In these times of massive recession and general tightening of credit, popular discourse is rediscovering the joy of Keynesian macroeconomics, in particular Keynes’ views on how to stimulate an economy that is underperforming. What this generally boils down to is a call for protectionism (consider, for example, the US administration’s woefully misguided ‘buy American’ policy), restriction on free movement of labour, and for the counter-intuitive nostrum of increased spending, as a means to stimulate business performance.
In this essay, I’m going to take a look at these measures and investigate them from the point of view of a more modern view of macroeconomics, and a first-principles analysis which fully understands its presuppositions, unlike the proponents of this neo-Keynesian thinking, who do not seem to be fully aware of theirs. I will conclude that of the three measures described above, the first two are totally misguided, while the third may have limited applicability if used correctly.
I will start with a discussion of general macroeconomic principles, with an aim to exposing my assumptions. After that I will discuss the neo-Keynesian measures in turn giving reasons why they should be set aside or modified. Finally, I will make a tentative proposal as to what a viable economic stimulus package could look like.
The health of the economy is measured in terms of its ability to create wealth
Basically, Adam Smith got it right first time: macroeconomics really is about the wealth of nations. Wealth (which isn’t the same as money) is a direct measure of how much economic production there is going on. Creating wealth / growing the economy means that there are more jobs available for people to take up, because there is a greater need for people to assist in the creation of wealth. Therefore, if wealth grows, unemployment falls, while if wealth shrinks or stagnates, unemployment rises or stagnates. Moreover, as wealth grows people become better off. Wealth arises from the exchange of money for services, and this money flows round to those who help provide the services. And, in a neat feedback loop, people being better off and willing to spend means that more services are required, and so wealth grows.
The free market is the best judge of a business’ success
It is a key truth that free markets, provided they remain free, are extraordinarily good at ensuring that businesses flourish precisely when they have something to sell that people want, and (via free competition) that the correct price is achieved for all services: correct here meaning the maximum price that consumers are prepared to pay for the service. Now, note that there are several provisos here. The reason why some ostensibly ‘privatised’ businesses have manifestly failed to find the correct price (e.g. privatised railways in the UK) is that there is not free competition to provide services: each route belongs to one company, so in fact there are a number of mini-monopolies. Likewise, it is necessary that government regulate the market to ensure that it does remain free and fair, precisely so as to avoid monopolistic behaviour.
These macroeconomic assumptions are quite orthodox, but are not especially favoured in popular discourse. First, there is a common belief that failing or uncompetitive businesses should be supported because if they went under then jobs would be lost. But what would be the macroeconomic result of that? If uncompetitive businesses are artificially preserved, then in fact they will be made artificially competitive, and so will be able to prevent new, innovative businesses from acquiring market share. Therefore, in fact what will happen is that the economy will start to stagnate, and eventually shrink, because consumers will go elsewhere. And so, the stabilisation plan of preventing short-term unemployment will eventually lead to recession. And if there is already a recession, it will make the recession that much deeper. Unfortunately, the macroeconomy is a rather Darwinian creature, and surviving in it is a matter of adapt or die. Rather than artificially prolong the death-throes of a moribund business, we should be ensuring that the economic climate (in terms of regulation, taxation and legislation) favours the establishment of new, wealth-generating businesses.
Second, wealth is often confused with riches. The wealth of a nation is not measured in terms of the size of the money-bags of a few plutocrats. Plutocrats, like the poor, are always with us. Wealth is about the ability of individuals in the economy to create marketable services for which people are prepared to pay and so is in the hands of all of us. Individual wealth (if one can apply a macroeconomic indicator to an individual) is a matter of how much one puts directly into the economy in the sense of how much one enables production of services. And moreover, wealth directly benefits all in the economy, because they share in the value of the services they help create. Therefore, contrary to the rhetoric of anti-capitalists, wealth is a very good thing.
Third, and returning to the market, in an extension to my first point, there is a popular tendency to get over-attached to whole economic sectors. So, cultural conservatives complain because the UK’s economy is now largely post-industrial, and similarly in the US, which is undergoing the transition from industrial to post-industrial. But, to look at it in larger terms, why does a country need to have any industrial sector? Provided it is possible to buy the necessary services from elsewhere, and provided the country can function with a growing economy without an industrial sector, why should it matter? Well, the obvious objection is that losing the industrial sector causes unemployment. But note that I just assumed that the economy could maintain a growing post-industrial economy. This means wealth is still being created at (more than) the old rate, and that there is increased demand for jobs. Unless one takes a rather essentialist view of what people are and are not fit to work on (which I find offensively prejudicial) then there is no reason why unemployment should rise provided workers are prepared to be flexible. Therefore, we conclude that any country will retain a residual industrial sector, consisting of those services that cannot be sourced from abroad, but that there is nothing to fear from the transition from industrial to post-industrial, just as there was no need to fear the transition from agrarian to industrial, and there will be no need to fear the next paradigm shift.
The goal is to create jobs, not wealth
This is, in fact, the fundamental fallacy of what one might call folk-economics. It largely seems to result from the confusion discussed above between wealth creation and plutocracy. But there is a crucial point here. As I said above, wealth creates jobs. Jobs do not necessarily create wealth. To see this in its crudest form, imagine a scheme in which we had the ministry for digging holes and the ministry for filling holes in, whose work teams followed one another round the country. This would undoubtedly create jobs, but it would do nothing whatever to grow the economy. In fact, the situation is worse than that. By pulling people into economically unproductive labour, this scheme would reduce the workforce available to do economically productive work. Moreover, by paying people to do (essentially) nothing, one slows down the motion of money between suppliers and consumers of services, by introducing a whole new class of non-producers who only consume, and so effectively the money supply is reduced. Therefore a deflationary contraction of the economy is likely.
This example is deliberately contrived, but a very important point follows from it. If people are doing work that is not economically productive, then they have at best a net neutral impact; in fact they are likely to have a small effect. This is not to say, as some might have at the height of the monetarist craze, that therefore nobody should be paid to do unproductive work. There are clear benefits in terms of culture, knowledge and future potential to having some unproductive work. However, in a time of recession, when one is considering means to stimulate the economy, creating new unproductive jobs is a fatal error. Which means that in a time of recession, the emphasis should be firmly on looking at ways to promote the creation of wealth, knowing, as we do, that to create wealth you need people, which means jobs, and more wealth means more people, which means more jobs.
Neo-Keynesian cures for a recession
During a recession, market freedom should be limited
The argument here is more or less that local businesses will not be able to compete with those abroad, and that therefore a deliberate imbalance should be introduced into the economy (in the form of tariffs, for example) so as to make them competitive, and hence more likely to survive, guaranteeing that jobs will be sustained. I could repeat the argument from above, but there’s an interesting alternate viewpoint. Suppose I do sustain uncompetitive businesses using tariffs or whatever; how do I ever emerge from recession? Because now there is no incentive either for the uncompetitive businesses to improve, become competitive and start generating wealth, or for new businesses to arise to replace them. In fact, there is an extremely strong risk that in propping up uncompetitive businesses I will stifle innovation at home, and in fact prevent the economy from growing.
Let me run through that more slowly. I would only impose a tariff if my local businesses could not compete internationally. Now, the thing to remember here is that they have internal competitors as well, in the form of other businesses in the same market segment, or of start-ups. Now, if I bias the market in favour of existing non-competitive businesses, it will be very hard for start-ups to gain market share and start generating wealth. Moreover, there is no incentive for the existing businesses to make themselves competitive, and hence start generating wealth. But if I am ever to emerge from recession I either need new, strong businesses to replace the old, weak ones, or else I need the existing weak businesses to become strong, and I have just created a strong disincentive for either of those outcomes to occur. Imposing the tariff can only work if the economy depends on ‘national champions’: businesses which are the sole player in their respective market segments. It is not, therefore, surprising that an enthusiasm for Keynesian thinking often goes together with a touching faith in the merits of nationalisation.
During a recession, free of movement of labour should be limited
Note, by the way, that all of these arguments apply equally well to protectionism involving the restriction of free movement of labour. Protecting the ‘native’ work-force simply institutionalises those features that made it non-competitive in the first place. As a result, there is no incentive to (say) acquire new skills or shift to developing market segments, because everything is comfortable just the way things are. And so the measures become self-reinforcing and, with time, the economy becomes moribund.
Large-scale public sector investment will stimulate the economy
This is another idea that only really works if the state and the economy are one. But to start from the beginning, investment to stimulate the economy is not a bad idea, but one has to be certain that the investment has the right result. For example, investment in the hole digging and filling businesses described above would result in zero net benefit to the economy, and so would be money down the drain. What is needed is investment that incentivises existing businesses to generate more wealth, and new businesses to start up and add their wealth-generating capacity to the economy. Therefore a system of, say, tax incentives for new businesses, or grants for innovation would work (note, by the way, that this is not a tariff, as this is not incentivising businesses to stay the same, but actively incentivising them to change and grow), as would large-scale procurement programmes.
But the idea is strongly embedded in the public consciousness that investment in the public sector is de facto good for the economy. Of course, it creates jobs (so we’re back with the jobs not wealth fallacy), but what does it do to create wealth? Well, assuming that we actually have an open economy, and not one tilted in favour of state-owned enterprises (in which case we are in trouble anyway, as described above), then the public sector is (with the exception of spending departments, of which more below) not a producer of wealth. This is not to say that it is unimportant. Health-care, education, regulation, etc are all vital functions of the state, and have long-term macroeconomic implications (an unhealthy and ill-educated work-force is not a productive workforce) and so there is a strong argument for sustained investment in these services regardless of the state of the economy. But if we are in a recession, there is nothing that extra investment in these services can do to get us out of it.
Now, what can be done? We can do a number of things, for example start procurement programmes, or sponsor research and development, with an aim to growing new capability in the economy. Though it is not especially fashionable to say so, investment in defence spending is probably a good move in times of recession, especially if it can be used to spur new developments (this is not to say that non-productive research should be cut, but it is not a good target for investment specifically aimed at getting the economy out of recession). Likewise, sponsoring applicable research, indeed providing funding for transition from research to production, is sensible. More indirectly, funding to promote retraining and skill acquisition, giving people an incentive to move from moribund market segments to more productive ones, will be effective. So we can say that public sector investment can be effective, provided that investment is used to enable business development and hence creation of wealth.
So what can be done?
We have seen that the Keynesian views on how to stimulate an ailing macroeconomy range from the outright dangerous (interfering with the freedom of markets) to the simply wrong-headed (public sector investment is the answer), and yet they remain startlingly popular. Why is this? I think there are several reasons, all rooted in folk economics.
Equation of wealth with plutocracy
As I noted in the discussion of the Keynesian fallacy that what matters is creating jobs, not wealth, this idea is popular because when one starts talking about wealth with non-economists, the almost automatic response is for people to start thinking about the obscenely rich and start frothing at the mouth about the inequities between rich and poor. But, as I said (again), wealth is not money. Wealth is, in a sense, the potential to create money, and it belongs to everyone who plays an active role in the economy. Which means that we all have a stake in making sure that there is as much wealth in the economy as possible, because it is something from which we all benefit, not just plutocrats.
But, if we follow on from the equation of wealth equals very rich people, then it becomes almost logical to conclude that wealth is a bad thing, and that rather than striving for wealth, we should strive for some intangible concept such as quality of life. Indeed, we hear people complain of politicians who talk in terms of economics that they know the price of everything and the value of nothing. But what is value? Who defines value? How can we be sure that my idea of what constitutes value is commensurate with yours? There are as many definitions of value as there are people. This is the problem: if something cannot be measured, then it is well nigh impossible to tell whether you are delivering it, and therefore how to deliver it. Wealth, on the other hand, is susceptible to an agreed on definition and it has the inestimable advantage that it enables all of us to acquire the value we want.
Failure to grasp pain for gain
The problem, I believe lies in basic facts about understanding of risk. It is well known that risk is not a concept that is easy to understand, or that many people do understand. Two particular aspects of this are as follows. First, people are very poor at quantifying risk. Second, people are risk averse. So if doing nothing carries no obvious immediate risk, whereas taking action does carry immediate risk, then people will almost certainly prefer to do nothing, even if in the medium to long term doing nothing carries very high risk. In other words, people do not readily grasp the pain for gain principle: in fact one can almost guarantee that they will do almost anything to avoid the short-term, beneficial pain, even if they know about the long-term consequences of their choice.
When applied to macroeconomics this notion is very powerful. We see immediately why there are outcries whenever moribund industries die, and calls for government to bail them out. People see the short-term loss of jobs, and ignore the long-term economic benefits of letting the business die and disbenefits of sustaining it, because keeping it going avoids short-term pain, and the macroeconomic arguments in favour of allowing the market to have its way are somewhat abstruse, dealing with abstractions like markets, wealth, and so on and so forth, and if there is one thing folk wisdom is worse at than understanding risk, it is understanding abstractions. Indeed, in the somewhat anti-intellectual atmosphere of many Western cultures, the mere fact that economists can present well-rounded theoretical justifications for their claims will actually tend to count against them (and, unfortunately, this is not limited to economics).
Hankering for paternalism
It is only if people are (pace Thomas Jefferson) left free to pursue wealth that they will be able to obtain happiness. If the state decides what constitutes ‘the good life’ then one is essentially removing the element of freedom of choice from the vast majority of people, and therefore edging towards totalitarianism. And yet in spite of this, an awful lot of people seem to have a hankering for a situation in which the state is expected to take macroeconomic decisions on their behalf, even though they would not trust it with making personal decisions for them. But the expectation is that those macroeconomic decisions should be based not on economic indicators but on the ideas, following from failure to grasp pain for gain and general dislike of abstract thinking, that failing industries should be supported, jobs should never be lost in any market segment, and what matters is value, not wealth.
This is, needless to say, a contradictory position. When Keynes was active, the idea that the state should somehow determine what industries should exist was intellectually respectable, and, after all, it did have a history going right back to feudalism. What is amazing is that even now, when the folly of attempting to control the market (which is, after all, a chaotic system, and so insusceptible to control – though susceptible to gentle pertubation) should be clear to all, not only do some governments still maintain that it is right and proper to do so, but a large number of people who really should know better seriously argue that capitalism, and with it the idea of the free market, is dying. And so we have the simultaneous, and rather bizarre, belief that the state and those of its servants who make sure that it continues to tick over, and that currency still means something and so on and so forth are the enemy, while the public sector and publicly owned businesses are the salt of the earth. So we have healthy individualism mixed with a yearning for the state to be our parent, absolving us of any responsibility to behave like adults.
It is time to leave the nursery.