Economics 3: Keynes, market failure and fiscal policy

by George Hatjoullis

We return to the concept of potential output which we noted is operationally redundant because it is captured by the behaviour of inflation expectations. The two have been combined in the idea of a non accelerating inflation rate of unemployment or NAIRU. GDP is produced by a combination of the means of production with labour. However, this does not mean that ‘maximum output’ is achieved when everyone that wants a job has a job and is working as many hours as they wish, at least not in a market economy. Maximum output is achieved just before inflation expectations start to accelerate. This normally occurs with some positive level of unemployment. This is why in the forward guidance on monetary policy currently in vogue with central banks, they promise to start tightening monetary conditions when unemployment is still numerically quite high. The other element of forward guidance is the measured inflation rate which is usually required to be in the vicinity of 2% and not moving away from it. The definition of ‘price stability’ or non accelerating inflation/deflation and the level of unemployment consistent with price stability differs from economy to economy. For the moment we will note the concepts without further development and return to the subject later. The important point is that there is a notion of maximum or potential GDP that is operationalised using inflation expectations and unemployment.

Actual GDP produced is distributed between labour and the owners of the means of production (which overlap to some extent). However, labour, in aggregate, does not normally wish to consume or use all of its share of GDP in any one year. It normally saves part of income for a rainy day ( or retirement, which is becoming a perfect storm). It saves by accumulating claims on future GDP ( or wealth) in money terms. Similarly, the owners of the means of production will save part of their share of GDP as money wealth. So what happens to the real goods and services that they have produced? How do they convert their share of what has been produced into money wealth unless someone buys it? In part this unused part of GDP is taken up by dissavers (like pensioners) and in part it is used to invest in more means of production. The latter is undertaken by existing owners of the means of production, developing existing and new products, and by new producers using borrowed claims to GDP and shared ownership (equity). However, there is no automatic reason why the saving of those that have a claim to the output should exactly match the dissaving and investment of those wishing to use the unused part of output. What if there is a lot of output that no one wished to use in any one year?

If inventories accumulate then the owners of the means of production tend to cut back output. People are laid off and factories mothballed or even closed. A recession sets in. The central bank may respond by encouraging banks to lend and at lower rates. The availability of cheap credit is meant to encourage existing and new owners of the means of production to use some of the surplus GDP to invest in new and improved means of production. This may not help in the long run as, although it uses up existing GDP, it also expands future output. It may just move the demand/supply imbalance along (kicking the can down the road). Worse still, the action of the central bank may have no effect. It all rather depends on the expectations of the owners of the means of production (or more precisely, their agents, the management). Unless the owners of the means of production see some prospect of selling their output, they will be disinclined to produce let alone invest. The economy could thus settle at a level of employment and output well below any notion of potential and stay there for quite a long time.

Prior to the publication of J.M Keynes’ The General Theory of Employment, Interest and Money‘, economists did not believe this was possible. The reason was their complete faith in markets. If there was capacity to produce, wages and relative prices would adjust until some ‘entrepreneur’ saw a possibility of profit and so eventually markets would see to it that all resources were ‘fully employed’. Keynes, a financial market speculator, was aware from his experience in financial markets, that markets can fail. [The concept of financial market failure has been discussed at length in the Gestaltz blogs]. Keynes applied this idea to labour and product markets. What if, he postulated, labour and product markets fail? What if the owners of the means of production became so negative on the prospect of selling output that cheap credit, lower wages and lower input costs became irrelevant to them. Indeed as wages fell the prospect of selling things must have deteriorated. Workers could offer to work for less and less and still not induce the owners to start up factories. The labour market could fail just like the credit market failed in 2008. Such ‘perfect uncertainty’ could paralyse entrepreneurs and keep economic activity depressed well below potential for a long time. So Keynes made a suggestion; enter the state.

Prior to the General Theory the state limited its activities to the provision of public goods (and defined public goods quite narrowly) and ran its finances rather tightly (much like modern Germany). Keynes suggested the state expand its role to include stimulating demand. The state did not need to do anything productive. Indeed given that this might just kick the can down the road, the less productive the better. Digging holes and filling them in would do. The point was the state would pay people, the pay would be spent and this would break the cycle of depression and anxiety that was keeping entrepreneurs from expanding their activities. The state would finance this demand stimulating expenditure by borrowing (state borrowing is necessarily very cheap in nominal terms at such times) and repay the borrowing from growing tax revenue as GDP recovers. From this simple idea of kick-starting an economy in depression, grew the notion that the state has a duty to keep the economy operating near potential and that this can be achieved through a deliberate fiscal policy. This is a very modern concept in economics though one could argue that unemployment is just another externality given its social consequences.

The operation of fiscal policy is simple in concept though quite messy in practice. Recall the problem arises when labour and the owners of the means of production do not want to use all of current output and want to accumulate money claims instead. Moreover, dissavers and entrepreneurs are not willing to take up all of that which is left. The state is expected to provide claims on future consumption in the form of government debt. It borrows to acquire the part of GDP that no one wants to use now. This is not how fiscal policy is usually characterised but it amounts to this. There is a reason for choosing this characterisation which will become evident in due course.

So, to recap:

1. Potential GDP is operationalised by the concept of NAIRU.

2. Market failure can lead to a long-term depressed state in which the economy operates well below potential.

3. Keynes suggested breaking the cycle of depression through state borrowing and public employment programmes.

4. From Keynes’ suggestion has grown the notion that the state has a duty to take up any part of GDP that the private sector does not want to use now and provide claims on future consumption.

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