Depression through Different Lenses: The Schools of Economic Thought Respond to Recession | Caroline Greeley, University of Massachusetts Amherst

Abstract

Different schools of economic thought, such as, the classical, neoclassical, Marxist, Keynesian, American Institutionalist, and Modern Money Theory, differently approach the problem of economic depression in capitalism. I illustrate the differences by describing their alternative responses to a scenario of recessionary crisis.

Periodic, systemwide economic downturns — depressions and recessions — are a regular feature of capitalism, and any explanation or analysis of capitalism has to account for depressions and recessions and to prescribe a response (or non-response). I discuss how the different schools of economic thought such as, the classical, neoclassical, Marxist, Keynesian, American Institutionalist, and Modern Money Theory approach the problem of economic depression in capitalism. I consider the following scenario: the economy has experienced a sudden collapse of asset prices, with the stock, real estate, and commodity market experiencing declines of over 50 percent relative to last year. Data show a loss of nearly 1 million jobs since last month, which brings to year-to-date loss of jobs to nearly 5 million. And, bank lending has slowed sharply, and initial data on investment suggests a sharp decline in new projects. The central bank reports that that bank balance sheets have deteriorated significantly, and it is contemplating emergency monetary actions. The country's Prime Minister claims to be “on top of the situation,” but polls suggest her popularity is falling fast as confidence in the government's economic leadership diminishes. This appears to be the start of a serious recession, with the rate of decline in production rivaling the rapid declines in 2008 and 2009.

Each economic school of thought would approach this recession phenomenon in a different way. What models they use and how they use them are the main differences in their approach to dealing with recessions. The biggest difference between each school’s model is whether they are static or dynamic. Dynamic approaches show how the real world is changing and complex, which makes them hard to model. Most models are static, linear representations of a trend occurring in real life. They often only taking a few variables into account but can be useful because they can be added and have solutions that can give some answers. Another difference is how they would view equilibrium balance. Do they consider equilibrium to be stable? Do they think that markets will correct themselves when they fall out of equilibrium or will the government need to intervene? Do they think that they are moving towards the optimal outcome or just a circumstantial outcome? These questions are all crucial to understanding how a school of thought would approach an economic recession. Another way the schools differ in their thinking is based on how they view the economy in a historical and institutional context. Some schools will care more about how the economy affects individuals, while some will care about how the economy impacts society as a whole. Some will think that the economy is a separate entity from other aspects of life and will not care to look into other fields such as sociology, psychology, or behavioral sciences to understand what's happening in the economy. Other schools will argue that it is impossible to make sense of the economy without taking these subjects into account. How the schools make sense of recessions such as the one described in the prompt will depend greatly on what they consider important to economic models.

The classical school of economics was divided on how it addressed recessions. Classical economists were heavily influenced by the work of Adam Smith, who concluded that recessions could not occur. Smith, and nearly all of other classical economists, thought that aggregate demand would always rise to meet aggregate supply and that the “invisible hand” that controls and corrects markets would prevent recessions from happening. The only classical economist that challenged this was Thomas Malthus, who put forth his theory of gluts. This theory stated that over-accumulation of capital would lead to a break in the circular flow of money, causing demand to go down because people could not afford to buy the supply of commodities. Although Malthus recognized that people needed more money to purchase the supply, he opposed raising wages, because he saw this as hurting the capitalist class’ profit. His solution to recessions was for landowners to hire more servants. These servants would be unproductive, but they would still consume; therefore, they would increase demand without increasing supply and allow them to meet at equilibrium again. Most classical economists were members of the landowning class and their theories often were biased in favor of this class. The classical approach to solving recessions is very limited in addressing the recession demonstrated in the prompt. The classical all believed in the laissez-faire policies, so they would not advise the government to take steps to intervene in the economy. The modern financial system and all of its complexities did not exist in the 1700s, so their solution would be to wait out this recession because the “invisible hand” would eventually reverse this recession and growth will start again.

The Marxist models aim to be complex and to analyze change over time. They take history into account and see how capitalism developed over time from feudalism and how the capitalists are those who benefitted from primitive accumulation. The Marxist school of thought would see this recession as an unavoidable part of capitalism. They would say that this recession is an example of why capitalism needs to end. Marxists believe that as capitalism expands, balanced economic growth is impossible. In their models, the capitalist class over accumulate wealth so that the circular flow is broken. This point is expressed in the quote:

Capitalism is therefore increasingly prone to crisis. The crisis explodes when production has developed beyond the possibility of profitable realization. This can occur for different reasons, and what matters for the explanation of specific crises is how their underlying cause – the subordination of the production of use values to the production of surplus value – manifests itself through disproportionality, overproduction, under consumption and the falling rate of profit. (Marx’s Capital, 95)

Here, it is explained how it is impossible for demand for goods to grow at the same pace as production of those goods within a capitalist nation’s economy. Because there was not enough demand for the goods produced, recessions like the ones described in the prompt are inevitable.

Marxists would hope that this recession would spark a revolution led by workers to overthrow capitalism. Recessions affect the livelihood of the poor much more than the rich, and Marxist would hope that the poor living conditions of the proletariat would inspire a communist revolution to take place. They would want the workers to take control of the means of production so that capitalists cannot exploit their labor any longer. They would argue that the country’s prime minister is incapable of saving the economy because she is defending the capitalist class’s interests. The Marxists point out valid flaws in the capitalist system, but communist societies do not have a better quality of life than capitalist ones. Communist revolution is a realistic goal in modern day America, and that trying to fix capitalism is the best chance we have at a fair and relatively equal society.

The Neoclassical school would view this oncoming recession as the market correcting itself. The neoclassical models of the economy are stable, self-correcting, and optimal. This means that the economy will naturally rebound from a recession like this, and that the government should not intervene. Neoclassical economist would urge the government not to intervene in the economy at a time like this because they would disturb the market from correcting itself naturally. Neoclassical economics also assumes that the economy is perfectly competitive and will operate at full employment. Neoclassical economists would advise the central bank to not interfere in the economy with monetary or fiscal policy. They would also certainly be against the government bailing out certain industries or banks as they did in 2008.

Because of these beliefs, the neoclassical approach to this recession similar to 2008 would be to not interfere and allow the market to correct itself. An important assumption that neoclassical economics makes is that “market adjustments would be fast and effective and should be relied upon completely” (H&L, 270). One of the most famous neoclassical models is that of the Walrasian auctioneer, which demonstrates how prices reach equilibrium by establishing prices that consumers react to in order to get perfect equilibrium. In Walras’ model it was assumed that “each consumer acts so as to maximize his utility, each producer acts so as to maximize his profit, and perfect competition prevails, in the sense that each producer and consumer regards the prices paid and received as independent of his own choices” (Arrow-Debreu, 1). Here, it is explained how Walras arrived at this perfect equilibrium. The main features of a neoclassical model are that they are linear, partial, and individualist. This means that their models tend to look at an individual, rather than the society at large. They believe that everyone acting in their own rational self-interest will create perfect competition. They also look at the economy as an entity separate from other institutions; their models of supply and demand do not take historical context and other societal institutions into consideration. While those may be some of the downsides of neoclassical models, their simplicity allows them to be solvable, and can show some information about how prices and utility affect supply and demand.

The American Institutionalist approach to solving this recession would be extremely different from the neoclassical approach. This school of thought was very complex and dynamic, and viewed the economy as being connected to other societal institutions such as the government, culture, and fields. Pierre Bourdieu, an influential Institutionalist, broke culture down into two subcultures: habitus, which is the outward forms of behavior such as dress, body language, and other things that you do and are associated with, and the doxa, which is the common belief within the habitus that brings them all together as one subculture. American Institutionalists believed that our economic system has evolved over time and is a direct result of history. Therefore, they believe that historical and societal context is absolutely necessary to make sense of and model the economy. In many ways, they incorporate social and behavioral sciences when studying economics. The founder of American Institutionalism is Thorstein Veblen, who showed how informal and formal institutions affected the economy. He believed that firms did not act in a way that is beneficial for communities. In his book, The Theory of Business Enterprise, he states, “Work that is, on the whole, useless or detrimental to the community at large may be as gainful to the business man and to the workmen whom he employs as work that contributes substantially to the aggregate livelihood” (Theory of Business Enterprise, 20).

For example, businesses often exploit natural resources that everyone relies on in order to create more profit. Veblen saw the class struggle between workers and capitalists as one of the biggest problems in a capitalist economy that would lead to depression. He also thought that depressions were a natural part of the business cycle in capitalism. American Institutionalists would advise the government to intervene in a recession to help the economy from failing. However, they believe that the government is doing this in order to help the wealthy capitalist class, and not the working class who are the most hurt by recession. Veblen saw capitalist governments as “the enforcers and guarantors of the profits and privileges of the capitalist class.”

Under their view of the government, the prime minister would probably take action to save large businesses assets, but the working class would be left to fend for themselves during the Recession. The Keynesian school of economics would see this recession as a natural part of the capitalist system. Keynes was not anti-capitalist, he saw flaws in capitalism and wanted to know how to make the capitalist system work. Keynes witnessed the Great Depression and realized that the government could intervene to lessen the effects of the periodic recessions that occurred under the capitalist system. Keynesian economists would advise the central bank to lower interest rates so that people are more inclined to borrow money and invest. They would advise the prime minister to increase government spending on things like infrastructure and investment to stimulate the economy. This approach is diagrammed in the IS-LM model that shows the relationship between the money market and interest rates in an economy. This model is shown below.

Using this model, Keynes’ theory that increasing the money supply and government spending would help to reverse the economic catastrophe of a recession by increasing aggregate output is shown. Modern Money Theory combines Institutionalist and Keynesian thinking, recognizing the role institutions play in money, the monetary system, and policies. In MMT, money is not only a physical item that can be printed or felt; it can also be created very easily with a computer.

They argue that a dollar is nothing, but a liability issued by the US government, which promises to accept it back in payment of taxes. The dollar in your pocket represents a debt owed to you by the federal government. Money isn’t a lump of gold but rather an IOU. The government sets monetary policy; this includes the amount of money in circulation and interest’s rates. The government and our institutions are critical to our financial systems and the role of money. Part of the MMT thinking is that because the government can always create the money it needs, it should not worry about things like deficit spending, and should boost the economy whenever it needs to in order to help economic growth. In this theory, the United States government creates the US dollar, therefore, “it can never run out, it can never go broke, and it can never be forced to miss a payment.” Because of their unique view of money, MMT would suggest that the central bank take extreme monetary policies to help turn the recession around. They would advise the central bank to lower interest rates and tell the prime minister to lower taxes and fund large projects to promote investment by running up a budget deficit.

In a recession the government should take the steps laid out by the Keynesian and the Modern Money Theory schools. The government should definitely take steps to intervene and turn the economy around when a massive recession comes. I tend to agree with Keynes that there are certain problems with the capitalist system that need to be addressed in order to stop these periodic recessions. Keynes famously said that “in the long run, we’re all dead.” This is a great way of thinking about how government intervention can help boost the economy in the short term. Short term fixes may not be ideal, but they can help millions of people avoid poverty. The financial crisis in 2008 led to many people losing their homes and jobs, the government should strictly regulate the financial market in order to prevent a crisis like that from happening again. I agree with Epstein and Montecino (2016) when they wrote that a healthy financial system “channels finance to productive investment, helps families save for and finance big expenses such as higher education and retirement, provides products such as insurance to help reduce risk, creates sufficient amounts of useful liquidity, runs an efficient payments mechanism, and generates financial innovations to do all these useful things more cheaply and effectively.” (High Cost of Finance). The United States government should regulate the financial market so that it is less speculative and hold Wall Street accountable when they make disastrous mistakes that throw the entire economy into recession.