Key insights and ideas for thirteen core topics in economics, organised by selecting the most relevant theoretical approaches per topic and contrasting them with each other.
This chapter provides a map through the complex jungle of economic theories. There are many different theoretical approaches, and each aspect of the economy has been analysed by a number of different ones. However, it is neither feasible nor productive for students to engage with every possible angle for every topic. Hence, the chapters on different topics, together with Building Block 8: Economic Theories, sets out an alternative approach: pragmatic pluralism. Rather than pursuing the extreme of either only focusing on one approach, or including every possible strand of thought for every topic, we propose a pragmatic middle ground: teaching a select number of approaches for each topic. In this way, it is possible to introduce students to the variety and diversity of economic thinking, whilst still having enough time and space to properly discuss each of the insights in detail with them.
“The central problem of depression-prevention [has] been solved for all practical purposes.”Robert Lucas (incoming address to the American Economic Association, 2003)
Booms and busts, academically known as ‘business cycles’, have been part of the economic system for a long time. Contrary to Lucas’ optimistic statement, they also remain one of the most central problems both to economic theory and policy. Old questions are still hotly debated. How do business cycles work? What causes the economy to sometimes crash or slump into recession, while at other times it cranks into the highest gear? What can be done to prevent crises and what should be done once the economy is in a depression or recession? An important debate in this field is whether the government is the solution or the problem, and whether the emphasis should be placed on the demand or supply side of the economy. Besides this, economists have analysed the impact of external shocks on the economy.
Main opposing perspectives
■ Post-Keynesian Economics: Effective demand is the crucial driver
■ Austrian School: Malinvestment is the crucial driver
Main complementary perspective
□ Neoclassical Economics: Crises happen because of external shocks
Additional perspectives and insights
+ Marxian Political Economy: Crises are inevitable and inherent to capitalism
Main opposing perspectives: Post-Keynesian economics vs Austrian school
A core insight of the Keynesian approach is that the private capitalist economy can be radically unstable and unable to recover by itself, staying stuck in long periods of high unemployment. This can be theorized as an underemployment equilibrium or disequilibrium, meaning that markets are not cleared and supply and demand do not meet. Contrary to then dominant laissez-faire ideas, Keynes argued markets would not automatically achieve full employment, even if markets had no imperfections and workers were fully flexible in their wage demands. Keynes, in particular, attacked the idea that “supply determined its own demand”, often referred to as ‘Say’s Law’, and built on earlier underconsumption theories. The key idea in Keynesian thought is that business cycles happen, instead, because of fluctuations in effective demand, which refers to demand backed by money and mainly depends on fundamentally uncertain investment decisions and animal spirits. Keynesians further argue that effective demand can be stabilized, and persistent high unemployment can be eradicated by counter-cyclical fiscal and monetary policy. With the Keynesian family of approaches, there are multiple specific models of how business cycles develop and should be tackled. There were, for example, two (complementary) post-Keynesian approaches, Minsky’s financial instability hypothesis and Godley’s stock‐flow‐consistent approach, which were used to explain and predict the financial crisis of 2008 (Keen, 2015). The Minsky approach focuses on the mechanisms of debt accumulation, speculation and financial crises, and the Godley approach is about following economic flows and stocks throughout the whole economic system and modelling them consistently.
The Austrian school, in contrast, contends that the problem is not the private capitalist economy, but the state. More specifically, they argue that a key cause of crises is that central banks set interest rates too low. By setting rates too low, central banks create excessive bank credit, which leads to bad investments, referred to as malinvestments, and therefore must end in a bust. Monetary policy by central banks thus prevents markets from reaching their equilibria as relative prices and capital allocation are assumed to no longer correspond to the preferences of individuals. Austrian economists argue that if there would be no government interference in the private capitalist economy, there would be no instability and markets would efficiently and smoothly self-regulate.
Main complementary perspective: Neoclassical economics
While the above two approaches investigate the origins and mechanisms of economic crises, neoclassical economics treats crises as being caused by external, or exogenous, shocks. These shocks come from outside of the economic system as modelled by neoclassical economists: factors such as natural disasters, wars, technological inventions, international or political developments. Most research and debates within neoclassical economics, therefore, focuses on how the impact of such shocks on the economy should be modelled.
A key point of argument is, for example, whether one should include various market imperfections. In new classical macroeconomics and real business cycle theory there are no market imperfections, while in new Keynesian macroeconomics and the new neoclassical synthesis, which combines the other three approaches, market imperfections are assumed. All these approaches share, however, assumptions such as hyper-rational and far-sighted expectations, and work from a neoclassical microfoundations and general equilibrium framework.
While all neoclassical macroeconomic approaches have a clear shared foundation of theoretical assumptions, there also are important differences. Some subschools are more interventionist, like new Keynesian macroeconomics and neo-Keynesian macroeconomics with its famous IS-LM model. Other subschools are more laissez-faire, such as new classical macroeconomics, real business cycle theory and monetarism.
Additional perspectives and insights
Marxian political economists argue that booms and busts are an inevitable and inherent element of capitalism, which can only be solved by getting rid of the capitalist organisation of production. Within Marxian political economy, as well as in classical political economy, there are economists who adhere to the underconsumption theory and those who argue against it. The core idea of underconsumption theory is that capitalism has an inherent tendency to expand production capacity faster than it generates effective demand, thereby resulting in underconsumption and causing the system to periodically experience crises. For this reason, various underconsumption theorists argued capitalism relies upon external sources of demand to grow and otherwise stagnates, thereby giving rise to international tensions through trade and imperialism. Marx opposed this idea, arguing that capitalism is an inherently growing system driven by profitability. The reason for recurring crises, according to Marx, is that profitability has a tendency to fall in the long-run. This in turn puts extra pressure on capitalists to cut labour costs through mechanisation, reducing wages, and/or offshoring, thereby intensifying class struggle.
Within Marxian thought, the idea of underconsumption has had politically diverse groups of proponents and opponents, with Malthus, Sismondi, Luxemburg and Sweezy arguing for it and Ricardo, Say, Marx and Lenin arguing against it.
Other: Empirical work. Finally, it must be mentioned that besides these various theories about business cycles, there is a long tradition of empirical research, performed by a broad range of economists such as the institutional economist Wesley Clair Mitchell, that has resulted in a number of robust findings. Various economists, such as Schumpeter, have tried to develop a typology of business cycles according to their periodicity and characteristics: the Kitchin inventory cycle of 3 to 5 years; the Juglar fixed-investment cycle of 7 to 11 years; the Kuznets infrastructural investment cycle of 15 to 25 years; and the Kondratiev wave, or long technological cycle, of 45 to 60 years.
Chapters & Papers:
- Economics After The Crisis by Irene van Staveren, from 2015, chapter 10. This well-written textbook sets out the neoclassical, post-Keynesian, social economic and institutional perspectives on macroeconomic flows in a single chapter, side-by-side.
- The Economy by The CORE Team, from 2017, chapters 13 & 17. This successful textbook introduces students to economic fluctuations and their history.
- Introducing a New Economics by Jack Reardon, Maria A. Madi, and Molly S. Cato, from 2017, chapter 14. This ground-breaking textbook introduces recessions and financial crises and weaves together pluralist theory and real-world knowledge.
- Principles of Economics in Context by Jonathan Harris, Julie A. Nelson and Neva Goodwin, most recent edition from 2020, chapter 24. This useful textbook, which pays particular attention to social and environmental challenges, contains a chapter on economic fluctuations.
- Macroeconomics by William Mitchell, L. Randall Wray, Martin Watts, from 2019, chapter 26. This ground-breaking and much-discussed textbook written by three leaders of Modern Monetary Theory (MMT), contains a useful chapter setting out different economic theories of crises.
- Capitalism: Competition, Conflict, Crises by Anwar Shaikh, from 2016, chapters 12, 13, 14, & 16. This impressive and extensive book compares multiple perspectives on many traditional economic topics including business cycles.
- The Routledge Handbook of Heterodox Economics: Theorizing, Analyzing, and Transforming Capitalism by Tae-Hee Jo, Lynne Chester, and Carlo D’Ippoliti, from 2017, chapter 26. This broad and diverse book sets out a variety of theories on business cycles.
- Alternative Ideas from 10 (Almost) Forgotten Economists by Irene van Staveren, from 2021, chapters 1-4. This book emphasizes often ignored and neglected ideas and contains chapters on the ideas of Minsky, Keynes, Marx and Knight on crises, debt, demand, capitalism, risk and uncertainty.
- Post Keynesian theories of crisis by Steve Keen, from 2015. A useful article describing the two (complementary) theories, Minsky’s financial instability hypothesis and Godley’s stock-flow-consistent approach, that were used to predict and explain the financial crisis of 2007-8.
- A Reformulation of Austrian Business Cycle Theory in Light of the Financial Crisis by Joseph T. Salerno, from 2011. Written in the aftermath of the financial crisis of 2007-8, this paper aims to revitalize the Austrian theory of business cycles by building on ideas of Mises, Hayke and Rothbard to explain the events of the last decades.
- Business Cycle Economics: Understanding Recessions and Depressions from Boom to Bust by Todd A. Knoop, from 2015. This book introduces students to what business cycles are and why they are relevant, the different theories that aim to explain them, the relationship with the financial sector, and the older and more recent history of crises.
- Modern Macroeconomics: Its Origins, Development and Current State by Brian Snowdon and Howard R. Vane, from 2005. This book sets out key macroeconomic ideas with chapters on Keynes and the classics, as well as the monetarist, new classical, new Keynesian, Post Keynesian, Austrian and public choice perspectives, and includes interviews with their key thinkers.