Are Keynesian Economics and Neoclassical Economic Thinking Incompatible? Term Paper

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economics is derived from "oikonomikos," which means to be skilled in household management. Although the root word is very old, the discipline of economics as we understand it today is a relatively recent development. Modern economic theories emerged in the 17th and 18th centuries as the western world began its transformation from an agrarian to an industrial society. Despite the enormous differences between then and now, the economic problems with which society struggles remain the same. How does a nation balance the available resources with the demand on a regional, national, and now global scale in order to produce high levels of employment, and create real and lasting wealth which benefits her citizens? What is the motivating factor for workers to engage the economic struggle of building wealth? How does a nation provide, create and maintain a rising standard of living for ourselves and future generations?

Progress in economic thought toward answers to these questions tends to take small steps rather than to evolve smoothly over time because economics are most often governed by the old adage "if it works, doesn't fix it." Only when problems arise, or a set of new significant economic influences enter the market place do individuals become willing to change a complicated economic system. A new school of thought suddenly emerges as changes in the economy yield fresh insights and make challenge old ways of thinking. The new school eventually becomes the consensus view, only to be pushed aside by the next wave of new ideas, or brought into question by the next economic crisis. This process continues today and the motivating force behind the evolution of economic ideas remains the same as it was three centuries ago: to understand the economy so that we may use it wisely to achieve society's goals.

The dominant economic theory of the day is that of John Maynard Keynes. Keynes developed theories of 'demand side' economic controls, and his theories were chiefly influenced by the experience of the Great Depression, which affected not only the America's but Europe and Australia as well. Reacting to the severity of the worldwide depression, John Maynard Keynes in 1936 broke from the Classical tradition of a laissez-faire approach to government involvement with the economy, and published the General Theory of Employment, Interest, and Money. In order to fully understand Keynes, on must understand his work as a reaction to, or a response to the existing conditions of the economic slowdown which created the depression. His theories which have shaped the economic policy of democratic governments for the past 70 years may or may not have been founded in a sound approach to ongoing economic progress. Rather his view effectively brought government involvement into a lagging economy to revitalize it. However, the Keynesian theories have begun to decay in more modern times.

AS a response to his times, Keynes' theories must be understood in light of the dominant theory of his time, which was a classical economic theory. The classical view assumed that in a recession, wages and prices would decline and thus restore full employment. Because of lower prices for goods, individuals would be able to purchase more with their limited wages, and the economic cycle would reenergize itself. However the widespread nature of the depression had left individuals without any income for a long period of time, and therefore the economy did not have enough resources to jump start itself again. It needed investment before it could recover. Responding to the current economic reality, Keynes held that falling prices and wages, by depressing people's incomes, would prevent a revival of spending. As the global economy languished, his theories proved themselves.

Keynes insisted that direct government intervention was necessary to increase total spending by investing in the economy and thereby restarting the economic fires. Keynes' arguments created the basis for the modern rationale for the use of government spending and taxing to stabilize the economy. Under Keynes, government should spend money and decrease taxes when private spending was insufficient and threatened a recession. Government should reduce spending and increase taxes when private spending was too great and threatened inflation. Thus Government was to abandon the laissez-faire approach to economic activity and become a flywheel on the engine, preventing it from slowing down under great strain and restraining it from moving too fast during times of economic expansion. Keynes' analytic framework, focusing on the factors that determine total spending, remains the core of modern macroeconomic analysis.

Neo-Classical School

However, just as the classical theory encountered opposition when it proved unable to restart the economy from the collapse of the 1930's, Keynesian theory has encountered the same unexplained failures during recent years, giving rise to the return of a neo-classical philosophy of economic theory.

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The classical theory began with the publication in 1776 of Adam Smith's monumental work, The Wealth of Nations. The book identified that land, labor, and capital were the three factors of production that fueled economic engines. These three factors were the major contributors to a nation's wealth.

In Smith's view, the ideal economy was a self-regulating market system that automatically satisfies the economic needs of the populace thorough measuring supply and demand. He described the market mechanism as an "invisible hand" that leads all individuals, in pursuit of their own self-interests, to produce the greatest benefit for society. Smith rejected the idea that only agriculture was productive and recognized that individual labor was an asset to the country, as was manufacturing power. While Adam Smith emphasized the production of income, David Ricardo added to the theory and focused on the distribution of income among landowners, workers, and capitalists. Ricardo saw a conflict between landowners on the one hand and labor and capital on the other and he suggested that the growth of population and capital, pressing against a fixed supply of land, would push up rents and holds down wages and profits. Together with Thomas Robert Malthus' idea of diminishing returns that explained low living standards could continue in the face of continuing economic expansion, these three men accurately described the conditions which would bring about the depression.

However, after Smith, and after Keynes, a revival of the classical theories has become a strengthening force in economic policy which is being termed neo-=classical or supply side economics. Reintroduced in America by president Reagan, supply side economic focused on getting government out of the way of economic policy so that the forces which were accurately identified by Smith, Ricardo and Malthus can once again power the economy without government encumbrances. Milton Friedman could be said to be a modern Adam Smith, and is known worldwide for his belief in defending free-market capitalism. According to Friedman, and neo-classical thinking, free markets can most proficiently and impartially distribute wealth throughout a nation. Friedman has well founded suspicions of government interference in the business of a nation's economy because after 70 years of Keynesian policy, economic stability thorough the use of government regulation is stills an elusive and unattainable goal.

The problem with ongoing use of Keynesian theory by government is the motivation of the government and the motivation of the people begin to interfere with one another. According to Smith, and Friedman, the desire of individuals working for their own benefit creates conditions which benefit all the people, and benefit the individual. However, when government steps into the equation, while the numbers can work on paper, the motivations change. Government begins to make policy for its own benefit, and workers, becoming used to receiving benefits from government rather than from the work of their own hands, begin to depend on the government. Thus individuals have less motivation to engage in wealth producing activity as they turn their attention to government for the supply of their needs. The government is dependant on individuals to produce wealth in order to fund its own activity, and if people depend on government, the people will in effect cut off the supply line which feed the very organization on which they depend.

His suspicions are well founded, as can be understood from the spiral of codependency described above. Based on his belief in a limited government and that a capitalist economy free of government interference would provide the best choices for a consumer, Friedman inspired Reagan to test the theory by cutting taxes and cutting government spending in the 1980's which lead to the beginning of a global economic recovery. Economic activity increased because the government took itself out of the equation, and left more money in the hands of individual citizen. Thereby, government created incentive to work rather than incentive to be dependant. According to neo-classical thinking, the governments has a responsibility to keep a high standard of living through certain functions like defense, education, and public utilities and set certain laws regarding economic policy in order to keep in check the "game" of economics rather than be involved in attempting to redistribute wealth through social programs and higher levels of taxation. Besides serving this….....

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