The extent to which an economy moves naturally towards equilibrium without the interference of government, is the subject of intense debate in economics and has been so since its origins. Although there are many different views, these are often classified as the Classical, Neo-Classical, and Keynesian perspectives.
The Neo-classical era of economics sits between two great periods of economic theory, the Classical era (1770’s – 1870’s) and the Keynesian era (1940’s – 1970’s). Neo-Classical economics can be summarised as the general belief that a market economy will automatically adjust towards equilibrium and there is no need for government intervention – in short, markets are said to work effectively, both at the micro and the macro-economic level.
Each sector is brought into equilibrium through automatic adjustments in product, labour and financial markets. All the markets clear because of the effectiveness of the price mechanism. The Neo-Classical economists argued that any problem with markets not clearing is the result, of government failure of some sort, or the activities of interest groups and other third parties not directly involved in market transactions. For example, economists from the Classical tradition would tend to argue that unemployment exists because government welfare payments are too generous and artificially distort the effectiveness of labour markets.
If the price mechanism is free to work, the economy will always be moving towards equilibrium such that full employment will occur. The Neo-Classical line of argument is that wages will adjust to ensure that the labour market clears; so if an economy experiences a downturn in the business cycle, wages would fall, and the same number of workers would be employed, but at a lower wage rate.
Classical economists also argued that, in the financial market for loans, savings would always equate with investment because interest rates will naturally adjust to bring them into balance. If savings are greater than investment at the current interest rate then the rate will fall, as financial institutions have excess funds, and this will encourage investment and deter savings. In the next time period savings will fall and investment rise.
Similarly, imports and exports will always move towards equilibrium through adjustments in the exchange rate. If imports are greater than exports, the supply of currency will increase, and the exchange rate will fall. In the next time period, exports will increase, because the lower currency makes exports more price competitive, and imports will fall, because they are less price competitive.
Classical economics became influential again during the 1980s with the work of New Classical economists like Robert Lucas, who revived interest in Classical macro-economic theory.
The alternative view – that markets do not always self correct - is based largely on the ideas and work of British economist, John Maynard Keynes. Keynes’s work culminated in the publication of The General Theory of Employment, Interest and Money (1936), commonly known as The General Theory, which became the most influential book on economics of the 20th Century. Keynes argued that a market economy is not always effective at creating full employment equilibrium, and there are likely to be times when governments should compensate for the failure of free markets. Full employment equilibrium is simply a ‘special case’ of equilibrium, and not a ‘general’ case.
In particular, Keynes argued that savings and investment would not always respond to changes in interest rates in the way the neo-Classical economists assumed. This is because the connection between savings and investment is weak. Savings are more directly affected by national income than interest rates.
Keynes was also critical of the Classical assumption that wages and prices are flexible downwards as well as upwards. According to Keynes, the inflexibility of wages downwards created the possibility of unemployment.
At a deeper level, Keynes also saw that self interest, regarded as the key driver for market interaction, was potentially harmful. From Adam Smith onwards, the orthodox view was that the economic welfare of everyone is maximised when individuals pursue self-interest. In his paradox of saving Keynes was able to demonstrate that the self interest associated with increased saving could be harmful to others because saving would lead to a fall in spending, and to a fall in other people’s income. Eventually, even the saver suffers as economic activity in the economy collapses.