A 200 year old economic theory tells us what is wrong with the developed world today

Jean-baptiste_SayVivek Kaul

I like to quote a lot of John Maynard Keynes in what I write. The reason for that is fairly simple—Keynes is the Mirza Ghalib of economics. He has written something appropriate for almost every occasion.
Nevertheless, I’d like to admit that even though I have tried to read his magnum opus
The General Theory of Employment, Interest and Money a few times, over the years, I have never been able to go beyond the first few chapters.
The economist whose books I find very lucid is the Canadian-American economist John Kenneth Galbraith. Galbraith unlike other economists of his era was a prolific writer and was one of the most widely read economists in the United States and other parts of the world between the 1950s and 1970s. He was even the US Ambassador to India in the early 1960s.
His most popular book perhaps was
The Great Crash 1929, a fantastic book on the Great Depression, which he wrote in the mid 1950s. His other famous work was The Affluent Society published in 1958.
But the book I am going to talk about today is
A History of Economics—the past as the present. In this book Galbraith looks at the history of economics and writes it in a way that even non-economists like me can understand it.
One of the laws that Galbraith talks about is the Say’s Law. This law was put forward by Jean-Baptise Say, a French businessman, who lived between 1767 and 1832. “Say’s law held that out of the production of goods came an effective aggregate of demand sufficient to purchase the total supply of goods. Put in somewhat more modern terms, from the price of every product sold comes a return in wages, interest, profit or rent sufficient to buy that product. Somebody, somewhere, gets it all. And once it is gotten, there is spending up to the value of what is produced,” wrote Galbraith explaining Say’s Law.
The Say’s Law essentially states that the production of goods ensures that the workers and suppliers of these goods are paid enough for them to be able to buy all the other goods that are being produced. A pithier version of this law is, “Supply creates its own demand.”
And this law explains to us all that is wrong with the developed world today. As Bill Bonner writes in his latest book
Hormegeddon—How Too Much of a Good Thing Leads to Disaster “French businessman and economist, Jean-Baptiste Say, discovered that “products are paid for with products,” not merely with money. He meant that you needed to produce things to buy things; you could not just produce money…has anyone ever mentioned this to the Federal Reserve?”
The central banks in the developed world have printed
close to $7-8 trillion in the aftermath of the financial crisis which broke out in mid September 2008, with the investment bank Lehman Brothers going bust. The Federal Reserve of the United States has printed around $3.6 trillion dollars in the aftermath of the crisis to get the American economy up and running again.
The standard theory that has emerged in the aftermath of the financial crisis is that consumer demand has collapsed in the Western world and this has led to a slowdown in economic growth. In order to set this right, people need to be encouraged to borrow and spend. As John Maynard Keynes put it: “Consumption—to repeat the obvious—is the sole end and object of economic activity.” (There I have quoted him again!)
To get borrowing and consumption going again central banks have printed a lot of money to ensure that the financial system remains flush with money and interest rates continue to remain low. At low interest rates the chances of people borrowing and spending would be more. And this would lead to economic growth was the belief.
Now only if economic theory worked so well in practice. Also, it was “excessive” borrowing and spending that led to the crisis in the first place.
Raghuram Rajan and Luigi Zingales explain this very well in a new afterword to
Saving Capitalism from the Capitalists, “For decades before the financial crisis in 2008, advanced economies were losing their ability to grow by making useful things. But they needed to somehow replace the jobs that had been lost to technology and foreign competition… So in an effort to pump up growth, governments spent more than they could afford and promoted easy credit to get households to do the same. The growth that these countries engineered, with its dependence on borrowing, proved unsustainable.”
It is worth pointing out here that the share of United States in the global production of goods has fallen over the last few decades. Thomas Piketty makes this point in his magnum opus
Capital in the Twenty First Century. Between 1900 and 1980, 70–80 percent of the global production of goods happened in the United States and Europe. By 2010, this share had declined to around 50 percent, around the same level it was at in 1860. Also, faced with increased global competition, Western workers were unable to demand the pay increases they used to in the past.
Piketty further points out that the minimum wage in the United States, when measured in terms of purchasing power, reached its maximum level in 1969 and has been falling since then. At that point of time, the wage stood at $1.60 an hour or $10.10 an hour in 2013 dollars, taking into account the inflation between 1968 and 2013. At the beginning of 2013, the minimum wage was at $7.25 an hour, more than 28 percent lower than that in 1969.
This slow wage growth has led to Western governments following an easy money policy by making it easy for people to borrow. As Michael Lewis writes in
The Big Short—A True Story: “How do you make poor people feel wealthy when wages are stagnant? You give them cheap loans.”
In case of the United States, trade with China had an impact as well. As the historian Niall Ferguson writes in
The Ascent of Money: A Financial History of the World: “Chinese imports kept down US inflation. Chinese savings kept down US interest rates. Chinese labor costs kept down US wage costs. As a result, it was remarkably cheap to borrow money.”
Ironically, what worked earlier is not working now. What has happened instead is that financial institutions have borrowed money at low interest rates and invested it in financial markets all over the world, in search of a higher return. Despite the central banks printing a lot of money, Japan recently entered a recession, with two successive quarters of economic contraction.
Europe is staring at a deflationary scenario. And the economic recovery in the United States continues to remain fragile.
Further, over the coming decades, a billion more people are expected to join the work force in Asia, Africa and Latin America. This will apply a downward pressure on costs and prices in the years to come and hence, wages in developed countries aren’t going to go up in a hurry.
Moral of the story: Western nations need to go back to making things, if they want a sustainable economic recovery. But as the American baseball coach Yogi Berra once famously said “In theory there is no difference between theory and practice. In practice there is.”

The article originally appeared on equitymaster.com as a part of The Daily Reckoning, on Nov 28, 2014

Food inflation is down but the figure Raghuram Rajan is watching hasn’t even budged

ARTS RAJANVivek Kaul  

As soon as some new economic data is declared by the government, the business lobbies demand that the Reserve Bank of India(RBI) should cut interest rates. The response is almost Pavlovian. Something similar happened yesterday as well. The index of industrial production(IIP) shrunk by 0.6% for the month of December 2013.
The manufacturing sector which constitutes close to three fourths of the index declined by 1.6% during the month. In comparison, it had declined by 0.8% during December 2012. The IIP is a measure of the industrial activity within the country and given that the number is in negative territory, what it tells us is that all is not well with the Indian businesses.
No sooner had the number been declared, the Confederation of Indian Industry I(CII), a leading business lobby in the country demanded that interest rates be cut. “We are especially concerned about the performance of the manufacturing sector, which continues to be in the red,” 
CII Director General Chandrajit Banerjee said. “We look forward for an accommodative monetary policy to spur demand and revive investment activity especially as inflation has started receding,” he added. Accommodative monetary policy essentially refers to the RBI cutting the repo rate, the rate at which it lends to banks.
The logic is that if the RBI cuts the repo rate, the banks will cut the interest rates at which they lend. This will ensure that people will borrow and spend more, which will translate into greater revenue and profit for businesses. Once businesses start making more money, they are likely to invest more as well. All this will lead to a higher economic growth, which for this financial year is likely to be at or around 5%. Or so goes the argument.
Another reason why business lobbies feel that the RBI should be cutting interest rates is the fact that the consumer price index(CPI) inflation in January 2014 fell to a two year low of 8.79%. This was on the back of food inflation falling to a 22 month low of 9.9%. Food products constitute nearly half of the consumer price index. Food inflation was at 12.2% in December 2013.
Food inflation came down because of the vegetable prices falling by 13.2% between December and January. This was primarily on account of greater supply of vegetables hitting the market. During the period August-September 2013, farmers made significantly better returns on their produce. This led to them planting more vegetables, leading to an oversupply in the recent months.
So with the consumer price inflation falling to a two year low, the business lobbies want the RBI to start cutting interest rates in order to revive consumer demand, which has been stagnating for a while. The IIP data when looked from a use based point of view, indicates towards the same. The consumer durables measure fell by 16.2% during December 2013.
But the question is will a cut in interest rates revive consumer demand? While in theory the link appears to be fairly straightforward, that is really not the case. Let’s consider a case where an individual takes a three year two wheeler loan of Rs 40,000 from the State Bank of India to be repaid over a period of 36 months at an interest of 18.25%. The EMI for this comes to around Rs 1451.
Now lets assume that interest rates crash dramatically by one third from their current levels and the rate of interest on a two wheeler loan from the State Bank of India falls to 12.25%. In this case, the EMI falls to Rs 1333 or around Rs 118 lower. Hence, even if interest rates come down by a third, the EMI falls only by around Rs 118 or a little over 8%.
Someone who wants to buy a two-wheeler will definitely not be influenced by it. As John Kenneth Galbraith writes in 
The Affluent Society, first published in the 1950s, “The customer, in contemplating the purchase, is less aware of the interest rate than of the monthly charge…There is, in fact, considerable agreement that monetary policy does not make any effective contact with consumer borrowing and spending. During periods of active monetary policy, increased finance charges have regularly been followed by large increases in consumer loans.”
Given this, the customer who wants to purchase a consumer good by taking on a loan should be comfortable with the idea of paying an ‘x’ amount of money every month as an EMI, irrespective of what the interest rate is.
In this scenario, what becomes very important is the rate of inflation. For more than five years, inflation as measured by the consumer price index has been very high. This has largely been on account of food prices having gone up at a very fast rate. High inflation has eaten into the incomes of people and led to a scenario where their expenditure has gone up faster than their income. This has led to people cutting down on expenditure which is not immediately necessary. This is reflected in the consumer durable number which fell by 16.2% in December 2013.
Food prices have now started to come down and that is some good news for the Indian consumer. But if one looks at what economists call core inflation (i.e. non food non fuel inflation which forms around 40% of the consumer price inflation index) that remains to be high at 8%, as it has over the last few months. The core inflation contains measures of housing, medical care, education, recreation, transport, personal care etc, basically, everything that is required for a reasonably comfortable living.
Interestingly, this number is closely tracked by the RBI governor Raghuram Rajan. 
He had said on January 29, 2014, “that he would have liked to see a greater reduction in core inflation.” A day earlier in an interaction with the media he had said that “. Core (inflation) tells us something about the second round effects. Even within core, there are some which we need to pay attention to like some aspects of services like education, which have been going up quite strongly.” Given this, it is unlikely that the RBI will cut the repo rate anytime soon.
If the consumer demand story is to be revived again, the core inflation needs to be brought down, so that consumers feel comfortable in spending money. The ironical part here is that despite the economic growth falling from more than 10% to less than 5%, over the last few years, core inflation continues to remain high. The explanation for this lies in the fact that the high price of food, leads to a demand for higher wages and that leads a higher core inflation. When businesses have to pay higher wages, they, in turn, demand a higher price from consumers. And this in turn impacts consumer demand.
The government can definitely play a role here by cracking down on hoarders of food and at the same ensure that there is no shortage of wheat and rice in the market, of which it has enormous stocks.
As far as businesses lobbies are concerned it is worth looking at what Galbraith said in that context. “To restrict consumer borrowing by increasing the interest cost on instalment and other loans collides abruptly with the process of consumer-demand creation…Any step to discourage borrowing and buying will be automatically opposed by the machinery for consumer-demand creation.”

 The article originally appeared on www.FirstBiz.com on February 13, 2014
(Vivek Kaul is a writer. He tweets @kaul_vivek)