We have noted that since early times, governments have issued standard coinage and set standard weights and measures. Private property and a system of laws are also required in a market economy[1].
Most of the economies in the world today use a more-or-less managed capitalism model. Such a system has a robust market economy with private ownership, but government works to keep markets competitive, deal with market externalities, promote full employment, ensure that wages are sufficient to live on, provide some forms of social insurance, and smooth out business cycles. There has been an ongoing debate in both economics and politics about the extent to which government should intervene in the working of the market. “Neoliberalism” which is paradoxically a philosophy associated with conservatives, asserts that less government intervention in the market and lower taxes increases growth and makes us all richer, at least in the aggregate. Neoliberal policies (think “deregulation” and “supply side” and “trickle down” economics) were put in place in the United States under Ronald Reagan and in Britian by Margaret Thatcher. You can draw your own conclusions as to whether this was good, bad, or indifferent, when we look at the data on growth and inequality in Part II. Suffice it to say that too little government involvement in the market can be as bad as too much.
Managed capitalist economies, indeed, any market economy, is prone to booms and busts. These can be extremely painful, the Great Depression being a prime example. At the time, economic theory said that the free market would address these busts automatically: workers would simply have to take lower wages until full employment was again restored. Under supply and demand curves as usually drawn, this might seem to make sense. But what if there is no demand for labor? The economist, John Maynard Keynes, pointed this out and suggested that the problem was one of inadequate demand. If, for whatever reason, demand for goods and services falls in an economy, the demand for workers falls and some of them are let go. The unemployed are going to spend less, reducing demand further, and other workers become insecure and start spending less as well. Demand crashes, unemployment rises, and voila, you have a depression. Keynes suggested that governments should pump up demand by spending to make up for the lack of consumer spending. This is precisely what was done by FDR, and it worked.
When you think about it, the idea is common sense. The Biblical story of Jacob has him interpreting the dream of the Pharoah: save during the fat times and spend during the lean years. In Aesop’s fable, during the summer the ant puts away food for the winter. In similar fashion, governments can cool overheated inflationary economies by cutting back on spending or increasing taxes and spur a sagging economy by spending more or cutting taxes. This is called “fiscal policy” since it relates to spending. A second tool, monetary policy, is used to manipulate interest rates: lowering interest rates makes money cheaper, which boosts spending and the economy, while raising interest rates makes big ticket items more expensive and can cool inflation. Governments around the world use fiscal and monetary policy now to smooth economic swings.
The recent COVID epidemic shows how powerful these tools are. Without governments “printing money” as some would say (actually, borrowing) the world economy would have crashed. The Great Depression would have been a picnic in comparison. After the end of COVID a mismatch between low levels of supply and high levels of demand resulted in inflation which prompted central banks to raise interest rates.
In short, government has a crucial role to play in market economies.
[1] Strictly speaking you don’t need private property in a market economy. A farmer doesn’t need to own his land to take his crop to market, but he must have ownership of the product of his labor.