344 LE Final Exam Study Guide I. OVERLAP FROM MIDTERM: ADAM SMITH
Adam Smith Wealth of Nations (4 Points):
1. Law of Markets: Notion of the invisible hand. Through competition, markets produce quantities, prices, and wages of the market: Perfect Competition 2. Division of Labor: Key to increasing productivity is the division of labor, both within a factory, but also within entire industries. Reasons it works: A. Increased dexterity: become process expert B. Save time from shifting to different tasks C. Develop innovation through process familiarity Absolute Advantage: Smith believed that it was always best to buy what was cheaper domestically, domestically, and go abroad for what was cheaper there. Definition of Wealth: Divides population into productive and unproductive labor. Productive labor produces tangible objects (like physiocrats, but including manufactures). Unproductive was essentially the service sector (Lawyers, teachers, etc.). Wealth was defined as the value of goods produced by productive labor. 3. Theory of Value: Diamond-Water Paradox: The use-value of water is much higher than its market value, where diamonds commands high market value but low use-value. Smith focuses on value of a commodity as it relates to its exchange value. Natural value is determined by its cost of production (just as Aquinas defined it). In the short run, a single supply meets with the market demand to produce the price of the good. While sometimes high or low, this price will tend toward the natural value of the product. 4. Theory of Distribution: Smith classified people into three groups: landlords earned rent, capitalists receive profit, and workers receive wages. Wage Fund Theory: Wages determined by available variable capital, divided by the labor force. This equation explained the short run wage rate. The long run wage rate tended toward a subsistence wage. Economic growth leads to increase in the wage fund, which leads to population growth, leads to larger labor supply, lowering wages. Believes that higher wages lead to higher productivity.
Profit: defined as rate of return on invested capital. Over time in a growing economy, these levels will inevitably fall. The most profitable investments are pursued first, because of invisible hand. Interest Rates are indicative of profits. Smith believes that b/c all investment comes out of profits, we should focus on maximizing profits. Rent: Price paid to landlord for the use of the land. Rent is revenue from the land-profit. Smith believed that landlords were getting wealthier and wealthier as other two classes would get poorer and poorer.
Smith, Book 1 Chapter 10
Part one: Variance in wages across occupations (5 reasons)
1.Some jobs more disagreeable, resulting in higher wages 2.Necessity of skill can increase wages 3.Regularity of employment: more regular, lower wages need be 4.Entrusted Responsibility: more trust, more wages 5.Probability of success: lawyers have low probability of success, makes good
ones more expensive
Part Two: Wage inequalities as a function of government Settlement law: Smith hated settlement law because it prevented migration of workers, which was key to economic growth
II. NEW MATERIAL: POST-MIDTERM Thomas Malthus (1766-1834)
Argument of Essay on Population (1798): Malthus's father believed the human race was progressing toward some sort of perfected utopia. Malthus disagreed, and wrote Essay on Population to explain why humans would never be able to improve their conditions toward perfection. The argument was based on two main premises, and had one conclusion (three points): 1. Food is necessary to the existence of mankind 2. Passion between the sexes is inevitable (people aren't going to stop fucking) 3. The conclusion is that the power of population to grow is much greater than the power of the earth to produce subsistence
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This is because population increases at a geometric rate(2,4,8,16, etc), while food production may only increase at an arithmetic rate(1,2,3,4,etc). Malthus holds that population increases faster than food production can accommodate, leading to either death or reduced
pregnancy, which works to lower the population level to one which can be sustained.
Malthus's two checks on population growth: 1. Positive Check: Refers to events that stops population growth that has already began. These checks will typically work to raise the death rate, such as plague, famine, infanticide, etc. These checks operate largely among the poorer classes. 2. Preventive Check: These types of checks work to lower the birthrate, and include things such as restraint of sexual passion and delay of marriage. These checks work more effectively among the wealthy, and work preemptively as opposed to reactively.
Malthus and the Poor Laws: Malthus hated that shit. He believed that the laws worked to counteract both positive and preventive checks. It prevented the poor from facing the positive check of famine and disease, and lowered the effects of the preventive check by allowing for earlier marriages and more births. This would lead to unnatural population levels which would have the effect of higher demand for food, raising the price of food, and thus making the impoverished classes that the law sought to help even worse off than they had been. Malthus and Charity: Malthus believed that the answer to the problem was private charity. The poor laws were inefficient because they provided the guarantee of economic security. Malthus distinguished between deserving and undeserving poor, and claimed that rightly dispensed private charity could help the deserving poor that have been stricken with calamity, while ignoring the free riders.
David Ricardo
Five Basic Assumptions: 1. 2. 3. 4. 5. Wages approach subsistence levels All investment comes from Agriculture subject to diminishing returns At any point in time, profit rate is the same for everyone Profit=Revenue minus the cost of the last land cultivated
Model of British Economy (W/ Corn Laws)
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Although wages will tend toward subsistence levels, they may always remain above these levels as long as capital accumulations result in an increased demand for labor. So: Profits-->increase in labor force->increase in wages-->increase in demand for/price of food. Because Corn Laws don't really allow for exports, higher food demand means that rents on agricultural land will increase, moving food production to less and less
fertile land. Ricardo holds that if this trend continues, the economy will eventually move toward a stationary state where there is no room for economic gains, and can only be avoided if Corn Laws are repealed. Model of British Economy (W/O Corn Laws) o If Corn Laws were repealed, the world market for grain would be factored into the domestic economy. When the domestic supply curve meets the world supply, domestic production will not be perpetuated. Instead, British would turn abroad to meet the rest of the demand. Rents would not increase, and profits would not fall (they would not rise either). This is essentially the basis of comparative advantage.
John Stuart Mill
Mill essentially agrees with the arguments of Malthus and Ricardo, but just believes that their conclusions need to be amended to account for historical events. There are three main ways that Mill argues Malthus and Ricardo went wrong: 1. Between 1814-1846, price of wheat falls by 29%, going against Ricardo's model. Mill argues that this price decrease does not counteract Ricardo's argument, but rather was the result of significant tech. advances. 2. Iron Law of wages (wages tending toward subsistence) doesn't seem to be holding up either. Starting in the 1820's, real wages began to rise, after remaining constant for 40 years. Also, the wage gap between skilled and unskilled begins to grow, increasing the skill premium. 3. Rate of population growth slows after 1821.
Mill on the Law of Population: o Theoretically, Malthus is entirely right about the effects of the positive and preventive check. The difference is that Mill believes that lower skilled workers are starting to figure out the preventive check (b/c of education), realizing that fewer children-->higher SOL, making the positive check less applicable. This also helps to explain #3 above, explaining why birthrates are decreasing. Regarding #2, Mill believes that as skilled workers are paid more, they become better educated and tend to therefore favor the preventive check, widening the gap between skilled/unskilled wages. Mill on the Stationary State: o Mill sees the stationary state as a desirable goal for the economy as the progressive state was simply allowing more people to live in the same drudgery. Mill believed that in a stationary state, no one would be poor, and no one would desire to be richer. To achieve this stationary state balance sooner, Mill favors personal frugality and government intervention to help evenly distribute the wealth. Mill on the Wages Fund Theory:
Because the wages fund theory proposes a set amount of money to be spent on wages, classical economists had seen unions as monopolies, because the only way to raise wages was to decrease the number of participants in the labor pool. Mill counters this idea, explaining that while the wages fund exists, it is a maximum rather than an actuality (in other words, just because employers have 20,000 to spend on wages doesn't mean that workers will receive 20,000). Therefore, the role of the union is to ensure that the maximum is reached. Mill also believed that in any given firm, the employer is a monopoly in the labor market, so the competing monopoly of the union could counteract this. In 1869, because of work released by Thorton, Mill agrees that there is no actual labor fund, but rather that the only limit to wage rate is enough profit to keep firm in business. Mill on Distribution of Wealth and Taxation: o Mill believes the easiest way to tweak the distribution of wealth is through taxation. Mill divides income into two categories (earned and unearned) suggesting a flat (proportional) tax for earned income, and a sharply progressive tax for unearned income. Mill held that progressive taxes on earned income are unfair and dissuade people from hard work, while they are more fair for unearned income and rent, because it doesn't take away from someone's productivity. Mill Book V, Ch. 11***BOYER SAID THIS WILL BE ON THE FINAL*** o Chapter 11 discusses the role of government intervention in domestic affairs. The chapter starts with Mill arguing that minimal government intervention is ideal. He goes on to list several reasons why: Preventing free-will and personal decision making is degrading, like slavery. Great majority of affairs performed better by private individuals. o After arguing for minimal intervention, Mill provides a list of exceptions, where in fact the government should intervene: Government should police and regulate the employment of children Government should have forced elementary education Poor Relief: Mill believes that those who are destitute are entitled to help from those better off. But Mill is careful to note that any poor relief must grant relief to those who need it, while also not encouraging people to rely on it. His proposal. Assistance should be given such that it is always less desirable than working.
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Karl Marx
Karl Marx used the same concepts of his contemporaries, such as the LR equilibrium wage rate, but framed these theories in much different ways. Marx believed that the falling rate of profit would lead to violent revolution instead of Mill's stationary state. Marx's Two Types of Production
1. Simple Commodity Production: Workers own their own means of production. They use their own machines to produce a good, consume some of it themselves and sell the rest in exchange for other necessary goods: C(ommodity)1-->Money-->C2, where C1=C2 2. Capitalism: Different because the workers no longer own the means of production, owning only their labor. In this equation, M1-->C-->M2, where M1>M2. M1-M2=surplus value. Marx believes that this surplus is derived from the exploitation of workers, and horded by the capitalists.
Source of Profits o Since workers can't afford to buy the means of production, they are forced into selling their labor to the capitalist. o Marx agrees that the LR equilibrium wage will approach subsistence, defining subsistence as enough to support 2 child family. By translating this into work hours, Marx believes that after the worker has reached subsistence in terms of real wages, his work becomes profit for the capitalist. Example: If a man can produce enough goods in 4 hours to meet subsistence, the other 8 hours of the work day would equate to profit for the capitalist. Necessary Labor is the amount of labor required to reach this level of subsistence. Surplus Labor is the labor beyond this where the capitalist reaps the benefit. Total Value of a Commodity o There are three components to the price of a commodity: 1. Money spent on machines, etc. C=Constant Capital 2. Money spent on Labor, V=Variable Capital 3. Profits enjoyed by Capitalists, S=Surplus o o o o o C+V+S= Total value of a commodity Rate of surplus value = S'=S/V (surplus hours divided by necessary hours) Rate of profit = P = S/(C+V) All investment comes from profit, and the key to profit is exploiting the worker (b/c workers are the source of surplus). Marx sees the goal of capitalism to be accumulation not consumption.
Marx and the Law of Population o Believes subsistence is the equilibrium, but as technology replaces workers, there is a larger labor pool, further driving down wages. This is his concept of the Industrial Reserve Army, or the masses of unemployed, who ensure that wages will not rise, b/c workers can be replaced immediately. Marx sees the Malthusian cycle as a capitalist apology for why workers have low wages. Workers are rather at the mercy of the capitalist. The Collapse of Capitalism:
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Marx believes that the first step in the collapse of capitalism is the falling rate of profit. As capitalists are forced to replace labor with machines to benchmark with competitors, they are gradually removing from production their only source of profit, which is labor. This causes the ratio of labor/capital (q) to increase. This progression will gradually diminish the rate of profit, however it may be counteracted by the fact that it takes workers fewer hours to reach subsistence with the aid of new technology. As these workers are replaced by machines more and more, capitalists will see falling rates of profit, but the Industrial Reserve Army will get larger and larger, as capitalists become fewer and fewer. Eventually Industrial Reserve Army will be large enough that it will revolt.
V.I. Lenin
Capitalists have postponed the revolution through imperialism, where they can turn for higher profit returns. These higher returns enjoyed abroad can have the effects of raising domestic wages, but a revolt is still inevitable.
Friedrich Engels
On industrialization: o Engels discusses the pre-industrial golden age, where textiles were made in the workers' homes, on their own terms. He argues that this was favorable to the factory system of post-industrialization, because in the former, the poverty was less severe, and less miserable than industrial poverty. Living Environments in Cities (Ch. 2): o Engels describes the slums of industrial British cities in tremendous detail. Lots of squalor, unplanned slums, and deaths. Working Conditions (Ch. 5+6) o First Factory Act of 1833: Prevented children under the age of 9 from working in textile factories, and limited the work of those ages 9-15. Workforce is extremely young as children become preferred, and older workers not able to carry on as long (early deaths). Engels also proposes that because more women work in factories, their morality has decreased. Work weeks were long, physical deformities common, and higher chance of early death. Most people over 45 are fired for being unproductive. Attitude of the Bourgeoisie (Ch. 11): o Engels hated the Bourgeoisie, and noted their reckless spending habits. o Poor Law Amendment Act (1834): Recommended that all able-bodied poor should be sent to workhouses. Engels disagreed with this, placing himself completely at odds with Malthus, who favored workhouse relief programs. Predictions: o Believed that each economic downturn (7-10 yrs) would be worse than the last, with the worst downturn occurring in the 1850's, when he predicted
capitalism would end, with workers killing their bosses until the bosses converted to socialism. Marginalism:
Overview: 4 years after the publishing of Kapital, Jevons released Theory of Political economy, and Menger released Principles of Economics. These books along with many others published around the same time were notable in that they ignored the questions asked by the classical economists, focusing more on the issue of how to allocate limited resources within a community to maximize economic returns. Concepts such as marginal utility, marginal cost, etc. **Motive force shifts from accumulation to consumption. Development of Marginalism: In the 50 years since Ricardo, many countries had enjoyed unprecedented growth, that had not slowed down. Real wages continued to rise, and population growth was slowing. The fears of the classical school of economics seemed to be unfounded. Growth became the constant, rather than the means to some end (stationary state, revolution, etc) proposed by the classical economists. While the theories of both Marx and Ricardo featured an inverse relationship between wage rates and profit levels, marginalists examined the economy from a non-political approach.
W. Stanley Jevons
Jevons frames his argument as an attack on classical economics. Theory of Value: While classical economists had always defined value as the equal to the cost of production, Jevins claims that value depends on the utility of the good. This shifted the derivation of value from the supply side (cost of production) to the demand side (utility). This theory was drawn from the work of Jeremy Bentham who presented the pleasure/pain calculus, which stated that individuals seek to buy the most pleasure while expending the least amount of pain. The development of this theory led Jevons to be known as the founder of utilitarianism. This also kicked off a huge shift to a greater focus on mathematical economics. Utility: The abstract definition of a commodity's worth. Not intrinsic to a commodity, but determined by the taste of the individual. Different people may find different levels of utility in the same good, and the same person may find different utilities at different points in time. Total versus Marginal Utility: o Total Utility: Using food as an example: food has a very high total utility because we need it. A decrease in food consumption will lead to a decrease in the utility of food. o Marginal Utility: Idea that as quantity increases, the utility assigned to a good will decrease after a point (think of eating 10 candy bars in a row). o Cardinal Utility: Jevons went so far as to claim that we could quantify utility in terms of utils in order to measure a market. This was later rejected in place of:
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Ordinal Utility: Which is the concept that we cannot assign specific values, but we can order our preferences. Diamond Water Paradox: Jevons rejects the paradox claiming that the use value is inconsequential because it relates to the total utility of a good, while the exchange value relates to the marginal utility. The point is that a good does not have any intrinsic worth, but is rather worth whatever the individual values it at any given time.
Alfred Marshall
Known as the greatest marginalist economist. Principles of Economics was published in 1890, and is still a frequently cited text. Was also the teacher of John Meynard Keynes. Where Jevons went against the classical economists, Marshall saw his work as an extension of those thinkers, and rather than disagreeing with them, Marshall claimed that the focus of economics needed to shift to a more micro-level analysis. Supply and Demand Curves: Dude invented the demand curve. Took the concept of marginal utility and related it back to the price and quantity of a Also good. developed the upward-sloping supply curve to create a graphic interpretation of the market. Agrees with both Jevons and the classical economists, claiming that demand and supply come together to determine the market price of a good (uses the example of cutting a piece of paper with scissors--which blade is doing the cutting?). Value: Marshall believed that the value of a good was determined in the market place based on these two prevailing forces, and so there was no such thing as a natural price or a fixed value.
Globalization:
1850-1914 marked a period of tremendous economic growth, and also a period of spreading globalization. Three aspects of this globalization: 1. Rapid Increase in International Trade 2. Capital and Labor flowing across boundaries 3. Convergence in living standards across countries, by almost every measure
This period of growth started when Britain repealed corn laws, and renegotiated tariffs in favor of free trade: o Most Favored Nation clause (MFN), which stipulated that if any tariff negotiated with another country was lower than the current tariff with the MFN, the terms of the more beneficial treaty would automatically transfer to the MFN. This trend continued across countries, gradually melting away tariffs, leading to dramatic increases in exports.
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In 1873, an economic downturn leads many countries to re-establish protective tariffs. Even in the face of these tariffs, exports as a share of GDP continued to grow. Why exports were raising so rapidly (2 reasons): 1. Elimination of the Tyranny of Distance: world prices converge as transport costs decrease. Suez Canal and railroads help to decrease these costs. Wheat was 50% cheaper in NA than in Britain, but this was corrected with largescale exporting to Europe, and the prices eventually converged. 2. Implementation of the Gold Standard: Each country fixes the price of their currency against gold, and then doesn't change it.
The Gold Standard
Pros:
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Benefit was that the exchange rate remains constant. Allowed consumers to have consistent expectations regarding purchases and investments, eliminating a large degree of exchange risks. Because of these benefits, all countries desired to be on the gold standard. Also increased international capital outflows, mostly from Great Britain, spreading to US, Africa, India, Russia, etc. Investment focus rested heavily on railroads and mining, allowing the capitalists who invest to reap the natural resources abroad Result is specialization in world economy Before WWI, US was the biggest borrower in terms of total foreign capital invested.
Cons: It is extremely hard to maintain the value of a currency. Being pegged to the gold standard prevents the government from using monetary policy (manipulating the interest rate) in order to regulate inflation or eliminate poverty, because monetary policy must be focused on maintaining the constant value of the currency. Example: During WWI, in the face of high unemployment and deflation, the government still decided to raise the interest rate, with the aim of stabilizing the international value of the dollar, rather than addressing the domestic problems. Effects: o This trend led to foreign capital dependency. Example: Argentina relied on foreign capital for over 50% of its economy. This is why the onset of WWI led to the collapse of and hyperinflation in the Argentinian economy. o Realignment of economic power: because of help from foreign investment, US becomes world leader in industrial production. Example: Share of world industrial production: 1820: GB--32%, US--23%, Germany--13%, France--10%. 1913: GB--14%, US-36%, Germany--16%, France--6%
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Following Franco-Prussian War, Britain fears Germany, and a naval arms race ensues. o All of this international economic cooperation collapsed at the onset of WWI, leading to economic despair. Keynes believed that the 'Malthusian Devil' had returned, with technology no longer increasing faster than population. Labor (3rd aspect of globalization) o 1850-1914: Period of globalization of labor: Roughly 50 million European emigrate from home continent. The US would accept 60% of these emigrants. o Rational migration: Labor was almost always flowing from low-wage countries in Western Europe into high wage countries such as the US. Of course, this redistribution had the effect of converging international wage rates, as if Smith's invisible hand were correcting inequalities in the labor market. In high wage countries such as the US, wages would fall as the supply of labor increases. In European countries, the massive emigration increased wage rates by lowering domestic labor supply. o Effects of wage convergence: Workers enjoy higher real wages and higher standards of living, higher literacy, shorter work days, social spending on welfare still quite low, but begins increasing. WWI o Brief history: Gabriel Princep shoots Franz Ferdinand, leading Austria to declare war on Serbia, which makes Russia declare war on Austria, which makes the Germans declare war on the Ruskies, which makes the French declare war on the Germans. Germany invades Belgium in order to invade Northern France, however this violated Belgium's neutrality, leading GB to declare war on Germany. War ends on 11.11.1918. Effects of WWI: o Massive anti-globalization backlash: the debt created by the war meant that most countries involved failed to meet the standards for staying on the gold standard.Most countries re-establish tariffs in efforts to protect domestic industry against foreign imports. o In the US, this anti-globalization fear led to significant backlash against immigrants. 1921 quota system was biased against "new immigrants." Reasons for anti-immigrant backlash:
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1. Belief that WWI would lead to huge inflow of impoverished central Europeans. 2. Racist Xenophobia 3. Politicians fought immigration to pander to the American working class, who saw immigrants as a valid threat to domestic wages.
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Following the war, the pre-war convergence of international wage rates began to divide once again, as isolationism took over. Armistice (1918): Germans sign the armistice with the belief that the treaty would be somewhat fair. Instead, the Treaty of Versailles was
extremely harsh on the Germans, calling for huge reperations. John Meynard Keynes had sat in on the treaty discussions, but was displeased with the outcome, so he resigned and wrote a book: JMK Response: o Claimed the treaty was both unfair and economically stupid: unfair because Germany had expected a fair deal, and stupid because it would declaw one of Europe's major economies. Instead, JMK proposed: 1. All reperations should be reduced to an amount that Germany was actually capable of paying. 2. Americans and British should forgive debts between allies. 3. Proposes that US floats an immediate 2 billion dollar loan to Europe to help with reconstruction.
This is essentially the Marshall Plan, but for WWI. What actually happened: US loans a lot of money to Germany to help with reconstruction. Germany uses this money to pay European reparations, which is then used by those countries to begin repaying their wartime debt to the US. However, as soon as the great depression hits, all countries default on their US debt, and Finland ends up as the only country that ever pays the US back. In order to fund reparations payments, Germany prints currency, leading to a 600% per week level of hyperinflation, wiping out the savings of the entire middle class, creating a vulnerable economic situation in Germany, which allowed Hitler to come topower.
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Say's Law (1803)
Basic Idea: o Supply creates its own demand: Aggregate demand will always be equal to value of all goods produced. Because when you produce a good, you are dispersing money into the economy to cover all aspects of the production (for example, to produce a good, you must pay workers, which in turn allows them to purchase goods.) Essentially, the production of a good produces aggregate demand equal to the value of that product. The policy implication that follows is that the government should not intervene in macro-economy. Explanation of Depressions: Say called these 'general gluts' and believed they were impossible. While a 'partial glut' could be created by overproduction in one sector, the economy would work itself out because this must be accompanied by underproduction in another sector. Example: Say uses a 2 good economy as an example: D1+D2=S1+S2 (b/c aggregate demand=aggegate supply), so if S1>D1 (glut), than D2>S2 (shortage). And Say held that a free market economy will always readjust accordingly. Malthus's critique of Say's Law:
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Malthus was the only classical economist to disagree with Say's Law: Malthus said that while production does generate the propensity to purchase goods in the economy, but it does not produce the will to purchase goods. Malthus used a 2-good economy example with the two goods as food and luxury. While food cannot be overproduced, luxuries can, because the poor workers that get some economic benefit from producing luxury items don't get enough to actually buy these goods. Similarly, Malthus believes that the rich won't buy every luxury in the economy, introducing the idea that rich people horde and save their wealth. Malthus's Proposal: Encourage the rich to toward more consumption and less saving. If consumption among the rich is not high enough, government should fund public works to create jobs He is essentially arguing for Keynesian economics
The Great Depression
Starts in the US, but quickly spreads throughout Europe, which was especially vulnerable economically because of WWI. US Collapse: Between 1930-1941, unemployment averaged 17% Response: In Britain, both the conservative and labour parties kept hands off of the macro-econ, focusing instead on balancing the national budget to increase business confidence. o Lloyd George proposes public works projects to bring down unemployment. Alfred Marshall: o Providing the neoclassical perspective, Marshall examined the flow chart of marginalism (house-->banks-->firms, with consumption and wages connecting houses and firms), and he believed that the key to equilibrium was for every dollar saved must be invested, so it is not taken out of the equation, thus upholding Say's Law. If Savings > Investment, money is trickling out of the circular flow. o Why Marshall believed S must equal I: 1. Believes it would be irrational to save and not invest, because it would be essentially foregoing the possibility of income in the form of accumulated interest. 2. Both savings and investment are functions of the interest rate, so if unhindered, the market for investment will always produce an equilibrium interest rate, producing equilibrium levels of savings and investment.
Marginalist explanation for British slump: o Wages were too high: when demand for labor slows because of an economic downturn, marginalists believed that wages were not lowering
to equilibrium levels, because they were 'sticky,' or downwardly inflexible. Belief was that organized labor was producing this stickiness, and would perpetuate unemployment, until wages could be subjected to free market conditions. o Believed that cutting wages would reduce unemployment. Sydney and Beatrice Webb: o Put forth the belief that the government should intervene during an economic downturn, by putting aside a fund for when the economy slumps, so that the government can fund capital development projects. Belief was that counter-cyclical spending would keep unemployment low during economic downturns. David Lloyd George: o Said that if elected Prime Minister, he would spend millions of pounds for the next three years to bring down unemployment. Believed that more public spending and improvements to infrastructure were desperately needed. o Conservatives countered that every pound spent by the government was a pound taken away from private industry. John Meynard Keynes o Tract on Monetary Reform (1923): Strongly against idea that government should stay out of economic affairs. Went against the belief that individuals should work in pursuance of their own self-interest. Theories were largely rejected by both right and left. o Rejected notion that lower wages would correct downturn. If all firms cut wages, cost of production would fall, but this would cause the purchasing power of workers to fall by an even greater degree. Workers real wages would fall, decreasing the general demand for products. o Rejected neoclassical idea that S=I, because there are speculative reasons for holding money, which creates an incentive to hold money. For instance if you believe that interest rates will increase in the near future. Two arguments: 1. Interest rates determined by the demand for money, not by the rate of savings and investment. 2. Speculations about interest rates can create real incentive to horde money.
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Suggestions: Keynes added the government to the neoclassical circular flow diagram. Taxes from houses and firms act as inflows and public spending is the outflow. Believed that the government could correct for the net leakage created by S>I with a net injection of government spending being greater than the incoming taxes, such that S-I=G-T. This also can be stated as G+I=S+T. During a downturn, government could offset the net leakage created by S>I by either lowering taxes (T) or by raising
government spending (G). However, increasing government spending was more effective for 2 reasons: 1. Could be enacted quicker (didn't need to wait for trickle down) 2. Can take it away easier Keynes advocates public works projects, but holds that money should only be spent on useful projects, such as schools, public housing, cleaning slums, etc. Further built on in Keynes course pack reading. Very similar to proposal set forth by the Webbs. Critics of Keynes: Tend to exaggerate notion of running defecits. Keynes only favored this approach during economic downturns, otherwise, the government should run balanced budgets. Similarly, when private demand is too high, government should run a surplus by raising taxes and decreasing government spending. Many critics felt that Keynes didn't account for politics, especially the idea that politicians must appease voters. Keynes and Peace: Two causes of wars:
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1. Pressure of Population 2. Competitive struggle for markets
Believes that when there is distress at home, countries export goods to shift those problems on to other countries in an effort to maintain full domestic employment. But when everyone does this same strategy, it ends up hurting everyone. Keynes believed that because his system addresses the problems of unemployment, all trade would bevoluntary and willing, because no country would need to trade internationally to protect domestic employment.
William Beveridge:
Had been an advisor to Lloyd George, had worked with the Webbs, and was appointed in 1941 to recommend postwar social policies, and came up with a plan to merge all social policies into one comprehensive plan, which was the beginning of the welfare state. The Beveridge Report: o Believed there were 5 giant evils: Want, disease, ignorance, squalor, and idleness (unemployment) o Government should pledge to eliminate these evils in the postwar period, creating a new Britain, with an increased focus on the working class, and start by addressing the problem of want.
Government should adopt a minimum national income (not wage), to ensure that no one lacks the means of subsistence (cradle to grave protection). However in enacting this, government must be careful to not stifle incentives or responsibility. High enough to get rid of poverty, low enough that people still want more money. Two additional policies to eliminate want: 1. Comprehensive national health insurance: This would help restore the national capacity to work. Sick/dead workers didn't help the economy at all. 2. A policy of maintaining full employment: believed it was not feasible to eliminate want when there was still unemployment. For this reason the government needed to be involved in the macro-economy: the first fiscal responsibility of government should be to manipulate aggregate demand to maintain target employment rate. (ambitious 3% unemployment suggested).
Minimum national income: provides economic benefits for a large number of reasons (disasters, deaths, etc.), as long as the individual has been making compulsory payments into the plan. People who want more coverage can still subscribe to private insurance programs, known as 'friendly societies.' Beveridge admits that standards of living and wages increases have helped to eliminate want, but he sees this as a problem that can't be corrected in the private sector, thus necessitating a national system. Government should also ensure the essential liberties of its citizens
Response: o After the war, Churchill is lukewarm on the Report, claiming the cost is too high, it is socialist, and may overinflate the hopes of British citizens. He calls a general election, and the labour party runs on a platform of enacting the Beveridge report, and win in a landslide victory. Within three years, the entire welfare system is almost entirely in place. Even when the conservative party took control again, the welfare state was so wellreceived that it was never repealed. Postwar Britain (two periods): 1. Golden Age (1946-1973): Average unemployment between 2 and 2.9%, extremely low. Economic growth, increasing wages, and many believed that macro-economic questions had been answered. 2. In 1973, with the first Arab oil crisis, the golden age came to an end. Western economies begin falling off, characterized by stagflation. In 1976, PM James Calahan announces that Keynesian economics no longer works. Although not as pronounced, the US economy also suffers during this time.
Other Theories
Monetarism (Milton Friedman): Argued that the government can't solve economic problem. Believed the phillips curve (which stated that as inflation decreases, unemployment increases), was wrong, because it should actually be vertical in the long run, because the economy tends toward a natural level of unemployment. o Believed that Keynesian economics didn't work, and that the government should do nothing but set a monetary growth rate. RCO Matthews: Believed that the effects of WWI, Great Depression, and WWI were just catching up with the world economy, so it is actually impossible to determine the efficacy of Keynesian economics. Debate over effectiveness of Welfare State: o On the one hand, most economists believe that the price of a welfare state comes in the form of slower economic growth by increasing tax rates. o On the other, when welfare recipients get jobs, their marginal tax rates skyrocket as they lose benefits as well as incur more taxes Peter Lindert: Argued for the effectiveness of the welfare state: Agreed that from a calculative economic perspective, critics were right, but in terms of the actual data, Lindert saw comparable growth rates in welfare and non-welfare states. Welfare states offered some hidden drivers of economic growth: 1. Welfare states typically have pro-growth tax policies, where taxes are levied largely on consumption and labor, rather than on capital and land. 2. Some policies that appear useless economically may actually be productive. For example, unemployment and retirement benefits may keep unproductive workers out of the workforce, increasing the productivity of the active workforce. 3. Some transfer programs are actually pro-growth. For example childcare programs prevent women from exiting the economy, which helps to develop their productive capacities.
Lindert on Healthcare: Premature death rates (below age 70) is higher in coutnries with lower social spending. High incomes can help to reduce premature deaths, but other things equal, larger public share of spending on healthcare yields a lower mortality rate. o All Healthcare systems face a tradeoff: Basic versus specialized care. Public systems tend to focus on low cost basic services for all, while private systems tend to focus on high cost specialized care (In US, tons spent on keeping old people alive). Spending on basic care more beneficial for economic growth.