Does Capitalism Cause Recessions?

Why do recessions occur? This question divides free market economists. After recently blogging on the classical conception of the business cycle, in which I described how “classical” economists believed that economic crashes are due to production errors, a commenter linked to an alternative perspective which suggests that recessions are the result of central banking. While this is true some of the time, it doesn’t explain why recessions plagued the economy before the introduction of the Federal Reserve (Fed) in 1913.

Is Classical Theory Irrelevant?

For the last 70 years, macroeconomics has become so entrenched within a demand-side framework that arguments that don’t operate within that paradigm are often derided as irrelevant.

A couple weeks ago I wrote a piece explaining classical business cycle theory and its denial of demand deficiency. Someone from a prominent think tank (not my former employer) messaged me, asserting that although he agreed classical theory is routinely misunderstood, he didn’t understand why it mattered:

It seems to me that the piece is really about …the fact that goods will command some price in the market - that demand for them will never literally reach zero – [which] is not a terribly interesting finding … and I would really like a clear explanation of why this matters...

Given the difficulty of discarding the macroeconomic lens that has prevailed since the 1930s, this misunderstanding and subsequent dismissal of the argument isn’t surprising. Virtually all modern theory is rooted in an “aggregate demand” paradigm—that is, demand management is understood as the key to a well-run economy. This is true for “Monetarists,” “Keynesians,” and even many free market variations, where disagreement has been reduced to whose model best achieves that end.

How Keynesian Economics Has Distorted Economic Thinking (Somewhat wonkish)

For the better part of a century, most economists have believed that recessions are caused by overall demand failure—total purchasing power dropping below the number of total goods on the market.

Part of the reason for the predominance of this thinking is that the man who popularized it, John Maynard Keynes, mischaracterized “classical” arguments in order to better refute them. Unfortunately, few are aware of the success these distortions have had on economic theory.

Keynes began his criticisms of the classical school by insisting that it offered no explanation for “involuntary unemployment”—or forced unemployment—and hence recessions:

Classical theory…is best regarded as a theory of distribution in conditions of full employment. So long as the classical postulates hold good, unemployment, which in the above sense involuntary, cannot occur… [emphasis added]

He then added to his criticism by accusing his opponents of fallaciously arguing that “supply creates demand,” which Keynes would repudiate: