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