Marx and Keynes?

In the aftermath of the Keynesian revolution, too many

economists forgot that classical economics provides the right

answers to many fundamental questions.

—N. Gregory Mankiw (1994)

To judge from the climate of opinion, we have

won the war of ideas. Everyone—left or right—talks

about the virtues of markets, private property,

competition, and limited government.

—Milton Friedman (1998)

At the end of the twentieth century, the editors of Time magazine

gathered around to choose the Economist of the Century. They chose

John Maynard Keynes, who more than any other economist provided

the theoretical underpinning of an active role for an enlarged welfare

state during the post–Great Depression era. And yet Keynes left

economics in a state of disequilibrium when he died after World

War II. His disciples had clearly taken the profession too far away

from the classical tradition. During the heyday of Keynesianism,

which lasted into the late 1960s, too many economists were fearful

that thrifty consumers might damage the economy, that progressive

taxation and federal deficits could do no harm, that monetary

policy didn’t matter, and that centrally planned economies such as

the Soviet Union could grow faster than the free West. The spirit

of Keynes, and even Marx, dominated the political and intellectual

atmosphere.

Milton Friedman Leads a Monetary Counterrevolution

However, by the early 1960s, a counterrevolution had begun that went

a long way toward restoring the virtues of free markets and classical

economics. The primary force behind this revolt against Keynesianism

was the Chicago school of economics, led by Milton Friedman

(1912–2006). His fierce, combative style and ideological roots were

ideally suited for the task of taking on the Keynesians. Moreover, he

had impeccable credentials in technical economics to command respect

from the profession. Friedman earned his Ph.D. in economics from

Columbia University; he won the highly prestigious John Bates Clark

Medal two years after Paul Samuelson won it; and he taught economics

at one of the premier institutions in the country, the University of

Chicago. In 1967, he was elected president of the American Economic

Association. His focus on monetary policy and the quantity theory of

money was particularly attractive in an age of inflation. In 1976, on

the 200th anniversary of both the Declaration of Independence and the

publication of The Wealth of Nations, it was fitting that Friedman won

the Nobel Prize. Adam Smith was his mentor. “The invisible hand has

been more potent for progress than the visible hand for retrogression,”

he wrote in his best-seller, Capitalism and Freedom (1982 [1962],

200). It is worth noting that Time magazine came very close to naming

Friedman the Economist of the Century because of his unique ability

to “articulate the importance of free markets and the dangers of undue

government intervention” (Pearlstine 1998, 73).

Except for Friedman, the free-market response to Keynesian theory

was almost completely ineffectual. Ludwig von Mises, the dean of the

Austrian school, wrote little about Keynes; his magnum opus, Human

Action (1966), makes only a handful of references. Friedrich Hayek, the

leading anti-Keynesian in the 1930s, made the strategic error of ignoring

The General Theory when it came out in 1936, a decision he later

regretted. During World War II, Hayek lost interest in economics and

went on to write about political philosophy in works such as The Road

to Serfdom (1944) and The Constitution of Liberty (1960). Other freemarket

economists, such as Henry Hazlitt and Murray Rothbard, wrote

largely from outside the profession and had marginal influence.

How did Friedman almost single-handedly change the intellectual

climate back from the Keynesian model to the neoclassical model of

Adam Smith? After acquiring academic credentials, he focused on

scholarly technical work, particularly empirical evidence to test the

Keynesian model. He learned the importance of sophisticated quantitative

analysis from Simon Kuznets, Wesley Mitchell, and other stars

at the National Bureau of Economic Research.

Friedman started teaching at Chicago in 1946, where he stayed

until his official retirement in 1977. Following Frank Knight’s retirement

in 1955, Friedman continued the Chicago tradition and even

strengthened it with an upgraded version of Irving Fisher’s quantity

theory of money, which he applied to monetary policy. He wrote on

numerous topics related to monetary economics, culminating in the

research and writing of his most famous empirical study, A Monetary

History of the United States, 1867–1960, which was published by the

prestigious National Bureau of Economic Research and Princeton

University, and coauthored by Anna J. Schwartz (1963).

Essentially, his monumental study thoroughly contradicted the

Keynesian view that monetary policy was ineffective. According to

Friedman, it was quite the opposite. His magnum opus demonstrated

the unrelenting power of money and monetary policy in the ups and

downs of the U.S. economy, including the Great Depression and the

postwar era. Even Yale’s James Tobin, a friendly critic, recognized

its greatness: “This is one of those rare books that leaves their mark

on all future research on the subject” (1965, 485).

Friedman had a twofold mission in researching and writing Monetary

History. First, he wanted to dispel the prevailing Keynesian notion that

“money doesn’t matter,” that somehow an aggressive expansion of the

money supply during a recession or depression cannot be effective, like

“pushing on a string.” Friedman and Schwartz showed time and time

again that monetary policy was indeed effective in both expansions

and contractions. Friedman’s work on monetary economics became

increasingly important and applicable as inflation headed upward in

the 1960s and 1970s. His most famous line is “Inflation is always and

everywhere a monetary phenomenon” (Friedman 1968, 105).

Friedman Discovers the Real Cause of the Great Depression

That money mattered was an important proof, but the research by

Friedman and Schwartz revealed a deeper purpose. One startling

sentence in the entire 860-page book changed forever how economists

and historians would view the cause of the most cataclysmic economic

event of the 20th century: “From the cyclical peak in August 1929 to

the cyclical trough in March 1933, the stock of money fell by over a

third” (Friedman and Schwartz 1963, 299).

For thirty years, an entire generation of economists did not really

know the extent of the damage the Federal Reserve had inflicted

on the U.S. economy from 1929 to 1933. They had been under the

impression that the Fed had done everything humanly possible to

keep the depression from worsening, but like “pushing on a string,”

were impotent in the face of overwhelming deflationary forces. According

to the official apologia of the Federal Reserve System, it

had done its best, but was powerless to stop the collapse. Friedman

radically altered this conventional view. “The Great Contraction,” as

Friedman and Schwartz called it, “is in fact a tragic testimonial to

the importance of monetary forces” (Friedman and Schwartz 1963,

300). The government had acted “ineptly,” turning a garden-variety

recession into the worst depression of the century by raising interest

rates and failing to counter deflationary forces and bank collapses.

On another occasion, Friedman explained, “Far from being testimony

to the irrelevance of monetary factors in preventing depression, the

early 1930s are a tragic testimony to their importance in producing a

depression” (1968, 78–79).

One of the reasons for this ignorance about monetary policy is

that the government did not publish aggregate money supply figures

until Friedman and Schwartz developed the statistical concepts

of M1 and M2 in their book (1963). Friedman commented, “If

the Federal Reserve System in 1929 to 1933 had been publishing

statistics on the quantity of money, I don’t believe that the Great

Depression could have taken the course that it did” (Friedman and

Heller 1969, 80). See Figure 7.1 for the money supply figures during

the 1929–32 crash.

Did the Gold Standard Cause the Great Depression?

Keynesians have blamed the international gold standard for precipitating

the Great Depression. “Far from being synonymous with stability,

the gold standard itself was the principal threat to financial stability and

economic prosperity between the wars,” contends Barry Eichengreen

(1992, 4). Critics of the gold standard have pointed out that in a crucial

time, 1931–32, the Federal Reserve raised the discount rate for fear

of a run on its gold deposits. If only the United States had not been

shackled by a gold standard, they argued, the Federal Reserve could

have avoided the reckless credit squeeze that pushed the country into

depression and a banking crisis.

But Friedman and Schwartz dispute this widely held belief. They

point out that the U.S. gold stocks rose during the first two years of

the contraction, but the Fed once again acted ineptly. “We did not

permit the inflow of gold to expand the U.S. money stock. We not

only sterilized it, we went much further. Our money stock moved

perversely, going down as the gold stock went up” (Friedman and

Schwartz 1963, 360–61). The U.S. gold stock reached an all-time high

in the late 1930s. In short, even under the defective gold exchange

standard, there may have been room to avoid a devastating worldwide

depression and monetary crisis.

50

45

40

35

30

Billions of Dollars

9

8

7

6

Money stock

High-Powered Money

Billions of Dollars

THE GREAT CONTRACTION

The Stock of Money and Its Proximate Determinants, Monthly,

1929–March 1933

Ratio Scales

Figure 7.1 The Dramatic Decline in the Money Stock, 1929–33

Source: Friedman and Schwartz 1963: 333. Reprinted by permission of Princeton

University Press.

Is Free-Market Capitalism Unstable?

On a more philosophical scale, Friedman’s monetary research countered

a core assumption behind Keynesian economics—that free-enterprise

capitalism was inherently unstable and could be stuck at less

than full employment indefinitely unless the government intervened

to increase “effective demand” and restore its vitality. As James Tobin

put it, the “invisible” hand of Adam Smith required the “visible” hand

of Keynes (Breit and Spencer 1986, 118). Friedman concluded differently:

“The fact is that the Great Depression, like most other periods

of severe unemployment, was produced by government mismanagement

rather than any inherent instability of the private economy”

(1982 [1962], 38). Furthermore, he wrote: “Far from the depression

being a failure of the free-enterprise system, it was a tragic failure

of government” (1998, 233). From this time forward, thanks to the

profound work of Friedman and Schwartz, most textbooks gradually

replaced “market failure” with “government failure” in their sections

on the Great Depression.

Friedman came to the conclusion that once the monetary system

is stabilized, and prices and wages remain flexible, Adam Smith’s

system of natural liberty could flourish. In contrast to Keynes,

Friedman faithfully maintained that the neoclassical model represents

the “general” theory and only a monetary disturbance by the

government’s central bank can derail a free-market economy. In

short, according to Friedman, the business cycle is government-, not

market-, induced, and monetary stability is an essential prerequisite

for economic stability.

The Quantity Theory of Money: Friedman vs. Keynes

Friedman also took issue with Keynes and his disciples over the

quantity theory of money. Recall Fisher’s equation of exchange,

MV = PT,

where M = the quantity of money, V = velocity of circulation, P = price

level, and T = transactions, or real output of goods and services.

Keynes argued in The General Theory that monetary policy was

largely impotent because if you increased M, V would decline, since

the new funds would simply go into bank reserves and not be loaned

out. Hence, monetary policy would be incapable of stimulating the

economy. However, Friedman discovered in his empirical work that V

always moved in the same direction as M. When M increased, so did

V, and vice versa. An increase in M could generate a recovery. Friedman

concluded that even though “Keynes’s theory is the right kind of

theory in its simplicity. . . . I have been led to reject it because I believe

it has been contradicted by experience” (Friedman 1986, 48).

Friedman Raises Doubts About the Multiplier

The Chicago economist began his attack on Keynesianism in his 1962

book Capitalism and Freedom, where he questioned the effectiveness

and stability of Keynesian countercyclical finance. He debunked the

concept of the multiplier, calling it “spurious.” “The simple Keynesian

analysis implicitly assumes that borrowing the money does not have

any effect on other spending” (Friedman 1982 [1962], 82). Inflation

and crowding out of private investment are two possible outcomes of

Keynesian deficit spending. Subsequent studies have demonstrated

that the spending multiplier has historically never reached the heights

of 5–7 as the Keynesians originally estimated, while the money multiplier

has proven to be consistently higher.

Regarding the role of fiscal policy, Friedman noted that the federal

budget is the “most unstable component of national income in the

postwar period.” The Keynesian balance wheel is usually “unbalanced,”

and it has “continuously fostered an expansion in the range

of government activities at the federal level and prevented a reduction

in the burden of federal taxes” (1982 [1962], 76–77).

Friedman Takes On the Phillips Curve

In his American Economics Association (AEA) presidential address, published

in 1968, Friedman introduced the “natural rate of unemployment”

concept to counter the Phillips curve. As noted in chapter 6, Keynesians

quickly incorporated the Philips curve to justify a liberal fiscal policy;

to them, inflation could be tolerated if it meant lower unemployment. A

“little inflation” could do no harm and considerable good.

Friedman objected, arguing that “there is always a temporary

trade-off between inflation and unemployment; there is no permanent

trade-off.” Accordingly, any effort to push unemployment below the

“natural rate of unemployment” must lead to an accelerating inflation.

Moreover, “the only way in which you ever get a reduction in

unemployment is through unanticipated inflation,” which is unlikely.

Friedman concluded that any acceleration of inflation would eventually

bring about higher, not lower, unemployment. Thus, efforts to

reduce unemployment by expansionary government policies could

only backfire in the long run as the public anticipated its effect (Friedman

1969, 95–110). In the late 1960s, Friedman even predicted that

unemployment and inflation could rise together, a phenomenon known

as stagflation.

By the late 1970s, Friedman was proven right. The Phillips curve

became unrecognizable as inflation and unemployment started rising

together, opposite to what had happened in Britain in the 1950s. In a

famous statement, British prime minister James Callaghan confessed

in 1977, “We used to think you could spend your way out of a recession.

. . . I tell you, in all candor, that that option no longer exists;

and that insofar as it ever did exist, it only worked by injecting bigger

doses of inflation into the economy followed by higher levels of

unemployment at the next step. This is the history of the past twenty

years” (Skousen 1992, 12). In his Nobel lecture, Friedman warned that

the Phillips curve had become positively inclined, with unemployment

and inflation rising simultaneously.

Out of this Phillips curve controversy rose a whole new “rational

expectations” school, led by Robert Lucas, Jr., who won the Nobel

Prize in 1995. Rational expectations undermine the theory that

policymakers can fool the public into false expectations about inflation.

Accordingly, government policies are frequently ineffective in

achieving their goals.

Rules Versus Authority

One principle Friedman learned from Henry Simons, a monetarist

mentor at Chicago, was that strict monetary rules are preferable to

discretionary decision making by government authorities. “Any system

which gives so much power and so much discretion to a few men that

 [their] mistakes—excusable or not—can have such far-reaching effects

is a bad system,” he wrote (Friedman 1982 [1962], 50). Among

many choices, including the gold standard, Friedman has favored a

“monetary rule” whereby the money supply (usually M2) is increased

at a steady rate equal to the long-term growth rate of the economy.

One of the problems with Friedman’s monetary rule is how to define

the money supply. Is it M1, M2, M3, or what? It is hard to measure

in an age of money market funds, short-term CDs, overnight loans,

and Eurodollars. Notwithstanding theoretical support for a monetary

rule, central bankers have largely focused on “inflation targeting,”

that is, price stabilization and interest rate manipulation, as a preferable

method.

The Shadow of Marx and the Creative Destruction

of Socialism

The Herculean efforts of Milton Friedman, Friedrich Hayek, and

other libertarian economists were not the only reason neoclassical

economics has made a stupendous comeback. The other reason is

the collapse of Marxist-inspired Soviet communism and the socialist

central planning model in the early 1990s. Since then, globalization

has opened the floodgates to freer economic policies, especially within

developing countries. Nations that for decades engaged in systematic

policies of nationalization, protectionism, import substitution, foreign

exchange controls, and corporate cronyism have opened their

borders to foreign investment, denationalization and privatization,

deregulation, and other market policies. Even the World Bank, once

a severe critic of the capitalist model, has shifted dramatically in

favor of market solutions to underdevelopment problems (with some

important exceptions). The radical model of Marx and the socialists

was clearly losing ground.

But it wasn’t always that way. In fact, during most of the twentieth

century, heavy-handed central planning was considered more efficient

and more productive than laissez-faire capitalism. At the depths of

the Great Depression, radical thinking dominated the atmosphere in

intellectual and political circles. Suspicious of free-market capitalism,

many were attracted to central planning and the Soviet model.

Ludwig von Mises and Friedrich Hayek were in the minority in

questioning the collectivist zeitgeist and offering a critique of socialism

on purely economic grounds. Hayek published Mises’s 1920 article,

“Economic Calculation in the Socialist Commonwealth,” and other

essays in a volume entitled Collectivist Economic Planning (Hayek

1935). In these articles, Mises and Hayek, among others, contended

that competitive prices provided critical information necessary for a

well-run, coordinated economy between producers and consumers.

Vital information is inherently local in nature, Hayek noted, and if

channeled through a distant central planning board, actions determined

by the state would distort the signals necessary to run an economy

efficiently. For a central authority to “assume all the knowledge . . . is

. . . to disregard everything that is important and significant in the real

world” (Hayek 1984, 223). In sum, decision making must be decentralized,

and profit incentives and property rights must be established.

But Mises’s and Hayek’s arguments were largely ignored as a

result of counterarguments and historical trends. In the 1930s and

1940s, Nazi Germany and the Soviet Union were heralded as apparent

economic success stories. Journalists returned from tours of Russia

exclaiming “I have been to the future, and it works” (Malia 1999,

340). In 1936, Sidney and Beatrice Webb came back with glowing

reports of a “new civilization” and the “re-making of man,” a vibrant

nation with full employment, good working conditions, free education,

free medical services, child care and maternity benefits, and the

widespread availability of museums, theaters, and concert halls. Oskar

Lange, a Polish socialist, and Fred M. Taylor, president of the AEA,

contended that central planning boards could imitate the market’s success.

Austrian economist and Harvard professor Joseph Schumpeter

chided Mises and Hayek by concluding, “Can socialism work? Of

course it can,” adding even more damagingly, “The capitalist order

tends to destroy itself and centralist socialism is . . . a likely heir apparent”

(Schumpeter 1950 [1942], 167).

Foreign Aid and Development Economics

After World War II, European and Latin American countries began

experimenting with socialism on a gigantic scale, nationalizing industry

after industry, raising taxes, imposing wage–price controls,

inflating the money supply, creating national welfare programs, and

engaging in all kinds of collectivist mischief.

The postwar Marshall Plan demonstrated the efficacy of government

aid, and the new Keynesian approach to development of Third World

countries became state-driven growth. International development

organizations, such as the World Bank and the Alliance for Progress,

were established to assist developing nations suffering from disease,

famine, low literacy rates, high unemployment, rapid population

growth, and agriculture-based economies. MIT’s W.W. Rostow wrote

his “noncommunist manifesto,” The Stages of Economic Growth

(1960), which, along with the Harrod-Domar model, promoted the

centralized nation-state and high levels of government-driven capital

formation via foreign aid and government investment as the key to

sustained growth.

Economists were convinced by data from the Central Intelligence

Agency (CIA) that Soviet-style socialist planning had produced

high levels of economic growth, even exceeding that experienced by

market economies in the West. Paul Samuelson was one who became

convinced of Soviet economic superiority. By the fifth edition of his

Economics textbook, Samuelson began including a graph indicating

that the gap between the United States and the USSR was narrowing

and possibly even disappearing (1961, 830). In the twelfth edition,

the graph was replaced with a table declaring that, between 1928 and

1983, the Soviet Union had grown at a remarkable 4.9 percent annual

growth rate, higher than that of the United States, the United Kingdom,

or even Germany and Japan (Samuelson and Nordhaus 1985, 776).

Ironically, right before the Berlin Wall was torn down, Samuelson and

Nordhaus confidently declared, “The Soviet economy is proof that,

contrary to what many skeptics had earlier believed [a reference to

Mises and Hayek], a socialist command economy can function and

even thrive” (1989, 837).

Even conservative Yale economist Henry C. Wallich, a former

member of the Federal Reserve Board, was so convinced by CIA

statistics that he wrote a whole book arguing that freedom leads to

lower economic growth, greater inequality, and less competition. In

The Cost of Freedom, he concluded, “The ultimate value of a free

economy is not production, but freedom, and freedom comes not as

a profit, but at a cost” (Wallich 1960, 146).

One ardent critic of the Keynesian development model was P.T.

Bauer of the London School of Economics. In the postwar period,

Bauer waged a lonely battle against foreign aid, comprehensive central

planning, and nationalization. According to Bauer, state planning was

neither benevolent nor sustainable, but would lead to a concentration

of power in the hands of a political elite that would inevitably create

a corrupt and abusive system. In one of his classic essays, he wrote

about how the tiny colony of Hong Kong prospered despite no central

planning, its lack of natural resources, including water, and despite

being the most densely populated place in the world (Bauer 1981,

185–90). But Bauer’s views were largely ignored until the 1980s.

“Mises was right!”

The collapse of the Soviet Union and Eastern-bloc communism

virtually ended the century-old debate over comparative economic

systems and changed the minds of many economists about the virtues

of socialism. A prominent example is Robert Heilbroner, a socialist

who toyed with Marxism in his early years. He would later write The

Worldly Philosophers (1999 [1953]), a popular history of economics.

Under the influence of Schumpeter and Adolph Lowe, among others,

Heilbroner joined the rest of the profession and concluded that Mises

was wrong and socialism could work. He maintained that position

for decades.

In the late 1980s, shortly before the collapse of the Berlin Wall,

Heilbroner began to reconsider his views. In a stunning article in the

New Yorker entitled “The Triumph of Capitalism,” Heilbroner wrote

that the longstanding debate between capitalism and socialism was

over and capitalism had won. He went on to say, “The Soviet Union,

China, and Eastern Europe have given us the clearest possible proof

that capitalism organizes the material affairs of humankind more satisfactorily

than socialism: that however inequitably or irresponsibly the

marketplace may distribute goods, it does so better than the queues of

the planned economy; however mindless the culture of commercialism,

it is more attractive than state moralism; and however deceptive

the ideology of a business civilization, it is more believable than that

of a socialist one” (Heilbroner 1989, 98).

In a follow-up article after the demise of the Eastern bloc, Heilbroner

was even more explicit: “Socialism has been a great tragedy

this century. . . . There is no doubt that the collapse marks its end

as a model of economic clarity.” Furthermore, the debate between

the socialists and Mises had to be reexamined in light of contemporary

events. “It turns out, of course, that Mises was right,” declared

Heilbroner (1990, 91–92).

New Empirical Work Confirms Mises’s Thesis

The fall of the Soviet Union brought about a major revision of economic

history under communism. Based on research coming out of

the previously secret KGB files in Moscow, historians confirmed

negative views about social central planning that Mises, Hayek, and

Bauer elucidated. In her work about Soviet Russia in the 1930s entitled

Everyday Stalinism, Sheila Fitzpatrick countered the old conventional

view held by Sidney and Beatrice Webb and George Bernard Shaw that

the Soviet system during the 1930s was a glorious “new civilization.”

On the contrary, Fitzpatrick wrote, “With the abolition of the market,

shortages of food, clothing, and all kinds of consumer goods became

endemic. As peasants fled the collective villages, major cities were

soon in the grip of an acute housing crisis, with families jammed for

decades in tiny single rooms in communal apartments. . . . It was a

world of privation, overcrowding, endless queues, and broken families,

in which the regime’s promises of future socialist abundance rang

hollow. . . . Government bureaucracy often turned everyday life into

a nightmare” (Fitzpatrick 1999, dustjacket).

Nations Grow Faster Under Economic Freedom

In addition, recent studies comparing the economic growth of nations

and their degree of freedom have confirmed Mises’s thesis. According

to the work of James Gwartney and Robert Lawson, countries with

the greatest level of economic liberty enjoy the highest standard of

living (see Figure 1.2 in chapter 1).

And so ends a critical chapter in the history of economics. Mises,

long dead, was finally vindicated. The words of the physicist Max

Planck apply here: “Science progresses funeral by funeral.”

As we begin the twenty-first century, the winds of change are

everywhere. As Francis Fukuyama declared in Time magazine, “If

socialism signifies a political and economic system in which the government

controls a large part of the economy and redistributes wealth

to produce social equality, then I think it is safe to say the likelihood

of its making a comeback anytime in the next generation is close to

zero” (2000, 111).

The Winds of Change in Development Economics

With the downfall of Eastern-bloc communism, the paramount

question became how to dismantle the socialist state and reestablish

capitalism and the culture that goes with it. The watchwords became

denationalization, privatization, deregulation, and flat tax rates. Developing

countries, which in the past had depended on foreign aid

and government programs to stimulate the economy, now opened up

their economies to trade and foreign investment.

Since the collapse of the Soviet central planning model, Rostow’s

thesis has been largely discredited and Bauer’s less orthodox views

have triumphed. Even Rostow admitted, “There are, evidently, serious

and correct insights in the Bauer position” (Rostow 1990, 386).

Recently, the World Bank has moved toward Bauer’s side. In a 1993

study of the Four Tigers and the East Asian economic miracle, it concludes,

“The rapid growth in each country was primarily due to the

application of a set of common, market-friendly economic policies,

leading to both higher accumulation and better allocation of resources”

(World Bank 1993, vi).

Perhaps the best example of change in development economics is

reflected in the work of Muhammad Yunus, president of the Grameen

Bank in Bangladesh and founder of the micro-credit revolution. In

his book, Banker to the Poor, Yunus tells how he grew up under the

influence of Marxist economics. But after earning a Ph.D. in economics

at Vanderbilt University, he saw firsthand “how the market [in the

United States] liberates the individual. . . . I do believe in the power of

the global free-market economy and in using capitalist tools. . . . . I also

believe that providing unemployment benefits is not the best way to

address poverty.” He strongly opposes foreign aid from the World Bank

and the International Monetary Fund. Believing that “all human beings

are potential entrepreneurs,” Yunus is convinced that poverty can be

eradicated by loaning poor people the capital they need to engage in

profitable businesses, not by giving them a government handout or

engaging in population control (Yunus 1999, 203–07).

In 2006, Yunus won the Nobel Peace Prize. But his former Marxist

colleagues call it a capitalist conspiracy. “What you are really doing,” a

communist professor told Yunus, “is giving little bits of opium to the poor

people. . . . Their revolutionary zeal cools down. Therefore, Grameen is

the enemy of the [communist] revolution” (Yunus 1999, 204).

Neoclassical Economics Today

Where does economic thinking stand today? We have seen throughout

this history of the Big Three that each economist has at times stood

taller than the other two. During times of strong economic performance,

Adam Smith has been on top; during crises and depression,

Keynes and Marx have stood out. Since the end of World War II, we

have seen a gradual advance in esteem for the founder of modern

economics, Adam Smith, and this despite occasional monetary crises,

recessions, natural disasters, terrorist attacks, and complaints about

inequality, trade deficits, and wasteful government programs.

A growing number of economists recognize that the neoclassical

model is the keystone of economic analysis. In microeconomics,

this means incorporating the principles of supply and demand,

and profit and loss, which, under broad-based competition, leads to

an efficient allocation of resources, economic growth, and a selfregulating

economy. Under competition and a reasonable system of

justice, man’s natural tendency toward self-assertion leads to social

well-being. As Adam Smith wrote over 200 years ago, “Little else is

required to carry a state to the highest degree of opulence from the

lowest barbarism, but peace, easy taxes, and a tolerable administration

of justice” (Danhert 1974, 218).

In macroeconomics, it means teaching the classical model of thrift,

a stable monetary policy, fiscal responsibility, free trade, widespread

economic and political freedom, and a consistent rule of law for the

justice system. As James Gwartney notes, “It turns out that the legal

system—the rule of law, security of property rights, an independent

judiciary, and an impartial court system—is the most important function

of government, and the central element of both economic freedom

and civil society, and is far more statistically significant than the other

variables,” including size of government, monetary system, trade, and

regulation (Skousen 2005, 32). Gwartney and coauthor Lawson point

to a number of countries that lack a decent legal system and as a result

suffer from corruption, insecure property rights, poorly enforced

contracts, and inconsistent regulatory environments, particularly in

Latin America, Africa, and the Middle East. “The enormous benefits

of the market network—gains from trade, specialization, expansion

of the market, and mass production techniques—cannot be achieved

without a sound legal system” (Gwartney and Lawson 2005, 35). All

these basic principles were established over 200 years ago in Adam

Smith’s Wealth of Nations.

A Surprise Counterrevolution at Harvard

The shift back to market principles and the classical model of Adam

Smith is best illustrated by the recent work of Harvard’s Gregory

Mankiw. In his textbook, Macroeconomics, written in the early 1990s,

Mankiw surprised the profession by beginning with the classical model

and ending with the short-term Keynesian model, the reverse of the

standard Samuelson pedagogy.

Recall that Keynes in 1936 attempted to replace the Adam Smith model

with his own “general theory” of the economy. The classical model, Keynes

insisted, was actually a “special case” of the general theory, and only applied

at times of full employment. Now we see that Mankiw, who considers

himself a “neo-Keynesian,” has once again made the classical model

of Smith the real general theory and the Keynesian model of aggregate

supply and demand the “special” case, relegated to the back of the book.

It was a brilliant, revolutionary—or rather counterrevolutionary—move,

a reflection of a changing fundamental philosophy.

Dubbing the classical model “the real economy in the long run,”

Mankiw pinpointed the effects of an increase in government spending—

that rather than act as a multiplier, it “crowds out” private capital.

“The increase in government purchases must be met by an equal

decrease in [private] investment. . . . Government borrowing reduces

national saving” (Mankiw 1994, 62).

In previous textbooks, Samuelson and his colleagues emphasized

the cyclical nature of capitalism and how the economy could be stabilized

through Keynesian policies. In contrast, in Macroeconomics,

Mankiw discussed economic growth up front, ahead of the chapters

on the business cycle. Using the Solow growth model, Mankiw took

a strong prosaving approach. Accordingly, “the saving rate is a key

determinant of the steady state capital stock and high level of output.

If the saving rate is low, the economy will have a small capital stock

and a low level of output” (1994, 62). What is the effect of higher

savings? “An increase in the rate of saving raises growth until the

economy reaches a new steady state.” Far from accepting the paradox

of thrift, Mankiw wrote favorably about those nations with high

rates of saving and investment, and even includes a case study on the

miracles of Japanese and German postwar growth (examples virtually

ignored in Samuelson’s textbook). Mankiw therefore supports policies

aimed at increasing the rates of saving and capital formation in

the United States, including the possibility of altering Social Security

from a pay-as-you-go system to a fully funded plan, though he did

not discuss outright privatization (1994, 103–34).

Unemployment is another issue Mankiw approached in a non-

Keynesian way. What causes unemployment? Relying on Friedman’s

“natural” rate of unemployment, insurance and similar labor legislation

reduce incentives for the unemployed to find work. He provided

evidence that unionized labor and the adoption of minimum-wage and

living-wage laws actually increases the unemployment rate. Finally,

he offered a case study on Henry Ford’s famous $5 workday as an

example of higher productivity and increasing wages.

He approvingly quoted Milton Friedman on monetary policy: “Inflation

is always and everywhere a monetary phenomenon.” Mankiw

used numerous examples, including hyperinflation in interwar Germany,

to confirm the social costs of inflation (1994, 161–69).

Mankiw has followed up with a new Principles of Economics textbook,

published since 1997. Like his intermediate text, it is devoted

almost entirely to classical economics, relegating the Keyensian model

to the end chapters. Amazingly, Mankiw’s textbook does not mention

most of the standard Keynesian analysis: no consumption function,

no Keynesian cross, no propensity to save, no paradox of thrift, and

only a brief reference to the multiplier. Thus, we have a sea change

in economics, and this coming from Cambridge, Massachusetts, the

same place the Keynesian revolution originated in America.

Samuelson: Fiscal Policy Dethroned!

Even Paul Samuelson has been forced to change his focus in recent

editions of his text, in part because of the force of history, in part due

to the influence of his coauthor, Bill Nordhaus. Samuelson’s fiftieth

anniversary edition (1998) is telling. In addition to the replacement

of the paradox of thrift with a prosavings section and the statement

that “a large public debt is likely to reduce long-run economic

growth” (Samuelson and Nordhaus 1998, 652), the biggest shock

is Samuelson’s abandonment of fiscal policy. This sixteenth edition

highlights this statement in color: “Fiscal policy is no longer a major

tool of stabilization in the United States. Over the foreseeable future,

stabilization policy will be primarily handled by Federal Reserve

monetary policy” (1998, 655).

In short, Milton Friedman, Friedrich Hayek, and the free-market

proponents may have lost the debate early on, but they seem to have

won the war. “The growing orientation toward the market,” concluded

Samuelson, “has accompanied widespread desire for smaller government,

less regulation, and lower taxes” (1998, 735). Samuelson

expressed dismay at this outcome, ending his fiftieth anniversary

edition on a sour note by calling the new global economy “ruthless”

and characterized by “growing” inequality and a “harsh” competitive

environment. But the deed—the triumph of the market and classical

economics—appears irreversible. Friedman and Hayek, representing

the two schools of free-market economics (Chicago and Vienna)

have combined forces for a one-two punch that has reversed the tide

of ideas (Yergin and Stanislaw 1998, 98).

From Dismal Science to Imperial Science: May a

Thousand Flowers Bloom

Spearheaded by economists from the University of Chicago, the

reestablishment of classical free-market economics in the classroom

and the halls of government has resulted in a surprising plethora of

applications to social and economic problems. Kenneth E. Boulding

(1919–93), longtime professor at the University of Colorado and

former AEA president, always believed that economics should be

eclectic and shared with other disciplines. Now his dream is being

fulfilled. Like an invading army, the science of Adam Smith is overrunning

the whole of social science—law, criminal justice, finance,

management, politics, history, sociology, environmentalism, religion,

and even sports.

Economics used to be the “dismal science,” a term of derision

coined by the English critic Thomas Carlyle in the 1850s. But attitudes

are quickly changing in the twenty-first century by applying its micro

principles of competition, incentives, and opportunity cost to solve

a host of public and private problems. In short, twenty-first-century

economics is the “imperial science” (Skousen 2001, 7–10).

Here are just a few examples of the expanding role of economics

in other areas: Gary Becker has been instrumental in applying the

principles of supply and demand to the human behavioral sciences

in areas such as racial discrimination, crime, and marriage. Ronald

Coase, Richard Posner, and Richard Epstein have contributed to the

development of law and economics.

Harry Markowitz, Merton Miller, William Sharpe, Burton Malkiel,

and Fischer Black, among others, have created the field of financial

economics, especially the application of efficiency markets to Wall

Street. Robert Fogel and Douglass C. North have applied statistical

analysis (known as “cliometrics”) to a variety of historical events and

trends. Robert Mundell, Art Laffer, and Paul Craig Roberts have advanced

the “supply side” impact of economics on the issues of taxes,

regulation, and trade, and have been a major force in the movement

toward low flat taxes instead of progressive taxes.

Market-oriented economists have also applied their tools to public

finance issues. During the 1950s and 1960s, the field was dominated

by Keynesians, led by Richard Musgrave with his textbook, Public

Finance in Theory and Practice (1958). Musgrave saw the need for a

three-pronged government policy: (1) allocation—to provide public

goods that the private sector could not; (2) distribution—to redistribute

wealth and institute social justice; and (3) stabilization—to steady an

inherently vacillating capitalist economy.

Musgrave debated James Buchanan, a professor at George Mason

University and one of the founders of the public-choice school. In

their 1998 published debate, Musgrave defended social insurance, progressive

taxation, and the growth of the public sector as the “price we

pay for civilization” (Buchanan and Musgrave 1999, 75). Addressing

today’s worries about an overbloated government, Musgrave wrote,

“Is the state of our civilization really that bad? . . . There is much that

should go on the credit side of the ledger. The taming of unbridled

capitalism and the injection of social responsibility that began with

the New Deal. . . . . Socializing the capitalist system . . . was needed

for its own survival and for building a good society” (1999, 228). He

also mentioned the “enormous gains” by blacks and women in the

twentieth century.

Buchanan, on the other hand, blamed democratic politics for a

“bloated” public sector, “with governments faced with open-ended

entitlement claims,” resulting in “moral depravity” (Buchanan 1999,

222). He argued in favor of constraining government through constitutional

rules and limitations. He succinctly described the difference

between the two: “Musgrave trusts politicians; we [Buchanan] distrust

politicians” (Buchanan and Musgrave 1999, 88).

Who won the debate? Musgrave’s views are still prevalent in

Keynesian textbooks, but his books are seldom cited and long out

of print. On the other hand, James Buchanan won a Nobel Prize in

1986 and public-choice theory has been added to most curricula. Even

Samuelson cites the public-choice work of Buchanan and Gordon

Tullock in his latest textbook.

According to public-choice theory, the incentives and discipline

found in the marketplace are frequently missing from government.

Voters have little incentive to control the excesses of legislators, who

in turn are more responsive to powerful interest groups. As a result,

government subsidizes the vested interests of commerce and other

groups while imposing costly, wasteful regulations and taxes on the

general public. Buchanan and other public-choice theorists have

recommended a series of constitutional rules and restrictions to alter

the misguided public sector into acting more responsibly (Buchanan

and Tullock 1962).

Economic Historian Resolves the Mysteries of the

Great Depression

Another example of the revisionist history is a new interpretation of

the Great Depression by historian Robert Higgs of Seattle University.

According to Higgs, there were essentially three transitional periods

in this critical event: the Great Contraction (1929–32), the Great Duration

(1933–39), and the Great Escape (1940–46). What caused the

Great Depression? Why did it last so long? Did World War II really

restore prosperity?

As we learned earlier in this chapter, Milton Friedman was instrumental

in addressing the cause of the Great Contraction. It was not

free enterprise, but the government-controlled Federal Reserve that

pushed the economy over the edge in 1929–32.

What produced the decade-long stagnation of the world economy

that in turn caused a paradigm shift from classical economics to

Keynesianism? Higgs provides an answer that economists had only

vaguely considered. In an in-depth study of the 1930s, Higgs focused

on the lack of private investment during this period. Most economists

recognize that investment is the key to recovery in a slump. Higgs

showed how the New Deal initiatives greatly hampered private investment

time and time again, destroying much-needed investor and

business confidence. These programs included the National Recovery

Act, prolabor legislation, government regulation, and stiff tax increases

(Higgs 2006, 3–29).

In another brilliant analysis, Higgs attacked the orthodox view

that World War II saved us from the depression and restored the

economy to full employment. The war gave only the appearance of

recovery because everyone was employed. In reality, however, private

consumption and investment declined while Americans fought and

died for their country. A return to genuine prosperity—the true Great

Escape—did not happen until after the war was over, when most of

the wartime controls were lifted and most of the resources used in

the military were returned to civilian production. Only after the war

did private investment, business confidence, and consumer spending

return to the fore (Higgs 2006, 61–80).

Ignoring the government (G) in GDP figures leads to a better understanding

of what occurred during World War II. Consumption (C)

and investment (I) slowed and even declined slightly during 1940–45,

then rose sharply after the war in 1946–48.

Not everyone has accepted these relatively new findings, but a

growing consensus contends that “government failure” has to take

much of the responsibility for the troublesome 1930–45 period of

the U.S. economy.

Today’s Debates: The New Challenge of

Keynes and Marx

The application of market principles has expanded in every direction

in the recent past, but the triumph of free-market economics is far

from complete. Many victories have been won on paper, but not in

policy. Despite U.S. president Bill Clinton’s observation that “[t]he

era of big government is over,” the size of government in industrial

nations has reached gigantic proportions (see Figure 7.2).

On the positive side, it appears that the government sizes have reached

their upper bounds. In most countries, the private sector is now growing

faster than the public sector. This is especially true in developing countries

(government as a percentage of GDP has fallen from 80 percent

to 20 percent in China, for example). But that trend could reverse itself

quickly if economic conditions change and a nation or region suffers

another slump or crisis. Witness the growth of government following the

terrorist attacks in the United States and around the world in 2001.

Despite privatization, deregulation, and supply-side tax cuts, governments

are still intrusive, revenue hungry, and bureaucratic. Freemarket

economists have much to offer legislators and business that

can help them improve efficiency.

It would be inaccurate and highly misleading to suggest that Keynes, or

even Marx, is dead. Quite the contrary. Keynesian and Marxist thinking

still carry a strong voice today. If a country falls into a military conflict,

a deep slump, or other crisis, the Keynesian model immediately comes

to the forefront: maintain spending at all costs, even if it means significant

deficit financing. The misleading Keynesian notion that consumer

spending, rather than saving, capital formation, and technology, drives

the economy, is still very much in vogue in the halls of government and

in financial circles. Countries such as China and Japan are criticized for

saving too much; Keynesians insist that they need to stimulate “domestic

demand” if they hope to advance. Fear that a laissez-faire global financial

world is subject to unexpected and debilitating crises is common

among both Keynesians and Marxists. They also express deep concern

that the entrepreneurs, speculators, and the wealthy class in general are

benefiting more from the new global economy and the political process

than the middle and lower classes. “Tax cuts help the rich more than

the poor” is a common refrain. Critics of the market also constantly

complain about growing inequality of income, wealth, and opportunity,

despite claims to the contrary by free-market economists. They are

sharply critical of free-trade agreements and the potential loss of jobs

to producers in China, Mexico, and other developing countries.

The central role of government monetary policy is a global concern.

Fiscal policy may have been dethroned as a stabilization tool, but

central bank policy might fail to do its job in maintaining macroeconomic

stability. Monetary authorities have been known to blunder,

overshooting their interest-rate or inflation targets. Their response to

every crisis, whether it be a currency crisis or economic downturn,

seems to be to adopt an “easy money” policy by injecting liquidity

into the system and cutting interest rates below the natural rate. The

result has been an increasing structural imbalance and asset bubbles

in stocks, real estate, and other sectors. How far they can go with

such unstable policies without creating a major global financial crisis

remains to be seen. The price of gold is a valuable monitor of global

economic instability, and it has been rising lately.

Environmentalism is a major subject of debate. How can nations

grow and increase their standards of living without destroying the

air, polluting the water, devastating the forests, and causing global

warming? The debate goes back to Thomas Malthus (chapter 2)

and is related to historical and present-day concerns over unlimited

growth and limited resources. In this ecological debate, economists,

while not alarmists, have made numerous contributions to minimizing

pollution and other environmental problems. To solve the “tragedy

of the commons,” for example, market economists have emphasized

the need to establish defensive resource rights in water, fishing, and

forestland, so that owners have the proper incentives to preserve these

resources in a balanced way. In the case of air pollution, economists

have recommended pollution fees and marketable permits to pollute.

Pollution fees are taxed on polluters, penalizing them in proportion

to the amount they discharge, a common practice in Europe. Marketable

permits allow polluters to sell their permits to other firms, and

have successfully reduced the rate of pollution in the United States

(Anderson and Leal 2001).

Stiglitz’s Challenge: Is Market Imperfection Pervasive?

Joseph Stiglitz, Columbia professor and winner of the Nobel Prize in

2001 for his work in the economics of information, is a Keynesian who

has taken a hardened stance against Adam Smith and the competitive

equilibrium model. The invisible hand, according to Stiglitz, is either

“simply not there, or at least … if there, it is palsied” (Stiglitz 2001,

473). He declares that market imperfections and market failures are

so pervasive and so serious that the market is always inefficient and

requires government correction. Imperfect information exists in labor,

products, money, trade, and capital markets.1 Serious unemployment

could exist even without minimum wage laws or labor unions, he

contends. During the Great Depression, “had there been more wage

and price flexibility, matters might have been even worse,” he states

(2001, 477). According to Stiglitz, involuntary unemployment is still

a problem! Gary Becker, Milton Friedman, and other Chicago economists

may claim that the competitive marketplace discourages discrimination,

unemployment, and poverty, but Stiglitz’s hometown of

Gary, Indiana, “even in its heyday . . . was marred by poverty, periodic

unemployment, and massive racial discrimination” (2001, 473).

Stiglitz makes another paradigm shift back to a Keynesian model of

imperfect information that “undermines” the foundations of competitive

analysis, including the denial of the “law” of supply and demand,

the law of the single price, and the efficient market hypothesis (2001,

485). Why? Because information in a decentralized market economy

is “asymmetric”—“different people know different things,” which in

turn can lead to “thin or non-existent markets” (2001, 488–89). What

Hayek views as positive, Stiglitz sees as negative.

Market economists counter Stiglitz by arguing that while imperfect

information may indeed be pervasive, the outcome of the imperfect

competitive market system acts “as if” it is perfectly competitive.

For example, experimental economics seems to confirm this “as if”

approach. Vernon L. Smith, Nobel laureate from George Mason University

and founder of experimental economics, ran an experiment to

test the Chamberlin-Robinson “imperfect competition” model. Recall

from chapter 5 that this model suggested that a small number of

sellers (or buyers) creates an imperfect form of competition, causing

prices to rise, and output to fall. The imperfect monopolistic model

was therefore inefficient, and gave support to government antitrust

actions to break up big businesses and force more competition into

the industry.

However, Smith made an interesting observation. When he reduced

the number of buyers and sellers to only a few in his experiments,

the results were the same—the final price approached the same

competitive price that was achieved with a large number of buyers

and sellers. By implication, competition within an industry is not

necessarily reduced when it is limited to only a few large companies

(Smith 1987, 241–46).

Smith’s observation confirmed the earlier work of George Stigler,

Harry Johnson, and other members of the Chicago school that competition

is strong even among only a few large firms. Monopolistic

firms tend to keep prices competitive because of the ever-present threat

of entry by other large firms. The world is “as if” fully competitive

(Bhagwati 1998, 411–12).

The Return of Adam Smith’s Vision

We have come a long way since Adam Smith proposed that the path to

economic growth, prosperity, and social justice lies in nations’ granting

citizens the maximum freedom possible to pursue their public and

private interests under a tolerable system of justice. But Adam Smith’s

system of natural liberty has been challenged in every generation since

his Wealth of Nations was published in 1776. Today is no exception.

Adam Smith’s vision of unfettered markets flourished initially

across the English channel among J.-B. Say, Frédéric Bastiat, and

the French philosophes, but it was not long before the revolutionary

Smith came under attack from the least likely place—his own British

school. Thomas Robert Malthus and David Ricardo turned the optimistic

world of Adam Smith upside down into the abyss of the iron

law of subsistence wages. John Stuart Mill joined the social reformers

in seeking a utopian alternative to the so-called dismal science

and, when voluntary means were not forthcoming, along came the

irrepressible radical Karl Marx, who plunged economics into a new

age of alienation, class struggle, exploitation, and crisis.

Just as we were about to give up on our almost-dead protagonist,

three good Samaritans revived the life of Adam Smith—Stanley

Jevons, Carl Menger, and Leon Walras. The marginalist revolution

restored the Smithian soul, and with the help of Alfred Marshall in

Britain and John Bates Clark in the United States, among others, it

resurrected Smith and transformed him into a whole new classical

man. Despite efforts to renounce the new capitalist model by Thorstein

Veblen and other institutionalists, the critics were effectively countered,

especially by Max Weber. The neoclassical paradigm stood tall,

ready to make contributions to the new scientific age.

The golden age of neoclassical economics continued to face hurdles

as Irving Fisher, Knut Wicksell, and Ludwig von Mises searched for

the ideal monetary standard to house Adam Smith, but no consensus

had been achieved by time the 1929 stock market crash plunged the

world into the worst depression of modern times. Once again, Adam

Smith faced imminent demise. Marxists were in the wings waiting to

take over when a new doctor, John Maynard Keynes, presented the

world with new medicine, with which he proposed to save Adam Smith

and restore him as the father of capitalism. But Keynes turned out to

be a temporary savior only, as the long-run effects of his medicine led

to an overbloated patient. It would take the inventiveness of Milton

Friedman and Friedrich Hayek, intellectual descendants of Adam

Smith, to correctly diagnose the cause of the distress and restore the

model underlining a competitive, robust economy.

No doubt the bold challenges made by Marx and Keynes and their

disciples have had a positive effect. They have caused market economists

to respond to their deft criticisms and improve the classical model

that Adam Smith created. Today the neoclassical market framework is

stronger than ever before, and its applications are ubiquitous.

In 1930, at the beginning of the Great Depression, John Maynard

Keynes wrote an optimistic essay, “Economic Possibilities for Our

Grandchildren.” After lambasting his disciples who predicted neverending

depression and permanent stagnation, Keynes foresaw a bright

future. Goods and services would become so abundant and cheap

that leisure would be the greatest challenge. What productive things

can be done in one’s spare time? According to Keynes, capital would

become so inexpensive that interest rates might fall to zero. Interest

rates have not fallen to zero, but our standards of living have advanced

remarkably, at least in most areas of the world. Keynes concluded,

“It would not be foolish to contemplate the possibility of a greater

progress still” (Keynes 1963 [1930], 365).

Market forces are on the march. The collapse of the Keynesian

paradigm and Marxist communism has turned “creeping socialism”

into “crumbling socialism.” There is no telling how high the world’s

standard of living can reach through expanded trade, lower tariffs, a

simplified tax system, school choice, Social Security privatization, a

fair system of justice, and a stable monetary system. Yet bad policies,

wasted resources, and class hatred die slowly. As Milton Friedman

once wrote, “Freedom is a rare and delicate flower” (1998, 605).

Unless market economists are vigilant, natural liberty and universal

prosperity will be on the defensive again.