In the study of macroeconomics, there are many different schools of thought. Each school has its own approach to the various economic factors that affect our complex economy, including both the public and private sectors. Two main schools of thought are neoclassical and Keynesian economics. Neoclassical economics was developed in the 18th and 19th centuries and includes the works of Adam Smith and David Ricardo. Keynesian economics was founded by John Maynard Keynes in the early 20th century. At this time, Keynes sparked an economic revolution which challenged the ideas of previous neoclassical economists.
The main point of difference between these two approaches is the role of the government. Classical economics states that the market can adjust and balance itself on its own, while Keynesian economics says that government intervention is often needed to solve economic problems. The debate between classical and Keynesian economists has been going on for years. To begin, we must first understand classical economics because that is the underlying basis for many other economic theories to come.
The idea that markets best function without government interference goes back to eighteenth century France. At this time many states, including France, practiced economic protectionism through regulation of industry and restriction of trade. Protectionist policies were supposed to allow fair competition between domestic and foreign goods. These policies helped domestic businesses, producers, and employees that must compete with imported goods.
Although certain industries or groups of people may have benefited from these policies, the macroeconomic effect was eventually realized. Economists concluded that the affect of protectionism on economic welfare is detrimental, which opened the door to the idea of a free market economy—an economy with little to no government interference. In her book Laissez Faire and the General-Welfare State, Sidney Fine states:
"The physiocrats, reacting against the excessive mercantilist regulations of the France of their day, expressed a belief in a ‘natural order’ or liberty under which individuals in following their selfish interests contributed to the general good. Since, in their view, this natural order functioned successfully without the aid of government, they advised the state to restrict itself to upholding the rights of private property and individual liberty, to removing all artificial barriers to trade, and to abolishing all useless laws."
This idea of a free market established the economic term “laissez-faire” (meaning “hands off”), referring to the governments role in the economy. It is essentially the genesis of classical economics. Today, this term is widely referenced to in economic debate and serves as the backbone for many economic theories.
After French economists coined the term, other economists further developed this model shortly after. The most prominent economist that theorized on the basis of a free market economy is Adam Smith. Today, Adam Smith is considered the father of classical economics. Although he never actually used the phrase “laissez faire”, many of his concepts and theories are closely related. Thought to be one of his most notable concepts, the “invisible hand” can be directly applied to laissez faire economics.
The invisible hand is used by Adam Smith to describe an economy’s unintentional benefits of each individual’s incentives. Analyzing the concept of the invisible hand, economist William Grampp says the “invisible hand is self-interest operating […] in which a private transaction yields a positive externality that augments a public good”. In simpler terms, the effects of micro transactions naturally generate positive outcomes on the macroeconomic level. This idea that individual self interest results in socially positive outcomes can only be executed when people and businesses have the economic freedom to do what they choose, thus Adam Smith’s invisible hand can be viewed as the primary justification for laissez faire economics. According to classical economics, the government should interfere as little as possible with the natural tendencies of the market because individual interests will drive economic growth and prosperity.
While classical economics relies on the each person’s rationality (regarding supply and demand in the market place), Keynesian economics doesn't carry as much faith in the individual. Contrary to classical assumptions, Keynesian economists theorize that economies tend to need government guidance or management to achieve optimum performance. They do not believe that Smith’s invisible hand will maintain equilibrium in a free market economy. In essence, classical economists believe government spending will slow down an economy and Keynesian economists think it will stimulate an economy.
In the early 20th century John Maynard Keynes began to challenge the classical views of Adam Smith and other classical economists. The main theory he wanted to debunk was the assumption that an economy experiencing economic downturn would naturally restore itself. To define the market place he focused on aggregate demand—or the total spending in an economy. With this approach, Keynes identified one key economic problem that he thought classical economists had failed to consider: insufficient demand. According to classical economists, if there is insufficient aggregate demand, a few individuals with capability will naturally help restore the economy through their own personal business ventures and interests. Keynes didn't believe this issue would realistically be solved in that manner. He theorized that without intervention, insufficient demand will lead to growing unemployment, which would cause many more issues. Princeton economist Alan Blinder summarizes this quite simply, “if there aren't enough buyers, the sellers won't produce […] and if they don't produce, they don't hire workers. And if they don't hire workers, the workers don't have income — and if the workers don't have income, they can't buy stuff”. It’s easy to say that Keynes was a critic of Adam Smith’s invisible hand theory.
The underlying assumption for Keynes’ economic approach is that independent markets naturally fail. In his most influential book The General Theory of Employment, Interest and Money (1936), Keynes argued this notion. He also asserted that if not enough private individuals spend or invest in the short run, then the government must do so to stimulate employment. Therefore according to Keynesian economics, some individually rational actions can lead to negative outcomes which results in the economy performing below its maximum potential. For example, it is rational for an individual to save money rather to invest it, but when this collectively takes place on a macroeconomic level, it can have detrimental effects. According to Keynes, consumption is what makes “the world go ‘round” (Welna), thus economic intervention is necessary when there is a decrease in spending or investment.
Keynesian economics tend to focus on the short run because he believed that the recipe for long term prosperity is quite simply short term prosperity. Keynes argued that a government should remedy the short run instead of waiting for the market to naturally fix itself in the long run. In his own words, we should fix the short run because “in the long run, we are all dead”.