The Hindu Business Line : Tweaking John

John Maynard Keynes wanted government spending to stabilise the real sector. But now it seems to be stabilising the financial sector, says T. C. A. SRINIVASA-RAGHAVAN. What does this imply for macroeconomics?

In physics, great insights have led to great changes. In economics, it has tended to be the other way around where great changes lead to great insights. For example, the Great Depression of 1929-38 led to the Keynesian revolution.

Being a very clever man, Keynes was essentially providing an intellectual basis and, therefore, political respectability, to support a policy of government spending designed to prop up sagging economies.

This was a new idea. Until then, markets were supposed to equilibrate the economy while the government looked on hopefully or helplessly depending on the context.

But in the face of massive unemployment, the Communist threat of the 1930s loomed large in the Western hemisphere. Governments needed to be more pro-active to keep the Soviet contagion from spreading. But there was great resistance to the idea in political circles.

‘Prime the pump’

So enter Keynes. He captured the whole economy in a single identity, Y ■ C+I+G+(X – M), where G (government expenditure) was the controlling variable which, Keynes suggested, should be used by governments to boost demand when it fell short. The reverse also held good.

The whole analysis was based on deficient aggregate demand. In the Keynesian system, the restoration of demand is the key to stabilising the economy.

Keynes’ new theory rested on two pillars. One was the quiet smuggling of politics into economics. This took the form of the postulate that, thanks to politics (trade unions) wages were ‘sticky’ in the downward direction. This meant that unlike what classical economics assumed, they would not adjust instantaneously when demand for labour fell short of its supply.

The other pillar was that as a result, economies when faced with shocks would face turbulence that would eventually result in output and employment falling far below their potential levels.

The resulting unemployment would lead to persistent deficient aggregate demand. And the cycle would feed on itself. The only way out was for the government to “prime the pump”.

To preclude fuss by the nay-sayers, Keynes presented the whole thing as an identity, not an equation. Once his theory was accepted by a frightened political class — Hitler, with his massive re-armament programme of Germany, had already proved that the idea worked — there could be no further argument with an identity.

Thus did governments position themselves like the Nandi bull at the centre of economic activity. In due course, all they needed to do was to swish their tails to move the economy in this direction or that.

Role of G in the identity

Modern economists, with their heads full of econometrics, have convinced themselves that their analytical frameworks are as immutable as those of the physical sciences.

This is especially true of macroeconomics, whose several conceits can be forgiven as natural for a relatively youthful discipline. But sadly for them, economics is about people and politics, not physical phenomena that exist independently of humans. Once you recognise this, you begin to wonder if the analytical framework of macroeconomics is now due for a change. This article argues that such indeed is the case because the role of G in the Keynesian identity has undergone the most fundamental change imaginable. This is that instead of governments intervening to stabilise the real sector — Keynes’ famous let them dig holes and fill them dictum — they are now intervening to stabilise the financial sector.

Government spending, from once being something that sought to boost investment and activate the employment multiplier, has now become the greases in the wheels of finance. One wonders what Keynes would have thought. He did once say, though, that when faced with new facts he changed his opinions.

How should the theoretical stance of macroeconomics change when orthodox Keynesianism still rules the roost as a way of looking at the economy, namely, through the prism of demand? Certainly, finance ministers (through fiscal policy) and central bank governors (through monetary policy) approach the economy from the demand side. Supply augmentation is mostly left to the private sector.

Gone past expiry date

Perhaps things need to change now and we need to view macroeconomic policy not merely through the demand prism. After all, 80 years after the Great Depression, a situation of sustained globally deficient aggregate demand, on a scale comparable to the Great Depression, is unlikely to emerge because of three factors: Growth in China and India, the gains in productivity that new technologies are bringing and, of course, the removal of the restraint that Keynes’ ‘barbarous relic’ imposed on global liquidity.

There is really no limit to how much money can be pumped in to restore confidence. In that sense, the Keynesian deficient demand system could have gone past its expiry date.

The fundamental change that has occurred now is that for the time in history, both labour and capital are in excess supply — never mind the current temporary blip.

Superior technology, as Marx predicted, requires fewer units of labour to be employed per unit of capital, whence the excess supply of labour. Also, capital is almost completely mobile and labour, though not mobile, thanks to new technology, is delivering services in a disembodied way, that is, via satellites. The net-net result is that both manufactures and services have become extraordinarily cheap.

The only limiting factor is the supply of physical resources and it is this that will determine the shape and level of supply, and thus economic activity, including more frequent burst of speculation as excess capital looks for higher returns.

This is different from the previous periods when, in the final analysis, it was the supply of currency, namely, gold and, and to a lesser extent, silver (that is credit and confidence in it) that eventually determined the levels of activity.

Existing tools ineffective

As I have argued elsewhere under the current framework of macroeconomics, the existing tools have become ineffective. Boosting supply to match demand, although intuitively strongest, is not easy to do, simply because output is nearly at its full-employment level, growing only as quickly as technology will allow. The current blip is just that — a blip.

For similar reasons, constraints on liquidity through monetary policy as a means of controlling spending and reductions in government expenditure as a means of lowering demand have been made toothless. This suggests that the current framework is perhaps not equipped to handle the current problem.

Theoreticians need to address this issue, especially in regard to the role of G in the identity. In the meantime, the role of G appears to have changed anyway. It is — as usual — governments which have had to take the lead by tweaking the Keynesian paradigm to prop up the financial sector, rather than the real sector.

There is no point in agonising over whether this is good or bad. It was necessary, that is all. But it will have a profound impact on the conduct of policy, which is why economic theoreticians need to look smart. Otherwise, Left ideas will begin to look smarter.