Is our economic system sound?

Written by: Shahrokh Afrasiabi


A relation between savings and investment is employment, according to Keynes. Also there must be employment so there would be savings. Keynes knew that unemployment or employment is the key factor. According to Keynesian Macroeconomics theory, based on traditions in economic theory before him, mainly by Adam Smith and David Ricardo; the level of total capital expenditure (Investment) determines the rate of expansion and economic condition in a market society. When this level is high it means high employment, therefore high purchasing power and high consumption. When the level of total expenditure is low, it means lower employment and lower purchasing power and therefore lower level of consumption. Keynes in his General theory of Employment, Interest and Money challenged his predecessor’s notion who believed that government should not interfere with the market because economy would correct itself in the long run. He responded to this notion by saying: “In the long run, we are all dead”.
Instead Keynes argued that when the level of total capital expenditure is not sufficient to ensure economic growth and there is unemployment because of shortage of private investment, then government should step in temporarily by injecting investment to substitute for the shortage until the economy could rebound itself. In addressing the economic downturn of the 1930’s when the fall of overall capital expenditure among other factors had created huge unemployment and economic recession in the U.S, even though Keynes was aware that these interventions could increase government deficit and inflation, he argued that government deficit could be carried forward like corporate debt and the recovery of the economy and eventual rise of wages could correct the inflationary effect. Keynes also suggested that macroeconomic should be used as well as playing with people’s expectations. According to him, irrationality comes from that people act on both positive and negative wishes based on their level of fear; then Keynes introduced the principles of mass psychology based on people’s “lack of rational”. Keynes believed that market worked on “the psychology of fear and expectations”; Bad news in the market creates fear among investors causing them to withdraw their investments which can multiply the effect of an economic downturn. Positive signs create expectations of profit which in turn will encourage people to invest their savings in the market and make the economy boom.
The phrase Stagnation is referred to slow or negative economic growth measured by GDP. Gross Domestic Product (GDP) or national income based on Keynes Macroeconomic theory is a measure of economic well being and when measured per capita, of its individuals. It is consisted of the sum of domestic consumption, gross private Investment, total government spending and net export (Y=C+I+G+NX). GDP is positively affected by change of each of its components and each component responds differently to change in interest rate in addition to affecting interest rate itself. They are also interrelated with other factors like exchange rate which directly determines the demand for export and employment among other factors. All of which can be explained through the mechanism of demand and supply.
Prior to this theory, market thought to be a self correcting mechanism in which government should not interfere. This was based on the Adam Smith’s concept of “invisible hands” which stated that the market would eventually correct itself with no state interference. Even though the role of state according to Smith was only to ensure the competitive nature of the market, he also had mentioned that government should undertake large public projects that private sector is unable of doing, while he did not think of its overall stimulus impact on the economy. This view however proved to be inadequate following the great depression and failure of the U.S. economy to rebound on itself for a lengthy period of time. The stock market crash of 1929 was caused by a series of factors including but not limited to problems with credit market, agriculture and technological change. Credit market freeze partly was caused by speculation in the stock markets, by banks and trust companies as well as other investors. Problem in agriculture and weakness of farms was also linked to lack of funding and uncompetitiveness of traditional farms. Also effects of technological change on employment and increased disparity between rich and poor were among other reasons. These factors among others contributed to crash of the stock market in late 1929 when the market suddenly lost a great portion of its value and brought the U.S. economy to a near standstill.
Stock market is based on profit of its underlying stocks. Stock market is a place where shares or ownerships of companies are bought and sold. Problem arises when the underlying companies are not productive, meaning that they do not generate profit or meet the expectations of the investors. Following the industrial revolution, capital entrepreneurs had an irrational desire to accumulate wealth where dummy companies and pyramid skims were a common phenomenon. These companies had no real business activity but instead they pretended to be profitable. Since stock market is fueled by speculation, high returns would push their stock prices further up until the pyramid would come down and all their stock values would be lost. As a result investors would lose either all or a great part of their investments. To cut their losses or in pursuit of a better return for their investments, they were likely to sell their shares. However this was only possible with a loss, meaning that they would receive an amount less than what they paid for those shares initially. Since most of the investors invest with borrowed money, it meant that even after selling their shares with a loss they were still expected to pay back their loans. Investor’s inability to pay back loans eventually created problem for the credit markets and lending institutions. From 1925 onward leading up to the great depression, banks were going out of business at the rate of almost two per day.
Other reasons for failing banks were problems in the agriculture sector. Following the industrial revolution, application of technology spread to agriculture sector among other industries. While this modernization due to development of new fertilizers and pesticides as well as machinery and automation drastically increased productivity in agriculture, it had its disadvantages too. An increasing number of people working on farms became unemployed as a result of this automation and modernization. Also due to inelastic nature of the agricultural products more production and lower prices did not mean more consumption. Low prices translated to less money in farmer’s pocket while their taxes increased and like all other borrowers, they had to make payments their financed equipments. As farmer’s income dwindled, they felt the need to produce more, and the more they produced, prices further dropped and it further worsened their situation, to the point that they were no longer able to meet their obligations. Therefore, perishable nature of farm products and lack adequate storing and transportation and over production and decrease in prices in places of production on one hand and a great number of work force previously employed in agriculture becoming unemployed on the other hand contributed to the problem in agriculture.
Following the industrial revolution and continued technological change, the trend towards automation substituted more and more men with machine in the production process. Therefore as technology advanced more, more workforces became unemployed. This was mainly the case with manufacturing and farming industries. Increase in productivity thanks to technological change from one hand required more consumers, but as more labors lost their jobs due to the same process, they could afford less to buy products. Technology therefore negatively affected the demand for labour and created unemployment.
Running up to the 1929, uneven distribution of income had concentrated a high percentage of wealth in the hands of a few who could not spend it all on consumer’s goods and saved their excess income. This saved portion did not contribute to the consumption demand. Therefore unemployment and uneven distribution of income both contributed to low consumption demand.
We know that the bulk part of total capital expenditure in a capitalist market society consists of consumption. It is the level of consumption that sustains production and encourages private capital investment in production. As unemployment rises, people have less income to spend and can consume less. Less consumption means less demand for production. Low demand in turn forces more production facilities to closure and therefore pushes more people out of work. This ripple effect further reduces the consumption level and leads to an even lower demand. This cycle if continued will lead to an economic stagnation, as it did in 1929.
As Karl Marx had predicted some years before the great depression, capitalist system tends to monopolization and convergence of the supply. The more application of technology becomes essential in the competition, only leading firms are able to increase their productivity and undersell all competitors. This process slowly forces smaller firms out of the market and creates further unemployment, diminishing the demand for products. Monopolization and decline in demand also pushes the prices higher. Therefore, prices don’t go down as much relative to the increase in productivity.
More unemployment also means higher demand for employment which can be translated to the labour accepting lower wages and as a result wages don’t rise at the same level and don’t match the rise in prices. A combination of rising prices and fall in income effects consumption level even more negatively.
Keynes suggested that there must be a macroeconomic solution to this problem, but didn’t see the government’s role in the economy as a permanent one. Keynes solution to this clog in expansion of the economy was to create more expansion with the help of the government. To ease the flow of funds in the credit market, government was to inject investment into the economy. It did so by undertaking public projects as well as altering country’s money supply by buying or selling government debt. These measures were later called fiscal and monetary policies. Fiscal policy would mean that the government by undertaking large projects such as in country’s infrastructure creating employment and income for a large number of people. Income in turn can increase consumption and savings. Savings then would promote new private investments and capital expansion when invested, which can stimulate production and create more employment. Monetary policy on the other hand meant altering the monetary base in the economy by the central bank. Increase in the supply of money relaxes the interest rate and makes more credit available for private sector to be invested in capital expansion which can also create employment. The common effect of both policies on the economy in addition to the budget deficit for the government is inflation.
Keynes revolutionized the economics by introducing monetary and fiscal policy as tools for directing the economy. This brought forward the rise of public sector and emboldened the role of government in the capitalist system more than ever. Government interventions were mainly in areas that the free capital system on its own had failed to address. The New Deal Started by Roosevelt represented a tremendous amount of state legislations and emergency acts such as banking act, mortgage act, wage act and bare labour standard act to protect labour unions, setup minimum wage and maximum working hours and to eliminate child labour.
President Roosevelt upon his presidency in 1933 introduced some fifteen major bills to address all possible areas which had failed and caused the American economy to a recession. They included measures to supervise bank activities and to regulate the stock market. These bills also included antitrust laws and were intended to limit the formation of cartels and collusion in the market place. They also included in addition to acts for protection of labour unions and youth employment, some measures to ease credit flow for farmers to address problems in agriculture sector.
Keynes’s Monetary and fiscal policies despite being inflationary are to this day being implemented mainly to tackle unemployment and sluggish economy. It is however interesting to observe that expansionary policy’s direct result which is inflation, as we will further examine is the main case for unemployment and decrease in total capital expenditure in the economy! That may be one of the reasons why capital economies since the great depression have gone through such frequent cycles of booms and busts.
Expansionary policies have their pros and cons. On the plus side these measures in the short run help stimulating the economy by creating employment. Higher employment creates positive outlook of the economy which promotes more inflow of investment in anticipation of profit as Keynes had predicted. Inflationary side effects however cannot sustain a low unemployment rate in the long run.
William Philips (1914-1975) explained how inflation and unemployment are in negative relationship in short run:

This is known as Philips curve. It shows that the lower the unemployment in an economy, the higher the rate of inflation. While it is the case that there is a short run tradeoff between unemployment and inflation, it has not been observed in the long run as wages don’t tend to match the rising prices. This is the case when inflation and unemployment rates remain high at the same time to create a condition called Stagflation.
Another problem arising from expansionary economic policies which to this day remain the only tools available to the governments is that inflation created by these policies is negatively related to the level of savings and consumption. A decrease in the amount of goods and services that consumers can consume as a result of increase in prices relative to their income means above all less consumption. Consumers after paying for their essential goods are left with little or nothing to save. In additions, consumers when facing with the rising prices choose to consume in the present period as oppose to save for the next period. Less incentive to save and less money to spend means less private investment in the first period. It also means less consumption in the next period. Lack of investment freezes capital expenditure which in turn causes a downturn in the economy and unemployment again.
Among other disadvantages of expansionary policies apart from inflation of which we spoke before is that they create government budget deficit. To balance the budget governments have to cut their services to the public which they usually include essential services such as education and healthcare as well as social security. Cutting these services further contributes to disincentive for employment as well as higher rate of unemployment in the future periods which sets the condition for a higher frequency of recessions in the future.
Keynes knew that unemployment or employment is the key factor to the economic expansion but we know today that application of expansionary economic policies are only quick fixes that in fact can only postpone today’s structural economic problems to a time in the future. This however does not come without a cost. As we can observe today, the cycle of boom and bust has repeated itself numerous times since its first occurrence during the great depression. As our brief examination of the dynamics of the components of growth in a capital market society reveals, in many cases short term results can be very different from those in the long run. Further we have not taken to account the rise of the price of energy and oil. According to another Philips curve, rise in the price of energy reduces the total capital expenditure or GDP and reduces profit which in turn means less employment. Given the current level of unemployment and the current prices of energy, it is not hard to observe a state of stagflation in the U.S. This situation combined with a huge budget deficit leaves little choice for the U.S than to engage in yet another conflict to consume its expensive military hardware in an attempt for another economic recovery.


Sources:
1. The Making of Economic Society, Robert Heilbroner& William Milberg
2. The Worldly Philosophers, Robert L. Heilbroner