Tag Archives: Politics of Full Employment

Introductory Macroeconomics: On Crowding Out

Macroeconomics textbooks and journalists write in earnest about the crowding out effects of fiscal policy. Government expenditure is widely believed to displace private investment by raising interest rates which increases entrepreneurs’ borrowing costs. On this basis, governments have been ordered to cut down expenditure. Government deficits are identified as the cause of decreasing private investment as well as for creating inflationary pressures in the economy. This blog post argues that crowding out occurs under special circumstances – (1) when the economy is at full employment and (2) money supply is exogenous. In fact, when the economy operates at less than full employment and money supply is endogenous (that is, the central bank conducts monetary policy by adjusting the interest rates and the quantity of money endogenously adjusts to the demand for money at that set interest rate) government expenditure results in crowding in.

The crowding out argument can be represented with the help of the IS-LM diagram. IS refers to equilibrium in the goods market (quantity demanded = quantity supplied). LM refers to equilibrium in the money market (money demand = money supply). The intersection of the IS and LM curves gives us the equilibrium output and interest.

When government expenditure increases, IS curve shifts outwards. Both output and interest rates increase in an exogenous money model (upward sloping LM curve). The automatic increase in interest rate because of government expenditure is then said to result in crowding out of private investment.

Next, we look at interest setting monetary policy (with endogenous money) using the framework of IS-LM. In this case, LM is horizontal because the interest rates are set by the monetary authorities keeping in mind their inflationary target. This scheme is more realistic given the role played by Central Banks today. Interest setting monetary policy can be represented in an IS-LM framework as follows.

The goods market is also referred to as the real sector and the money market as the financial sector. We additionally assume (as is the case with not only the Indian economy but many other economies) the economy to be in a less than full employment position. If the economy operates at full-employment, increase in government expenditure will undoubtedly lead to inflation. In fact, an increase in private expenditure will also create inflation in a full employment set-up. In this realistic model, let us see what happens when there is an increase in government expenditure.

The diagram above clearly shows that an increase in government expenditure, represented as a shift in the IS curve does not raise the interest rates. The entire increase of government expenditure translates into increase in equilibrium income. That is, there is zero crowding out in this case as the economy operates at less than full employment. The increase in demand for money is met by endogenous increase in the supply of money through credit creation. In short, fiscal policy has no systematic effect on interest rates in a setting wherein the interest rates are set by monetary policy.

Therefore, it is clear that the basis of crowding out argument rests on the unrealistic assumptions of (1) full-employment positions and/or (2) exogenous money. Ordering the Indian government or other governments to cut back their expenditure by the IMF or by the ‘top’ economists therefore lacks a sound basis. The role of the government in aiding an economy towards its full-employment levels therefore can never be reiterated enough. Moreover, it is an argument which is based on sound economic principles.

Reference

Smith, Matthew (2012), ‘ECOS 2002: Intermediate Macroeconomics’, Lecture Notes, University of Sydney.

 

Employment: The Neglected Variable

Today, the issue of employment receives attention in public discussion mainly because of NREGA. It is economic growth or GDP growth which is given prominence in most policy documents. In economics, employment generation and related aspects form a part of macroeconomics alone. Financial economics, international trade, monetary economics, etc hardly comment on the issue of employment. Increasingly, the question of employment is getting less attention in most academic and policy oriented discussions. This post attempts to revive certain issues pertaining to employment. For this purpose, we revisit the 1943 paper of a neglected macroeconomist – Michal Kalecki. His paper straddles the fields of industrial economics, financial economics, public economics and macroeconomics, and provides insights regarding employment generation.

The generation of more employment, rather full employment, according to Kalecki, is beneficial to both government and capitalists. In addition, it also benefits the class of workers. Employment can be generated by capitalists or by the government. However, the government is restricted from generating employment because apparently government investment crowds out private or capitalist investment. In Kalecki’s words:

“The economic principles of Government intervention require that public investment should be confined to objects which do not compete with the equipment of private business, e.g. hospitals, schools, highways, etc. Otherwise the profitability of private investment might be impaired and the positive effect of public investment upon employment offset by the negative effect of the decline in private investment.”

It is for this purpose that we have Acts such as the FRBM Act to ensure sound finance. This Act regulates and limits the employment generation capacity of the government. As for the corporate sector, they never support public investment. Hence, the employment generating capacity gets solely determined by the corporate sector/capitalists.

Kalecki questions this stance of the capitalists. For, full employment, as noted above, clearly benefits the capitalists by providing them greater profits. He argues that it is the “political realities” associated with the maintenance of full employment which prevents the government and big business or capitalists from doing so. Given that the Government has to adhere to sound finance, largely, the capitalists determine the volume of employment in an economy. The capitalists tend to increase employment and output if they expect a good economic and political environment to be forthcoming. This environment is a dynamic and complex function of government policies, international events, political outcomes, etc. In economics, we call it state of confidence. Today, one factor which reflects this state of confidence is the bullish trend seen the stock markets. It is for this reason that, in India, SENSEX occupies such an important place in everyday news. Hence, the state of confidence assumes such an important role only in an economy where the government is supposed to maintain sound finance. As Kalecki points out:

“The social function of the doctrine of ‘sound finance’ is to make the level of employment dependent on the ‘state of confidence’.”

Similarly, on the politics involved in capitalists pressing for sound finance, Kalecki powerfully notes that:

“Under a laisser-faire system the level of employment depends to a great extent on the so-called level of confidence. If this deteriorates, private investment declines, which results in a fall of output and employment (both directly and through the secondary effect of the fall in incomes upon consumption and investment). This gives to the capitalists a powerful indirect control over Government policy: everything which may shake the state of confidence must be carefully avoided because it would cause an economic crisis.”

Thus, regardless of whether we agree with Kalecki or not, he provides an interesting way to examine the issue of employment creation; especially for the Indian economy where FRBM Act is taken seriously and because of the growing significance of SENSEX. Such an analysis also calls for greater interdependence between macroeconomics, public economics, industrial economics and financial economics on one hand and between economics, political science, sociology and culture studies on the other. The latter sort of interdisciplinary inquiry will provide descriptions of actual processes by which such “politics” take place. This analysis by Kalecki also revives the classical notion of “political economy” which understands that economics cannot be divorced from politics. For practical purposes, it is of utmost importance that we pay more attention to the variable – employment, in our economics curricula and debates, especially in a country like India.

References

Kalecki, Michal (1971), ‘Political Aspects of Full Employment’, in Selected Essays on the Dynamics of the Capitalist Economy 1933-1970, Cambridge: Cambridge University Press. (full text available at Monthly Review)

Further reading

Bhaduri, Amit (2006), ‘The Politics of Sound Finance’, Economic and Political Weekly, 4 November.