How to Spend the Money

The ongoing financial and economic crisis has had at least one significant impact on the world of ideas: it has brought back to the forefront the recognition of the crucial role of government expenditure in stabilising economies and averting or mitigating recessions. It is true that the continued opposition of some leaders, such as Angela Merkel in Germany or some Republicans in the US Congress, suggests that it may not be true to argue that ”we are all Keynesians now”.  Nevertheless, the international acceptance of some of Keynes’ more important propositions has not been so widespread for at least three decades.  This in turn has meant that many arguments in favour of public spending that were jettisoned, or simply disregarded until quite recently, are now back in vogue.  And so at one level, proponents of such spending have less to prove.

One important Keynesian notion which has great applicability in the current context is that of the liquidity trap, in which banks are unwilling to lend to all but the most preferred and ”safe” borrowers, but such borrowers are in turn unwilling to borrow because of prevailing uncertainties.  The financial crisis spawned a ”credit crunch”, not only in the US where the crisis first broke, but also across the world, even in countries that at first had appeared to be relatively insulated.  A credit crunch is associated with fear and market uncertainty, when expectations are bearish and private agents (whether they are investors or consumers) are unwilling to take risks.  This means they tend to cut down on their own spending and prefer to save.  This paradoxically has the opposite effect of what is intended: since everyone spends less, economic activity slows down and reductions in output and employment follow.  So the depressed expectations become self-fulfilling and create a downward spiral or, at the least, an unemployment equilibrium.

In such situations, monetary policy typically has little effect in reviving economies.  Reductions in interest rate or easing borrowing conditions for banks cannot be indulged in beyond a point (the interest rate cannot go lower than zero, for example) and in any case do not ensure that banks who are in the phase of what Kindleberger called ”revulsion” will actually start lending normally.  So the clear requirement is for fiscal policy, for the government to maintain an expansionary fiscal stance that will pull the economy out of the downswing.  Fiscal deficits in such a context are not only acceptable but even necessary and essential to ensure economic recovery.

However, fiscal deficits too can come about in various ways.  One option is to provide tax cuts in the hope that this will reduce prices and thereby cause increased private spending.  This is indeed the route that several governments, including in India, have chosen at least to some extent.  But another insight of Keynes was that tax cuts too will have less of an impact than direct spending because of the depressed state of expectations.  Japan in the 1990s faced a prolonged recession: the government continuously provided both tax cuts and lower interest rates, but in a period of falling economic activity and very negative expectations of the future, people simply saved the money instead of increasing their own private spending.  Similarly, tax cuts that have been recently applied in several developed and developing countries have had very limited effects in terms of actually increasing aggregate demand.

Another way that fiscal deficits are likely to increase in the current context is through the government having to provide large bailouts to financial firms and other corporations facing threat of closure or other very serious problems.  These may be essential (or at least may be seen to be essential) to save the system as a whole from collapse, though there are always complex and nuanced judgements to be made about which firm deserves how much bailout, and what the implications would be if it were not bailed out.  The implications are obvious for the effects of crony capitalism and differential treatment of firms — and there are other broader income distribution effects as well.

But Keynes and Kalecki, who both pointed out the criticality of fiscal policy in capitalism, were essentially talking about direct public expenditure, not resources provided indirectly as tax cuts or bailouts.  It is important to note that they were not concerned with the pattern of expenditure, and whether it is ”productive” or unproductive”.  In fact Keynes famously argued that even completely unproductive expenditure ”hiring men to dig holes and fill them up again” would serve the required purpose of reviving demand in a situation of excess capacity and unutilised resources.  And the operation of the multiplier — the process by which each bout of spending generates additional spending of those whose incomes increase in the first round — ensures that this initial unproductive spending raises output and employment over time.

But we now know that the pattern of spending does indeed make a difference, especially in developing countries where resources are constrained in the medium term even if not in the short run.  Obviously, public expenditure need not be completely wasteful: there are huge opportunities and avenues for productive investment and expenditure because of the huge development gaps that exist.  But there is the further point that the value of the multiplier itself may not be a given, but may depend upon the pattern of expenditure.  For example, public spending on employment schemes, and on health and education, not only generates more direct employment but also more indirect employment because those who are newly employed by this are more likely to consume a higher proportion of their incomes.  Conversely, simply raising the pay of middle class and professional workers whose requirement for essential consumption forms a smaller part of their income does not necessarily lead to much increase in consumption but may simply translate into greater saving, leading to a lower value of the multiplier.

What this means is that, even in a period when fiscal expansion is seen as necessary for economic regeneration, the direction of such public spending matters greatly.  Fiscal policy that provides more wage income directly to unskilled workers and in rural areas is likely to be much more effective in increasing aggregate incomes than other forms of public spending, because of the higher value of the multiplier in such expenditure.  And therefore, particularly in the current situation of global economic crisis and national economic slowdown, expenditure on the NREGS assumes very great significance.

The point that is being made here is that ”inclusive” public spending, such as in the NREGS, is not only desirable from a social or welfare perspective — it also provides very direct economic benefits because it is much more effective in dealing with the economic situations of credit crunch and aggregate demand slowdown.  Because wage employment schemes tend to be self-targeting in terms of increasing the incomes of those who are most likely to spend their income rather than save it, they necessarily imply higher multiplier effects that make the public expenditure more effective in reviving output and indirect employment.  Therefore the NREGS is about more than equity; it is also a macroeconomic weapon against slump, and this is at least partly so because it does generate more equity.

Jayati Ghosh is Professor of Economics and currently also Chairperson at the Centre for Economic Studies and Planning, School of Social Sciences, at the Jawaharlal Nehru University, in New Delhi, India.  With C.P. Chandrasekhar, she co-authored Crisis as Conquest: Learning from East Asia.  This article was published by MacroScan on 6 March 2009; it is reproduced here for educational purposes.