Just in the past few months, three small- to mid-size U.S. banks failed after a bank run was triggered, raising concerns about the possibility of a recession. With rising interest rate, high inflation, and bank failures, should we worry about another potential financial crisis? Although it is difficult to forecast the future business cycle, in this blog, I will explore two significant schools of thought in macroeconomics: the classical approach and the Keynesian approach. By examining their theories and historical events, we can gain insights into the dynamics of financial crises.
The classical approach, introduced by Scottish economist Adam Smith in 1776, emphasizes the concept of the “invisible hand” in his famous work, The Wealth of Nations. According to this perspective, the economy operates as a self-regulating system driven by the forces of supply and demand. In a free market, when individuals pursue their self-interest, resources are efficiently allocated through voluntary exchanges and competition, leading to economic growth. Classical economists believe that prices and wages are flexible and can easily adjust to changes in supply and demand. Consequently, they view disturbances like recessions and unemployment as temporary and expect the market to self-correct without much significant government intervention.
Despite the dominance of classical economics in the 18th and 19th centuries, the world was confronted with a monumental challenge during the Great Depression of the 1930s. The United States adhered to the principles of classical economics, allowing the market to heal itself after the 1929 stock market crash. However, the crisis worsened, leading to massive unemployment rates that lasted for over a decade. Similarly, Germany, burdened by war reparations, experienced a collapse of its banks and a significant decline in industrial production. These events ultimately caused the rise of the Nazis and set the stage for World War II. The classical approach and the invisible hand idea appeared to be strongly inconsistent with the data and was unable to explain the persistence of the recession.
In 1936, British economist John Maynard Keynes proposed an alternative explanation for persistent high unemployment. Keynes argued that inadequate demand could lead to prolonged periods of economic disequilibrium, as wages and prices adjust slowly. Keynesian economists agree that wages and prices will eventually equate aggregate demand and supply in the long run, but as John Maynard Keynes said, “in the long run we’re all dead.” They advocate for government intervention to alleviate unemployment and solve the problems in the short run, rather than wait for market forces to fix things over the long run.
The bursting of the U.S. housing bubble in 2007 triggered a widespread financial crisis, resulting in mortgage defaults and significant losses for financial institutions. With Lehman Brothers going bankrupt and Merrill Lynch being acquired, the US stock market plummeted by over 40% within a year, and the unemployment rate soared from 4.5% to 10%. In response, policymakers implemented measures aligned with Keynesian economic ideas. Through fiscal stimulus and expansionary monetary policy, they aimed to boost demand and stabilize the economy. Although the crisis still had severe repercussions, the implemented measures helped mitigate the damage when compared to the Great Depression. This demonstrated the potential effectiveness of Keynesian policies in managing and recovering from financial crises.
In October 2022, the Nobel Memorial Prize in Economic Sciences was awarded to the American economists Ben S. Bernanke, Douglas W. Diamond, and Philip H. Dybvig, for their analysis that significantly improved how society deals with financial crises. Notably, Ben S. Bernanke, the former chairman of the US Federal Reserve during the 2007 financial crisis, played a crucial role in preventing it from escalating into a full-blown depression with the Keynesian approach. The study of macroeconomics and its different schools of thought provides us with valuable insights into the dynamic of financial crises, and it instills confidence in the ability of economists and government institutions to learn from past experiences and develop strategies to prevent and mitigate the impact of future possible financial crises.
