Political Economy:

Keynesianism
and the liberal paradigm
Lecture structure

Keynesianism Neoliberalism

13:45 – 14:00

13:00 – 13:45 14:00 – 14:45

Break
Micro vs. macroeconomics
• Microeconomics: concerned with how supply and demand interact in
individual markets.
• The subject is typically a single market, consumers (consumer demand
theory), or firms (production theory).
• Applications are numerous and easily recognizable in the real world:
• Trade, industrial organization, labor markets, financial markets, etc.

• These can still involved government decision making:

• E.g., effects of minumum wage, taxes, price supports, market power for monopolies, etc.
Micro vs. macroeconomics
• Macroeconomics: the study of the economy as a whole, and how it works.
• What people mean when they talk about “the economy.”
• Unit of analysis is often a nation.
• The government is a major player in macro, as are other governments.

• Deals with large, aggregate relationships:

• National income and national savings.
• National income in the long run
• Deviations from equilibrium and the short run and how to design policies to stabilize national
economies (i.e., large fluctuations in growth and prices).
• Recognizes failures of the market economy and the role of government in
correcting them.
Some building blocks
• What is GDP?
• Often considered the best measure of how well the economy is performing.
• Two ways to look at GDP:
1. The total income of everyone in the economy.
2. The total expenditure on the economy’s output of goods and services.
The market value of all final goods and services produced within an economy in a
given period of time.

Y = C + I + G + (X − M)
GDP Consumption Investment Govt. spending Net exports
Tools of macroecomomics
• Fiscal policy tools
• Government spending
• Taxation
• Monetary policy tools
• Interest rates
• Expansionary (stimulating economic activity and increasing employment
and inflation)
• Increase spending, decrease taxes, decrease interest rates
• Contractionary (dampening economic activity and decreasing employment
and inflation)
Keynesianism
• Partially reconciled opposing views of
capitalism:
• Efficiency of the market economy vs.
its shortcomings, particularly episodes
of massive unemployment.

• To Keynesians, aggregate demand is

volatile and market economies experience
inefficient macroeconomic outcomes.
• Recessions when demand is low and
inflation when demand is high.

• Therefore, government intervention

through public policies that aim to achieve
full employment and price stability are
justified.
Keynesianism

• “If we discovered that space

aliens were planning to
attack, and we needed a
massive build-up to counter
the space alien threat, and
inflation and budget deficits
took secondary place to that,
this slump would be over in
18 months.”
Paul Krugman --- Nobel Prize winning economist,
2008.
Keynesianism
• According to Keynesian economics, state intervention is necessary to
moderate the booms and busts in economic activity.
• Inadequate overall demand could lead to prolonged periods of high
unemployment.

• Primarily guided by the private sector but with activist government

intervention to smooth business cycles of utmost importance.
• Pre-Keynesian view: government budgets should be balanced
Countercyclical economic policies
• When the economy is running too hot and there is high inflation:
• Raise taxes to decrease consumption.
• Raise interest rates to decrease investment.
• This will typically create a budget surplus.
• When there is a recession:
• Increase government spending (and deficits) to stimulate employment and stabilize wages.
• Reduce interest rates to increase investment.
• This will typically create a budget deficit.
• Governments should do this proactively and in the short run, not wait to long-run
equilibrium to reappear.
• “In the long run, we are all dead.” – John Maynard Keynes

• Does not mean government should constantly intervene, but should in times of crisis, and
in proportion to the crisis at hand.
Keynesianism
• Dream scenario for Keynesians is:
1. No business cycles (i.e., booms and busts).
2. Low and stable inflation.
3. Low unemployment
4. Trend of high productivity and real GDP per worker.
• But goals 2 and 3 are in conflict.
• And decision is not just academic.
• After 1980s downturn, US Fed engaged in expansionary macroeconomic policy.
Bundesbank, afraid of inflation, did not.
Phillips
curve
 Milton Freidman’s
contribution

Phillips
curve
Source:
Smith, G. “Japan’s Phillip’s curve looks like
Japan”
Source:
Smith, G. “Japan’s Phillip’s curve looks like
Japan”
Critiques of Keynesianism
• Austrian School of Economics
• Business cycle is natural and government intervention only makes it worse.
• 1970s “stagflation”
• High unemployment and high inflation? What now?
• New classical economics
• Keynesians, you’re too obvious.
• Rational market actors therefore anticipate the changes and counteract them.
• Today, some would argue there is a newer “consensus” in which households
and firms have rational expectations, but market failures that require
government intervention also exist.
Keynesianism comes roaring back
• Great Depression
• Keynes argued for reducing interest rates and using government spending on
infrastructure.
• 2007-2008 financial crisis (aka Great Recession)
• USA:
• 2008 Emergency Economic Stabilization Act
• 2009 American Recovery and Reinvestment Act (spending and tax cuts)
• Interest rates cut to zero
• Japan: Stimulus equal to 5% of GDP
• EU stimulus plan and individual country plans
Keynesianism comes Survey of economists: “Because of the ARRA, the U.S.
roaring back? unemployment rate was lower at the end of 2010 than it
would have been without the stimulus bill.”

• The capacity of the state to implement

Keynesian economic policies is dependent
upon political will.
• Example: 2009 American Recovery and
Reinvestment Act (ARRA)
• 0 Republican members of the US
House of Representatives and 3
Republican members of the US
Senate voted for.
• CARES Act
• Largest economic stimulus in US history.
An aside: the political business cycle
• How might Keynesian economic ideas be abused by politicians?
• Politicians might increase government spending and decrease taxes before elections
to improve the economy, then decrease spending and increase taxes after elections.
• This is called the “political business cycle.” (Nordhaus 1975)
• Is the political business cycle real?
• “There are… clear electoral effects on macroeconomic variables. However, at least
for the opportunistic model in developed countries, there is much less hard evidence
than both the theoretical models and the conventional wisdom about the prevalence of
"election-year economics" would suggest.”
• Alesina, Roubini, and Couhen (1997) find no empirical evidence for the political
business cycle across a sample of 18 OECD countries.
15-minute break
Milton Friedman
• Classical liberal

• Won the Nobel Prize in Economics in 1976

• For work on monetarism, not his ideas in
Capitalism and Freedom.
• But Capitalism and Freedom has arguably had a
larger impact on political leaders, public opinion,
etc.

• Friedman sought to revive a market-liberal tradition to

counter socialism, both in the extreme form of Eastern
European communism and in the more moderate form
of the Western European welfare state.
• “The advocacy of ‘democratic socialism’ … is a
delusion.”
Milton Friedman
• Economic freedom as a critical component of freedom, and therefore
one that should not be limited.
• Example: the government “forcing” you to pay into a retirement fund is
depriving you of your economic freedom.
• Capitalism is therefore a “necessary condition for political freedom” because it
allows for freedom of choice.
• Absense of coersion in both economic and political matters is a defining
characterstic of freedom for Friedman.

• “Underlying most arguments against the free market is a lack of belief

in freedom itself.”
Milton Friedman
• How does capitalism provide freedom in Friedman’s view?
• Reduces the number range of issues that must be decided through political means.
• It serves as a check on political power.
• It allows ideas to spread as long as you have the funds to spread them (i.e., makes
dissent easier).
• It allows individuals to earn a living regardless of other beliefs.
• It reduces discrimination.
• Consumer is protected from coercion by a seller because there are other sellers.
• Employees protected from coercion by employers because there are other employers.
Market liberals acknowledge role of
government
• “The consistent liberal is not an anarchist”
• Not just Friedman
• E.g., one of his predecessors and influences, Friedrich Hayek
• The Road to Serfdom
• Competition requires legal foundations and government regulations.
Milton Friedman: Role of government
• “Determine, arbitrate, and enforce the rules of the game.”
• Remember this? What are the ‘rules of the game’ of a society called?

• For Friedman, capitalism requires that the government:

• Prevents one individual for coercing another
• Enforces laws and contracts
• Protecting property rights
• Manages money
Milton Friedman: Role of government
• “We may also want to do through government some things that might
conceivably be done through the market but that technical or similar
conditions render it difficult to do in some way.”
• Monopoly
• Neighborhood effects (i.e., externalities)
Monopoly
• A market with an absence of competition.
• Monopoly sells goods for which no close substitute exists and which they can
therefore sell at a higher price than would multiple firms in competition.
• When a company has little to no competition and can therefore set its own terms and
prices. Monopolies can also price discriminate.
• How does monopoly arise?
• Abuse of market power
• Prohibitive costs of entry
• Ownership of all inputs
• Collusion
Natural/technical monopoly
• Sometimes it is technically more efficient to
have a single producer.
• Often arise due to high start-up costs.

• Demand within a relevant market can be

satisfied at lowest cost by one firm rather
than more
• Typical examples:
• Public utilities such as water, electricity,
railways, telecommunications, mail, etc.
• Natural monopolies require regulation to
avoid abusing market power and setting
extreme prices.
 Neighborhood
effects/externalities
• Friedman accepts need for government to regulate externalities:
• But as usual, to the most limited possible degree.
• “When government engages in activities to overcome
neighborhood effects, it will in part introduce an
additional set of neighborhood effects by failing to charge
or compensate individuals properly.
• E.g., should tax or prohibit someone from polluting a river.
• But he thinks, e.g., a nature reserve, could be privatized.
• “If the public wants this kind of an activity enough to pay
for it, private enterprises will have every incentive to
provide such parks.”
 Price supports for agriculture
Milton Tariffs

Friedman: Government control of output

Rent control
Where Minimum wage

government Most regulation of industries

Control of what can be said on TV or radio
has gone too Government-run or mandated retirement programs

far in Licensensure requirements (e.g., liquor license)

Public housing
economic Military conscription

matters National parks

Toll roads
Do modern economists
agree? “Freer trade improves productive efficiency
and offers consumers better choices, and in the
• Price supports for agriculture long run these gains are much larger than any
• Tariffs effects on employment.”
• Government control of output
• Rent control
• Minimum wage
• Most regulation of industries
• Control of what can be said on TV or radio
• Government-run or mandated retirement
programs
• Licensensure requirements (e.g., liquor
license/alcoholvergunning)
• Public housing
• Military conscription
• National parks
• Toll roads
Do modern economists
agree? “Local ordinances that limit rent increases for
some rental housing units have had a positive
• Price supports for agriculture impact over the past three decades on the
• Tariffs amount and quality of broadly affordable
rental housing in cities that have used them.”
• Government control of output
• Rent control
• Minimum wage
• Most regulation of industries
• Control of what can be said on TV or radio
• Government-run or mandated retirement
programs
• Licensensure requirements (e.g., liquor
license/alcoholvergunning)
• Public housing
• Military conscription
• National parks
• Toll roads
Do modern economists
agree? “The distortionary costs of raising the federal
minimum wage to $9 per hour and indexing it
• Price supports for agriculture to inflation are sufficiently small compared
• Tariffs with the benefits to low-skilled workers who
can find employment that this would be a
• Government control of output
desirable policy.”
• Rent control
• Minimum wage
• Most regulation of industries
• Control of what can be said on TV or radio
• Government-run or mandated retirement
programs
• Licensensure requirements (e.g., liquor
license/alcoholvergunning)
• Public housing
• Military conscription
• National parks
• Toll roads
Do modern economists
agree? “Regulating the leverage and
liquidity of non-bank
• Price supports for agriculture financial intermediaries
• Tariffs would substantially improve
financial stability.”
• Government control of output
• Rent control
• Minimum wage
• Most regulation of industries (“another
example is detailed banking regulation”)
• Control of what can be said on TV or radio
• Government-run or mandated retirement
programs
• Licensensure requirements (e.g., liquor
license/alcoholvergunning)
• Public housing
• Military conscription
• National parks
• Toll roads
Do modern economists
agree? “There are net social benefits
to adjusting retirement ages
• Price supports for agriculture for state-financed pension
• Tariffs systems upwards, so that
revised retirement ages better
• Government control of output
reflect longer life
• Rent control expectancies.”
• Minimum wage
• Most regulation of industries
• Control of what can be said on TV or radio
• Government-run or mandated retirement
programs
• Licensensure requirements (e.g., liquor
license/alcoholvergunning)
• Public housing
• Military conscription
• National parks
• Toll roads
Milton Friedman: Role of government
• Negative income tax
• Give people a % of the difference between their income and an income cutoff.
• E.g., if the income cutoff was set at €40,000, and the negative income tax percentage was 50%,
someone who made € 20,000 would receive € 10,000 from the government. If they made €
35,000, they would receive $2,500 from the government. Friedman thought of this as a better
system than welfare.
• Just give people cash instead of conditional welfare benefits.
• E.g, instead of Healthcare allowance (Zorgtoeslag), Rent benefit (Huurtoeslag), Children’s
allowance (kinderbijslag), Unemployment benefit (WW uitkering).

• How does this differ from the modern-day idea of UBI?

• With UBI everyone receives the same amount of money, regardless of income level.
Milton Friedman: Role of government
• Is it empirically supported?
• Multimillion-dollar field experiments in the United States in the 1960s and
1970s were implement to measure its effects on labor supply.
• Experiments found that the effects of the negative income tax on labor supply
may differ across places, across groups and across time.
• So, it’s not clear that it necessarily discourages work, which is often the
biggest criticism of such a policy.
Was Milton Friedman influential?
• We know Marx was influential: his ideas sparked revolutions.

• In a way, so did Milton Friedman’s

• Strongly influenced US president Ronald Reagan and British PM Margaret Thatcher
Was Milton
Friedman
influential?
Was Milton
Friedman
influential?
Privatization
• UK 1980s
• British Airways, British Telecom, British Gas, British Rail

• Japan
• Japan Rail, Nippon Telephone and Telegraph, Japan Post (ongoing)

• In the United States, telecoms, railroads, electrical power generation

and transmission, gas distribution, oil, coal, etc. mostly privately
owned already.
Characteristics of neoliberalism
• In general, favor limiting the role of government in the economy and
allowing market forces to operate as freely as possible.
• Free market as the ideal
• Advocate for policies designed to remove barriers from markets.
• Ostry, Loungani, Furceri give two primary components:
1. Increased competition
2. Smaller role for the state.
Characteristics of neoliberalism
• Ostry, Loungani, Furceri identify three primary failures:
1. Did neoliberal policies actually lead to increased growth?
2. Increased inequality.
3. Increased inequality in turn hurts the level and sustainability of growth.
• IMF conclusion: inequality associated with economic instability, with shorter growth periods
when inequality is high. (short run)
• OECD conclusion: income inequality has a negative and statistically significant effect on
medium-term growth. (medium-to-long run)
• Why?
• Weakens aggregate demand
• Worsens inequality of opportunity
• Less likely to make public investments that enhance productivity (e.g., public transportation,
infrastructure, and education).
Economics after Neoliberalism
• Naidu, Rodrik, and Zucman (2020)
• “Provide an overall vision for economic policy that stands as a genuine
alternative to the market fundamentalism that is often—and wrongly—
identified with economics.”
• Identify the following as key sources of growing inequality:
• Deregulation
• Financialization
• Dismantling of the welfare state
• Deinstitutionalization of labor markets
• Reduction in corporate and progressive taxation
• Pursuit of hyper globalization.
Economics after Neoliberalism
• Argue that neoliberal policies ideas implemented in the 1980s of the are not
supported by economic theory or statistical evidence.
• “Neoliberalism is not the consistent application of modern economics but its
primitive, simplistic perversion.”
• Urge us to look at the data, as recent findings, have found that, e.g.:
• International trade produces large adverse effects on some communities
• Minimum wages do not reduce employment
• Financial liberalization produces crises rather than faster economic growth.

• “When an economist draws a supply-and-demand diagram on the

blackboard, she may not list all the institutional prerequisites that lie behind
the two curves.”