What is the 'Accurate' extent of the government's involvement in a free market?

When you hear about the government's presence in a market, you probably think about the tax you pay whenever you purchase something - be it new shoes or a bottle of juice. While it is true that tax is regulated by the government, the Congress to be exact, the presence of the government in markets is not limited to tax regulation. The government continually monitors economic patterns to see whether the economy is growing or leaning towards recession. Through applying different fiscal policies, the government tries to make sure that the markets in the economy are stable, as economic crises also have a negative impact on a country's politics. Yet, economists have been struggling to determine the accurate extent of government involvement in the free market. Surprisingly, there is no one right answer to this problem. Many prominent economists have developed contrary arguments to address this issue. Who were they, and for what did they argue? And most important, whose argument is most accurate?

The two of the most noteworthy views, as mentioned earlier, oppose each other. These views were presented by John Maynard Keynes (1883-1946) and Milton Friedman (1912-2006). Keynes believed that the recession was mainly caused by the decrease in investment, while Friedman saw the lack of money as the main problem.

Keynes developed a theory that when people, especially business owners, start to stock up the money rather than invest it (for instance, in a new factory), the amount of money circulating in the economy begins to diminish. When people invest, they allocate their income back into the economy: if a company decides to invest its earnings by building a factory, it needs to pay the architect for planning out the building and people working at the construction site. In this way, the company is boosting up the economy - the money they invest ends up as somebody's else income. As a result, these people can then spend the money earned by working at the construction site on consumption or investment - the money is once again passed from one hand to another, so it is in circulation. However, when companies stop investing (as a result of high-interest rate, perhaps, or insecurity about the future), the money does not go back into the economy. Rather, it is 'stocked' in a company's account or safe, and it does not end up as somebody else’s income. Thus, the amount of money in the economy is diminishing - more is "taken out" than "put in". Of course, the economy is a very complex phenomenon, consisting of millions, if not billions, of different companies and consumers - surely, if one company stops investing, it cannot have such a significant impact on a general economy. However, what if other companies follow the one not investing, and they also terminate their expenditure? In this case, the effect of such action is drastic. Significantly more money flows out of the market rather than flows in. It might result in a recession, which means that the economy is shrinking. Keynes argued that this is exactly what caused the Great Depression in the 1930s.

To prevent economic depression, Keynesian theory suggests that the government should be actively involved in the market. When firms stop investing (the outflow of money is increases more rapidly than the inflow), the government should invest in the absence of businesses. By building a new school or a highway, the government employs people to build these constructions and pays for their work, generating the cash flow-in back to the economy. As a result, the money inflows and outflows of the economy remain around the same level, holding the economy stable.

Another way the government could stimulate the cash inflows and outflows is through the decrease in taxes, which is precisely what John F. Kennedy proposed while holding the office of the President of the U.S (Tax Reduction Act from 1964). When the taxes are relatively lower, households' disposable income increases, incentivizing people to spend more on consumption and investment. As a result, the expenditure increases, so more money flows back into the economy. Kennedy's policy was successful, as the unemployment rate fell from 5.4% (at the time of reinforcing the act) to 3.6% in 1966, and the growth rate of the real GDP was on average 5%, according to Mark J. Perry.

As the first two approaches were connected to the fiscal policy, Keynesian economists argue that there is yet another way for the government to stimulate the economy's growth: monetary policy. The central bank, Federal Reserve in this case, should decrease the interest rate. When the interest rate is high, businesses do not have an incentive to take a loan, as they will have to repay more. However, when the interest rate is low, it is relatively cheap for companies to borrow the money needed for the investments. The same applies to the private consumers: when the interest rate is high, a family might not be able to later repay the loan taken for the house - when the interest rate is low, the family can afford to take a loan from the bank and invest it through buying a house. Keynesian economists believe that all three approaches of government involvement in the economy (increased government spending, tax reduction, and decrease in interest rate) can stimulate the economy and prevent a significant recession.

On the other hand, the famous economist Milton Friedman (, who received the Nobel Memorial Prize in Economic Sciences in 1976) claimed exactly the opposite. In fact, he argued that an economic depression is caused by government involvement, not the decrease in investment. When the government supplies more money into the market, it results in increased cash flow in the economy. Thus the unemployment rate falls, more people have jobs, and the average income rises. However, Friedman developed a significant drawback of such an approach: if the income is increasing, it is natural for the price level to also increase in the long-run. People indeed have more money, yet because of the price increase, they can buy only the same (if not smaller) amount of goods compared to when they had less money - a phenomenon called 'inflation'. Friedman argued that the government's increased supply of money will work only in the short-run, but in the long-run, it will always cause high inflation and maybe even economic depression. Thus, the problem is not the amount of investment but the amount of money circulating in the economy. While Keynesian economists argued that too little investment was the cause of the Great Depression, Milton Friedman claimed that in that case, it was the shortage of money. Moreover, Milton argued that the government is not capable of accurately predicting the future changes in the economy. Hence its action of increasing and then decreasing the money supply might worsen rather than strengthen the economy. That is why he proposed that the government should set up a constant level of the money supply. Thus, the economy will steadily grow in the long-run, simultaneously keeping the inflation rate at a low level.

To sum up, Keynes argued that the economy itself is unstable, and government involvement is necessary to balance it. In contrast, Friedman argued that the economy is stable by itself and should be left alone by the government. Who was correct? It is safe to say that both the economists were right - the truth is in between their arguments. History shows that Keynesian solutions are to some extent accurate, as seen in the 1960s when the government widely adopted them into the economic policy. Nonetheless, after about a decade, the U.S. economy once again suffered from the recession, causing economists to change their opinions about Keynesian theory, especially in a long-run. That is why Milton Friedman developed the argument that the government should be less involved in the economy and focus mainly on the money supply. His theory seems to be successful in the long-run as eventually, the economy grows at a steady rate while keeping the inflation rate fixed. However, the implications of this approach are difficult to observe in the short-run. That is why the government should adopt the policy on its involvement in the market based on the intended magnitude of the results: whether the economy should experience growth in the short-run or a long-run.

Sources:

Friedman, Milton. Capitalism and Freedom. The University of Chicago Press, 2020

Friedman, Milton, and Rose Friedman. Free to Choose: A Personal Statement. Mariner Books, 1990

Kishtainy, Niall. A Little History of Economics. Yale University Press, 2018

Perry, Mark J. “Let’s not forget the decade the liberals love to hate: The 1960s and President Kennedy’s successful, supply-side tax cuts.” American Enterprise Institute, American Enterprise Institute, 17 August 2013, https://www.aei.org/carpe-diem/lets-not-forget-the-decade-the-liberals-love-to-hate-the-1960s-and-president-kennedys-successful-supply-side-tax-cuts/

Tooze, Adam. Crashed. How a Decade of Financial Crises Changed the World. Penguin Random House, 2019