The power of economic theory: Graphically illustrated

Good piece by Zaman on the relationship between economic outcomes and economic ideology. One can think of the period from the 1930s to the 1970s as the Keynesian era, and the period since then as the Chicago era (or, more accurately – though clumsily, the Monetarist-Rational Expectations-Real-Business-Cycle era). During the Keynesian era the share of wealth owned by the bottom 90% grew, while the share of wealth owned by the top 0.1% declined. Then, in the current Chicago era the patterns were reversed, with the bottom 90% seeing their share fall while the top 0.1% saw their share rise.

While I’m drawn to the implications suggested by this relationship, I’m not sure that causality is from ideology (or economic theory, if the suggestion that economic theory is ideological seems too extreme) to economic outcomes, mostly because the policies that account for the outcomes in both eras where not necessarily driven by theory. They were instead driven by changes in the balance of power that took place, and is still taking place, between capital and labor. The politics that emerged from that changing balance of power had a bigger impact on the resultant policies of the two eras than the arguments offered by Keynesian or Chicago economists.

The two different ideologies that came to dominate these two eras were more a reflection of the underlying power relationships than a causal force leading to the different policy regimes.

What’s more, while it’s true that economic ideology has gone through a transformation from Keynesianism to Chicagoism it’s a bit of stretch to suggest that Chicagoism was an outcast in the era of Keynes. True, Keynesian theory and policy were dominant in that era, but it was a type of Keynesianism that accepted, in principle, the Chicagoian belief in free markets.

The major difference between these two ideologies, in this regard, was that the Keynesians saw all kinds of imperfections and rigidities interfering with the free market’s ability to do its wonders, while the Chicagoians were confident that, in the real world, free markets move toward full employment. In short, both ideologies accepted the magic of the market. It was just that the Keynesians saw the need for policies that nudge the free market toward outcomes it’s prevented from achieving because of imperfections and rigidities, while the Chicagoians are convinced that real world markets do just fine, even in the presence of imperfections and rigidities.

The Keynesians were, and still are, unwilling to embrace the more radical conclusion arrived at by John Maynard; namely that, even if the free market system were purely competitive, there still would be no guarantee it would arrive at a full employment equilibrium.

For this reason, the Chicagoians were never quite the outcasts. This helps explain the ease with which their ideology was so quickly accepted in the 70s. It also helps explain why the economics of Keynes never moved to center stage.

The ideologies of the two eras never questioned the system’s ability to move toward that magical equilibrium. What instead happened was that the ideology that got the most play was the one most congenial to the structure of power of each corresponding era. But throughout both periods, the system’s capacity to move, of its own accord, toward full employment – even if only in principle – was never up to debate.

Real-World Economics Review Blog

from Asad Zaman and the WEA Pedagogical Blog

A near perfect graphical illustration of the power of economic theory is provided by the following graph; copied from RWER Blog

The impact of the roaring 20’s can be seen clearly as the shares of the bottom 90% drop steadily from 20% to around 13%, while the shares of the top 0.1% shoot up. The Great Depression led to a slew of regulations on banking, and also eventually the development and implementation of Keynesian ideas, which provide an economic rationale for government interventions to reduce unemployment. From 1930 to 1980, we see the rise of populist ideas, implementation of Keynesian theories, and the eclipse of Hayek and the Chicago School. After reaching a nadir in 1978, we see an upswing in the fortunes of the top 0.1%.

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About Mayo Toruño

Professor of Economics, Emeritus California State University San Bernardino
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