A printer stuffs a copy of the newspaper he has just printed under his arm before he leaves the factory. An off-duty air hostess takes advantage of a free flight to Hong Kong. A lawyer stands up in court to conduct his own defence. Notice anything strange about these activities?
Now that you mention it - I don’t, no.
Well, the workers are consuming what they themselves produce - a rare event nowadays. Usually we have no idea who makes the things we use: indeed the pattern of international production and consumption is so complex that just documenting the origins of everything that you use in one day would fill quite a thick volume.
Is that the kind of book you’ve been reading then?
Fortunately not. I don’t need to know where anything comes from providing I can pay for it. Money is the great lubricant of international trade - drawing in produce from all over the world - and should allow our own economies to run smoothly at high speed.
But as you might have noticed, the economic machine does stutter and cough a lot. Words like slump, recession, unemployment and depression sully our news bulletins every day’. Everybody should in theory be furiously buying and selling to each other all the time but every so often they seem to slow down, and, moreover they all tend to do so simultaneously - with disastrous consequences.
If factory owners decide they don’t need new buildings, for example, electricians and bricklayers and carpenters will be laid off. These workers in turn will have less money to buy corn flakes and beer and TV sets and shoes. So the workers in these cornflakes and beer industries too start to suffer and have less to spend on holidays and records and coffee. Before you know it you have a full-blooded downwards spiral.
Very nasty. But why did people stop wanting new buildings in the first place?
There could be many reasons. But to find a plausible one let’s look more generally at the various spending decisions that we take every day.
It is the spending of money, keeping it circulating, that makes our economies keep moving.
You probably spend almost everything you earn - and that makes the workers in all the other industries very happy because they then have the money to buy what you produce. But you also save - maybe five per cent of your income, maybe 20 percent. And if you stick that money under the mattress it will drop out of circulation. Just be saving in this way you will start a little downward spiral and make a lot of people very unhappy.
A little recession all of my own. I never realised I was such a creep.
You may not be. If you put the money into a bank someone else can then borrow it so the spending can go on and everyone can stay happy.
You mean someone else will use my money to buy cornflakes and beer? They’re eating my savings.
People who borrow money from the bank don’t usually buy booze or breakfast cereals with it. They know they are going to have to pay the money back eventually - as well as the interest - so they have to look for a way of using it that is going to give them income in the future.
So a shopkeeper might extend his premises, a manufacturer could find a fast new machine for making cornflakes, a taxi driver might buy a new taxi. What they are doing is employing your money to make an investment which they think will eventually pay off. Such investment still involves spending and will generate jobs and incomes for builders, for engineers, for taxi manufacturers so your money keeps circulating and people are kept busy.
Photo: Camera Press
But how do I know that my savings will be borrowed? I’m scared of causing a recession. I want to keep my money moving.
Deepdown I think you’re a wonderful person. But you could ask the banks to do the work for you. It’s their job to make sure that money is always employed so they play’ about with the interest rates. If there are savings which no one is borrowing they can always drop the interest rate to encourage investors. And if there are not enough savings to finance all the factories that people want to build or machines they want to buy, they’ can increase the interest rate to attract more savers.
Up until the 1930s this is the way that economists thought the market would work: that interest rates would always ensure that all the money’ saved would be used for investment and the money would keep moving. Then came the Great Depression and this theory’ crashed to the ground along with all the bankrupt businesses and suicidal stockbrokers. Half of America’s production was wiped out and a quarter of the workforce lost their jobs. It was a disaster for which the conventional economic wisdom of the day had no convincing explanation.
I have a feeling, though, that you have an explanation.
Actually I’m going to pass on the explanation offered by British economist John Maynard Keynes. In 1936 Keynes published the General Theory of Employment, Interest and Money in which he argued that there was nothing ‘natural’ about full employment at all. Employment could settle down at any level. The economy could stand still with millions of people out of work.
He focussed his attack on the assumption that interest rates would always change to balance savings and investment. He pointed out that investors might be reluctant to borrow money no matter how low the interest rates if they did not think that they would earn enough from them to pay the money back. They wouldn’t build a new factory if they didn’t think they could sell the produce.
Very sensible too.
Yes - from their point of view. But if the money sits in the bank it drops out of circulation and prompts the kind of downward spiral that we started out with when you put your savings under your mattress. This, to go back to an earlier question, is why people might have decided not to order new buildings in the first place. They might just have had a change of mood - a feeling in the water that people will not spend so much. It just requires a few people to become pessimistic about the future for investment to drop. This infects other investors and becomes a self-fulfilling prophecy - things do get worse.
But surely one or two people stopping building factories is only going to put a few people out of work?
No. It’s not just the builders who are put out of work. Don’t you remember? The effects are felt throughout the whole economy when money is taken out of circulation. There is what Keynes called a ‘multiplier’ effect. To see how this happens let’s look at a few figures.
Let’s suppose that there is an economy where $100,000 worth of goods are produced and sold each week - so there is $100,000 worth of income - one person’s expenditure becomes another person’s income. Let’s suppose too that the cautious workers always save 20 per cent of their income - so $20,000 a week is being saved (See the diagram above).
If investors are also borrowing $20,000 a week from the bank there will be no problem. The money will keep moving round and if somebody has a job they still have one the following week.
Now comes the setback. The owners of the factories and shops start to get nervous about the future - because of political unrest, say - and only invest $15,000. So $5,000 will have to stay in the bank.
In the next week of spending, therefore, there will only by $95,000 in people’s pockets - and some builders of factories might have lost their jobs.
But things don’t stop there. Those workers still with jobs can carry on saving 20 per cent of their income. In week two this will amount to $19,000. Investors, however, probably more nervous than ever only invest $15,000 in week two as well, so another $4,000 will get added to the savings in the bank. Overall spending and income will thus drop further to $91,000. And the income will keep on dropping, week after week.
A frightening prospect. When does it stop falling?
Fortunately it will stop. But stability will only be reached when the investors are taking up each week all the savings being created each week and that will not happen until savings are exactly what investors want - $15,000. So total income and expenditure will have to keep dropping until 20 per cent of it comes to $15,000 and that occurs when the figure is down to $75,000.
So you can see that a small drop in investment can have disastrous consequences for everyone’s income. But you can also see that a similar problem would arise if people - nervous perhaps about the possibility of losing their jobs - changed their behaviour and started to save more - say 25 per cent. So the spiral arises when ever spending is reduced - that is when there is what the economists call a drop in ‘demand’.
Wait a minute, I think I’m going to read all that lot again.
Fair enough, I’ll fill in here with a few dots... Now if the economy can only be stable when savings are equal to investment you can see that it might well stabilise at a very low level of income with a lot of people having lost their jobs. Economists used to think that the economy would tend towards full employment. Keynes’s breakthrough was to show that full employment would only arise if there was a remarkable coincidence - that all the thousands of investors chose to spend precisely the same sum of money that millions of savers had tucked away in their bank accounts.
Very. And fortunately he didn’t stop at just pointing out the problem. He also proposed a solution. If there was to be a hiccough in spending then the government should do something about it. It could, he said, encourage people to spend more or it could actually spend more itself.
The central plank in Keynes’ strategy was reserved for government spending. Governments normally collect the money they need through taxation and the spend it on things like education and road building. Keynes said that if private industry wouldn’t take up the savings then the government should borrow that money and spend it itself. It could build more hospitals - or pay teachers more. Or it could pay people to dig holes in the road and fill them up again. The important thing would be to keep the money moving round.
But that just means the government gets into debt. How is it going to pay it back?
If a government gets into debt by borrowing the savings of its own people this doesn’t really matter. The government is the people - or it should be. So it’s just like you moving money from one of your pockets to another. In any case it should be able to pay the money’ back if it can keep the economy expanding. If it borrows enough to keep people employed it will keep raking in their taxes and if this encourages other investors to expand too then the amount that the government can cream off in taxes will increase as output increases. So this kind of ‘deficit financing’ as it is called can be very productive all round.
Did governments take Keynes advice?
Yes they did. Most of the Western governments after the Second World War adopted Keynesian policies of ‘demand management’ - adjusting the level of spending to try to keep everyone employed and spending their salaries. I should add that there were other measures apart from changing government expenditure - like reducing taxes so private individuals could spend more. But taken together the tactics were very successful. Unemployment was kept down to most of the industrialised countries. That’s not to say that there were no economic crises. Many countries suffered from problems with their ‘balance of payments’ for example - an issue that we will return to some other day. But it was thought that the days of massive unemployment were over.
One shouldn’t exaggerate, however, the ease of applying the Keynesian techniques. Governments might not know precisely what was going on - or they might create too much demand, or too little. But generally speaking they were able to keep things moving in the right direction.
Half your life might be spent in a factory and the other half spent consuming what other factories have produced.
The constant circulation of money transforms other people’s expenditure into your income.
But some of the circulating money is saved so banks have to lend it out to keep the money moving.
When investors don’t want to borrow this money Keynes argued that governments should borrow the savings and spend them.
Keynesianism involves government intervention in the market to keep it working at full capacity.