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TEXTO PARA DISCUSSÃO N 612

HOW ECONOMICS BECAME AN INTERVENTIONIST SCIENCE

(AND HOW IT CEASED TO BE)

Rafael Galvão de Almeida

Setembro de 2019
Universidade Federal de Minas Gerais
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2019 How economics became an
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23 p. - (Texto para discussão, 612)
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ISSN 2318-2377
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 UNIVERSIDADE FEDERAL DE MINAS GERAIS
FACULDADE DE CIÊNCIAS ECONÔMICAS
CENTRO DE DESENVOLVIMENTO E PLANEJAMENTO REGIONAL

HOW ECONOMICS BECAME AN INTERVENTIONIST SCIENCE

(AND HOW IT CEASED TO BE)*

Rafael Galvão de Almeida

Mestre em Economia, PPGEC/UFSCar-Sorocaba
Doutorando em Economia, CEDEPLAR/UFMG

CEDEPLAR/FACE/UFMG
BELO HORIZONTE
2019

*
Work in progress.
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 How Economics Became an Interventionist Science (and how it ceased to be) - TD 612(2019)

SUMÁRIO

 
1. INTRODUCTION ............................................................................................................................... 6

2. ECONOMICS IN THE 1930S ............................................................................................................ 7

2.1. Importance of Keynes .................................................................................................................. 8
2.2. Socialist economic calculation debate .......................................................................................... 9
2.3. Quantitative methods .................................................................................................................... 9

3. DEVELOPMENT OF THE THEORY OF ECONOMIC POLICY .................................................. 11

3.1. Theoretical developments........................................................................................................... 11
3.2. Theory and ideology ................................................................................................................... 13

4. THE RETURN OF FREE-MARKET TO A RELEVANT POSITION ............................................ 14

4.1. Fall in the 1930s and reorganization .......................................................................................... 14
4.2. Public choice and political business cycles ................................................................................ 14
4.3. Friedman and rational expectations ............................................................................................ 16

5. CONCLUSION: ECONOMICS AND ITS POLICY RECOMMENDATIONS CHANGE ............ 17

REFERENCES ...................................................................................................................................... 19

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 How Economics Became an Interventionist Science (and how it ceased to be) - TD 612(2019)

ABSTRACT

The relationship between economics and State has been intimate ever since classical political
economy. However, perceptions about the role and size of the State have changed according to the
epoch. In other words, economic theory assigned a bigger or a smaller role to the State depending on
the political situation. This article analyses the change in economists and economic theory’s perception
of the role of the State in the economy, from favoring an interventionist approach from the 1930s to the
1960s, and a liberal approach from 1970s, in order to understand the factors behind this change.

Keywords: theory of economic policy; economic planning; liberalism; neoliberalism

RESUMO

O relacionamento entre ciência econômica e o Estado tem sido íntimo desde a economia política
clássica. Porém, as percepções sobre o papel e o tamanho do Estado mudaram de acordo com a época.
Em outras palavras, a teoria econômica aceitou um papel maior ou menor ao Estado dependendo da
situação política. Esse artigo analisa a mudança da percepção dos economistas e da teoria econômica do
papel do Estado na economia, de uma abordagem intervencionista da década de 1930 até a década de
1960, e uma abordagem liberal da década de 1970 em diante, a fim de entender os fatores por trás dessa
mudança.

Palavras-chave: teoria da política econômica; planejamento econômico; liberalismo; neoliberalismo

JEL: B22

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 How Economics Became an Interventionist Science (and how it ceased to be) - TD 612(2019)

The world under heaven, after a long period of division, tends to unite; after
a long period of union, tends to divide.
Luo Guanzhong, Romance of Three Kingdoms

1. INTRODUCTION

Economics and public policy have had an intimate relationship ever since the establishment of
the classical political economy. The current attitude towards State intervention in the economy is not
positive towards it:

“In an article published in the New York Times not long before the financial
crisis exploded, some interviews with eminent economists implied that rules
in favor of ‘free markets’ had become social norms. Princeton professor Alan
Blinder declared that ‘anyone who says anything even obliquely that sounds
hostile to free trade is treated as an apostate’. David Card, a professor at
Berkeley, said, ‘You lose your ticket as a certified economist if you don’t say
any kind of price regulation is bad and free trade is good.” (Dequech, 2017, p.
1638-9).

The stereotype of the economist is someone who is a supporter of the free-market, that problems
eventually will solve themselves through supply and demand (Klein, Stern, 2007), exemplified by
Margaret Thatcher’s famous dictum: “there is no alternative”1. However, it was not always like that. By
the 1940s, Durbin (1949, p. 41) wrote “we are all planners now”, Alvin Hansen pronounced the death
of individualism in his textbook on economic policy (Hansen, 1947, p. 14), and Seymour Harris claimed
that the invisible hand abandoned its followers in the hour they needed it most (Harris, 1949, p. 15).
Frank Knight wrote in 1933: “We cannot go back to laissez-faire in economics even in this
country…Now it seems to me inevitable that we must go to a controlled system” (apud Burgin, 2012,
p. 4). Stigler complained about the conservatism of economists in policy, part of their stereotype of the
time, and how they do not give the due attention to entrepreneurs, instead focusing on bureaucrats
(Stigler, 1959, p. 522).

For an economist in our current age, the idea that free-market used to be a heterodox idea seems
a bit weird. It shows how the perception of economists towards their own discipline tends to change
over time. In contrast, Tinbergen (1956, p. 6, emphasis added) was blunt on what entails economic
policy: “economic policy consists of the deliberate manipulation of a number of means in order to attain
certain aims”. What cause this change?

The primary objective of this article is to show how this change occurred in time, so it is, by no
means, an extensive history of all the changes related to the interventionist-liberal dichotomy, only the
ones we considered to be most important. This article has 5 sections besides this introduction: Section
2 explores, in a summarized way, the source of the transformations in economic theory in the 1930s that

1 “This is the mantra chanted by 'dries' during the prime ministerial reign of Margaret Thatcher, by which they demonstrated
their belief that free-market capitalism was the only possible economic theory. It was said so often amongst them that it was
shortened to TINA”. Source: <https://www.phrases.org.uk/meanings/376000.html>, accessed March 16th, 2018.

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 How Economics Became an Interventionist Science (and how it ceased to be) - TD 612(2019)

led to the development of the interventionist logic; Section 3 is about the theory of economic policy,
elaborated in Northern Europe by names like Jan Tinbergen and Ragnar Frisch; Section 4 writes about
how liberal and free-market ideas were ignored and how they resurged in the 1970s with rational
expectations and public choice theory; Section 5 concludes, wondering about the possibility that
economic theory may or may not be influence by trends and vogue.

2. ECONOMICS IN THE 1930S

As Acoccella (2017) showed, it is fundamental to start our research from the 1930s, even in a
summarized way. The 1930s was a singular time where both theoretical and practical changes happened
in economics, because it occurred concurrent to one of the most important economic crisis of recent
history: The Great Depression. The crash of 1929 initiated the Great Depression, an economic crisis that
plunged practically the entire world in an economic depression, with millions of unemployed, a halt to
world trade and a worsening of social conditions that led to the rise of fascism and Nazism in many
countries.

The economic theory did not remain passive against the economic situation. The failure of most
economists in foreseeing the crash of 1929 was not the only reason that created a crisis in economics.
New theories went and to-and-fro, debates changed the way people understood economics, and
economists became professionals in different parts of the world (e.g. Fourcade, 2009). The result was
that many authors consider that the interwar period was pluralistic because it is difficult to characterize
“interwar economics or economists in any convincing way” (Morgan, Rutherford, 1998, p. 2). It was a
crisis that would change the face of economics.

It should be noted that the economic role of the State has been changing during the Great
Depression, in a process that started with the formation of modern national states, translating into an
unprecedented growth in the middle of the 20th century, more than any time before. Tanzi (2011)
attributed this change to the obsolescence of artisanship, that lead to many workers to become
unemployed; fearing these workers might cause unrest, thus many governments created a safety net by
means of retirement and unemployment support programs, in national accounts term, increased the
transferences to the population, a process that increased after the Second World War, after the Allied
governments wanted to compensate the soldiers that fought in there (and thus had to grow its
bureaucracy to manage this increase in social security demand), and thus increasing taxes; in addition
to it, Tanzi identified another factor which was the increase of universal suffrage, which led to greater
political demands from the poor population. It should be noted that Tanzi wrote in the context of Western
developed countries (in which the most known related document is the Beveridge Report), but the
process was not different in underdeveloped countries, to which it can be added development policies.
These changes in the way of conducting policy also reflected changes in the way economic theory
evolved.

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2.1. Importance of Keynes

The economists affiliated to the German Historical School were the first economists to provide
an important contestation of the laissez-faire, in their indictment of English liberal economics and that
“the economy wrought by industrial capitalism was a new economy, and a new economy necessitated a
new relationship between the state and economic life.” (Leonard, 2016, p. 21). Although they never
went as far to propose a theoretical system, their influence was important in German and American
progressivist thought. But, according to authors such as Burgin (2012) and Pierson (2012), the modern
view on interventionism came to be with the work of John Maynard Keynes in the 1920s. His thought
on economic policy started in The Economic Consequences of Peace (Keynes, 1920), in which Keynes
criticized the harshness of war reparations imposed on Germany in the aftermath of World War One.
He blamed not only on a vengeful spirit but also on bad policy choices, relying on the laissez-faire
orthodoxy.

In the 1926’s essay “The End of Laissez-Faire” he wrote “The world is not so governed from
above that private and social interest always coincide.” (Keynes, 1932, p. 287, emphasis in the original),
thus rejecting the premise that self-interest is enlightened, that the ‘invisible hand’ automatically moves
society in the best possible path and that it should not suffer interference from the government. The
laissez-faire narrative seemed more “natural” because it established a narrative in which the unbounded
market creates wealth, and much stronger narrative than its opponents, viz. protectionism and Marxism.

He criticized not only the theoretical foundation of the laissez-faire but also the attitude of its
supporters: “devotees of Capitalism are often unduly conservative, and reject reforms in its technique,
which might really strengthen and preserve it, for fear that they may prove to be first steps away from
Capitalism itself.” (p. 294). Keynes wanted, above all, the establishment of an alternative between
laissez-faire and socialism that preserved the individual rights and entrepreneur spirit and a more just
income distribution.

The origin of those challenges to laissez-faire also had their influence thanks to the climate in
Cambridge, which fostered a pro-intervention ideology, especially in face of the Great Depression.
Richard Kahn, one of Keynes’s professors and collaborators, wrote on how an increase of government
spending (like building roads) can make improve the national economic situation by increasing the
investment and all the secondary markets surrounding it (by building a road, not only it employs the
workers that are working directly on building road, but also the infrastructure surrounding it, like
restaurants and hotels), and thus helping to improve the state of general confidence of a country (Kahn,
1931).

The neoclassical synthesis by Hicks (1937) allowed to build a model capable of combining the
original Keynesian political activism with a theoretical base to justify intervention according to
economic models, making it a synthesis of theory and practice, with the aim of full employment. Klein
(1966 [1949], ch. 7) argued Keynesian reforms would not lead to socialism or the loss of individual
rights, and they were needed to combat unemployment, which was an evil that led to fascism and war;
planning, then, would be the best tool for this objective. And the socialist economic calculation debate
validated research on planning from the theoretical point of view.

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 How Economics Became an Interventionist Science (and how it ceased to be) - TD 612(2019)

2.2. Socialist economic calculation debate

The socialist economic calculation debate happened during the 1920s and 1930s decades and it
opposed socialists and laissez-faire economists on the question whether a socialist economy would be
possible. It started when Mises argued that a moneyless economy would be impossible. Socialists
ignored the practical problem of the economy. He argued that they ignored the real nature of prices: they
serve as a benchmark on how to compare alternative projects. Since resources are limited, prices could
be used to determine the opportunity cost of projects, prices permit calculation. “Without economic
calculation there can be no economy.” (Mises, 1990 [1920], p. 18).

Mises’s article elicited a series of debates in the following years. Barbieri (2004, p. 82) argued
that the English debate was the most important because it had a greater audience and because it applied
the Walrasian general equilibrium to a socialist economy and the socialists proved that from a theoretical
point of view, for the Walrasian model, there is no difference between socialists and capitalist
economies.

This result had been already advanced by the Italian economist Enrico Barone (1935 [1908]),
that the socialist State would have the same role of the producer-consumer agent in the general
equilibrium model and would become the ‘benevolent dictator’ or the ‘Walrasian salesman’2. Authors
such as Fred Taylor, Henry Dickinson and Oskar Lange expanded the claim of equivalence between
capitalist and socialist economies to a theoretical level. Among them, Lange (1936) proposed the
definitive socialist answer to Mises’s challenge. In his two-part article, On the economic theory of
socialism, he argued that if we understand prices as opportunity costs, establishing centrally-fixed prices
would not be something only present in a socialist system. Under the management of a central planning
board, the government would use historical prices to fix prices in a socialist economy and then instruct
the managers of the factories to find an optimal combination of inputs.

Although Hayek would give a reply based on the diffusiveness of information, that would give
origin to the concept of a knowledge-based economy (Hayek, 1945), due to this equivalence between
capitalist and socialist economies explained by the general equilibrium model, the socialists were seen
as the “winners” of the debate for a good period of time. Their victory meant that manipulation of
economic variables was a viable way to do economic policy, either for a capitalist or socialist society.
Bockmann (2013) showed how the teaching of economics, especially the Walrasian paradigm, was
almost identical in the West and the Iron Curtain. As we shall see in the next section, Western socialists
were pivotal in creating tools of economic intervention.

2.3. Quantitative methods

The rise of econometrics, input-output analysis and national accounts were also important for
the establishment of an interventionist economic science. It should be noted that most of these advances
in quantitative methods were related to statistics and would find use later to policymaking. This should

2 Walras himself had socialist leanings and defended a central distribution of goods coexisting with a perfectly competitive
market. See Cirilo (1980).

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not surprise because historical research shows that “statistics was born as an auxiliary tool to the State”
(Duarte, 2011, p. 230, translated). Earlier pre-econometrics economic statisticians, like Henry Ludwell
Moore, defended “that complex mathematical theories could in fact be given substantive empirical
content to yield concrete results for social policy.” (Epstein, 1987, p. 13).

The foundation of the National Bureau of Economic Research (NBER) by Wesley Mitchell in
the 1920s, and lots of similar statistical bureau throughout the world, inaugurated an age where
compilation of statistical data was a primary objective of economists. A lot of statistical, monetary,
socioeconomic and financial data was available for researchers, thanks to Mitchell and his
institutionalist associates (Rutherford, 2003, p. 366). And this availability of data allowed the
development of a theory to test it, since the main concern of the institutionalists was to gather data on
the business cycle, instead of testing economic theories that might explain the business cycle (Morgan,
1990, p. 45).

And the founders of the econometrics saw an opportunity to use the data available. Two of the
most important founders were Ragnar Frisch and Jan Tinbergen, both of them would end up winning
the Nobel Memorial prize in economics in 1969 for their contributions to the establishment of the
econometrics.

Frisch was one of the “founding fathers” of the Econometric Society, of the Econometrica
journal (Louçã, 2007, p. 9-25) and Hoover (2012) credits him for creating the terms econometrics,
microeconomics and macroeconomics in their current incarnation. Meanwhile, Tinbergen was a
physicist of formation (having Paul Ehrenfest, one of the pioneers of quantum mechanics, as his advisor)
and went to economics to think about solutions for the problem of poverty and unemployment, thinking
it would be more useful to the society as an economist than a physicist (Boumans, 1993; Magnus,
Morgan, 1987).

It is worth to note that some of the fathers of econometrics had an ideological inspiration. Unlike
Moore, who was an avowed antisocialist, Jan Tinbergen’s motivations to study quantitative methods
and to develop econometrics were political, since he was associated with the Dutch socialist party; Frisch
also had connections with Norwegian socialist parties as well (Magnus, Morgan, 1987; Alberts, 1994;
Louçã, 2007).

Tinbergen also produced two of the most important policy models of the 1930s. The first was
the 1936 model, in the article “An economic policy for 1936” (Tinbergen, 1959 [1936]). It is credited
to be the first macroeconometric model ever developed and it had an attempt to influence national
policymaking with policy recommendations. Tinbergen developed the model under request from the
Dutch Economic Association, in an attempt to understand the bad economic situation of the Netherlands
and provide scenarios for its recovery (Magnus, Morgan, 1987, p. 122). In spite of being a rough and
problematic effort and because it was addressed to a national audience, the impact of the model was
minor, although Tinbergen still considered that it was accurate enough to the actual economic situation
(Tinbergen, 1959 [1936], p. 45), and it did help to settle foundations for future models, such as the 1939
model (Dhaene, Barten, 1989).

The 1939 model present in the two-volume report Statistical testing of business-cycle theories
(Tinbergen, 1939) was commissioned by the League of Nations, in order to empirically test theories on

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the business cycles. It should be noted that there was no consensus amongst the economists about which
variables were the cause of business cycles (Boumans, 2005, p. 45), so an empirical analysis would be
useful to find, at least, negative evidence (that some theories are wrong) through econometrics
(Tinbergen, 1939, p. 11). The effort was considered an important mark in the history of econometrics
and the debate that followed from Keynes’s negative review (Keynes, 1939) helped to establish
econometrics as a viable tool for policy (see Louçã, 2007, ch. 7). Without it, the developments in the
theory of economic policy (which will be the next section) would be impossible.

3. DEVELOPMENT OF THE THEORY OF ECONOMIC POLICY

3.1. Theoretical developments

With the prevalence of the synthesis of interventionist Keynesian policy, validation of planning
through general equilibrium models and development of planning and econometric tools, it created an
environment to allow the development of a theory of economic policy (TEP) and planning tools. Again,
Tinbergen and Frisch are the ones credited with developing a theory of economic policy. Before them,
theoretical work on economic policy was “little more than a collection of examples of empirical policy”
(Acoccella, 2017, p. 662).

After the Second World War was over, the European countries needed to reconstruct their
economies, many times almost from the scratch. From now on, planning in both capitalist and socialist
economies would become the standard way to do economic policy (Klein, 1947b) and many economists
started to follow suit, leading to the creation of a theory of economic policy. Both Tanzi (2011) and
Acoccella et al (2016) recognize that the Northern Europe provided the perfect climate for the
emergence of a theory of economic policy.

Acoccella (2017) argued that the emergence of TEP the openness of Scandinavia and the
Netherlands to theoretical innovation by Wicksell, Ohlin, Myrdal, among others, and their exchange
with Keynes (Louçã (2007) added the geographical proximity with the Soviet Union that allowed them
being aware of its planning techniques), the interaction between experts and policymakers through the
inter-Scandinavian Marstrand meeting and the meetings of the Dutch Economic Association, and the
style of planning, being an indicative one.

Amongst the most important of them, Frisch first mentioned that policy could be optimized
through flexible variables in a memorandum to the United Nations (Frisch, 1949). His interest in
econometrics and quantitative methods existed with the intention of providing tools for economic policy.
He showed this intention already in the 1930s (Frisch, 1934), in which planning would obey economic
laws of circulation under a general equilibrium framework (Dupont-Kieffer, 2012). His importance in
establish a system of national accounts in Norway, the Ecocirc-System, cannot be denied (Bjerve, 1995;
Lie, 2007). He was aware of problems such as the Arrow’s paradox and how the political arena could
be a place where existed more conflicts than anything else, but he defended that scientific planning was
a way to conciliate societal preferences, allowing politicians and scientific experts to cooperate for the

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national welfare, and thus heavy mathematical modelling was a way to give impartial validation to
planning (Frisch, 1971; Long, 1979, p. 149).

In Sweden, Erik Lindhal and Gunnar Myrdal moved to implement a welfare state, with help
from economic theory. Vellupilai (2013, p. 1331) wrote, with a personal testimony of Gertrude Lindhal,
Erik’s wife, that Ernst Wiggforss, Swedish finance minister in 1933, came to Lindhal and Myrdal
requesting them to elaborate a theory to justify the underbalancing of the budget, against criticism of
liberal oppositionists.

In the Netherlands, Tinbergen saw the opportunity to combine his econometric research with
concrete policy application. Thus, when he was appointed to the Dutch Central Planning Board (DCPB),
he developed the first ideas that would become his theory of economic policy. After the end of the war,
there was a shortage of supplies in the Netherlands, so restoring equilibrium in the economy was the
primary objective, through intensive control of the economic machinery in order to return to pre-war
levels (Tinbergen, 1947). The DCPB itself had little influence in decisive methods, but it provided a
large amount of data and techniques for the policymaking (Hughes Hallet, 1988).

First published in 1952, On the theory of economic policy became the first text in an attempt to
give theoretical treatment of economic policy. There, he proposed the fundamental concept that “the
choice of instruments cannot be separated from the targets and hence from the form of the indicator”
(Tinbergen, 1952, p. 4) and that the number of target variables must be equal to the number of
instruments, so that its sum with the number of irrelevant variables is equal to the number of structural
relations (p. 27).

Later, Tinbergen would consider his theory of economic policy important to the proposal of
development policies, with the intention of both creating an environment to development and active
intervention in the economy to facilitate the development, and quantitative techniques would be
indispensable, making part of the “scientific planning” (Tinbergen, 1967). And even later in his life, he
would maintain that “the purpose of economic research is either (a) to attempt to explain an economic
phenomenon or (b) to recommend an economic policy or structure” (Tinbergen, 1991, p. 33), showing
that economic theory must be purposeful.

The most important modification to Tinbergen’s TEP came from his fellow countryman Henri
Theil, colleague and pupil of Tinbergen. According to Hughes Hallet (1989, p. 198-202), his
contributions were the result of combining microeconomic demand theory and identified some problems
with Tinbergen’s approach, that it was too rigid, because it did not consider the uncertainty of non-
controllable variables and poorly specified models, the misnomer of irrelevant variables that turned out
to be relevant and the arbitrariness of the value of some target variables.

Theil proposed a way to turn flexible the policy options for the government and turn the choice
of the government a tradeoff that could be maximized. Theil’s efforts gave birth to the quadratic loss
function , (Theil, 1966, p. 16), which is familiar to any student of
intermediate macroeconomics. He mentioned this function has applications in engineering (p. 19) and
now he adapted it to economics. Usually the terms are assigned to the variables inflation and
unemployment and the policymaker is then given the choice to use policies to minimize both and
maximize the product.

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These are some of the most important traditions in TEP. According to Acoccella (2017), there
are others traditions in different countries. In Britain, for example, in spite of being one of the most
important centers of interventionist ideas, besides Meade, no British economist made an effort to create
a systematic theoretical treatment of economic policy (p. 666). This justifies why Tanzi (2011, p. 193)
called TEP the “Nordic European economic theory of fiscal policy”. Although the term “theory of
economic policy” could mean different things in different contexts, the term became associated with the
Theil-Tinbergen approach.

3.2. Theory and ideology

As Acoccella mentioned, “the weight and the left-wing orientation of the ‘intelligentsia’, as well
as of the political parties supporting the governments or of some strong opposition parties and
institutions (such as trade unions), together with the widespread idea that public happiness should be
served by a visible hand” (Acoccella, 2017, p. 668). Planning was invariably associated with what can
be considered “left” and it was developed in a time the divide between Capitalist West and Communist
East was most hostile. It should be noted that Tinbergen and Frisch’s effort to establish a scientific
planning aimed to be a neutral one, in spite of initial socialistic leanings presented their early years and
the association of planning with socialism during the economic calculation debate. In other words, they
attempted to give a value-free approach to planning through extensive use of quantitative methods, thus
they indirectly wanted to imply that “to intervene is to be scientific”.

The use of quantitative methods was also a way to disperse the ideological fears present in the
1950s. Sir Eric Roll wrote that “for a long time any discussion of the forms, methods, merits, and risks
of planned tended to be political and emotional” (Roll, 1968, p. 55), but many writers turned to
quantitative methods in order to disperse these subjective matters. Bockmann (2013) argued that both
in the United States (during the McCarthyism period) and Soviet Union (the Stalinist purges),
economists saw in quantitative methods a way to “escape” ideology, to not have their respective secret
services prying on their research3. In Latin America, there was an effort to show how planning
techniques were neutral, but the leftist stigma was still present (Bielschowsky, 2004, p. 387).

Tinbergen himself had concrete examples of this dilemma. During his time in the Dutch Central
Planning Office, there was a conflict between those who wanted a Soviet-style economic planning (with
yearly plans) and those who wanted policy guidelines (Hughes Hallet, 1988). He had to rephrase
“emotionally charged words, such as ‘planning’ and ‘National Welfare Plan’, redrafting them into
‘organized foresight’ and ‘Central Economic Plan’. Tinbergen also put considerable effort into
promoting ‘The Third Road’, showing the alternative between no planning at all and Soviet-style
planning.” (Jolink, 2009, p. 395).

It should be noted that the theory of economic policy was something different from the planning
techniques that emerged and were widely used. Propagation of planning techniques was encouraged by
the United Nations as a way to develop Third-world countries (e.g. United Nations, 1963). Sir Erich

3 However, see Weintraub (2017) for a critique of this view.

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 How Economics Became an Interventionist Science (and how it ceased to be) - TD 612(2019)

Roll wrote that “it is however, by no means clear that the next twenty years will produce so radical a
change in basic approach as did the last twenty in comparison with the preceding prewar period.” (Roll,
1968, p. 57). He wrote this in 1968. Economic theory would indeed undergo through a radical change
but not in the direction he wanted to.

4. THE RETURN OF FREE-MARKET TO A RELEVANT POSITION

4.1. Fall in the 1930s and reorganization

Up until the Great Depression, the laissez-faire doctrine was commonly held as the dominant
approach in economics. We saw that Keynes was one of the most important defenders of the idea that
laissez-faire harmed capitalism and held it responsible for the crisis of the 1930s. It should be noted that,
while economists are not entirely and unambiguously sure of what caused the Great Depression, if lack
or excess of intervention prior it and how the countermeasures might have deepened it, the commonly
held view is that the countermeasures influenced by the laissez-faire attitude was the “liquidationist”
answer to the Great Depression, that is considered the view that worsened the depression (White, 2008)4.

As mentioned before, the association of the 1929 crisis with the liquidationist view and the fact
that the equalization of the Walrasian model of a socialist economy with a capitalist one, during the
socialist calculation debate, meant a theoretical defeat for the liberals and non-interventionists. With the
promise of a social engineering, which Hayek (1973, p. 5) negatively labelled “rationalistic
constructivism”, the neoclassical Keynesianism dominated the policy guidance.

Thus, fearing their diminishing influence, they organized first through the Walter Lippman
Colloque, in 1938, and then through the Mont Pèlerin Society (MPS), in 1947 (Burgin, 2012). The MPS
was pivotal in organizing the liberal movement, in spite of the disputes between the factions (for
example, the German ordoliberals and American neoliberals, which ended up in the prevalence of the
latter group and posterior alienation of the former in the MPS), the society was important to provide a
forum for liberals on how to influence society for the improvement of liberalism.

4.2. Public choice and political business cycles

Amongst the main critics of interventionism were the public choice theorists. Although public
choice has different strands, the term is usually associated with the Virginia School of Political Economy
(MacLean, 2015), whose most important representative is James Buchanan – although Besley (2006, p.
29) argued that the term “public choice” is referred to any analysis that combines economics and politics,
in some circles (a definition we will use for this paper due to the necessity of encapsulating many views
into this section). Public choice emerged after application of the concept of the self-interested rational
economic agent to politics itself. As we have seen in the previous section, economists believed that the

4 White argues that economists associated with the liquidationist (like Hayek and Robbins) view are incorrectly blamed, and
blames the creation of central banks instead.

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 How Economics Became an Interventionist Science (and how it ceased to be) - TD 612(2019)

policymaker was an altruistic agent that believed that, through extensive mathematical modelling, he
could manipulate instrument variables to achieve policy targets.

In one of its earlier papers, Buchanan (1949, p. 505) concluded that we need an “individualistic”
theory of government, in which the government is just the collective will of individuals and thus cannot
be held responsible by economic action in the abstract sense. Downs (1957) applied utility concept to
show that this is how citizens use the government as proxy to enact policies that benefit them. Riker
(1962) showed, through extensive use of game theory, how political coalitions are rationally built to win
elections. Buchanan and Tullock (1999 [1962]) provided the foundations for constitutional political
economy. And Olson (1965) provided a theoretical treatment of political groups and issues of tragedy
of commons.

These works are considered the foundational works in public choice theory because they
managed to analyze political problems from an economic point of view and, in varying degrees, they
provided an alternative to the pro-interventionist TEP by treating policymakers as any other economic
agent. In the end, for them, market failure was not a problem as big as government failure (Keech,
Munger, 2015). Thus, during its formative years, public choice could be placed in the heterodoxy of
economic theory. Rowley (2008) went to the point of claiming that there was a conspiracy of mainstream
economics against public choice authors. Medema (2011, p. 232) claimed that public choice theorists
might exaggerate the lack of receptivity of public choice ideas, but the fact they were not part of the
mainstream during the 1950s and 1960s is clear. Medema (2011) also focused on the fact that public
choice theorists built a creative community to help discuss and propagate ideas. The ultimate recognition
of public choice ideas came with the Nobel memorial prize of 1986 being given to James Buchanan.

Similarly to public choice, and many times intersecting with it, the research in political business
cycles also showed to be an important criticism to the TEP idea of a benevolent policymaker. First
formalized by Nordhaus (1975), it provided an important criticism of how state action happens.
Basically, a political business cycle happens when the government increases fiscal/monetary
expenditures in election years; these policies increase the popularity of the incumbent government, by
transferring income to the electorate, and increasing its chances of being reelected at the cost of inducing
future inflation. Then, the government has to enact austerity policies to curb this inflation and, when
there is a new election, the cycle begins anew.

Although there are debates about the nature and actual existence of political business cycles
(e.g. Dubois, 2016), it provided a conceptual problem for long-term planning: “A final reason for
explaining the scarce attention to long-term planning (and then to an ingredient of the core) might be
tied to the importance of the Nordhaus political business cycle and the political aspects of policy, at least
in some countries, such as the USA, Canada, Japan and, possibly, Germany, in contrast with
Scandinavian countries.” (Acoccella, 2017, p. 668-669). If the government freely manipulated the
economy in order to achieve reelection, it remained little attention to long-term planning questions,
although Acoccella argued that it depends on the political culture of the country, a result that is
corroborated by recent political business cycle literature (Franzese, Jusko, 2006).

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 How Economics Became an Interventionist Science (and how it ceased to be) - TD 612(2019)

4.3. Friedman and rational expectations

Milton Friedman was, probably, the most important economist to challenge the synthetized
Keynesianism. Burgin (2012) considered him to have the same influence Keynes had, since they both
used similar methods (becoming public intellectuals) in order to propagate their ideologies. One of his
first academic articles was a critical review of Tinbergen’s report (Friedman, 1942) and he remained
critical of the Klein-Goldberg and structural models. “From Friedman’s point of view, his monetary
theory was a little David that succeeded against the Goliath of Keynesian multi-equation system. His
results were all the more disturbing to Keynesians who, as mentioned before, were positing structures
of greatly increased complexity.” (Epstein, 1987, p. 126). Further, Burgin argued that:

“The publication of “The Methodology of Positive Economics”

[Friedman, 1953] was a pivotal moment in the history of free-market
advocacy for two reasons. First, Friedman’s emphasis on the
necessary descriptive simplification entailed in the act of generating
hypotheses reinvigorated the embattled theory of perfect competition.
Economists had long struggled against the descriptive inaccuracies of
the homo economicus…The defense of simplified hypotheses in [the
article] was, implicitly if not overtly, a defense of the mode of perfect
competition…Friedman had opened a formidable new front in an
argument that many in the prior generation of free-market economists
had abandoned as lost.” (p. 161)

Thus, according to Burgin, Friedman’s methodological views proved to be a theoretical base for
laissez-faire theory, to contrast with the neoclassical Keynesian’s theoretical base for interventionist on
econometrics and the theory of economic policy. His reason for the Great Depression argued that it was
the FED’s failure to keep the supply of money in the economy, thus shifting the “blame” of the Great
Depression from the markets to State intervention – or lack of (Friedman, Schwartz, 1963). He helped
to popularize the label “monetarist”, which was initially related to the control of money supply by the
Central Bank and skepticism towards fiscal policy, but became associate with liberalization and
opposition to State intervention.

Friedman worked with theory (especially monetary theory), but his greatest achievement for
liberalism was his capacity of being a public intellectual. The theoretical role would belong to Robert
Lucas and the proponents of the rational expectations hypothesis.

The rational expectation hypothesis (REH) changed the economic theory again. The apparently
simple but mathematically complex definition that economic agents use all the information available,
both in the past and present, to make their judgements. Not only this, but, as De Vroey (2016) shows,
Lucas had an intention of replacing the Keynesian theory.

The REH paved way to the real-business cycle theory and the dynamic stochastic general
equilibrium (DSGE) models, that followed calibration instead of estimation. However, while the REH
meant an evolution in economic theory, the relationship with economic policy was shaken. For once,

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 How Economics Became an Interventionist Science (and how it ceased to be) - TD 612(2019)

the REH established the “policy ineffectiveness proposition” (PIP), in which policy intervention would
be neutral due to rational expectations (Sargent, Wallace, 1975).

The PIP meant that the agents could predict the consequences of an announced economic policy
and adjust their expectations accordingly and thus eliminating the effect of the policy. However, even
in spite of the PIP, economic policy has still been practiced. Some authors try to incorporate the REH
tenets into their economic policy research, while other have been attempting to formulate alternatives to
the REH and DSGEs. Thus, the theory of economic policy was just mere management of some variables,
with little mention of active intervention (e.g. Sargent, Wallace, 1976). “This state of affairs had led to
a widening of the gap between the production of economic science and the art of economic policy.” (De
Vroey, 2016, p. 306).

5. CONCLUSION: ECONOMICS AND ITS POLICY RECOMMENDATIONS CHANGE

The epigraph of this paper quotes the opening line of The Romance of the Three Kingdoms, a
highly fictionalized history of the Warring States period in Ancient China, 169-280AD, written in the
14th century (Luo, 2015). It opened with the breakdown of the Han dynasty and ends with its
reunification under the Jin dynasty. It recognized a constant process in Chinese history, of cycles of
separation and unification of the Chinese state. Though this principle was meant to be broadly
understood. In economics, this article attempted to provide an overview of the fact that interventionism
was once understood as a standard belief in economics and free-market liberalism was considered a
heterodox belief. The situation inverted after the 1970s, when theoretical developments that criticized
state action and defended a return to laissez-faire became the norm. In both cases, the change in
economic theory was linked to a change in the global economic situation

Interestingly enough, some authors had thoughts about whether there is a cyclical component.
W. Arthur Lewis, winner of the Nobel memorial prize of 1979, and John Jewkes, president of the Mont
Pèlerin Society from 1962-1964, though writers themselves of treatises on economic planning,
wondered if the euphoria of planning would be transitory - whether it was just a fad5 (Jewkes, 1950, p.
3), or part of a cycle wherein the importance given to the powers of the state in economic theory
oscillated (Lewis, 1952, p. 21).

Changes in the way economists perceived intervention happened in other periods of time.
Thomas Leonard, in his Illiberal Reformers (2016), had a historical account of how progressive
American economists, influenced by German thought and eugenics, attempted to create a State planned
and managed by science that would induce to a biologically efficient State. Lots of economists and other
social scientists (such as Richard T. Ely, John R. Commons, Irving Fisher, Edward A. Ross, Oliver
Wendell Holmes and even presidents Theodore Roosevelt and Woodrow Wilson) supported a social
engineering that would eventually turn the United States in a perfect moral managerial state. The
classical liberal thought, which included free-market, was seen as a superstition at best by them and they
proclaimed the future would be collectivist. The cost was that undesirable, disenfranchised Whites,

5 In an article from 2016, the writers at The Economist claimed that economists are prone to fads, especially in quantitative
methods (The Economist, 2016).

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 How Economics Became an Interventionist Science (and how it ceased to be) - TD 612(2019)

Blacks, Asians, Eastern Europeans, Native Americans, the disabled and women would have to have
their liberties limited or even they would be forcefully kept in the worse parts of society, all in name of
efficiency. This still has enduring effects on American society today.

And yet, the views on interventionism in the United States changed; Acoccella wrote that the
reasons why a theory of economic policy did not develop in the United States “where the dominant
credo was one of scarce public interventions, with the exception of unemployment and anti-inflationary
policies” and the scarce literature “lacked systematic treatment of the general ends of public economic
action, dealing mainly with more or less technical notions of the policy instruments that can be used to
further specific ends” (Acoccella, 2017, p. 666).

The recent financial crisis in 2007-2008 also provided an occasion to discuss economic theory.
Due to overall failure in predicting the crisis, many people started to question the fundamentals of
mainstream economic theory, with many articles demanding a revision of central tenets, such as general
equilibrium and the relationship between theory and evidence (e.g. Colander et al, 2009; Kirman, 2010;
Stiglitz, 2011). However, Dobusch and Kappeller (2009) argued that the presence of restrictive norms
concerning research and publication will ensue that the situation will not change much, not to mention
the bigger importance of networks that keep the current orthodoxy afloat.

Perhaps the very idea of an interventionist-liberal cycle might be coincidental or farfetched, but
this article showed how economists can change their minds, due to a series of processes it should be
noted that some studies find out that, even in spite of the unbounded free-market stereotype, most
economists tend to be “middle of the road”, preferring a mix of intervention and liberalism (Klein, Stern,
2007), and the theory of economic policy has absorbed much of earlier criticism and has evolved (e.g.
Acoccella, Di Bartolomeo, Hughes Hallet, 2016). We identified there is an overall change and proposed
some basic explanations. While this article used a “broad” approach to history of economic thought, it
provides guidelines for more applied work.

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 How Economics Became an Interventionist Science (and how it ceased to be) - TD 612(2019)

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