How Crises Shaped Economic Ideas and Policies

Interactions between economic crises and economic theories have been strong and important, as the authority in charge of the economic entity (be it the ruler, the state or an international organization) tries to respond to it by seeking policy guidance and explanation. Economic theories fall or flourish, adapt or perish, according to whether or not they are capable of facing this challenge. The outbreak of a crisis may be the reason for a previous tenet to vanish or the opportunity for a new one to be born and prevail. An economic theory that is well articulated may lead a society to prosperity and stability by avoiding major crises or—if it is frail and erroneous—to bring about instability and collapse.

Similarities between ancient and current malaises are not necessarily found in the form that a crisis erupts, but certainly in the way that a mechanism of reaction, recovery and future prevention is carried out. The 7-year famine in ancient Egypt is a prime example of crisis-management that deeply influenced economic developments in the then known world. Later, a crisis of over-indebtedness in classical Athens led to a wide range of political and economic reforms that proved to be pivotal to the rise of democracy and power. In turn, the decline of Athens prompted philosophers to think how the City should be restructured so as to regain prosperity, and this gave birth to several advances in economics. In other empires, a centralized system was adopted for collecting and distributing production, in many ways foretelling the central planning applications of the twentieth century.

The Roman Empire was too much relying on slave labour to feel the need for technical innovation, but nevertheless the recurrence of economic crises exercised a constant pressure to improve policies and institutions. When a real-estate bubble collapsed, Caesar invented a scheme of financial support to save households and banks. After the monetary collapse in the times of Diocletian, the introduction of coinage based on Gold restored confidence in the Eastern Roman Empire and ushered in a long period of flourishing trade and economic reforms. Economic thinking was advanced too, ranging from pragmatic rules on lending and profit to the concept of single tax and distribution theories.

Feudal Europe witnessed not only the suppression of liberties but also the stagnation of economic thinking. For several centuries, lending and commerce were demonized as unholy activities, until an unprecedented disaster that took place during the four century in Europe shook the feudal structures and catalyzed a wave of political change and social mobility. Economic thinking was rapidly advanced so as to interpret the new realities of emerging trade and wealth accumulation. As taxation becomes less repressive and monetary corrosion more repulsive to the awakening masses, sovereigns seek alternative forms of borrowing from the nascent banking system. This brings about new financing opportunities for the rising national states and, when it becomes excessive, a new type of economic malaise: the debt crises.

At the dawn of the modern era, the combination of political liberties and rational thinking was quickly undermining the dominance of religious doctrines and superstitions. Social order could not be any more imposed by ruthless repression, and political philosophers set out to propose a new balance between individuals and the state with various degrees of state empowerment and individual choice.

As deep conflicts of interest emerge among the protagonists of the new economic order, rival economic theories are formed to defend them: mercantilism supports the expansion of trade as the only means for a nation to accumulate wealth, while Physiocracy argues in favor of land owners and producers. The ceaseless quest for overseas investment opportunities and the increasing availability of credit lead to speculative bubbles and the outbreak of the first financial crises. Governments are puzzled on whether individual and collective interests can ever be compatible and new challenges open up for economists. On another ongoing crisis, however, authorities and thinkers were less eager to take up the challenge and, in sharp contrast to the progression of liberties in Europe and North America, the suppression of human labour in the form of slavery was often justified.

On the eve of the industrial revolution, new economic theories were sought to displace mercantilism and Physiocracy, and instead promote savings and investment as the main drives of economic growth. A combination of technological advance, market incentives and better institutions made England the hotbed of the new age, leaving behind wealthier—yet dysfunctional and repressive—France. Adam Smith provided a theory on how markets can ensure unhindered progress for the mankind, laying the foundations of modern economic theory. Subsequently, Malthus warned on the limited availability of resources and the risk of a society collapsing if population expansion is not checked. Ricardo reaffirmed the potential of continuing growth if capital accumulation is freed from high land rents and trade is liberalized so that each nation is specialized in its competitive advantage.

The optimism of Adam Smith did not exactly resonate with the reality of markets: persisting imbalances between supply and demand quickly led to the first capitalist crises. With falling profits, wages were further squeezed and soon a new movement was born demanding better conditions for the working class. Two formidable Germans interpreted the crises as a structural weakness of the capitalist system that would inevitably lead to its destruction. Building upon the Hegelian premises of historical phases, the newly founded Marxist theory advocated a new economic order that eventually would replace markets and ownership and uproot the profit mechanism for the benefit of the working class. The second half of the nineteenth century is marked by the second wave of industrialization, deep social divisions on how output is distributed and new monetary structures to achieve better coordination worldwide. New schools of economic thought in Germany and Austria dispute the prevalence of economic process and focus on the importance of history and the actions of individuals as the engine of growth. In the fast-rising US, economists search for how to stabilize wages and prices. Disapproving of the unproductive wealthy classes, Veblen supported the new strata of engineers and managers as the driving force towards more efficient production.

The founding fathers of economics were too concerned with the process accumulation and production to pay attention on whether the product is fairly distributed to the various social classes. Utilitarianism appears in the nineteenth century as a new theory that attempts to resolve the issue, but agreement was not easy. Should society pursue a collective prosperity as advised by Bentham or each person’s utility is inalienable and cannot deteriorate to improve a third party as ruled by the Pareto criterion? In the course of history, utilitarianism served as the basis of the welfare state but also provided arguments for those pursuing sectarian policies in the name of society. In the meanwhile, a middle class is emerging and this makes the polarization between capitalists and workers to look less threatening than in the early years. Capitalism proved to be a lot more resilient than the Marxist prophesies foresaw, but not as much in equilibrium as envisaged by its own theorists. A succession of peaks and crises is becoming a common characteristic of the developed economies, and a constant challenge to economic theories.

No other single event has so profoundly transformed the fundamentals of economic thinking as the Great Crash in 1929. In the aftermath of the crisis, academic orthodoxy and policy makers were passively waiting for the economy to automatic return to normality, while Marxist orthodoxy was contemplating the doomsday of capitalism. It took a radical new approach to understand the intricacies of the crisis and mobilize a new type of policies that ultimately succeeded in restoring employment and confidence in the system. The rise of Keynesianism inspired a host of related disciplines on measuring and modeling economic phenomena and ushered in a new period of understanding economics and conducting economic policy. Studying fluctuations became a central theme in economic theory, but views were still in conflict as to whether they can be dampened by policy intervention or should be left to attenuate themselves.

Marxist theory was certain about the inevitable demise of capitalism but less so on the system that would succeed it. Critical problems of production and distribution were only coarsely dealt with, thus the practical implementation of socialism was full of ideological experimentation, policy shortcomings, and food shortages. Early famines led to the formation of a highly bureaucratic central planning which enabled a speedy industrialization of Soviet Union but failed in the production of consumer goods and the efficient allocation of investments. The failures of central planning invited a variety of critiques, from the suggestion of an intermediate mix of markets with socialist production to the utter denouncement of price dirigisme in the economy. Several economic and political thinkers put in doubt the very character of the socialist system and tried to explain it as a modern replica of Asiatic despotism.

Marxist economists were not alone in their complacency that cycles are ruled out under central planning. The stability of post-war economies has made Governments and mainstream economists alike to believe that Keynesian fine-tuning is able to thwart any sort of a recessionary threat. In a parallel development, microeconomics was dealing with all problems of individual behavior and market imperfections so that distortions could be minimized and a high level of prosperity would be constantly attained. The disintegration of the Bretton Woods system opened the Pandora’s Box of economic malfunctions. Soon, Western economies were engulfed in the oil-price turbulence and a novel type of crisis that pushed both unemployment and inflation upwards. This development shattered dominant theories and ushered in the era of monetarism, rational expectations and strategic behavior. But as unemployment was piling up, economic theories and governments had to pay more attention to market imperfections and this enabled a more consensual approach among the old rivals of Keynesianism and Monetarism.

Economic growth became the catch word for many countries in the postwar period, no matter their ideological preferences and political realities. New theories try to explain the laws of capital accumulation and how the process can be improved so as to ensure a balanced and sustainable trajectory. Two off-springs of Keynesianism offered competing explanations on capital accumulation, while countries in Latin America attempted to achieve it by curtailing imports and mobilizing domestic resources. In most cases, inward economic development was mired with rising indebtedness and countries ended up with heavy-handed adjustment programs and external surveillance. In other cases with a thin domestic accumulation, development was encouraged by international aid. Yet again, misallocation and abusing of foreign resources trapped many poor countries into high debt. Economic theories faced several challenges on how a debt-crisis is efficiently handled and what kind of institutions can minimize the recurrence of malpractices.

Dominant economic theories were too confident on the efficiency of markets to guide and discipline the private sector, thus they concentrated on providing Governments with advice and rules on how to impose fiscal and monetary prudence. In most developed economies, the lessons paid off: inflation was checked, public debt was put under control and investment flourished. The collapse of communism led to further integration of international markets and a new era of global growth and prosperity seemed to be dawning. Some speculative bubbles appeared and disappeared, but were capable neither of destroying the big moderation of fluctuations nor undermining the prospects of further growth. In such exuberance, explosive external imbalances between over-saving and over-consuming nations went unnoticed for a long time. The global crisis of 2008 was soon reverberated as a crisis in economic theories and several questions on how our understanding of inherent instability can be improved are still pending.

The key lesson of the global crisis is that there is no such thing as inherent stability in economic systems and only a continuously revised and self-critical theory can provide knowledge, guidance and warnings on how a crisis can be dealt with or avoided altogether. Yet, the propagation of economic ideas in general and the teaching of economics in particular, are frequently characterized by overconfidence and lack of self-critical awareness. Some approaches are indulging in complex calculations disregarding the realism of the assumptions on which they are premised, while other schools of thought preach their ideas, no matter how they come to terms with reality. But economics are going to enjoy neither the deterministic certainties of natural sciences, nor the aloofness of philosophical purity. It is destined to be a knowledge system intrinsically linked to social dynamics and, therefore, continuously challenged by unforeseen problems. A major inspiration for improving this knowledge is by thoroughly reading the history of ideas and how they shaped, and were themselves triggered by, economic history.