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 state is often at the heart of public and intellectual debates about the economy, as the amount of contrasting perspectives below shows. This should be no surprise: governments are the biggest single actors in the economy, whether measured in employment or in total budget. How should these economic giants behave? Should they sit back and allow the economy to unfold on its own, merely providing an efficient level playing field for private actors through rule-based policy? Or should the state play a more active role to stabilise the economy, take an entrepreneurial role to spur innovation, and/or pursue social policies to ensure the wellbeing of its citizens?
Main opposing perspectives
■ Post-Keynesian economics: Discretionary policy works best
■ Neoclassical economics: Rule-bound policy works even better
Main complementary perspective
□ Evolutionary economics: The entrepreneurial state
Additional perspectives and insights
+ Behavioural economics: Nudging
+ Complexity economics: Modern economies require diverse and flexible policy tools
+ Historical school: Social policy takes the sharp edge off capitalism
+ Marxian political economy: Class struggles play out through the state
+ Classical political economy: Night-watchman state
+ Austrian school: Dispersed knowledge precludes effective government intervention
+ Other: The economic dimension of governments in political science
Main opposing perspectives: Post-Keynesian and neoclassical economics
A key debate concerning the state is between (post-)Keynesian economists, who argue for discretion in economic policy, and neoclassical economists, who argue for rule-bound policy. Keynesian economists argued the state has a role to fulfil in the economy because it is the only actor that can successfully solve economic problems such as mass unemployment. The state can provide stability and freedom by creating and adjusting policies in a discretionary manner, mainly with regard to fiscal policy to influence effective demand.
Neoclassical economists, on the other hand, often argue that the state should focus on providing a framework in which private actors can operate. Policy should be rule-bound, also known as commitment policy. Instead of relying on expert and political judgement of the specific situation, a prescribed mathematical model should be ollowed (i.e. the Taylor rule). As such, only the factors included in the model have an influence on decisions. This is important because neoclassical economists, and more specifically public choice theorists, warn us about government failures, which are assumed to derive from self-interested behaviour of voters, politicians and bureaucrats and/or imperfect information.
A core idea in the neoclassical framework is what is often called ‘sound finance’. Simply put, it means governments should run balanced budgets, with revenues equalling expenditures. This stands in opposition to the Keynesian idea of ‘functional finance’, which argues public finance should not be a goal in itself but merely a means through which to achieve economic and social goals. The latter idea is also associated with Modern Monetary Theory, which combines functional finance with the chartalist state theory of money, to argue that (monetary sovereign) governments face no inherent financial restrictions on their finances, although they do face important limits in the real economy. While neoclassical economists favour central bank independence and a disconnect between fiscal and monetary policy, modern monetary theorists argue for using fiscal and monetary policy in harmony to create desired economic outcomes.
Main complementary perspective: Evolutionary economics
Another insight that has gained greater attention recently is that the state is crucial for innovation. Contrary to the myth that prosperity is the result of new technologies developed and funded purely by private companies operating in a free market, Mariana Mazzucato and others have used an evolutionary approach to show how economic success is largely the result of state-funded investments in innovation. Mazzucato argues that the dominant neoclassical view of the state as an actor that is only there to address market failures and provide public goods is fatally limited. She points out that governments create, shape and guide markets, and also should embrace this ability to give direction to the economy. For this reason, she has advocated mission-oriented policy in which a clear goal is formulated, experimentation and risk-taking are encouraged, dynamic capabilities are cherished, budgets are based on (achieving) outcomes, collective value creation is recognised, risks and rewards are shared, the public, private and civic organisations partner in a symbiotic rather than parasitic way, and democratic participation in decision-making is central. In this way, a mix between top-down guidance and facilitation, and bottom-up initiatives and participation, is created to solve the big problems of the day.
Additional perspectives and insights
Classical political economy: The discipline of economics is often said to have started with the arguments of classical political economists against mercantilist ideas and policies, which aimed at increasing national economic power through running a trade surplus. Classical political economy argued, instead, that the state should have the limited role of a night-watchman, which secures external defence and the rule of law, in particular the protection of property rights and enforcement of contracts. Today, many people and economists still advocate this. Many classical political economists, however, also recognise that the state should provide services which the market is not well-suited to deliver, such as infrastructure, postal services, standard weights and measures, and a stable currency. A key logic behind the night-watchman state is to eliminate the rents that various powerful special interest groups were able to acquire through the mercantilist state.
Marxian political economists built on classical political economic ideas but came to a starkly different conclusion and argued against the idea that the state can be a neutral passive organisation that ensures that private individuals can flourish in a fair economy. Marxian scholars see the state as an indispensable tool for class domination, which protects the wealth of the rich and punishes the poor if they do not accept the inequalities. The similarities with classical political economists in this regard are surprising. Adam Smith (1776, p. 299), for example, wrote “Civil government, so far as it is instituted for the security of property, is in reality instituted for the defense of the rich against the poor, or of those who have some property against those who have none at all.” Instead of advocating for free trade and laissez-faire as classical political economists do, Marxian political economists argue that in order to end the exploitation and suppression of the working class, the working class has to seize control over the state and undue class domination.
Historical school: Largely in reaction to the problems associated with the industrial revolution, such as child labour, poor working conditions and low standards of living, historical economists argued that the state should ensure through social policy that the national community was flourishing, instead of falling apart. As such, they oppose both laissez-faire liberals, who viewed society as the total sum of individuals and favoured a night-watchman state, and socialists, who emphasised class conflict and aimed to overthrow the capitalist economic system. Although social policy was initially conceived in this way, largely thanks to the innovative work of the Verein für Socialpolitik in Germany during the late 19th and early 20th century, it has since been argued for and thought of in many different ways. Within Germany after the second world war, for example, ordoliberal thinking and the concept of the social market economy were influential. In this line of thinking, both planning and free markets are rejected, in favour of the combination of a capitalist economy with a strong state that ensures fair market competition as well as a social welfare system. More recent research indicates that government spending on social policies not only enhances the wellbeing of citizens, but also stimulates the economy and productivity.
Austrian school builds on the classical idea of the minimalist night-watchman state and argues that if governments go beyond this limited role, they will cause, rather than solve, problems. A key reason for this is that knowledge is necessarily dispersed, leaving central authorities with a lack of information needed for effective action. Instead, ‘free’ markets are seen as the best way to communicate the local knowledge of individuals to create efficient economic outcomes. Austrian economists thus embrace the classical liberal idea of protecting “negative liberty” and ensuring freedom from government intervention, while they reject the social liberal idea that the government should guarantee people’s “positive liberty” and enable them to be able to act upon their free will.
More recent contributions to thinking about government policy come from behavioural and complexity economics.
Behavioural economics sees people as susceptible to manipulation in their decision-making. People’s bounded rationality causes suboptimal choices that do not maximize their welfare, thus creating ‘internalities’. To tackle this issue, governments can nudge people towards more ‘rational’, or desirable, behaviour by making use of behavioural insights into social proof heuristics, default bias, salience, positive reinforcement, and indirect suggestions. The underlying political philosophy of this policy approach is often called libertarian paternalism, as it pushes people in a direction that is deemed as desirable by the authorities, without hurting the freedom of choice of individuals.
Complexity economics, on the other hand, focuses on the fact that policy tries to influence complex and dynamic systems, and therefore argues that governments should pay more attention to the unexpected consequences of policies. Complexity economists believe that policy tools need to be diverse and flexible enough for the systems that they try to control, so that adaptation and the learning process can work more effectively.
Other: Quite naturally, political economists and political scientists have extensively studied governments and their economic roles. In doing so, many important approaches within political science, such as realism and constructivism, have also played a major role in analysing the economic dimension of governments. An important topic here is to what extent companies are in practice regulated by the state, and the influence that companies have on the rules and regulation that they are subject to. Furthermore, political economists study economic policy more broadly, from how the dynamics of political competition influence policy decisions, to the influence of experts and the internal structures of government institutions.
- Economics: The User’s Guide by Ha-Joon Chang, from 2014, chapter 11. This brief and accessible pluralist book contains a useful introductory chapter on the role of the state.
- Economics After The Crisis by Irene van Staveren, from 2015, chapter 6. This well-written textbook sets out the neoclassical, post-Keynesian, social economic and institutional perspectives on the state.
- The Economy by The CORE Team, from 2017, chapters 14, 15 and 22. This successful textbook provides an introduction into mainstream ideas and empirical findings on fiscal, monetary and public policy.
- Principles of Economics in Context by Jonathan Harris, Julie A. Nelson and Neva Goodwin, most recent edition from 2020, chapters 12 and 25. This useful textbook, which pays particular attention to social and environmental challenges, devotes two chapters to tax and fiscal policy in specific.
- The Microeconomics of Complex Economies: Evolutionary, Institutional, Neoclassical and Complexity Perspectives by Wolfram Elsner, Torsten Heinrich, and Henning Schwardt, from 2014, chapter 17. This innovative textbook makes readers familiar with new insights coming from frontier mainstream economic research, with one chapter devoted to the policy implications of the findings discussed in the book.
- Macroeconomics by William Mitchell, L. Randall Wray, Martin Watts, from 2019, chapters 20, 21, 22 and 23. This ground-breaking and much-discussed textbook written by three leaders of Modern Monetary Theory (MMT), describes in detail the history of economic thinking about the state and macroeconomy as well as recent theoretical and policy debates.
- The Handbook of Economic Sociology by Neil J. Smelser and Richard Swedberg, from 2005, chapters 22, 23 and 24. This extensive and yet accessible book for non-sociologists, provides an impressive and useful overview of the field of economic sociology, including three chapters on the role of the state in the economy.
- The Entrepreneurial State: Debunking Public vs. Private Sector Myths by Mariana Mazzucato, from 2013. An influential and well-written book, inspired chiefly by evolutionary economics, on the role of the state in innovation.
- Alternative Theories of the State by S. Pressman, from 2006. A useful and informative collection of essays which introduces readers to the institutional, Marxist, post-Keynesian, feminist and behavioural perspectives on the state.
- Money and Government: The Past and Future of Economics by Robert Skidelsky, from 2018. This well-written and insightful book introduces readers to historical and current debates about the state, with particular attention to neoclassical and Keynesian ideas.
- Political Economy: The Contest of Economic Ideas by Frank Stilwell, most recent edition from 2011. A well-written textbook, with parts devoted to classical, Marxist, neoclassical, institutional, and Keynesian economics and particular attention to ideas surrounding the state, reform, policy and economic systems.
- Routledge Handbook of International Political Economy by Mark Blyth, from 2009. A useful and extensive book which provides an overview of the wide field of international political economy with particular attention to its North American, British, and Asian branches.
- Frontiers of Heterodox Macroeconomics by Philip Arestis and Malcolm Sawyer, from 2019. A useful collection of essays on recent insights coming from unconventional thinkers, and in particular post-Keynesian economists.
- Handbook of Public Economics, Volume 5 by Alan J. Auerbach, Raj Chetty, Martin Feldstein, and Emmanuel Saez, from 2013. Another useful collection of recent insights coming from mainstream economists on topics, such social insurance, charitable giving, urban public finance, and taxing labour, wealth, and internationally.