Economics is not a homogenous or unified subject, rather there are a series of competing ideas over the key areas. These ideas can be roughly divided into several schools of thought and I’ll give a guide to them here. It is the great myth that economists pretend to be non-partisan when in reality we all have our own biases and opinions. It is impossible to study a topic without forming an opinion of it and economists are no exception. So by understanding the different schools of thought you can not only understand why economists give different and contradicting policy advice but also how they see through different lenses.
Before I begin, let me emphasise that this is a short guide and as such contains summaries of beliefs rather than full explanations. Hence I will undoubtedly end up leaving some important points out due to space. It should also be said that few people will belong solely to one school; most people are a mix of a couple of ideologies. Ideologies are hard to pin down, so my definitions will probably be different to other people’s, an unfortunately unavoidable problem. Like all economics pieces, this one will maintain an official position of neutrality while in reality be subject to the unconscious biases of the author.
Main Theories: Rational Expectations, Efficient Market Hypothesis, Real Business Cycle, Utility Maximization, Marginalism, Perfect Information, Perfect Competition, Equilibrium, Ergodicity, Mathematical Modelling, Microfoundations
People: Alfred Marshall, Leon Walras, Robert Lucas, Milton Friedman, Eugene Fama
Response To The Financial Crisis: Crisis? What Crisis?
Without a shadow of a doubt, the Neo-Classical (also known as New Classical) school dominates economics to the extent that when lay people speak of economics, they are usually referring to neo-classical economics. It is the mainstream, the traditional view of economics and all other schools define themselves in contrast to neo-classicalism. It is the mainstream and the view presented in textbooks in universities. In a way, Neo-Classical is a bit like Capitalism. Both words are used more as insults than self-descriptions, both dominate the world and both form background to most discussions.
Neo-Classical economics is noted for its emphasis on the micro level and viewing economics from the view of the individual. It assumes that markets always clear and that supply always equals demand, that is to say markets are always in equilibrium. Individuals are viewed as rational utility maximers who act based on the marginal benefit of their action. It is also heavily mathematical and devoted to developing mathematical models to explain the economy and how individuals interact.
Neo-Classicalism is unusual in that there are few people who truly believe in it. There are some notable exceptions who tend to win Nobel Prizes and remain blissfully unaware of the recession, but these are like fundamentalists, strange, dangerous and rare. It is rare to find anyone who honestly believes that people are rational, have full information etc. Instead even those who teach neo-classical economics will admit that it does not accurately describe the world, but rather that it simplifies it. So rationality is acknowledged as unrealistic but used as it makes it easier to construct models and perform mathematical equations. As some say, “All models are wrong, but some are useful”. What they mean is that although they know neo-classical assumptions are unrealistic, they help economists find answers.
Critics argue that unrealistic assumptions lead people to the wrong answers and that modelling is too heavily relied upon. Neo-Classicalism is criticised for being obsessed with mathematics and failing to realise that not all human actions can be reduced to numbers. The Financial Crisis has done enormous damage to the school to which it has failed to explain. In fact, in a Neo-Classical world, recessions, mass unemployment and financial crises, don’t happen. While it remains dominant, alternative views are starting to make their way through the cracks.
Name: New Keynesian
Main Theories: Sticky Wages & Prices, DSGE, Imperfect Competition, Liquidity Trap
People: Greg Mankiw, Paul Krugman, Joseph Stiglitz, Michael Woodford, Robert Shiller, Olivier Blanchard, John Taylor
Response To The Financial Crisis: Fundamental Rethinking/Return To Roots
New Keynesian economics is unusual in that it is less of a school in its own right and more of a dilution of Neo-Classical economics. However due to the large number of economists who subscribe to it and the fact it is the only opposition to Neo-Classical economics presented in textbooks, is why it deserves mention here. New Keynesian is a misleading name as it draws more from Milton Friedman than from Keynes, hence New Freidmanite Economics would be more accurate. It is regularly criticised as ignoring Keynes’ important theories and as such unworthy of his name. It has its roots in the Neo-Keynesian Synthesis of post war America and uses the assumptions of Neo-Classical economics as a starting point.
It accepts that people have rational expectations and that like Neo-Classicals emphasise microfoundations and representative agents. In fact such is the similarity with Neo-Classicals that it is easier to list their differences rather than similarities. They take Neo-Classical assumptions and relax the most extreme of them, while keeping a pretty similar overall framework. The primary difference is the emphasis on stickiness which can prevent the market from clearing.
During times of prosperity and in the long run, New Keynesians agree with Neo-Classicals. There are two main exceptions to this agreement. Firstly, they believe that the normal rules don’t apply when the economy is in a recession. In this case, rigidities in prices and wages mean the market doesn’t clear and hence it is necessary for the government to intervene. If the economy is in a liquidity trap then fiscal action is necessary for recovery. Secondly, while they agree that markets will naturally recover from recessions, they argue that this recovery can be slow due to price and wage rigidities preventing the economy from fully adjusting. Therefore they support government intervention to speed the process up. So while they agree with Neo-Classicals in the long run, they believe there are exceptions in the short run
New Keynesians are a diverse group containing Greg Mankiw who worked as an advisor to George Bush and Mitt Romney and wrote a paper in defence of the 1%. It also contains liberal icons like Paul Krugman and Joseph Stiglitz who have been loud in their class for government intervention in the economy. The Financial Crisis has had the greatest effect on this group, causing many to re-examine their main assumptions. An economy with rigidities is more accurate than Neo-Classical models, but it still fails to describe the recession. As a result, some (such as Krugman) have begun to drift to the left and towards Post-Keynesian economics.
Name: Post Keynesian
Main Theories: Financial Instability Hypothesis, Endogenous Money, Cost-Plus Pricing, Animal Spirits
People: John Maynard Keynes, Michal Kalecki, Joan Robinson, Nicolas Kaldor, Hyman Minsky, Paul Davidson, Richard Koo, Steve Keen
Response To The Financial Crisis: I told you so/ Now’s our time to shine
The main challenger to the Neo-Classical orthodoxy is Post-Keynesian economics. In fact it would be only a small exaggeration to say that it is the opposite of Neo-Classical economics and they disagree on almost every point. A huge amount of Post Keynesian writing is dedicated to debunking Neo-Classical theories. Neo-Classical assumptions come in for particular criticism and Post Keynesian argue their theories are based on the real world unlike the fiction dream world they believe Neo-Classical economics lives in. Such is their claim to reality that a leading Post Keynesian journal is named The Real World Economics Review. It can be argued that like all heterodox economics it spends more time arguing what it does not believe than stating what it does, but it is necessary to show why a theory must be replaced before a replacement can be accepted.
Post Keynesian see themselves as the true followers of Keynes, the people who have stayed loyal to the true faith. They regularly cite him and appeal to his authority on policy issues. They particularly resent the New Keynesians title as blasphemy to the name of Keynes. Although heavy use is made of Keynes’ theories, Post Keynesianism is by no means a stagnant school. New theories have been developed, particularly in the area of financial economics and debt which is of huge importance and relevance to the current problems with the economy.
They have the strongest claim to have predicted the crisis and the financial crash has given it a huge boost. Unlike other schools which skirt around the issues of recessions, Post Keynesians dive right in and are best at home with depression economics. Recessions are not rare and unusual exceptions to the rule that cannot be understood; rather they are systemic crises which cannot be ignored. Post Keynesian is also an explicitly political school and actively engages in policy debates over inequality, unions, regulation etc. The core of their policy recommendations is the need for a fiscal stimulus to boost the economy out of recession and towards full employment. After the Financial Crash, Post Keynesianism should no longer be seen as a fringe school; rather its views must be taken seriously by economists and policy makers.
Main Theories: Austrian Business Cycle Theory, Say’s Law, Gold Standard
People: Ludwig von Mises, Fredrich Hayek, Murray Rothbard, Carl Menger, Robert Murphy
Response To The Financial Crisis: Government isn’t the solution, it’s the problem
Austrian economics is unusual for a heterodox school as it tries to be more Catholic than the Pope. It has few differences with Neo- classical economics and their policy conclusions are similar. Austrians have a diehard commitment (bordering on fanatical) to the free market and oppose almost all forms of government intervention. In this sense it is probably the most political of the schools. They have almost a religious devotion to markets (leading them to be ridiculed as market fundamentalists) and sound money, and nothing infuriates them more than price controls or printing money. They are particularly strong in their denunciation of socialism, a sport which is somewhat ruined by the general lack of socialists to argue with. Its name is misleading as it is really an American rather than Austrian school and is linked to the American libertarian movement and its distrust of the government. Such is its dislike of the government that some strands of Austrian (such as the Rothbard group) are essentially anarchists.
Austrians are the main outlier as unlike other schools it has seen the Financial Crash as a reason to doubt the efficiency of the free market. Rather it lays the blame for the crash firmly with the government, arguing contrary to other economists, that the crash is proof we need less government involvement in the economy rather than more. Key to this argument is the Austrian Business Cycle Theory, which postulates that central banks distort the economy by artificially lowering the interest rates. This leads to an unsustainable boom followed by an inevitable bust. In contrast to other schools who propose various solutions to the crash, Austrians believe that no action should be taken as any intervention would only make the problem worse. Rather the market should be left to recovery naturally.
Austrian economists have few positions of influence either in academia or government. Instead they have disproportionate influence on the internet and the American libertarian movement. Most non-Austrian economists do not take them seriously believing their ideas to belong to the past. Austrian arguments for a gold standard and the abolition of central banks are seen as an attempt to turn back the clock by a hundred years. Say’s Law and the refusal to support government intervention even in a severe recession, remain key Austrian ideas decades after they have been abandoned by mainstream economists. Austrian economics has been criticised as for being stuck in the past and it is charged that it has not advanced since the 30s (a point they obviously disagree with). Unlike the rest of economics it defines inflation, not as a rise in prices but rather as an increase in the money supply. It comes in for particular criticism for its belief that economic theories cannot be proven either mathematically or empirically, a position that is better suited for theology than economics.
Main Theories: Prospect Theory, Heuristics, Predictable Irrationality, Nudges, Framing, Bounded Rationality
People: Daniel Kahnemann, Amos Tversky, Dan Ariley, Richard Thaler
Response To The Financial Crisis: Didn’t we tell you people aren’t rational?
Behavioural economics is a relatively new school and is essentially the application of psychology to economics. It is based on running experiments to find out how people really act and make decisions rather than the Neo-Classical practice of making assumptions of how people should act. In this way, it can be seen as a school dedicated to debunking Neo-Classical economics on the micro level. It takes particular aim at the view that people are rational utility maximers. Thaler has parodied Neo-Classical assumptions as assuming individuals “think like Albert Einstein, store as much memory as IBM’s big blue, and exercise the willpower of Mahatma Gandhi.” Work by Ariely has lead him to conclude that even the basic laws of supply and demand are debunked by behavioural economics.
Behavioural economics has been criticised as not having an overarching general theory and not offering replacement theories for the ones they criticise. However, part of the point of Behavioural economics is that it rejects one-size-fits-all approaches to economics, instead highlighting the diversity of human action. It is also a predominately micro theory which is less open to general theories than macro. As such it is less affected by the financial crisis, though it sees it as validation of its arguments that people are not rational in the way Neo-Classical economics supposes. The evidence that we are subject to subconscious influences as lead to some argue that we should be nudged towards making best decisions in a form of libertarian paternalism.
It should be stated that when Behaviouralists argue that people are not rational, they are not arguing that people are stupid or unpredictable. Rather they argue that people have limited information and limited time to make decisions. So rather than processing information like a computer as Neo-Classicals assume, people rely on heuristics or rules of thumb that allow them to make rough judgements. Kahnemann has argued that we have two types of decision making, the first kind which is rational and thinks decisions fully true and the second which is impulsive and relies more on gut feeling. Crucially these actions are not random; hence we can be irrational in predictable ways.
Name: Modern Monetary Theory
Main Theories: Monetarise the Debt, Job Guarantee, Endogenous Money
People: Warren Mosler, Billy Mitchell, Randall Wray, Stephanie Kelton
Response To The Financial Crisis: Deficits are not problem, they’re the solution
Modern Monetary Theory (MMT) (also known as Chartalism or Soft Currency Economics) is the newest school of thought and owes its growth and development to the internet. It only began during the 90s and the term Modern Monetary Theory was only coined in 2007, though it draws on ideas going back to the early 20th century. It is the first theory to pay explicitly close attention to the fact that developed economies are based on fiat currencies and build their theory around money (as their name suggests). There are disputes as to whether or not it can be considered a school in its own right or whether it is a branch of Post Keynesianism. Either way there is a strong overlap between the two, with MMT being different as it goes a step further.
What makes MMT unique is its view of debt and deficits. Unlike Keynesians who argue that deficits should be temporary until the economy recovers from the recession, MMT argues that the government can run deficits indefinitely. Nor is the national debt a cause for concern as a government with its own currency cannot be forced to default. Instead it can print money to cover the deficit. MMT is often crudely expressed as “deficits don’t matter” whereas it would be more accurate to say that “other things matter more than deficits”. MMT acknowledges that there are costs to deficits but that these are less than the costs of high unemployment and an economy in recession.
MMT is completely devoted to the aim of full employment, more so than even Keynesians. They propose that there should be a Job Guarantee where everyone who wants a job is able to get one. They believe the government should be an “Employer Of Last Resort”. They are loudest in their support for money printing believing that if the economy is below full capacity, this will not lead to hyperinflation. MMT has the novel argument that governments are not dependent on taxes to fund themselves. They can print whatever money they need and taxes are merely money taken out of the economy in order to prevent inflation. Hence unlike the rest of economics, they do not necessarily see budget surpluses as a positive. If the surplus is too high then too much money is being taken out of the economy, which could cause a recession. They highlight the important point that as currency is not backed by gold or any other asset, it is in essence whatever the government says it is.
MMT is a very new school and as such it is not well known. The usual response upon first hearing of MMT is shock followed by dismissal as it suggests that government can get something for free, an idea all economists have been trained to reject. Printing money to success sounds like a recipe for hyperinflation and thus MMTers have a tough challenge to convince economists to take them seriously.
Main Theories: Labour Theory of Value, Declining rate of profit, Class conflict, Reserve Army of Unemployment, Surplus Value
People: Karl Marx, Fredrich Engels, Leo Trotsky, Antonio Gramsci
Response To The Financial Crisis: We warned you capitalism would collapse
There are few ideas in history which have had an impact comparable to that of Marxism. Since its development in the mid 19th century, the rallying cries of revolutions have been inspired consciously or unconsciously by Marxism. It has been the inspiration for the labour movement and the cause of numerous social upheavals, particularly in Continental Europe and colonial independence movements. It was one half of the greatest ideological power struggle in history during the Cold War, dominating the might of the Soviet Union and China. Some of the world’s greatest atrocities were done in its name and the legacy of Stalin has tainted its appeal. With the collapse of the Berlin Wall, Marxism was declared dead and written out of economics books, except as a dead horse to flog on occasion to prove a point.
Marxist economics is generally seen as belonging to a time long since passed, where fat cat businessmen smoked cigars and wore top hats while cloth cap workers slaved away in dangerous factories for miserable wages that left them living in slums. It is argued that world no longer exists and with it any rational for Marxism. As a result it is rare to find any economists who will call themselves Marxists, none of which are in any position of influence.
However, the financial crash suggests that Marxism is not yet destined for the dust heap of history yet. The idea that crisis’s may be inherent in capitalism seemed a lot more plausible. Class is an issue that has not gone away and with historic levels of wealth been concentrated in the hands of a small elite, it is possible that some elements may be salvaged from Marxism. Marxism itself is moving away from traditional emphasis on Soviet steel mills and the dictatorship of the proletariat and towards worker co-operatives and democracy in the workplace, which has a greater appeal. The crisis has lead to only small increases in support for Communist parties and it is unlikely that Marxism will be revived as a school of thought.
There are other theories that I don’t have the space to mention such as the Institutional school (both New and Old). There is Monetarism which was a major theory in the 70s and 80s but even Friedman himself admitted its policy of targeting the money supply was a failure. The school has now been absorbed into the Neo-Classical school. There is a growing Econophysics school which attempts to apply theories of physics to the economy. While there may be some merit in complexity, the school needs a lot of development before it can draw any links between physics and economics. There is also a general “Economics As If People Mattered” school which is a mixture of Buddhist, ecological and ethical economics that is popular among lay people but ignored by economists. Supply side economics is more a political theory based on tax cuts. An almost endless could be created encompassing Sraffian, NGDP, Market Monetarist etc. It also should be said that there are many economists and theories which do not easily fit into any one school (Schumpeter for example).
Anyway, that about does it. Leave a comment leaving your thoughts on the schools and my description of them.