Sudhir Mulji: Has Keynesism failed?

For good or bad, the tools of Keynes have become a feature of macroeconomics

In a scorching attack (Business Standard, September 3), Kaushik Das, a research fellow at the Centre for Civil Society, has argued against Keynesian economics, in particular its "key vice" as he describes it, the abuse of fiscal policy in inducing misguided public investments through credit expansion and fiscal deficits.

He maintains that these investments eventually prove to be unproductive and costly to the economy. Since many practical men of common sense generally share such views there is perhaps some justification for explaining Keynesian reasoning in greater detail.

Das opposes Keynesian expenditure by pointing out that continuous doses of deficit finance have proved to be unworkable as they lead to stagflation.

In the long run the trade-off between rising inflation and growth in output disappears, so the economy ends up with the worst of all solutions, inflation in prices and stagnation in output.

However, illustrations for such propositions have relied upon examples from developed economies where economies already have a high level of activity and employment.

Further, their population and labour force do not have a natural growth rate, unlike an economy like India that adds to its population by a staggering figure of 15 million people annually, where in the last 50 years the gross population has trebled, probably with corresponding impacts on the unemployed.

Unlike modern economics, classical economics, that is the economics of Adam Smith, Ricardo, and Malthus, developed against a similar background to India's; that is, there was a sustained increase in population and a growing labour power.

Classicists argued that wages could not rise much over sustenance levels because the labour force was constantly and naturally expanding; thus, provided governments and do-gooders did not interfere by enacting such humanitarian legislation as the Poor Laws, there could be no shortage of labour at the going wage rate.

Now, such a state of affairs may have been economically justifiable in a starker age, but it would be a gross mis-reading of democracies or even modern totalitarian states to believe that a non-intervening authority can simply rely upon the workings of economic principles in the face of hunger, famine, or suicides or for that matter any form of calamitous distress.

It is characteristic of those who advocate "sound finance" to accept that such severe outcomes can be mitigated but cannot be avoided. It was perhaps Keynes's greatest achievement to have intuitively recognised that expectations of what governments and authorities were required to do in economic policy were radically different from the story told by classical economics.

In other words, a non-interfering uninvolved government is not a plausible framework for a modern government, however desirable it may be. But to sound financiers, the failure of Keynesian theory is not the discovery that some minimal intervention was desirable.

For them his ultimate sin was to argue that the entire structure of classical economics was based upon a false concept of an equilibrium to which an economy would settle if it was not interfered with by government.

To make his point, Keynes accepted the assumptions of classical economics; further he recognised that outcomes could be influenced by an inability to reduce wages as a consequence of restraints induced by collective bargaining.

But if the price of labour could not be brought down by a fall in wage rates, nothing prevented the relative cost of labour from falling by an increase in producer prices.

If indeed there was idle labour willing to be employed at the going wage rate""and during the great depression who could deny that""what prevented producers from moving to fuller employment by raising prices?

One answer could be that there would not be the demand for goods at higher prices but that could not be part of classical logic: "Say's Law that the aggregate demand price of output as a whole is equal to its aggregate supply price for all volumes of output, is equivalent to the proposition that there is no obstacle to full employment" (General Theory, p. 26).

Say's law and many versions since, have relied upon the proposition that real constraints on any economy are from an insufficiency of supply and resources and never from an insufficiency of demand. Supply creates its own demand and there is no provocation for artificially stimulating demand.

If that proposition is economically sound we must conclude that in poorer countries like India there is no supply surplus, that either labour is fully occupied or that it cannot be used at all.

If it is so occupied why are there such horror stories like suicides and hunger strikes? Are they merely isolated incidents or is the economic story more Keynesian than classical?

Keynes argued that producers fail to use up surplus labour because they are uncertain about demand for their goods. The economy does not move to its full potential because private investors will only venture if they have confidence in the outcome of their investments. They invest to make profits and shy away from ventures if uncertainty prevails.

This is what Keynes wrote in Chapter 12 of The General Theory. To businessmen this chapter is the very core of Keynesian economics, for though it is woolly and full of colourful generalisations it captures the real mood that determines investment. Curiously it is a chapter that has been underplayed by Keynes's closest disciples.

For example, Keynes's famous pupil Richard Kahn describes "animal spirits" as appearing at the end of "the more light-hearted" Chapter 12 and "not in the fundamental Chapter 11", which deals with the mathematical expectations of investment returns.

But to businessmen, chapter 11 is simply a mechanical calculation of net present value that an investor would expect his accountants to carry out, not the decisive influence in undertaking an investment.

It was essentially in this context that Keynes recommended increasing effective demand by public investment. He had not lost sight of the fact that "the ineptitude of public administrators strongly prejudiced practical men in favour of laissez-faire" (Keynes, Essays in Persuasion, p. 275).

Keynes did not think that there was an automatic system within the classical system that could ensure an adequate use of resources; he saw a logical flaw in the assumption that potential supply would provide adequate demand simply by the working of prices; nor did he think that governments could ignore distress without intervention.

It is said that Keynes's suggestions for intervention could worsen the state of affairs, and Friedman demonstrated that by showing that the Federal Reserve's intervention in the thirties did more damage; but in fact the Fed acted exactly as prudent businessmen would by withdrawing credit at a time when there was actually a need to pump in more money.

They intervened in the wrong direction not because of Keynesian recommendations but by pursuing the objectives that common sense, as it was then understood, dictated.

It is not possible, nor would it be particularly interesting to show whether Keynes's specific policies alleviated the state of affairs that prevailed at the time of the depression.

What Keynes provided was a set of tools for analysis. For good or bad these tools have become a feature of macroeconomics. Whether the Fiscal Responsibility Act will demolish Keynesism from Indian economics, as Kaushik Das hopes, is yet to be seen.

sjmulji@aol.com