Keynes versus the IMF
Can we spend efficiently on social services and productive investments, leading to full employment without inflation?
The writer is vice-chancellor of the Pakistan Institute of Development Economics
Leading economists like John Maynard Keynes and Irving Fisher had forecast prolonged and permanent prosperity, just prior to the Great Depression of 1929. The shock of the Great Depression led Keynes to create Keynesian Economics. According to conventional economic theory, increasing the quantity of money in circulation has only one effect: increasing the level of prices. That is, printing money is inflationary and has no effects on the real economy. Many economists of the time noted that massive bank failures had led to substantial reduction in the money supply. They came to a realisation that these events were related. Contrary to the classical theory that money only affects prices, there was a possibility that shortfall in the money supply caused the massive unemployment of labour and other resources.
Keynesian theory is based on a very simple idea that conduct of the ordinary business of an economy requires a certain amount of money. If the amount of money is less than this amount, then businesses cannot function — they cannot buy inputs, pay labourers or rent shops. This was the fundamental cause of the Great Depression. The solution was simple: increase the supply of money. Keynes suggested that we could print money and bury it in coal mines to have unemployed workers dig it up. If money was available in sufficient quantities, businesses would revive and the unemployed labourers would find work. By now, there is nearly universal consensus on this idea. Even Milton Friedman, the leader of the Monetarist School of Economics and an arch-enemy of Keynesian ideas, agreed that the reduction in money supply was the cause of the Great Depression. Instead of burying it in mines, he suggested that money could be dropped from helicopters to solve the problem of unemployment.
But what about inflation? Isn’t it true that printing money in massive quantities would lead to inflation? According to Keynesian theories, this would happen after full employment was achieved. That is, once the economy reached its maximum production capabilities, further money could not contribute to an increase in production. At this point, printing more money would only lead to inflation, exactly as the classic economic theory predicts. The Keynesian theory gives the central banks of the world an extremely important task: maintaining the money supply at exactly the right level to create maximum production without running the risk of inflation. Keynes also said that monetary policy may be insufficient for the task and the government had the direct responsibility of ensuring full employment using fiscal policies.
Regulation of financial markets, social support for the poor and the governmental responsibility to provide jobs for all led to decades of prosperity in Western economies. The share in the wealth of the bottom 90 per cent increased, while the share of the top 0.1 per cent decreased. This state of affairs did not please the wealthy elite, who launched an extremely successful attack against Keynesian ideas in the 1970s. The Arab oil embargo led to a sharp rise in oil prices and inflation, while simultaneously disrupting productive activities and creating unemployment. Keynesian theories state that we can only have one or the other: ‘stagflation’ or simultaneous presence of high inflation and high unemployment is ruled out.
This weakness in the Keynesian theory was successfully exploited by the rich and powerful to argue that the main problem lay with government interventions. Ronald Reagan dismantled some post-Depression regulations, which limited the powers of wealthy financiers. In particular, with great fanfare, Reagan deregulated the savings and loan (S&L) industry. Exactly as in the Great Depression, the banks took advantage of this to speculate in risky investments with depositors’ money and lost billions of dollars, creating a nation-wide banking crisis. However, the US government had learnt its lessons from the Great Depression and gave a massive bailout to prevent the collapse of the S&L banks. Over the next few decades, deregulation unleashed the power of the financiers, and cuts in social services weakened the labour class, with predictable results. Speculative financiers gambled heavily with the money of others deposited in banks, leading to myriad monetary crises. At the same time, the labour class was squeezed, resulting in rising inequalities and massive concentration of wealth at the top.
In the post-Keynesian era, the clarity of Keynes has been lost. Many central banks have gone back to pre-Keynesian ideas, abandoning the goal of full employment, and focusing solely on controlling inflation. Substantial doubt has been created as to whether or not monetary policy, or helicopter money, can be useful in solving problems of unemployment. When countries spend more foreign exchange on imports than they can earn, they are forced to borrow dollars from the IMF. As a condition of such loans, the IMF insists on austerity — governments should balance budgets and not print money to finance deficits. According to the IMF, financing deficits with increases in money supply can lead to high inflation, with heavy economic costs. However, according to Keynes, we should increase the money supply in an economy with high unemployment, such as Pakistan. Printing money is not inflationary in such a situation. So who is right? Keynes or the IMF?
Recent research by Princeton economists Atif Mian and Amir Sufi sheds considerable light on the answer, which is obvious in retrospect: both Keynes and the IMF are right. What happens depends on who picks up the helicopter money and what they do with it. If those who get the money buy land, property values will go up. If they invest in stocks, this will create a bubble in the stock market. If they put it in their Swiss accounts, this will lead to depreciation of the exchange rate. However, if the money is used wisely, to invest in projects which increase the productive capacity of the economy, this will create employment and generate the economic returns needed to provide support and backing for the newly created money.
When Keynesian policies of full employment and social support for labourers eroded the wealth shares of the elite, the counter-attack created alternative policies, as well as theories and ideologies to support these policies. Decades of experience with these policies, codified in the Washington Consensus as privatisation, liberalisation and stabilisation, has shown that they produce increasing inequality but do not produce growth. Alternative models for successful development are available. The most spectacular recent example is of Brazilian leader Luiz Inacio Lula da Silva. After being elected president in 2003, his deficit-financed programmes of social support and investment created progress and prosperity. Under him, Brazil went from being the most heavily indebted country in the world to the eighth largest economy, and 20 million people rose out of poverty. There are many other examples of wise public spending listed by Ellen Brown in The Public Bank Solution: From Austerity to Prosperity. Other kinds of examples also exist, where reckless and corrupt governments can wreak havoc on the economy, as the IMF fears. Can we rise to the challenge of spending efficiently on social services and productive investments, leading to the Keynesian outcomes of full employment without inflation?
Published in The Express Tribune, March 16th, 2015.
Keynesian theory is based on a very simple idea that conduct of the ordinary business of an economy requires a certain amount of money. If the amount of money is less than this amount, then businesses cannot function — they cannot buy inputs, pay labourers or rent shops. This was the fundamental cause of the Great Depression. The solution was simple: increase the supply of money. Keynes suggested that we could print money and bury it in coal mines to have unemployed workers dig it up. If money was available in sufficient quantities, businesses would revive and the unemployed labourers would find work. By now, there is nearly universal consensus on this idea. Even Milton Friedman, the leader of the Monetarist School of Economics and an arch-enemy of Keynesian ideas, agreed that the reduction in money supply was the cause of the Great Depression. Instead of burying it in mines, he suggested that money could be dropped from helicopters to solve the problem of unemployment.
But what about inflation? Isn’t it true that printing money in massive quantities would lead to inflation? According to Keynesian theories, this would happen after full employment was achieved. That is, once the economy reached its maximum production capabilities, further money could not contribute to an increase in production. At this point, printing more money would only lead to inflation, exactly as the classic economic theory predicts. The Keynesian theory gives the central banks of the world an extremely important task: maintaining the money supply at exactly the right level to create maximum production without running the risk of inflation. Keynes also said that monetary policy may be insufficient for the task and the government had the direct responsibility of ensuring full employment using fiscal policies.
Regulation of financial markets, social support for the poor and the governmental responsibility to provide jobs for all led to decades of prosperity in Western economies. The share in the wealth of the bottom 90 per cent increased, while the share of the top 0.1 per cent decreased. This state of affairs did not please the wealthy elite, who launched an extremely successful attack against Keynesian ideas in the 1970s. The Arab oil embargo led to a sharp rise in oil prices and inflation, while simultaneously disrupting productive activities and creating unemployment. Keynesian theories state that we can only have one or the other: ‘stagflation’ or simultaneous presence of high inflation and high unemployment is ruled out.
This weakness in the Keynesian theory was successfully exploited by the rich and powerful to argue that the main problem lay with government interventions. Ronald Reagan dismantled some post-Depression regulations, which limited the powers of wealthy financiers. In particular, with great fanfare, Reagan deregulated the savings and loan (S&L) industry. Exactly as in the Great Depression, the banks took advantage of this to speculate in risky investments with depositors’ money and lost billions of dollars, creating a nation-wide banking crisis. However, the US government had learnt its lessons from the Great Depression and gave a massive bailout to prevent the collapse of the S&L banks. Over the next few decades, deregulation unleashed the power of the financiers, and cuts in social services weakened the labour class, with predictable results. Speculative financiers gambled heavily with the money of others deposited in banks, leading to myriad monetary crises. At the same time, the labour class was squeezed, resulting in rising inequalities and massive concentration of wealth at the top.
In the post-Keynesian era, the clarity of Keynes has been lost. Many central banks have gone back to pre-Keynesian ideas, abandoning the goal of full employment, and focusing solely on controlling inflation. Substantial doubt has been created as to whether or not monetary policy, or helicopter money, can be useful in solving problems of unemployment. When countries spend more foreign exchange on imports than they can earn, they are forced to borrow dollars from the IMF. As a condition of such loans, the IMF insists on austerity — governments should balance budgets and not print money to finance deficits. According to the IMF, financing deficits with increases in money supply can lead to high inflation, with heavy economic costs. However, according to Keynes, we should increase the money supply in an economy with high unemployment, such as Pakistan. Printing money is not inflationary in such a situation. So who is right? Keynes or the IMF?
Recent research by Princeton economists Atif Mian and Amir Sufi sheds considerable light on the answer, which is obvious in retrospect: both Keynes and the IMF are right. What happens depends on who picks up the helicopter money and what they do with it. If those who get the money buy land, property values will go up. If they invest in stocks, this will create a bubble in the stock market. If they put it in their Swiss accounts, this will lead to depreciation of the exchange rate. However, if the money is used wisely, to invest in projects which increase the productive capacity of the economy, this will create employment and generate the economic returns needed to provide support and backing for the newly created money.
When Keynesian policies of full employment and social support for labourers eroded the wealth shares of the elite, the counter-attack created alternative policies, as well as theories and ideologies to support these policies. Decades of experience with these policies, codified in the Washington Consensus as privatisation, liberalisation and stabilisation, has shown that they produce increasing inequality but do not produce growth. Alternative models for successful development are available. The most spectacular recent example is of Brazilian leader Luiz Inacio Lula da Silva. After being elected president in 2003, his deficit-financed programmes of social support and investment created progress and prosperity. Under him, Brazil went from being the most heavily indebted country in the world to the eighth largest economy, and 20 million people rose out of poverty. There are many other examples of wise public spending listed by Ellen Brown in The Public Bank Solution: From Austerity to Prosperity. Other kinds of examples also exist, where reckless and corrupt governments can wreak havoc on the economy, as the IMF fears. Can we rise to the challenge of spending efficiently on social services and productive investments, leading to the Keynesian outcomes of full employment without inflation?
Published in The Express Tribune, March 16th, 2015.