Economics is not a science where we can say “If you do x, y will happen”, it is rather an attempt to understand human behaviour and their reactions to various circumstances. It starts with the assumption that people will always do what they perceive to be in their best interests. Perception is all about the future, and we do not all see it the same way, so our exact reactions to a circumstance are as unpredictable as the weather!
Or as the song says “The future is not ours to see, so ….”
The world Financial system continues to stumble from “crisis” to “crisis”, we need to pause and reflect.
During the “Credit Crunch” it was easy to blame factors like the sub-prime mortgages in the USA, or the lack of Bank regulation in the UK and USA, or even the peculiar packages of “securitised” debt and “credit default swaps” the Banks were trading with each other.
While all these things played a role in bringing about the 2007/2008 credit crisis, I now believe that, they were more symptomatic than actual causes.
We currently see a clamour from the Left to maintain high deficits pointing to Keynes as their justification. We should be careful about this, as it is by no means certain that using Keynes theories would result in an increase in outputs. Before considering the effectiveness of Keynes we should understand a few of the underlying concepts.
Ones thinking is always coloured by the environmental circumstances of the time, we should therefore, try and understand Keynes in the context of the times when he wrote his main work. So let's start by giving some historical perspective.
Keynes Theories … a Historical perspective
The two works which make up Keynesian Theory are:
Treatise on Money published in 1930
The General Theory of Employment Interest and Money published in 1936.
The General Theory was written between 1932 and 1935. These were written under the influence of the Great Depression 1929 -1932 as well as the UK's return to a Gold standard at an excessively optimistic exchange rate, which had resulted in a run on Sterling in 1931 forcing it's abandonment of the standard.
The underlying principles, of what has become known as Keynesian economics, are to a greater or lesser degree attributable to the following (which both pre-date The General Theory … 1936);
The von Schleicher Public works program instituted in 1933, continued by Schacht, during the Hitler Chancellorship, and reinforced to incorporate a low interest rate policy.
The Roosevelt “New Deal” of 1932.
I wonder to what extent the apparent German economic miracle influenced Keynes General theory, certainly by the end of 1933 they had fully reversed the unemployment created during the Depression and indeed increased GDP growth.
What is Keynesian economics?
Now that we have a picture of the context of the World Economy at the time Keynes wrote his major theoretical works. We should be better able to digest and understand what Keynes was saying.
From the time of Hume, in the 1700's, economists have believed, with certain caveats, that an increase in the supply of money results in an increase (inflation) of prices. Generally a debasement of the currency.
Keynes set about proving that the primary effect would be on interest rates, with far less impact on prices. The logics of the argument are reasonable, the holders of money, when it is plentiful, would be more willing to accept a lower rate of interest than if it were scarce. His analysis, however, does show that there would also be a tendency for prices to be increasing, and in this regard is not a contradiction of the Classical theory.
He does not look on increasing prices as inflation, which he considers only comes into play when there is full employment. In this regard I guess it is really a matter of degree and our own tolerance to price increases. (Most of Keynes differences with Classical Economics are bound up in differences of definition and the level of tolerance that is acceptable. For example in Chapter 25 section v, he says; “The view that any increase in the quantity of money is inflationary (unless we mean by inflationary merely that prices are rising) is bound up with …”. The Classical view is that inflation is the erosion of the purchasing power of the currency unit, it possibly fails to see that there is a tolerable level of inflation.
Probably it would have been better for Keynes to have said that it is easier to drive an economy toward full employment with a certain degree of erosion of the purchasing power of our currency, rather than take the view that the classical concepts were simply wrong. It would have been, like saying, “taking an aspirin a day could be a prophylactic, whereas too many might be bad for you”
Economists have generally accepted, certainly since Ricardo's time, that Investment is the driver of output or growth in the economy. Simply stated … without Investment there can be no output.
Classical economics tends toward what we may call “the supply side” in other words the enterprises and producers of goods. Or in a rather crude statement of Says Law … “Supply creates its own demand”. Wrapped up in this statement are a lot of factors, not least being invention. A simple example … 5 years ago there was little or no demand for an iPad, but, once Apple had produced (“invented”) it, the demand has grown on an exponential scale.
Keynes Theory is based around the following equations;
Y(Income) = O(utput) = C(onsumption) + I(nvestment)
S(avings) = Y(Income) – C(onsumption
Therefore S(avings) = I(nvestment)
While Keynes tends to analyse from “the aggregate demand side”, he accepts that without Investment there can be no growth in employment. In his chapter on the multiplier he says … “If, on the other hand, they seek to consume the whole of any increment of income, there will be no point of stability and prices will rise without limit.”
If you followed my somewhat simplified discourse on money creation, with it's emphasis on the UK, you will probably have worked out that the ability to stimulate growth in the internal productive economy through monetary policy has become very limited.
Deficit financing only has a full Keynesian impact if the take up is mainly from foreigners.
Bank credit has already reached the point where it is in an end game phase, far beyond the vision of Keynes. The additional Capital raised by the banks (largely from foreign sources or Government printed money) provides for a relatively short term breather, as there is little doubt that their Liquid Asset Reserves should be raised further.
Quantitative Easing only serves to keep the Capital Markets (Stock Exchange, Guilt Market and Property Market) propped up.
Outside of digging holes and filling them back in again there is little available to the Government to provide direct impetus to the economy, from the aggregate demand side.
On the subject of foreigners providing for a true increase in money supply here are the figures.
Foreigners deposits in UK Banks £3.97 trillion £3.54 trillion
UK Banks investments overseas £3.91 trillion £3.71 trillion
Source: IMF International Global Financial indicators.
As we can see there has been a withdrawal of some £430 billion by foreigners from our economy.
More ominous is the fact that our banking sector appears to be taking a £170 billion bet against the UK economy. (Generally they should be keeping their foreign assets in line with their foreign liabilities, to obviate exchange rate risk. This is not an anomaly of timing as the situation still exists at the end of March 2012 and had been growing ever since 2008. The other possibility is that foreign assets are being over valued and need to be written down.)
Back to Keynes and the 1930's
Great Britain had throughout the 1800's enjoyed a steady, albeit moderate rate of growth under a Gold Standard that was introduced in 1821 by Lord Liverpool under the influence of Ricardo. This was mainly as a counter to the extreme inflation that followed the Napoleonic Wars, during which time there had been a massive expansion of paper currency, without any real replenishment of the Treasury. This was a specie standard, in that the face value of the coins was more than the underlying value of the gold, which however brought about a renewed sense of confidence in the currency in that the paper currency issued by The Bank of England was convertible into the gold and silver coinage.
This standard was suspended at the outbreak of First World War, although it still existed in law. Following the war, in common with other countries Britain experienced a period of strong inflation with the pound having devalued by about 30% against the US dollar.
In 1925 Churchill, while not returning to the specie standard, chose to return the United Kingdom to a gold bullion standard as regarding foreign trade in 1925. With the idea of putting Britain back at the forefront of International trade, he chose to do so at the exchange rate that ruled prior to the war totally ignoring the fact of the effective devaluation and rise in wage rates as a result. This met with strong criticism from Keynes who considered a 20% lower exchange rate closer to reality. Churchill's oratory skills won the day and Keynes was side lined.
The over valued currency reversed the surplus in foreign trade that had existed throughout the 1800's and until the War. British goods had become uncompetitive while imports started competing strongly in the local market. The semi-captive market that the Empire had been throughout the preceding century was breaking down. The 1931 run on Sterling ended the short return to a gold standard, this resulted in a devaluation of about 23% which was a justification of Keynes original view and one of the reasons for Britain coming out of the Depression a lot faster than the USA.
Keynes however always saw the Treasury reserves, as the real money or capital of the nation. Although he uses the term Capital as though interchangeable with Money, analysis usually shows that when he refers to Capital he is often meaning the underlying asset, fairly close to our common understanding.
The Banking system and traditions at that time were also very different from those of today. Banks were conservative, probably holding in excess of 25% of deposits in Liquid Assets, Government Bonds and even Gold or other precious metals. Banks loaned money to businesses and enterprises mainly to fund working capital requirements. Fixed Capital requirements were the obligation of the shareholders and stock exchanges.
The individual (unless a person of very high wealth) had virtually no access to bank credit. Mortgage Finance was found from the Mutual Societies and other savings repositories. Credit, if available, was from the Butcher, the Baker and the Candlestick maker. In other words from the trade.
It was inconceivable to Keynes that credit to the consumer should be so readily available and is such quantity that the consumer, in aggregate, could or would spend more than his total income on consumption goods. This was one of the two situations where he considered the price rises (inflation) that were inevitable with stimulatory economics would get out of hand. See the quotation above. If the overall savings of the Nation are not growing the consequences are … dare I say it … Greece!
We should have gathered from the preceding, that the easy Keynes stimulations are no longer a viable option, the bulk of bank credit, has been extended to individuals and not businesses. For Keynes theories to work, businesses need to be investing, we say banks are not lending to businesses, but if as I constantly hear, credit is available but on unfavourable terms then we need to look more closely at ourselves. If a business expects a Bank to take the bulk of the risk or spends its efforts in paying down its debt rather than investing in working capital … any Government debt incurred for capital projects will have no lasting effect on the projects it undertakes. And we are down to digging holes and putting bottles down mine shafts.
Or as Keynes says;
“There is no remedy but to persuade the public that green cheese is practically the same as money and to have a green cheese factory ”