The Economics Book

INDUSTRIAL AND ECONOMIC REVOLUTIONS 149 See also: Free market economics 54–61 ■ Boom and bust 78–79 ■ Marxist economics 100–05 ■ Technological leaps 313 the entrepreneur as a new class of New products and new Joseph Schumpeter person, an “upstart” outside the methods compete with the capital-owning or working class old… not on equal terms but at Born in 1883 in Moravia, who innovates, creating new a decisive advantage that may then part of the Austro- products and forms of production in Hungarian Empire, Joseph uncertain conditions. mean death to the latter. Schumpeter was the son of Joseph Schumpeter a German factory owner. His The entrepreneur’s creative father died when he was four, response to economic change as US economist Clayton M. and Schumpeter moved with makes him or her stand out from Christensen have distinguished his mother to Vienna. There the owners of existing firms, who between two types of innovations. she married an aristocratic only make “adaptive responses” to “Sustaining” innovations maintain Viennese general who helped minor economic change. Forced to an ongoing system and are often launch the brilliant young borrow to bring their innovations technological improvements. economist on a whirlwind to market, entrepreneurs take risks On the other hand “disruptive” career that saw him become and inevitably meet with resistance. innovations upset the market and a professor of economics, They disturb the old system and really get things moving, changing the Austrian Minister for open up new opportunities for the market through product Finance, and President profit. For Schumpeter innovation innovation. For example, although of the Biedermann Bank. creates new markets far more Apple did not invent the technology effectively than Smith’s “invisible of the digital music player, it After the bank collapsed hand” or free-market competition. combined a high-design product in 1924 and Austria and (iPod) with a music download Germany succumbed to Breaking through program (iTunes) to provide a nazism, Schumpeter moved Schumpeter argued that, although new way of accessing music. to the US. He became a a new market may grow after an lecturer at Harvard, where innovation, others soon imitate Marx believed that creative he acquired a small cult and begin to eat into the profits destruction gave capitalism huge following. Schumpeter died of the original innovator. In time energy but also explosive crises in 1950 at the age of 66. the market begins to stagnate. that would destroy it. Schumpeter Recessions are a vital way of agreed but argued that it would Key works moving things forward again, destroy itself due to its success, clearing away the dead wood, even not failure. He saw monopolies as 1939 Business Cycles if the process is painful. In recent the engine of innovation but said 1942 Capitalism, Socialism years business strategists such these were doomed to grow into and Democracy over-large corporations, whose 1954 History of Economic Apple’s iPhone was introduced by bureaucracy would eventually Analysis visionary entrepreneur Steve Jobs. stifle the entrepreneurial spirit 1961 The Theory of Economic It was an industry “game changer,” that had given them life. ■ Development forcing competitors to come up with products that could rival it.

WAR AND DEPRESS 1929–1945

IONS

152 INTRODUCTION Joseph Stalin The Econometric The Gold Standard John Maynard Keynes announces Society is founded in (a monetary system that writes an open letter to the US to research the linked the value of each President Roosevelt in the compulsory mathematical and The New York Times, collectivization statistical aspects country’s currency to recommending government of farming in the gold) is suspended. spending to kick-start Soviet Union. of economics. the economy. 1929 1930 1931 1933 1929 1931 1932 1933 The Wall Street Crash Friedrich Hayek Lionel Robbins Ragnar Frisch makes (a dramatic fall in the argues that state formulates his definition the distinction between value of stocks and macroeconomics and interference in of economics as “the shares in the US) economies is wrong science of scarce microeconomics. marks the beginning of and will ultimately resources.” the Great Depression. lead to repression. I n the years following World much of the decade, many countries economy, for which a completely War I confidence in traditional worldwide were in a severe new approach was needed. The economic thinking was put to depression. It was during this period answer came from British economist the test by events in Europe and that the British economist Lionel John Maynard Keynes (p.161), who North America. Social and political Robbins formulated his often-quoted recognized the failings of a totally unrest had led to a communist definition of economics as “the free market—one that is untouched revolution in Russia while science of scarce resources.” by any form of intervention. Where hyperinflation had made the previous generations had trusted the German economy collapse. A new approach market’s own workings to right Trust in the free market’s ability to the system’s shortcomings, Keynes During the 1920s the US provide stability and growth was advocated state intervention, and enjoyed such prosperity that in 1928 shaken, and economists looked for specifically government spending, President Herbert Hoover said, “We new strategies to tackle economic to boost demand and lift economies in America are nearer to the final ills, particularly unemployment. out of depression. triumph over poverty than ever Some began to examine the before in the history of any land.” institutional problems of developed At first his ideas were met with One year later the Wall Street capitalist economies. US economists skepticism, but they later gained Crash took place: shares collapsed Adolf Berle and Gardiner Means, for support. His model envisioned the and thousands of firms folded. example, showed how managers economy as a machine that could By 1932, more than 13 million were running corporations for their be regulated by governments Americans were unemployed. The own benefit rather than for the through adjusting variables such US recalled the huge loans they firm’s. The most pressing need was as the money supply and public had previously made to Europe, to find a means of stimulating the spending. In 1933, Keynes’s and European banks collapsed. For arguments provided a rationale for

WAR AND DEPRESSIONS 153 President Franklin John Hicks describes Simon Kuznets The Bretton Woods D. Roosevelt introduces the ISLM model, identifies business agreements are signed, mathematically cycles and lays the regulating the post-war the New Deal— modeling the foundations for the field financial relations of the a package of state major industrial states. intervention policies to Keynesian multiplier. of development reinvigorate the economy. economics. 1933 1937 1940S 1944 1936 1939 1944 1945 Keynes publishes The Outbreak of World Karl Polanyi World War II ends General Theory, setting War II in Europe. challenges traditional and a period of economic out his approach to economic thought rebuilding macroeconomics and the by approaching begins. economics from a vital role of the state in the economy. cultural perspective. President Franklin D. Roosevelt to the Keynesian solution to the Hayek (p.177). His stance was kick-start the US economy with the depression of the 1930s, the idea of as much anti-communist as it was stimulus policies known as the state intervention was still seen by pro-capitalist. He argued that the New Deal. Government money was many economists as unhealthy freedom and democracy of the West used to fund huge infrastructure interference with the market was bound up with its free market projects, and all banks were placed economy. Some Americans saw it economies, while the tyranny of under federal control. The New Deal as alien to the “American way,” communist regimes, with their formed the basis for economic while European economists planned, centralized economies, policy in America and Europe associated it with socialism. removed this freedom. Others took following World War II. Keynes himself saw it as part of a this view further, arguing that British Liberal tradition, in which competitive markets are essential Norwegian economist Ragnar the hard facts of economics are to growth, as evidenced by the Frisch (p.336) drew attention to the tempered by social considerations. higher standards of living in two different ways in which an Western capitalist countries. economy could be studied—in part Global differences (microeconomics) or as a whole Economics developed certain The migration of many German system (macroeconomics). The new national characteristics, with and Austrian thinkers to Britain and field of econometrics (mathematical different schools of thought the US during the 1930s led these analysis of economic data) emerged developing along broadly cultural ideas to become widespread. Later as a useful tool in economic lines. In Austria a radical school on, as faith in Keynesian economics planning and forecasting. Modern of thought evolved that supported began to wane, a new generation of macroeconomics took its approach an absolutely free market, based economists reintroduced the idea from Keynes, and his approach was largely on the work of Friedrich that markets should be left to their widely admired. However, despite own devices. ■

UNEMPLOYMENT IS NOT A CHOICE DEPRESSIONS AND UNEMPLOYMENT



156 DEPRESSIONS AND UNEMPLOYMENT IN CONTEXT I n 1936, John Maynard Keynes (a section of the economy). published his groundbreaking Originally tutored in the classical FOCUS work The General Theory of school, Keynes claimed that he The macroeconomy Employment, Interest, and Prices, struggled to escape from its often referred to simply as The habitual modes of thought. His KEY THINKER General Theory. The book was success in doing so, however, led to John Maynard Keynes important because it forced people a radical economic approach that (1883–1946) to consider the workings of the suggested an entirely different set economy from a completely of causes for unemployment and BEFORE different perspective. It made equally different solutions. 1776 Scottish economist Keynes one of the world’s most Adam Smith argues that the famous economists. This Edgar Degas painting of 1875 “invisible hand” of the market shows absinthe drinkers idling in a café. will lead to prosperity. Ever since the Scottish Until Keynes’s ideas were published in economist Adam Smith (p.61) had 1936, alcohol abuse and other vices 1909 British social published The Wealth of Nations were seen as causes of worklessness. campaigner Beatrice Webb in 1776, outlining what came to be writes her Minority Report, known as classical economics, the saying that the causes of economy had been viewed as a poverty are structural and perfectly balanced collection of cannot be blamed on the poor. individual markets and decision makers. The consensus among AFTER economists was that the economy 1937 British economist John would spontaneously and naturally Hicks presents his analysis of achieve a state of equilibrium with the Keynesian system. all those who wanted to work finding employment. 1986 US economists George Akerlof and Janet Yellen Keynes was to turn much of explain involuntary the basic cause-and-effect of the unemployment through their classical model on its head. He efficiency wage models. also argued that the macroeconomy (the total economy) behaved quite differently from the microeconomy Classical economics states But wages change slowly, so that unemployment is always a during recessions, as prices fall, the choice—there are jobs if people are prepared to work for lower wages. value of wages rise—and firms demand less labor. Unemployment is not As demand in the economy a choice. slumps, workers are trapped in unemployment, and firms are trapped in underproduction.

WAR AND DEPRESSIONS 157 See also: Free market economics 54–61 ■ Gluts in markets 74–75 ■ The Keynesian multiplier 164–65 ■ Inflation and unemployment 202–03 ■ Rational expectations 244–47 ■ Incentives and wages 302 ■ Sticky wages 303 Anxious crowds gather on Wall Street on October 29, 1929, the day the stock market crashed. Half the value of US shares was wiped out in a day, starting the Great Depression. For a century prior to the publication of The General Theory, poverty, rather than unemployment, was the enduring problem. Until the 1880s countries such as Britain and the US, which were undergoing rapid growth as a result of the Industrial Revolution, enjoyed general advances in living standards, but pockets of grinding poverty remained. The idle poor upon a Minister.” The term that the workers have been left with Economists had long seen poverty “involuntary unemployment” came no choice about whether they work as the greatest social policy issue, into use for the first time. With this or not. At this time the classical but by the end of the 19th century came the idea that unemployment view of unemployment still the unemployment of workers is caused not by the shortcomings dominated. This held that began to cause increasing of individuals, but by surrounding unemployment was largely concern. At first it was thought economic conditions outside of voluntary, that it existed because the problem was caused by illness their control. workers chose not to work at the or some defect in the character of going wage rate or would rather the worker, such as idleness, vice, a Involuntary unemployment be involved in some “non-market lack of enterprise, or a lack of a By 1913, the concept of involuntary activity,” such as child care. Those work ethic. This meant that unemployment was understood as holding this view insisted that unemployment was seen as a defined by the British economist any involuntary unemployment problem for individuals who were Arthur Pigou (p.336): it was a would be dealt with by automatic for some reason unable to work, situation where workers in an and self-correcting mechanisms rather than a problem for society in industry were willing to provide of the free market. general. It was certainly not seen more labor at the current wage level as an issue that public policy than was being demanded. Even Under the classical view needed to concern itself with. today this definition would be involuntary unemployment could regarded as a good representation not persist for long: the play of In 1909, British social of the involuntary nature of markets would always quickly campaigner Beatrice Webb (p.135) unemployment, in that it suggests return the economy to full produced The Minority Report of employment. There is evidence ❯❯ the Royal Commission on the Poor Laws. This was the first document to lay out the concept and policies of a welfare state, and it claimed that “the duty of so organizing the national labor market as to prevent or minimize unemployment should be placed

158 DEPRESSIONS AND UNEMPLOYMENT Sales fall Depression More people at because there work generate aren’t enough The state demand and people at work to funds projects government buy goods. that create revenue. new jobs. Falling sales According to Keynes, mean that the Recovery a depression can lead to a work force is vicious cycle in which unemployment reduces laid off. demand so much that no new jobs can be created. Government intervention creates a positive circle by stimulating demand. to suggest that Keynes originally living standards is evident in the problem of high, persistent, had some sympathy with this view. images of poverty and desperation involuntary unemployment in the In A Treatise on Money (1930), he from that era. Witnessing this economy. In general, the number wrote that firms have three choices devastation inspired Keynes to of people at work is determined by when prices fall faster than costs: write The General Theory. the level of real wages—the level to put up with the losses, close of wages relative to the prices of the business, or embark on a The Great Depression goods and services being offered. struggle with the employees to Keynes took the world of the Great In times of recession prices of reduce their earnings per unit Depression as his starting point. goods tend to fall faster than levels of output. Only the last of these, The normal workings of the market of wages because demand for Keynes said, was capable of seemed unable to create the goods lowers and prices fall, while restoring real equilibrium from pressure necessary to correct the workers resist cuts in their wage the national point of view. packets. This causes the real The difficulty lies wage to rise. At this higher level However, after the 1929 stock not in the new ideas of real wages the number of people market crash in the US and the willing to work will increase, and Great Depression that swept across but in escaping the number of workers demanded the world in its aftermath, Keynes from the old ones. by firms will fall because they changed his mind. The financial John Maynard Keynes are more expensive. The result collapse of Wall Street trapped the is unemployment. economies of the world in a cycle of falling production—it fell by Sticky wages 40 percent in the US. By 1931, One way to eliminate US national income had fallen from unemployment would be for the a pre-crash level of $87 billion to excess labor (the people not $42 billion; by 1933, 14 million working) to create pressure on Americans were unemployed. money wages to fall by being Their gaunt figures haunted the willing to work for less than the landscape, and the rapid fall in

WAR AND DEPRESSIONS 159 Men seek work in a Chicago job agency in 1931. By 1933, more than 10 million Americans had lost their jobs. The state responded with a stimulus package named The New Deal. going wage. Classical economistsUNEMPLOYMENT PERCENTAGEby a lack of demand in the wholeof laissez-faire to dig the notes up believed that markets were flexible economy for the goods they make. again.” As long as the government enough to adjust and bring down Workers want to supply more, and injected demand into the economy, real wages. But Keynes suggested firms want to make more because the whole system would start that money wages might be otherwise factories and machinery to recover. “sticky” (p.303) and would not lie idle. A lack of demand has adjust: involuntary unemployment trapped workers and firms into Real wages would persist. Keynes argued that a vicious cycle of unemployment The General Theory is not easy to workers were unable to price and underproduction. understand—even Keynes said he themselves back into work by found it “complex, ill-organized, accepting lower wages. He pointed The government’s role and sometimes obscure”—and out that after a collapse in demand, Keynes saw that the solution there is still considerable debate such as that seen in the Great to the problem of involuntary about exactly what Keynes meant, Depression, firms might be willing unemployment lay outside of the particularly by the difference to employ more workers at lower control of both the workers and between involuntary and voluntary real wages, but in reality they the firms. He claimed that the unemployment. One explanation cannot. This is because the answer was for governments for high unemployment being demand for output is constrained to spend more in the economy involuntary is based on the idea so that the overall demand for that a firm’s demand for labor The unemployment rate in several products would rise. This would is determined by the real wage countries between 1919 and 1939 is encourage firms to take on more that firms have to pay. Workers and shown here. Most economies recovered workers, and as prices rose, real firms can only negotiate what the in the 1920s only to suffer soaring wages would fall, returning the money wage is for that job or that unemployment with the onset of the economy to full employment. To industry—they have no control Great Depression in 1930. Keynes it did not matter how the over the price level in the wider, state spent more. He famously general economy. In fact lower Germany said that “the treasury could wages will generally reduce both 25 fill old bottles with banknotes and the cost of production and bury them… and leave it to private therefore the prices of goods as 0 enterprise on well tried principles well, meaning the real wage ❯❯ US 25 0 Canada 25 0 Britain 25 0 France 25 0 1919 1924 1929 1934 1939 YEAR

160 DEPRESSIONS AND UNEMPLOYMENT will not fall by the level required Keynes said and framing it in terms also cause a reduction in real wages, to remove the unemployment. of more formal models and is resisted less strongly because it In this way the unemployment equations. British economist John affects all workers equally. is involuntary because workers Hicks (p.165) formulated Keynesian are powerless to do anything ideas in terms of a financial model Economic theories known as about it. There is a commonly known as the ISLM model. After efficiency wages models (p.302) held view that trade unions can the war this became the standard ask why firms don’t cut wages to resist the adjustment of wages macroeconomic model, and it is increase profits and suggest that to the level required for full still one of the first things taught firms are reluctant to do so because employment through the process to economics students. a wage cut would demotivate the of collective action, so that those existing workers, who would see who are unemployed are prevented New interpretations their relative position in the league from getting work. Keynes placed Modern considerations of table undermined. The net effect this type of unemployment in the Keynes’ work suggest that of cutting wages would in fact voluntary category, arguing that what workers are most concerned be a loss in profits because the workers as a whole are agreeing with is their wage relative to other benefit of lower wages is more openly, or tacitly, not to work workers. Workers have an idea of than offset by the reduction in for less than the current wage. their position in a theoretical productivity that results from Keynes’ reasoning was different “league table” of pay and will low morale or skilled workers from that of later economics, fiercely fight any wage reductions leaving. In this way workers cannot which became dominated by that would push them further down choose to price themselves into mathematical modeling. Much of the table. It is interesting to note work. Related “New Keynesian” macroeconomics in the post-war that a general increase in the price models of wage determination period was about clarifying what level through inflation, which would provide other explanations for rigid wages (p.303). If by a regularization of national demand we prevent… the involuntary idleness of unemployed men, we make a real addition to the national product. Sidney Webb Beatrice Webb President Franklin D. Roosevelt invested in vast new infrastructure projects, such as the Hoover Dam on the Colorado River. Even so, the government was not pursuing Keynesian policies.

WAR AND DEPRESSIONS 161 The sooner involuntary unemployment is disposed with, the better. Robert Lucas Is an accountant driving a taxi an out- driver, the man is still an John Maynard Keynes of-work accountant or an in-work taxi involuntarily unemployed driver? Keynesians might say that he is accountant. When demand in Born in 1883, the year that involuntarily unemployed. New classical the economy returns to a normal Karl Marx died, John Maynard economists say he has got a job. level, he will return to his most Keynes was an unlikely savior productive and efficient of the working class. Raised in Classical resurgence occupation: accountancy. Cambridge, England, by Keynesianism became discredited Fundamental difference in views academic parents, he lived a in the 1970s as European about the ability of markets to life of privilege. economies ran into trouble. adjust lie at the heart of the debate He won a scholarship to Classical ideas about between Keynesians and the Cambridge University, where unemployment were revived by classical economists. he studied mathematics, then the so-called “new classical” spent time working for the school of economists, who once Classical reality British government in India again denied the possibility Keynes would probably have and published his first book: of persistent involuntary agreed with the American Nobel Indian Currency and Finance. unemployment. The US economist Prize-winning economist Joseph Robert Lucas (1937– ) was one Stiglitz (p.338), who said that Keynes was an advisor of the leaders of the assault on during the Great Depression in at both the Paris Peace Keynesianism. When he was the US one quarter of the Conference after World War I asked how he would describe unemployed workforce of Chicago and at the Bretton Woods an accountant who was driving might be said to have chosen to Conference after World War II. a taxi because he could not find a be unemployed because they He always did several things job as an accountant, Lucas could have migrated west to at once—while writing The replied, “I would describe him as California to pick fruit on farms, General Theory, he built a a taxi driver, if what he is doing is along with the millions of others theater, and he counted driving a taxi.” For the modern who did so. He said that leading writers and artists classicists the market always nonetheless, this still represents among his friends. Keynes clears, and workers always have a massive failure of the market, made his fortune on the stock a choice whether to work or not. and if classical theory suggests market and used much of it to that there is nothing more to be support his artist friends. He Efficiency wage theorists done than commiserate with the died of heart problems in 1946. might agree that all workers who unemployed on their bad luck, we want jobs in a recession might would be better off not consulting Key works be able to get one, but they think the theory at all. ■ that some workers—like the 1919 The Economic accountant—are underutilized Consequences of the Peace and are not maximizing their 1930 A Treatise on Money value to the economy. As a taxi 1936 The General Theory of Employment, Interest, and Money

162 SOME PEOPLE LOVE RISK, OTHERS AVOID IT RISK AND UNCERTAINTY IN CONTEXT Less risky investments Riskier investments tend to tend to have lower returns. have higher returns. FOCUS Decision making Risk-averse investors are Risk-loving investors prepared to accept a lower are prepared to accept KEY THINKER more risk in order to get Frank Knight (1885–1972) payoff in order to get a guaranteed return. a higher return. BEFORE 1738 Dutch-Swiss Some people love risk, mathematician Daniel others avoid it. Bernoulli formulates a theory of risk aversion and utility. T here is an element of risk is generally preferred to the riskier in any business venture option, unless the expected return AFTER or investment in a market on the riskier option is considerably 1953 French economist economy. Before deciding on a more attractive. The greater the Maurice Allais discovers a course of action, an individual has risk, the higher the profit has to be paradox in decision making to consider the possible outcomes to attract investors. that contradicts expected and weigh their potential returns utility theory. against their probability, that is, The similarity to weighing calculate the “expected utility.” If the odds in gambling is clear, and 1962 US economist Daniel there is a safe alternative, this one early studies of risk were made by Ellsberg shows how people’s 18th-century mathematicians, who decisions in conditions of uncertainty are not based purely on probability. 1979 Israeli psychologists Daniel Kahneman and Amos Tversky question the rationality of economic decisions in their prospect theory, based on real-life experiments.

WAR AND DEPRESSIONS 163 See also: Economic man 52–53 ■ Irrational decision making 194–95 ■ Paradoxes in decision making 248–49 ■ Financial engineering 262–65 ■ Behavioral economics 266–69 Profit arises out of the Investors and entrepreneurs often also framed in terms of risk: inherent, absolute operate under conditions of risk whether we work for an employer and uncertainty, recognizing or start up our own business, and unpredictability of things. the potential for high returns. On how we invest our personal Frank Knight occasions this “who dares, wins” savings. Insurance markets exist attitude can become extreme, as because we are risk averse. analyzed the probabilities in in the cases of bond traders and Insurers and actuaries, credit- gambling games. In the 1920s US bankers who have made headlines rating agencies, and market economist Frank Knight became for losing or gaining vast fortunes. research can help us assess the one of the first economists to Most people, such as ordinary level of risk and whether the analyze the relationship between savers who place their life savings returns make it worth taking, but risk and profit in a free market in a fixed-interest saving account, some unfathomable degree of economy. He also made a distinction prefer to play it safe, forgoing profits uncertainty will always remain. ■ between risk and uncertainty. Risk, in return for a risk-free investment. by his definition, occurs when the There is essentially a spectrum of Traders in a futures market in São outcome of a course of action is not risk preferences, ranging from the Paulo, Brazil, are effectively betting on known, but where it is possible to risk-loving to the risk-averse, just as the future movements of commodity determine the probability of various there is a range of levels of risk. The prices. Even a small price change can possible outcomes. This allows a attraction of a higher return can result in enormous profits or losses. mathematical assessment of the begin to tempt even the risk-averse level of risk, which can then be to take on some level of risk. He was an early member of the insured against. Also, the expected Chicago School of economists. utility can then be compared Levels of risk His students included future realistically with alternatives. Risk applies to all kinds of economic Nobel prize winners Milton activities, including investing Friedman, James Buchanan, and For Knight “uncertainty” money in stocks and shares, George Stigler, who described describes a situation where the making unsecured rather than Knight as having “unceasing probability of outcomes is not secured loans, and selling goods intellectual curiosity.” known so the various possible in a completely new market. Our outcomes cannot be compared in personal economic decisions are Key works terms of expected utility. This means that the risk cannot be Frank Knight 1921 Risk, Uncertainty and Profit measured mathematically. Knight 1935 The Ethics of Competition argues that when firms are prepared One of the foremost economists 1947 Freedom and Reform: to accept this uninsurable of his generation, Frank Knight Essays in Economics and Social uncertainty, and their risk-taking was born in Illinois in 1885. He Philosophy pays off, it produces profits—even studied philosophy at Cornell, when the economy is in a state of switching to economics after a long-term equilibrium. year. His PhD dissertation formed the basis of his best- known work, Risk, Uncertainty and Profit. Knight was the first Professor of Economics at the University of Iowa, and then moved to Chicago University in 1927, where he remained for the rest of his life.

164 GOVERNMENT SPENDING BOOSTS THE ECONOMY BY MORE THAN WHAT IS SPENT THE KEYNESIAN MULTIPLIER IN CONTEXT Government spending boosts the economy by FOCUS more than what is spent. The macroeconomy If the government increases KEY THINKER spending during a recession John Maynard Keynes (by building new infrastructure, (1883–1946) for example), it will… BEFORE 1931 British economist This spending will … create employment. Richard Kahn sets out an increase demand and… The newly employed explicit theory to explain workers will… the multiplying effects of government spending … save some of their income, suggested by John and spend the rest. Maynard Keynes. AFTER 1971 Polish economist Michal Kalecki further develops the notion of the multiplier. 1974 US economist Robert Barro revives the idea of “Ricardian equivalence” (that people alter their behavior to adjust to government budget shifts). This implies there are no multiplier effects from government spending.

WAR AND DEPRESSIONS 165 See also: The circular flow of the economy 40–45 ■ Gluts in markets 74–75 ■ John Hicks Borrowing and debt 76–77 ■ Depressions and unemployment 154–61 The son of a journalist, John M acroeconomics seeks Vast infrastructure projects, such as Hicks was born in Warwick, to explain the working the Three Gorges Dam, China, can create England, in 1904. He received of entire economies. In thousands of jobs. The new workers’ a private-school education and 1758, the French economist François wages then pour back into the economy, a degree in philosophy, politics, Quesnay (p.45) demonstrated how creating a second round of spending. and economics from Oxford large amounts of spending by those University, all funded by at the top of the economic tree— income will be saved or spent on mathematical scholarships. the landlords—was multiplied as goods from abroad. A standard In 1923, he began lecturing others received money from them estimate is that every $1 of at the London School of and re-spent it. government spending might create Economics alongside Friedrich an increase in income of $1.40 Hayek and Ursula Webb, an In the 20th century British through these secondary effects. eminent British economist economist John Maynard Keynes who became his wife in 1935. looked specifically at why prices and In 1936, British economist Hicks later taught at the labor do not revert to equilibrium, or John Hicks devised a mathematical universities of Cambridge, natural levels, during depressions. model based on the Keynesian Manchester, and Oxford. Classical economics—the standard multiplier, known as the ISLM model Humanitarianism lay at the school of thought from the 18th to (Investment, Savings, the demand heart of all his work, and he the 20th centuries—says that this for Liquidity, and the Money supply). and his wife traveled widely should naturally occur through the It could be used to predict how after World War II, advising normal working of the free market. changes in government spending many newly independent Keynes concluded that the fastest or taxation would impact on the countries on their financial way to help an economy recover was level of employment through the structures. Hicks was to boost demand through an increase multiplier. During the post-war awarded the Nobel Prize in in short-term government spending. period it became the standard 1972. He died in 1989. tool for explaining the working A key idea here was that of the of the economy. Key works multiplier, discussed by Keynes and others, notably Richard Kahn, Some economists have attacked 1937 Mr. Keynes and and then developed mathematically the principle of the Keynesian the Classics by John Hicks. This says that if multiplier, claiming that governments 1939 Value and Capital a government invests in large would finance spending through 1965 Capital and Growth projects (such as road building) taxation or debt. Tax would take during a recession, employment will money out of the economy and Besides the primary rise by more than the number of create the opposite effect to that employment created by workers employed directly. National desired, while debt would cause the initial public works income will be boosted by more than inflation, lessening the purchasing expenditures, there would be the amount of government spending. power of those vital wages. ■ additional indirect employment. This is because workers on the Don Patinkin government projects will spend a portion of their income on things US economist (1922– 95) made by other people around them, and this spending creates further employment. These newly employed workers will also spend some of their income, creating yet more employment. This process will continue, but the effect will lessen on each round of spending, since each time some of the extra

166 ECONOMIES ARE EMBEDDED IN CULTURE ECONOMICS AND TRADITION IN CONTEXT E conomists believe that and tradition. It is this soup that is people are rational, in that the nourisher of economic life, he FOCUS they will take the action claimed, not the profit motives of Society and the economy that promises the highest economic calculating individuals. return, whether this is choosing a KEY THINKER car or a president. The Austrian- Island economics Karl Polanyi (1886–1964) born economist Karl Polanyi turned In The Great Transformation (1944), this idea on its head. He said that Polanyi wrote about the Trobriand BEFORE the important thing about people Islands, off Papua New Guinea, 1776 In The Wealth of Nations, is that they are social beings whose tribal economy was driven Adam Smith argues that man submerged in a “soup” of culture by non-economic behavior in has a natural tendency to trade and barter for profit. People are social beings. Social beings desire status. 1915 Polish anthropologist These cultural norms People gain status by Bronislaw Malinowski influence economic acting in accordance with describes the kula system of the Trobriand Islands. organization. cultural norms. 1923 French sociologist Throughout history, cultural Economies are Marcel Mauss publishes The and social factors have embedded in Gift, a study of gift-giving in been the main fuel traditional societies. of economic life. culture. AFTER 1977 US economist Douglass North argues that Trobriander behavior can be explained using economics. 1990s Israeli economist Avner Offer shows that non-economic behavior plays an important role in modern economies.

WAR AND DEPRESSIONS 167 See also: Economic man 52–53 ■ Religion and the economy 138–39 ■ Institutions in economics 206–07 ■ Social capital 280 The economic system is, and modern economies—are done Karl Polanyi in effect, a mere function for their usefulness rather than for profit. Offer estimates that in late- Born in Vienna to Jewish of social organization. 20th-century Britain, this type of parents in 1886, Karl Polanyi Karl Polanyi non-market production amounts to was brought up in Budapest, 30 percent of national income. Hungary, where he studied striking ways. Trade, even today, law. As a student he mixed happens through gifts, not by Individualistic economies with radicals such as the haggling. Islanders make dangerous Polanyi believed that economies Marxist philosopher Georg voyages to neighboring tribes to come from the “substantive” Lukács and the sociologist give presents of red-shell necklaces features of societies—their special Karl Mannheim. During World and white armbands, and the histories and quirks of culture. For War I he served in the Austro- practice is regulated by customs the economic purist all this is Hungarian army, then moved and magical rites known as kula. irrelevant, obscuring what really to Vienna, working as a The gifts are not kept, but passed propels economies: the signals that journalist. He married a young on. By showing generosity, the prices send to rational individuals revolutionary, Ilona Duczynska, islanders enhance their social in whom the thirst for gain trumps and the two of them fled to standing. The drive for status, religion or culture, even in the Britain in 1933 to escape the not profit, is the motor of trade. most traditional communities. rise of nazism. These two positions can only be Tribal economies are, of course, resolved if it is possible to reduce In London Polanyi worked different from those of today’s the social norms that govern whole as a journalist and taught industrialized countries. Polanyi societies to the actions of self- working people whose poor argued that as European nations interested individuals. Polanyi living conditions left a lasting developed, custom and tradition rejected this. He believed that impact on him. From 1940 were supplanted by the anonymity modern markets and social until his retirement he of the market. Even so, the soup of structures are in conflict, and that lectured in the US but had to culture and social ties still sustains where markets expand, social live in Canada and commute advanced economies. upheaval inevitably follows. ■ because his wife’s involvement in the Hungarian Revolution The Israeli economic historian Trobriand islanders follow unusual banned her from entering the Avner Offer (1944– ) has documented customs of gift exchange. Red-shell country. He died in 1964. the role of non-market precepts in necklaces are carried clockwise around modern economic life, including the islands by sea; white arm bands Key works those of gift giving and favors. Like are circulated counter-clockwise. the islanders, modern societies 1944 The Great Transformation practice wealth redistribution— 1957 Trade and Markets in otherwise it would not be possible the Early Empires (with C. to build roads or raise armies. Arnsberg and H. Pearson) Home-based economic activities 1966 Dahomey and the Slave such as cooking, cleaning, and Trade (with A. Rotstein) child care—in both traditional

168 MANAGERS GO FOR PERKS, NOT THEIR COMPANY’S PROFITS CORPORATE GOVERNANCE IN CONTEXT M ost people assume that Berle and Means claimed that the the basic principle of a dominance of management began FOCUS free market economy during the Industrial Revolution Markets and firms is that companies are run by with the emergence of the factory management in the best interests system. An increasing number of KEY THINKERS of the shareholders. According to workers came together under one Adolf Berle (1895–1971) the US economists Adolf Berle and roof, where they handed their labor Gardiner Means (1896–1988) Gardiner Means, this view is over to management in exchange entirely wrong. Their 1932 book, for a wage. Modern corporations BEFORE The Modern Corporation and bring together the wealth of 1602 The Dutch East India Private Property, shined a light on innumerable individuals (the Company is the first joint-stock corporate governance and showed shareholders). They hand control of company to issue shares and how the balance of power had it to a small management group, begins trading on the swung from the owners of a this time in return for a dividend. Amsterdam Stock Exchange. company toward the management. Both result in a powerful management answerable to no one. 1929 The Dow Jones loses 50 percent of its value in one The failure of corporate governance Apathetic shareholders day, Black Thursday, kick- became a big issue in 2008 when many Berle and Means identified modern starting the Great Depression. felt that the pay of top executives rose shareholders as passive owners. out of proportion to their company’s These owners surrender their AFTER results and falling share prices. wealth to the governance of the 1983 US economists Eugene company and no longer make Fama and Michael Jensen decisions about how to “look after” publish The Separation of their investments—they have Ownership and Control, passed that responsibility, and that viewing the company as a power, to management. The apathy series of contracts. of small-time shareholders results in them either merely maintaining 2002 The Sarbanes-Oxley the status quo or failing to exercise Act becomes law in the US, their voting options. This may be laying down stricter standards beyond their grasp in any case— for US boardrooms. if they really wished to change things, they would have to hold a

WAR AND DEPRESSIONS 169 See also: Public companies 38 ■ Free market economics 54–61 ■ Executive pay The competitive market 126–29 ■ Institutions in economics 206–07 Berle and Means warned of More and more the dangers of self-interested individuals start to buy executives in 1932, but some into companies on the people argue that the problem has become worse in the US stock market… and Europe in the last 20 years. Shareholders vote to … diluting the … giving the choose the board of directors, ownership of management more but executive pay is set by a the company. money to spend. remuneration committee composed of other high- Management is earners. They keep pay high not held responsible by to enforce a “market rate,” investors, who are apathetic and they can then look forward to receiving a large pay raise and have little power. due to “market forces.” Shareholders have the power Management’s priority Managers go for to dismiss the board, but this is self-enrichment, perks, not their would not be well received by not the advancement company’s profits. the markets—which, in turn, of the company. could cause share prices to fall. larger shareholding or galvanize a hold regular general meetings. The problem is worsened sufficient number of shareholders When their book was first by the fact that many shares to force through a change. As a published, US corporate law did not are held by hedge funds result, the owners of companies generally include such measures, (speculative investment firms) have a smaller and smaller and Berle and Means were with no long-term interest in influence in the running of their instrumental in the founding of the the company. Fund managers companies. This is not a problem modern corporate legal system. aim to receive large pay when management interests increases in line with chief coincide with those of the Corporate failures executive officers (CEOs), shareholders. However, if we Today, the failure of corporate so it is not in their interest assume that management are governance is the focus of popular to vote against high acting in a self-interested way and discontent with capitalism. Since remuneration packages. seeking their own personal profit, taxpayers have become majority their interests will be very different owners in some large corporations, Today, a merry-go-round of from those of the owners. corporate leadership is in the remuneration committee members spotlight, revealing the self-interest sets corporate pay. Legislation that Berle and Means argued for a of some chief executives who are would allow shareholders a voice in change in corporate law that would awarded ever increasing pay and these committees seems likely. return power to shareholders over bonuses. Many feel that shareholders the corporations. They insisted that remain powerless in the face of the shareholders should be given rights corporate machine. ■ to hire and fire management and to

170 THE ECONOMY IS A PREDICTABLE MACHINE TESTING ECONOMIC THEORIES IN CONTEXT I n the 1930s Norwegian “a better education leads to a economist Ragnar Frisch higher salary,” may be correct, FOCUS developed a new discipline but can only be proven through Economic methods that he called “econometrics.” His an equation that takes data on aim was to develop methods to educational attainment levels KEY THINKER explain and predict the movements and compares it with salary Ragnar Frisch (1895–1973) of the economy. Econometrics is levels. Econometrics also enables the application of mathematical economists to analyze past BEFORE testing methods to economic market trends and predict future 1696 English economist theories, providing a statistical performance by extracting Gregory King publishes basis on which to prove or disprove patterns from economic data. Natural and Political a theory. Economic beliefs, such as Observations, containing the Statistical pitfalls first quantitative (measurable) Intermediate between Although econometrics is an analysis of economics. mathematics, statistics, important tool of empirical and economics we find explanation, there are pitfalls. For 1914 US economist Henry instance, past market trends are Moore publishes Economic a new discipline no real guarantee of future market Cycles: Their Law and Cause, which… may be called performance. It is also difficult to laying the foundations for take all variables into account. In statistical economics, the econometrics. the education example educational forerunner of econometrics. Ragnar Frisch attainment is not the only factor that affects the wage—other, AFTER unmeasurable skills might also 1940 Austrian economist play a role. These kinds of problems Ludwig von Mises argues that can weaken the validity of the empirical methods cannot be results of economic models. applied to social sciences. It is also important not to confuse statistical significance 2003 British economist with economic significance. ■ Clive Granger wins the Nobel Prize for his analyses of the See also: Measuring wealth 36–37 ■ Inflation and unemployment 202–03 ■ relationship between economic Financial engineering 262–65 ■ Complexity and chaos 278–79 variables over time.

WAR AND DEPRESSIONS 171 ECONOMICS IS THE SCIENCE OF SCARCE RESOURCES DEFINITIONS OF ECONOMICS IN CONTEXT I n 1932, the British economist the best way of using resources. Lionel Robbins provoked Robbins believed that this is the FOCUS controversy by publishing key problem facing every society— Economic methods his Essay on the Nature and deciding which goods to produce, Significance of Economic Science, and in what quantity, in order to KEY THINKER which contained a new definition best satisfy consumers. It is the Lionel Robbins (1898–1984) of economics. Robbins defined it very scarcity of resources that as the science of human actions gives them their value. BEFORE in the face of limited resources 1890 UK economist Alfred with multiple uses. He based his Today, Robbins’s definition is Marshall publishes Principles definition on the fact that human widely accepted, but some argue of Economics, which defines needs are infinite, yet there are that economics should be seen in economics as “… that part only a finite amount of resources. broader terms—as an investigation of individual and social of how societies generate more action which is most closely As one need is fulfilled, another resources over time. ■ connected with the attainment one takes its place. However, there and use of material requisites are only limited resources (land, for well-being.” labor, entrepreneurship, and capital) available to fulfill these AFTER desires. Scarcity means that 1962 US economist Milton every desire can never be satisfied. Friedman endorses Robbins’s definition, yet expands the Needs versus resources Lionel Robbins’s definition focuses boundaries of what Robbins The tension between unlimited on the fact that scarcity forces an has defined as economics. needs and limited resources is economic choice—such as whether to the basis of economics. Every use a field to feed cattle or grow wheat. 1971 US economist Gary resource has an alternative use— Becker publishes Economic for example, if a field is used for Theory, in which he defines grazing livestock, it cannot produce economics as “the study of the a crop at the same time. This allocation of scarce means to means that we have to decide satisfy competing ends.” See also: Demographics and economics 68–69 ■ Opportunity cost 133 ■ Markets and social outcomes 210–13 ■ Shortages in planned economies 232–33

WE WISH TO PRESERVE A FREE SOCIETY ECONOMIC LIBERALISM



174 ECONOMIC LIBERALISM Firms do not know everything about the entire economy. IN CONTEXT But each firm has information about FOCUS production and the market’s demands Society and the economy that are relevant to itself. KEY THINKER Friedrich Hayek (1899–1992) Firms make decisions based on these facts and act on them, for example BEFORE 1908 Italian economist Enrico by changing output. Barone shows how a central government planner can Prices move in response to these replace the free market if it individual actions, and so reflect total can calculate prices. market information. 1920 Ludwig von Mises refutes Barone’s argument. This produces a free market that governments should protect, because 1936–37 Oskar Lange argues against von Mises’s position. we wish to preserve a free society. AFTER 1970s Hayek’s arguments for free markets gain ground. 1991 US historian Francis Fukuyama says free market capitalism has defeated all possible alternatives. Late 2000s Criticisms of government bank bailouts prompt a revival of interest in Hayek’s ideas. M ainstream economics has a unique place within the discipline. for private property, and deep always had its critics. Its Most prominent of these radicals pessimism about the ability of focus on mathematical was an Austrian-British economist, governments to shape society. formulas and its sometimes Friedrich Hayek. Hayek vies with sweeping assumptions have led John Maynard Keynes (p.161) for Creating dictatorships economists to challenge both its the title of the 20th century’s most The argument for which Hayek is methods and its lack of empirical influential economist, and he made best remembered appeared in 1944 evidence. Many of these critics have a range of contributions to political in The Road to Serfdom. At the been from the political Left, who see and economic thought. These time there was a growing the mainstream as providing a glossy covered economics, law, political enthusiasm for government support for an unjust free market. theory, and neuroscience. His intervention and central planning. writings maintained a closely Hayek argued that all attempts to One minority tradition, the argued, consistent set of principles, impose a collective order on society Austrian School, has argued quite which he saw as being in the are doomed to failure. He said they differently. Vociferous defenders of tradition of classical liberalism: would lead, inexorably, to the the free market, but critical of the support for free markets, support totalitarianism of fascism or Stalinist mainstream, they have carved out

WAR AND DEPRESSIONS 175 See also: Property rights 20–21 ■ Economic man 52–53 ■ Economic equilibrium 118–23 ■ Central planning 142–47 ■ The Keynesian multiplier 164–65 ■ Shortages in planned economies 232–33 communism. Since all planning economy.” Only a free market The more the state necessarily acts against the with private property can ‘plans’, the more difficult “spontaneous order” of the market, provide the basis for the it can only occur with a degree of decentralized pricing decisions planning becomes for force, or coercion. The more that a complex economy requires. the individual. a government draws up plans and imposes them, the more coercion Socialism defended Friedrich Hayek is needed. As governments are Polish economist Oskar Lange, poorly informed about the detailed however, disagreed with von around the prices given. The workings of the market, planning Mises. He famously responded planning board could then adjust is bound to steadily fail in its aims, to von Mises’ claims in a 1936 prices according to demand and while becoming increasingly article, On the Economic Theory supply. The outcome, he argued, coercive to compensate for those of Socialism, using a development would be efficient. A planner could failings. At that point a society of general equilibrium theory. This also reduce income inequalities and would lurch toward a totalitarian theory, which was not perfected constrain the market’s tendency to state, in which all freedom was until after World War II, is a short-term thinking. extinguished, however moderate mathematical representation of the planners’ initial goals. a market economy stripped to its Lange had taken the usual bare essentials. All imperfections assumptions of microeconomics Economists of the Left had in markets have been removed, and (that supply and demand ❯❯ argued that a centrally planned all participants in the market are economy was not only possible, but fully informed and concerned only more efficient than a free market. with their self-interest. On this basis, Their first significant opponent, in Lange said, a central planning board 1920, was another member of the could fix the initial set of prices for Austrian School, Ludwig von Mises the economy, and then allow all (p.147). He argued that socialism— those in society to trade freely, here defined as central planning— adjusting their demand and supply is not economically viable. It offers no rational means of pricing commodities since it relies on the diktat (unquestionable command) of one central planner or committee to perform the allocation decisions that in a free market are undertaken by many hundreds of thousands of individuals. The amount of information needed to assess the scarcities and surpluses of a market and set prices correctly is so huge that the attempt is doomed to failure. Socialism, wrote von Mises, is the “abolition of the rational The totalitarian state of North Korea suffers regular shortages and famine. Economists of the Austrian School claim that this is the inevitable result of central planning that ignores markets.

176 ECONOMIC LIBERALISM determine price), and turned them they have goods and services people increasingly to political questions. on their head. His work later formed demand, they can plan for the future, These were discussed most fully in the basis for welfare economics, and they see the prices that are The Constitution of Liberty (1962), which looks at how free markets relevant to them. Information is which argues that government can achieve socially desirable aims. specific and dispersed among should act only to preserve the all those in society. Prices move in spontaneous workings of the The Austrian School response to actions by individuals market, in as far as this is possible. However, Hayek and his colleagues and firms, and so come to reflect Private property and contracts are offered quite a different version of the entire amount of information legally sacrosanct, and a free society the free market’s virtues. They did available to society as a whole. must observe rules that bind all not assume that markets lack parties—including the state itself. imperfections or that individuals Hayek maintains that this Beyond this, the state can, if the are completely informed. To the “spontaneous order” is the best need arises, act against those contrary, they argued, it is because available means to organize a collectivist forces threatening to individuals and firms are poorly complex modern economy, given undermine the rule of law. Hayek informed and society imperfect that that knowledge about society can was broadly in favor of democracy, the market mechanism is the best never be perfect. Attempts to but critical of its inclination in some way to distribute goods. This view impose collective restraints on this cases toward a “democratic tyranny became an important tenet of the order represent a reversion to of the collective.” Austrian School of thought. primitive, instinctual orders of society—and the free market must Birth of neoliberalism In a situation of continual be defended against this. Following World War II the necessary ignorance, Hayek argued, the rebuilding of countries led to a market is the best available means Collective tyranny Keynesian consensus, which not to provide information, but to The idea of spontaneous order proposed increased government acquire it. Each individual and every came to dominate Hayek’s intervention in the economy. firm knows their own situation best: thinking, and his writing turned The free flow of information between individual sellers and vendors (left) results in the correct pricing of goods, according to Hayek. Centrally planned economies, on the other hand, impose the view of one person or committee (right), curtailing individual freedom to communicate and firms’ ability to trade.

WAR AND DEPRESSIONS 177 Auctions are free markets where Mainstream economists strongly Friedrich Hayek prices arise from the direct and rapid influenced by free market thinking, exchange of localized information such as Milton Friedman, have Friedrich August von Hayek between buyers and sellers. risen to influence. By 2000, a was born in Vienna, Austria, “new consensus” prevailed in to a family of intellectuals. By At the same time Hayek and others macroeconomics that emphasized the age of 23, he had received in the Austrian School formed the the limited role of the state. doctorates in law and politics Mont Perelin Society, which acted in addition to spending a year as a guiding influence on the New relevance in the Italian army during free market think tanks that arose Despite the apparent triumph of World War I. Initially drawn to during the breakdown of the Austrian themes in economics socialism, he attended Ludwig Keynesian consensus in the and Hayek’s 1974 Nobel Prize, the von Mises’ seminars while in 1970s. A similar new approach distinctive methods and theory of Vienna, and with von Mises’ to economic policy sprang up in the Austrian School remained support founded the Austrian South America, but it was its largely confined to the fringes. Institute of Business Cycle adoption by the governments of However, the collapse of the global Research. In 1923, he traveled Ronald Reagan in the US and financial system in 2007–08 and to New York for a year, and Margaret Thatcher in the UK that the subsequent bank bailouts have the accuracy of US newspaper made it globally significant. This provoked a renewed interest in accounts of the war compared was neoliberalism, and it followed its doctrines. Austrian School to those in Austria led to his closely the ideas of the once- economists have been prominent in deep distrust of governments. maligned Austrian School. attacking bank bailouts, claiming that they represent an unwarranted In 1931, he moved to Nationalized industries were interference in the market. The Free London to teach at the London privatized, and governments rolled Banking School, which calls for an School of Economics and back their intervention in the end to the government monopoly of became embroiled in a very workings of the market. The Soviet the money supply, takes its cue from public, two-year argument Union collapsed, giving further a 1976 Hayek paper, Denationalization with John Maynard Keynes. impetus to the apparent triumph of of Money, and its ideas have gained Hayek became a British citizen Hayekian themes in politics. Across ground. Keynesian programs of in 1938, but in 1950 left the world even those parties once increased government spending London for the University of most adamantly opposed to free have been similarly criticized. Chicago. He died aged 93 in markets came to believe that there With mainstream economics in Freiburg, Germany, in 1992. was no viable alternative, including a continuing state of turmoil, the Britain’s Labour Party—who had Austrian School is set to achieve Key works been the direct target of Hayek’s fresh influence. ■ Road to Serfdom. 1944 The Road to Serfdom 1948 Individualism and Economic Order 1988 The Fatal Conceit

178 INDUSTRIALIZATION CREATES SUSTAINED GROWTH THE EMERGENCE OF MODERN ECONOMIES IN CONTEXT With new technology … people increasingly and the growth move from rural areas FOCUS to the cities for work. Growth and development of manufacturing… KEY THINKER Workers benefit from Industrialized work Simon Kuznets (1901–85) learning and contribute requires more skill toward cultural change and education than BEFORE and business growth. 1750s French economist agricultural work. François Quesnay states that wealth comes from agriculture, Succeeding generations Industrialization not from industry. continue to benefit from creates sustained 1940 British-Australian these cultural and growth. economist Colin Clark argues industrial advances. that economic growth involves a shift from agriculture to T he Russian-born economist process “modern economic manufacturing and to services. Simon Kuznets described growth,” and showed how success the emergence of the in achieving this is what sets AFTER modern economy as a controlled rich countries apart from the rest. 1967 US economist Edward revolution—in which the factory Denison highlights the replaces the farm. The resulting The key characteristic of Kuznets’ important contribution of higher living standards require growth theory is that income per technological change and economic and social changes that person grows rapidly, even in the productivity growth to run deeper than might at first be face of an expanding population: economic growth. suggested by a simple, numerical there are more people and they are rate of growth. Kuznets called this richer. This expansion is driven by 1975 US economists Hollis the spread of factories and machines. Chenery and Moshe Syrquin find evidence that as agriculture declines, economies grow, and then industry and services increase.

WAR AND DEPRESSIONS 179 See also: Agriculture in the economy 39 ■ Demographics and economics 68–69 ■ Economies of scale 132 ■ Market integration 226–31 ■ Technological leaps 313 With an increase in capital to sustain industrial growth, workers are redeployed out of small family enterprises into impersonal firms and factories. Yet new technologies and large-scale production methods cannot be exploited if people are illiterate, superstitious, or tied to the village. For Kuznets this growth causes profound social changes, with an increase in urbanization and a weakening of religion. Industrial Revolution improvements in the living The steam hammer, invented in Britain was the first country to standards of a growing population. 1837, was one of the machine tools that achieve modern economic growth. increased the pace of industrialization, The Industrial Revolution of the 18th The spread of true modern allowing machines to build machines. century put Britain on the path to economic growth has been limited. becoming an advanced industrialized Among the rich nations, including away from heavy industry and nation. Steam power and inventions the US, Australia, and Japan, the toward the service sector, which reshaped production. Workers left process continues today. After a first will inevitably involve further kinds the fields and entered the factories. wave of industrialization these of social change. ■ Cities grew. New means of transport economies have typically evolved and communication technologies allowed British firms to penetrate the global economy. Its own economy did not transform overnight, but the changes—technological, social, and institutional—kept going. They led to unprecedented Simon Kuznets Simon Kuznets was born in Pinsk, Kuznets helped set up the in present-day Belarus, in 1901. International Association for His involvement with economics Research in Income and Wealth, began early—he became head of a advising many governments. He Russian statistical office while taught widely, and in 1971 won still only a student. After the the Nobel Prize for his analysis Russian Revolution Kuznets’ of Modern Economic Growth. family left for Turkey, then the US; He died in 1985, aged 84. he followed them in 1922. Key works Kuznets enrolled at Columbia University in New York, earning a 1941 National Income and Its PhD in 1926. He then worked at Composition, 1919–1938 the National Bureau of Economic 1942 Uses of National Income in Research, where he developed the Peace and War modern system of national income 1967 Population and Economic accounting used to this day by Growth governments worldwide. In 1947,

180 DIFFERENT PRICES TO DIFFERENT PEOPLE PRICE DISCRIMINATION IN CONTEXT I n the 1840s the French for different people for the same engineer and economist Jules service. This is known as price FOCUS Dupuit suggested that tolls discrimination. It can usually only Markets and firms should be set for the bridges and happen where there is some degree roads he was building. He proposed of monopoly power, which allows KEY THINKER to charge people according to how firms to charge different prices. Joan Robinson (1903–83) much each was willing to pay. Dupuit was the first economist In 1920, three different “degrees” BEFORE to consider setting different prices of price discrimination were 1849 Jules Dupuit considers identified by the British economist how different prices can be charged for the same goods. Firms want to maximize profits. 1891 US economist Frank They will normally attract more buyers at a lower price… Taussig says that differences in train prices reflect different … but then they miss out on the extra profits that would levels of demand. come from people who would happily pay more. 1920 Arthur Pigou defines The key is to find a way of selling the three basic types of the same product at different price discrimination. prices to different people. AFTER 1933 US economist Edward Chamberlin says that close competitors try to gain market power by differentiating their products. 1996 US economist Thomas Holmes shows that price discrimination is possible even in markets with only a few firms.

WAR AND DEPRESSIONS 181 See also: Markets and morality 22–23 ■ Effects of limited competition 90–91 ■ Monopolies 92–97 ■ The competitive market 126–29 ■ Efficient markets 272 Arthur Pigou (p.336). First degree Price discrimination is Joan Robinson discrimination is the model that the act of selling the same Dupuit used: a firm charges each article produced under single Born in 1903 into a wealthy individual the maximum he or she control at a different price English family, Joan Violet is willing to pay. In practice this is Robinson (née Maurice) is rare because it requires the seller to the different buyers. considered to be the greatest to know every individual’s valuation Joan Robinson female economist of the 20th of the good. century. She was educated at the same to make, why doesn’t St Paul’s Girls’ School, London, Second degree discrimination the supermarket sell the first bottle and studied economics at involves reducing the price for each at the low price too? How can some Cambridge University. She additional unit that is bought. This movie tickets be cheaper? We married young and then option is often used in supermarket interpret these offers as meaning traveled to India for two years deals, in offers such as “buy one that a monopolist is increasing before returning to Cambridge bottle of soda and get the second its profits at the expense of most to teach. Here, she became for half price.” of its consumers. part of a team around John Maynard Keynes that included Third degree discrimination, Robinson found that if the economist Richard Kahn, with which is probably the most monopolist produces the same whom she formed a lifelong common form, involves identifying output but charges higher prices intellectual partnership. customers by their differing to certain people, then consumers Robinson enjoyed traveling, characteristics. Movie theaters, for do lose out. However, sometimes and lectured abroad widely example, offers cheaper tickets for price discrimination can allow until her 70s—she was children and senior citizens. people to do things they could familiar to students in North not otherwise afford. When rail and South America, Australia, Discriminatory effects companies price discriminate, for Africa, and most of Europe. In her 1933 book The Economics of instance, commuters in peak times An original thinker who was Imperfect Competition, the British are charged higher prices, but in unafraid of controversy, she is economist Joan Robinson looked at off-peak periods it makes sense for said to be the best economist the results of price discrimination the firm to set much lower prices, never to win the Nobel Prize. on society. Most customers because they need to encourage She died at the age of 80. instinctively think that price people to take a train. So even discrimination in all three forms is though some consumers pay Key works unfair. If each bottle of soda costs more, a larger number may find themselves able to travel at 1933 The Economics of Students have low incomes, so high the lower price. In this way it is Imperfect Competition prices effectively bar them from doing possible for consumers in total to 1937 Essays on the Theory or buying certain things. Student benefit when firms set different of Unemployment discount rates bring activities and prices to different people. ■ 1956 The Accumulation goods within an affordable range. of Capital

POST-W ECONOM 1945–1970

AR ICS

184 INTRODUCTION The International Konrad Adenauer Mathematician John János Kornai’s General Motors Monetary Fund starts to build Nash pioneers Overcentralization becomes the first US game theory, company to make a is put in place, Germany’s social which is used to gives a critical operating from a base in market economy, analysis of the profit of more than with large private and explain economic planned economies $1 billion in a year. Washington DC. decision making. of communist states. public sectors. 1945 1949 1951 1953 1955 1949 1950S 1951 1953 The People’s Milton Friedman Kenneth Arrow’s Maurice Allais Republic of advocates a impossibility presents a paradox in China is founded, monetarist theorem shows decision making that shows how people hate led by the policy, in which that there is losing more than they Communist Party. governments limit no perfect the money supply. voting system. like winning. T he years immediately Soviet Union, the UK, and the US influential after World War II. following World War II agreed on the founding of major In the US Keynesian policies were were, inevitably, a time for new institutions, such as enthusiastically advocated rebuilding economies. Even before the International Monetary Fund by economists such as Canadian- the end of the war, politicians and (IMF), the International Bank for American John Kenneth Galbraith economists had started planning Reconstruction and Development and quickly adopted by the liberal for peace. They were working to (IBRD), and the General Agreement democratic government. In Britain avoid the problems that had on Tariffs and Trade (GATT). the incoming Labor government followed World War I and to brought in measures that set up a establish a peaceful world of Post-war Keynesianism welfare state. The rebuilding of the international economic cooperation. The British delegate at Bretton economies of Japan and Germany Woods was John Maynard Keynes was to mark a turning point in their The League of Nations, an (p.161), whose 1919 book, The histories. Germany, in particular, international organization set up to Economic Consequences of the experienced an “economic miracle,” maintain peace, had collapsed at Peace, had warned what might the Wirtschaftswunder, under the beginning of the war, and in happen after World War I as a result Chancellor Konrad Adenauer. The 1945, it was replaced by the more of economic policy. Keynes’s work success of their social market robust United Nations (U.N.). One had inspired President Franklin D. economy, tempering free market of the U.N.’s first tasks was to vote Roosevelt to lift the US out of the economics with government on proposals drawn up by delegates Great Depression of the 1930s by intervention, became the model to the U.N. Monetary and Financial the state spending package of the for many Western European Conference, now better known by New Deal. It was not surprising economies in the second half its location—Bretton Woods, in New that his ideas were equally of the 20th century. However, other Hampshire. Here, delegates from the

POST-WAR ECONOMICS 185 Richard Lipsey and Bill Phillips describes The Organization Andre Gunder Frank uses Kelvin Lancaster the Phillips curve, of Petroleum dependency theory to suggest that Exporting showing the argue that the global intervention to correct relationship between Countries (OPEC) economy creates a market failure can is founded make matters worse. inflation and in Baghdad. a division between rich unemployment. and poor countries. 1956 1958 1960 1970 1955 1957 1958 1962 1970 The Warsaw Pact The European Mao Zedong starts the Robert Mundell and Eugene Fama proposes is signed between Economic Great Leap Forward, Marcus Fleming the efficient market seven communist describe the hypothesis, suggesting states in Eastern Community an attempt to that investors cannot (EEC) is founded industrialize China relationship between Europe and exchange rates consistently beat the Soviet Union. by the Treaty that leads to a and output. the market. of Rome. catastrophic famine. countries were not moving along economics of the turn of the 20th international nature of economics. the same lines. Much of Asia was century, which focused its analysis Although the US and Europe still under communist rule, and the Iron on supply and demand. Economists dominated economic thinking Curtain now separated Europe into of the Chicago School turned to outside the communist states, East and West. This was the era of science for inspiration. Kenneth more notice was being taken of the Cold War between the Soviet Arrow (p.209) used mathematics to the developing countries, not just bloc and the West. The spread of prove the stability and efficiency of as a source of raw materials but as communist regimes prompted a markets, and Bill Phillips (p.203) economies in their own right. reaction among many economists used ideas from physics to describe in the West, especially those with the trade-off between inflation and Globalization continued apace, experience of their tyranny. unemployment. Some Western and economists began to examine economists, such as Maurice Allais the reasons for the gap between Free market revival (p.195), introduced ideas from rich and poor countries, and how Influenced by Austrians such as psychology in the 1950s and 60s. this could be narrowed. Ideas for Ludwig von Mises (p.147) and This inspired new models of development moved from capital Friedrich Hayek (p.177), the US’s decision making that challenged investment to debt relief, but it Chicago School of economists took the belief in “rational economic man” became clear that the problems a conservative stance against the first described by Adam Smith. were more complex, involving prevailing mood of Keynesianism. politics, culture, and economics. At They advocated a move back to Huge advances in communication the same time economists began a free market system with less technologies made the world seem increasingly to suggest that perhaps government interference. The roots a smaller place during the post-war economic prosperity was not the of this idea lay in the neoclassical decades, and economists became only—or even the best—way to more aware than ever before of the measure a country’s well-being. ■

186 IN THE WAKE OF WAR AND DEPRESSION, NATIONS MUST COOPERATE INTERNATIONAL TRADE AND BRETTON WOODS IN CONTEXT T he gold standard was a reflect new balances of trade and monetary system that capital flows. However, World War I FOCUS backed paper money placed exceptional demands on Global economy with gold, thereby guaranteeing government financing, and the its value. It came into effect in system began to break down. KEY EVENT Britain in 1812 and was adopted The Bretton Woods internationally in 1871. Some countries suspended agreements are signed in New their gold standard membership Hampshire, in July 1944. The system provided a stable to allow substantial borrowing and anchor for the international monetary expenditure, often financed simply BEFORE system by fixing the exchange rates by printing money. The war’s end 1930s The world economic of various currencies relative to the did not see a smooth return to the system collapses during price of gold. It also acted as a status quo—countries such as the Great Depression, and mechanism for making gold Germany had exhausted their gold cooperation between transfers between countries to reserves and could not return to economies breaks down. membership, while other nations reentered the standard at wildly 1944 John Maynard Keynes variable rates. publishes his plans for an “international currency union” Dresden was among countless cities Abandoning gold to regulate world trade. in Europe and Asia destroyed during During the Great Depression of the World War II. The International Bank 1930s nations left the gold standard AFTER for Reconstruction and Development in droves as they tried to expand 1971 President Nixon cuts the was set up to fund reconstruction. their economies by devaluing their link between the dollar and currencies to promote exports. At the price of gold, ending the the same time international trade, Bretton Woods system. which had been fairly unrestricted before the war, became subject to 2009 The Bank of China says an increasing range of restrictions, the dollar is unable to act as as countries tried to maintain their a credible reserve currency position in a shrunken world because of conflicts between market. These policies helped to the US’s domestic and prolong the Depression since each international policies. new restriction or devaluation further reduced the world market.

See also: Comparative advantage 80–85 ■ Depressions and unemployment POST-WAR ECONOMICS 187 154–61 ■ Market integration 226–31 ■ International debt relief 314–15 The International Monetary Fund The gold standard This came under strain after Created by the Bretton Woods forced fixed exchange World War I and as countries agreement, the International Monetary Fund (IMF) is rates on the world. went into recession. today one of the world’s most controversial international But without The system collapsed bodies. It was established cooperation nations and cooperation between initially as an emergency fund devalue currencies to promote for countries experiencing exports and impose nations ended. financial difficulties arising from balance of payments trade restrictions. deficits, debt crises, or often both. More than 180 member This shrinks the world In the wake of countries contribute toward market, and everyone war and depression, a central fund, depending on becomes worse off. the size of their economy, and nations must they can apply for cheap loans cooperate. from that fund. When the Bretton Woods fixed-exchange After World War II, the Allied Trade (GATT) aimed to rebuild system was abandoned in powers turned to the question of international trade. Together these 1971, the IMF’s role changed. post-war economic reconstruction. new organizations sought to renew It began to impose strict A conference was held in June, 1944, economic cooperation among conditions on its loans. Since at Bretton Woods, New Hampshire, nations, the lack of which had the late 1970s these were where delegates agreed to a US plan been so costly between the wars. heavily influenced by neoliberal to peg currencies against the dollar. ideas (pp.172–77), which The dollar, in turn, was to be This system held for nearly advocated privatization and maintained by the US government 30 years of exceptional economic cutting government spending. at a fixed rate of exchange with growth, but it was structurally Economists have criticized the price of gold. flawed. Continuous US trade deficits the IMF for making crises (where imports exceed exports) worse, such as the East Asian This system was overseen by a helped keep the system working, crisis of the late 1990s. new International Monetary Fund but dollars flooded abroad until (IMF), which would be responsible the stockpiles exceeded US gold Traders watch as the crisis for providing emergency funding, reserves, pushing the price of caused by the collapse of the Thai while the International Bank for gold in dollars above the fixed price baht spreads across Asia in 1997. Reconstruction and Development of gold. As US government The Thais had given in to pressure (now part of the World Bank group) expenditure increased, the strain from the IMF to float the baht. was established to provide funding worsened. In 1971, President Nixon for development projects. In 1947, a suspended the dollar–gold link, General Agreement on Tariffs and ending the Bretton Woods system. ■

ALL POOR COUNTRIES NEED IS A BIG PUSH DEVELOPMENT ECONOMICS



190 DEVELOPMENT ECONOMICS IN CONTEXT To develop, poor countries need many investments… FOCUS Growth and development … in both infrastructure (such as roads and ports) and industry (such KEY THINKERS Paul Rosenstein-Rodan as factories and power stations). (1902–85) Walt Rostow (1916–2003) These investments must all be made at once, because they BEFORE need each other to survive. 1837 German economist Friedrich List argues the use Only governments can afford of import protection to help to make this level of investment. establish domestic industry. AFTER 1953 Estonian economist Ragnar Nurkse proposes the policy of balanced growth for developing countries. 1957 Austrian-Hungarian economist Peter Bauer criticizes the idea of the big push and the orthodoxy of state planning. If they do so, countries will grow. All poor countries need is a big push. O ne of the central questions the US government that funded the is the big push that triggers a take- for economists is “how did rebuilding of infrastructure and off into self-sustained growth. This poor nations become rich?” industries. The Polish economist eventually transforms poor countries After World War II this question Paul Rosenstein-Rodan argued that into mature economies with high reemerged with new force. The to make economic progress, the living standards for the majority crumbling of colonial empires had newly independent countries of the of the population. The question of spawned young, independent 1950s and 60s needed a “big push” how the investments needed for a nations whose living standards were in investment, just as Europe had big push might be made became falling farther and farther behind received from the Marshall Plan. the central question of the new field those of their former masters. Many of development economics. of them were experiencing rapid Another related idea was that population growth and needed a countries pass through a series of Building simultaneously corresponding growth in the goods stages, taking them from traditional Rosenstein-Rodan argued that in and services they produced in order societies to mass consumer-based less-developed countries the market to improve living standards. economies. Walt Rostow, the US fails to funnel resources efficiently economist who put forward this into beneficial investments that Europe had quickly recovered theory, said that for traditional generate growth. This is because from the war, aided by the Marshall nations to develop, massive capital big projects such as roads, ports, Plan—a huge infusion of funds from investments would be required: it

POST-WAR ECONOMICS 191 See also: Economies of scale 132 ■ The emergence of modern economies 178–79 ■ Markets and social outcomes 210–13 ■ Economic growth theories 224–25 ■ Asian Tiger economies 282–87 and factories are complementary: range of goods. Suppose people Most industries catering the existence of one makes the spend 60 percent of their incomes for mass consumption are others more economically viable. on bread, 20 percent on clothes, complementary in the sense This can lead to a logical dilemma: 10 percent on paraffin, and 10 that they provide a market for, the first investment might only be percent on shoes. If factories and thus support, each other. profitable once a second has been making bread, clothes, paraffin, and made, but the second investment shoes were built in exactly this ratio, Ragnar Nurkse is only viewed as profitable if the the incomes generated from these first has been made. For instance, enterprises would be spent on Estonian economist (1907–59) a factory needs a power station each industry’s products in the nearby to be economically viable, same proportion. Only when these as a “backward linkage.” In practice, but the power station is only industries exist together, in the right industries have multiple forward profitable if there is a factory to proportions, do they become viable. and backward linkages to other buy its power. Two outcomes are industries, creating a complex web possible: one in which there is no Essential linkages of interactions, which can lead to factory and no power station, The German economist Albert the economic viability of an entire another in which there are both. Hirschman used the term “linkage” diversified production base. to describe the interconnections The same kind of argument between industries. For instance, a The big push involves countries applies to more complex mixes of paint plant helps the development going from having nothing to production. Imagine that a huge shoe of a car industry by increasing the having everything. From having ❯❯ factory is built in an underdeveloped supply of paint. Hirschman called economy. It makes $15 million worth this a “forward linkage.” The of shoes, and the sales revenues go expansion of the paint industry into wages and profits. However, also increases demand for the this factory is only viable if all the chemicals used to make paint, and incomes it generates (for its workers) so increases the profitability of are spent on shoes, while in fact chemicals factories. This is known people spend their money on a Cattle farm Chemical plant Albert Hirschman described connections between industries as “linkages.” A cattle farm creates a forward linkage, helping the growth of other industries by increasing the supply of meat and leather. A chemical plant creates a backward linkage, required by this growth. Shoe shop Abattoir Leather tannery Shoe factory Supermarket Power station Coal mine

192 DEVELOPMENT ECONOMICS A large nut-shelling factory built State-directed investment has led relationships between governments with Indian investment employs workers to beneficial industrialization in and politically connected to shell nuts in Tanzania. Other industries some places. Some Southeast industrialists, which hampered sprang up to service the factory, aiding Asian countries saw industrial competition and innovation. the country’s general development. expansion and fast income growth; their successful tying together of During the 1970s the big push no power station and no factory, an activist state and big business came under intellectual attack by developing economies suddenly need became known as the Developmental new classical economists (p.247) to have both. Starting from a position State model. However, the conditions such as the American Paul Krugman, where they have no industrial sectors, in which the Marshall Plan was who believed that developing they must establish all of them at enacted in 1948 were different from economies were not fundamentally once. But because each investment those in the newly independent different from developed ones. They requires others, it is difficult for nations of the 1950s; many attempts said economically rational behavior individual entrepreneurs to lead the at a big push ran into trouble. and the power of price signals were push. For this reason Rosenstein- as valid in poor as in rich countries. Rodan and others like him argued Inefficient investment Investment was important, but it that the big push has to come from At early stages the investments needed to be correctly distributed the state, not from private markets. needed for economic development around the economy. Markets, not may seem obvious. Even so, governments, were the best arbiter In line with this thinking coordinating an investment drive of where to invest. post-war governments across the across many industries is a huge developing world became involved task. Governments can only create This new wave of thinking held in large investment programs, viable industries if they know the that developing economies were undertaking industrial and correct balance of production—the hampered not by the inherent infrastructure projects as part of right share of shoes, clothes, and inefficiency of their markets, but by national development plans. Less- bread—which is implied by the the wrong policies. Too much state developed nations were viewed as composition of consumer demand. involvement had undermined the having dual economies, consisting It is only possible to exploit the price mechanism (where prices are of traditional agricultural sectors interactions between different set by supply and demand), and (containing a lot of unproductive kinds of production when there is had disrupted its ability to allocate labor) alongside modern sectors detailed knowledge of the forward resources efficiently. Good policy made up of new industries. The idea and backward linkages between involved “getting prices right” and was that the big push would siphon industries. Not all governments allowing the market mechanism off excess labor from the rural areas have the expertise, information, or to operate freely so that resources and deposit it in the new industrial political clout to do this successfully. would be put to the best use. enterprises. This way of thinking provided the rationale for large What many countries ended up Complementarity of infusions of foreign aid, intended with was bloated, inefficient, state- different industries provides as the fuel for the investment drive. owned industries that failed to trigger take-off into sustained the most important set of growth. Industrialization was arguments in favor of a frequently attempted behind trade tariffs—foreign goods were shut out large-scale planned of the domestic market in the hope industrialization. that this would give fledgling industries a chance to develop. Paul Rosenstein-Rodan The state’s protection of firms from foreign competition generated “rent- seeking”—wasteful lobbying of the government by commercial interest groups seeking to preserve their privileges. Often this led to cozy

POST-WAR ECONOMICS 193 The way forward was to roll back with a more sanguine view of Post-war development the boundaries of the state, remove markets. Markets are now seen as in Latin America rent-seeking, and let the price vital in poor countries for creating mechanism take over. incentives for mobilizing resources After World War II many in a profitable way. At the same Latin American governments In the 1980s this revision in time economists such as American intervened in their economies thinking led to the rise of free Joseph Stiglitz have pointed to to promote industrialization market development policy. The market failures at the small- across a broad range of sectors. World Bank and the International business level that commonly They restricted imports and set Monetary Fund (IMF) introduced restrain developing countries. For up new industries to produce “structural adjustment programs” instance, profitable investments the same goods, imposing to inject market principles into can’t be made when small tariffs and exchange controls African economies. The so-called firms can’t get loans. The state may to stifle foreign competition. “shock therapy,” used in Eastern have a role to play in correcting Europe by these institutions after these failures, and in this way help Governments also invested the fall of communism, was aimed at the price mechanism to function directly in the infrastructure rapidly establishing market systems. more smoothly. This consensus, that industry needed, helped However, these free market sometimes called the market- by foreign aid and technical experiments eventually came under friendly approach, sees the state assistance. This process was attack for making poverty worse and markets as complementary. known as Import Substitution while also failing to build dynamic, Industrialization, and it was diversified economies. However, at the start of the 21st most successful in countries century, there was a resurgence of that had internal markets that Market-friendly policies more explicit big push ideas. In were large enough to allow Today, disillusionment with 2000, the United Nations drew up heavy industry to sit alongside structural adjustment has led to a development targets for 2015, which consumer-oriented enterprises new consensus, fusing the insights included universal primary education, in a viable way, such as Brazil of the early development thinkers the eradication of hunger, and the and Venezuela. reduction of child mortality rates. Singapore became a modern nation- This involves promises by donor Critics argue that Latin state in 1965. Government policies countries to keep up aid flows American countries should attracted foreign investment and the and requires large, coordinated have focused on strengthening state thrived on its export industries, investments across a range of sectors the sectors in which they had such as refined petroleum. and infrastructure projects. ■ a comparative advantage, encouraging firms to become internationally competitive and to export their products. Bolivia’s oil industry enjoyed record investments from its government in 2011. Privatized in the 1990s, the industry was renationalized in 2006.

194 PEOPLE ARE INFLUENCED BY IRRELEVANT ALTERNATIVES IRRATIONAL DECISION MAKING IN CONTEXT Individuals are In theory they choose assumed to be rational only on the basis of the FOCUS Decision making decision-makers. probability and desirability of KEY THINKER People sometimes change separate outcomes. Maurice Allais (1911–2010) their preferences when common alternatives But observed BEFORE are added. behavior contradicts this. 1944 John von Neumann and Oskar Morgenstern publish People are influenced by A Theory of Games and irrelevant alternatives. Co-operative Behavior, laying the foundations for expected I n 1944, the US mathematician when faced with choices in which utility theory. John von Neumann and the there are no guaranteed outcomes: German-born economist Oskar they weigh the utility gained from 1954 US mathematician Morgenstern developed expected each possible outcome by the L. J. Savage shows how people utility theory to describe how people probability that it will occur, then calculate the probabilities of make decisions under conditions of choose the option that promises the uncertain events. uncertainty. “Utility” is a measure greatest utility. The model uses a of satisfaction, and economists use mathematical approach to decision AFTER units of utility to talk about the making, and has been used to 1979 Daniel Kahneman amount of satisfaction gained from analyze all sorts of economic and Amos Tversky explain various outcomes. The theory behavior in situations of uncertainty. some discrepancies between assumes that people are rational However, in 1953, French economist psychological experiments and the claims of economic theory. From 1980s Behavioral economics is established, integrating psychology with the mathematical techniques of economics.

POST-WAR ECONOMICS 195 See also: Economic man 52–53 ■ Risk and uncertainty 162–63 ■ Paradoxes in decision making 248–49 ■ Behavioral economics 266–69 Maurice Allais challenged this apple again, or the peach, but you Whatever their attraction theory from what he referred to as would not choose the orange— might be, none of the the American School of economics. because the addition of the peach cannot change your preference for fundamental postulates He pointed out that expected apples over oranges. forumulated by the American utility theory is based on an School can withstand analysis. assumption, known as the The violations of independence independence axiom, that says that Allais detected, however, take Maurice Allais people will dispassionately look at place in situations of uncertainty. the likelihood of outcomes and the Suppose you had a choice between the independence axiom. This utility they will gain from each one. two “lotteries,” each of which has conflicts with the standard In particular, they will view each several possible outcomes with economic idea that humans always choice independently, ignoring any particular probabilities. The first act rationally. For some reason the factors that are common to each lottery gives you a 50 percent presence of other choices in a set of option. Allais said that this was chance of an apple and a 50 percent options seems to matter to people— rarely, if ever, true. His contention chance of a peach. The second it makes a difference. The discovery became known as the Allais paradox. lottery gives you a 50 percent of these kinds of behaviors has chance of an orange and a 50 spawned the new field of behavioral Irrational choice percent chance of a peach. Because economics (pp.266–69), which We cannot directly see people’s you prefer apples to oranges, you attempts to devise more thought processes when they choose, should choose the first lottery: psychologically realistic models but we can observe the choices they under the independence axiom, of decision making. ■ make and see if these are consistent the addition to each lottery of a with rationality and the independence peach—making the peach equally axiom. Imagine that you are given a probable as an outcome in both choice between an apple and an choices—should make no difference orange, and you choose the apple. to the choice of apple over orange. Now imagine that you are offered the But in practice, very often it does. choice of an apple, an orange, and a peach. The independence axiom In experiments using more assumes that you might choose the complex forms of this kind of choice, people frequently violate Maurice Allais Maurice Allais was born in Paris, professor of economic analysis. France, in 1911. His father died A polymath, Allais also made during World War I, and this contributions to physics. In affected Allais deeply. He excelled 1978, he was the first economist at school and studied mathematics to be awarded a gold medal by at the elite École Polytechnique, France’s National Centre of graduating first in his class in Scientific Research, and in 1988, 1933. He then served in the he won the Nobel Prize for military before working first as an economics. He died in 2010. engineer, then as departmental manager for the École Nationale Key works Supérieure des Mines. During this time he also published his first 1943 In Search of an Economic pieces on economics. In 1948, the Discipline École Nationale allowed him to 1947 Economy and Interest focus entirely on teaching and 1953 The Behavior of Rational writing, and he became their Man Confronting Risk

GOVERNMENTS SHOULD DO NOTHING BUT CONTROL THE MONEY SUPPLY MONETARIST POLICY



198 MONETARIST POLICY IN CONTEXT FOCUS Economic policy KEY THINKER Milton Friedman (1912–2006) BEFORE 1911 Irving Fisher formalizes the quantity theory of money, which proposes that prices are directly related to the size of the money supply. 1936 John Maynard Keynes questions the effectiveness of policies to control the money supply. AFTER 1970s Robert Lucas develops models that assume “rational expectations.” 1970s–80s Many countries that “money matters.” Friedman The Great Depression saw millions adopt formal monetary believed that money affects of Americans migrate west in search of growth targets, by which output in the short run and prices work on farms. Milton Friedman blamed governments attempt to only in the long run. He argued the slump on the Federal Reserve’s control growth in the size of that monetary policy has a valuable reduction in the money supply. the money supply in order to role to play in managing the keep down inflation. economy: an idea now known the US, allowing or causing as monetarism. the quantity of money to fall W riting in the 1930s, John by more than one third. Maynard Keynes (p.161) In 1963, Friedman published argued that policies A Monetary History of the United Theory of consumption aimed at controlling the money States, 1867–1960 with his colleague Keynes’s case for government supply were often ineffective. He Anna Schwartz. They tracked the spending in a slump was believed that altering interest rates role of money in business cycles, based partly on his ideas about or the money supply did not affect finding that fluctuations in consumption. He argued that the economy in a predictable way. monetary growth preceded as people’s income rises, their Instead, governments could better fluctuations in output growth. consumption also goes up, but use fiscal policy—changing the In particular they attributed the not by as much. In a slump people mix of government spending Great Depression of 1929–33 to hoard money, which prolongs the and taxation—to protect against the incompetence of the Federal slump. State spending in such a unemployment or inflation. By 1945, Reserve, the central bank of his views were widely accepted. From the 1950s, however, US economist Milton Friedman began to challenge Keynes with the idea