1. Political Economy How Governments Manage Their Economies

2. Unit Goals In this unit, we will look at the relationship between politics and economics. While this is often not the topic that generates the most excitement among students, it is perhaps the one that is most central to the basic concerns of many citizens; jobs, money, and wealth. In order to fully grasp the importance of political economy, you should, by the end of this unit, be able to do the following; In this unit, we will look at the relationship between politics and economics. While this is often not the topic that generates the most excitement among students, it is perhaps the one that is most central to the basic concerns of many citizens; jobs, money, and wealth. In order to fully grasp the importance of political economy, you should, by the end of this unit, be able to do the following; 1.Identify the central concepts used by political economists, such as inflation, growth, depreciation, per capita income, Keynesian management, etc.; 2.Understand the broad range of economic instruments that are available to governments to manage their economies; 3.Identify different management strategies, and discuss their relationship to the economic market.

3. Political Economy Defined Political economy, as the name implies, lies at the intersection of concerns that economists normally deal with and those that political scientists generally treat Political economy, as the name implies, lies at the intersection of concerns that economists normally deal with and those that political scientists generally treat When we look at political economy, we are trying to think about the way in which collective choices (remember, we defined those as being at the heart of politics) affect economic outcomes. When we look at political economy, we are trying to think about the way in which collective choices (remember, we defined those as being at the heart of politics) affect economic outcomes. Clearly, there are going to be a range of both normative and empirical concerns that fall into this area. Clearly, there are going to be a range of both normative and empirical concerns that fall into this area. So; we might be able to define political economy as, So; we might be able to define political economy as, “The study of how communities pursue collective economic goals and deal with conflicts over resources and other economic factors in an authoritative manner”

4. Economics without politics If politics was not involved in the making of collective economic choices, then we would probably focus on nothing more than pure markets. If politics was not involved in the making of collective economic choices, then we would probably focus on nothing more than pure markets. Economists, for example, like to look at the distribution of goods and services, both at a community level (macro- economics) and at the individual level (micro-economics). Economists, for example, like to look at the distribution of goods and services, both at a community level (macro- economics) and at the individual level (micro-economics). The key object of study for economists is the market, which is for them the most important mechanism by which choices about resource allocations are made. Economists rarely consider political institutions as being the primary arena in which collective choices are made. The key object of study for economists is the market, which is for them the most important mechanism by which choices about resource allocations are made. Economists rarely consider political institutions as being the primary arena in which collective choices are made. Economists like to look at humans as “rational” beings, who pursue their goals on a cost-benefit basis (we have seen this before; indeed, RCT in political science was imported from economics). Economists like to look at humans as “rational” beings, who pursue their goals on a cost-benefit basis (we have seen this before; indeed, RCT in political science was imported from economics). Tend to focus on concepts such as zero-sum games, dynamic equilibrium, etc. Tend to focus on concepts such as zero-sum games, dynamic equilibrium, etc.

5. Economics with politics However, the consequence of unrestricted market-based transactions is, as we know, inequality. Whether we like it or not, markets produce winners and losers. However, the consequence of unrestricted market-based transactions is, as we know, inequality. Whether we like it or not, markets produce winners and losers. Although classical economists such as Adam Smith and David Ricardo saw the market as the most efficient form of distributive mechanism, they also recognized the need for government to (a) guarantee the market, and (b) regulate the market. However, they saw little need for government to intervene in market outcomes. Market guarantees are needed so that we can trust the actions of others (we would be unlikely to trade if we thought there was no guarantee of honesty and fair treatment), and regulation is needed to make sure that all those who participate in the market conform to agreed-upon standards. Although classical economists such as Adam Smith and David Ricardo saw the market as the most efficient form of distributive mechanism, they also recognized the need for government to (a) guarantee the market, and (b) regulate the market. However, they saw little need for government to intervene in market outcomes. Market guarantees are needed so that we can trust the actions of others (we would be unlikely to trade if we thought there was no guarantee of honesty and fair treatment), and regulation is needed to make sure that all those who participate in the market conform to agreed-upon standards. But political economy pushes these questions a bit further. The fundamental questions that most political economists deal with in some shape or form are; to what degree should governments intervene in (a) market regulation, and (b) mitigating market outcomes? But political economy pushes these questions a bit further. The fundamental questions that most political economists deal with in some shape or form are; to what degree should governments intervene in (a) market regulation, and (b) mitigating market outcomes? This clearly raises both a set of normative and empirical questions. For normative theorists, the questions are those of choices, while empirical studies in political economy may focus upon the effects of different patterns of regulation and different patterns of market mitigation. This clearly raises both a set of normative and empirical questions. For normative theorists, the questions are those of choices, while empirical studies in political economy may focus upon the effects of different patterns of regulation and different patterns of market mitigation.

6. Normative approaches to political economy If we consider some of the main theorists who have made contributions to the study of the relationship between government and the market, we can place them on a continuum like the one below. The placement varies according to how much government intervention in the market was advocated by each theorist. Then we will have a quick look at each of them. If we consider some of the main theorists who have made contributions to the study of the relationship between government and the market, we can place them on a continuum like the one below. The placement varies according to how much government intervention in the market was advocated by each theorist. Then we will have a quick look at each of them. Most intervention Least Intervention Adam Smith Karl Marx John Maynard Keynes

7. The Classical Liberals - Adam Smith Inquiry Into The Nature And Causes Of The Wealth of Nations (1776) Core contribution: An economy that is made up of individuals each pursuing his or her own self-interest may work for the good of all. Within the framework of the rule of law, economic transactions will be voluntary for either the seller or the buyer. Since transactions are voluntary, none will take place that will not benefit both parties. A trade that benefits both and does not harm anyone else will be socially beneficial. The more trades there are, the more that society will benefit. The free market economy leads to an ‘optimal’ or ‘efficient’ allocation of resources. An economy that is made up of individuals each pursuing his or her own self-interest may work for the good of all. Within the framework of the rule of law, economic transactions will be voluntary for either the seller or the buyer. Since transactions are voluntary, none will take place that will not benefit both parties. A trade that benefits both and does not harm anyone else will be socially beneficial. The more trades there are, the more that society will benefit. The free market economy leads to an ‘optimal’ or ‘efficient’ allocation of resources. Government intervention is unnecessary because an individual who, “intends only his own gain is led as if by an invisible hand to provide an end which was no part of his intention. Nor is it always the worse for society that was not part of it. By pursuing his own interests, he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affectuated to trade for the public good.” Government intervention is unnecessary because an individual who, “intends only his own gain is led as if by an invisible hand to provide an end which was no part of his intention. Nor is it always the worse for society that was not part of it. By pursuing his own interests, he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affectuated to trade for the public good.”

8. The Role of Government: For Adam Smith, the role of government should be quite limited. In an extract from The Wealth of Nations, we find that he wrote: For Adam Smith, the role of government should be quite limited. In an extract from The Wealth of Nations, we find that he wrote: “The sovereign has only three duties to attend to: three duties of great importance, indeed, but plain and intelligible to common understandings: first, the duty of protecting the society from the violence and invasion of independent societies; secondly, the duty of protecting, as far as possible, every member of society from the injustice and oppression of every other member of it, or the duty of establishing an exact administration of justice; and, thirdly, the duty or erecting and maintaining certain public works and certain public institutions, which can never be for the interest of any individual or small number of individuals, though it may frequently do much more than repay it to a great society.”

9. Karl Marx Core contribution: Marx believed that the relationship between individuals engaged in economic transactions is necessarily unequal in a capitalist economy. Marx believed that the relationship between individuals engaged in economic transactions is necessarily unequal in a capitalist economy. Inequality, for him, stems from the division of society into two great classes, capitalists and labor. Inequality, for him, stems from the division of society into two great classes, capitalists and labor. Even if trade in the marketplace is voluntary, outcomes are not equally beneficial because the parties do not start with equal endowments (i.e some have more money and capital than others). Even if trade in the marketplace is voluntary, outcomes are not equally beneficial because the parties do not start with equal endowments (i.e some have more money and capital than others). Therefore, Marx argued that capitalists have an unfair advantage in the marketplace due to their accumulated wealth and privilege. Therefore, Marx argued that capitalists have an unfair advantage in the marketplace due to their accumulated wealth and privilege.

10. In an extract from Das Kapital, Marx writes that: In an extract from Das Kapital, Marx writes that: “Political economy conceals the estrangement inherent in the nature of labor by not considering the direct relationship between the worker (labor) and production. It is true that labor produces wonderful things for the rich - but for the worker it produces privation. It produces palaces - but for the worker, it produces hovels. It produces beauty - but for the worker, deformity. It replaces labor by machines, but it throws one section of the workers back to a barbarous type of labor and it turns the other section into a machine. It produces intelligence - but for the worker, stupidity, cretinism.”

11. The Role of Government Under capitalism, Marx tells us, the state was necessarily an instrument of class oppression, the “management committee of the bourgeoisie” The Communist Manifesto of 1848). The state, and its political institutions, would only be used by those with privilege, power, and wealth, to further their interests and to make sure that their dominance of the marketplace could not be threatened. Under capitalism, Marx tells us, the state was necessarily an instrument of class oppression, the “management committee of the bourgeoisie” The Communist Manifesto of 1848). The state, and its political institutions, would only be used by those with privilege, power, and wealth, to further their interests and to make sure that their dominance of the marketplace could not be threatened. Thus Marx argued that the only way to redress this situation would be for a socialist revolution. Under socialism, the state would manage the communal redistribution of property and the allocation of equal endowments. To do so, the state would need to appropriate the means of production (i.e. take over the factories and industrial production facilities). Thus Marx argued that the only way to redress this situation would be for a socialist revolution. Under socialism, the state would manage the communal redistribution of property and the allocation of equal endowments. To do so, the state would need to appropriate the means of production (i.e. take over the factories and industrial production facilities). As endowments became equal, in this line of thinking, class distinctions would disappear. As that happened, Marx thought that there would simply be no more need for the state. In this stage, which Marx termed communism, the state would simply wither away. As we know, this did not happen at all under communism; indeed, the state was rather strong and omnipresent! As endowments became equal, in this line of thinking, class distinctions would disappear. As that happened, Marx thought that there would simply be no more need for the state. In this stage, which Marx termed communism, the state would simply wither away. As we know, this did not happen at all under communism; indeed, the state was rather strong and omnipresent! Although Marx may have been wrong about communism, his analysis of the inequality of capitalism was ground-breaking and is still fresh and relevant today. Once does not have to be a Marxist at all to see that he was fundamentally correct about the inequalities of the market place. Although Marx may have been wrong about communism, his analysis of the inequality of capitalism was ground-breaking and is still fresh and relevant today. Once does not have to be a Marxist at all to see that he was fundamentally correct about the inequalities of the market place.

12. John Maynard Keynes John Maynard Keynes probably shaped our modern views about political economy more than anybody else. John Maynard Keynes probably shaped our modern views about political economy more than anybody else. Despite the fact that Keynesianism was severely criticized from the 1970’s onwards, his ideas still shape almost all of the economic strategies used by governments. Despite the fact that Keynesianism was severely criticized from the 1970’s onwards, his ideas still shape almost all of the economic strategies used by governments. However, some of the instruments that he identified are now used a bit differently than he would have anticipated. However, some of the instruments that he identified are now used a bit differently than he would have anticipated. Keynes reshaped our ideas about political economy in the aftermath of World War One and the Great depression. Keynes reshaped our ideas about political economy in the aftermath of World War One and the Great depression. Fundamentally, he was concerned with finding a way to end the seemingly deeper and deeper economic downturns that were being witnessed by the global economy. Fundamentally, he was concerned with finding a way to end the seemingly deeper and deeper economic downturns that were being witnessed by the global economy.

13. The General Theory of Employment, Interest, and Money (1936) In the classical model (i.e. the work of Adam Smith and others), the unemployment caused by the Great Depression should have been solved by wage reductions that would rapidly clear the labor market. The laws of supply and demand tell us that when there is a surplus, it drives down prices; so as people become unemployed, they should be willing to work for less, and eventually this will allow producers to cut prices to the extent that they can build more goods. At that point, they will need to hire more workers, and so unemployment would fall. In the classical model (i.e. the work of Adam Smith and others), the unemployment caused by the Great Depression should have been solved by wage reductions that would rapidly clear the labor market. The laws of supply and demand tell us that when there is a surplus, it drives down prices; so as people become unemployed, they should be willing to work for less, and eventually this will allow producers to cut prices to the extent that they can build more goods. At that point, they will need to hire more workers, and so unemployment would fall. However, this did not seem to be happening at all. Keynes thought about this, and tried to analyze the reasons for it. However, this did not seem to be happening at all. Keynes thought about this, and tried to analyze the reasons for it. Ultimately he came to the conclusion that it was because there was no single entity large enough to withstand the effects of a massive depression and to help restart economic growth. Ultimately he came to the conclusion that it was because there was no single entity large enough to withstand the effects of a massive depression and to help restart economic growth. He argued that market forces are not an adequate ‘adjustment mechanism’; he concluded that only government has the capacity to stabilize the economy. Furthermore, he argued that government had the responsibility to do it as well. He argued that market forces are not an adequate ‘adjustment mechanism’; he concluded that only government has the capacity to stabilize the economy. Furthermore, he argued that government had the responsibility to do it as well.

14. The Role of Government For Keyes, the role of government is to stimulate demand in the marketplace through spending in times of economic slack. He argued that only government would be able to do this, since governments are somewhat immune to the pressures of the market. For Keyes, the role of government is to stimulate demand in the marketplace through spending in times of economic slack. He argued that only government would be able to do this, since governments are somewhat immune to the pressures of the market. Policy makers should manipulate government expenditures to achieve a desirable level of aggregate demand. By this, he meant that governments should go out and buy goods in times of economic downturn, contrary to normal market behavior. Policy makers should manipulate government expenditures to achieve a desirable level of aggregate demand. By this, he meant that governments should go out and buy goods in times of economic downturn, contrary to normal market behavior. In times of economic downturn, this can be achieved either through (a) lowering tax rates or (b) increasing government expenditures. In times of economic downturn, this can be achieved either through (a) lowering tax rates or (b) increasing government expenditures. According to Keynes, governments should incur deficits and borrow money in times of downturn; these debts can be repaid through higher taxation in times of economic growth. According to Keynes, governments should incur deficits and borrow money in times of downturn; these debts can be repaid through higher taxation in times of economic growth. As Keynesianism became tried and tested in the new deal period, governments showed a marked preference for increasing expenditures over lowering tax rates. As Keynesianism became tried and tested in the new deal period, governments showed a marked preference for increasing expenditures over lowering tax rates. Keynes introduced the radical notion of government borrowing, and many thought it was sound economic theory. However, governments began to forget to pay back there debts when times were better, leading to massive accumulated debts and deficits. Keynes introduced the radical notion of government borrowing, and many thought it was sound economic theory. However, governments began to forget to pay back there debts when times were better, leading to massive accumulated debts and deficits.

15. Modern Economic Management: Four Approaches  Today, there are really four distinct schools of economic management, each of which has its roots in one or more of the theories discussed above. They are; 1. Monetarism: Inflation is caused by too much money chasing too few goods. Solution is to match increase in money supply with growth in economic productivity. 2. Supply-Side Economics: Problem is the lack of incentive to save and the lack of incentive to work. Solution is for government to increase these incentives by (a) reducing taxes (particularly the capital gains tax), and (b) reducing levels of government expenditure. 3. Keynesianism: Health of the economy depends upon how much people save or spend. Too much saving leads to too little demand. Too much spending leads to too much demand. Solution is for the government to create the right level of demand. 4. State Planning: Problem is the free market, caused by the power of the corporations and unions to dominate the marketplace. Solution is for government to control prices and wages.

16. Modern Approaches: a summary Pro-Market (theorists such as Adam Smith, David Ricardo, Milton Friedman) 1. Monetarism: more associated with capitalism and very limited government intervention, the favorite of Margaret Thatcher. 2. Supply-side: again, very associated with unregulated capitalism, associated with tax- cutting (the United States). Market skeptical (theorists such as John Maynard Keynes, Karl Marx) 1. Keynesianism: more identified with capitalism, although involving heavy government intervention. 2. State-planning: more identified with socialism and communism, involving heavy government ownership of the economy.