(1819-1978)[75]
All truth passes through three stages. First, it is ridiculed. Second, it is violently opposed. Third, it is accepted as being self-evident.[76]
Arthur Schopenhauer
Macroeconomics deals with the economy as a whole. The major parameters of a national economy include aggregate production, consumption, investment, savings, international trade, and employment, government expenditure, taxation, inflation, growth, balance of payments, national debt, and income distribution. Macroeconomics also deals with the effects of economic cycles on these variables and appropriate stabilization policies.
An understanding of macroeconomics began in the early 19th century. However, a broad appreciation of the potential for manipulating a national economy only emerged in the 1930s, when pioneering economists articulated expansionary fiscal and monetary policies to counter the effects of the Great Depression. This paved the way for better handling of unemployment, inflation, balance of payment deficits, and economic growth. It was equivalent to discovering a revolutionary new technology, and its economic consequences were as important, if not more so.
Jean Charles Léonard de Sismondi
Swiss economist Jean Charles Léonard de Sismondi (1773-1842) is, regrettably, the unrecognized father of macroeconomics and economic cycle theory. His work, Nouveaux principes d’économie politique (New Principles of Political Economy), published in 1819, was the first systematic exposé of periodic economic crises. It challenged the classical general equilibrium theory, which focused on the long run and avoided formal discussion of business cycles, attributing them to transitory exogenous factors, principally wars.
De Sismondi confronted the economic theories of his contemporaries, like David Ricardo, by refuting that the economy could achieve full employment equilibrium quickly and independently. He wrote, “Let us beware of this dangerous theory of equilibrium which is supposed to be automatically established. A certain kind of equilibrium, it is true, is reestablished in the long-run, but it is after a frightful amount of suffering.” The Panic of 1825, an international economic crisis that occurred during peacetime, disproved the classical claim that contractions were a consequence of war and confirmed de Sismondi’s theory.
De Sismondi observed that industrial producers in England increase production to the point of oversupply, resulting in falling profits, wage reductions, and layoffs. These actions reduced workers’ purchasing power, which produced underconsumption. De Sismondi was the first to conclude that raising wages, by increasing labor’s purchasing power, would stimulate demand, increase employment, clear markets, and revive the economy. This conclusion was a macroeconomic landmark because it recognized the impact of stimulative economic policies on aggregate demand. It was a concept that was ahead of its time because too few economists understood it.
De Sismondi and a contemporary, Robert Owen (1771-1858), independently identified another cause of underconsumption and economic cycles, namely, extreme wealth inequality. They proposed government intervention instead of laissez-faire.
Charles Dunoyer (1786-1862) extended de Sismondi’s periodic crisis theory to a theory of economic cycles and Johann Karl Rodbertus (1805-1875) proposed a similar theory. This research established underconsumption as a branch of economics. Karl Marx popularized the concept in his Das Kapital, attributing underconsumption to the worsening periodic crises of capitalism.
Durations and Stages of Economic Cycles[77]
In 1860, French economist Clement Juglar (1819-1905) estimated an economic cycle’s duration at between 7 and 11 years. Subsequently, three additional cycles of shorter and longer durations were identified bringing the total to four: the Joseph Kitchin (1861-1932) inventory cycle (3 to 5 years), Clement Juglar fixed investment cycle (7 to 11 years) Simon Kuznets (1901-1985) infrastructural investment cycle (15 to 25 years), and Nikolai Kondratiev (1892-1938) long technological cycle (45 to 60 years).
Austrian American economist Joseph Schumpeter (1883-1950) proposed a novel explanation of the causes of cycles: entrepreneurs, by adopting new inventions and innovations in their products, unleash cycles of creative destruction that produce economic growth. However, he also recognized that increases in aggregate demand increased production, profitability, and prices, bringing about economic recovery and prosperity. He saw cycles as complex waves resulting from the simultaneous influence of all the above-mentioned cycles. He used a nine-year Juglar cycle to divide the business cycle into four stages:
a. Expansion
b. Crisis
c. Recession
d. Recovery
Viscount Takahashi’s Macroeconomic Revolution
The English-language economic literature hardly mentions the father of modern Keynesian economics. In the early stages of the Great Depression, Japan began pursuing uncompromising and innovative economic policies that were diametrically opposite to those advocated by neoclassical macroeconomists and accepted at face value in the West. The outstanding economist who was the first to demonstrate the effectiveness of expansionary fiscal policies as a solution to cyclical underconsumption and depression was Japan’s finance minister, Viscount Korekiyo Takahashi (1854-1936). That transformation in economic assessment required a profound and courageous thinker to realize the futility of neoclassical macroeconomic passivity and to make the 180-degree policy shift against the then-prevailing economic wisdom.
In 1929-1931, the Great Depression had engulfed the Japanese economy, shrinking it by 8 percent. To counter the depression, Viscount Takahashi articulated and promoted powerful expansionary fiscal and monetary stimuli. Those policies required economic flexibility, which was impossible within the confines of a gold standard; accordingly, Japan abandoned it. It would take the United States another dozen years before abandoning the gold standard.[78] In 1933, Japan set the record as the first industrial nation in the world to recover fully from the Great Depression.[79] Viscount Takahashi’s intellectual vision and daring had paid off.
In 1932, before the results of the Japanese policy shift became abundantly evident, Germany’s commissioner for employment in the Schleicher government, Günther Gereke (1893-1970), instituted a public works program to relieve unemployment. In 1934, Dr. Hjalmar Schacht (1877-1970), Germany’s new economics minister, maintained that public works program. Those expansionary economic policies brought about a rapid recovery in Germany as well. It also inspired President Franklin Roosevelt to undertake an extensive US highway construction program later.
Japan and Germany continued to grow rapidly, while the rest of Europe and the United States lingered in neoclassical macroeconomic depression. Japan, in particular, had performed a remarkable economic feat, four years ahead of Keynes’s General Theory of Employment, Interest, and Money, and nine years ahead of the full recovery in the United States in 1942 (following America’s mobilization in World War II). Japan and Germany’s economic recoveries had a profound effect and provided fresh ideas to a stagnant macroeconomic theory. The United States and Great Britain did not benefit from the Japanese and German examples, probably because of the influence of Austrian School, Friedrich von Hayek and Lionel Robbins, who in the 1930s were in London preaching doing nothing, as discussed in the next chapter.
Keynesian Economic Explanations
Neoclassical economics, like its classical predecessor, used static-equilibrium analysis to conclude that full-employment equilibrium was the natural state of the economy. It explained unemployment as a voluntary choice by lazy workers who refuse to work for less pay; hence, government intervention was unnecessary. Yet, business contractions were often painful and protracted affairs; the resultant high unemployment rate was not a collective personal choice of reluctant workers. The neoclassical explanation was unimaginative, lacking in empathy and indifferent to the suffering of workers and businesses alike; at best, it was an intellectually lazy explanation.
Economies are alive, dynamic, and subject to a myriad of disturbances, which makes attaining equilibrium a chancy affair. For instance, exceptionally good weather can cause agricultural production to be greater than planned, the equivalent of a rightward shift in its supply curve, resulting in lower prices. Because agricultural supply is inelastic in the short term, oversupply and lower prices would persist, pending adjustment in the next harvest with the distinct possibility of over adjustment, leading to further market reverberations. Superimposed on this cobweb path in agricultural supply are future weather patterns, making any movement toward a stable equilibrium tentative.[80]
At the other extreme, adjusting supply can require several years, a decade, or longer, as with increasing (or reducing) the global shipping tonnage. For example, the closure of the Suez Canal (1967-1975) following the 1967 Six-Day War was equivalent to a huge reduction in shipping capacity because overnight ships had to travel much longer distances from the North Atlantic shores to East Africa and Asia. The long lead-time required to construct significant additional shipping tonnage prolonged the adjustment process. Generally, the more durable the life of an asset, the longer it takes to increase or decrease its supply. This makes for wider price fluctuations, as cycles move from undersupply to oversupply. These are but two of the many examples that make attaining general equilibrium improbable, yet classical and neoclassical theories cheerfully assume it is the natural state of economic affairs.
John Maynard Keynes (1883-1946) was not just a brilliant economist with compassion and high standards of social morality, but also a shrewd investor. The economic policies he proposed reflected his broad expertise and values. He insisted on making the attainment of full employment a primary objective of economic policy. He held that the economy, on its own, could have a short-run equilibrium at higher or lower than full-employment output, and that full employment was an exceptional state rather than the norm.
Keynes believed underconsumption and underinvestment could persist for prolonged periods, giving rise to chronic unemployment, recession, or depression. Hence, the government’s role is to act as an economic stabilizer by managing aggregate demand: increasing public spending and/or reducing taxes to offset a shortfall in private demand, or cutting public spending and raising taxes to curtail excessive aggregate demand and inflation. During contractions, he thought monetary easing was necessary to eliminate restraint but ineffective on its own to bring about economic expansion, while monetary restraint was more effective in curbing demand-pull inflation.
Keynes also observed the market’s tendency toward periodic irrationality. This played out as exuberant optimism, resulting in overinvestment, vigorous expansion followed by excess supply, falling profits, despondent pessimism, falling investment and consumption, and recession.[81]
Paul Samuelson successfully depicted the tendency for a Keynesian model to oscillate where an exogenous shock affected investments by using an accelerator, which in turn affected aggregate demand, consumption, and the multiplier.[82]
Neoclassical economists criticized Keynes for emphasizing the short run over the long run, to which Keynes famously replied, “In the long run we are all dead.” Paradoxically, Keynesian countercyclical policies, although short-term, tactical, and lacking in long-term strategic measures, had far superior long-run results than the neoclassical policy of passivity. By ignoring the large shortfalls in aggregate demand, waiting for markets to self-correct and the economy miraculously to climb out of depression, the neoclassical policy of inaction was tantamount to an abdication of economic responsibility. Keynes saw no evidence that markets behaved as neoclassical macroeconomists expected. He considered the economy too important to leave unattended. He thought passive laissez-faire neoclassical macroeconomic policies were inflicting elective economic hardship on nations by prolonging recessions, depressions, and poverty. He sensed no logic in workers enduring hunger and employers going bankrupt, while economists sit back, observing and wishing. Indeed, such a policy makes the economic profession an impediment to economic stability and redundant.
The Interest Elasticity of Investment
Classical and neoclassical economists assumed that investment demand was interest-elastic, such that a fall in interest rates would discourage savings, encourage investment and employment, stimulate the economy and help bring about general equilibrium and vice versa.81
Keynes, on the other hand, saw the relationship between investment and interest rates as asymmetrical: Higher interest rates can curb investment and economic activity during an expansion, but falling interest rates usually coincide with falling investment during a recession. He attributed this to the fall in the marginal efficiency of capital (MEC) during a recession, making the undertaking of new investments unattractive. Thus, when the profit outlook is bleak, businesses turned cautious, preferring to husband their resources as a precaution against continued economic weakness, regardless of low interest rates—hence, Keynes’s famous liquidity trap.[83]
The Golden Age of Keynesianism (1946-1973)
In the aftermath of World War II, the foresight of Keynesian economic policy prevented military demobilization and cuts in military spending from precipitating a severe post-war recession. In the United States and the United Kingdom, relatively light taxation and shortages in civilian goods during the war left households with plenty of cash, little debt, and a large pent-up demand. Moreover, as mentioned previously, the threat of communism induced Western plutocracies to initiate gentler capitalism by raising labor living standards and promoting welfare programs.
The decades immediately following World War II revealed what Keynesianism was capable of delivering: a golden age of unrivaled economic prosperity. The United States achieved its best economic performance on record: the fastest sustained economic growth, rapidly rising living standards, low unemployment, and subdued inflation. Keynesian countercyclical fiscal and monetary policies made recessions brief and shallow. Remarkably, the Keynesian economic miracle took place while unions were at their strongest, real wages rising, investment in education and welfare high, and tax rates on upper incomes steep, yet inflation remained slight.
The exceedingly high personal income tax rates prompted the landmark Kennedy tax cut in the 1960s, increasing employment and the rate of economic growth and, surprisingly, through the multiplier, augmenting tax revenue to boot.
During those golden decades, the labor movement in Europe and America enjoyed its best conditions, including widespread unionization, collective bargaining, the right to strike, unemployment benefits, pensions, free education, medical care, childcare, and care for the elderly, to name a few. The West moved from parasitic to moral capitalism, implementing an economic democracy that rendered political democracy meaningful. The unprecedented success of Keynesian economics exposed the fundamental errors of neoclassical macroeconomic theory.
The Challenge of Stagflation (1973-1982)
By the 1970s, the excessive demands of the Vietnam War were pushing the United States to live beyond its means; rising inflation indicated the economy was overheating.83
In August 1971, the Republican administration of President Richard Nixon terminated the dollar gold convertibility to preserve US gold reserves in the face of deteriorating US trade deficits, thereby unilaterally terminating the Bretton Woods system. This resulted in a dollar devaluation of 8 percent against the major currencies, adding to US inflationary pressures through imported inflation. Shockingly, to curtail inflation, a right-wing US administration borrowed a leaf from the communist command economy by resorting to a broad range of wage and price controls, thereby partially abandoning the capitalist model of supply and demand and Keynesianism.
In 1973, a confluence of negative factors made for an exceptionally difficult year. Poor agricultural harvests resulted in higher food prices, adding cost-push inflation to imported-inflation, following the dollar devaluation, and the already simmering demand-pull inflation. In October the 1973, the fourth Arab-Israeli war (Yom Kippur War) flared, quadrupling oil prices and sending a global shock wave of cost-push inflation and payment imbalances. The oil price escalation was a windfall to oil-exporting countries and Western oil companies, greatly multiplying their revenues and the value of their oil reserves underground.
In the rest of the world, it produced bizarre and contradictory economic effects, generating, at once, stagnation and inflation, hence stagflation. A British Member of Parliament (MP), Iain Macleod, had coined the term “stagflation” to describe a similar condition in Great Britain back in 1965. Payment for a dramatically higher oil bill was a huge financial leakage that drained funds out of the economic cycle of oil-importing countries. Oil-exporting countries could not recycle back to the oil-importing countries their sudden and huge financial surpluses fast enough; they needed time to formulate and implement massively larger national development and expenditure plans before they could significantly increase their imports.
Similarly, although some Western oil companies increased their cash dividends, they continued to hold substantial cash reserves for several years to finance their hugely expanded oil exploration and development plans. This sudden parking of vast funds, pending investment and recirculation, restricted economic activity in oil-importing countries. Thus, the oil price spike was more contractionary than a hefty tax hike because the associated revenue was not recirculating back into the economies of the oil-importers. This powerful economic brake caused the stagnation.[84]
In the United States, inflation peaked in 1974 at 11.03 percent, the contraction in GDP was 3.2 percent, and unemployment peaked in 1975 at 9 percent.[85] Several Eastern European and developing countries faced spiraling national debts denominated in foreign currencies, mostly US dollars, to finance their bulging trade deficits because of the steep oil price rise.
The sudden jump in the oil price produced widespread cost-push inflation because oil and energy went into the production of most goods. Unlike the more familiar demand-pull inflation, controlling cost-push inflation by curtailing demand was ineffective at best because its source was on the supply side of the market equation. Economic policymakers in the United States and Western oil-importing countries faced a schizophrenic economic choice: economic restraint to counter inflation or easing to counter high unemployment. Worst still, neither choice was very effective in achieving its objective.
The oil crisis ushered in the deepest and longest recession since the Great Depression. It was intractable in the short term, given simultaneously high inflation and unemployment. It violated the underlying assumptions of the familiar Keynesian Phillips curve, depicting a trade-off between unemployment and inflation because both were rising concurrently. Nixon’s price controls followed by the oil crisis disrupted almost three decades of a brilliant Keynesian economic record. There was no quick fix to stagflation.
Keynes had focused on short-term aggregate demand management to counter cyclical swings. Stagflation was not a problem that he encountered, hence, he had not addressed it.
In the early 1970s, economists were unfamiliar with stagflation and unsure how best to tackle it. At first, US policymakers tried applying traditional Keynesian anti-inflationary policies to curb demand by tightening fiscal and monetary policies, but that increased unemployment without resolving inflation. Conceivably, they were hoping a global recession would decrease global oil demand, leading to a breakup of the oil cartel and a quick collapse in the oil price. Indeed, global oil demand did fall but the response of the oil producers was to cut supply instead of lowering price; the oil cartel held. Ironically, had the global recessionary policy succeeded in reducing the oil price quickly, it would have removed the incentive to increase oil supplies, making the global economy prone to repeated oil shortages, crises, and stagflation following each recovery.
Since the problem was on the supply side, it required long-term supply-side solutions that, on the one hand, augmented oil supply and, on the other, provided new technologies that improved the efficiency of oil consumption. Eventually, effective economic policies evolved to tackle inflation and unemployment by liberalizing the domestic oil price in the United States and granting investment tax credits to encourage oil exploration and development, as well as encouraging the design and production of energy-efficient cars. The investment tax credits contributed to modest improvements in employment, but were insufficient to offset the large leakage caused by the high oil price.
Fine-tuning that policy to speed up the transition to greater availability and efficient use of oil could have included more generous investment credits, purposely limited to a few years to speed up investment in that sector, and a sharply rising sales tax on new oil-guzzling cars. Another measure should have been the immediate removal of the US price ceiling over old oil, because that resulted in some withholding of cheaper older oil, whereas it was the fastest route to increasing oil supplies. Indeed, price controls on natural gas continued for many years. These restrictions decreased the price elasticity of energy supplies and protracted the problem.
Strictly speaking, the oil investment tax-credits and the introduction of better energy-efficiency standards were not traditional Keynesian policies, but rather supply-side microeconomic policies to achieve macroeconomic objectives. The structural adjustments to solve the cost-push inflation required time to increase the supply of oil and improve the efficiency of its use. Normally, it takes about seven years to identify a new oil field, develop it, and bring its oil to market. Moreover, developing and marketing fuel-efficient cars in sufficient numbers to dent the fuel consumption of the national car pool needed about a decade.[86]
The persistence of high unemployment, high inflation, and anemic economic growth exasperated the public. In a rare confluence of interests, stagflation managed to unite the capitalists and labor unions, the former opposing high inflation and the latter protesting high unemployment. Keynesianism took the blame for not providing a fast economic solution where none existed. In that confused and despairing economic environment, neoclassical economists claimed to have a solution.
For almost a century, Anglo-Saxon economics departments and their economic literature have been in violation of international academic standards by not recognizing Viscount Takahashi’s landmark contribution to macroeconomics.
At the time, Keynes was a professor of economics at Cambridge University, as well as senior advisor to the British Treasury. Unless British commercial attachés stationed in Tokyo were on an extended holiday during the 1930s, they were bound to notice and report to the British Foreign Office and Treasury the exceptionally rapid Japanese economic recovery, while the rest of the world lingered in depression. Moreover, it was practically impossible not to notice the super-fast German economic recovery across the Channel that followed on the heels of the one in Japan by using similar economic tools.
Although unlikely, it is conceivable that Keynes was unaware of the Japanese and German economic miracles and their tools.[87] It is more plausible that the growing prospects of war in 1936, when Keynes published The General Theory of Employment, Interest and Money, dictated not to recognize the stunning macroeconomic revolutions in Japan and Germany so as not to concede a moral advantage to potential adversaries. Or else, British academia did not want to acknowledge that other nations were now better at economics, a disciple in which the British were traditionally leaders. In any case, there is no longer a valid reason for persisting with that charade. Metaphorically, Viscount Takahashi had successfully designed and flown the aircraft; six years later, Keynes masterfully explained to English speakers how it flew and, thus, his was an important contribution too.
Viscount Takahashi’s contribution is worthy of special recognition for another reason. Like Keynes, he comes from a rare breed of economists with a solid moral fiber. In his capacity as a minister of finance, Viscount Takahashi insisted, despite threats to his life, on reducing Japanese military spending. His refusal to compromise resulted in his assassination, paradoxically, in 1936.
To a lesser extent, credit should also go to Günther Gereke and Dr. Hjalmar Schacht. Like Viscount Takahashi, Dr. Schacht also opposed German rearmament. His intransigence resulted in his being sacked from the German government in 1937. Subsequently, German authorities arrested him and sent him to a concentration camp.
The academic world expects Cambridge University, that traditional citadel of learning excellence, to observe and maintain the highest and most uncompromising academic standards, particularly giving credit where credit is due. Academic standards require Cambridge to recognize the unparalleled contributions of Viscount Takahashi to macroeconomics, precisely because Keynes was a senior Cambridge faculty member at the time. This oversight has lingered for nearly a century; a correction is long overdue. Indeed, any university that claims to uphold academic standards must insist that the macroeconomics textbooks it uses recognize the contribution of Viscount Takahashi fairly.
Critique of Keynesian Economics
The General Theory was revolutionary; it provided English speakers with the theoretical basis for adopting countercyclical policies, particularly expansionary fiscal policies to counter recessions. Keynes proposed applying effective tactical measures, after the event, once a recession had set in. However, he stopped short of proposing strategic economic measures that could—other things being equal—dampen the tendency for cyclicality, cut the rate of structural unemployment and income inequality, achieve faster economic growth, and improve long-term macroeconomic performance, thereby reducing the need for tactical measures in the first place.
The Great Depression must have exposed Keynes to the flaws of the banking and tax regimes, two important structural destabilizers.[88] Irving Fisher (1867-1947) had been discussing indebtedness extensively and had written about it in 1933. Regrettably, Keynes did not give sufficient thought to the destabilizing impact of financial institutions, debt and inefficient taxes to propose economically efficient alternatives that could improve long-term employment, economic stability, and growth. With his stature, Keynes was ideally positioned to propose those changes, especially since he harbored no ideological bias against making the economic system more efficient and fair, a sorely missed opportunity.