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Back to the Future: Economics for the Real World

A progressive economics for the 21st century

| Wed Jan. 25, 2006 3:00 AM EST

Many Americans have rightly identified China, uncontrolled trade deficits, and Wal-Mart style competition as looming threats to the American economy. However, they remain hard-pressed countering the free market/free trade story of mainstream economists that these are all for America’s long run benefit.

In a previous piece I explained how mainstream economics has been captured by laissez-faire idealizations that are heavily peppered with smuggled political ideology. Now it is time to present an alternative real world economics. America’s economic problems can only be solved by good policy rooted in sound economic analysis. And to find that analysis, Americans must look to their own past.

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The Great Depression of the 1930s was an era of tumultuous economic debate. Though now largely confined to history books, those debates have vital relevance for today’s challenge of globalization. The economy of that earlier era was marked by callousness, gross inequalities of wealth, and vicious boom – bust cycles. These problems were ultimately solved by a combination of New Deal institutional reforms and Keynesian economic stabilization policies. While some of the reforms of that period may have aged, the economic principles that motivated them remain intact. This is a cruel irony, since the thinking that can help address our present malaise has been forgotten by many who once championed such thinking.

The policies that emerged from the Depression provided the foundation of the prosperity that followed World War II. But familiarity and success tend to breed forgetfulness. As a result, the thinking forged on the anvil of those hard times has been gradually expunged, and replaced by revived pre-Depression era free market thinking. Carried by this intellectual tide, policymakers have created a modern variant of the Victorian economy under the rubric of globalization.

Today’s economic conditions hint of the 1920s, a period when America experienced a credit boom and a speculative bubble while the rest of the world experienced relative stagnation. Hopefully, enough post-Depression era policy thinking remains to avoid another great slump. But simply avoiding a slump is not sufficient. The challenge is to design policies that will once again engender the broadly shared prosperity that defined the early post-war decades. That, in turn, will require recovering economic thinking that has been relegated (by mainstream economics) to the history books.

One lasting contribution from the Depression came from the British economist John Maynard Keynes, who identified the importance of total demand for determining employment. Total demand is defined as the aggregate of household, business and public spending within the economy. Unemployment can result from reduced spending by business and households. At best, markets are painfully slow in dealing with such declines, and at worst they can get trapped with permanent high unemployment.

Keynes recognized that the market economy price system does not automatically ensure adequate total demand, and what works for an individual product market does not automatically work for the economy as a whole. In individual markets, lower prices make goods relatively cheaper, providing an incentive for households or businesses to switch expenditures away from other products. However, for the economy as a whole, this mechanism does not work since all prices (including wages) are falling so that there is no ability or incentive to increase spending. Worse than that, the mechanism may operate in reverse as falling prices increase the burden of debts and interest payments, which reduces demand and can also bankrupt the banking system.

Consequently, there is reason for policy to step in and stabilize demand to avoid such outcomes. This is classic Keynesian policy, sometimes referred to as counter-cyclical spending. The essence of the principle is that when household and business demand falls off, policymakers should step in and, through federal spending on infrastructure and lower interest rates, stop the downward spiral and prime the economy.

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