Differences in Economic Theories--or--How to Avoid Another Depression

John Maynard Keynes, British economist (1883–1946), developed the economic theory that has become predominant in most, if not all, modern economies.  This theory states that during recessions the government should borrow money to use in stimulating economic activity, such as public works and farm subsidies. 

Then when there is an economic upturn, the government should raise taxes to pay down the debt.  The problem has been that the political policy setters have not (with rare exception) raised taxes or cut spending in good times.  In fact, government debt has increased in good times as well.

Part of the complexity comes with the fact that high taxes draw off capital from its creative potential (profit, jobs, etc.) into what seems more and more like a black hole of consumer welfare and sometimes welfare for businesses. 

Keynesian economics warns against the practice of "too much saving" and "not enough spending" (underconsumption vs. consumption) in the economy, and it also supports considerable redistribution of wealth, when needed. Keynesian economics further concludes that there is a pragmatic reason for the massive redistribution of wealth: if the poorer segments of society are given sums of money, they will likely spend it, rather than save it, thus promoting "economic growth."

It was Keynes' "simple explanation" that was the cause of the Great Depression (for which he is most well-known).  His ideas spawned a slew of interventionist economic policiesand was based on a circular flow of money. One person's spending goes towards another’s earnings, and when that person spends her earnings she is, in effect, supporting another’s earnings. This "circle" continues on and helps "support" a "normal" functioning economy.

When the Great Depression hit, people's natural reaction was to hoard their money. However, under Keynes' theory this stopped the "circular" flow of money, keeping the economy at a standstill.  Keynes' solution to this poor economic state was to prime the pump. By prime the pump, Keynes argued that the government should step in to increase spending, either by increasing the money supply by printing more money, or by actually buying things on the market itself. 

Another analogy for "increased spending" is:  Can a drunk get sober by giving them more alcohol? 

Milton Friedman (1912-2006) was a professor at the Chicago School of Economics (a monetarist school of economics) for many years.  A great deal of his work was positive and promoted the growth of free markets, unfortunately some was negative.  During his early years as a young economist in the Treasury Department he helped design the income withholding tax as a means to increase the flow of government revenue.  His suggestion was accepted and implemented, and thus, we have the federal and state income tax of today.

In contrast, when Thomas Jefferson was president of the United States, he rejected the live-and-let-live type of physiocrat’s idea of a flat-tax on the land.  He advocated that all Americans should be absolutely un-taxed, and instead of having the citizens taxed to defray the costs of government, he implemented a very small import tariff, or tax, to be charged to foreigners to pay the costs of government. This helped promote his concept of a very limited size and scope regarding  government activity, leaving the citizens free to keep all the money they earned and decide what to do with their own money themselves.  This was a great success and contributed to the United States becoming a leader in prosperity.

Proponents of free-market capitalism, which supportes the exclusion of the public sector in the market and teaches that an unfettered market would achieve balance on its own, includes the Austrian School of economic thought, of which one of its earliest founders, Friedrich von Hayek (1899-1922) also lived in England alongside Keynes. The two had a public rivalry for many years because of their opposing thoughts on the role of the state in the economic lives of individuals.

Austrian economics isn't about government planning or statistical models. It's about human beings and the choices they make in the real world.  

“Economics is the study of how real people act to relieve dissatisfaction. For example, dissatisfied with the inconvenience of barter, folks start using more marketable goods for indirect exchange, a practice that eventually results in one or two commodities becoming the preferred medium of exchange, usually gold or silver….

“The 'health-care crisis' is a prime example of how 'the problems resulting from one intervention tend to lead to calls for other interventions to fix those problems.' While the hated HMOs are generally viewed as creatures of capitalism, these 'strange entities' are just a response to the soaring costs arising from the government-instituted system of third party payments.

"'We do not see AMOs in the automobile industry or CMOs in the computer business'...That insight cuts to the core of what is really going on. Auto dealers might also find their professional lives unbearable, just as many physicians do, if AMOs told them how to service their customers. But happily, the disease of third-party payments has only infected health care.

"On the issue of government subsidizing business to build things, the author of Economics for Real People: An Introduction to the Austrian School, Gene Callahan, quotes from a review by Newt Gingrich of a book about the transcontinental railroad, in which the former congressman celebrates the 'public-private partnership' without which 'the railroad could not have been built for another generation.' To which the Callahan responds, 'Gingrich simply assumes that a transcontinental railroad ought to have come before the alternatives that entrepreneurs might have created with those same resources.'" http://mises.org/store/Economics-for-Real-People-An-Introduction-to-the-Austrian-School-2nd-edition-P116C0.aspx

What's YOUR economic theory of how to resolve the $$ problems?  We welcome comments from all guests---as the saying goes, "Ideas never die."