Essays on the History of Economic Thought

By Pira Saravanamuthu

ContentsPage

A Short History of Economic Thought 1

The Wisdom of the Ancients 3

The Two Faces of Ben Bernanke 5

How To End an Economic Depression 8

Essays Complied in December 2011

A Short History of Economic Thought

By Pira Saravanamuthu

October 2008A description...Adam Smith

Generally, individuals acting in their self interest improve the welfare of the society. This is the liberal orthodoxy. However, in certain circumstances, individuals acting in their self interest harm the welfare of the society. Adam Smith and the liberal orthodoxyAdam Smiths great insight was that when people co-operate spontaneously to better themselves the whole society benefits. Each individual only has the aim of bettering himself but in the process everyone becomes better off. This insight had a profound influence on the conduct of public affairs. Adam Smith presented his ideas in The Wealth of Nations (1776).Adam Smiths insight formed the basis of classical political liberalism. Liberalism was the dominant political philosophy for two centuries. Public intellectuals and public officials of the 18th and 19th century understood that the general welfare of the society could be increased by abolishing practices and laws which get in the way of co-operation amongst individuals. In the economic sphere this meant reducing restrictions on trade and simplifying the tax code. Adam Smith was Chair (Professor) of Moral Philosophy at Glasgow University. He had a deep and rich understanding of human motivation and behaviour. Unlike many modern advocates of free markets Adam Smith did not believe that markets exist in a social vacuum. He understood that markets exist in a social, political and legal framework. Since Adam Smiths days, one of the core principles in economics is that markets are usually a good way to organise economic activity. Yet even in the 19th century people began to appreciate that markets could fail. That individual acting in their self interest (even when their actions do not violate social and legal norms) does not always produce the best outcome for the society as a whole.However, for two centuries these recurrent intellectual doubts were always quashed and the liberal orthodoxy prevailed.John Maynard Keynes broke the liberal orthodoxyThe liberal orthodoxy was only broken by the insights gained by John Maynard Keynes during the Great Depression of the 1930s. He showed that if everyone tried to get out of debt at the same time then this would result in an economic depression. This is what he called the paradox of thrift.

For these insights John Maynard Keynes is remembered as the second most important economist after Adam Smith. To this day, policy makers use the tools that he outlined in his classic General Theory of Employment, Interest and Money (1936) to fight recessions.The Wisdom of the Ancients

By Pira Saravanamuthu

17th September 2011

Paul Samuelson

After the Great Depression and the Second World War, far-sighted thinkers (such as Paul Samuelson) conceived and implemented a policy framework that would prevent similar calamities in the future.

Having lived through epic disasters, the Ancients had accumulated a vast amount of wisdom. We are now realizing that they were much wiser than we are.

The policy framework that the Ancients set up can be called Social Democracy. As Paul Krugman explains it is "a regime that by and large lets markets work, but in which the government is ready to both rein in excess and fight slumps."

However the economic stability brought by the Social Democratic policy regime made subsequent generations very complacent and arrogant about public policy. Subsequent generations would ask: Why do we have to toil under this heavy superstructure, when there has been no hint of a crisis for decades?

So, ironically the very success of the policy regime became a major challenge to Social Democratic framework. As a result support for the regime "can last for a generation or so, but not much longer" according to Paul Krugman. And since the 1980s unwise and arrogant policy makers have been chipping away at the Social Democratic policy regime set up after the Great Depression.

In particular the banking sector was heavily regulated after the Great Depression. As Paul Krugman wrote much of modern banking would have been considered illegal in the 1960s and 1970s. The restrictions on banks were eased throughout the world from the 1980s onwards. The repeal of the Depression-era Glass-Steagal Act in 1999 was the final big victory for banking sector. This enabled the banks to behave like Casino operators.

The recent disaster is making us realize that we were very unwise to dismiss the wisdom Ancients so quickly. Brad DeLong is an economic historian at the University of California, Berkeley. He recently wrote that he would be a much wiser person if he forgot everything else in economics and and just learnt the collected work of John Maynard Keynes:

I would be a smarter man if I simply wiped existing programs and data structure from my wetware and installed a John Maynard Keynes emulator.

In other words, every passing day makes the Ancients look taller.

The Two Faces of Ben Bernanke

By Pira Saravanamuthu

11th August 2010

Ben Bernanke

Ben Bernanke the academic

Ben Bernanke is the head of Americas central bank, the Federal Reserve. He was appointed to that position in 2005. Before that he was Chair of the Economics department Princeton University. Ben Bernanke is the person who enticed Paul Krugman to come to Princeton from his beloved MIT.

At Princeton Ben Bernanke, Paul Krugman and a few others academics formed a group that thought hard about Japans liquidity trap in the late 1990s. They wrote a series of landmark papers on how to get out of a liquidity trap (ie an insolvency crisis). This is what Bernanke wrote in a paper in 1999:

Krugman (1999) and others have suggested that the Bank of Japan quantify its objectives by announcing an inflation target, and further it be a fairly high target. I agree that this approach would be helpful, in that it would give private decision making more information about the objectives of monetary policy. In particular, a target in the 3-4% range for inflation, to be maintained for a number of years, would confirm not only that the Bank of Japan is intent on moving safely from a deflationary regime.

So, Ben Bernanke, the academic was forceful about the need for inflation in Japan in 1999.

Ben Bernanke the central banker

However, as a central bank official he has taken a very different position. Back in December 2009, Brad DeLong asked him why the Fed wasn't targeting an inflation rate of 3%. After all, the rate of inflation in America has been falling for the last 2 years.

Ben Bernanke was direct in answering the question:

The Federal Reserve has not followed the suggestion of some that it pursue a monetary policy strategy aimed at pushing up longer-run inflation expectations.

In theory, such an approach could reduce real interest rates and so stimulate spending and output. However, that theoretical argument ignores the risk that such a policy could cause the public to lose confidence in the central banks willingness to resist further upward shifts in inflation, and so undermine the effectiveness of monetary policy going forward. The anchoring of inflation expectations is a hard-won success that has been achieved over the course of three decades, and this stability cannot be taken for granted. Therefore, the Federal Reserves policy actions as well as its communications have been aimed at keeping inflation expectations firmly anchored.

So you see the situation looks different depending on whether you are an academic or a central banker. When you are a dispassionate academic commenting on far away events an inflation rate of 3-4% seem like a good thing. However, when you are a central banker that has to implement a difficult policy prescription, then 3-4% inflation seems like a dangerous thing.

How to End an Economic Depression

By Pira Saravanamuthu

January 2011

In theory ending economic depressions is really easy. However, in practice ending economic depressions turns out to be really difficult.

In order to end an economic depression caused a by too much debt, the government just needs to keep printing and spending money until the unemployment falls back to a normal level. However, in practice government officials find it very difficult to implement this policy for two reasons.

Firstly, government officials cant believe that the solution to such a complicated problem could be this easy. For instance, one of President Roosevelts advisers suggested to him that printing money might end the Great Depression. President Roosevelt is said to have replied, too easy.

Secondly, the political system has built in roadblocks that prevent radical policies from being undertaken. Strictly limiting amount of money the central bank prints and requirements to balance the government budget are usually principles of good government. However during a debt crisis (i.e. liquidity trap) these policies become a major handicap.

World War II ended the Great Depression because government officials finally stopped worrying about the principles of good government and focused on winning the war. The American government printed and spent money until it won the war.

The $30 trillion (in today's money) the American government spent on World War II was more than enough to end the Great Depression. The inflation that arose from the massive government spending reduced private sector debt to a safe level.

The lesson is that when there is no external existential threat to the state, democratic governments have a really difficult time doing what is necessary to end an economic depression.

This insight has led Paul Krugman to recently say that a fake alien invasion would end the slump.