Keynes disposed of the assumption that supply creates its own demand. He argued instead that producers’ expectations of demand and consumption determine their investment, and consequently the employment and production that follow from it;28 therefore, low expectations could lead to underemployment. This he called the ‘principle of effective demand’: investment can fall as a result of expectations or bets on the future – and we know, not least from the 2008 financial crisis, that such bets can go horribly wrong.
On the back of this theory, Keynes proposed a new role for government. When the private sector cuts production in times of downbeat expectations about demand, he argued, government could intervene positively, increasing demand through additional spending, which in turn would lead to more positive expectations of future consumption and induce the private sector to invest, with higher GDP as a result.
In Keynes’s macroeconomics, therefore, government creates value in that it allows the economy to produce more goods and services than it would without government involvement. This was a pivotal shift in the way we regard government’s role in the economy. For Keynes, government was in fact essential because it could create value by reviving demand – precisely when demand might be low, as in recessions, or when business confidence is low.
Of course, government would have to borrow to finance this spending, which means bigger government debt in a recessionary economy. But higher debt is a result of a crisis, not its cause. Keynes argued that this increased debt should not overly worry the government. Once the recovery was under way, the need for big deficits would pass and the debt could be paid off.
Keynes’s concept of a deficit-led recovery quickly won over governments. It was applied most intensively at the end of the 1930s to stimulate post-depression growth, and at the beginning of the 1940s as wartime spending. Spreading rapidly after the Second World War, Keynes’s ideas were widely credited with generating the unprecedented prosperity of the three post-war decades – the trente glorieuses. Towards the end of the twentieth century, Keynes’s ideas earned him a place in Time magazine’s list of the 100 most important people of the century: ‘His radical idea that governments should spend money they don’t have may have saved capitalism.’29 As it turned out, these words were prophetic. Some eighty years after the publication of the General Theory, in the wake of the financial crisis governments around the world introduced stimulus packages: a move that owed much to Keynes.
In the end, however, Keynes only went part of the way. He changed our thinking about how government can create value in the bad times, through counter-cyclical policies; but he, and his followers, had much less to say about how it can do so in good times as well. Even as Keynesianism and the post-war boom were at their height, dissenting voices could be heard. With great ingenuity, the American Paul Samuelson (1915–2009) – one of the most influential economists of the second half of the twentieth century, a professor at the Massachusetts Institute of Technology and the first American to win the Nobel Prize in Economics – attempted to prove that neoclassical theory could explain how the economy behaved in normal times, except when recessionary periods made monetary policy have little effect: i.e. when increasing the money supply does not lower interest rates and only adds to idle balances rather than spurring growth (what is known as the ‘liquidity trap’). In essence, Samuelson argued that in normal economic times there was little need for governments to try to manage the economy along Keynesian lines and that government intervention (e.g. aimed at increasing employment) in these cases would only lead to higher inflation.
In the 1970s, inflation began to increase, opening the way for the monetarists, led by Milton Friedman. A libertarian, Friedman rejected the idea that government spending is beneficial, arguing that it most likely leads to inflation, ignoring that this assumes that the economy is already operating at full capacity so that any extra demand (stimulated by government) would result in higher prices. But Keynes’s whole point was that the economy would often be working at under-utilized capacity. For Friedman, what mattered was controlling the quantity of money in the economy. The new classicals also challenged Keynes by arguing that government spending was useless and only crowded out private investment. According to them, an increase in the public deficit raises the rate of interest (due to the effect of issuing bonds on interest rates) which, in turn, decreases the amount of private investment. For these reasons, government’s role should be restricted to incentivizing individual producers and workers to supply more output and labour – for example by cutting taxes.
The new classicals, however, misunderstood how interest rates affect investment. First, interest rates are not a market phenomenon determined by supply and demand. Rather, they are set and controlled by the central bank through monetary policy,30 and an increase in government expenditure financed by the deficit does not raise the interest rate. Second, lower interest rates do not necessarily lead to more investment, since firms tend to be less sensitive to interest rates and more sensitive to expectations of where future growth opportunities lie. And it is precisely these opportunities that are shaped by active government investment, as we saw in Chapter 7.
GOVERNMENT IN THE NATIONAL ACCOUNTS
As we saw in Chapter 3, national accounts were highly influenced by Keynes’s thinking. GDP can be calculated in three ways: production, income and expenditure. Despite its size and importance in the economy, however, the word ‘government’ rarely appears in discussions of production and income. Instead, it is usually examined simply in terms of expenditure – how the value produced and earned is spent.
For Keynes, additional public spending was needed to make sure economies were not constantly prone to recessions and depressions; by purchasing goods, government added to GDP on the expenditure side to make up for what was often too low business investment. The accounting method adopted was simply to add up the costs of government production, subtract intermediate material inputs and equate the difference – basically, government employees’ salaries – with the output of government. Although government played an active part in national accounting, its image was still as a big spender rather than a producer.
This is all extremely important. The accounts seem to say that government is just spending what it taxes away from value-adding companies. But can that be true?
The national accounts fail to capture the full amount of this government value added and have several major flawed assumptions. First of all, national accounts regard most of government value added only as costs, mainly pay to government employees; government activity lacks an operating surplus, which would increase its value added. Let’s compare it with the private sector. The share of pay in private-sector value added is rarely above 70 per cent. On that basis, you could say that government value added is on average only 70 per cent of what it should be.
Second, the return on investment by government is assumed to be zero; by this logic it does not earn a surplus. If it were more than zero it would show up as operating surplus. The US did not officially separate public current expenditures (e.g. costs to run the everyday business of government, such as civil servants’ salaries) and capital expenditure (e.g. to fund new infrastructure) until the 1990s, which strengthened accountants’ impression that the government only spent money. But of course vital government investments abound: obvious examples include infrastructure projects like the Federal interstate highway system in the US or motorways in the UK. It makes no sense simply to assume that the return on enormous government investments is zero, when similar investments by the private sector do produce a return. Moreover, it is perfectly possible to estimate a return. One way of doing this is to assume a market rate of return such as the yield on municipal bonds – the overall return on bonds issued by cities.31 The crucial point here is that zero government return on investment is a political choice, not a scientific inevitability.
Third, to assume that the value of government output equals the value of input means that government activities ca
nnot increase the economy’s productivity in any meaningful way: an increase in productivity, after all, is obtained by growth of output outpacing the growth of inputs. But if the output of government is defined simply as what it costs to do something, then an increase in output will always require the same increase in inputs. In 1998, the UK’s Office for National Statistics began to measure public-sector output by deploying different physical indicators, for example the number of people benefiting from public services (in areas such as health, education and social security) for every pound spent. In 2005 the British economist Sir Anthony Atkinson (1944–2017) improved on this by introducing important changes to the quantity measures of each public service, along with elaborating some quality measures for health and education.32 Intriguingly, when these changes were applied, it was found that productivity fell on average by 0.3 per cent per year between 1998 and 2008.33 Productivity increased significantly only after the financial crisis. But the increase was the result of fewer inputs, not improved outputs. Austerity aimed to cut back the inputs (government spending) while producing the ‘same’ outputs.34 It is hardly surprising that this kind of productivity ‘improvement’ does not result in better services – we only have to look at the long NHS waiting times to see this.
Fourth, governments often own productive businesses such as railways, postal services or energy providers. But, by accounting convention, state-owned enterprises that sell products at market prices are counted as private enterprises in the value added of the relevant sector: public railways are part of the transport sector, not the government sector. Even though state-owned corporations earn profits (and in the stats, higher profits means higher value added), their profits are accounted for in the industrial sector they work for, not the ‘government’ sector. So if the state-owned railway makes huge sales and profits (high value added), it boosts the transport sector value added, even if that sector is perhaps only successful because of state ownership. Only government-owned entities that don’t sell at market prices are by definition included in the government sector. In short, from the perspective of national accounting, you don’t count as government if you are doing market production. So, in the case of free public education, while increasing the number of teachers might add to GDP (because they are paid), the value they actually produce does not increase GDP. All of which means that government can only increase its value added with non-market production, thereby obscuring the true importance of government in the economy: value that government businesses do add is not shown in official statistics, nor is the value that education or health generate.
These rules have been made in order to find a straightforward way to account for economic activity. Yet, when you consider the combined weaknesses of accounting conventions – government is lumped with households as a ‘final’ consumer; government cannot make a surplus, earn returns, increase its productivity or raise value added through market production – you can’t help but notice that, while every effort has been made to depict finance as productive, the opposite seems to be true for government. Simply because of the way that productivity is defined, the fact that government expenditure is higher than value added reinforces the widely held idea that ‘unproductive’ government has to take before it can spend. This thinking by definition restricts how much government can influence the course of the economy. It underpins the theory of austerity. And it is a consequence of fables about government told over several centuries.
Multiplying Value
National accounts do not consider the interaction between public expenditure and other components of output, consumption, investment and net exports.
In order to understand this interconnection, economists estimate the value of what is called the ‘multiplier’. The multiplier was an important reason for Keynes’s positive view of government. Developed by Keynes’s Cambridge student and colleague Richard Kahn (1905–1989) and used by Keynes himself, it formalized the idea that government spending would stimulate the economy. Quite literally: every pound that the government spent would be multiplied, because the demand it created would lead to several rounds of additional spending. Importantly, the Keynesian approach also quantified the size of the multiplier, so policymakers – who quickly took up the idea – could support their arguments for stimulus spending with hard numbers.35
More precisely, the multiplier refers to the effect that an increase in expenditure (demand) has on total production. Its significance lies in the fact that, in the view of Keynes and Kahn, government spending benefits the economy way beyond the amount of demand that spending generates. The company from whom the government purchases its additional goods – let’s say concrete for motorways – pays incomes to its workers, who go out and spend those extra incomes on new goods – let’s say wide-screen TVs – which another company produces, and that company’s employees have more to spend – let’s say on holidays in Cornwall – and so it goes on multiplying through the economy. Additional government demand creates several subsequent rounds of spending, multiplying the original amount spent. Government spending in recession was seen as especially powerful in getting the economy back on track, since its effect on overall output was much greater than the actual amount invested.
This powerful and important idea has inevitably attracted controversy, particularly over the size of the multiplier – that is, how much £1 of government spending generates in the economy. The sizeable literature on the subject can be divided into two schools of thought: the ‘new classical’ and the Keynesian.
According to the ‘new classicals’, the proponents of fiscal austerity measures, the multiplier’s value is less than one, or even negative.36 On this basis they can argue that public expenditure has a non-Keynesian effect on output. In other words, an increase of £1 of public expenditure is supposed to generate less than £1 or even have a negative effect on total GDP because it crowds out private investment. In the case of a negative multiplier they assume that public expenditure destroys value, since the increase of £1 in public expenditure is more than offset by a decrease in the other components of GDP: consumption, investment and net exports.
However, the Keynesian view has been revived recently, since it has been shown that austerity measures implemented in, for example, southern European countries have led to a fall in total output and consequently a rise in unemployment, rather than GDP growth and increased employment. The poor economic performance of these countries calls into question the austerity prescription of the ‘new classical’ authors. Recent IMF studies have also suggested that government spending has a positive effect on output37 and that the value of the multiplier is greater than one – to be precise, 1.5.38 An increase of £1 of public expenditure leads to an increase in total output of £1.50. In short, more credence is being given to the view that government expenditure does not destroy private value but can create value added by stimulating private investment and consumption.
PUBLIC CHOICE THEORY: RATIONALIZING PRIVATIZATION AND OUTSOURCING
The 1980s backlash against government was in part driven by the notion that economies should worry more about ‘government failure’ than ‘market failure’. Government failure emerged as a concept from Public Choice theory, a set of ideas closely associated with economists like the American James Buchanan and the University of Chicago, where Buchanan studied. In 1986 he was awarded the Nobel Prize in Economics.
Public Choice theory argues that government failure is caused by private interests ‘capturing’ policymakers through nepotism, cronyism, corruption or rent-seeking,39 misallocation of resources such as investing public money in unsuccessful new technologies (picking losers),40 or undue competition with private initiatives (‘crowding out’ what might otherwise be successful private investment).41
Public Choice theory stresses that policy must be vigilant to make sure that the gains from government intervention in the economy outweigh the costs of government failures.42 The idea is that there is a trade-off between two inefficient outcomes: on
e generated by free markets (market failure) and the other by governmental intervention (government failure). The solution advocated by a group of economists called the neo-Keynesians (people who built on Keynes’s ideas) is to focus on correcting only some failures, such as those that arise from positive or negative externalities. The former might include ‘public goods’ like basic research, which the government needs to fund when the private sector doesn’t (because it’s hard to make profits), while the latter could involve the costs of pollution which companies do not include in their regular cost-accounting, so government might have to add that cost through a carbon tax.43 So while Public Choice theorists worry more about government failures and neo-Keynesians more about market failures, in the end their debates about policy intervention have not seriously challenged the primacy of marginal utility theory.
Taken to its extreme, Public Choice theory, which derives from marginalism, calls for government to intervene as little as possible in the economy in order to minimize the risk of government failure. The public sector should be insulated from the private sector, for example to avoid agency capture – when a regulatory body grows too close to the industry it is meant to regulate.
Fear of government failure has convinced many governments that they should emulate the private sector as far as they can. The premise here is that government is inevitably prone to corruption and laziness because agent and principal are too close to each other. It is essential, therefore, to make public services more ‘efficient’. From the 1980s onwards, private-sector measurements of efficiency were applied to the public sector and in the process ‘marketized’ government. Even the very language changed: hospital patients, social-service beneficiaries and even students all became ‘clients’ or ‘customers’.
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