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A note on the relevance and limitations of Keynesian economics

Now that this century is nearly over, we can say with some degree of confidence that John Maynard Keynes was its most influential economist. His "General Theory of Employment, Interest and Money", first published in 1936, revolutionised the discipline of economics and has dominated attitudes towards economic policy ever since. The parallel development of the basic ideas by the Polish economist Michal Kalecki, operating with a Marxist perspective on the capitalist economy, is worth noting.

In the first three decades after the publication of the "General Theory", governments and economic analysts were heavily influenced by Keynes' ideas, or at least one version of them; and macroeconomic management in both industrial and developing countries was dominated by the implications of these ideas in terms of the state's role in maintaining effective demand through fiscal and monetary policy.

The subsequent thirty years witnessed the reaction to this. Keynesian economics - especially in terms of the policy implications that had been derived - was seen as not just outmoded but wrong, based on aggregations and assumptions about economic behaviour that were unjustified. The mainstream economics profession tended to swing to the opposite side of the pendulum, reaffirming slightly revised versions of the old monetarist

ideas which the Keynesian revolution was supposed to have definitively swept away. As Keynes' student Lorrie Tarshis put it recently, "though almost no one now reads his book, almost everyone claims to know what it contains, and incidentally, why it is wrong."

In this note I shall briefly consider the some of the most essential ideas of Keynes, and then how the interpretation of these ideas has changed over time in different forms of Keynesian economics. I will point out how the essential ideas retain their relevance, and how ignoring them can lead to very negative consequences. I will then consider the political economy factors and other reasons for the changing perceptions regarding the

validity of these ideas. Finally, I will talk about what Keynesian policies would imply in the current international economic context, and about their limitations and possibilities of adaptation.

The Economics of Keynes

The basic idea underlying the Keynesian approach is the principle of effective demand. The effective demand is simply the aggregate income or sales which entrepreneurs expect to receive from their current production. Keynes' innovation was to consider the role this plays not just in the production of individual goods, but for the economy as a whole. He put forward the proposition that the equality between savings and investment in any one period is ensured not by changes in the interest rate as was generally believed, but by changes in the aggregate level of output or economic activity.

The argument can be briefly stated as follows : When employment increases, aggregate real income increases. Then consumption increases too, but not as much as income (that is, there is a marginal propensity to consume in the society, which is less than unity). So, if employers were to produce goods to meet only consumption equivalent to the whole of the increased income, they would make a loss. This means that to justify any given amount of employment, there must also be current investment, for without this employers would not receive profits sufficient to make them offer the given amount of employment. The current investment, in turn, depends upon the inducement to invest, which depends upon the relation between interest rates and expected returns on investment (or what Keynes called the marginal efficiency of capital).

The anticipation of future demand is thus critical in determining the level of investment, and it is this which gives the aggregate level of employment and therefore economic activity. Since saving is the excess of income over consumption, it follows that saving is then determined as a residual, which must be equal to investment. Keynes highlighted the

critical role of expectations about the future in determining current levels of investment and therefore total employment. While the received wisdom of the time believed that "supply creates its own demand", Keynes reversed the causation to infer that effective demand brings forth aggregate supply.

This then leads to the central argument of the theory, that of the possibility of an unemployment equilibrium. Keynes showed that there is no automatic tendency in a capitalist market economy, which ensures that the level of aggregate output is one which corresponds to full employment. Indeed, the effective demand associated with full employment is just a special case, realised only when there is a certain relationship between the marginal propensity to consume and the inducement to invest. This follows, since it is not conditions of supply which create the demand, rather supply is determined by aggregate demand which reflected both investment decisions as well as the propensity to consume.

Once there is a level of aggregate output which is below the full employment level, there is no automatic mechanism within a capitalist economy which can raise the level of economic activity. Investors' low expectations about markets tend to be confirmed by their low sales proceeds, and this reduces their inducement to invest in the next period

as well. If this is so, then once the economy is in such an unemployment equilibrium, then it can only be raised from it by something outside the system per se. This brings in the critical role of the state in increasing effective demand through its own expenditures, and therefore acting as macro-manager in ensuring full employment. Keynes spoke of the need for "the socialisation of investment" in order to achieve full employment.

Related to this idea of investment determining output and therefore saving, is the concept of the multiplier, which was originally developed by Richard Kahn, but is very much part of the Keynesian tradition. This is the idea that an increase in investment induces further increases in consumption, income and saving. The initial expenditure adds to purchasing

power, which then demands more goods, and so on. Thus the final effect of any initial outlay will depend on the propensity to consume of the society. The higher this is, the higher will be the multiplier effects of investment on income.

It should be clear that all this is dependent on the idea that there are no supply bottlenecks in the system, and that excess capacity in the productive sector allows for expansion and for the multiplier process to work itself through. This has been seen as limiting the applicability of this argument in developing countries where in some specific sector (say agriculture) production cannot be easily increased and becomes a bottleneck.

Of course, this argument relates to the real economy, but it is naturally crucially affected by the perception of the role of money, and this was another of Keynes' major innovations. His notion of liquidity preference is an important plank of the broad argument, and remains a significant factor in disputing the conclusions of monetarist theory today. According to Keynes, there are three reasons why money is held. The first is the "transactions" motive, on the part of households and other economic agents for their ordinary economic transactions. This demand is a stable function of the level of income or economic activity. Second is the holding of money for "precautionary" purposes, that is against the possibility that some unexpected payment may have to be made or that some expected receipts may not materialise. Finally, there is the "speculative" motive, which occurs because of possibilities of changes in the interest rate, and is therefore critically dependent upon expectations.

The theory of liquidity preference was intended to describe the market mechanism through which changes in the interest rate occur, rather than its absolute level. The speculative motive played an important role in this, not only because of its quantitative significance, but also because of its high degree of volatility. What is important is the essentially unstable nature of the speculative demand for money, which is affected by

expectations regarding interest rate changes, and therefore by expected variations in the capital value of financial assets.

The significance of this idea in the current world economic context must be emphasised. Not only does it provide a powerful insight into the functioning of money and financial markets, but it also offers several compelling reasons to be sceptical of the monetarist arguments which currently hold sway over so many of our policy makers across the world. First, it becomes impossible to define money in a way that will lead to universal agreement, and distinguish it clearly form other liquid assets, "quasi-moneys" and "near-moneys". So establishing the quantity of money in an economic system is near-impossible. Second, the idea of liquidity preference emphasises that the demand for money cannot be a stable function of real income, because it contains at least one high unstable element, the speculative demand. Third, and following from these, it can be argued that the supply of money does not operate automatically as a significant brake on the possibilities of portfolio reshuffling by financial players, even though it can dramatically affect real economic decisions. The relevance of this argument to economies like those in Southeast Asia today should be obvious.

Keynesian Economics

Keynesian economics has followed a trajectory rather different from that explored by Keynes himself. There have been two broad strands. One sought to integrate Keynes with the basic neo-classical tradition, and became the dominant mainstream opinion, especially in Western academia. The other, which was possibly more reflective of Kalecki's influence, has emphasised the impossibility of achieving socially desirable outcomes through capitalist market processes.

The attempt to integrate Keynes with the basic neo-classical model began fairly early after the publication of the General Theory, and found its clearest and most famous expression in the "neo-classical synthesis" of John Hicks. The purpose was to show that, far from being a general theory, Keynes' argument referred to a special case of the broader neo-classical analysis. The basic idea was that the notion of equilibrium in which all markets (including that for labour) clear, was still an accurate description of the economic system. However, the forces that ensured this full employment market-clearing outcome could be frustrated by rigidities and imperfections, and also took a long time to work themselves through.

Thus, Keynesian unemployment was attributed to rigid money wages, and supposedly confined to short-run rigidities which inhibited the operations of labour markets. Similarly, liquidity preference was treated as a theory determining the level of the rate of interest, rather than changes in it. This completely bypassed Keynes' emphasis on the inherent instability of the demand for money because of the uncertain character of expectations about the future level of the interest rate, and made it a stable function.

The neo-classical synthesis accepted that the economy could be found for certain periods of time to be experiencing sustained unemployment due to the inadequacy of overall effective demand. Therefore there was a role for government to reinforce and speed up the processes by which the economy could find its way back to long-run full-employment equilibrium. Once at that point, the traditional neo-classical theory of resource allocation

would be relevant once again.

This approach caused the label of "Keynesian" in industrial countries to be put on policies of macro-management which eschewed micro-economic intervention by the state and did not incorporate any comprehensive "socialisation of investment" as envisaged by Keynes. Economic management by government became the search for appropriate mixes of monetary and fiscal policies, with the relative weight of each being based on the

assumptions of the responsiveness of investment and money demand to the interest rate, which in turn depended upon the degree of faith in the market mechanism.

All this was furthered by the advocacy of the "Phillips Curve" - the idea (not to be found in Keynes' own writing) that there is an inverse relation between the rate of inflation and the rate of unemployment. Essentially, the macro-economic conclusions were grafted onto micro-economic foundations which had the same theoretical basis as the neo-classical approach. This made it quite vulnerable to counter-attack, especially when

the stagflation of the 1970s blew the Phillips Curve sky-high, and when aggregate demand management policies proved to be incapable to meet the tasks of economic restructuring and maintaining competitiveness in industrial countries.

This period also brought out another weakness of this type of economic management, which was subsequently highlighted by the "rational expectations" school. That is that the continued use of Keynesian aggregate demand management policies will lead economic agents to predict such policies and discount for them in their own actions, so that they will become ineffective because they will not stimulate greater economic activity.

This entire approach was seen to be illegitimate use of Keynes' ideas by a (minority) Keynesian tradition, giving rise to the term "Bastard Keynesianism" first coined by Joan Robinson. This view from this perspective was that the basic insight of Keynes was that markets do not necessarily function efficiently and to the common good, and that the neo-classical theory of resource allocation is not a good guide to understanding either the functioning of capitalist economies or working out appropriate policies for them. The work of Kalecki has been particularly influential in this context, especially in some developing countries which tried to incorporate some notions of the socialisation of

investment, of planning and of micro-economic management by the state.

The Political Economy of Keynesian Economics

and its Relevance Today

It is now commonplace to argue that the dethroning and even discrediting of Keynesian economics has been closely related to the rise to dominance of finance, both nationally and internationally. The latter is of course a complex process calling for explanation in its own right. But there is no doubt that the growing political and economic power of finance has indeed played a role in three major ways : first, by rendering Keynesian policies far more difficult to engage in on a purely national level; second, by creating domestic conditions allowing for greater social tolerance of high levels of unemployment and greater intolerance of inflation; and finally, by constraining even the possibility of concerted expansion across the world.

Keynesian economics was really developed for closed economies. The possibility of external trade did not alter the basic results or insights, although it did bring in the option of using external markets to compensate for insufficient domestic demand. It also forced recognition of the fact that expansionary domestic policies designed to bring about full

employment could cause external deficits which would have to be met somehow.

However, international capital mobility created an entirely new set of problems for such policies. Any attempt at domestic expansion could now bring about not only a trade deficit, but also a flight of capital and consequent pressure on the currency, forcing a retreat from such policies. The experience of the Mitterand Government in France in the 1980s was the first glaring example of this in industrial countries; for developing countries, of course, it had long been a well known fact of life. But having tasted blood in this way, it was not to be expected that financial markets would give up the possibility of being able to control and influence economic policy making through such movements. Indeed, the world of the 1990s, which is now showing the effects of successive waves of

financial deregulation and liberalisation across first developed and then developing and formerly socialist countries, bears testimony to the power of finance in determining economic policy.

This may be the single most important reason for the downfall of the Keynesian strategy, at least in its neo-classical synthesis form. As long as financial markets remain open and capital can move across borders in response to policy changes or expectations, there are clear limitations to the use of Keynesian policies to attain full or near-full employment.

However, even Global Keynesianism, or the idea of co-ordinated economic expansion which will not cause punitive capital flight in any single country, faces constraints. These also became evident in the 1970s, in the form of the inflationary barrier posed by the effects of such capitalist expansion on wages and commodity prices. Thus, concerted expansion will increase demand for labour and for goods produced by primary product

exporters, leading to a rise in their bargaining power. If any attempts by these groups to raise their income share consequently is resisted, the result will be inflation. Not only can this be destabilising, it is complete anathema to finance.

It is this feature, which essentially amounts to a fight over distributive shares of income both across regions and between economic classes within regions, which is responsible for current unemployment equilibrium in the world economy as a whole.

But while Bastard Keynesianism may indeed be dead, this does not mean that the economic ideas of Keynes are no longer relevant. In fact, each of the basic principles of Keynes' economic thought outlined above - the principle of effective demand, the possibility of unemployment equilibrium, the working of the multiplier, the role of the state, and the concept of liquidity preference and monetary instability - remain as important as ever.

The trouble is not just that policy makers have abandoned the old Keynesian ways of attempting demand management. The real problem is more that all of us seem to have forgotten the implications of these basic insights, which are sought to be obscured by the miasma of half-truths forced upon us by financial institutions and market analysts. The task before us today is to translate these insights into practical policy alternatives that we can demand from all of our governments.

Jayati Ghosh
Jawaharlal Nehru University
New Delhi, India
March 1999


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