6
Macroeconomics: Aggregate Demand as Leading Lady
Before the Great Depression of the 1930s there was only “economic theory.” Thanks to the Great Depression and John Maynard Keynes we now have “microeconomics” and “macroeconomics.” Economic theory bifurcated because some in the mainstream of the profession finally recognized that standard economic theory shed little light on either the cause or cure for the Great Depression. The old theory was relabeled “microeconomics” and preserved as the center piece of the traditional paradigm, and a new theory called macroeconomics was created to explain the causes and remedies for unemployment and inflation.
The leading lady in Keynes’ new drama was aggregate demand, the demand for all final goods and services in general. By focusing on aggregate demand Keynes was able to explain why the production of goods and services can fall, why these economic “downturns,” or recessions, can occur and become self-reinforcing, and what causes demand pull inflation as well. More importantly Keynes explained how government fiscal and monetary policies could be used to combat unemployment or inflation when these problems appear. Short-run macroeconomics can be understood using one new “law,” one “truism,” and simple theories of household consumption and business investment behavior.
The Macro “Law” of Supply and Demand
The new “law” is the macro law of supply and demand. It is the macro analogue of the micro law of supply and demand which is the key to understanding how markets for particular goods and services work. The macro law of supply and demand is the key to understanding how much goods and services in general the economy will produce, that is, whether we will employ our available resources fully and produce up to our potential, or we will have unemployed labor and factory capacity and consequently produce less than we are capable of. The macro law of supply and demand is also the key to understanding whether or not we will have inflation because the demand for goods and services in general exceeds the supply of goods and services the economy is capable of producing, resulting in excess demand which “pulls” up the prices of all goods and services.
The macro law of supply and demand says: aggregate supply will follow aggregate demand if it can. Aggregate supply is simply the supply of all final goods and services produced as a whole, or in the aggregate, which economists call gross domestic product, or GDP. It includes all the shirts and shoes produced, all the drill presses and conveyor belts produced, and all the MX missiles and swing sets for parks produced. Aggregate demand is the demand for all final goods and services as a whole. It includes the demand from all the households for shirts and shoes, the demand from all businesses for drill presses and conveyor belts, and the demand from every level of government for missiles and swings sets for parks. The rationale behind the macro law of supply and demand is as follows: The business sector is not clairvoyant and cannot know in advance what demand will be for their products. Of course individual businesses spend considerable time, energy, and money trying to estimate what the demand for their particular good or service will be, but in the end they produce what amounts to their best guess of what they will be able to sell. The business sector as a whole produces as much as they think they will be able to sell at prices they find acceptable. They don’t produce more because they wouldn’t want to produce goods and services they don’t expect to be able to sell. And they don’t produce less because this would mean foregoing profitable opportunities.
What if the business community is overly optimistic? That is, what will happen if the business sector produces more than it turns out they are able to sell? This does not mean that every business, or every industry is producing more than it can sell. No doubt some businesses, and maybe even entire industries, will have underestimated the demand for their product. But what if, on average, or as a whole, businesses overestimate what they will be able to sell? Most businesses will find they are selling less from the inventories in their warehouses than they are producing and therefore they are adding to inventories each month. While a business may decide this is a temporary aberration and continue at current levels of production for a time, if inventories continue to pile up in warehouses businesses will eventually cut back on production rates. When that occurs the supply of goods and services in the aggregate will fall to meet the lower level of aggregate demand – aggregate supply will follow aggregate demand down.
What if businesses are overly pessimistic? That is, what will happen if the business sector produces less than it turns out they are able to sell? They will discover their error soon enough because sales rates will be higher than production rates, and inventories in warehouses will be depleted. So even if they initially underestimate the demand for their products, businesses will increase production when they discover their error, and therefore production, or aggregate supply, will rise to meet aggregate demand – aggregate supply will follow aggregate demand up.
But there might be circumstances under which the business sector won’t be able to increase production. What if all the productive resources in the economy are already fully and efficiently employed? In this case the increased labor and resources necessary for one business to increase its production would have to come from some other business where they were already employed, so the increased production of one business would be matched by a decrease in the production of some other business, and production as a whole, or aggregate supply could not increase. This is why the macro law of supply and demand says that aggregate supply will follow aggregate demand if it can. If the economy is producing the most it can, if it is already producing what we call potential, or full employment gross domestic product, aggregate supply will not be able to follow aggregate demand should the aggregate demand for goods and services exceed potential GDP.
Like the micro “law” of supply and demand, the macro “law” of supply and demand should be interpreted as the usual results of sensible choices people make in particular circumstances, rather than like the law of gravity that applies exactly to every mass in the presence of every gravitational force. The macro law of supply and demand derives from the common sense observation that, on average, when businesses find their inventories being depleted because sales are outstripping production they will increase production rates if they can; while if they find their inventories increasing because sales rates are less than production rates, they will decrease production.
Notice how this simple, common sense law provides powerful insights about what level of production an economy will settle on, and whether or not the labor, resources, and productive capacities of the economy will or will not be fully utilized. And notice how the answer to the question: “How much will we produce?” is not necessarily: “As much as we can.” If the demand for goods and services in the aggregate is equal to potential GDP, then when aggregate supply follows aggregate demand we will indeed produce up to our capability. But if aggregate demand is less than potential GDP then, when aggregate supply follows aggregate demand, production will be less than the amount we are capable of producing, and consequently, there will be unemployed labor and resources, and idle productive capacity. This does not happen because the business community wants to produce less than it can. It is because it is not in their interests to produce more than they can sell. And while it is true that the owners of the businesses in a capitalist economy are the ones who decide how much we will produce, there is no point in blaming them for lack of economic patriotism when they decide to produce less than we are capable of, because any “patriotic” business that persisted in producing more than it could sell would be rewarded by being competed out of business by less “gung-ho” competitors.
The size and skill level of the labor force, the amount of resources and productive capacity we have, and the level of productive knowledge we have achieved, determine what we can produce. We call this level of output potential, or full employment GDP. But whether or not we will produce up to our capacities depends on whether there is sufficient aggregate demand for goods and services to induce businesses to employ all the productive resources available. If they have good reason to think they wouldn’t be able to sell all they could produce, they won’t produce it, and actual GDP will fall short of potential GDP. Any changes in the size or skill of the labor force, quantity or quality of productive resources, size or quality of the capital stock, or state of productive knowledge will change the amount of goods and services we can produce, i.e. the level of potential GDP. But what will determine the amount we will produce is the level of aggregate demand, and only changes in aggregate demand will lead to changes in what we do produce.
In sum: If aggregate demand is equal to potential GDP, actual GDP will become equal to potential GDP. But if aggregate demand is less than potential GDP, actual GDP will be equal to the level of aggregate demand and less than potential GDP. If aggregate demand is greater than potential GDP businesses will try to increase production levels to take advantage of favorable sales opportunities. But once the economy has reached potential GDP, as much as businesses might want to increase production further, as a whole they won’t be able to. Instead, frustrated employers will try to outbid one another for fewer employees and resources than there is demand for – pulling up wages and resource prices. And frustrated consumers will try to outbid one another for fewer final goods and services than there is demand for, pulling up prices in what we call demand pull inflation – a rise in the general level of prices caused by demand for goods and services in excess of the maximum level of production we are capable of.
Aggregate demand, AD, is composed of the consumption demand of all the households in the economy, or what we call aggregate, or private consumption, C, the demand for investment, or capital goods by all businesses in the economy, or what we call investment demand, I, and the demand for public goods and services by local, state, and federal governments, or what we loosely call government spending, G.
One of Keynes’ greatest insights was that the forces determining the level of consumer, business, and government demand are substantially independent from the forces determining the level of production or output. He also pointed out that, even though businesses would try to adjust to discrepancies between aggregate demand and supply when they arose, in addition to the equilibrating forces described in the micro law of supply and demand, disequilibrating forces could operate in the economy as well. In particular, Keynes pointed out that weak demand for goods and services leading to downward pressure on wages and layoffs was likely to further weaken aggregate demand by reducing the buying power of the majority of consumers. He pointed out that this would in turn lead to more downward pressure on wages and more layoffs, which would reduce the demand for goods even further. The logical result was a downward spiral in which aggregate demand, and therefore production, moved farther and farther away from potential GDP. Keynes ridiculed his contemporaries’ faith that excess supply of labor during the depression would prove self-eliminating as wages fell. He quipped that no matter how cheap employees became, employers were not likely to hire workers when they had no reason to believe they could sell the goods those workers would make. Keynes pointed out that the demand-reducing effect of falling wages on employment could outweigh the cost-reducing effect of lower labor costs on employment – particularly during a recession when finding buyers, not lowering production costs, is the chief concern of businesses. As a result Keynes rejected the complacency of his colleagues in face of high and rising levels of unemployment during the Great Depression based on what he considered to be their unwarranted faith that (1) demand should be sufficient to buy full employment levels of output, and (2) unemployment should be eliminated by falling wages.
If ever we needed an example of humans unlearning something we once labored hard to understand, we need look no farther than the sorry transformation of macroeconomic theory over the past thirty years. In the most famous economic book of the twentieth century, The General Theory of Employment, Interest, and Money, published at the height of the Great Depression in 1936, Keynes not only explained the causes of the Great Depression where his predecessors had failed to do so, he also explained what governments could do to reverse the downward spiral of too little demand for goods and services leading to layoffs, leading in turn to even less demand for goods and services, leading to more layoffs, etc. Challenging pre-1930 economic orthodoxy, Keynes preached that the government can increase aggregate demand directly by increasing its own demand for public goods and services, G, and/or induce an increase in consumer demand by reducing their taxes; and that monetary authorities can induce businesses to increase investment demand, I, by increasing the money supply to reduce interest rates, and thereby reduce the cost of financing investment projects. Focusing on the macro law of supply and demand and how to use fiscal and monetary policy to correct for undesirable levels of aggregate demand was the core of the Keynesian “revolution.” However, all this wisdom, which was incorporated into mainstream macroeconomic theory and validated empirically as it was applied by governments throughout the world with great success for four decades, suddenly fell “out of favor” among mainstream macroeconomists beginning in the 1980s. Ever more complicated and mathematically sophisticated macroeconomic models whose intricacies PhD students were required to master in all the “top” economics departments became ever more divorced from reality. It is tempting to compare a macroeconomist trained in a mainstream program during the past few decades to an idiot savant whose impressive esoteric technical exploits are accompanied by a complete lack of basic understanding. The greatest economist of the twentieth century was literally purged from the macroeconomics curriculum before the century drew to a close. As we shall see, this has a great deal to do with why governments in Europe responded to the Great Recession with fiscal austerity rather than stimulus, and why fiscal stimulus fell victim to deficit reduction mania in the US, i.e. why governments have responded in the same counterproductive way to the Great Recession that Herbert Hoover did at the onset of the Great Depression eighty years earlier. A new generation of macroeconomists firmly in control of all the top departments were back to preaching the virtues of balancing budgets in any and all circumstances, just as Andrew Mellon as Treasury Secretary had preached to Herbert Hoover in 1930, leaving only a few grey beard “scolds” like Paul Krugman and Joseph Stiglitz, ostracized by the mainstream of the profession despite their Nobel prizes, to preach Keynes’ wisdom when the crisis hit in 2008.
Keynes reasoned that the largest component of aggregate demand, household consumption, was determined for the most part by the size of the household sector’s disposable, or after tax, income. He postulated that household consumption: (1) depended positively on disposable income, (2) that only part of any new or additional disposable income would be consumed because part of additional income would be saved, and (3) that even should disposable income sink to zero, consumption would be positive as people dipped into savings or borrowed against future income prospects to finance necessary consumption. No economic relationship has been more empirically tested and validated than the consumption income relationship. Countless “cross section studies” using data from samples of households with different levels of income and consumption in the same year, as well as “time series studies” using data for national income and aggregate consumption over a number of years in hundreds of different countries, all invariably confirm Keynes’ bold hypothesis and intuition. The “consumption function” is far and away the most accurate indicator of economic behavior in the macroeconomist’s arsenal. In its simplest, linear form: C = a + MPC(Y – T) where C stands for aggregate consumption, Y stands for gross domestic income, GDI, T stands for taxes which are the part of income households can neither consume nor save since they are obligated to taxes, “a” is a positive number called “autonomous consumption” representing the amount the household sector would consume even if disposable income were zero, and MPC stands for the “marginal propensity to consume out of disposable income,” that is, the fraction of each additional dollar in disposable income that will go into consumption rather than saving.
The most volatile and difficult part of aggregate demand to predict is investment demand. First, note that in short-run macro models investment is treated as part of the aggregate demand for goods and services because what happens when businesses decide to undertake an investment project is they first must buy the machinery and equipment necessary to carry it out. That is, the first effect of investment is to increase the demand for what we call capital or investment goods. This is not to say that the purpose of investment is not to increase the ability of businesses to produce more goods and services. But while investment increases potential GDP, and may lead to an increase in the actual supply of goods and services in the future, its immediate effect is to increase the demand for investment goods. Second, Keynes himself had a very eclectic theory of investment behavior emphasizing the importance of psychological factors on business expectations and the rate of change of output as an indicator of future demand conditions. Moreover, political economists emphasize the importance of the rate of profit and capacity utilization in determining the level of investment as we will see in the long-run political economy macro model 9.5. But a simple relationship between investment demand and the rate of interest in the economy is sufficient to understand the logic of monetary policy, and all we need at present.
Businesses divide their after tax profits between dividends, paid to stockholders, and retained earnings, income available for the corporation to use as it sees fit. If a business wants to finance an investment project they generally use retained earnings first. But often retained earnings are not sufficient to finance a major investment project, and therefore a business must borrow money to add to its retained earnings to purchase all the investment goods a major project requires. A company can borrow from a bank or from the public by selling corporate bonds, but no matter how it decides to borrow it will have to pay interest. If interest rates in the economy are high, the cost of borrowing will be high. When the cost of borrowing is high the rate of return on an investment project will have to be high to warrant undertaking it given the high cost of borrowing required to finance the project. Presumably fewer investment projects will have this high rate of return, and therefore businesses will want to undertake fewer investment projects when interest rates in the economy are high.1 We can express this negative relation between the rate of interest and investment demand most simply in a linear function such as: I = b – 1000r, where I is investment demand measured in billions of dollars, b is the amount of investment the business sector would undertake if the real rate of interest in the economy were zero, and r is the real rate of interest in the economy expressed as a decimal. While primitive, this investment function is sufficient to illustrate the logic of monetary policy we explore in Chapter 7. It says that whenever interest rates rise by 1% investment demand will fall by $10 billion, and whenever interest rates fall by 1% investment demand will increase by $10 billion.
If we ignore the foreign sector for the moment, the only other source of demand for final goods and services besides the household and business sectors is the government sector. We call the final goods and services demanded by national, state, and local governments G. While most state and local governments face restrictions on whether or not they can run a deficit, it is possible for the federal government to plan to spend either more or less than it collects in taxes.2 If the government spends less than it collects in taxes we say the government is running a budget surplus. If it spends more we say it is running a budget deficit. And if it spends exactly as much as it collects in taxes during a year we say the budget is balanced. Any individual or business can spend more than its income in a year if it can convince someone to lend it additional money, and the government can spend more than it collects in taxes by borrowing as well. The Federal Government usually borrows directly from the citizenry by selling treasury bonds to the general public.
So aggregate demand, AD, will be the sum of household consumption demand, C, business investment demand, I, and government spending, G – all measured in billions of dollars. Household consumption will be determined by household income and personal taxes. Business investment will be determined by interest rates in the economy, among other things we ignore for the time being. And the government can decide to spend whatever it wants independently of how much taxes it decides to collect, since the government can always run a surplus, and can finance deficits by selling treasury bonds. If AD ends up higher than current levels of production there will be excess demand for goods and services and businesses will try to increase production – successfully if current production is below potential GDP, but unsuccessfully if current production is already equal to potential GDP, in which case the excess demand will lead to demand pull inflation. If aggregate demand is below current levels of production there will be excess supply, businesses will reduce production to avoid accumulating unsellable inventories, and the economy will produce less than its potential and fail to employ all its productive resources.
One piece of the puzzle is still missing. How much income will there be in the economy? Just as we have to know the rate of interest before we can determine investment demand, we have to know the level of income before we can determine consumption demand. We can wait to see how interest rates are determined in Chapter 7 when we study money, banks, and monetary policy. But we cannot wait any longer to know what income will be if we want to know what GDP will become in the economy. The answer is given by a simple truism I call the pie principle: The size of the pie we can eat is equal to the size of the pie we baked. If we produced X billion dollars’ worth of goods and services during the year, then we have X billion dollars’ worth of goods and services available to use – not a dollar more nor a dollar less. Income is just a name for the right to use goods and services. So if we produced X billion dollars of goods and services, i.e. if gross domestic product or GDP is X billion dollars, then we also distributed X billion dollars of income to the actors in the economy, all told, i.e. gross domestic income or GDI is exactly X billion dollars as well.
This truism is easiest to see if we pretend for a moment the economy only produces one kind of good. Suppose we produce only shmoos – which we eat, wear, live in, and use (like machines) to produce more shmoos. If a shmoo factory produces 100 shmoos what can happen to them? Some will be used to pay the workers’ wages. And those that are left over will belong to the factory owners as profits. How much did our shmoo factory contribute to gross domestic product? 100 shmoos. How much income was generated and distributed at the same time by our shmoo factory? 100 shmoos no matter how that income was divided between wages and profits. Suppose the workers were powerful and succeeded in getting paid 95 shmoos in wages. Then profits would be 100 – 95 = 5 shmoos. Wages, 95 shmoos, plus profits, 5 shmoos, add up to 95 + 5 = 100 shmoos of total income. On the other hand, suppose employers were powerful and only paid out 60 shmoos in wages. Then employers’ profits would be 100 – 60 = 40 shmoos. And wages, 60 shmoos, plus profits, 40 shmoos, add up to 60 + 40 = 100 shmoos of total income again. The sum of the workers’ wages and owners’ profits cannot exceed 100 shmoos, nor can it be less than 100 shmoos. Since the same will hold for every shmoo factory, gross domestic product, measured in shmoos, and gross domestic income, measured in shmoos, have to be the same in an economy producing one good.
This conclusion extends to an economy that produces many different goods and services where we use some kind of money, like the dollar, to measure both the value of all the goods and services produced and the value of all the income generated and distributed in the process. The level of income in the economy will always be equal to the value of goods and services produced in the economy because the size of the pie we can eat is always equal to the size of the pie we baked. Which is why we don’t need two different symbols for GDP and GDI in our model and equations. We can use the letter Y to stand for the value of all final goods and services produced, GDP, and for the value of all income paid out, GDI, since they always have the same value.
The Simple Keynesian Closed Economy Macro Model
We are ready to summarize our simple Keynesian macro model of an economy “closed off” from international trade and investment with the following equations:
(1) Y = C + I + G; (2) C = a + MPC(Y – T); (3) I = b – 1000r; (4) G = G*; (5) T = T*
Equations 4 and 5 simply state what the chosen levels of government spending and tax collection are, allowing for the fact that they need not be equal to one another. Equation (3) tells us what investment demand will be depending on the interest rate in the economy. Equation (2) tells us what household consumption demand will be depending on income and taxes. And equation (1) is what we call the macroeconomic equilibrium condition. The Y on the left side of (1) is interpreted as GDP, or the aggregate supply of goods and services. The right side of equation (1) is the sum of private consumption demand, investment demand, and government demand, i.e. the total, or aggregate demand we will have in the economy. So equation (1) says that Aggregate Supply, AS, equals aggregate demand, AD.
The macro law of supply and demand says that the business sector will increase or decrease production (aggregate supply) until it is equal to the level of aggregate demand – if it can. We define equilibrium GDP, or Y(e), to be the level of production at which aggregate supply would be equal to aggregate demand. Depending on how great aggregate demand is, it may be possible for the business sector to produce equilibrium GDP or it may not be. If AD is less than or equal to potential GDP, which we now call Y(f) for “full employment GDP,” it is possible for the economy to produce Y(e), and the macro law predicts that actual GDP will eventually become equal to Y(e). But if AD is greater than potential GDP actual production cannot equal Y(e) but must stop short at Y(f). However, we can still ask: How high would GDP have to be in order for aggregate supply to equal aggregate demand? And the answer, Y(e), has great significance because when the business sector produces all it can, Y(f), Y(e) – Y(f) will be the amount of excess demand for final goods and services in the economy giving us a measure of how much “demand pull” inflation to expect.
For any given r*, G*, and T* we can use the equations in our simple model to find the equilibrium level of GDP. All we do is substitute equations (2), (3), and (4) into equation (1). If we use equation (1) we have stipulated that AS = AD. Therefore the Y we calculate when we use equation (1) is Y(e). Moreover, even though Y represents production, or aggregate supply on the left side of the equation, and Y represents income in the expression for disposable income in the consumption function on the right side of the equation, the pie principle assures us that Y as production and Y as income must have the same value on both sides of the equation. Substituting we get:
Y(e) = a + MPC(Y(e) – T*) + b – 1000r* + G*
Which is a single equation in a single unknown, Y(e). Multiplying MPC through the parenthesis gives:
Y(e) = a + MPCY(e) – MPCT* + b – 1000r* + G*
Subtracting MPCY(e) from both sides of the equation gives:
Y(e) – MPCY(e) = a – MPCT* + b – 1000r* + G*
Factoring Y(e) out of each term on the left side of the equation gives:
Y(e)(1 – MPC) = a – MPCT* + b – 1000r* + G*
Dividing both sides of this equation by (1 – MPC) gives a “solution” for Y(e):
Y(e) = [a – MPCT* + b – 1000r* + G*]/(1 – MPC)
If we know a, MPC, T*, b, r* and G* we can calculate Y(e). If Y(e) is less than potential GDP, the macro law of supply and demand tells us the economy will settle at a level of production less than potential GDP equal to Y(e). If Y(e) is greater than potential GDP the macro law tells us that the economy will produce up to potential GDP, or Y(f), but the supply of goods and services will still fall short of the demand so we will have demand pull inflation. If Y(e) = Y(f) we will have neither unemployed labor and resources nor demand pull inflation, and we will produce all we are capable of given our present level of resources and productive know-how.
So after “solving” for Y(e) we can compare it with potential GDP, Y(f), to see if we will have an unemployment problem, an inflation problem, or neither. If Y(f) – Y(e) is positive, we say we have an unemployment gap in the economy of that many billions of dollars. The size of the unemployment gap represents the value of the goods and services that we could have made but did not make because there wasn’t sufficient demand for goods and services to warrant hiring all of the labor force and using all the available resources and productive capacity. Another way of interpreting the size of an unemployment gap is as the value of the goods and services that those unemployed workers and resources could have produced but didn’t because they were unemployed. If Y(f) – Y(e) is negative, we have an inflation gap in the economy because the level of aggregate demand which is equal to Y(e) is that many billions of dollars greater than the maximum value of goods and services the economy is presently capable of producing, Y(f).3
We are now ready to understand the logic of fiscal policy defined as any changes in government spending and/or taxes. The microeconomic perspective on fiscal policy is that because of the free rider problem the government must step in and provide public goods since otherwise the economy will produce and consume too few public goods relative to private goods. In this view, according to the efficiency criterion the government should buy an amount of each public good up to the point where the marginal social benefit of another unit, MSB, is equal to the marginal social cost of producing another unit, MSC. Then the government simply collects enough taxes to pay for the public goods the government buys and makes available to the citizenry. But the macroeconomic perspective focuses on the fact that government spending and taxation affect aggregate demand, and therefore, by changing spending or taxes the government can change the level of aggregate demand in the economy.
If the economy is suffering from an unemployment gap – if there are people willing and able to work who can’t find jobs and we are therefore producing (and consuming) less than we could – by increasing G* the government could increase aggregate demand and thereby reduce the unemployment gap. Or, by reducing spending the government could decrease aggregate demand and reduce the size of any inflation gap in the economy. Changing taxes will also have a predictable effect on aggregate demand. If the government increases taxes disposable income will fall and household consumption demand will fall. This would be helpful if the economy is suffering from demand pull inflation. If the economy has an unemployment gap, reducing taxes would be helpful because it would increase households’ disposable income and induce them to consume more, raising aggregate demand and equilibrium GDP. However, before proceeding to analyze the macroeconomic effects of three different fiscal policies – changing only G, changing only T, and changing G and T by the same amount in the same direction – we stop to ask why most economists before Keynes were unable to see something that seems so straightforward and simple in retrospect. And we pause to unravel something surprising about the workings of the economy – the multiplier effect.
Despite objections raised by the likes of Thomas Malthus and Karl Marx, most economists prior to the “Keynesian revolution” labored under an illusion regarding the relation between the level of production of goods and services in general and demand for goods and services in general. The misconception that undermined the ability of most economists before Keynes to understand the macro law of supply and demand, and therefore to understand depressions, recessions, and unemployment, went under the name of “Say’s law,” named after the nineteenth-century French economist Jean-Baptiste Say. According to Say’s law, in the aggregate, supply creates its own demand – exactly the opposite of what Keynes’ macro law of supply and demand says. Moreover, Say’s law implies there can never be insufficient demand for goods in general, and governments therefore need not concern themselves with recessions which should cure themselves.4
The rationale for Say’s law was best explained by the famous British economist and banker David Ricardo. In a series of famous letters to a concerned friend, Robert Malthus, Ricardo explained there was no cause for alarm nor need for the government to do anything about a serious recession in Great Britain at the time. Ricardo began by explaining the pie principle to Malthus, namely that every dollar of goods produced generated exactly a dollar of income, or purchasing power. When Malthus pointed out that people generally saved part of their income, and therefore consumption demand must inevitably fall short of the value of goods produced, leading inevitably to recession, Ricardo responded that savings earned interest only if deposited in a bank, such as his, and that he, like all bankers, was always at great pains to lend those deposits to business borrowers since otherwise his bank could make no profits. Ricardo explained that his business loan customers borrowed in order to invest, i.e. buy investment or capital goods, which meant that whatever consumption goods households failed to buy because they saved was made up for by business investment demand for capital goods. As long as the interest rate was left free to equilibrate the credit market, Ricardo concluded that any shortfall in aggregate demand due to household savings would be made up for by an exactly equal amount of business investment demand.
Ricardo’s explanation of Say’s law was appealing, so appealing in fact that it persuaded generations of economists who subscribed to it. But it contains a fallacy that fell to Keynes to point out. While it is true that every dollar of production generates exactly a dollar of income, or potential purchasing power (the pie principle), it is not necessarily true that a dollar of income always generates a dollar of demand for goods and services this year. This is one of those situations where timing is everything. Aggregate demand can be less than income this year if all actors in the economy as a whole spend less than current income, saving and adding part of current income to their stock of wealth. Or, aggregate demand can be greater than income this year if actors on the whole use previous savings, or wealth, to spend more than their current income, or borrow against future income.
What deceived Ricardo (and many others) was that just because the supply of loans is equal to the demand for loans at the equilibrium rate of interest, this does not mean that business demand for investment goods will necessarily be equal to household savings. The easiest way to see this is to recognize that not all loans to businesses are used to buy investment, or capital goods. Sometimes business borrowers use borrowed funds to buy government bonds, or shares of stocks in other businesses. When they do this they are borrowing someone else’s savings only to “save” in a different form. For example, at the time it was made, a loan to USX Steel Company in the early 1980s was the largest loan in US history. But USX didn’t use a penny of the loan to buy new steel-making equipment to replace obsolete equipment in its US plants because USX had decided that producing more steel in the US was no longer profitable. Instead USX used the “borrowed savings” to buy a controlling interest in Marathon Oil Company. This was a wise business decision, no doubt appreciated by USX stockholders. But buying all those shares of stock in Marathon Oil did not add a single dollar to the aggregate demand for investment goods, nor therefore for goods and services in general. So even though the interest rate may have equilibrated the market for lending and borrowing in this case, that did not mean the savings of households who did not buy consumer goods was translated into spending on investment goods by business.
Because it was so firmly entrenched among his fellow economists, Keynes went to great lengths to explain the fallacy of Say’s law in The General Theory. He never tired of explaining that while the interest rate may equilibrate the market for borrowing and lending, this does not necessarily equilibrate savings and investment, and thereby guarantee that in the aggregate, supply will create its own demand. A given value of production does generate an equal value of income. But when that income gets used to demand goods and services can make a great deal of difference. If less income is used to demand goods and services in a year than were produced in that year, aggregate demand will fall short of aggregate supply, and production will fall as the macro law of supply and demand teaches. If the sum total of household, business, and government demand is greater than production during a year, production will rise (if it can), as Keynes’ macro law teaches. It is simply not true that however much businesses decide to produce, exactly that much aggregate demand will necessarily appear to buy it. In any given year there may be either more or less demand since opportunities exist for whole economies to save and dis-save for months, or years.
Income Expenditure Multipliers
Since G is part of aggregate demand one would think that if the government increased G by, say $10 billion, aggregate demand would increase by $10 billion. Or if the government decreased G by $10 billion, aggregate demand would fall by $10 billion. But surprisingly, this is not the case. If G increases by $10 billion, aggregate demand can increase by a multiple of $10 billion.
Let’s see how it would happen. Suppose the government increases spending by buying $10 billion more stealth bombers from Northrop Grumman. Assuming aggregate demand were equal to aggregate supply in the first place, as soon as the government buys $10 billion worth of invisible bombers aggregate demand will be $10 billion larger than aggregate supply. But the macro law of supply and demand tells us that production, or supply, will rise to meet the new demand, i.e. Northrop Grumman will produce $10 billion more bombers. But because the size of the pie we can eat is equal to the size of the pie we baked, income, or GDI, will now be $10 billion bigger than it was initially. Northrop Grumman will pay out more wages to its employees who made the new bombers, and more dividends to its stockholders. And since households consume more when their income is higher according to our theory of consumption, household consumption demand will rise once income has risen. This is a second increase in aggregate demand, above and beyond the original increase in government spending. This second increase in aggregate demand will take the form of an increased demand for shirts and beer by Northrop Grumman employees, and for sail boats and champagne by Northrop Grumman stockholders, whereas the first increase in aggregate demand was an increased demand for stealth bombers. It is an additional increase in aggregate demand, induced by, but clearly different from, the initial increase in government spending.
How much will consumer demand increase? Since production and income have risen by $10 billion, according to our consumption function households will consume MPC times $10 billion more than before. If the MPC were 3/4, then household consumption would rise by (3/4)($10) billion or $7.5 billion. But once again, the economy is now out of equilibrium. When production rose by $10 billion to meet the new government demand for $10 billion new stealth bombers, we were back to where aggregate supply equaled aggregate demand. But now that consumer demand has risen by an additional $7.5 billion, aggregate demand is, once again, higher than aggregate supply. The macro law of supply and demand tells us that production will again rise to meet this demand, if it can. But when production of shirts, beer, sail boats and champagne rises by $7.5 billion to meet this new demand, income will rise by $7.5 billion as well. And when income rises by $7.5 billion, household consumption will rise by MPC times $7.5 billion, and production will have to rise a third time for aggregate supply to again equal aggregate demand.
This multiplier chain of events goes on forever, but each additional increase in aggregate demand, and induced increase in aggregate supply, is smaller than the last.5 The government spending multiplier just described is: $10B + MPC($10B) + MPC2($10B) + . . . which can be rewritten: $10B[1 + MPC + MPC2 . . .] The multiplier chain in brackets will sum to less than infinity as long as the MPC is a positive fraction – which it is as long as people save any of their new income. In high school algebra one proves that [1 + d + d2 + . . .] is simply equal to [1/(1 – d)] provided 0 < d < 1, which means our multiplier chain, neatly sums to [1/(1 – MPC)], and the overall increase in aggregate demand that would result from an initial increase of $10 billion in government spending is $10B[1/(1 – MPC)]. For MPC = 3/4, $10B[1/(1 – (3/4))] = $10B[4] = $40B. In other words, when the government raises spending by $10 billion, aggregate demand eventually rises by a multiple of $10 billion, a multiple of 4 if MPC = 3/4.6 Hardly what one would have guessed at first glance!
The government spending multiplier is a logical necessity of: (1) the macro law of supply and demand which says if aggregate demand increases then production, or aggregate supply, will rise to meet it if it can; (2) the fact that the size of the pie we can eat is always equal to the size of the pie we baked, so when production increases income will increase by exactly the same amount; and (3) our theory of consumption behavior that says when income rises household consumption demand will rise by a fraction, MPC, of the increase in income. Which leaves us with our first policy multiplier formula. If we let ΔY represent the change in equilibrium GDP, or Y(e), and ΔG represent the change in government spending, then: ΔY = [1/(1 – MPC)]ΔG and the expression in brackets, [1/(1 – MPC)], is called the government spending multiplier. It is what we have to multiply any change in government spending by to find out what the overall change in aggregate demand, and therefore equilibrium GDP, will be.
If, instead of changing G, the government chose to change T by ΔT, this would lead to an initial change in consumption demand of –MPCΔT. But this initial change in consumption demand would unleash the same multiplier process unleashed by the above change in government spending. The macroeconomy is an “equal opportunity respondent” – reacting to all initial changes in aggregate demand in the same way, irrespective of the source or nature of the initial change. So the overall change in aggregate demand from a change in taxes, ΔT, would eventually be [1/(1 – MPC)] times – MPCΔT, or ΔY = [–MPC/(1 – MPC)] ΔT.
Finally, if the government did change both spending and taxes at the same time, and if it changed them both by the same amount and in the same direction so that ΔG = ΔT, the government would be changing both sides of the budget by the same amount, ΔBB = ΔG = ΔT. Under these conditions when we add the initial and induced effects of the two changes together we get:
ΔY = [1(1 – MPC)]ΔBB + [–MPC(1 – MPC)]ΔBB = (ΔBB – MPCΔBB]/ (1 – MPC) = ΔBB(1 – MPC) /(1 – MPC) = [1]ΔBB
Which gives us the third “fiscal policy” multiplier: if G and T are changed by the same amount in the same direction, aggregate demand and therefore equilibrium GDP will be changed by one times the change in both sides of the government budget. So we have three fiscal policy “tools”: change government spending alone, change tax collections alone, and change both spending and taxes by the same amount in the same direction. Any of the three fiscal policies can be used to increase aggregate demand to combat an unemployment gap, or decrease aggregate demand to combat an inflation gap. Deflationary policies reduce aggregate demand and inflationary pressures. Expansionary policies increase aggregate demand and raise production closer to potential GDP, i.e. increase the size of the pie we bake. Economists define equivalent macroeconomic policies as policies that change aggregate demand, and therefore equilibrium GDP, by the same amount. So by definition equivalent fiscal policies have the same effect on the size of the pie we will bake or on inflationary pressures. But while different equivalent fiscal policies change the size of the pie we bake by the same amount, they have different effects on how the pie is sliced, that is, the proportion of output that goes to private consumption, the proportion that goes to public goods, and the proportion that goes to investment goods, or what economists call the composition of output. When we increase G the share going to public goods, G/Y, increases, while the shares going to private consumption, C/Y, and investment, I/Y, both decrease. When we reduce taxes the share going to private consumption, C/Y, increases, while the shares going to public and investment goods decreases. If we increase G and T by the same amount the composition of output shifts much more dramatically in favor of public versus private consumption.
Different equivalent fiscal policies also have different effects on government budget deficits or surpluses. Of course when both sides of the budget are changed by the same amount in the same direction there is no change in the government budget deficit or surplus. However, if G is increased a budget deficit will be increased, and if T is decreased a budget deficit will be increased as well. However, because the government spending multiplier is larger than the tax multiplier, a tax cut will have to be larger than a spending increase to achieve the same overall increase in aggregate demand. This means that reducing an unemployment gap by cutting taxes aggravates a budget deficit more than increasing spending does – a “truth” anti-tax conservatives seldom mention.
So besides looking at who gets a tax cut or pays for a tax increase, or whether it is human welfare or corporate welfare programs that are being increased or cut, it is important to consider the effects of different equivalent fiscal policies on the composition of output and the budget deficit when deciding which fiscal policy tool to use. Different classes and interest groups have different interests in these regards and therefore fiscal policy is always about more than simply the most effective way to combat unemployment or inflation. After adding monetary policy to our model in Chapter 7 we use our simple macro model 9.3 in Chapter 9 to explore the controversies surrounding US government macroeconomic policy in the aftermath of the Great Recession.
Other Causes of Unemployment and Inflation
While the simple Keynesian macro model is helpful for understanding demand pull inflation and unemployment caused by insufficient aggregate demand for goods and services, commonly called cyclical unemployment, there are other kinds of unemployment and inflation the simple Keynesian model does not explain. Beside cyclical unemployment there is structural unemployment and frictional unemployment. Cyclical unemployment is caused when low aggregate demand for goods leads employers to provide fewer jobs than the number of people willing and able to work. Structural unemployment results when the skills and training of people in the labor force do not match the requirements of the jobs available. In the case of structural unemployment the problem is not too few jobs, but people who are suited to jobs that no longer exist but not to the ones now available. Changes in the international division of labor, rapid technical changes in methods of production, and educational systems that are slow to adapt to new economic conditions are the most important causes of structural unemployment. But even if there were a suitable job for every worker there would be some unemployment. Frictional unemployment is the result of the fact that people do not stay in the same job all their lives, and changing jobs takes time, so when we “take a picture” of the economy the photo will show some people without jobs because we have caught them moving from one job to another even when there are enough jobs for everyone and people’s skills match job requirements perfectly.
From a policy perspective it is important to realize that increasing aggregate demand for goods, and thereby labor, adds jobs, but mostly jobs like the ones that already exist. If the unemployment is largely structural, expansionary macroeconomic policy may not put much of a dent in it while increasing inflationary pressures. Instead, changes in the educational system and retraining and relocation programs are called for to combat structural unemployment. The true level of frictional unemployment, or what is sometimes called the “natural rate of unemployment,” can have important implications for policy. If unemployment is only frictional, there is no need or purpose for government intervention. Adding more jobs or training people to better fit the jobs we have will not reduce frictional unemployment that results from the simple fact that people change jobs from time to time. Conservative economists have argued that the rate of frictional unemployment in the US rose from 3–4% in the middle of the last century to 5–6% by the beginning of this century. If this were true, it would imply that strong policy intervention is not warranted until unemployment reaches 7% in today’s economy, even though all conceded that intervention was called for when the unemployment rate reached 5% in the past. But why should the rate of frictional unemployment have changed? Are job search methods less efficient than before? Are people less anxious to start their new jobs than before? Conservatives allude to changes in the composition and motivations of the US labor force insinuating that new entrants into the labor force – primarily women and minorities – have characteristics that lead them to have higher rates of frictional unemployment. But there is little scientific evidence to support the conservative claim which reduces to little more than prejudice and a strong wish to curb government initiatives aimed at reducing unemployment.
The important point is that employers benefit from unemployment. Employer bargaining power vis-à-vis their employees over wages, effort levels, and working conditions is enhanced when the unemployment rate is higher and there are more people willing and able to replace those working. Since capitalism relies on fear and greed as its primary means of motivation, a permanently low level of unemployment would reduce employees’ fear and thereby pose serious motivational and distributional problems for employers. So it is hardly surprising that there is a “market” for economists who invent rationales to convince the government and the public to accept higher levels of unemployment as unavoidable. There is little more than this to the academic “debate” over changes in the “natural rate of unemployment.”
There are also other causes of inflation beside excess demand for goods and services in general. Along with demand pull the most important kind of inflation is cost push. Imagine the following scenario. Employers and employees sit down to negotiate wage increases. At current price levels, employees need a 10% wage increase to get 80% of the value added in the production process – which let us assume is the least they think they deserve. Initially, employers resist these demands because they believe they deserve at least 30% of value added which cannot be achieved at current prices if wages rise at all. But faced with potential losses from a strike, employers finally agree to the 10% wage increase, only to turn around and “trump” the workers’ play by raising prices 10%. Now that both wages and prices have risen by 10% the distribution of output is exactly what it was initially – 30% to the employers and 70% to the workers. Of course the workers cry “foul” and demand another 10% wage increase “to keep pace with the 10% inflation.” If employers give in, only to increase prices again, we have a “wage-price spiral” and inflation as well. Notice that the cause of this inflation is not excess aggregate demand. The cause is an unresolved difference of opinion between employers and employees over who deserves what part of output that plays out in a way that causes wages and prices to spiral upward. Whether we call this “cost push inflation” – wages and profit “costs” are “pushing” prices up – “wage push” or we call it “profit push” depends on whose view we agree with regarding the distribution of output. If one agrees with labor that workers deserve 80% of output and employers only 20% the process would logically be called “profit push inflation” since the problem is obviously that employers keep trying to get more than they deserve by raising prices and voiding a non-inflationary and just settlement. If one agreed that owners deserved 30% and therefore workers only deserved 70% of output, the process would logically be called “wage push inflation” since the problem is that workers disrupt a non-inflationary, just settlement by insisting on a 10% raise.7
It is important to note that structural unemployment can exist in the presence of adequate aggregate demand for goods and services, and cost push inflation can exist even when aggregate demand does not exceed aggregate supply. There is no doubt that an increasing tendency toward stagflation – defined as simultaneously increasing rates of unemployment and inflation – plagued the US economy from the mid-1970s through the mid-1980s. Unlike today, when our simple Keynesian macro model very nicely explains both the cause of the Great Recession as well as why ill-conceived government policy has failed to overcome continued stagnation, our model does not help us understand how stagflation is possible. According to the simple Keynesian model the economy has either an unemployment gap, or an inflation gap, or neither. It cannot simultaneously have both too little aggregate demand – yielding cyclical unemployment – and too much aggregate demand – yielding demand pull inflation. Many anxious to dismiss Keynes and bury his wisdom six feet under seized on this failure to spread the unwarranted conclusion that “Keynes was wrong” – that a period of roughly ten years when the US economy suffered from stagflation had “proved Keynes wrong” – when it does nothing of the kind. Demand pull inflation can coexist with rising structural unemployment. And cyclical unemployment can coexist with increasing cost push inflation. An analysis that incorporates cost-push inflation and structural unemployment along with Keynes’ insights about cyclical unemployment and demand pull inflation provides a perfectly sensible explanation for the stagflation that once plagued the US economy. The fact that the simplest Keynesian model fails to explain everything says nothing about whether it explains some important dynamics and issues brilliantly – which it does.
Most Americans think inflation is bad for everyone while unemployment is bad only for the unemployed. In reality, the reverse is more the case – unemployment hurts us all and inflation hurts some but helps others. Okun’s law estimates that every 1% increase in the US unemployment rate reduces real output by 2%. That is, the pie we all have to eat shrinks by 2% when 1% of the labor force loses their jobs. Moreover, a study prepared for the Joint Economic Committee of Congress in 1976 – back when someone still cared about such things – estimated that a 1% increase in the unemployment rate leads to, on average: 920 suicides, 648 homicides, 20,240 fatal heart attacks or strokes, 495 deaths from liver cirrhosis, 4227 admissions to mental hospitals and 3340 admissions to state prisons – each tragedy impacting a network of connected lives.
On the other hand, for every buyer “hurt” by paying a higher price due to inflation, there was necessarily a seller who must have been equally “helped” by receiving a higher price because of inflation. Moreover, we are all both sellers and buyers in market economies. How could you buy something unless you had already sold something else? But many people think of themselves only as buyers when they think about inflation, forgetting for example that they sell their labor, and therefore erroneously conclude that inflation necessarily hurts them – and everyone else whom they think of only as buyers.
This is how it really works: By definition inflation means that prices are going up on average. But in any inflation some prices will go up faster than others. If the prices of the things you buy are rising faster than the prices of the things you sell, you will be “hurt” by that kind of inflation. That is, your real buying power, or real income will fall. But if the prices of the things you sell are rising faster than the prices of the things you buy, your real income will increase. So for the most part, what inflation does is rob Peters to pay Pauls. That is, inflation redistributes real income.
I might object to inflation on grounds that it reduced my real income – that I happened to be one of the losers. More importantly, we might find inflation objectionable because those whose real income was reduced were groups we believe are deserving of having higher incomes, while those whose real incomes rose we consider less deserving. And this is often the case, because inflationary redistribution is essentially determined by changing relative bargaining power between actors in the economy. If corporations and the wealthy are becoming more powerful and employees and the poor are becoming less powerful, as has been the case for the most part over the past forty years, inflation will be one mechanism whereby the redistribution of real income becomes more inequitable. But this needn’t be the case. Between 1971 and 1973 there was inflation in both the US and Chile. Yet wages rose faster than prices in Chile under the socialist government of Salvador Allende, while prices rose faster than wages in the US under Republican Richard Nixon. The redistributive effects of inflation can promote either greater equality or inequality.
Is the conclusion that inflation hurts us all then totally misguided? Not necessarily. We are all hurt whenever the production of real goods and services is less than it might otherwise have been. So if inflation makes the GDP pie we bake smaller than it would have been had there been less inflation, it would hurt us all – just like an increase in unemployment hurts us all. This can happen if inflation increases uncertainty about the terms of exchange to the point that businesses invest less and people work and produce less than they otherwise would have. When actors in the economy find inflation unpredictable and troubling this can happen. But to the extent that inflation is predictable and actors can therefore take it into account when they contract with one another there is little reason to believe it reduces real production and income.8 On the other hand, if the government responds to fears of inflation with deflationary fiscal or monetary policy which does reduce production and output, the government reaction to inflation will “hurt us all.” In sum, if the redistributive consequences of inflation aggravate inequities it is lamentable. Or, if inflation is so unpredictable and unsettling that real production falls it is a problem because it shrinks the pie we have to eat. Otherwise, most of us should think long and hard before joining corporations and the wealthy who put “the fight against inflation” at the top of their list of government priorities. The wealthy rationally fear that inflation can reduce the real value of their assets. And employers have an interest in prioritizing the fight against inflation over the fight against unemployment because periodic bouts of unemployment reduce labor’s bargaining power regarding wages and working conditions. But when the rest of the American public enthusiastically joins the fight against inflation, it usually does so contrary to its own economic interests.
Myths about Deficits and the National Debt
Much popular thinking about federal government debt and deficits is based on the following analogy: “If I keep borrowing, going farther and farther into debt, I will eventually go bankrupt. Therefore, if the federal government keeps borrowing, i.e. running deficits, going farther and farther into debt, it will eventually go bankrupt too.” But the analogy is false.
There is an important difference between the federal government and private citizens – or businesses and state and local governments for that matter. If anyone other than the federal government can’t get someone to loan them more money, they cannot spend more than their income. But if the federal government’s financial credibility bottoms out, and buyers in the market for new treasury bonds dry up, the federal government has one last resort. Unlike the rest of us who can be arrested and sent to jail for counterfeiting if we print up money to finance our deficits, the federal government could print up money in a pinch to pay for any spending in excess of tax revenues.
People in the know have long understood, even if the general public do not, that this is what a rational US government would do rather than fail to pay off treasury bonds when they came due, i.e. default on the national debt, since the disastrous consequences of a federal bankruptcy would be far worse than the inflationary effects of running the printing presses for a while. Which means that the “run the printing press option” never has to be exercised because there are always plenty of sophisticated big lenders willing to buy new bonds knowing that the US treasury would never default. But all this implicitly assumed that political sanity would prevail, i.e. that the US government would never choose to default even though it did not have to.
Debt ceilings, government shutdowns, furloughs, fiscal cliffs, and sequestration should all be understood for what they are – political insanity generated by partisan brinkmanship. The debt ceiling is a self-imposed limit on federal debt which began in 1917 as part of the Liberty Bond Act to finance World War I. The precise law governing the debt ceiling was modified in 1930, 1941, 1974, 1979, and 1995, but more importantly, whenever a self-imposed debt ceiling was reached Congress sensibly voted to raise the ceiling rather than leave the treasury unable to pay for spending authorized by a budget passed by Congress and signed by the President, or default on treasury bonds when they came due. However, in 1995, 2011, and 2013 a Republican-controlled House of Representatives turned the debt ceiling into a political football by refusing to raise it as the witching hour approached unless a Democratic President agreed to major political concessions. In 1995 federal employees were put on unpaid furlough and non-essential services were suspended for 27 days before the debt ceiling was raised. In 2011 the Government Accounting Office estimated that the delay in raising the debt ceiling had spooked investors enough to raise the government’s borrowing costs by $1.3 billion in 2011 alone. Starting on December 31, 2012 the game of political chicken over debt and deficits forced the treasury to commence “extraordinary measures” to enable the continuing financing of the government. As part of the deal to end the previous debt ceiling crisis Democrats and Republicans passed the Budget Control Act of 2011 which stipulated that if the two sides could not agree on how to reduce the deficit by the end of 2012, commencing on January 1, 2013 there would be automatic, across the board reductions in both defense and non-defense discretionary spending, called sequestration, sufficient to prevent falling off the so-called fiscal cliff created by the Budget Control Act. In other words, a self-imposed limit on the size of the budget deficit for fiscal year 2012–2013 – the fiscal cliff – was added to the long-established self-imposed limit on the size of the national debt – the debt ceiling – thereby creating two witching hours and multiple opportunities to engage in political brinkmanship. Not surprisingly the game of chicken dragged on longer, with more twists and turns, more temporary postponements, leaving more self-inflicted damage in its wake. But however much all this has cost taxpayers in the form of higher interest payments on bonds because investors were spooked, and what amount to “late fees” for delayed payments of various sorts, so far the treasury has not failed to redeem any bonds when they came due, and financial markets have continued to be willing to lend to the US government so it can rollover the debt.
However, not all sovereign governments are as fortunate as the US government today which should always be able to find new buyers for its treasury bonds. Governments of small, less developed countries have long had to rely on foreigners to buy their bonds. These lenders are often not satisfied with domestic currency if it cannot be translated into foreign currencies, which means that holdings of gold or foreign currency reserves can become necessary for these governments to be able to roll over their debt. The US government was once such a government. In 1777 the Continental Congress had to secretly borrow $8 million from France and a quarter million from Spain to buy food, tents, guns, and ammunition for the Revolutionary Army since it could neither raise enough taxes nor convince US merchants to accept more Continental dollars. During the Civil War the Confederate Government was forced to resort to printing more and more confederate currency when they could no longer sell Confederate bonds – both of which became worthless when the South lost the war. But since the US has long been the world’s largest economy foreigners are generally happy to hold dollars because there are plenty of US-made goods and assets one can use them to buy. Moreover, as the international reserve currency, US dollars can also be used to buy goods or assets anywhere else.
In any case, the national debt declined from a peak of almost 130% of GDP at the end of World War II to under 35% by 1980. But the Reagan era tax cuts and military spending increases raised the national debt from under 35% to over 75% of GDP between 1981 and 1991. This was totally unprecedented. Previously, the debt/GDP ratio had risen significantly only during major wars which caused government spending to increase dramatically, and during recessions or depressions when income and therefore tax revenues declined. The Reagan–Bush I era saw an unprecedented increase in the national debt during peace time and prosperity. It took nearly a century for the national debt to reach $1 trillion. Then the debt tripled in a mere decade in which there was neither war nor depression. The beneficiaries were the wealthy and corporations who saw their taxes cut dramatically, and the military industrial complex who fed at the Pentagon budget trough throughout the 1980s. Those who paid the consequences were the beneficiaries of social programs that were cut in the 1990s, and those whose taxes were increased to reduce the deficit from $290 billion in 1992 to $161 billion in 1995, to zero in 1998. The debt/GDP ratio declined throughout the two Clinton administrations, only to rise again for eight years during the two Bush II administrations despite economic prosperity. Obama has presided over the greatest recession since the Great Depression, during which the debt/GDP ratio climbed once again to over 100%.
However, it is important to remember who owns the debt. As of March 2013, 16% was owned by the two Social Security trust funds, 12% by the Federal Reserve Bank, 5% by the federal civil service retirement and disability fund, 3% by the military retirement fund, 1% by the Medicare hospital insurance fund, and another 4% by an assortment of federal government entities. In other words, the federal government owed 41% of the national debt . . . to itself! Another 3% was owned by state and local governments, meaning that governments in the US as a whole held 44% of the national debt. By 2013 the percentage owned by foreigners had risen from 22% in 1999 to 34% which means two-thirds of the national debt is still owed to ourselves. Moreover, the popular belief that “China now owns us” is highly exaggerated. As of 2013 China owned only 8% of outstanding US debt, which was only 1% more than Japan, and 4% less than was owned by the US Federal Reserve Bank.
The problem is not that the Federal government might go bankrupt, nor that we are hopelessly in hock to foreigners, or to China in particular. The problem is that interest payments on the debt can take up a lot of our tax dollars every year. In 1995 personal income taxes were $590 billion while net interest payments were $232 billion. In other words, before the government could buy anything with our tax dollars, it had to spend 40% of them simply to finance the debt. In 2000 interest payments on the national debt were 11% of all federal outlays while spending on all social programs was only 16%. With interest rates at historic lows over the past few years the debt service burden has eased somewhat, but the Great Recession has increased the debt substantially, so when interest rates rise again the debt burden “squeeze” on discretionary spending is likely to be worse than ever.
The problem is our ability to spend on social programs, and physical, human and community development is severely constrained not only by an absurdly unnecessary, obscene military budget,9 but also by a debt service burden that is the legacy of the banquet Reagan, Bush I, and Bush II threw for their well-heeled supporters in the 1980s and 2000s but refused to pay for, and the Great Recession it led to. And the problem is that since the average bond holder is a lot wealthier than the average taxpayer, the escalating interest payments on the national debt are an increasingly regressive transfer of income from the have-less taxpayers to the have-more bond owners.
In an op-ed piece published in the Washington Post on January 8, 1997 Robert Kuttner explained the “either/or budget fallacy” as follows:
How should the federal budget be balanced? By cutting aid to the poor? Or by reducing entitlements for the middle class? These, of course, are trick questions, since they leave out several options not on the menu: reducing defense spending; rejecting tax cuts which make budget-balance more difficult; cutting “corporate welfare,” or not insisting on budget balance at all.
Ed Herman called it the balanced budget ploy: “The real aims of the push for a balanced budget are two-fold: to constrain macro-policy and prevent its use in ways that would increase pressures on the labor market . . . and to scale back the welfare state.”
The Employment Act of 1946 and the Humphrey Hawkins Full Employment Act of 1978 nominally commit the federal government to whatever policies are necessary to provide jobs for all. And unlike the European Central Bank charter, the Federal Reserve Act directs US monetary authorities to conduct monetary policy so as to avoid both inflation and unemployment. Moreover, prior to the 1980s whenever unemployment rose above 5% public pressure mounted on the President, Congress, and the Federal Reserve Bank to fulfill these mandates by deploying fiscal and monetary policy tools to do something about it. However, efforts to make the President, Congress, and the Federal Reserve Bank responsible for guaranteeing Americans a right to a job were considerably watered down from the very beginning. Before they could be passed the guarantee of full employment had to be removed from the 1946 bill, and the goal of full employment in the 1978 bill was qualified as to be “consistent with price stability.” So for many years Wall Street and the business community concentrated on fanning the public’s irrational fear that the bonfires of inflation were about to consume the hard earned savings of us all as a means of rallying public pressure to oppose expansionary fiscal and monetary policy to reduce unemployment, and spending on social welfare programs in particular.
However, inflation has not actually been a serious problem in the US since the mid-1970s, as much as the usual suspects continue to insist that inflation is lurking around every corner. On the other hand, fiscally irresponsible tax cuts for the wealthy during the twenty years when Reagan, Bush I, and Bush II were in the White House, combined with excessive military spending by Republican and Democratic administrations alike from 1980 to the present, and most recently the Great Recession, have made it easier to stir up irrational fears about debt than inflation.10 As a result the “balanced budget ploy” has become the favorite public relations tactic for those always in search of ways to convince the voting public to tolerate slashing programs like head start, food stamps, and social security even though polls consistently show voters overwhelmingly favor them. And if we judge by results “the budget must be balanced or we will go bankrupt” has been an even more effective rallying cry against expansionary fiscal policy than “inflation is going to eat your life savings.” When politicians today wrap themselves in the patriotic banner of deficit reduction they are even less likely to be punished by discontented voters for presiding over a listless economy and draconian cuts to popular programs than when they used to march as crusaders against inflation.
The lines of interest are straightforward: Those who work for a living have greater bargaining power over wages and working conditions when the labor market is tight, because the more unemployed workers there are the more vulnerable are the employed. Employers, on the other hand, benefit from a loose labor market because they can find willing and capable workers more easily to use to threaten employees with replacement should they prove demanding. Similarly, the more humane and generous the welfare system, the more reasonable employers must be to induce people to work for them. When the “safety net” becomes less safe fear becomes a more powerful weapon in the hands of employers. This is not to say that employers do not suffer as well if a recession gets out of hand. Profits as well as wages took a hit when the Great Recession hit, although, as we saw in Chapter 2, profits rebounded quickly while wages have not. But in general employers have good reason to fear a successful application of Keynesian policies that stabilize the business cycle and keep labor markets permanently tight. Stabilization policies were particularly aggressive and successful in Sweden for thirty years after WWII, and labor’s share of national income in Sweden rose steadily to a peak of 80% in 1976. In the US where opponents became more successful at obstructing active stabilization starting in the mid-1970s labor’s share of national income has steadily declined.
For thirty years after WWII the ideological battle in the US was over prioritizing the fight against unemployment versus the fight against inflation, because, as we learned, demand management policies cannot battle one without aggravating the other. But now that inflation has not been a serious threat for more than a generation, the ideological battle has shifted to fighting joblessness versus balancing the budget. And those who fear tight labor markets have the ear of not only Republicans but “New Democrats” as well in the fight against budget deficits. While President Carter listened to the anti-inflation crusade out of one ear in the 1970s, President Clinton enlisted enthusiastically in the crusade to balance the budget in the 1990s, and with the economy still in the grip of the worst recession in over eighty years, President Obama made a crucial “pivot” from (too little) fiscal stimulus in 2009 to prioritizing deficit reduction in 2010. Obama collaborated with the usual suspects and used the Presidential bully pulpit to fan the flames of deficit mania when he should have been stumping tirelessly for a second stimulus which was clearly needed to speed recovery. He also appointed two austerity zealots, Erskine Bowles and Alan Simpson, as co-chairs of his National Commission on Fiscal Responsibility and Reform whose “findings” and recommendations have provided ammunition for Republican economic brinkmanship ever since. I suspect history will mark this ill-fated pivot as the defining moment of the Obama Presidency, since it guaranteed that a weak, sputtering, “jobless” recovery was the best that could be hoped for.
Mainstream macroeconomic theories invariably lead their users to expect a negative relationship between wage rates and the rate of economic growth in the long run. Even the few mainstream macroeconomists who still recommend aggressive expansionary fiscal and monetary policies to increase production in the short run see higher wage rates as an impediment to capital accumulation and therefore long-run economic growth. So how do political economists maintain that it is possible to choose a “high road” to higher rates of economic growth through higher wages, instead of the “low road” of increasing capital accumulation by suppressing wages?
Mainstream economists reason that wage increases in excess of labor productivity increases will squeeze profits and redistribute income from capital to labor. Since capitalists save more of their income than workers this will increase the proportion of output that goes to consumption, decrease the proportion available for accumulation, and thereby drive the growth rate down. Therefore, to increase growth mainstream economists argue we must increase capital accumulation by suppressing wages. Political economists like Michael Kalecki and Josef Steindl argued that even in the long run the relationship between wages and growth is complicated by demand considerations, and consequently that higher wages and higher growth rates are not necessarily at odds.
The rate of growth of actual GDP depends not only on the rate of growth of potential GDP but also on how close actual GDP is to potential GDP over the long run. If we hold technology constant, assume no increase in the size of the labor force, and assume no improvements in the quality of either capital or labor inputs, the rate of growth of potential GDP is determined entirely by the rate of capital accumulation. But for a given increase in the growth rate of potential GDP, the rate of growth of actual GDP will depend on the level of capacity utilization over the long run. For example, if potential GDP grows at 3%, but capacity utilization drops by 3%, actual GDP will not grow at all. Depressing wages, and thereby consumption, does leave more output available for capital accumulation, but by lowering the demand for goods and services it can also decrease capacity utilization. Kalecki pointed out that depressing wages may allow for greater capital accumulation, but it may also lead us to use less of the capital we have. He argued that if depressing wages lowered capacity utilization sufficiently it could lower the rate of growth of actual GDP even while increasing the rate of growth of potential GDP. Steindl pointed out that as corporations become larger and increase their monopoly power in the markets where they sell their goods to consumers, they can increase their “mark ups” over costs, raising prices and thereby diminishing the real wage. In other words, Steindl pointed out that real wages can be driven down when corporate power increases over consumers, not only when corporate power increases over workers.
In Chapter 9 we study a formal, political economy, long-run macro model 9.5 that captures the insights of Kalecki and Steindl, incorporates Keynes’ insights about the effects of capacity utilization and the rate of profit on business investment demand, and allows class struggle as well as labor productivity to affect wage rates, as Marx insisted it would. Model 9.5 demonstrates how depressing wages can retard the rate of economic growth through its negative effect on long-run capacity utilization, and conversely why raising wages can increase the rate of economic growth through its positive effect on capacity utilization. In other words, the model demonstrates the logical possibility of “wage-led growth” even in the long run. In mainstream long-run models, where actual production is assumed always to be equal to potential output, there is a “zero sum game” between consumption and growth, and between the wage rate and profit rate. By allowing capacity utilization to vary the political economy model allows for “win-win” scenarios and “lose-lose” scenarios as well. Anything that increases capacity utilization over the long run will increase actual production and income over the long run as well. This makes it possible to have more consumption goods and more investment goods, and have a higher real wage rate and a higher rate of profit. Anything that decreases capacity utilization, output, and income means that both consumption and growth, and both the wage rate and profit rate may fall.
One of the distinguishing features of capitalism in the advanced economies over the last twenty years has been the dramatic increase in corporate power. At the same time, even before the recent disastrous crisis, we had witnessed lower rates of economic growth in the advanced economies than during the first thirty years after WWII. The work of political economists like Michael Kalecki and Josef Steindl exploring the effects of income distribution on aggregate demand, and incorporating Keynes’ insights about the importance of aggregate demand into long-run models, provides a plausible explanation of declining growth rates in the advanced economies worthy of consideration: As corporations have increased their power vis-à-vis both their employees and their customers they have been able to keep real wages constant over the past thirty years even while productivity continued to grow. While this increased profits, making more potentially available for capital accumulation, it also prevented aggregate demand from increasing as fast as potential production and led to falling rates of capacity utilization and lower rates of economic growth. The work of Keynes, Kalecki, and Steindl and model 9.5 might also help explain how the Scandinavian economies could have had higher rates of economic growth than most other advanced economies during the middle third of the twentieth century despite higher tax rates and lower rates of technological innovation than many less successful advanced economies. Could it be that strong unions, high real wages, and high taxes to finance high levels of public spending, by keeping capacity utilization high, are not detrimental to long-run growth at all, but quite the opposite?
Even if a company can finance the entire investment project out of retained earnings, the opportunity cost of the project is high when interest rates are high because retained earnings could be deposited instead in a savings account paying a high rate of interest. So whether a company borrows or finances an investment project entirely out of retained earnings, it is less likely to undertake the project when interest rates are high, and more likely to invest when interest rates are low. |
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There are two easy ways to remind yourself that the Federal Government can spend more than it collects in taxes: First, it did so, in fact, every year from 1970 until 1998, and has resumed doing so again. Second, were it not possible for the government to spend more than it collects, politicians and economists would not bother debating the wisdom of passing a “balanced budget amendment” to the Constitution outlawing such behavior! |
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Suppose a = 90, MPC = 3/4, b = 200, r* = 0.10 (or 10%), T* = 40, G* = 40, and Y(f) = 900: Y(e) = 90 + 3/4(Y(e) – 40) + 100 + 40; Y(e) – 3/4Y(e) = 90 – 30 + 100 + 40; 1/4Y(e) = 200; Y(e) = 800. The business sector will eventually produce $800 billion worth of goods and services. Since the economy is capable of producing $900 billion worth of goods and services (Y(f) = 900) we will fall short of “baking” as big a pie as we could have by $100 billion. We will have unemployed labor and resources that would have produced an additional $100 billion had they been employed – but they won’t be because aggregate demand is only $800 billion so that’s all the business sector can sell. For what it’s worth the government budget is balanced (T* – G* = 40 – 40 = 0), but the economy is in a recession, only producing 800/900 = 0.89, or 89% of all it is capable of. |
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Amazing as it may seem, modern “rational expectation macroeconomics” once again falls under the spell of Say’s law, as agents formulate “rational expectations” about the necessity of future tax increases to pay for any government deficits today, thereby neutering fiscal stimulus in theory. The fact that fiscal stimulus continues to work in reality becomes an anomaly to be ignored or explained away by today’s mainstream macroeconomists. |
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These multipliers are called income expenditure multipliers – although “expenditure-income multiplier” would make more sense. They are also sometimes called Keynesian multipliers. Infinitely long series of positive terms can add up to infinity. After all, each term is positive and there is an infinite number of these positive terms. But if the terms diminish in size sufficiently, even though there is an infinite number of them, the sum total need not be infinite. It can, instead, be some finite number. Our government spending multiplier chain is of this second kind. As long as MPC < 1 successive terms will shrink fast enough so the overall increase in aggregate demand from an increase in government spending is finite. |
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We are implicitly assuming that production can keep rising in response to the sequence of increases in demand, i.e. that we were below potential GDP. |
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Mainstream economists try to label inflation “wage push” or “profit push” based on whether wages or prices rose first. But arguing over who hit who first is usually a pointless way to settle an ongoing conflict. More logically, it comes down to who one thinks has “right” on their side in the underlying disagreement. |
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On the contrary, empirical studies overwhelmingly conclude that economic growth is positively correlated with mild inflation, which is understandable since mild inflation is indicative of robust aggregate demand keeping actual GDP close to potential GDP. |
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In 2012 US military spending was not only the highest of any government in the world, it was greater than the spending of the next ten governments combined! |
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For an amusing example of a typical deficit scare gimmick visit www.usdebtclock.org. |