1. 8. THE CLASSICAL/NEOCLASSICAL ECONOMIC POLICY DOCTRINE 1. The self-regulating market economy 2. The principle of laisseq-faire 3. Neutrality of money 4. Fiscal prudence and balanced budgets Classical liberalism and classical economics advocated limited government under the rule of law, private property rights, and laissez-faire liberalism in economic policies. Neoclassical economics is analytically quite different from classical economics but both were lumped together into the category ‘classical economics’ by Keynes because they shared the same doctrine or the same views on economic policy.

2. The self-regulating market economy The idea that the market has a capacity for automatic adjustment and coordination of economic activities through the price system and with the help of economic incentives is fundamental to economics. As stated in a textbook: “Probably the most important accomplishment of economics is the demonstration that individuals with purely selfish motives can mutually benefit from exchange” (Mueller 1989). Also, ideally a market economy would generate an equilibrium that is Pareto-efficient (provided a number of conditions are fulfilled). The classical doctrine is based on the presumption that all wages and prices are flexible, and that the economy adjusts rapidly towards equilibrium. Full employment is therefore the natural state of affairs, towards which the economy automatically tends. Lack of overall demand for goods and services was not a concern to the classical economists (Say’s law). Given full employment, the classics naturally gave a lot of emphasis to the supply side. Important virtues were therefore “thrift” (a high propensity to save) and “enterprise” (a high propensity to invest). They were mostly also of the view that diligence of labor would best be fostered by minimizing poverty relief, reflecting the belief that people risk having the temptation to claim relief rather than work.

3. The principle of laissez-faire Consistent with the classical liberalism that they embraced, most classical economists saw no need for government beyond the so called night-watch state. Also, given the efficiency of the market economy, it seemed to make sense that the government sector should be as small as was compatible with its fulfillment of the functions necessary for the market economy. This would also be in accordance with the weight given to individual liberty in the sense of “negative” freedom (cf. ). In fact, laissez-faire was seen as the only reasonable or responsible or possible approach, and government intervention, with some exceptions, was seen as useless or harmful. The role of the government was just to uphold the conditions for free trade and free markets. There was no need for government intervention or activism, given that the economy was a mechanism capable of automatic adjustment to a state of efficiency and full employment.

4. Neutrality of money The quantity theory of money reigned supreme from the late 19 th century and up to the 1930s. It was almost never put into question (Wicksell being an exception). It implied that money was only a “veil”, which could be abstracted from when analyzing the determination of relative prices and real magnitudes. Monetary policy would have no long-run effects on phenomena in the real economy such as the level of output or employment. Given that monetary policy could not improve the real economy, the agreed and sensible line of action was to keep money supply stable with a view to achieving price stability. Also, a metallic standard, notably the international gold standard, was seen as the appropriate institutional device for realizing price stability. Assuming authorities to follow the ‘rules of the game’ of the gold standard, this institutional framework would constitute an automatic mechanism for ensuring monetary discipline and price stability.

5. Fiscal prudence and balanced budgets The classical model leaves no useful role for fiscal policy in the sense in which the term is nowadays commonly used. The level of output is determined by the supply side, full employment is ensured by price and wage flexibility. Overall developments of the price level depend on the quantity of money. The appropriate task for government was to finance the expenditures needed for the (small) night-watch state to fulfill its functions. This should be done with those taxes that minimized harmful effects on the economy. Increases in public spending only crowd out private investment, which is to the detriment of long-term growth of the economy. There is in these circumstances no reason to deviate from the simple rule that the government budget should be in balance. The balanced-budget doctrine made sense for the classics not only economically but also politically. It would constrain the temptation for using budget deficits as an instrument for living beyond the means currently available.