Healing the Dismal Science

Perhaps the most obvious feature of modern-day macroeconomics is the great Keynesian-Neoclassical divide.  Although it is a subject that is sure to turn up in any econ 101 course, I’ll provide a brief (if not crude) summary of the basics of each theory here:

Keynesian Economic Theory

  • Demand-focused & “consumer-oriented”
  • Advocates for active fiscal policy to combat recessions (cut taxes/increase gov. spending to boost aggregate demand)
  • Believes there is a “multiplier effect” of spending, including government spending (e.g. active fiscal stimulus can produce self-sustaining virtuous economic growth)
  • Highlights notions of excess capacity and full employment

Neoclassical (Supply-Side) Economic Theory

  • Supply-focused & “business-oriented”
  • Advocates for limited government to boost economy (e.g. cut taxes/trim regulations to boost supply of goods & services)
  • Places emphasis on incentives to save & invest

For years, especially since the Great Depression, macroeconomists have been split as to which theory best explains macroeconomic behavior and produces the best macroeconomic outcomes.  Although there have been periods of “consensus” (e.g. the postwar “Keynesian Consensus” from the 40’s to the 70s and a neoliberal “Washington Consensus” from the 80s up until 2008), divisions have been apparent for nearly a century.

Having studied the economic history of the nation and the pros and cons of each theory, I am left wondering: why must we accept only one theory to explain all macroeconomic behavior and to implement rigid pre-prescribed solutions for every economic situation?  After all, in my opinion, both theories have substantial vices and virtues, and both work well in different situations and for different objectives.  For example, Keynesianism appears to well when there are significant demand shortfalls (accompanied with a large excess capacity or low inflation).  I view it as the “short-term” theory as well, because it intends to boost consumer & business demand immediately.  However, when it comes to structural issues in an economy and promoting long-term growth, neoclassical supply-side solutions seem to work well.    It helps to alleviate supply shortfalls (which are usually accompanied with little excess capacity or higher inflation).  I view it as the “long-term” theory, as by increasing incentives to save and invest, it boosts productivity, which grows the economy in the long-term.

Even when one theory is better suited to address a specific situation, I don’t see why both theories can be implemented simultaneously.  Take today’s economic situation.  Almost 4.5 years after the 2007-2009 “Great Recession” ended, the United States still remains mired with low aggregate demand and enormous excess capacity (accompanied with high unemployment and very low inflation).  I am of the opinion that, in general, continued Keynesian short-term stimulus might be a feasible economic prescription (disregarding the role of public debt, which I’ll get to later).  However, there is no reason why we can’t simultaneously institute supply-side reforms now to boost long-term growth.  For example, I am of the opinion (as are many economists) that the healthcare sector is incredibly over-regulated.  Barriers to the supply of health care services include state prohibitions to sell insurance across state lines, underfunding of Medicare/Medicaid reimbursements, the threat to doctors of medical malpractice suits and new ObamaCare health insurance regulations that mandate that plans cover “essential services”.  If we were to lift state prohibitions on the out-of-state sale of health insurance, moderately boost funding for Medicare/Medicaid reimbursements, implement medical malpractice reform and lower or repeal ObamaCare health insurance benefit mandates, we could help to solve some of the healthcare sector’s supply problems, lower premiums, and boost growth prospects for that sector and the economy as a whole.  And that’s just for one sector.

My point is, we need to stop this zero-sum mentality in economics that one theory must be right while the other is wrong.  Only then can the “dismal science” finally begin to heal.  

 

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