I am indebted to Dr. E.K. Hunt for his wonderfully insightful and elucidative book, History of Economic Thought. Some ideas here are his; reading his book also helped me to organize and understand my own thoughts in meaningful and important ways. Dr. Hunt, your work has changed my life, and for that I am grateful.
The budgetary adjustment facing the United States on January 1st, 2013 is no long coming fiscal reckoning. The capital markets continue to eagerly lend to the United States government, as evidenced by record low yields on federal securities. There is no debt crisis; the US treasury continues to make interest payments on outstanding debt, and finances budgetary shortfalls via the sale of bonds and bills. If anything, the US has the opposite of a debt crisis. The federal government has lower borrowing costs and better access to financing than at any time in history. So the fiscal cliff is not the result of decades of Washington recklessness. Rather, it is an artificial deadline, imposed by a dysfunctional and insane Congress on an embattled President. Now that President has managed to get re-elected, despite the best efforts of the insurrectionists in the US House of Representatives who threatened to bring down the federal government and destroy its credit worthiness simply to win an election. If anything, President Obama's win last month was a victory for builders over destroyers, and a stinging defeat for those who would burn down the house rather accept the will of the majority of its occupants. But I digress. I wish to examine the fiscal situation facing our country from a historical perspective that begins long before the rise of the tea party, the ascension of Barack Obama, or the passage of the Bush tax cuts. For this, we must look back at a century and a half of economic thought and industrial history. For the current US fiscal outlook did not begin with cutting taxes for the rich, or two unfunded wars, though these events are certainly symptoms of the status quo. Rather, the situation we find ourselves in is the direct result of the slow but steady evolution of social, industrial, economic, and monetary structures, the understanding and elucidation of which is the only way possible to understand (and ultimately escape) our current predicament. In this paper, I intend to do just that.
The Great Depression of the 1930s was undoubtedly the biggest economic crisis of the past 100 years. As late as 1939, unemployment was as high as 20 percent. Apart from being an economic crisis with untold human suffering, the Great Depression represented a crisis for economic thought which until the 1930s had been dominated by the neoclassical school. Importantly, the neoclassical economists' theory of employment, wages, and income distribution held that involuntary unemployment was impossible, and that unemployment was the result of workers refusing to accept a lower wage. This conclusion rested solely upon the idea of the value of marginal product theory of income distribution which held that: 1. Each successive unit of output resulted in lower returns in terms of value for society. 2. Each successive worker to enter the labor force then resulted in a lower marginal return on the output of their labor. 3. Competition between workers caused the wage rate to fall to the value of the last successive unit of output. In other words, the wage rate equaled the marginal value of the product of labor. These three postulates also necessitate the conclusion that as competition drives down wages to the value of the marginal product of labor, profits must rise for the entrepreneurs by an equal amount. Or in macro-economic terms, as the wage rate falls, the interest rate on capital rises by an equal magnitude. We must therefore conclude as output and gross employment rises, the distribution of income necessarily becomes more unequal.
The conditions on the ground during the 1930s however struck at the very foundations of this elegant theoretical edifice which had been meticulously developed over the past half century. First, as industrial output plummeted wages for workers who remained employed fell sharply, while neoclassical theory predicted they would rise as the less output meant that the marginal value of the output of each worker lucky enough to keep his job would rise as well. Secondly, many unemployed workers were willing to work well below prevailing wage rates, yet no opportunities existed. Large masses could then be said to be legitimately 'involuntarily unemployed,' which directly contradicted neoclassical dogma.
For John Maynard Keynes, a British economist brought up on the neoclassical school, the Great Depression was a fascinating challenge. On the one hand, Keynes essentially agreed with the neoclassicists that both households and firms were rational maximizers whose interests were in harmony when the market was in equilibrium. Keynes' major contribution to economic theory were the following insights. 1. Interest on financial capital was the reward for parting with liquidity, not a reward for delaying consumption as held by neoclassical theory. 2. A large component in the demand for money was the so-called speculative motive. For example, when the market expected interest rates to rise, investors would be reluctant to hold bonds with long maturities for fear of a sharp rise in interest rates. It was always good to hold a significant amount of liquid cash to take advantage of a potential rise in the rate of interest. 3. While the rate of interest was the equilibrium point which balanced savings with investment, it was possible for there to be so much excess savings in the market that to bringing into equilibrium with investment would require a negative rate of interest. It was these cases which Keynes sought to understand better. Keynes essentially believed that when savings and investments could be brought into equilibrium by a rate of interest above zero, the simple prescription was for the central bank to create enough money to lower the rate of interest sufficiently to its equilibrium level. When this was impossible because the market demanded a negative rate of interest to make savings equal investment, another solution entirely was required.
Before proceeding, it is crucial to reiterate that Keynes, like his neoclassicist predecessors, believed that total income in the economy must equal total spending. For example, expenditures by households on consumption goods were income for firms. Likewise, the investments one firm made on machines to make goods was income for the firm which constructed the machines. Thus, total output must also equal total spending, since firms would not produce goods they could not sell. Keynes expressed this concept with the equation A = I + C + G, where A is 'autonomous spending,' I is investment, C is consumption, and G is government spending. We will revisit this equation shortly as we discuss the principal policy recommendation for Keynes' analysis, deficit spending by government.
Keynes' theory of interest essentially stated that excess savings as compared to investment drove down the rate of interest. However, the equilibrium rate of interest at which investments and savings were equal could be below zero. In practice, savers would never lend out their money at negative rates. In such cases, Keynes advocated that governments become the borrower of last resort by issuing bonds to finance large deficits. The government therefore was essentially providing an investment outlet for all of the excess savings in the economy. The government would then spend these borrowed funds to increase spending in the economy and therefore total output. Keynes advocated the initiation of 'useful projects' such as the construction of schools and roads. It should be noted however that Keynes saw the government's ultimate role was to soak up and spend the excess savings for which private investors could not find profitable outlets. For this reason, Keynes believed that spending money to employ men to dig ditches and then refill them would be nearly as effective as building bridges.
The problem of excess savings has its origin in two places. First is the lack of profitable investment outlets. This can be solved by the issuance of government bonds which pay a fixed rate of interest, as these securities are essentially seen as risk free. And as discussed above, investment can be stimulated by a lowering of the interest rate by the monetary authorities. But only when the equilibrium rate for savings and investment is above zero. A second and perhaps more important cause of excess savings is the gross and ever increasing income inequality which the neoclassical theory predicts is the inevitable outcome of capitalism. As a small but powerful class of absentee owners gains a larger and larger share of the national income which it cannot possibly consume or invest profitably, total spending drops (and savings rises) and therefore output falls. Is it any wonder, therefore, that as wealth has become more and more concentrated, government debt has soared and deficits have exploded? As more and more excess savings is socked away in the hands of the few, the government has been forced to provide the investment outlets (ie, issue more bonds) so that spending and therefore output does not fall.
The Keynesian prescription has necessitated the creation of incredibly intricate and fragile networks of creditors and debtors. Banks and financial firms become creditors of governments, while simultaneously being indebted to their depositors, investors, and shareholders. Inevitably, some of the excess savings has found its way into the hands of households in the form of bankcards and other forms of consumer credit. This enhances demand for the products and services of the entrepreneurs, who in turn issue bonds to finance capital investments to keep pace with growing consumer spending. The result is that nearly all actors become both large creditors and debtors. This elaborate network of debt knows no national boundaries, and any possible default at the government, firm, or household level could bring down the entire system.
Such a possibility explains the extraordinary action taken by central banks after the collapse of Lehman Brothers in 2008. The failure of such a large debtor to make good on its obligations threatened the capacity of many of the firm's creditors, themselves debtors, to meet their respective obligations. The potential ripple effects threatened to bring down the entire economy. We need not examine in detail the government response to the 2008 crisis. Suffice to say, this time, the worst seems to have been averted. However, the growing disparity of income become rich and poor, which has become worse still since 2008, will continue to put ever increasing stress on the financial system and central banks as economies are forced to create ever more elaborate and complex credit relationships to re-inject into the economy the huge sums of excess cash held by a super elite class of mega capitalists.
In sum, while it is indisputable that the massive government spending during the second world war and the post war reconstruction ended the great depression and brought on a two decades of relative global prosperity, I fear that long term sustainable growth will never be attainable without a more equitable distribution of income. Our present course which does not nothing to address income inequality will lead to a cascade of financial crises, growing in scope and complexity, as banks and financial firms are forced to create riskier and more interdependent credit relationships between households, firms, and a plutocratic elite. Meanwhile, central banks will come under ever increasing pressure as they are forced to constantly ease credit conditions to spur sidelined savings into profitable investment outlets. Central governments will become even more indebted as they try in vain to soak up all the excess savings by the endless issuance of bonds to both fund new projects and refinance old debt. The seas appear to be calming, and a debt deal in Washington seems likely. However, steering around the fiscal speed bump in January does nothing to change our trajectory towards the ultimate day of reckoning.
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