We are acting like ostriches!

I find myself baffled by the ‘unlearning’ that is dogging the level of debate when it comes to running the economy. What is going on? ‘Supply-siders’ blithely ignore well-founded reasoning, acting as if it never existed, insisting that the market is king, worshipping it like a deity, ignoring evidence to the contrary, acting like ostriches burying their heads in the sand!

Supply-siders root their beliefs in the neoclassical economics of the eighteenth century. They are best described as ideological extremists, insisting that the earth is flat when science tells us it is not!

Adam Smith’s Wealth of Nations is a landmark in theoretical reasoning for neoclassical economists.adam smith

Adam Smith gave us some useful tools for organising our thoughts when addressing the question of how markets might be expected to function, lauding the role of incentives as well as the characteristics of the market-clearing equilibrium, but even he wrote as much about ‘market failure’ (about how markets often don’t work well) as he did about what to expect when they do work well.

KeynesKeynes came along in the twentieth century, and he gave emphasis to some pretty important and readily apparent examples of market failure, like the long term unemployment of the inter war period. He asked himself what good is a theory if it cannot explain what you see in front of you every day! Our politicians would do well to ask themselves the same question! After seven years of austerity we are little closer to restoring economic prosperity for all but a very few.

Neoclassical reasoning was unable to provide us with a convincing answer to the long-term unemployment of the great recession. Keynesian theory explained the persistence of disequilibrium in the economy and highlighted the important role of demand. It baffles me that we seem to have forgotten his important contribution when we would do well to remember it in the light of the aftermath of the financial meltdown of 2008. The rising inequality, falling wages and deflationary policies at home and abroad make it less and less likely that we can kick-start growth and return to prosperity for all any time soon without addressing the issue of demand.

In supply-side neoclassical theory you can have big market failures (like monopolies, pollution etc) which call for some form of government intervention. ‘Supply-siders’ tend to prefer to use price incentives to offset market distortions. The tool they favour in a recession is monetary policy (adjustments to interest rates and money supply).

Lowering interest rates is a price incentive to encourage investment, but when interest rates are already very low and there is a widespread feeling that markets are not gong to improve for some time we have a classic case of the problem outlined in Keynesian theory. We should, therefore, be thinking of adopting Keynesian solutions.

Monetary policy is like ‘pushing on a string’, it does nothing to improve confidence. What it does do is spark a speculative bubble. Money is so cheap that anyone who can get hold of it can buy up assets at reduced rates and hope to make speculative profits simply by holding on to those assets and waiting for them to appreciate in value. Hence the venture capitalists step in and property prices take off. Sound familiar to anyone?

Keynesian economics adds demand-side instruments to the mix. He advocated increasing government expenditure not just to provide public services but also to inflate demand so as to boost growth in a recession through the ‘multiplier effect’. This multiplier effect operates even when increased tax revenue finances the increased government expenditure – increased growth, employment, wages and tax revenues lead to a ‘balanced budget multiplier effect’. There is no increase in public sector debt.

 unemployed1

The more you put money in the hands of those with a high marginal propensity to consume (the least well off in society) the higher the multiplier effect and the greater the boost to overall economic activity. It is clear then that high inequality is bad for growth from a demand-side point of view. Reducing inequality stimulates demand and this might be expected to improve investors’ confidence in the economy, thereby encouraging a return to economic growth, all without increasing government debt by one penny!

So why have we ignored all this well-founded economic theory? Could the answer lie in the political arena? The big players in the economy have great influence on our policy makers. They campaign hard to distort market conditions in their favour. Neoclassical theory rests on the premise that conditions are ‘given’ rather than a variable, and on some other pretty crucial preconditions, like no barriers to entry in the market, equal access to capital, perfect information etc. The absence of these preconditions in the real world means that rather than Thatcher’s vision of small, independent shopkeepers beavering away to meet consumer demands what we have is giant monolithic global entities which intervene actively to distort market conditions.
They don’t do this necessarily because they are evil but because this is the reality of competition in the twenty-first century. Modern capitalism is far from the benign vision that Adam Smith described in The Wealth of Nations.If neoclassical theory does not apply then direct intervention in the market, through, for example, the balanced budget multiplier, and direct government expenditure is altogether reasonable and well-founded. It is time we stopped acting like ostriches!

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