What should governments do about the phenomenon of boom and bust, if anything? Different schools of thought have different explanations for what is known as the economic or business cycle. Below I shall touch upon three of them, and consider the implications for policy.
In brief: Marxists and Keynesians tend to think that the economic cycle is endemic or endogeneous to capitalism, while Austrians think it is the result of meddling governments and central banks. For Marx, the solution was ultimately to abolish and replace the system with socialism. For Keynes, intelligent government policy could mitigate the cycle, while Austrians propose that this could happen if only government and central banks would get out of the way.
Which of these three sets of ideas is the most relevant and helpful, especially given recent economic history?
The Austrian school think that state interventions such as excessively low interest rates set by the central bank lead to an excessive growth of credit which funds a misallocation of investment or ‘malinvestment’. A boom is created in those industries which produce capital goods compared to those which produce consumption goods. This kind of imbalance only leads to an eventual bust, which is essential to rebalance the economy. There is probably some truth in this mechanism and one can see that credit growth, then its contraction, were part of the story of the 2008-9 recession; the controversial element is that it is all the fault of state intervention. Given that economic cycles existed prior to the creation of central banks, the role of the state in this theory is hard to square with reality over the longer term. The nineteenth century was peppered with recessions, at a time when the state intervened much less than it does today, closer to the Austrian ideal.
Marx held that economic cycles were endemic to the capitalist economy. One version of his ideas focusses on the rate of profit, which provides the main source of funds for investment by firms. The rate of profit tends to move in cycles, driven by variations in the organic composition of capital (OCC), a concept similar to the capital-labour ratio. A boom will typically be preceded by a rise in the rate of profit, driving rising investment which tends to raise the OCC. A rise in the OCC acts to reduce the rate of profit, ultimately reducing investment and growth, and leading the economy into a slowdown or recession. This will typically reduce the value of capital and labour, either through falls in prices and wages, or the scrapping of the least advanced capital goods used and a rise in unemployment. This will in turn tend to raise the rate of profit once more, stimulating investment and a recovery in the economy.
Many Marxists claim that booms and busts under capitalism cannot be prevented and are part of the normal working of the system. Strangely, given their antithetical political affiliations, they agree with the Austrian school that government monetary and fiscal policies are not much help and may even make things worse by preventing the devaluation of capital. A restructuring of the economy needs to take place to restore the rate of profit sufficiently for a recovery in investment and growth to take place. This is an explanation rooted in the supply-side of the economy: it emphasises the dynamics of production. Unlike the views of the Austrian school, imbalances in the economy are generated with or without government intervention and are ultimately impossible to avoid.
If we accept the need for the economy to restructure, then there is the potential for state industrial and welfare policy to encourage this process and manage changes in the sectoral and regional distribution of output and employment.
In some of his writings, Marx suggested that what he called ‘crises’ (recessions), would become progressively worse over time, becoming a potential stimulus to working class revolution and the replacement of capitalism by socialism. These predictions have not come true to date, leading many to unfairly discredit the whole of Marxist thought.
Keynes and his followers stressed that the economic cycle is driven by fluctuations in investment. The latter is subject to great instability due to the inescapable uncertainty inherent to economic life. This means that changes in the state of overall confidence among the business community exert a powerful effect on investment spending. Prominent post-Keynesians, whose work is most faithful to Keynes’ original ideas, also stress the importance of the rate of profit achieved in the current period as affecting profit expectations and investment decisions in the next. This idea is similar to that of some Marxists, with the added effect of expectations on behaviour.
Keynesians of all stripes tend to be more pessimistic about the ability of the economy to recover quickly from recessions in the absence of a stimulus from monetary and fiscal policy. No doubt Keynes himself was very much influenced by the Great Depression and the huge unemployment that it produced across the capitalist world. The depth of the depression and the slow recovery in many countries inspired him to write his General Theory, which tried to explain this dysfunction in the economy.
Keynesians (neo-, new and post-) tend to be sympathetic to state intervention through monetary and fiscal policy. In a recession, these tools are used to try to stimulate aggregate demand or expenditure in the economy as a whole. Different schools of thought within Keynesianism place different emphases on the combination of policy tools to use, but they are generally in agreement that ‘something should be done’.
In response to the recent financial crisis, governments intervened with unprecedented force. Interest rates were slashed to close to zero, budget deficits rose and the banks were recapitalised. They all became Keynesians for a while! While this did not prevent the recession, it mitigated it. However the huge build-up of private sector debt prior to the crisis and the ongoing deleveraging, along with a turn to austerity in many countries, have slowed growth since then. In much of Europe, economic performance has in fact turned out worse than during the Great Depression.
In terms of theory, there are clearly overlaps between Keynesians and Marxists with their focus on investment as the driver of growth and cyclical behaviour. If we drop the revolutionary aspect of Marxist thought, then there is room for economic reform instead, and the two schools of thought can find some affinity. Both claim that the cycle is endemic to capitalism and reformist Marxists can agree with Keynesians on the need for policy intervention, whether monetary, fiscal or industrial. This puts them in opposition to the Austrian school.
There is no doubt that governments in modern democracies face a pressure to ‘do something’ about problems in society, economic or otherwise. The left probably has this mindset more than the right; the latter are more critical of the ‘nanny state’ and locate many problems and their solutions at the door of the individual. But there are larger economic, social and political forces and institutions acting on the individual, shaping his or her behaviour. These can be analysed theoretically and empirically and used to influence policy.
Given the size of the modern state in developed countries and its influence (I avoid using the word control) on society, there is great potential for policy-makers to do good, but also scope to make very costly mistakes. This is not an argument for the state to do nothing in the face of social and economic adversity, as Austrian economists might wish. It is an argument for more considered behaviour, and learning from error. Maybe all sorts of institutions, from the state through to trade unions, firms and households, need to be smarter and more subtle when acting in a complex world. There is surely plenty to learn from the various theories of the economic cycle touched upon here.