/The Neoclassical Economic Dogma: Part I

The Neoclassical Economic Dogma: Part I

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 I am in Amherst, Massachusetts, teaching a two-week course to union activists enrolled in an MA program in Labor Studies.  The class is bright and eager to learn how our economic system works.  These students will go back to their unions and help spread the word, hopefully raising the consciousness of the members and building a stronger labor movement.  One of the things we do in the class is compare the mainstream (or neoclassical) and the radical (or Marxist) theories of how capitalist economies operate.  I thought that perhaps readers of this blog might be interested in this, especially those who have not been able to study this matter as much as they might have liked.  I wrote a book in 2002 titled Naming the System: Inequality and Work in the Global Economy.  Chapter Five looks at mainstream economics and Chapter Six explores radical economics.  I am going to place these chapters on this blog.  Below I have pasted (with some editing) the first part of Chapter Five.  Later I’ll post the remainder and then Chapter Six.  Comments are encouraged.
What Must Be Explained?  
The last two chapters have highlighted certain features of contemporary global capitalism. At least four of these characteristics stand out. First, the capitalist world economy is divided into a relatively few rich countries and a large number of poor countries. Why is this so? In addition, the gap between the per capita incomes of the two groups of countries has shown no sign of diminishing over a long period of time, and, in fact, has risen for perhaps over 100 years and certainly since 1980. Why is this so?
Second, there is great inequality in wealth, income, and various social indicators among individuals, households, and families within every capitalist country. Again, these inequalities show no sign of disappearing. Why is this so? Not only are there significant overall inequalities, but throughout the capitalist world, women and racial and ethnic minorities are over-represented at the bottoms of the various distributions: more likely to be without wealth, unemployed, poor, and sick. Why is this so?
Third, capitalist economies are frequently plagued by unemployment and underemployment. In the poor countries these are epidemic and have been for a long time. In both rich and poor countries, economic crises are recurring events, driving up the rates of unemployment and underemployment, sometimes with catastrophic results. Why are these things so?
Fourth, the overwhelming majority of workers in the capitalist world perform work which is physically or mentally debilitating, often both. Unskilled work, informal employment, child labor, sweatshops—these are the lots in life for most people. What is more, work is often insecure, unsafe and unhealthy, and only nominally free. Why are these things so?
In a word, why has more than three hundred years of capitalism raised the world’s output to what would not so long ago been unimaginable heights and fostered truly astonishing technological advances yet left more than two billion persons subsisting at the dawn of the twenty-first century on less than two dollars a day?
In this chapter, we will look at the answers to these questions given by mainstream or neoclassical economics. The neoclassical theory enjoys the allegiance of most professional economists, whose training in graduate school was steeped in this theory. It is the economic theory presented in nearly all introductory textbooks, so it is the only theory to which nearly all college students (and elementary and secondary students if they are taught any economics) are exposed.
Strictly speaking, neoclassical economics originated in Europe and England in the 1870s and was developed in part as a response to the radical economics of Karl Marx and Frederick Engels and the working class movements that this new school of economics was inspiring. However, the neoclassical economists drew much inspiration, as did Marx, from an earlier group of economists sometimes called the classical economists. This earlier group includes such great economists as Adam Smith and David Ricardo. I am lumping together in what follows all those aspects of classical and neoclassical economics that today form the corpus of the standard economic wisdom. This is a bit of a disservice to Smith, Ricardo, and all of their predecessors and progenitors who saw matters more clearly and realistically than do modern neoclassical economists.
In neoclassical economics, the individual is the primary unit of analysis. Society is seen as the sum of the individuals in it; social outcomes are the result of the decisions made by individuals. Economics is then conceived as the study of the individual decision maker. Neoclassical economics is basically the “science” of choice-making. Of course, we are talking about the choices made in the economic aspects of life. Since economic choices are primarily market choices, neoclassical economists study the choices that the participants in the market make. Neoclassical economists have also examined individual behavior outside the market—inside a business firm or inside a family, for example, but the analysis generally presumes that the individuals inside the firm or family act as if they were operating in markets.

We learned in Chapter One that a scientific investigation begins with assumptions. We have already mentioned that the primary assumption of neoclassical economists is that all persons act out of self-interest. To allow us to meaningfully trace out the logic of this assumption, the neoclassical economists argue that acting out of self-interest means that each person is a maximizing agent, trying single-mindedly to obtain the maximum amount of something.
The main actors in the marketplace are business firms (which sell outputs and buy the means of production), consumers, and workers. Each business firm, consumer, and worker is assumed to be a maximizer. The business firm is assumed to be trying to maximize its profits. The consumer is assumed to be trying to maximize his or her “utility,” the subjective satisfactions that are obtained by consuming the goods and services purchased. A consumer faced with two bundles of goods that yield the same utility will always choose the cheaper one. If the two bundles of goods have the same price, the consumer will always choose the bundle yielding the most satisfaction. Workers are assumed to maximize their utility, by allocating their time between wage labor (which is presumed to yield negative satisfaction, that is, to be painful) and not working (taking what the economist calls “leisure”) in such a way that they are subjectively better off than if they had chosen any other combination of work and leisure.
When all of the economic actors are busy pursuing their self-interests, they create both demands for and supplies of every conceivable type of good and service. The interaction of all of the buyers and sellers in the marketplaces generates a certain amount of production of any particular good or service and a price for it. The amount of a good supplied by business firms will tend to match the consumer demand for it. And the amount of labor supplied by workers will tend to be matched by the demand of the business firms for that labor. To see why this is so, we can ask what will happen in a world ruled by self-interest if the supply of something is larger than its demand or vice versa. When prices are too high, selfish business firms supply too much of it, looking toward the high profits they can make if they can sell a lot at a high price.
Consumers, on the other hand, see the high price as a sign that they should look for cheaper substitute products. So suppliers, unable to sell all that they have supplied, lower their prices, and this drives some suppliers out of the market. But consumers now demand more since the prices are lower. Eventually, the supply and the demand become equal, or as the neoclassical economists put it, there is an “equilibrium” between supply and demand.
This same sort of process is presumed to work in all markets. When prices are too high, supply is greater than demand. This surplus of output forces prices down until demand and supply are equal. If prices are too low, the opposite occurs. Demand is greater than supply, and prices rise until the two are equal. The higher prices reduce demand but attract supply. In a labor market, for example, if workers supply more than employers demand, a surplus of labor will exist in the market unemployment) and wages will fall, attracting demand but repelling supply ( “leisure” will become more attractive to some workers the lower is the wage rate) until demand and supply are equal.
To sum all of this up, we can say that all economic outcomes—the amount of each output produced, the price of every output, the amount of labor and the nonhuman means of production utilized, the wages of workers—are determined by the forces of demand and supply. If the Gross Domestic Product (GDP) of the United States is many times larger than that of Ethiopia, this must be a matter of supplies and demands in the two countries. The same must be true for any other differences between the two countries, from school attendance to infant mortality. If there are inequalities of wealth, income, jobs, wages, and hours within a country, these must also be connected intimately to supply and demand. Supply and demand must be at the root of unemployment, as well as differences in unemployment among various groups or countries and the sharp increases in unemployment associated with economic crises. Since both supply and demand are but the expression of the self-interested (maximizing) behavior of the individual actors in the marketplace, it is correct to say that ultimately, all of these phenomena are the consequence of individual choices made by buyers and sellers to maximize profits or utility.
Besides explaining economic outcomes as the result of self-interested individual choices in markets (supply and demand), neoclassical economists also argue that, if a society is willing to allow individuals to make their choices with a minimum of interference, the economic results will be a social optimum. What they mean by interference is intervention in the operation of markets by the government. By and large, governments should not do things such as set maximum prices for outputs or minimum wages for workers. They should not alter prices by placing taxes on outputs, and especially they should not impose restrictions on the mobility of any of the means of production. No nation should place a tariff, for example, on the import of another nation’s output.
The notion that a social optimum can be achieved by allowing each person to act in a self-interested manner when making economic choices was put into a famous maxim by Adam Smith, author of an early economics classic, The Wealth of Nations: “It is not from the benevolence of the butcher, the brewer and the baker that we expect our dinner, but from their regard to their own interest.”  Society as a whole benefits when each person looks only to his and her individual gain. We do not intend that society benefit, but that is the result that the market gives us. The market harnesses our “greed” and turns it into a gain for society.
A concept that neoclassical economists use to illustrate the power of the market to benefit society is “consumer sovereignty.” When markets are free of control, and when consumers are free to choose the outputs they want, then the market gives them just what they want. Suppose that a market, say for pizza in a large city, is in equilibrium, that is, the supply of pizza is roughly equal to the demand for pizza. For some reason (consumers have higher incomes or the prices of other fast foods have risen), consumers now want more pizza. What will happen? The existing pizza shops will not be able to keep up with the increasing demand—long lines will be seen at the entrances to the shops or they will be uncomfortably crowded. Observing this higher demand, the pizza shop owners will find it advantageous to raise the price of pizza pies (remember, they are profit maximizers). The pizza business will now be more profitable than before. Seeing this, the existing shop owners will start to enlarge their shops or open new stores, and budding young entrepreneurs will begin to open new shops. The rising competition in the marketplace does two things. It increases the supply of pizza and forces the price of pizza down. But lo and behold, pizza consumers get exactly what they wanted—more pizza! And this took place without any sort of government planning, indeed without any planning at all. As Ronald Reagan was fond of saying, this is a good example of the “magic of the marketplace.”
We could have worked the above example backward and shown that when consumers want less of a product, the market gives it to them, this time by less profitable firms leaving the market. Furthermore, when consumers tell the market (through their purchases) that they want more of something, the market also goes to work to make sure that the needed means of production are channeled into the market in which demand has increased. If the demand for pizza rises, so too will the demand for pizza shop workers. The higher demand for the workers will push the wage rate up, and the higher wage rate will attract the necessary labor to this market. So, the market not only gives consumers what they want (making them sovereign in the market), it also places (allocates) society’s means of production right where they are most needed.

And we are still not done with the wonders of the market. Suppose that an enterprising pizza maker invents a more efficient pizza oven and installs it in his store. This owner can now produce pizzas cheaper than his rivals. He can make higher profits because his costs per pizza are now lower. However, over time, his rivals will be forced to implement the new technology, and this will increase the supply of pizza, lowering its price (to the delight of pizza lovers) and returning everyone’s profits to rough equality. The implication of this example is that a competitive market will be very inducive to rapid technological development, but this is ultimately to the benefit of consumers.

Our pizza example can be extended almost infinitely. Suppose that workers demand more pleasant jobs. Just as in the pizza case, the increased demand for more pleasant jobs will raise the “price” of such jobs. That is, employers supplying less pleasant jobs will not be able to attract an adequate supply of workers. Wages for the less pleasant jobs will rise. The higher cost to employers supplying less pleasant jobs will encourage them or new employers to start supplying more pleasant (and temporarily less costly) jobs. Just as in the case of our pizza consumers, the workers get what they want. They are sovereign in the market.

Market Failures


Neoclassical economists recognize that there are situations in which the pursuit of self-interest does not necessarily lead to socially desirable outcomes. Such situations are called market failures. There are quite a large number of these. Let us briefly describe five of them.First, some socially useful outputs will not be produced in an economy where self-interest rules. If a shipping company builds a lighthouse along the ocean to protect its ships, it will not be able to prevent its rivals from using the light once it is turned on. Therefore, no shipping company will build a lighthouse, despite the obvious usefulness of lighthouses. Similar arguments apply to the national defense, general education, roads, bridges, and the like.
Second, if there are pervasive and severe inequalities in wealth and income when a market economy begins, these inequalities will be maintained by the normal operation of the markets. Markets are impersonal mechanisms, and they can make no judgments about what is right or wrong or good or bad. The example given in Chapter Two of the two children born in Pittsburgh illustrates the problem. If everything needed by a person has to be purchased in the marketplace, those with a lot of money to start with have an obvious advantage. Rich parents will be able to buy the things necessary for their child to face the labor market with good prospects, while poor parents will not be able to do so. Inequality can be socially and politically destabilizing, and we are now learning that it can, by itself, produce many bad social outcomes, including more crime and sickness. Inequality also takes some of the shine off the notion of consumer sovereignty. Those with the most money will be most sovereign.
Third, in a market economy, businesses must pay for their means of production, that is, they must bear certain costs of doing business. They must pay their workers, buy materials, supplies, machinery, and equipment, pay for advertising, transport, and a host of other necessary inputs. However, the production of most outputs also generates other costs to which the market does not automatically attach a price. The coal mining company in the village of my birth dumped its waste water into the nearby river, its waste byproducts into a ravine across town, and its noxious smoke into the air above the town. The residents, therefore, had to bear the costs of these corporate actions: rusty cars, infected lungs, poisoned water, dirty houses and laundry, and the debased natural beauty of the place. These costs, for which the mining company was not liable, are called “social” costs or “spillover effects.” Their existence means that, from society’s point of view, too much of the product that generates these costs is being produced. If these costs had to be taken into account when production decisions were made, the producer would find that some output was no longer profitable to produce.
Fourth, our example of consumer sovereignty assumed that when the existing pizza shops raised their prices and made higher profits, new businesses would open, and the increased supply from this new capital would give consumers what they wanted and lower the price at the same time. But what if the existing pizza shop owners could somehow prevent new shops from opening? In the case of a pizza shop, with its relatively low startup costs, this seems unlikely, barring some sort of criminal actions (which, of course, are not unknown). However, there are many examples of large companies successfully preventing new capital from entering a market. In automobiles, for example, the startup costs are so large that new entry is very unlikely even if demand is high and profits are large. The size of the existing firms acts as a “barrier to entry.” If barriers to entry exist, the notion of consumer sovereignty falls to the ground. Consumers will face higher prices and smaller outputs than they desire, and the suppliers will enjoy price and output setting power.
Fifth, there may exist what neoclassical economists call “involuntary” unemployment. The supply of available jobs might not be large enough to absorb all of those seeking employment. Certainly this has happened in market economies, most notably during economic depressions. We have already discussed the considerable social costs of such unemployment, so suffice it to say here that involuntary unemployment is a market failure. This is because, once a depression begins, market forces can make a crisis worse. In 1932, for example, business firms could have hired workers at bargain basement wage rates, and they could have borrowed money from banks at near zero interest rates. Had they hired workers and used borrowed money to build new plant and purchase new equipment, output would have risen and unemployment fallen. They did neither of these things. They believed that if they did do these things, they would have made themselves vulnerable to bankruptcy and competitor takeover if the crisis did not end. Since they could not possibly know if it would end, they took the prudent path of putting whatever money they had in safe places and waiting. This action made the crisis long-lasting and showed that markets can produce socially undesirable outcomes in the form of widespread involuntary unemployment.


Neoclassical Solutions to the Market Failures: the Libertarian View

Since the market mechanism does not itself solve these market failures, the neoclassical economist is compelled to admit that some force outside of the marketplace must try to solve them. That is, there must be some entity in a market economy that looks out for the society as a whole. In all modern societies, of course, this entity is the government. The neoclassical position is that it is the duty of the government to combat market failures so that society’s interests are served. Having said this, I must immediately add that neoclassical economists are not in agreement about either the severity of the market failures or the best methods of dealing with them. Although this simplifies a little, I think it is fair to say that neoclassicals can be divided into two camps: the libertarians and the liberals. Except for the period from the Great Depression until roughly the end of the 1960s, the libertarian camp has been the dominant one, and it certainly is the predominant group today. In the United States, for example, a look at President George W. Bush’s chief economic advisors tells us immediately that they espouse libertarian positions and are deeply imbued with a strong antipathy for all things liberal.
The libertarian view is that, first, none of the market failures seriously challenge the overwhelming superiority of capitalism as a system of production, and second, that, to the extent the government must take actions to resolve them, it should do so in ways that intrude upon markets as little as possible. The government’s duty is to make markets work better and to expand the sphere of the market whenever possible. Sometimes governments try to curry public favor by implementing rules that interfere with the marketplace. The libertarians see such rules as grave errors, ones which governments should avoid in the first place but rectify wherever they find them already in existence. Here is a representative list of market interventions which the libertarians oppose:
1. Price subsidies: A government should not place controls on prices such that they are below the level that would be set by self-interest driven supply and demand. Suppose a government sets a maximum price for milk below what the market price would have been. It does this with the goal of helping poor families who perhaps cannot afford to buy certain basic necessities. The artificially low price of milk does not really help the poor says the libertarian. The low price creates a shortage (demand larger than supply), and this shortage will give rise to various undesirable situations. Those with political influence will get the scarce milk first. More well-to-do people will be best able to wait in the long lines that shortages always precipitate (or hire others to do so). Black markets will develop as self-interested individuals see that a higher price will be paid by some persons rather than go without milk. To feed these black markets,  persons with influence will buy up the available milk and then resell it on the black markets. In the end, those who the government aimed to help will still not get the milk. And suppliers who would enter the market if the price were higher will not do so. What is true for milk is true for any product for which the government sets an artificially low price—electricity, bus fares, cooking oil, etc.
2. Minimum wages: A similar argument applies to minimum wages. If the government sets a minimum wage above that which would prevail in the marketplace, the result will inevitably be a surplus of labor (supply larger than demand), that is, unemployment. The people presumably helped by a minimum wage are the people unable to find work at the artificially high wage rate. Needless to say, libertarians also oppose “living wages,” which have been proposed for and implemented in a number of U.S. cities. The “living wage” mandated by such proposals is always higher than the minimum wage set by the federal government.
 4. Market-regulating laws: Libertarians ordinarily also take a dim view of laws aimed at regulating markets. In addition to minimum wage and price support laws, they oppose laws which protect workers’ right to unionize. For them, unions are by their nature inimical to the smooth functioning of markets. Unions use their power to force wages above their equilibrium levels, generating unemployment in a manner similar to legally-mandated minimum wages. The workers shut out of unionized markets must seek employment in an overcrowded nonunion market, meaning that if they obtain work, it will be at wages lower than those which would prevail in the absence of unions. Unions can also make domestic products uncompetitive on world markets, thereby reducing both exports and employment.6  Other regulating laws are seen as unnecessary, in the sense that the market would accomplish the same things as the laws set out to do. Consumer sovereignty will drive unsafe and unhealthy products out of the market, so why bother to regulate them. Free workers will best be able to decide whether to work in certain unsafe jobs or unhealthy work environments. If they freely choose not to, employers will have to make the jobs safer and healthier to obtain a sufficient supply of workers. Similar arguments can be made for banking regulations, indeed for
any type of business regulation.

3. Income subsidies: Many countries have provided income to people who find themselves in unfortunate circumstances such as extreme poverty, unemployment, illness, and disability. Libertarians take a dim view of such income subsidies.5  Outright grants to the poor are especially criticized. In the United States, for example, certain poor persons, mainly single women with children, were once eligible for public assistance in the form of monthly cash grants. Some poor single men were also eligible. Libertarian neoclassicals are opposed to these grants. They argue that they encourage idleness by providing income without work effort. Just as we expect a person who hits a large lottery to quit working (because the demand for leisure will rise as income rises), so too we can expect the poor to work less or not at all when they get cash grants not tied to work effort. With respect to unemployment compensation, the libertarians reason that such compensation will create a certain amount of voluntary unemployment by encouraging the unemployed to take longer to find new jobs than would otherwise be the case. Payments for disability, especially if they are generous, will simply encourage workers to fake injury and illness to collect the subsidy. Again, the society loses valuable labor. We have already had occasion to examine the hostility of libertarians to social security (in Chapter One, although there we did not identify Professor Feldstein as a libertarian, just as a neoclassical).

5. Publicly-supported production: Neoclassical economists agree that certain production can only be done under the auspices of the state. The building of basic infrastructure like roads, bridges, airports, and the like is not going to be undertaken by private businesses, and the same is true for the national defense, the court system, and other needed government functions. However, if at all possible, the actual production of roads, bridges, planes, government buildings, etc. should be undertaken by private companies. It is legitimate for the government to levy and collect taxes (though not progressive taxes, which might interfere with various kinds of individual initiative—entrepreneurs might not be willing to take risks if the income they get when a risky venture pans out is taxed too heavily) to pay private businesses to supply the government with outputs. But actual government production should be avoided. Government production is bound to be less efficient than private production because competition will be lacking. Without competition there will be no incentive for a government-run operation to be efficient or for public employees to work hard. Actual public enterprise should be strictly limited to things like the armed forces, the courts, and certain police, such as border guards. All else should be contracted out to the private sector.
6. Restrictions of foreign trade and capital flows: There is a strong presumption among neoclassical economists that nations should not impose constraints on the buying and selling of goods and services across their borders. Nor should they place restrictions on foreign capital, whether this capital is in the form of money or capital goods. Tariffs and quotas on foreign output prevent the world’s economy from operating as efficiently as it otherwise would. If each country specializes in those things it does best (in those for which it has what mainstream economists call a “comparative advantage”) and trades with other countries for the things these other countries produce relatively efficiently, both nations will gain, that is, they will get a greater output than they would have had they tried to be self-sufficient. Consumers in each country will also pay lower prices if imported goods and services are freely available and untaxed. When a nation place a tariff on, say, foreign steel, consumers must then pay higher prices for every product that uses steel. The domestic steel industry will also not have to face full international and will, therefore, not be as efficient as it would otherwise be.

Placing restrictions on the movements of foreign capital also denies people the benefits of higher production and lower prices. The more money available in domestic markets, the easier it  will be to find financing for any number of production projects. Poor countries, for example, are often starved for capital (At least this is what the economists tell us). So, foreign capital fills a void and allows these nations to begin to develop their economies.

The libertarian neoclassical economists advise governments, then, to eliminate whatever restrictions they have placed on the free operation of markets. But how should a government handle the market failures? We have hinted at the answers above. If the market will not allow the production of certain useful goods and services, the government should provide for their production. The government should strictly limit public production; whenever possible, it should use tax revenues to contract out with private companies. It is alright for soldiers to be public employees, but the weapons they use should be produced by private corporations.

Libertarian neoclassical economists do not take the market failure of inequality very seriously. In fact, they usually argue the contrary: that inequality is a socially desirable thing. Inequality gives those with lower incomes an incentive to work hard and achieve, while it gives everyone the hope that they might accumulate very large sums of money and enjoy the life that money makes possible. Without the possibility of great riches, people would not be willing to take risks and innovate production. The only role the government might play here is to provide for those few people who, because of physical or mental disabilities, cannot possibly work. Private charities should be encouraged to help the less fortunate, and the government must strictly monitor the recipients of any aid to prevent cheating. Libertarian neoclassical economists wold not be opposed to public incentive schemes to encourage those who are poor to obtain education and training, the results of which will make them productive enough to earn more
money. Some programs which might help are school vouchers to help families to pay for school, perhaps low interest loans for school or training, and tax credits or wage subsidies to private employers to encourage them to hire poorer persons.

Social costs such as environmental destruction are best handled by extending the market mechanism rather than by legislation. The libertarian neoclassical economist points out that the reason a private business pollutes the air and water is because the water and the air are not private property. Thus, there are no costs the company must pay when it pollutes. The water and the air belong to no one; they can be used “free of charge.” What needs to be done is to place a price on the use of the water and air. This could be done through the creation, by the government, of what we might call “rights to pollute.” Such rights would have to be purchased by a company that wanted to dump a certain amount of a particular pollutant into the water or air. Once a business had to buy a pollution right, it would try to economize on its expenses, either by producing (and polluting) less or by finding a way to control pollution cheaper than the cost of
the pollution rights. The production of pollution control devices would be encouraged, since now there would be a demand for them. Companies which purchased rights that they did not use could sell them to any company that needed to pollute more than its own pollution rights allowed. All in all, this pollution rights scheme is another example of the “magic of the marketplace.”

Libertarian neoclassical economists suggest that, while barriers to entry in markets might be a short-term problem, they should not be a long-term issue. Barriers to entry result in abnormally high profits for those businesses creating the barriers. High profits, however, serve as an exceptionally strong incentive for capital to find a way into a market. In the 1950s, for example, the U.S. automobile and steel industries dominated world automobile and steel markets. Moreover, only a few giant firms dominated each industry in the United States. Very few cars were not produced by General Motors, Ford, and Chrysler. U.S. Steel and a handful of smaller but still large-scale producers made most of the world’s steel. Automobile and steel corporations were extremely profitable. General Motors achieved a rate of profit on invested capital of 20 percent, a phenomenally high rate of return at that time. Yet despite the massive
amount of money necessary to enter these markets and compete effectively, these corporations could not prevent rivals from entering their markets. Today, there are numerous Japanese, Korean, French, German, Swedish, and Italian automobile companies, and there are scores of competitors in the steel industry. Consumers have benefitted for this competition, and, at the same time, the efficiencies (called “economies of scale”) of large-scale production made possible by companies like Ford have been maintained.

With respect to involuntary unemployment, libertarian neoclassical economists were shocked by the Great Depression. They had been of the view that market forces would quickly bring a return of prosperity to a depressed economy. When a crisis strikes an economy, unemployment will increase as businesses cut back production or close. At the same time, the demand for bank loans will fall for the same reason. The growing unemployment, however, will
put downward pressure on wage rates, and this will encourage firms to begin hiring again. The fact that bank loan demand diminishes means that banks now have excess money to lend out. Banks will be forced by market competition to lower their loan interest rates, and this will encourage borrowing. As newly-hired workers spend their paychecks and borrowers spend the proceeds of their loans, business will begin to pick up, and the crisis will soon come to end.
During the Great Depression, wages and bank loan rates fell dramatically, but businesses did not hire more workers and no borrowers showed up at the banks. The Great Depression just dragged on. At first, the libertarians were  dumbfounded, but in the years since the 1930s, they have put forth the position that the great crisis was the result of bad policies followed by governments in most of the world’s market economies. One public (or quasi-public as is
sometimes the case) institution that all neoclassical economists believe is necessary in modern economies is a central bank and a central banking authority. In the United States the bank is the Federal Reserve System, and the authority is the Board of Governors. One function of a central bank is to regulate the availability of credit. Central banks do this by engaging in activities that put upward or downward pressure on interest rates. They can also serve as “lenders of last
resort,” making money available to troubled sectors in the market. Had the Federal Reserve put more downward pressure on interest rates as soon as the downturn began in late 1929, and if it had made funds available to cash-strapped businesses, banks, and brokers, the downturn would not have been nearly so severe and the upturn would have taken hold in a relatively short amount of time. In addition, most nations responded to the depression by placing high tariffs on imports. The resulting slowdown in international trade only made the depression worse. One country’s
exports are another country’s imports. If the United States levies a high tariff on foreign goods, as it did in 1932 with the notorious Hawley-Smoot law (which imposed tariffs as high as 100 percent, doubling the price of some imports), other countries will not be able get the revenue necessary to buy U.S. exports. The inability of U.S. exporters to sell their wares means that U.S. residents won’t be able to buy another country’s exports. A vicious spiral will drive output down in all countries. So, the libertarians say that had countries not reacted to the 1930s crisis with such high trade barriers, the crisis would not have been as severe as it was.

In general, libertarian neoclassical economists believe that prompt actions by central banks can either prevent recessions or depressions altogether or end them soon after they begin. No other government action is needed. If a government reacts to unemployment by increasing its own spending or cutting taxes, it will only waste money or cause total spending in the country to increase by too much, causing inflation. Sometimes, libertarian neoclassicals favor tax cuts when a recession begins, but this is usually done for the strategic purpose of forcing the government to spend less money in the future. By reducing public revenues, a tax cut puts pressure on the government to curtail its spending or risk running a budget deficit.