April 7, 2020 Reading Time: 8 minutes
Revive the economy

In my previous article, A Classical Economic Response to the Coronavirus Recession,” my aim was to discuss why modern macroeconomics cannot explain the nature of an economy, and more importantly cannot provide a sound analytical basis for policy. If we follow modern macro in dealing with the coronavirus, we will leave our economies mired in slow growth, higher unemployment and even deeper in debt.

That, however, is not the full story, but you will have to read right to the end to find out how things could turn out well if we understand what needs to be done.

Here we are in the midst of a new kind of policy, something never experienced anywhere ever before, where the deliberate aim of government policy has been to slow the rate of growth, raise the level of unemployment, and rack up much higher levels of debt. 

We are on the breathtaking edge of a global consensus on entering a socialist compact to manage the economy from the centre, or at least, for the time being from each nation’s own economic centre. Global government perhaps is now on the horizon if things continue as they are. It is a truly terrifying prospect, made all the worse because of how complacently it has all been accepted.

The ease with which all this has come about is in part because of the way the role of the dead hand of government has already been meshed into the prevailing theory of the economy as a whole, which is a direct descendant of the Keynesian theory brought to life with the publication of Keynes’s General Theory in 1936.

I will state the problem in a single sentence and then elaborate from there. Modern macroeconomic theory looks only at the money value of what is being bought and sold at the present time and virtually never looks at the economy as a whole in structural terms nor over the longer term.

This is modern macro’s fundamental equation: the level of domestic economic activity is determined by the total level of demand for goods and services. Leaving out net exports, the core matter is what is bought in total by Consumers [C], Investors [I] and Governments [G]. The basic equation is that aggregate demand (represented by the letter “Y” for GDP) is the sum of C+I+G. This is macro’s fundamental equation, accepted by practically all economists.

Y = C+I+G

That is, the level of production occurs in response to whatever happens to be the level of demand for goods and service. It’s what we are buying right now that matters. And why it is supposed to matter is that the more demand there is, the more workers will be employed. Because it is so plausible because supply and demand are valid concepts within microeconomics, virtually everyone thinks it’s true for macro, including most of the professional economists in the world today. That it is untrue ought to be evident since every Keynesian stimulus in history, with no exception, has been a disastrous failure. 

My aim here is to explain what is left out by modern economic theory and the extent to which modern theory distorts our understanding of economic realities.

What macroeconomics leaves out is, firstly, the physical capital that is already in place. Then secondly, left out is the labour force with all of its specific skills in existence and intact. Then, thirdly, left out are all of the economy’s entrepreneurs who direct their businesses, and whose own money is at stake in the enterprises they run. Fourthly, left out is any analysis of how the entire economic system fits together, the actual structure of the economy. And fifthly, almost always ignored is the role of the price mechanism in directing resources to where they will create the greatest economic value.

Recessions are not due to a failure of demand. Recessions are normally due to the changing underlying structure of the economy, usually due to runaway growth in the availability of money and credit although not always. The collapse of the world’s economies in the 1970s was due to the OPEC “boycott,” the refusal by the major oil-producing nations to sell their oil to Western economies. It was a structural problem unrelated to the credit conditions of the time, but also, of course, unrelated to the level of demand for goods and services. 

Mostly, however, downturns occur because of very large increases in unproductive public spending, or vast increases in private sector debt through the credit creation process that lead to investment into all kinds of unproductive and unprofitable forms of output, as occurred during the Global Financial Crisis. 

In a recession, firstly one part of the economy will fail, leading to a succession of other failures in other parts of the economy. The recession is a period of repair, which involves large-scale structural change. Some businesses contract or disappear, while others expand with others still created from scratch. The period of recession is the economy’s attempt to find its way back to a productive base of profitable firms. Full employment occurs almost automatically in such circumstances. 

A “stimulus” made up of large increases in public spending, rather than being helpful in returning an economy to full employment, is instead an obstruction that slows down the recovery process. Money is spent where no productive outcomes occur, where labour is misdirected into dead end forms of activity, where debt is built up with little or no increase in real output to allow the debts to be repaid. 

This time, however, industry has contracted because governments have deliberately stopped many of our firms from producing. There are now enormous sums of money being paid out by governments to displaced workers and business owners which do not represent payments for contributions in helping to produce the goods and services available for sale. Oceans of money will enter into the economy, money which will be spent, but with far fewer goods and services available for that money to purchase.

For many, the loss of jobs and the closure of the businesses they run are catastrophic, and will be all the more catastrophic for those who have no access to money, with the crucial word being money, as in having some means to buy what they need. An absence of savings in a liquid form, or an absence of any savings at all, would lead to instant destitution. If the government takes on the responsibility of closing down large parts of the economy, it must therefore ensure that those who no longer have access to purchasing power through an earned income nevertheless have some means to buy what they need. 

Similarly, businesses, if they are to stay solvent, need some means to pay their fixed costs, such as rent and interest payments. Even so, many firms will go bust and some firms will just call it a day, so the economy is already undergoing structural change. Here, however, is the central point from a pre-Keynesian classical point of view.

Most of the physical capital in existence before this interruption occurred will remain in place and can be put back to work almost immediately. Some of our capital will have lost its value in use. The economy will therefore be less productive than it had previously been. But most of it, not all of it, will still be there ready to be activated again.

Same again for the workforce. Most of those who had jobs before will return to work, either where they had previously been employed or in different jobs. Some employers will find it relatively easy to retool and find the employees they need. Many others, however, will find their closures have added to their start-up costs (think of reopening a blast furnace), will find it hard to employ the skills they need and will never operate again. But jobs will return and most of those who had previously been employed will be working again.

A modern economist believes re-starting the economy is a relatively simple process of telling everyone to get back to work and because of the various stimulus packages, rising demand will largely take care of everything on its own. The underlying economic structure will never enter into their thoughts. 

Once things start up again, near enough most firms which already exist will come back into operation, but by no means all will. And of those employees who have been pushed away from their jobs, almost all will return either to the ones they had or to new ones instead, but again not all. And some entire industries, even if they eventually come back to the level of activity they had previously reached, will take a very long time to get back to previous levels.

Beyond even that, the monetary debt just created – both private and public – will be a fantastic drag since it will distort the economy’s future direction and slow the ability to create new forms of productive capital. 

Governments have been enjoying their Santa Claus routine by creating new money to support both individuals and business, and of course, to pursue their own agenda items. That money will be sloshing around in our economies. Much higher rates of interest could clear up the inflationary effects, if central banks are willing to raise rates as soon as possible, as high as needed and for as long as necessary. Governments will also need to raise taxes to bring down the even more massive deficits that have been created.

Governments won’t like it. But if they let inflation take hold, the problems will be much worse and take much longer to fix. The problem here, as always, will be that this might instead be considered a problem for some future government to deal with. Many of those making these spending decisions right now will want to see the can kicked further down the road.

Let me ask you this, based on your own experience with governments. Are they likely to fix these problems right away, in spite of the political pain it might cause? Or are they likely to wait, and defer, and delay and leave things to someone else in the future to deal with? 

Even worse, and there is worse, there are all kinds of people who now believe they have seen a socialist economy working, who believe they can do it again, and keep it going forever. This episode in pretending to manage our economies from the centre will have many looking to try it all once again, who now believe it can work far into the long term, just like in Venezuela. Money for no work will seem like a good idea for those who have no idea how an exchange economy works. 

There is no end to the dangers we have just created for ourselves. The one thing that is certain, however, is this. Unless we restore our market-based economy, and allow economic outcomes to be determined by the decisions made by private entrepreneurs in a competitive environment, our economies will be heading for the rocks upon which they will founder and sink, along with us, their passengers, as well.

There are risks of all kinds everywhere. Getting the economy back on the road as soon as possible will limit the damage although the damage caused on the financial side, even in what has been a brief moment in time, will be massive. For some, there will be no recovery of the ground they have lost.

All that said, the reality is that virtually all of our infrastructure is still in place, we have a skills-enriched workforce across the economies of the West, entrepreneurial talents remain in place who, however gun shy they may have become, are willing to take a chance, and, most importantly, we live in a market economy where everyone is welcome to apply their talents in the areas best placed to use them. 

The potential for the real economy to respond and turn things around is no different than it was at the end of World War II when, financially speaking given the size of the debt-to-GDP ratio at the time, things were even worse. Yet, the circumstances then led to an economic revival which continued for thirty years, right through until the 1970s when another Keynesian experiment was put in place. 

There’s no reason why, if we allow the private sector to grow again, that we could not end up with the same kind of revival as we had back then. But if we try to revive our economies with further stimulus spending, there is no level of self-destruction we might yet be able to achieve.

Steve Kates

Steve Kates was the Chief Economist for the Australian Chamber of Commerce for 24 years and a Commissioner on the Productivity Commission. He is now an honorary adjunct associate professor in the College of Business at RMIT University in Melbourne. He has written the first post-GFC textbook in economics, Free Market Economics: an Introduction for the General Reader – now in its third edition – which explains amongst other things why the stimulus packages that followed the global financial crisis created many economic problems and solved none. His next book, Classical Economic Theory and the Modern Economy, provides a detailed and historical explanation of how the Keynesian Revolution completely distorted our ability to understand the operation of a market economy and undermined our ability to provide sound policy during economic upheavals.

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