. How do Keynes' ideas relate to those of Smith and Marx? 8. Which of Keynes' ideas do you find most compelling in capturing the realities of the modern world? Explain and give examples. 9. Which of Hayek's ideas do you find most compelling? Which are least compel- ling? Support your answer with examples and analysis. 10. Compare and contrast Keynes' ideas with those of Hayek. 11. Explain the concept of creative destruction and give examples from the world around us. 12. Describe the evolution of the U.S. economic system from 1920 to the present. How has our approach to regulating the economy shifted over time