A Simple Keynesian Narrative

The coalition government has been remarkably successful in establishing its narrative that identifies the economic crisis with public debt. The falsehoods behind this narrative are well documented, but the success of this story will be halted not by argument but only when the electorate has grown tired of austerity which fails to lead to economic revival.

Recently, the prime minister has found a different narrative.We are in a race with other countries; emerging economies are catching up; we risk being left behind. Britain must be more competitive. This narrative is no more honest than the last. The global economy is not a zero sum game. One country's win is not another country's loss and new arrivals in the club of rich nations do not make the old members poorer.

I keep asking where is Labour's narrative?

The Tory narrative works because it deals with familiar ideas. Personal debt and household debt may be completely different from national debt but the Tory tale has a feel of familiarity. "Maxing out the national credit card" is an absurd notion, but it connects to how people feel when personal debt is out of control. Equally the global race sounds plausible not just to sports fans but to people whose only connection to racing is school sports day.

As a simple Keynesian I would like to see narrative which emphasises investment to boost effective demand and increase growth. The problem is that these terms lack the immediacy of the Tory metaphors. I want to propose one small step towards a more homely narrative.

Instead of talking about growth we should talk about income. The parallels between national income and household income may not be exact but it does open a way of connecting to people's experience. For example, if you are in debt one way out is to increase your income. Paying down the national debt will be easier if we increase national income.

Britain's economic problem is not debt, but the failure to increase national income. The government cannot increase national income itself, but it should remove the obstacles to increasing income. That is where the narrative turns to investment.  The language of investment should also connect to people's direct experience. We invest now to increase income in the future. We should avoid talk of "stimulus" and of tax cuts or deficit financing.

Investment is not just public, although that is needed. Equally important is removing the constraints on private investment, through reform of the finance sector including flagship projects like regional enterprise banks.

This is a small contribution towards constructing a coherent narrative to counter the Tory dominance of the political story.

1776 and all that

When Adam Smith said this, could he have foreseen Mr Osborne's policies:

To diminish the number of those who are capable of paying for it is surely a most unpromising expedient for encouraging the cultivation of corn.

Corn or anything else...

Prescient

The Fabian Pledge

The Fabian Society is asking its members to propose policies which could be included in a pledge card.

It is a nice idea, however once you start to formulate a pledge it becomes quite a complex task. On the one hand the pledge needs to describe the outcome, preferably in a concrete and measurable way. On the the other hand policy advocacy is concerned to propose the actions that would lead to the outcome. So "cut unemployment by 500,000" would be an outcome, but what policies would lead to that result?

The challenge forces you to look for a symbolic policy which provides an example of a deeper idea. Given my simple Keynesian approach I want to argue for more investment, but to what concrete result? I have settled on this idea:

We will build 100,000 affordable homes, sell them and use the proceeds to build 100,000 more.

It provides an example of a simple Keynesian policy. When the private sector is unwilling to invest the government can step in and undertake the investment itself. The resulting assets can then be sold to the private sector. It has the beauty that the initial borrowing can be repaid once the economy recovers simply by selling all the assets. In my pledge example, the government would borrow £3bn to build the houses which would be sold on the open market to households or housing associations, realising £3bn+ in revenue which can be used to continue constructing housing. Once the private sector begins to build again, the government scheme can be wound up and the money repaid.

I would advocate giving a government agency the responsibility of handling this fund. I would also back up the policy by creating compulsory purchase powers to allow the agency, or local government, to acquire any brownfield site which has had planning permission for housing for more than five years without the owner developing the site.

"Failure was Predictable"

In anticipation of the chancellor's Autumn statement, Lord Skidelsky goes on the attack:

The chancellor’s policy is based on the wrong theory of the economy; the BoE’s on the wrong theory of money. Failure was predictable.

 His argument is simply Keynesian. Keynes would have argued that:

 ...cuts would reduce the level of total spending in the economy and thus perpetuate the slump.

As for the bank:

The BoE’s mistake has been to believe it is the supply of money that is critical for economic recovery; Keynes said it was the demand for money.

His solution is to restore the programmes of capital investment, accelerate infrastructure projects, expand the programme of the Green Investment Bank and  replace the bank's inflation target with a nominal income target.

As Will Hutton once said - Keynes is best.

Thinking About Rude Books

When I studied mathematics, many years ago, we began by doing analysis on the real number line. The course proved all the fundamental theorems of calculus on real numbers. In the second year I studied analysis on the complex plane and learned the proofs of the same theorems for complex numbers. The next year I moved on to n-dimensional space and, yes, the same theorems work in n dimensions. In my final year I took an optional course which proved the same theorems on topological space*.

When I went on to study economics I learned all sorts of results in simplified worlds where there were two goods and a budget constraint or a production possibility frontier. I assumed that the same results could be demonstrated for worlds with n goods and n-1 hyperplanes as budget constraints or PPF. Strangely no-one bothered to show that they did.

Thanks to Steve Keen's book, I now know the answer. Serious economists have indeed checked whether the simple models can be generalised. For example, the consumer theory model (the one with two goods where the consumer has a budget constraint) is used to demonstrate the downward slope of a demand curve. It might work when there are more than two goods but it falls apart once there is more than one consumer. Consumer theory only gives the traditional downward sloping demand schedule under conditions which amount to there being only one consumer.

Keen's book goes on to demolish the traditional supply curve. Some  simple mathematics (which was first published in 1957 but still doesn't feature in the textbooks) shows that the idea that firms have zero market power in a competitive market is false. Consequently, price does not equal marginal cost. To be fair, when I first studied economics in the 70s we were aware of the empirical work which showed that the textbook equation was not how real firms set their prices.

In the first part of Debunking Economics Keen uses the results of economic research to show that most of microeconomic theory has been tested and found wanting. This matters for macroeconomics as the last few decades have been dominated by an approach which insists that macro has microfoundations. In effect, modern macro is built on crumbling foundations.

The second part of the book does the same wrecking job for macroeconomics. The argument here is more complex and demands more from the reader. One difficulty is that macro models are less well known than supply and demand. Few outside the economic profession understand the DSGE models used, nor even the simpler IS-LM model. Nevertheless, it is worth persevering; Keen is writing for a general audience. He points out the failures of conventional macro to deal with the nature of money and credit, the effect of time, and the analysis of disequilibrium. By the end the case for abandoning neoclassical economics is made.

In a final part, Keen sets out the alternatives. This section sits less well with the overall argument and has the effect of making the volume read like two books joined together. Perhaps it is, as the earlier version of the book - published before the crises - did not go into the alternatives in such detail.

I strongly recommend this book to anyone interested in how economics has failed in predicting or dealing with the current depression. It is an angry book which pours scorn on the mainstream economics profession. If you would prefer an less polemical approach, then I would point you towards a book by Marc Lavoie, Introduction to Post-Keynesian Economics.This is a short book with a more academic approach which covers similar ground.

*A topology is defined in such a way that it has all the properties needed to make calculus work, and no more.

Simple Keynesian Political Economy

The real question behind the prime minister's fibs at his party conference, just like last year's fibs by the chancellor of the exchequer, is this: why does the Labour Party let the Tories define the narrative?

Last year Mr Osborne's fibs were in the service of creating a version of history in which the crisis was caused by too much debt. (Respectable Keynesians might agree that the explosion of debt was a cause but it was mainly household and businesses who were running up the debt.)

In Mr Osborne's version the borrowers were the British government, European governments and (bizarrely) the banks. This was and is nonsense. Before the crisis the government's net debt ratio was 36.4% of GDP. European countries which are now highly indebted include Spain and Ireland who, before the crisis were paying down their national debt, which was already very low. The banks were culprits not because they borrowed too much, but because they lent too much.

Mr Cameron returns to the theme by painting Labour as inveterate borrowers.

This alternative history needs to be countered. The opposition must create a different narrative, and one which is more honest. Against the Tory story of a debt crisis which must be cured by austerity we need a narrative to explain that the problem is a financial collapse and the solution is  investment.

Simple Keynesian analysis reminds us that the stimulus the economy needs is investment rather than general government spending or tax cuts. The investment may be in the public sector or the private sector or done by the public sector because the private sector is unwilling.

Investment should raise the potential of the economy and so provide more jobs and output in future and reduces the structural deficit. Investment should provide future income streams and so it is usual to fund investment by borrowing.

This is not the time to be slashing government investment in half, as Jonathan Portes of NIESR argues.

Source: Jonathan Portes blog, Not the Treasury View

To boost private sector investment a future Labour government will need to fix the still broken financial sector to provide the economy with the kind of banks which supply credit to small and medium sized businesses. New lenders will be needed, such as regional enterprise banks, and barriers to entry for new retail banks should be removed.

These then should be the themes of a new narrative to explain the crisis and its resolution. They are easily understandable. People remember that the crisis began as a financial crisis, but perhaps need to be reminded of collateralised debt obligations, shadow banking, securitisation, special investment vehicles, sub-prime lending and all the other instruments of financial destruction. Investment too is an attractive concept which points to a brighter future.

A narrative is not yet a policy, but as I will argue, the policy should point in this direction.

Update: link added

Simple Keynesian Economics

One day I will find the time to write my pamphlet on an alternative economic strategy for the Labour party.

In the meantime here is one of the key ideas. In place of "crude Keynsianism", I want to offer simple Keynsianism. Keynes devised a complex and subtle theory which he laid out in a difficult book. I attempt to simplify his core idea as a base for policy prescriptions.

Simple Keynesianism can be explained in four steps and one diagram.  

These are the key steps:

1.      Income increases as employment increases.

2.      Income is the sum of consumption and investment.

3.      Consumption increases as income increases but not by as much.

4.      Investment decreases when entrepreneurs prefer to hold cash.

In step 1, income means the total of all income in the economy - ie wages and profit. Because everyone's purchases are someone else's income, income is equal to the total value of production. Step 2 means that everything which is produced is either consumed or used to contribute to future production. Investment, therefore, includes capital equipment, infrastructure, stocks of raw or finished goods and other working capital. Keynes used the term 'propensity to consume' to describe step 3. A society with a low income will use most of its income to meet immediate needs. A richer society will consume more in total but a lower proportion of income is spent on consumption. The first three steps are illustrated in figure 1.

A number of factors influence the level of investment, such as the expected return and the interest rate. Keynes innovation was to identify the importance of a psychological factor, 'liquidity preference' which means the desire to hold money rather than tie it up in investment.

In the diagram we have the economy a full employment (N₀), with a high level of income (Y₀) and consumption. Following an external shock, (for example a banking crisis) liquidity preference rises, which means that businesses postpone investment in order to hold more cash. Lower investment means lower income (Y₁) which means lower employment (N₁). At this lower level of employment consumption is also lower and so employment falls even further. The fall in employment means a fall in income which means another (smaller) fall in consumption. Employment continues to fall until a new equilibrium is reached, but now with employment (N₂) and income (Y₂) below their potential level.



That is it, the simple version of Keynes' theory of employment.

Perhaps a little algebra will help. Keynes says that income (Y) equals consumption (C) plus investment (I). Y = C + I.

At full employment Y₀ = C₀+ I₀. When liquidity preference rises investment falls, let's say by the difference between Y₀ and Y₁. Now Y₁ = C₀ + I₁. At Y₁ the propensity to consume gives a level of consumption below C₀. Thus consumption falls as does income and employment. At this lower level of income consumption falls again, and keeps falling until equilibrium is reached, Y₂ on the diagram.

I have explained the simple Keynesian theory without mentioning the multiplier. In fact the explanation is there. A fall in investment caused a fall in income more than the initial cut in investment spending.

 My idea is to argue that Keynes theory is not about boosting government spending. It is primarily about increasing investment. Part of the investment will be by government but we need to start by looking at private sector investment as well.

My first question however is does this explanation do the job. Is simple Keynesianism sufficiently clearly explained and easy to grasp?