Wednesday, 27 October 2010

Economic Theory & The Cuts - Part 3

The Cuts, in so far as they threaten to send the economy into a serious recession, are not in the interests of Big Capital, but addressing the problem of reducing the Value of Labour Power, in the West, as part of a strategy to make it more competitive, so as to restructure and rebalance western economies, in order to restructure and rebalance Global Capitalism, is in the interests of Big Capital. Its in that context that policy formation has to be analysed, at the same time as analysing the complex of contradictions that exist between Party, Class and State, and between different fractions of Capital within and between States, and the contradictory interests of States within the global social relation that is Imperialism. Trying to understand the Cuts, or any other aspect of Government policy, according to a method of crude determinism, and superficialities, is bound to lead to error. The truth is always concrete.

The question that has to be addressed then is, to what extent do the Cuts threaten to send the economy into a tailspin. Once again, it is perhaps easier to understand this discussion with the aid of a graph, this time Keynes' graph setting out the basic relationships between Expenditure and Income, and the part played by Consumption, Investment and Saving.

Economists do not argue over the relationships set out in this diagram by Keynes, which is essentially descriptive. The disagreements come over the policy prescriptions drawn from it. What Keynes says, and what the diagram illustrates is that Expenditure and Income are equal. It should not matter whether we calculate the GDP on the basis of all the Expenditures within the Economy, (by Consumers, or Firms), or whether we calculate it on the basis of Incomes (in the form of wages, rent, interest and profit) because all of the latter are payments earned as a result of the sale of goods and services, which make up the Expenditure figure. However, Keynes recognised the fallacy of Say's Law, (actually developed by Mill not Say) which says that Supply creates its own Demand i.e. that markets will always clear because the incomes earned in production will be used up in purchasing goods and services, provided the market is allowed to adjust relative prices accordingly to ration Supply. As soon as society moved beyond barter, that is the act of production and consumption were completely separated, this no longer holds. Producers can sell their products, but have no necessity to immediately spend the proceeds of the sale, in another purchase. Money allows them to save instead. Consequently, he deals with this by making Saving equal investment, and includes under the term investment, any increase in inventories. That is, if firms find they have fields of unsold cars, this increase in inventories, is classed by Keynes as “Investment”.

The line, which runs up at 45 degrees from the origin, is a line which symbolises this equation of Income with Expenditure. At any point on it, a line down to Income, or across to Expenditure will result in the same amount of money. The other two lines show how Consumption rises with income. The angle of this line is determined by what is called the Marginal Propensity to Consume. In other words, if on average, people spend 90%, of their earnings on Consumption, and save 10%, then the MPS is equal to .9. That means that for every £1 billion of new income, in the economy, £900 million will be spent, and £100 million will be saved. However, precisely because of the relation between Income and Expenditure. If this £900 is spent on consumption, that means that £900 million is received as new income by those firms and workers producing these goods and services. That means that rather than £1 billion of new income in the economy, we now have £1.9 billion. But, similarly, this additional £900 million of income will result in 90% of it also being spend or £810 million, and so on until we reach zero. In fact, this “multiplier effect”, will mean that if the MPC is .9 then any new income in the economy will result in income and expenditure increasing by 10 times that figure. But, don't get carried away just yet, the last estimates I saw for the multiplier in the UK was for a figure not of 10, but of more like 1.2.

But, another reason that it is difficult to assess exactly what the economic consequences of the Cuts will be is that it is clear from this figure that the Marginal Propensity to Consume is not the same for everyone. Someone earning £750,000 a year, might only spend a quarter of that, saving the rest. But, someone on Income Support is likely to need to spend all of it, and more besides! Just from a consideration of economic efficiency, the Tories proposals, which target the Cuts on the poorest in society rather than the richest are badly aimed, because they will result in a bigger proportionate fall in spending, and therefore of income, and economic activity.

The other side of this equation is the saving. Because Saving = Investment, as National Income rises, it is not just Consumption that increases. Alongside it, the saving is also matched by an increase in Investment, as firms spend money buying machines, factories, and materials – and building inventories. These two things Consumption and Investment form the basis of the total demand (Aggregate Demand) for Goods and Services within the economy.

But, another consequence of the equation, between Income and Expenditure, is that, given an average figure for Income per head, it is possible to calculate what the level of National Income would have to be for there to be Full Employment. Consequently, according to Keynes, if there is not Full Employment, it can be achieved by raising National Income to the necessary level, and National Income can be raised by increasing Expenditure to that same figure. There are a number of ways that Expenditure (Aggregate Demand) can be raised. One way is to promote additional demand from overseas, by increasing exports, or encouraging Tourism etc. Additional foreign investment in new factories, mines etc. would have the same effect. But, of course, Governments cannot control, only encourage these things, and if other countries are facing difficulties, exports might fall not rise etc.

But, Governments CAN directly affect the amount of spending that takes place within the economy. If consumer spending is too low, and therefore, saving is high, leading to firms increasing inventories, then the Government can cut taxes like VAT. This will encourage people to spend rather than save, and the spending will create additional income, which will in turn promote additional spending and so on. It can increase taxes on unearned income, which will dissuade saving, and encourage spending, or as Charlie Bean admitted recently, it can use its control over interest rates to penalise savers, in order to persuade them to spend instead. But, in a market economy, there is no guarantee this will work. In Japan, interest rates have been near zero for a decade, yet saving remains very high. The reasons can be many fold. Firstly, in Japan there has been prolonged deflation – prices continually falling. As I pointed out in my blog Why Charlie Bean Could Be Disappointed, with house prices falling like a stone, one of the major items that households spend money on, housing is deflating rapidly. In September, house prices fell 3.6%. That's more than 40% a year, which is a better return on your money than you would get from many high risk investments. You are not going to worry about only getting 2% p.a. Interest on your money, if, in effect, by leaving it in the bank, it has become worth almost twice as much in terms of the house you could buy with it! That's what happened in Japan with all prices.

If, the Tories send the economy into a serious recession, or if Mervyn King was right in his warnings that a continuing Currency War, which is a direct result of various states introducing austerity measures at home, whilst trying to maintain economic activity by exporting under cover of a devalued currency, threatens a repeat of the 1930's, then that kind of deflation suffered by Japan will become widespread. Attempts to reflate the economy by printing money will fail, as they did in Japan, because as Keynes pointed out, in such an economy, where no one has a demand for that money, Monetary policy becomes like pushing on a piece of string. Velocity slows down, as, however, much money the Government prints, it simply gets stored up in bank vaults, waiting for someone to want it. Under such conditions the only economic agent that can have the will to step in to borrow that money and put it to use, is the State.

Consequently, another line can be drawn on the graph in addition to the Consumption and Investment lines, and that is a line representing State Expenditure. By stepping in to spend money, the State can raise the level of Aggregate Demand, thereby creating additional income, which in turn creates additional expenditure and so on, via the multiplier. That is what most States have done over the last two years in order to prevent the Financial Crisis leading to an uncontrolled economic downward spiral. But, the reverse is true, when the State takes demand out of the economy by reducing its spending, or by increasing taxes, that same mulitiplier effect acts to reduce income in the economy, and thereby further expenditure.

But, just as with the varying consequences on the Marginal Propensity to Consume of giving money to rich people or poor people, the consequences of taking money out of the economy will vary too. On this basis the Tories policies fail the test of economic efficiency too. The Tories have made no secret, from even before the election, that they intended to cut the Public Sector in those areas of the country, like the North-East, where the Public Sector accounts for a large part of the local economy. But, one reason that the Public Sector accounts for a large part of these economies, is because they have suffered decades of low growth in the private sector going back to the 1920's. Aside from small pockets, they have high levels of deprivation, and low living standards. The Public Sector is not the cause of the lack of a private sector in these areas, but a response to that absence of the private sector. It is an application of the kind of Regional Economic policy that the EU could, had it been a rational Federal State, used over the last 30 years, to develop its periphery in Greece, Spain and so on, so as to avoid the current crisis of the PIIGS. In fact, were it not for the Public Sector in places like the North-East, much of the private industry that exists there would not have developed either. Consequently, removing Public Spending in these areas will have a far higher proportional effect than will Cuts of a similar amount in say the South-East.

An immediate effect will be that companies that depend on the Public Sector for contracts will go bust, and many more will barely scrape by. Their workers will be thrown on the dole. Given that these workers will more predominantly be those on low pay, with a higher than average MPC, the multiplier effect of that on the local economy will be more pronounced than in more affluent areas. The extent to which this will affect the private sector, and not just small companies, should not be underestimated as a result also of the effect of CCT and Best Value during the 1990's. The bloke who lived next door to me was a brickie with Stoke Council. That is until one day he come home in a Keir Van, because they had taken over all the Council's Direct Works. Now, everywhere you look you see Keir Vans, because the company has taken over much of that work for the Public Sector. At the Council where I worked all of the Grounds Maintenance work had been privatised in the early 90's, and what was left of other services such as the Sports centres was heading the same way.

Back To Part 2

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