Saturday, July 10, 2010


In this ‘error’ of economic turmoil, governments have come to favor the Keynesian/Samuelson/Krugmann/Stiglitz solution to an economic down-turn… stimulus! You could almost hear them shout in your mind every time you want to think of a new solution to recessions. Even IMF endorsed this policy response at some point, though now they seem to be backing austerity measures to counter growing sovereign default concerns. This has also been the standard reaction to the latest recessions in the US… and for a while it seemed to work.
Stiglitz, the economist, Nobel laureate and current advisor to the Greek government, seems to think that the appropriate way to deal with a recession is to increase government spending to sustain ‘aggregate demand’. To Stiglitz, aggregate demand which, to Keynesians is synonymous to national income (Y), is the be-all end-all of the economy.
Consumption is good, saving is bad (according to Keynesian teachings, ‘paradox of thrift’).
The basis of this argument lies in the Keynesian model expressed as Y=C+I+G+(X-M) which, to put it in layman’s English, translates to ‘Gross Domestic Product or total income (Y) is the sum of total consumption in the economy, total investment in the economy, total government expenditure as well as total exports less imports.’
As an identity, there’s little objection that anyone can raise- save for the measurement of the impact of international trade (Exports-Imports; X-M). The assertion that a nation that exports more than it imports means that the country is doing well is wrong. Krugman himself, and Ricardo, the great economist before him, have shown that this is not necessarily true. Perhaps the most eloquent prose on this subject was by Frederic Bastiat, a French economist who managed to bring out the absurdity behind the thinking best. The point, however, is that while the identity may appear sensible to us, it is just but an accounting deficit as it is not useful for anything other than this.
We can run various tests on the hypothesis that to improve GDP/National Income/Aggregate Demand (to use Keynes’s terminology), one needs to increase government spending. We shall investigate the logical relationship between the interaction of the standard units of an economy and the government.
It is important to note that government doesn’t produce, it owns nothing (to spend it must take from someone else through taxation) and it is not an expert in anything (if it was, then it would be only logical for government to be the sole producer- a notion that has been shown by the demise of Russia to be unworkable). Every time the government undertakes commercial ventures, the result has always been suboptimal. From this argument, it is fair to conclude that the government is not suited for business. The simple question thus is this, how does an entity that is unsuitable for business, owns nothing and produces nothing improve an economic activity? How does salt make tea sweeter?
The argument might seem too simplistic but it really isn’t because it questions the assumptions on a philosophical level. It may, however, be important to investigate this notion further for those who are undaunted by complexity. It is said by Keynesians that the government is important to the economy because, during a recession, the government is the consumer of last resort. In short, to increase Y, one must increase G if C, I and (X-M) are trending downwards.
Nominally, the argument seems logical. However, this argument ignores the underlying relationships between the concerned variables. In short, government expenditure is not independent of consumption and or investment. An increase in government expenditure necessarily means higher taxation, inflation or higher borrowing. All these have different implications for various units in the economy. For example, higher taxation will mean lower disposable income. Depending on the consumption patterns of the individual, this could mean lower savings or lower consumption or both. Higher borrowing by the government, also known as a deficit budget, could mean higher interest rates. Higher inflation could mean higher interest rates in the long run and possible irreversible damage to the economy.
This leads to structural issues. It may result in what Frederic Bastiat refers to as the broken window fallacy. The broken window fallacy is an allegory of a baker whose window is broken by a thug. Eye witnesses, though sympathetic to the damage the baker has suffered, mused that the broken window has, at least, offered employment to the glazer thereby bringing some good to the economy after all. Bastiat teaches us, in his essay ‘what is seen and what is not seen,’ a good economist not only analyses what we can see but we must also analyze what we cannot see. In this case, the glazer gains but we must also recognize that because the baker repaired the broken window, the baker cannot buy a new pair of shoes, or even a new pair of trousers, or even simply expand his business. So the gain of the window industry is the loss of the garment industry or the loss of the shoe industry or even the food industry which are more useful to the economy in terms of sustainable growth of the economy (because we cannot build an economy on the destruction of capital). Further, we have resources that will be diverted to making of the window rather than building providing windows for new buildings.
Similarly, as the government has nothing of its own, whatever it needs, it must take from someone else. So, in short, for the government to act as consumer of last resort, it must tax its people more leading to the government’s version of the broken window fallacy (the government could borrow but that leads to the notion of the Ricardian equivalence which states that today’s debt is tomorrow’s tax). The interesting thing to note is that when government taxes its citizenry, it increases the cost of the government by more than the taxes collected. This is because one also has to factor in the cost of administering and collecting the taxes. The government is also known to waste resources through bureaucracy as well as corruption and cronyism- a feature of all governments because they are run by politicians. Samuelson noted as much after realizing his folly in supporting central planning. This leads us to believe that government spending multiplier is, a lot of times, below 1. Estimates in the United States put returns on government spending at USD 0.7 for every USD 1 spent.
Some may ask why economies seem to recover from recessions through government spending. The answers are varied. It could be that sometimes this concept works. It could also be that recovery is in spite of government. There are two alternatives to economic recovery that governments can pursue. The first is to increase government spending and this goes hand in hand with increased borrowing or taxation or both. The other is to cut taxation, and for this to be effective, it must be accompanied by cutting government expenditure. According to research by various economists, it has been found that the latter is more effective than the former. We may, however, choose to analyse what happens when the government chooses the former.
A recovery where government spends a lot means the government must finance the new expenditure either through increased taxation, increased borrowing or inflation, otherwise known as ‘accommodative monetary policy’. The effects of the first two are straight forward. The first is that consumers shall consume less killing incentive to produce and thereby hurt the economy and very few governments actually pursue this course. The second leads to raising the cost of financing and this usually serves to slow down the vibrancy of the economy. The third is the method is the preferred method of choice. If inflation expectations are managed, the government can actually spend more resources than it actually has leading to a seemingly neutral position. This method is dependent on money illusion rather than fundamentals to get things moving. Therein lies the danger. Because the problem that brought about a recession has not been solved, the economic recovery remains fragile and open to future complications.
Finally, we can analyze the question empirically. If one took a look at firms listed in the Nairobi Stock Exchange, all government owned companies underperform their peers where competition is fair. It is therefore desirable that government participation is minimized in the economic lives of society.
To this end, we can qualitatively show that the government multiplier is less than 1. The government faces too many obstacles in the name of bureaucracy and politics (which is inclusive of special interests) and therefore the economic goals fall subsidiary to other considerations. In short, during a recession, government participation in the economy will lead to misallocation of resources in the economy leading to depressed growth in the short and medium term… and in all likelihood, even in the long run.
And this is just on the consumption side, the damage government spending does to the monetary side, in the long run, is incredible. All one has to do is to look at the fiscal as well as monetary positions of Greece, France, Ireland, Portugal, Spain, UK, US, Russia, Venezuela, Argentina etc. all in the same problem only in different stages.
All in all, Stimulus works only when money illusion can be a factor which is very much in the short run but its use creates much bigger problems in the long run. John Maynard Keynes was so wrong on many levels it’s a wonder governments still use his theories after so many public failures.

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