assignment 1: should the state intervene in the economy?...

Peter Risager PET – Final Exam 14/12-2017

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Assignment 1: Should the state intervene in the economy? Compare and

discuss the views of relevant thinkers from the course curriculum.

Political and Economic Thought – Final Exam – 14/12-2017 International Business and Politics, Copenhagen Business School, 2017 Peter Risager CPR: XXXXXX-XXXX Examiner: Joachim Lund Reference system: American Psychological Association 6th edition (APA) Number of characters (including spaces): 22,270 Number of pages: 9,8


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Introduction

Through time, there has been an ongoing discussion as to whether the state should

intervene in the economy, and to what extent. Many different thinkers and philosophers

have had their say on the matter, and different ideas have been implemented by different

governments through time. This essay will discuss the question: Should the state

intervene in the economy? This will be done by drawing upon and examining ideas from

primarily thinkers through the 20th century. The ideas of John Maynard Keynes will be

examined thoroughly, as well as the ideas of Milton Friedman and Friedrich Hayek. This

will be done by primarily looking at Keynes’ “The General Theory of Employment,

Interest and Money”, Friedman’s “Capitalism and Freedom”, and Hayek’s “The Road to

Serfdom”. Their different ideas will be compared and discussed. These scholars have

been chosen because they are the most influential economic thinkers through the 20th

century in the western world, and they lay all grounds for political economic discussions

today. A short introduction to the ideas of Adam Smith will also be presented, as he has

inspired both Milton Friedman and Friedrich Hayek. In order to properly understand the

ideas, the historical context in which they were presented will as well be considered. The

implementations of the ideas of the different thinkers and their consequences will be

discussed by looking at how economic politics have changed in the western world

through the 20th century. Finally, a discussion of the ideas and their effect will be made

by investigating the reasoning and consequences of the financial crisis in 2007/2008,

and looking at different western countries’ ways of getting through the crisis.

Adam Smith

Adam Smith is one of the early economic scholars, and is often times seen as the father

of economic liberalism. He believed in the market’s ability to regulate itself, because

there would, according to Adam Smith, always be an equilibrium that would be decided

by ‘the invisible hand’. He therefore introduced the idea of ‘laissez-faire economics’

which meant that the state should keep the interference in the private economy to a

minimum. In “The Wealth of Nations”, he describes how the state should be minimized

and provides a short list of what the state should focus on. This is for example protecting

the right to private property, defending the country against enemies and maintaining and

securing the rule of law. Smith was also a strong advocate of the division of labour


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theory, first introduced in ancient times by Plato. This meant that people should

specialize in a specific skill, in order to increase productivity. (Smith, 1776) Organizing

these skills in manufacturing would lead to a much more efficient production, and this

thought was essential to the industrialism. Although inspired by John Locke,

utilitarianists and physiocrats, his economic liberalism was ground-breaking, and many

economic scholars in present time are still inspired by the works of Adam Smith, as this

assignment will return to later.

John Maynard Keynes

John Maynard Keynes was an English scholar from the University of Cambridge. His

primary works were produced as a reaction to the great depression in the end 1920’s and

the beginning of 1930’s. Inspired by Sweden and some parts of the German politics,

Keynes introduced many new ideas in the world of economics. His basic idea was a

criticism towards capitalism, as the great depression, in his opinion, had proved the

capitalism to be inadequate at best – disastrous at worst. Instead of taking a completely

socialist approach opposing capitalism, like Marx and Engels had done 50 years earlier,

Keynes believed in a middle ground between these. His main ideas were created on the

assumption that demand creates supply – instead of the opposite way around, which had

been the main doctrine in economics for over a century, based on Say’s law. Keynes’

focus on demand was likely to be an elaboration on the supply-demand model created by

Alfred Marshall, who was also a lecturer at the University of Cambridge, in times where

Keynes was a student. Keynes was a great admirer of Marshall, as it can be read in his

obituary of Marshall (Keynes, 1924). Because of the importance of demand, the most

important thing to stabilize the economy was to make sure that consumers had the

economic income to actually demand goods. He agreed that the market would at one

point regulate itself, but his main concern was that this would simply take too much

time, and the regulation period would have serious consequences for too many people.

In his own words, he addresses the flaws of classical economic liberalism in the

following way: “…its tacit assumptions are seldom or never satisfied, with the result

that it cannot solve the economic problems of the actual world.” (Keynes, 1936, page

378) He saw the solution in government spending, and believed that the government

through fiscal policy could regulate and prevent crises. One of the main reasons for

government spending to be such an effective tool was in Keynes’ opinion because of the


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multiplier effect. The multiplier effect is one of Keynes’ many new perceptions of

macroeconomics. Its basic principle is that one dollar spent by the state leads to one

dollar of income for a person within the state, who will then spend some of that dollar –

leading to another person’s income, who will then once again spend some of that dollar

and so forth. All of these consumptions will influence the economy positively in two

ways: First and foremost – each time this dollar gives income, some of that income will

bring in taxes to the state. Secondly, the income spent will boost the economy, leading to

new businesses, new jobs, and most importantly a higher demand, which will once again

result in more tax income to the state. The state will therefore get each dollar spent back

in tax revenues, whilst creating jobs and income leading to a higher demand, ultimately

creating economic growth. (Keynes, 1936) Keynes’ thoughts led to a whole new school

of economics called Keynesianism. One should be aware that since Keynes died already

in 1946, many of the Keynesian thoughts are not actually the works of Keynes himself,

but instead scholars who have been inspired by him, and have interpreted his thoughts.

One of these interpretations led to the Phillips curve, created in 1958 by the Keynesian

scholar William Phillips. (Hoover, 2008) This portrayed the connection between

inflation and unemployment, describing that in periods of high inflation, the

unemployment would be low, whereas low inflation would lead to high unemployment.

This was proved to be empirically true through a long period of time. Because of this

empirical evidence for the connection, the Phillips curve was largely accepted in

economics for a long period of time.

Friedrich August von Hayek

While Keynes developed his ideas at the university of Cambridge, another scholar at the

London School of Economics had completely different thoughts. His name was

Friedrich August von Hayek. He was an Austrian/British scholar in economics, and he

was deeply inspired by the works of Adam Smith. Calling himself a classical liberal

economist, he was very much against the state intervention and government spending

that Keynes advocated. In “The Road to Serfdom” he describes how increasing state

intervention would lead to a totalitarian state, where the people would solely be Serfs of

the state tyranny. Much of the writing in this book is about how it was socialism that led

Germany to the Nazi-regime, and how such a totalitarian regime could appear in other

countries moving towards socialism. As he writes: “…many who think themselves


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infinitely superior to the aberrations of Nazism (…) work at the same time for ideals

whose realisation would lead straight to the abhorred tyranny.”(Hayek, 1944, Page 4),

hereby addressing scholars like Keynes, and others promoting a larger state. Elaborating

on the ideas of Adam Smith, he described how the market will regulate itself over time,

and how fiscal policy will be irrelevant at best, and might even be harmful as you would

create a forced market equilibrium. Like earlier scholars, he focused on the supply-side

of economics and did not believe in Keynes’ demand-side theory. He believed, like

Adam Smith, in the minimal state as being the optimal state, meaning that the state

should solely take care of matters that were not financially profitable, like health and

education. In the UK, Keynes obtained high influence, and the government during the

post war period were relying on Keynesianism. This naturally put Hayek out of power,

and he did not receive much acknowledgement for his works in the post-war period in

the UK.

Milton Friedman

Since Hayek’s thoughts were not well received in the UK, he decided to move to USA,

starting at the university of Chicago. Here he was well received by many, most

noteworthy by Milton Friedman. Hayek and Friedman shared many of the same

thoughts, both considering themselves economic liberalists. During the 1960’s,

Friedman developed a new branch of macroeconomics called monetarism. He believed

that the state should not intervene in the economy except when it came to monetary

policy. This meant that, according to him, the state should regulate the economy by

adjusting interest rates, the issuing of bonds and the currency, but apart from that the

state had almost no purpose. Government spending and fiscal policy was in his opinion

inefficient or even harmful for the economy. He believed that the state should instead

focus on balancing its budgets, and even called for a constitutional ban on public

deficits. (Cord & Hammond, 2016) Monetary policy was effectual because by

controlling the amount of money in the society, the government could control whether

prices would rise or fall. One might argue that the focus on money is inspired by David

Hume’s quantity theory, as money is a very measurable part of the economy. Friedman

argued against the Keynesian Phillips curve, as he believed it would only work in the

short run. (Friedman, 1968) The stagflation during the 1970’s proved him right. Instead,

he came up with the vertical Phillips curve, focusing on adjusting the inflation rather


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than the unemployment rate, since he believed in a natural unemployment rate, that

would inevitably regulate itself in the long run.(Hoover, 2008) This neoliberalism

provided by both Hayek and especially Friedman was maybe even more critical towards

the state than the views of Adam Smith. Apart from being a monetarist, Friedman also

believed that politics and economics are connected to a large extent. This view led to

him believing that socialism can never be democratic. He based this on the idea that if

the state intervenes in the private economy, the state is intervening in the personal

freedom, which is not democratic. As he states in “Capitalism and Freedom”: “Clearly

economic freedom, in and of itself, is an extremely important part of total freedom”

(Friedman, 1962, Page 9) Therefore, only countries with a free market and neoliberalist

politics can be fully democratic. This is very opposite from the thoughts of Keynes, and

you might almost argue that Friedman is against the whole concept of the state.

The Golden Years

The ongoing battle between Keynes and Hayek through the 1930’s and 40’s was in the

first place won by Keynes, since he came to influence especially the British policy quite

heavily in the post-World War II-period. First off, Keynes helped establishing the

Bretton Woods in 1944, which served to bring economic stability to the 44 participating

nations through a common monetary policy. (Helleiner, 1996) Secondly, the Marshall

Plan where USA gave huge amounts of money to the European countries within the

OECD, was an acknowledgement that government spending would boost the economy.

Much of the western world adopted Keynes’ thoughts in this period, and they led to the

‘Golden Years’ during primarily the 1960’s, where most western countries enjoyed huge

economic growth. Government spending was increasing, taxation was increasing,

minimum wages were introduced many places, and the public and private sector were

enjoying the growth of each other. Unfortunately, Keynes did not live to see his thoughts

brought to life, as he died in 1946. The rest of the world enjoyed Keynes’ policy, and the

economic boom in the western world seemed to be everlasting.

Crisis and the implementation of neoliberalism

This was all perfect until the crisis in 1970. Many elements are meant to have led to this

crisis, but the neoliberalist thinkers – most notably Friedman and Hayek - blamed the


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crisis on Keynesian politics in the western world. The so called ‘stagflation’ proved the

Keynesian politics to be inefficient, and the Phillips curve was proven to be wrong, since

there was both high inflation and a high unemployment rate. As a response to this,

Milton Friedman developed the vertical Friedman curve, stressing the importance of

monetary policy rather than fiscal policy. The political situation changed drastically, and

the leaders of the western world now changed from believing in Keynesian politics to

believing in the neoliberalist policies proposed by Friedman and Hayek. Especially

during the 1980’s, neoliberalist thoughts were shaping the economic politics very

evidently in USA with Ronald Reagan and in the UK with Margaret Thatcher. Even in

the Scandinavian welfare state Denmark, Poul Schlüter’s Conservative government was

implementing the neoliberalist ideas. A brilliant example of Hayek’s big influence on

Margaret Thatcher’s policy is that Margaret Thatcher is once said to have pulled out a

copy of Hayek’s “The Constitutions of Liberty” from her briefcase, saying “This is what

we believe”. (Ranelagh, 1991, Page 9). Friedman was at the same time an important

economic advisor for the Ronald Reagan administration in the USA (Ebenstein, 2007).

The effects were very apparent. Both countries, followed by many other western

countries, started rolling back the big governmental spendings, and the public sectors

were trimmed. Privatization, New Public Management, and many other new initiatives

were introduced, and the economy was once again stabilized. It can of course be

discussed how much of this stabilization was caused by the politics, and how much was

simply caused by the economic cycle. Nonetheless, the neoliberal thoughts all seemed as

the right way to go through several decades, until a crisis once again shook the political

picture with the financial crisis of 2007/2008, which this assignment will return to later.

Comparison of Hayek, Friedman and Keynes

Friedman and Hayek agree upon most things, but there are differences between the

views of these two thinkers. They are seen mainly in their views of monetary policy. As

a monetarist, Friedman was a big believer in the effects of a change in the monetary

policies. He made quantitative analyses to back his theory up, and many therefore

believed in monetarism more than the Austrian school, to which Hayek belonged. But,

as Hayek stated in his Nobel Prize Lecture in 1974: “…there may … well exist better

"scientific" evidence for a false theory, which will be accepted because it is more


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"scientific", than for a valid explanation, which is rejected because there is no sufficient

quantitative evidence for it.” (Hayek, 1974) In this address, Hayek is highest likely

addressing the Keynesian economists, but it can also be seen as Hayek’s denial of the

actual effect of the monetarist’s policies. Also, Hayek is more of a philosopher, focused

on ideas and thinking, while Friedman is more of a true ‘economist’, with factual plans.

For that reason, it is a bit difficult to say to exactly what extent Hayek believes that the

state should intervene in the economy, as his works are built more on thoughts than

empiricism. From their main works, it seems as though Friedman is more focused on the

minimal state than Friedrich Hayek, but it is difficult to draw a distinct line between

their views on fiscal policies.

The easier distinction is seen when comparing both Hayek and Friedman to Keynes.

Both Friedman and Hayek believed that the market would stabilize itself, and that fiscal

policies would not help this process. Keynes did not completely refute the market forces,

but he saw the short run effects while waiting on the market to regulate itself to be fatal.

He also describes a situation where the economy is so bad that it will reach an

underemployment equilibrium, in which the market can no longer adjust itself, and

government intervention is the only way to get back to full employment. (Galbraith,

1987) Based on the beliefs in the effects of fiscal policy, the entire view of the state is

very different from Keynes to Friedman/Hayek. Keynes believed in a welfare state,

where the state takes on many of the tasks earlier lying in the private sector, among

other to employ people. On the other hand, Hayek and especially Friedman believed that

in order to give the best service to the people, all businesses must work within a

competitive, capitalist market. With that being said, Friedman and Keynes might find a

small common ground on the fact that the state can influence the economy positively.

Friedman’s monetary policy is built upon some of the same assumptions as the

Keynesianism, but they highly disagree on the effect of their different economic

instruments. In most western countries today, both thoughts are embraced, since

governments acknowledge the effect of both fiscal and monetary policies to be effectual.


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Discussion of the importance of fiscal policy

The financial crisis of 2007/2008 ironically struck only one year after the death of

Milton Friedman. We therefore never got to hear his answer as to how this could have

happened. It showed the world once and for all that setting banks and the private sector

completely free had fatal consequences. Since especially the banks had not been

properly reviewed and controlled, there was no back-up plan for what would happen if a

crisis struck. Since the neoliberalist economics had proven fatal, many countries instead

looked towards Keynesianism to get back on track. Especially in USA, the Obama

administration decided to pump money into the economy by increasing the government

spending, and not firing staff or closing down public departments. (Krugman, 2009)

This has of course led to huge budget deficits in the American economy, but we are still

looking at the short run. According to Keynes’ multiplier theory, this money will all

come back, as earlier described. If we compare to the European Union, things look very

different. In the 2. phase of the European Economic and Monetary Union, the “Stability

and Growth Pact” was agreed upon by all 28 member states in 1997. Amongst other

things, this limits the government deficit to a maximum of 3% of the country’s GDP.

(European Commission, 2016) This goes hand in hand with Milton Friedman’s proposal

on an institutional ban on public deficits. After the financial crisis, this agreement forced

the member countries of the European Union to cut government spending instead of

pumping money into the economy. They were therefore forced to follow neoliberalist

economic ideas instead of following Keynesian politics, as they did in USA. Many

countries in the European Union has therefore struggled a lot with getting out of the

crisis, where for example Greece and Spain has led massive economic defeats.

Friedman, Hayek and Keynes would all agree that at some point, these countries will get

back on track, but as Keynes pointed out: “In the long run, we are all dead.” (Keynes,

1923) This is exactly the problem for these struggling countries in the European Union,

where it might take a very long time before they are truly out of the crisis, since the state

has no chance of helping to kick-start the economy. The now almost 10-year period after

the financial crisis has proven that the countries relying on Keynesian politics are the

ones who have done best, whilst many EU countries are still hardly influenced by the

crisis.


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Conclusion

This assignment has shown that there are many different views on how the state should

interfere with the economy. Basically, there are two schools of thought, which are relied

on in modern day politics. The neoliberalist school and the Keynesian school. Under

each school there are obviously many different perspectives as to what the optimal

amount of state intervention in the economy is. Within the neoliberal school lies the

monetarists, where this essay has provided a clear distinction between pure

neoliberalism and monetarism. Through times it has been empirically shown that

different approaches are effective in different economic situations. When the western

world tried to get out of the crisis in the 1970’s, it turned towards neoliberalism and

monetarism to find its way out, whereas Keynesianism helped the western countries in

the post-World War II period. After the quite recent financial crisis in 2007/2008, many

politicians once again used the toolbox provided by Mr. Keynes to find their way out of

the crisis, and it looks as though countries who were able to use these methods have

done better economically than those searching towards Friedman or Hayek’s

approaches. Therefore, it is difficult to answer the question as to whether the state

should intervene in the economy or not, and to what extent. History has shown us that it

depends on many different elements, and that the economic climate is of high

importance when discussing this question. There is of course also some ideology lying

behind this question, where the conservatives wanting a minimal state are easier

persuaded by the Hayek/Friedman approach, whilst Democrats/Labour are more drawn

to Keynes’ ideas of a big state with more power. It must therefore be concluded that

there is no right or wrong answer to the question. What cannot be discussed though, is

that the works of both Friedman, Hayek and Keynes are still of high importance to this

day when discussing economic politics, and their thoughts will live eternally for

economists to return to time and time again.


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Ebenstein, A. O. (2007). Milton Friedman : a biography. Palgrave Macmillan.

European Commission. (2016). Vade mecum on the Stability and Growth Pact.

Institutional Paper 021. https://doi.org/10.2765/47845

Friedman, M. (1962). Capitalism and Freedom. University of Chicago Press.

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https://www.jstor.org/stable/pdf/1831652.pdf

Galbraith, J. K. (1987). A History of Economics. Penguin Books.

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Krugman, P. (2009, August). Averting the Worst. The New York Times. Retrieved from

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