Sometimes the economy does well sometimes it does badly. In 1992 economies generally were doing badly. When Bill Clinton won the US presidential election in 1992 against a fairly popular incumbent, President George Bush senior, it was characterized by Clinton’s campaign: “it’s the economy, stupid”. Economic cycles are a powerful political force and governments, presidents, and prime ministers would always like to go to elections when the economy is doing well. That they don’t always manage this presumably says they have less power and influence than they give themselves credit for in good economic times. Perhaps if they took this to heart they would be less inclined to think they could resuscitate the economy once it falls into recession. But in fact what they take to heart is an exaggerated view of the power of Keynesian economics (Keynesianism).
John Maynard Keynes once said that “practical men, who believe themselves exempt from any intellectual influences, are usually the slaves of some defunct economist”. Although he died many years ago Keynes is by no means some defunct economist. US President Richard Nixon said in 1971 that “we are all Keynesians now”. The policies of Rudd, Obama, Brown and other national leaders bring the story up to date: and apparently we are all Keynesians still.
Keynesianism is a product of Keynes’ book: The General Theory of Employment, Interest and Money, published in 1936, when the impact of the great depression still lingered on. At the time Keynes was writing his book he wrote to George Bernard Shaw: “I believe myself to be writing a book on economic theory which will largely revolutionize…the way the world thinks about economic problems”. He was right; but was he right?
Numbers of recessions and depressions had happened before 1936; they all eventually gave way to prosperity. This happened without the benefit of Keynes’ General Theory or the policies which flowed from it. Keynes of course knew this so what value was he adding?
Prior to the General Theory there was a view that the economy was self-correcting at a full or close to full employment level. It was assumed that a recession would induce a fall in wages, making labour cheaper to hire; a fall in the price of capital equipment, making investment expenditure by businesses cheaper, and a fall in interest rates, making borrowing to invest and to consume cheaper. Acting together these things would boost production and employment back to a full employment level. Looked at less mechanistically, it was thought that as demand is insatiable so the production of goods and services would create sufficient purchasing power (effective demand) to absorb all that would be produced. Ergo under-employment could only be a temporary state. This was characterized and popularized as Say’s law after the early 19th century French economist J B Say.
Keynes did not disagree too much with the above ‘classical’ theory of events, as a theory. To that extent his economics was not radically different from his fellow economists. However he believed that in the practical world prices and wages, particularly wages, were sticky and therefore might not fall quickly enough; that if business confidence fell to very low levels interest rates might not fall far enough to stimulate borrowing and investment; and he believed that in some dire economic circumstances a “liquidity trap” might possibly occur making it difficult for central banks to orchestrate a sufficient fall in interest rates because people would be reluctant to purchase interest bearing financial securities, keeping as much money as was created in the bank.
The sub-prime crisis of 2007 and 2008 and its current aftermath underscore in stark terms what Keynes was talking about: low confidence, growing unemployment, no particular appetite among wage earners to reduce their wages, and interest rates remaining stubbornly high on a range of securities, even those that in normal circumstances would be regarded as prime and relatively risk free.
Keynes concluded that it was possible for an economy to be in equilibrium and at the same time to be in deep recession or if not quite in equilibrium at least without having any overwhelming and speedy impetus to move out of recession. Of course he knew that economies in recession would eventually recover but as he famously said, “in the long run we are all dead”. Part of Keynes’ proposed remedy to shorten recessions was public expenditure to make up partly for the deficiency of private expenditure, thereby boosting aggregate demand. More than anything else it is this remedy which defines Keynesianism and what President Nixon meant in saying we are all Keynesians now. Rudd’s’ $42 billion ‘stimulus’ package, for example, and Obama’s circa US$ 800 billion package affirm their Keynesian credentials.
Recessions do happen and they can last for years and a liquidity trap unfortunately has proved to be not just a possibility. Keynes was undoubtedly right about all of this. But this is only part of the story. It is one thing to be right about the longevity of some economic recessions, it is another to identify remedial polices. At question is whether Keynesianism is right: does increasing public expenditure help an economy to recover. A brief detour into the history of economic thinking is useful.
Another economist of the same era as J B Say, Thomas Malthus is often regarded as being on the same page as Keynes in supporting the proposition that there could periods of under consumption and a glut of commodities.
Why mention Say and Malthus? Nothing is new under the sun so Solomon purportedly said and both Say and Malthus throw particular light on the present from the past. Say and Malthus were more sophisticated than they are given credit for in contemporary headlines. Thomas Sowell  notes that Malthus, in explaining the possibility of gluts, said that they might occur ‘from the want of a proper distribution of the actual produce’. Say attributed temporary gluts, and he thought they could be only very temporary, to a wrong mixture of outputs compared with consumer demand. Few words, but if heeded and understood they would add to our ability to deal with recessions by dissuading governments from applying the Keynesian remedy.
Before Keynes the emphasis was on production enabling demand and making it effective. After Keynes the emphasis switched to demand initiating production. Really neither is right or wrong because production and effective demand are sides of the same coin.
If you are on a desert island and want some fish from a fellow islander you might need to obtain some coconuts to exchange. You make your desire, i.e. your demand, for fish ‘effective’ by climbing a tree and picking, i.e. producing, the coconuts. The act of producing at the same time makes your demand effective. If the economy is recessed we can talk sensibly and equivalently in describing the situation as production being too low or effective demand being too low. The real problem is how to get them back up once they have fallen.
Increasing public expenditure to boost demand and through that production is logical enough it would seem but, to turn the tables on Keynes, it is flawed in practice because it cannot be executed appropriately.
Production and demand are not homogeneous masses. When we say that the economy is in full employment equilibrium we are not just saying that aggregate production and aggregate demand are at a level which employs all available resources. It is more complex than that. What is happening also is that each different commodity produced is being matched by an equal effective demand for it; more or less. There are many separate commodities and an equal number of separate and corresponding demands; all adding up to aggregate production on the one side and aggregate demand on the other. Both Malthus and Say were right in looking at the make up of production as against the pattern of demand and attributing economic stress to mismatches. This more micro approach to the economy as a whole was buried by The General Theory with its emphasis on aggregates.
At this point we have to remind ourselves that there is a difference between what Keynes was about and Keynesianism as it influences government policy. For example, it is fair to say that Keynes may have seen public expenditure not filling all or most of the gap in demand but having most effect in resuscitating confidence and therefore demand among businesses and consumers. Moreover, Keynes may have changed his mind about some things and amended and refined his theories and policy prescriptions in the light of experience, we will never know: “When the facts change I change my mind – what do you do sir: he once said. What we do know is that governments and presumably their economic advisers slavishly follow and pay homage to a theory set down many years ago, seemingly without any contemporary rigorous questioning of its validity.
Economies fall into recession because they are shocked when overstretched. More often than not that shock is a credit squeeze, either orchestrated by policymakers in response to rising inflation or, as in the current recession, as a by-product of a sharp fall in the price of widely-held securitized assets. A credit squeeze makes borrowing harder and more costly. Businesses find it more difficult to borrow the funds they need as financial institutions become more risk averse. Higher interest rates mean that many business investments become unprofitable as their rate of return becomes less than the cost of borrowing. As well, an important but often overlooked factor is that credit shortages and interest rises are not uniformly felt across the economy. Some businesses are hurt more than others; some individuals (consumers) are hurt more than others. What this means is that not only is there a an initial decline in demand for investment goods and consumer goods but that the pattern of demand changes and no longer corresponds to the pattern of production capacity in the economy. This in turn cases more disruption and unemployment which further depresses demand; echoes of Malthus and Say.
In these circumstances it seems logical and politically alluring to attempt to push aggregate demand back up again through public expenditure. There is a magic pudding element to it all. The more you spend, the more it benefits. What is profligate, irresponsible and damaging in stable economic times becomes virtuous almost overnight and a weapon is put into the hands of government that they are singularly unfit to wield. Public expenditure is often directed to the poorer sections of society in the form of welfare benefits because it is thought that this section of the population, often mistakenly, will suffer worst in the recession or more cynically at times because it is the natural constituency of the party in political power. A range of expenditures on infrastructure are undertaken which in more considered times would not pass economic muster but which are, all of a sudden, good for the economy because they will boost aggregate demand. Pork barreling often determines what is spent and where. Industries and businesses that ought to incur the consequences of poor decision making are bailed out with public money, usually only delaying their fate or the adjustments they need to undertake to make their businesses profitable.
The problem is that restoring aggregate demand in any meaningful way means restoring demand to match the productive capacity of the economy. And it is more complicated than that because this is not the productive capacity of the economy when it began moving into recession but its productive capacity once it has readjusted following the recession. Recessions however painful are useful and necessary to remove inefficient and declining businesses and industries and allow and make room for the efficient and new to thrive. Public expenditure of the kind that always takes place is remote from the pattern of demand (and production) that will eventually arise once the economy has recovered. Governments have no insight into what this pattern of demand will be; no-one does.
Unfortunately government expenditure to combat recession is not just misdirected and wasteful it is positively damaging. First, it muddies economic signals. Some businesses survive longer than they should or are fooled into thinking that they can continue without adjustment, making the eventual necessary adjustment more painful. Second, it serves to crowd out the development and growth of efficient and new businesses. It does this as a by-product of willy-nilly increasing demand across the economy and thereby maintaining and inducing an inappropriate deployment of resources across the economy. It does this also as a by-product of the need to finance budget deficits. Budget deficits are financed by selling government securities and these compete with private sector securities and make it harder and more costly for businesses to obtain the finance they need. Nor does it stop there, because what governments mop up in security sales is often less than the size of their budget deficits. There is less crowding out but because of this a much greater chance of inflation occurring once the economy recovers.
Where does this leave us? Public expenditure to stimulate an economy in recession prolongs the necessary adjustment the economy needs to go through and thereby prolongs and deepens the recession; moreover it often sows the seeds of future inflation and the need to combat this with interest rate increases that can keep an economy struggling or send it back into recession. Why isn’t this evident? Well we can’t run experiments with the economy. Market economies are resilient and almost always survive government ineptitude. Governments can and usually do claim credit on the basis that things could have been worse without them taking the action that they did and they are armed with Keynesian economics which tells them they did the right thing. The great depression lingered on in the United States throughout all of the 1930s despite Roosevelt’s ‘new deal’ but it would have been worse if public expenditure had been more constrained and better if public expenditure had been less constrained; isn’t that so? Who is to say that the patient would not have recovered sooner if more leeches had been applied?
What governments can do productively in recessionary times is entirely consistent with Keynes’ diagnosis but also with the insights of Say and Malthus. Essentially governments should try to increase demand but in a way which hands the disposition of that demand to the market. This will ensure that forward looking market forces guide the pattern of demand and correspondingly the productive capacity of the economy. As part of this, interest rate cuts should be pursued with vigour to protect the position of businesses and individuals that are constrained, at risk, or struggling only because of the straitened times. Inflationary expectations can quickly fall to zero or below when recessions gather pace and therefore real interest rates will rise and worsen the recession and stymie recovery unless nominal rates are brought down substantially and quickly. Deep recessions are not the time for timidity and half measures in central banking. If necessary the range of securities that central banks are willing to purchase should be expanded (junk and anything close to junk excepted) to combat any liquidity trap; and we have seen this happening to some extent already in the current recession.. Cuts in business income tax rates are beneficial too if they can be sustained. While such cuts have to be financed and therefore have a crowding out effect they are well-targeted; benefitting profitable businesses while avoiding throwing money away subsidizing loss-making businesses. Is there any room in all of this for infrastructure spending; perhaps, provided it can be shown objectively and transparently that such spending can stand on its own feet in producing a commercially acceptable return. Recessions are not the time to build pyramids. What we cannot afford in good times we certainly cannot afford in bad times and that applies to communities as much as it does to individuals. There is no magic pudding.
1. “Say’s Law”, Thomas Sowell, Vol 4, pages 249-251, The New Palgrave Dictionary of Economics, Ed by Eatwell, Milgate and Newman, The Macmillan Press 1987.
Peter Smith is the former CEO of Australian Payments Clearing Association, and has been chief economist at State Bank of Victoria and economic adviser to the Australian Bankers Association. He has a PhD in economics from the University of Adelaide.