Transatlantic differences

To think about Keynesian economics while crossing the Atlantic may be seen as exhibiting a moribund taste. Leading Americans like Robert Barro of Harvard or Lucas of Chicago have been expressive in their condemnation of Keynes's economics.

In his latest book Nothing is Sacred: Economic Ideas for the New Millennium, Barro tells us that "it was too bad" that he did not realise early enough that Keynes's model "was theoretically and empirically deficient."

That is an intellectual blow to those who believe that Keynes invented macroeconomics.

A little further investigation reveals that it is not Keynesian logic that is under attack, but the proposition that Keynes advocated government spending.

Any form of government action in the economy is almost pathologically disapproved of by Barro.

And since for us in India or for China it is unlikely that our politics will allow development to take place without substantial government intervention, it is necessary for us to follow Barro's reasoning carefully.

This is not entirely easy because Barro relies on an invalid syllogism to develop his attack.  His argument does not seem to conclude from his premises; let me summarise his line of reasoning as best as I can.

His major premise is "Keynes was influential because he advocated more government intervention into what he perceived as poorly functioning private economies caught up in the Great Depression" (page 2, Barro, MIT Press, 2002).

His minor premise is that Friedman has been able to show that the Great Depression was aided by government intervention.

The authorities encouraged a policy of contracting credit instead of expanding credit as incidentally Keynes might have been expected to advocate after he analysed the problem in the 'General Theory.'

Friedman however argues that the government and the monetary authorities by their intervention worsened the situation by deliberately reducing the quantum of money in circulation and this hastened the Depression.

It therefore follows that Keynes was wrong in advocating government intervention for reducing unemployment, for when the government did intervene, it added to the economy's woes.

Barro now concludes that all government intervention is wrong and that Keynes's policies are theoretically and empirically flawed.

In contrast, as Friedman has shown that government intervention made things worse, it follows that all government intervention is damaging and that markets should be left free so that they can find their own solution.

Now I am in sympathy with Barro's general conclusion. I too like free markets, but I find Barro's logic defective to the point of incomprehension. It is surely unreasonable to condemn the principle of government intervention on the grounds that government intervention can from time to time worsen a situation.

To conclude from a particular analysis of Friedman's to the general conclusion that all government intervention is bad, reflects a line of reasoning that Hume would have condemned.

As I have said above, I have no difficulty in supporting Barro's advocacy of free markets. But, as a businessman, I am always amazed at the lack of experienced knowledge economists display about how business decisions are made.

The notion that the Great Depression could have been caused by credit contraction is as absurd as the present day argument that an increase in liquidity will lead to expansion.

Japan has surely demonstrated that a mere willingness of a government to expand credit is no reason for concluding that its country can pull out of a slump. Pointing out this limitation of monetary economics was one of Keynes's achievements as an economist.

However this did not make him a non-monetarist; what he recognised was that the process of investment required more than a simple monetary solution.

Every time there is an impasse between low interest rates and insufficient activity, one has to ask oneself the cause.

It may well be, either that interest rates are insufficiently low or that banks are contracting credit when they should be expanding it, but that in itself is not likely to be the final answer.

At the heart of the problem it has to be recognised that no project that has an outcome in the future can guarantee a return. For businessmen that element of uncertainty can assume different sizes at different times.

At a time of depression it might seem improperly large while in booms it may seem small.

Since private sector investment must depend on the assumption that whatever the outcome of the project, it must only be undertaken if at the outset it can be calculated to show a profit, during slumps private sector investment, even sound private investment, cannot be calculated as anticipating a profit.

Now in the case of governments, the necessity for calculating profits at the outset does not exist. It is always possible to justify investment by distinguishing between social benefits and arithmetically calculated profits.

Of course, this can lead to many unproductive activities, but strict calculation does not have to be the determinant force behind government intervention.

That is not so when it comes to business activity. As Friedman has pointed out, banks contracted credit during the Great Depression as a defensive "Sauve qui peut" policy.

The point at which banks came to contract credit during the Great Depression was precisely when there were some small signs of recovery and the banks interpreted this as an opportunity to reduce their losses.

Keynes would not have seen this as government intervention but quite simply as a case of the authorities emulating the private sector. For Barro to draw the conclusion that this was a failure of government intervention is to stretch a thin piece of rubber; and for him or Friedman to deploy credit contraction's by the banking system as an example of failure of Keynesian interventionist policies is to stretch the rubber to breaking point.

For essentially what Keynes advocated was expansionist policies; if this required government intervention he did not object to that, for he recognised that the private sector could not be expected to expand if there were serious apprehensions that the possibilities of losses outweighed the hope of profits.

It is valid to criticise these expansionist policies by bringing forward the oft-stated view that the pursuit of expansion can be destabilizing and eventually counter-productive.

However it is this very drive towards expansionism that has enabled China to develop its economy so swiftly. There are probably many dangers, many possibilities of destabilising their economy that lurk behind Chinese expansion, but it is hard to deny the consequences.

China, for whatever reason, with all the disadvantages of financing losses, is now moving ahead at a pace that makes it a world leader in development and a rising force in world trade.

India too has a choice; we have to decide between either concerning ourselves with the instability of government finances or with the promoting of development at a faster pace.

The path that Barro and other traditional economists want to follow, namely complete reliance on the private sector, is now unavailable probably to any nation in the world and was so even in Adam Smith's day.

The alternative to rapid expansion, whatever the resulting fiscal deficits, are through government spending for expansion.

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