A History of Economic Thought – What is Next?

If you’re interested in economics, and you haven’t seen this video yet, or seen this post, then you clearly need to replace your friends with more geeky ones like us.

”Fear the Boom and Bust” a Hayek vs. Keynes Rap Anthem (You may also want to check out the sequel)

The video illustrates the ideological battle between the Keynesian school of economics and the Austrian school of economics in the 20th century. If you’ve ever been curious about what each school represents, I hope to break that down for you today – while relating it to what you’ve learnt in your economics major.

The tide of the economic mainstream has oscillated over the past few centuries, much like a business cycle does. I’m no historian, but from hours of Wikipedia-ing over my five years at university, this is what I’ve gathered. (And my economics degree has helped too, I hope.)

Mercantilism (16th to late 18th century)

I’m going to start the narrative with one of the most primitive economic ideas in history: Mercantilism, which dominated in the 16th to late 18th century. In essence:

  • Mercantilists hold the unsophisticated notion that trade is fruitless.
  • They believed that you could not mutually benefit from trade, and that if there was a winner in trade, the other party was a loser.
  • The idea is flawed from the get-go, because while Mercantilists generally opposed free trade with other nations and empires, why didn’t they oppose trade within their nation?


Classical economics (Late 18th century to early 20th century)

Not long later, and possibly skipping past some other minor paradigm shifts, Adam Smith published The Wealth of Nations in 1776, which also happened to be the year of the American Revolution. Adam Smith formed the basis of what is commonly referred to as classical economics. Basically, everything you learn in first-year microeconomics is based upon classical economics:

  • Classical economics revolves around the idea of an “invisible hand” seeking the efficient allocation of resources.
  • Unlike Mercantilists, classical economists believe there is potential for mutually beneficial trade, and glorifies free trade and markets rather than shunning it.
  • The school provides a strong defence for the ability of markets to self-organise, and was formed the basis of capitalism, as well as a pre-emptive rebuttal of the rise to prominence of communism in the early 20th century with its findings about markets that showed the government’s role to be largely unnecessary or even detrimental to the health of the economy.

After more than a century of dominance as the mainstream economic thought (and once again skipping some minor additions again, though mainly to the classical school), when the 1930’s came around, the Great Depression struck. The lengthy periods of unemployment were seen to be a damning criticism of classical economics. If markets could really allocate resources properly, why was there a lingering excess of workers who could not find jobs?


Keynesian economics (1930s to 1970s)

This led to the rise of Keynesian economics. When you start off in first-year macroeconomics, you will generally learn a few Keynesian models. One of the big reasons why students who excel in first-year microeconomics sometimes struggle to grasp the concepts of macroeconomics is that Keynesian economics did not bother to build upon the classical model:

  • It scrapped the “micro-foundations”, and instead started from a top-down approach, with aggregate behavioural equations that John Maynard Keynes believed to be true.
  • He believed that the aggregate economy can suffer a “general glut”, and that a solution would be to simply increase spending – which would stimulate the economy via a multiplier effect, as the money circulates through the economy.
  • Hence, Keynes believed deficits would be an effective way to stimulate an economy out of a depression.


A Fork In The Road: Methodology vs. Ideology

At this point, economic academia progresses into the New Classical school, then the New Keynesian school. I will discuss these briefly, and then instead focus a bit more on the hidden Austrian economics.

  • The New Classical and New Keynesian schools are mainly methodological evolutions of rigorous academic economics.
  • The New Classical school makes an entrance into the world of macroeconomics (which Keynes is credited for “creating”), by attempting a more ground-up synthesis of aggregate markets. They create macroeconomic models from “micro-foundations”. However, the conclusions do not differ greatly from the classical school of economics.
  • Thus, the New Keynesian synthesis takes the micro-foundations of the New Classical school, but builds in mechanisms for obstacles to achieving market efficiency such as “price stickiness” and “search functions” – to describe the speed and lags that the market require to achieve “equilibrium” – in order to more realistically explain why markets don’t always seem to clear as well as predicted by the classicals.

What is next, if anything, will be interesting. There is a lot of dissent against the idea of an “equilibrium” to begin with, as markets are dynamic not static – but despite popular articles and books that are very fond of making this criticism, this has been largely addressed already by models that view economies as a time-series of static equilibria, thus building in a dynamic component to many models. If I knew what was next, I would be busy publishing that, so I’m not going to try and predict – after all, we know how good economists are at predicting!


The Austrian School of Economics

An oft-forgotten school of thought that followed the Keynesian shake-up of economic thought in the 20th century is the Austrian school. While the New Classical and New Keynesian synthesis display an enhanced sophistication in the academic rigor of economics, the Austrian perspective remains an enlightening collection of critiques of Keynesian economics, and perhaps more-so, an ideological critique against government interference in the economy:

  • The Austrian school, perhaps most famously known for Hayek (Nobel laureate in 1974) as depicted in the YouTube clip above, do not differ greatly to the classical economists in terms of their belief in free markets.
    • Although there are a great deal of methodological and foundational differences between the two, they largely come to the same conclusions. Bryan Caplan makes the point quite strongly here in Why I Am Not an Austrian Economist.
    • Instead, what I find to be a significant contribution from Austrian economics is the wealth of well-developed language and explanation that has been developed to defend free markets beyond the academic space.


To summarise some of their key ideas:

  • The “impossibility” of socialism, or the economic calculation problem: this critique is allayed against a government that thinks it knows how to organise economic allocation better than a marketplace of individuals. Austrians use the concept of “tacit knowledge”, the idea that information is distributed too widely for a central agency to collect all the data in order to determine how to best allocate resources. Instead, they believe that only a marketplace can assemble that data together, with individuals signalling to the rest of the market their information through the price mechanism.
  • “Too much aggregation” is a critique of general government spending, as Keynesian theory implies any spending will suffice in stimulating an economy. Austrians tend to believe that this ignores whether it actually benefits people, and focuses too much on the numerical value of GDP.
  • Schumpeter’s idea of “creative destruction” is a defence of letting companies fail, and against bailouts – believing that companies that cannot withstand the market test merely prove that they are inefficiently using resources, and they should be freed up for better uses.
  • Becoming more recently prominent in the public eye, with the call to audit the Federal Reserve in the United States, their critique of central banks artificially holding interest rates low is based on the premise that they are the cause of business cycles by fueling the bubbles in the first place – ironic because such measures are seen by Keynesians to “fix” recessions.

When combined, the Austrian school provides a skeptical lens to view Keynesian-based ideas of business cycle management. They believe that trying to prevent it with aggregated spending only covers up the fact that some of these businesses were supposed to fail, and not only that, but would only boost the economy into another illusory bubble which would culminate into a bust at some later stage again. This paints one side of the narrative put forward in the debacle about bailouts in the recent and ongoing Global Financial Crisis.



Collin Li is a sixth year university student, who studied a Bachelor of Engineering (Chemical) and Bachelor of Commerce, majoring in Economics and Finance. He is currently studying for an honours degree in Economics. He was introduced to Austrian economics after coming across some Ron Paul videos on YouTube in late 2007, and he identifies himself as a libertarian.


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