The Irrelevance of Keynes

This is not a provocative statement but meant in all seriousness, and hinges on several aspects relating to Keynes’ theory and the characteristics of modern economies. A discussion of key concepts and the role they play in Keynes’ system itself will make clear why it is time to recognize this and move on. Students of communication are taught that it is not advisable to take something head-on when it has acquired huge proportions but that is exactly what I intend to do here.

Let us start with a mistake that is almost universal – equating fiscal with Keynes. While it is true that Keynes’ prescription focused on income as a target and hence fiscal, to equate it with Keynes per se is a monstrous fallacy. Unfortunately, the mistake has fed on itself and grown into such a proportion that it seems obvious that this is the case. Pity, but it is not. In a sense, this error is understandable as mainstream economics has, at one level, been bifurcated into two schools – the fiscal and monetary. And since most western governments have followed some fiscal policy or the other after the Second World War, and since most have landed in some form of trouble or other, the blame has been laid at the fiscal door and on Keynes. This is a classic case of continued reproduction of an error as truth. The recent study by MIT into fake news discovered that such ‘news’ travels faster than truth. Lest there is any confusion, let us state this – fiscal is not equal to Keynesian. Let us also not forget that Keynes was addressing what he saw as an essentially short-term problem and he didn’t visualize a situation where government expenditure supplanted private investment.

The curious case of consumption

In Keynes’ system, it is investment not consumption that plays a decisive role because consumption is taken as a stable function, on average, what he called the ‘psychological law of consumption’, as extremes cancel themselves out. The basic and fundamental reason why Keynes is irrelevant is that his theory of consumption behavior is completely at variance with observed and documented consumption behavior in most advanced economies but especially in the US. Developing countries too have exhibited similar behavior albeit in some pockets of the population. What is most important is that he defined consumption as a function of current income – not just income but current income.

However, consumption, in most advanced economies, has been a function of not just current but anticipated income over a time span. Ever since the introduction of the deferred payment schemes in the US after the II World War, consumption has been funded by means other than just current income. Home equity loans, which had begun in the 1970s itself, supported consumption based on asset prices. Alan Greenspan was probably the first economist to recognize the significance of this development for the US economy (The man who knew – by Sebastian Mallaby). The link between the levels of stock markets and consumption (largely consumer durables) is by now a well-documented phenomenon. In sum, rather than being stable, consumption has become unstable – consumption of everything, including durables and services, among which the chief today will be housing, automobiles and education. Education loans are a major area of banking in the US, the UK and even India. In the US, it has crossed a trillion dollars and in India there are many new initiatives focused exclusively on student finance. In the case of housing, people don’t get into a 25-year mortgage based on their current income but projected income over a period of time. There is a loan to buy almost anything, even relatively smaller things like mobile phones which have been available on EMI for quite some time.

It is important to make a general but significant point here that the income elasticity of demand for comforts and luxuries is greater than unity, an indication of social and economic mobility. It is but natural that people will factor in projected increases in income while planning their consumption. Further, once you recognize that credit cards have been the principal means of paying for almost anything and the credit card dues can be paid through a deferred scheme, you see that credit has been central to consumption for quite some time. And it is taking roots in areas where it has so far not been extensively used. Apart from these, it is quite common to see people borrowing against assets to finance consumption. While this has a bearing on any economy, it has a special significance in the US, where consumption expenditure accounts for nearly 70% of GDP.

Equally important is the fact that the 2008 financial markets crisis and the subsequent uncertainty have had a dramatic impact on people’s consumption decisions. Central to this was confidence over future income, itself a function of confidence over the continuation of the current job and job opportunities. All of which goes to demonstrate that consumption is a function not of current income alone but anticipated, future income. And to repeat what we have said a while ago, unstable.

More

On this one point alone, one can argue the irrelevance of Keynes to any modern economy but there are other aspects as well. Keynes doesn’t treat consumption as a dynamic variable because the problem in his time was elsewhere, which furnished him his specific objective – how to get the economy back on its feet again so that the cycle resumes, without interfering too much with the normal functioning of the economy. Just a push was needed but that was possible only from without – hence the significance of the autonomous investment that plays a critical role in his solution. Such investment could come only from the Government, which had a role similar to a lever to push a boulder. You need only to find the right spot for the lever; the incline will do the rest. Government investment was not meant to supplant private investment and it didn’t matter what it was as long as it produced a cycle of income. But investment, not bail-outs. This is all that is needed in the short-run, the only time period he was concerned with. And because there was nothing radically wrong with the economy; it didn’t need dramatic policy decisions.

Clearly this is seriously at variance with the status of many economies, with some of them such as Japan a conundrum as they defy any explanation in terms of standard macro-economic concepts and analyses. The world we live in is full of economies where many things are radically wrong and which need not just dramatic but truly innovative policies that can help put them back on their feet again. There are structural issues – tax-GDP ratio, stagnant real incomes, rising inequalities of both income and wealth, infrastructure bottlenecks, inadequate capital markets, deflation, delinking of inflation and interest rates. And so on. A debate has already begun, initiated by the Governor of the central bank of Denmark, as to whether the link between interest rates and inflation holds true.

I wonder if Keynes would have been able to make sense of such a collection of economies through his system. Yes, there has been a fair amount of post-Keynesian work by followers but it doesn’t make any real sense for reasons that should be clear by now. One of the ways of paying homage to a thinker is to accept he is not relevant to the world we live in. In Keynes’ case, that has been true for long. What is needed is an open recognition and the search for other ways of coming to grips with a different world. Physics did it; why can’t economics?