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Summers, Secular Stagnation and Aggregate Demand Deficiency

Posted by Alex M Thomas on 28th February 2015

The foundations of a coherent theory of activity levels were first put forth by Kalecki and Keynes in the 1930s. Their economic theory states that an economy’s output levels are determined by aggregate demand and that there are no economic forces which ensure full employment of labour or the full utilization of capacity. In other words, aggregate supply adapts to aggregate demand. This principle was then extended to the question of economic growth, most notably by Roy Harrod. Subsequent work in this line of enquiry suggests that growth is demand led, as opposed to the mainstream/neoclassical view of economic growth as supply driven.

The idea of secular stagnation, recently articulated and advocated by Larry Summers, will be critically appraised in this blog post amidst the above backdrop. Here, we almost exclusively focus on Summers’ 2014 paper in Business Economics titled ‘U.S. Economic Prospects: Secular Stagnation, Hysteresis, and the Zero Lower Bound’. The principle (also simultaneously a policy prescription) of secular stagnation can be stated as follows: since interest rates have reached their lower bounds and aggregate activity levels are depressed, the solution is expansionary fiscal policy. Why are aggregate activity levels depressed? Secular stagnation suggests that negative fluctuations re-quilibrate the economy to a position characterised by lower output and employment levels. Moreover, ‘the amplitude of fluctuation appears large, not small’ (p. 65).

Macroeconomic equilibrium is characterised by equality between actual and potential output. According to Summers, ‘essentially all of the convergence between the economy’s level of output and its potential has been achieved not through the economy’s growth, but through downward revisions in its potential.’ (p. 66) This is because of aggregate demand insufficiency. ‘The largest part [of the downward trend in potential] is associated with reduced capital investment, followed closely by reduced labor input.’ (p. 66) To put it differently, aggregate demand deficiency leads to the unemployment (and underemployment) of labour and underutilization of capacity.

Despite Summers’ correct identification of the problem, his marginalist conceptualization forces him to connect this with the ‘equilibrium or normal real rate of interest’ which equilibrates saving and investment. As a consequence, he argues that a ‘significant shift in the natural balance between savings and investment’ (p. 69) has occurred. This post will only state that the idea of the rate of interest being sufficiently sensitive to changes in planned saving and investment is one that has been severely criticized and rightly so. [A follow-up post will examine this matter more closely.]

Towards the end of the paper, Summers makes a point which Keynes (and Kalecki) made in the 1930s: ‘We are seeing very powerfully a kind of inverse Say’s Law. Say’s Law was the proposition that supply creates its own demand. Here, we are observing that lack of demand creates its own lack of supply’ (p. 71). However, Summers states this as a contingent principle and not a general proposition as it is in Keynes (or Kalecki). This is not surprising given Summers’ economics being marginalist in nature.

Therefore, since demand creates its supply, Summers advocates public investments and vocally states the counterproductive nature of fiscal austerity. Furthermore, he hypothesises that ‘increases in demand actually reduce the long run debt-to-GDP ratio’ (p. 73). Lastly, he favours policy measures which place ‘substantial emphasis on increasing demand as a means of achieving adequate economic growth.’

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Posted in Economic Growth, Economics, Employment, Government, Keynes, Macroeconomics, Marginalist economics, Michal Kalecki, Neoclassical Economics | No Comments »

The Macroeconomics Underlying the Economic Survey of India 2013-14

Posted by Alex M Thomas on 10th November 2014

This blog post critically evaluates the first two chapters of the Economic Survey of India 2013-14 in order to get a sense of the macroeconomic theory underlying it. [This blog has assessed previous ones for the years:2012-13,2009-10;2010-11;2011-12.] What conceptual framework does the Economic Survey adhere to, implicitly and/or explicitly? This is of significance not just for those interested in theory but also for those who want to understand how economic policies are formulated. Attention will be mainly divided among the following macroeconomic themes: (1) role of investment in economic growth, (2) labour market flexibility and economic growth, (3) policies emanating from (1) and (2), and (4) the overarching aim of economic policy.


It is well-known and widely accepted that investment, be it private or public, is necessary for economic growth. By investment, we primarily refer to additions to fixed capital – machinery, tools, storage facilities, transport equipment, etc. Investment in education, health and environment should also be included, for they expand the productive capacity of the economy in the long term. Two questions may be posed now. First, what is the source of investment? Second, what ensures that the growth in productive capacity will be matched by an equivalent growth in demand?

Prior to the path-breaking work of Keynes, it was widely believed that investment is savings constrained and that saving and investment are equilibrated through variations in a sufficiently sensitive interest rate. Keynes convincingly argued that investment is not savings constrained, rather, it is finance constrained. Moreover, he demonstrated that it is activity levels (output and employment) which equilibrate saving and investment, and the causation runs from investment to saving. This is the principle of effective demand, also to be found in the work of the Polish economist Kalecki. The Economic Survey adopts the pre-Keynesian view, which, not surprisingly is still around, embedded in the neoclassical school of economics – the dominant school in economics teaching and publishing. This marginalist idea of saving-investment equilibrium is mirrored by the market equilibrium for ‘capital’ – the demand for and supply of capital is brought into equilibrium by variations in the interest rate; this is nothing but the marginal productivity theory of distribution.

Implicit in the Economic Survey is the pre-Keynesian view, an essential part of neoclassical economics. ‘…higher investment required for raising growth had to come from higher domestic savings…’ (p. 9). However on p. 11, the slowdown in investment growth is attributed to policy uncertainty, sluggish demand and high interest costs. Despite the reference to demand deficiency on the same page (on p. 13, it is acknowledged that an increase in aggregate demand has a positive impact on economic growth), the conclusion on the same page supports ‘structural reforms’ and the elimination of ‘supply-side bottlenecks’. Also, Keynes’s finance-constrained investment view is expressed when the ‘bank credit flow to industry’ is briefly discussed (p. 25); due to sluggish demand, the demand for credit was lower. [See an earlier post on the determinants of investment.]

Income earners make saving decisions (commonly referred to as households or wage earners) whereas it is the firms and entrepreneurs who make investment decisions in a decentralized economy as India. Firms also make use of their retained earnings for purposes of investment (p. 14). The intermediation of saving and investment is carried out via the banking and financial system – the suppliers of credit, so to speak. The point I wish to highlight is this: abundant savings or a low rate of interest is not sufficient for (physical) investment. There should be demand for the commodities and services produced. Also, there are no mechanisms which ensure that supply will create its own demand, famously known as the Say’s Law. At various points, it appears that the architects of the Economic Survey believe in the Say’s Law. In other words, they do believe that a growth in productive capacity will engender an equivalent growth in demand.

Policy uncertainty & investment

Policy uncertainty emanates from ‘difficulties in land acquisition, delayed environmental clearances, infrastructure bottlenecks, problems in coal linkages, ban on mining in selected areas, etc.’ (p. 11; also see p. 33). This particular statement is reflective of a view which does not take common property resources, ecosystems and environmental sustainability seriously and with caution. The uncertainty in policy vanishes when the government is clear, transparent and committed to socio-economic and environmental justice. Policy uncertainty arises from vague, untimely and arbitrary policy decisions. In fact, this approach to securing higher economic growth is inconsistent with the position adopted in the Economic Survey on sustainable development and climate change which, on paper, appears committed to environmental justice and inter-generational equity. And it is such inconsistencies which cause confusion and policy uncertainties for firms wishing to invest in India.


The marginalist growth theory (Solow’s growth model being the exemplar) makes use of the marginal productivity theory of distribution. Put simply, a growth in the factors of production (or factor endowments) is sufficient for economic growth. And, supply creates its own demand. According to this view, widely taught in macroeconomics courses, growth is supply-side. The impediments to growth then become imperfections in the factor markets, particular labour markets. Consequently, policy is supposed to make labour markets flexible/free/perfect so that the economy can gravitate towards the full-employment position. But, this theoretical view has been shown to be unsatisfactory given the logical problems associated with the marginal productivity theory of distribution. In addition, the creation of a just society must necessarily ensure a minimum wage for all workers sufficient for a decent living, the scope of which ought to widen as societies progress.

According to the Economic Survey, ‘[t]he inflexibility of labour markets have prevented high job creation’ (p. 30). For those brought up in the marginalist tradition, the usual culprit is the labour market. Of course, labour laws, like any other law, should be just and provide opportunities for workers to support each other given that the employers are more powerful than the workers. Also, working conditions, social security, equal opportunity across gender, caste and class and so on must be provided to the workers. This is the responsibility of institution builders – the government together with the civil society. Yes, labour market reforms are necessary: ‘changes in the legal and regulatory environment for factor markets’ (p. 31).

Reforms, unfortunately, have come to possess a single meaning in economics and politics. Reforms have come to refer to policies which make markets more free. There is no reason why reforms need to be thought of in this manner. Politics is about possibilities, and economics suggests some ways of engineering these possibilities in order to provide a decent life to all. There is nothing intrinsically good in any economic or political sense about reforms. The efficacy and goodness of reforms lies in its details.

‘Factor markets such as those for labour, land, and capital, however, remained largely unreformed. This has proved to be a constraint for growth and employment generation’ (p. 48). This statement also is very marginalist or neoclassical in nature. Moreover, one has to be cautious for the three factors of production are very different from one another. Capital refers to produced means of production – commodities and services. Barriers to entry and exit need to be reduced and firms need to operate in a competitive environment. Land is a resource which needs to be treated very carefully and on a case-by-case basis; it has immediate impacts on livelihood as well as on the natural environment. Labour market constitutes people, and there should be strong social security for workers and good working conditions.


Policy prescriptions include primarily supply-side measures. This is not surprising owing to the Economic Survey being fundamentally neoclassical. Investment, a component of aggregate demand, is rightly considered crucial. But, public investment is not much favoured. Investment, as noted in section I, will be revived if supply bottlenecks are removed – that is, projects get easily cleared. Policies are targeted at boosting productivity. Provision of physical and social infrastructure is of utmost importance. A market for food (reducing distortionary interventions in agriculture) needs to be created. Manufacturing must be improved.


What is the central aim of these economic policies? Repeatedly, in these two chapters, the objective is to create a ‘well-functioning market economy’ (p. 29; also 26, 46). This is much needed, but the ‘reforms’ need to be socially and environmentally sensitive. Also, just as with reforms, many different configurations of a market economy are possible. This must not be forgotten, and nor should social, economic and environmental justice be overlooked. To conclude, I would add a few words to the first sentence in chapter 2: ‘The defining challenge in India today is that of generating employment and growth’ (p. 29) which is economically, socially and environmentally inclusive. These additional words make all the difference, both in terms of economics and politics.

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Posted in Economics, Employment, Government, India, Macroeconomics, Marginalist economics, Neoclassical Economics, Supply side economics | No Comments »

Principles of Banking: A Review of a Review of Adamati & Hellwig’s The Bankers’ New Clothes

Posted by Alex M Thomas on 7th September 2014

The capacity of an economy to grow is dependent on the nature of financial institutions besides other factors. Financial institutions, particularly banks, channelise savings (via deposits) into investment (via loans for economic activity). That is, they play a vital societal function. Hence, Roger Myerson, the author of the review essay, writes: ‘So there is an essential role for public regulation of banks: to maintain stable trust in channels of credit that are vital to our society’ (p. 197). This blog post is a review of a review essay of Admati and Hellwig’s The Bankers’ New Clothes: What’s Wrong with Banking and What to Do about It by R. Myerson in the Journal of Economic Literature.

Banks are unlike other economic entities. Manufacturing firms do not require public trust to carry out their daily operations in the same way as banks do. If the public find the banks to be untrustworthy, no deposits will be made and nor will anyone borrow. This affects the saving-investment intermediation and consequently other ‘real’ economic activities (agriculture, manufacturing and services) are affected. What happens in the banking system does not stay within it but it both directly and indirectly impacts other parts of the economy – a financial contagion, as it is called. Thus, banks need to be publicly regulated. And, as Myerson points out, ‘the reliability of any regulatory system must depend on broad public monitoring of the regulatory process itself’ due to the vast wealth involved in the business of banking (p. 198). This is not all. According to Myerson, ‘any meaningful financial regulatory reform must include a clear explanation of its principles to millions of informed citizens and investors’ (p. 198).

For Amati & Hellwig, the problem is that bank owners have lost the incentive to keep their banks afloat. Why is this so? First, the owners’ stake in the bank’s investments has dwindled. In other words, banks possess less equity. Equity is the difference between the value of assets or investment the bank owns and all the debt liabilities the bank owes to its depositors and other creditors (p. 198). From about 25 percent equity capital in early 20th century, it fell to about 3 percent or less in 2008 (pp. 198-9). A large value of equity capital signals to the depositors that their deposits will be safe. This provides reassurance due to two reasons – (1) ‘the probability of investment losses large enough to affect the depositors become smaller when the bank has more equity’ and (2) ‘the owners who control the bank have more incentive to avoid risks of such large losses’ (p. 199). The second reason for a decline in bankers’ incentive is the ‘creation of government deposit insurance programmes in America and elsewhere’. Now, the risks of the owners of the banks get transferred to the government and therefore to the tax-paying public. Hence, as Myerson writes:

…when creditors are publicly insured, bank default risk becomes a public problem. Thus, the requirement that banks should have adequate equity has become a responsibility of public regulators. (p. 199)

Given the wider economic function banks play and the contagion effects, it is important that banks are not allowed to fail. Admati & Hellwig recommend banks’ equity levels to be 20-30 percent of their total assets (p. 209).

A firm can finance its investment by issuing debt or equity. The proportion of equity to total liabilities (sum of equity and debt capital) matters because the risks are borne by different groups. Government deposit insurance enables banks ‘to borrow at low rates that do not properly respond to the greater risks that their creditors must pay when the bank has less equity’ (p. 200).  Also, financial fragility intensifies if tax laws encourage financial institutions to use more debt than equity in financing investments (p. 201).

When short on cash, the banks go to the Central Bank, the lender of last resort, for assistance. It lends only to solvent banks. An assessment of solvency requires the Central Bank to be able to assess the assets of the bank – whether its collateral is ‘good’ and whether it has positive equity (p. 202). This also points to the importance of capital regulation for banks as it is ‘fundamental to liquidity’. A slight digression is in order here. Owing to the fundamental role of liquidity in all economic processes, the provider of liquidity ought to be publicly controlled. In fact, as Myerson rightly states:

…the role of monitor and lender of last resort should be recognized as a vital natural monopoly, maintain costly expertise to provide public information, but with monopoly power that should be publicly controlled. (p. 203)

The lender of last resort is therefore consequent on the central banks’ ability to monitor the equity of banks. Thus, measurement (financial accounting, imputing values, risk weighting and so on) assumes great importance (pp. 203-9).

To conclude, banks perform a fundamental socio-economic function in channelling savings into productive investment. The ability of banks to conduct their business depends on public trust. Public trust in turn depends on the proportion of equity capital to total liabilities which is deemed acceptable by the financial regulator. This acceptable ratio is computed by private experts who do not fully take into account the social cost of a low ratio. Given the high possibility of moral hazard in banking and the threat of financial contagion, it is imperative that there is public regulation of banks with the principles made transparent to the tax-paying public who have a direct stake as savers and an indirect stake as contributors to the deposit insurance.

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Posted in Economics, Government, Macroeconomics, Monetary Economics | No Comments »

Some Thoughts on Debt: The Indian Case

Posted by Alex M Thomas on 30th April 2014

Any entity, private or public, needs to borrow if its expenditure exceeds its income. The difference between expenditure and income will then be the volume of debt. This post discusses the following: the meaning and role of debt, a brief overview of various kinds of debt, the fundamental difference between private and public debt, the structure of the Indian debt market, corporate debt and government debt in India. The post ends with some reflections and suggestions.

It is public or government debt which receives maximum attention in the media and rightly so.  Some of the other kinds of debt are external debt (the proportion of a country’s debt borrowed from foreign lenders), household debt and corporate debt. Households borrow money in order to meet various needs such as the purchase of assets, for purposes of education, for medical expenses, etc. Corporate debt refers to the excess of expenditure over income which is financed through borrowing (via issuance of bonds and debentures) by the private non-bank sector. In India, besides these different kinds of debt, agricultural indebtedness has received significant attention from academics, policy makers and political agents. A market for credit is important not just for long-term asset purchases or constructing plants but it is also important for daily business transactions, and today, also for usual consumption needs. One needs only to look at the booming credit card industry for confirmation.

There is an overwhelming tendency to impose rules of finance employed by households on the government. This is fallacious. As individuals, we try to live within our means; we borrow reluctantly. Agricultural farmers, industrial firms and service providers need to borrow too. For, it is unlikely that every person who wants to start an enterprise will possess the required funds. If that were so, the meaning of entrepreneurship would have been different from what we know it to be. Similarly, for a government (central, state or local), which is expected to conduct policies which have social and environmental benefits, it becomes necessary to borrow. Taxation incomes are seldom sufficient to meet the recurring and capital expenditure of the government. Moreover, social programmes relating to education, employment, environment, food and health have very long gestation periods. The point is that government bodies (Ministry of Consumer Affairs, Food and Public Distribution, Ministry of Agriculture and Ministry of Drinking Water Supply and Sanitation to name a few) are not profit-maximizing bodies; but, this does not imply that they can be inefficient or irresponsible. By virtue of the fact that they are democratic bodies and because their incomes and borrowing are mainly from households (the voters), it is imperative that their functioning is transparent and organizationally efficient. Government borrowing or public debt is not, or rather, should not be, synonymous with organizational inefficiency.

The sovereign debt in India is issued by the Central and State government. The instruments include Treasury bills, Index bonds and zero coupon bonds. Government agencies, public sector undertakings (PSUs) and government owned banks issue debt instruments – bonds, debentures, commercial paper (CP) and certificate of deposit (CD). The private sector comprising the non-bank corporate sector and private sector banks issue bonds, debentures, CPs and CDs. In advanced economies, the debt market is the preferred route for raising funds. However, in India, the equity market is more preferred than the debt market, and government securities dominate the Indian debt market. [For more details, see the 2004 SEBI working paper no. 9 titled ‘Corporate Debt Market in India: Key Issues and Some Policy Recommendations’. Conditions are changing and more corporate debt is being issued, as a more recent (2013) CRISIL document indicates.]

A 2013 Credit Suisse report on India’s financial sector pointed out the high growth in the debt levels of ten corporate groups – Lanco, Reliance ADA, GVK, Jaypee, Adani Enterprise, Essar, GMR, KSW and Vedanta. Despite profitability pressures, their debt levels rose between 2012 and 2013. Also, 40-70% of the loans are foreign currency denominated. Delays in their planned projects can cause further strain on their cash flows and therefore on their debt servicing ability. Some of them have undertaken asset sales, but they have proved insufficient. Indian banks need to be concerned as well; although, majority of the non-performing assets (NPAs) are from agriculture and small & medium enterprises (SMEs). In 2014, the International Monetary Fund sounded a warning too.

The debt-to-GDP ratio is more important than debt levels themselves. Why is this so? This is because an economy whose GDP is growing faster than its growth in debt will not face the problem of repayment. However, if the GDP grows at a smaller pace than debt growth, the economy will not have adequate surplus (aggregate output net of replacement) to repay the debt. This is what we mean by debt sustainability. In early 2014, the credit rating agency, Moody’s warned that India’s sovereign rating can be affected due to the slowdown in growth and high inflation. [In so far as public authorities, via the central bank, can create money ex nihilo, debt can always be repaid (referred to as monetising the debt). However, this is the case if and only if the public debt is denominated in the local currency. In India, most of the public debt accrues to Indians and is therefore denominated in Rupees.] The following chart compares debt-to-GDP ratio of India with three advanced economies – Australia, UK and US.


Data from World Bank

Clearly, advanced economies have different debt-to-GDP ratios (also see this link for data on OECD countries). In short, there is no economic reason why a high debt-to-GDP ratio is bad for the economy; it is the growth in the debt-to-GDP ratio that must be closely monitored and appropriate measures undertaken to ensure that the economy grows at a faster pace than the growth in debt. As previously noted, government expenditure on education, environment and health have long-term positive benefits (significant positive externalities). Over time, these expenditures will boost economic growth and will therefore aid in debt repayments. Of course, the returns from any investment – private or public, depend on the effectiveness of the project undertaken such that they generate the expected yields.

The financial liabilities of the household sector have also risen over time, due to the attractive home loans and increased ease of obtaining credit cards. All economic agents – be it households, corporate bodies or the government, often (and have to) resort to borrowing. This post has shown that the borrowings undertaken by the Indian household sector, the Indian corporate sector and the Indian government have grown over the years. This, per se, is, and should not be a cause of immediate concern. However, this does warrant a more detailed analysis of the ability of the Indian government to make debt repayments, which hinge crucially on the rate at which the Indian economy grows and its rate of inflation. A serious macroeconomic analysis, perhaps based on the economics of Domar, Keynes and Lerner is in order.

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Posted in Economic Growth, Economics, GDP, Government, India, Keynes, Macroeconomics | No Comments »