The Power of Ideas – Explaining the Shift from Keynesianism to Neoliberalism

The importance of economic ideas and beliefs about the political-economic world have an enormous impact on public policy. There have been two dominant paradigms since World War two; Keynesianism and Neoliberalism – the first was a reaction, and a temporary stop-gap, to the dominance of economic liberalism that led to the financial collapse, and great depression in 1929. The rise of fascism and its clash with the march of communism led to world war 2. National governments  then instituted the Keynesian compromise, which lasted from 1950 to the late 1980’s. Since then we had a second coming of economic liberalism i.e. the belief in the rational-efficient market hypothesis; neoliberalism. After the second great financial collapse, brought about by similar capitalist-forces – neoliberalism, this time, has remained politically robust. The austerity response in Europe to financial-credit crisis is but one example of this. To explain why, we have to examine the power of ideas.

The neoliberal approach to aggregate demand, employment determination and income distribution can be described as follows. Economic demand comes from the free-intersection of market forces and any attempt to politically control or coordinate market resources leads to inefficiencies. The price mechanism will allocate value and efficiently distribute economic resources such as money. Employment determination emerges from this natural-market structure. Labour and capital are factor prices, and will be bought at a price that the efficient market sets. They move up and down (i.e nominal wage and price flexibility) because the market is efficient and responsive to exogenous shocks. Any interference such as wage setting institutions, corporatism(s) and trade unions upset the natural equilibrium and should be removed (of course, this can only be done by force or accommodation, thus requiring a strong state). Income distribution is a result of price-value. People get paid what they are worth in the market. The reward or return on labour and capital will distribute income in a normal-efficient manner. This might lead to inequality but reflects the resource allocation of the market and therefore it is efficient.

The neoliberal approach to monetarist and fiscal policies of the state are as follows. Monetary policy should be determined by independent central banks and the primary purpose is price stability. To keep inflation low ensures efficient capital investment as investors are certain about future price-returns. This creates a less risky betting (or investment environment). Fiscal policy, by design, is determined by elected governments, therefore it should be aggressively controlled, unlike the market. Government should step away from the market, shrink and minimize its direct role. Budgets should be balanced and taxes kept at a minimum. To pay for public services – privatize them. Governments under no circumstance should do what private market actors can do and never engage in deficit financed public spending. Macroeconomic policies should be left to market-technocrats.

The Keynesian approach to aggregate demand, employment determination and income distribution can be described as follows. The market should allocate resources but this is rarely sufficient to ensure aggregate demand, and therefore full employment. To ensure a balance between the two, requires activist state-political management. This commitment to non-market allocation of resources is primarily to ensure that labour is put to work. Employment determination in the market leads to inefficient outcomes – it is wasted. Wage coordination is not flexible and does not respond, like a price, to changes in supply and demand. It involves collective-corporatist actors such as trade unions and therefore we have to view the labour market not through the methodological-individualism of the market but societal-bargaining power. Income determination therefore is political. But, what is most important is a political commitment to full employment through activist-macroeconomic policies.

The Keynesian approach to monetarist and fiscal policies of the state are as follows. Monetary policy needs to be accommodating. Exchange rates need to politically adjust to boom-bust crisis. This might lead to inflation but in a recession, this is a lesser evil. Fiscal policy, in the periods of inevitable economic downturn in a capitalist mode of production, can replace a fall in domestic demand-investment. Whilst the private sector de-leverages, the state should engage in deficit-financed public spending. This, of course, is dependent upon a heavily regulated finance market, quite unlike what exists today.

The Keynesian ideational paradigm collapsed in response to a series of crisis that political-economists such as Marx and neo-classical economists predicted, albeit from two very different normative standpoints. The main problem was inflation and public debt. The state commitment to full employment, and comprehensive  social protection, in a period of recession generated a fiscal crisis for Keynesian welfare states.Furthermore, wage militancy could only be compensated by national income policies that some but not other countries could construct (USA, UK in the latter). The state response to a crisis of democratic capitalism (i.e. national governments trying to balance democratic stability through redistribution and capitalist-market expansion) provided the conditions for a return to neoliberalism. This led to a rapid change in the capitalist mode of production, a globalised financial-capital system of mobility, a rapid increase in precarious labour markets, the privatization, liberalization and re-regulation of the state-economy relationship.

The general point is that the last thirty years, despite its institutional variety, was an era of neo-liberalism and born out of the crisis of the brief Keynesian-welfare state. The type of capitalist-economy that gave rise to the great depression was, similar to what occurred over the past thirty years, premised on an idea and belief system about how the political-economic world works. Therefore we need to probe the power of the idea of efficient markets if we are to explain the current crisis and the future trajectory of institutional change in capitalist economies.

Neoliberalism is supported by a belief, reflected in the method of inquiry in much of social science, in a micro-rational theory of behaviour and a macro-theory of system-equillibrium. Mark Blythe, the international political economist, calls this belief ‘ELEN’. The four underlying assumptions are as follows. The first is that the world is in equilibrium. This is because the world is reduced to generalized market exchange with rational actors calculating the cost and benefits of their action. Secondly, underlying causes in a perfectly stable rational system are linear. If y exists in the economy it can be explained by x. All relations are causative. This is the opposite of the Marxian method of inquiry premised on dialectics. In this method, social relations are not causative but a configuration and dynamically interact with one another. It is holistic. The third assumption is that all change in an  efficient-equilibrium system, premised on causative relations are exogenous. It takes an oil shock, government intervention or a collapse of the monetary economy as external to the system. Change in any equilibrium system cannot be endogenous as it would no longer, by definition, be rational-stable-equlibrating. Finally, all outcomes in a rational-efficient system are normally distributed. Stability is the norm and fringe noises are to ignored. Think statistical averages.

All of these assumptions lend themselves to a rational-efficient method inquiry and simple public policy recommendations such as tighter fiscal rules on prolifigate politicians, and hence their dominance in the economics social sciences. Actor are rational, markets are efficient but require rules and regulations for risk management. This is why the EU is currently obsessed with instituting hard-fixed fiscal rules to avoid over indebtedness by national governments (despite the fact that this , if even, only applies to the Greek case). They cannot overcome the powerful belief that markets are efficient because their underlying public policy reccomendations are wedded to fixed epidemiological and ontological assumption of sceintific economic management. But, any common sense observation of the world would debunk the ELEN asssuptions.

We live in a world of capital accumulation, a particular mode of production that is in constant flux, change, process and motion. It is a dynamic system that has jumped from crisis to crisis, that are produced internlly within the system. Since the 19th century there have been 80 financial crisis but anyone doing an MBA, in a top university, is still taught that markets, financial or otherwise are self-regulating, efficient and capable of rapid adjustment. It is simply NOT true. Most relations are non-linear and change is almost always endogenous to social systems. Finally, interests and resource allocations are not normally distributed. They are conditioned by those with more or less market-bargaining power i.e. those with financial assets. Hence, the global tug of war between national-sovereign states and oligarchs in international finance markets.

All of this points to the need for an epistemological and ontological revolution in the social sciences to illustrate that the idea of efficient markets and their foundations in rational calculation are a Utopian illusion with political consequences. Change is not a process of technical management or the rational adjustment to exogenously induced problems but a dynamic interaction between social forces with unequal power resources.

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One response to “The Power of Ideas – Explaining the Shift from Keynesianism to Neoliberalism

  1. In that context, the work of Steve Keen is interesting. In Debunking Economics he shows fatal flaws in the assumptions underlying the economics 101 supply and demand curves (and, importantly, shows thatthese flaws have been available to the economics professions for decades), and he shows that the equilibrium that is assumedto exist in DSGE models so beloved of economic theorists has been shown to be unstable

    The prpblem with economics, he shows, arises even before the challenge you set in your final sentence.

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