Post-Keynesian Economics, an introduction

International Economic Policy Institute Institut International d’Economie Politique International Economic Policy Institute Institut International d’Economie Politique International TEconomic Policy HE POST-KEYNESIAN APPROACHInstitute : AN INTRODUCTION Institut International d’Economie Politique International Economic Policy Institute Nicolas Zorn Institut International d’Economie Politique International Economic Policy Institute WP-2016-01 Institut International d’Economie Politique International Economic Policy Institute Institut International d’Economie Politique International Economic Policy Institute Institut International d’Economie Politique International Economic Policy Institute Institut International d’Economie Politique International Economic Policy Institute Institut International d’Economie Politique International Economic Policy Institute Institut International d’Economie Politique International Economic Policy Institute Institut International d’Economie Politique International Economic Policy Institute Institut International d’Economie Politique IEPI IIEP IEPI IIEP IEPI IIEP IEPI IIEP IEPI IIEP IEPI IIEP IEPI IIEP IEPI IIEP IEPI IIEP IEPI IIEP IEPI IIEP IEPI IIEP MISSION STATEMENT The International Economic Policy Institute is a bilingual, non-partisan, non-profit policy research group at Laurentian University, Ontario (Canada), which seeks to offer critical thinking on the most relevant economic and social policies in Canada and around the world. In particular, the institute’s mission is to explore themes related to macroeconomic policies, globalization and development issues, and income distribution and employment policies. Our overall concern is with the social and economic dignity of the human being and his/her role within the larger global community. We believe that everyone has a right to decent work, to a fair and equitable income and to equal opportunities to pursue one’s self-fulfillment. We strongly believe that it is the role of policies and institutions to guarantee these rights. In accordance with its mission, the Institute is constantly seeking to create international research networks by hosting conferences and seminars and inviting other thinkers around the globe to reflect on crucial economic and social issues. The Institute offers ongoing, honest, and critical appraisal of current policies. DIRECTOR Louis-Philippe Rochon, Laurentian University ASSOCIATE DIRECTOR Hassan Bougrine, Laurentian University SENIOR RESEACH ASSOCIATES Amit Bhaduri, Jawaharlal Nehru University (India) Paul Davidson, New School University (USA) Robert Dimand, Brock University (Canada) Roberto Frenkel, University of Buenos Aires (Argentina) Robert Guttmann, Hofstra University (USA) Claude Gnos, Université de Bourgogne (France) Marc Lavoie, University of Ottawa (Canada) Noemi Levy, Universidad Nacional Autonoma (Mexico) Brian MacLean, Senior Researcher, Laurentian University (Canada) Philip A. O'Hara, Curtin University (Australia) Alain Parguez, Université de Franche Comté, (France) Sergio Rossi, University of Fribourg (Switzerland) Claudio Sardoni, University La Sapienza (Italy) Mario Seccareccia, University of Ottawa (Canada) Mark Setterfield, Trinity College (USA) John Smithin, York University (Canada) RESEACH ASSOCIATES Mehdi Ben Guirat, The College of Wooster (USA) Fadhel Kaboub, Drew University (USA) Dany Lang, National University of Ireland, Galway (Ireland) Joelle Leclaire, Buffalo State University (USA) Jairo Parada, Universidad del Norte (Colombia) Martha Tepepa, El Colegio de Mexico (Mexico) Zdravka Todorova, Wright State University (USA) 2 THE POST-KEYNESIAN APPROACH: AN INTRODUCTION NICOLAS ZORN Policy Analyst, Institut du Nouveau Monde, Canada ___________________________________________________________ Summary The Great Recession of 2009 and the current economic stagnation calls into question the validity and usefulness of Mainstream economic theories. The post-Keynesian approach provides a rich and relevant alternative, far better able to explain modern and complex economic phenomena. This article is intended as an overview of their main micro and macroeconomic contributions, as well as the significant limitations of their mainstream counterparts. Will be addressed the epistemological, ontological and methodological post-Keynesians principles and their theories of prices, firm, consumers, economic growth, money and international trade. The author thanks Louis-Philippe Rochon, Marc Lavoie, Jean-Claude Cloutier, Charles Carrier, Jean-Pierre Proulx and Mario Jodoin for helpful comments and suggestions on a previous version of this text. All remaining errors isn’t their fault. 3 1. Introduction Mainstream economics, namely the neoclassical and neo-Keynesian schools of thought, asserted until the last economic crisis that the growth path followed by the developed economies in recent decades was sustainable. Despite its flaws, pre-crisis economic growth and macroeconomic stability seemed to prove them right. The Great Recession of 2009 and the current economic instability left serious doubt on the validity of these precepts. The post-Keynesian approach has repeatedly underlined the unsustainability of this approach (Godley and Zezza, 2006; Palley, 2006). This school of thought brings more realistic and credible explanations to these issues but above all, it offers a complete alternative to mainstream economics. Its array of theoretical tools and empirical contributions are rich but less known by economists and the wider public. It deserves an important place in the economics curriculum as well as public debates on economic policies. The post-Keynesian approach is a heterodox school of thought that evidently draws on Keynes’s contributions, but also those of Michał Kalecki, Wassily Leontief, Piero Sraffa, Thorstein Veblen, John Kenneth Galbraith, Nicolas Kaldor, Joan Robinson and Nicholas Georgescu-Roegen, among others. Several disciplines contribute to its development, such as sociology, history, political science and psychology (Lavoie, 2004, p. 22). This article is an overview of the main contributions of post-Keynesian economics, as well as the significant limitations of their mainstream counterparts. Section 2 deals with the epistemological, ontological and methodological assumptions and principles of postKeynesians economics. Section 3 deals with their theories of price formation and the role of firms. Section 4 discusses the consumer in all its complexity. Section 5 shows how growth is primarily determined by demand rather than supply factors. Section 6 deals with the role and mechanisms of money, which is endogenous in its nature. Section 7 deals with international trade and section 8 concludes. 2. Epistemological, ontological and methodological assumptions and principles The post-Keynesian approach starts with the fact that market economies are inherently imperfect and inefficient. They do not tend to correct themselves automatically, and have a tendency to underutilize and sometimes misuse the productive capacity of the economy. Firms rarely operate at their full potential. They underutilize their utilization capacity and produce involuntary unemployment. Central postulate of post-Keynesian theories, the economy crucially depends on effective demand, regardless of the level of wages, in both the short term and long term. It is rather the entrepreneur’s expectations of future demand (and thus their investments) which determine the level of effective demand. According to Keynes, firms will hire the number of workers that will allow them to produce expected sales, which in turn depend on demand. The single most important variable determining effective demand is investment expenditures, 4 which depend on business sentiment ('animal spirits') or expectations not reducible to optimizing behaviour. (Stockhammer, 2012, p. 167) Large firms, the dominant oligopolies of our modern economies, have the ability to determine prices, invalidating the presupposed benefits of free competition. In addition to producing instability, the latter does not produce a situation of equilibrium which coincides with the full employment of resources (capital and labor). Markets do not automatically adjust, whereby calling for the intervention of the State to regulate them. Mainly concerned with macroeconomic issues, the post-Keynesian analytical framework distinguishes itself from the dominant theories in economics in several aspects (Lavoie, 2004, p. 12-16). To understand the economy, one has to ‘take reality as it is, with its main stylized facts, and not as a hypothesized ideal’ (ibid., loose translation). The hypothesis of absolute rationality of agents is abandoned; consumers instead use simple rule-ofthumb and emulation to determine their consumption and behavior. A holistic approach is preferred to the individualistic approach because ‘individuals are social being, powerfully influenced by their environment, their social class and the culture from which they have been impregnated’ (ibid., loose translation). To understand the functioning of the economy, exchange and scarcity have to be downgraded in favor of growth and production. Post-Keynesians give particular attention to institutions and power relations, as well as the distribution of income and wealth, which is one of the main determinants of demand and growth. However, heterodox schools of thought all share some or all of these assumptions. Among the more specific characteristics of post-Keynesian analysis, fundamental uncertainty1 and the principle of effective demand are essential elements. Since economic agents act in a monetary production economy, post-Keynesians reject Say's law and argue that investment determines savings, not the other way around. Although having fully developed theories of the firm, prices and consumers, postKeynesians focus most of their analyses at the macroeconomic level. Avoiding fallacy of composition traps, they believe that aggregates better explain the interworking of the economy, because individuals cannot be taken apart from of their social, historical and institutional context. Social classes (workers, capitalists and rentiers), as well as firms and banks, are preferred to the representative agent. This approach rejects the need for microfoudations of macroeconomics, a mainstream principle that require utilitymaximizing individuals making rational choices to explain macroeconomic phenomena. As the Sonnenscheinn theorem demonstrates, interactions become extremely complex when different individuals are involved. This approach ignores the issue of coordination between individuals. However, the representative agents of their models have no reason to trade between them, which calls into question the idea of market where transactions would take place. Assuming that this is the case, the issue of coordination arises. 1 The future is necessarily different from the past and cannot serve as a reliable guide to anticipate the future, a major characteristic of mainstream models. 5 The number of agents in mainstream models are reduced to the bare minimum (one or two), but representative agents being collective entities, they cannot adequately aggregate the very different objectives and unequal resources of the individuals they represent without falling in a fallacy of composition trap. Assuming the rationality of agents also presupposes that they consistently have access to the same information, that markets are efficient and that there is no fundamental uncertainty (so that every outcome can be given a probability). If some mainstream models do address some of these issues, they never address all of them in a consistent manner. Omitting the transition between equilibrium points The assumption that the economy is moving towards equilibrium doesn’t address how it moves from points A to B. However, historical time is irreversible and the future is uncertain. Mainstream approaches favor logical time in their models, failing to consider this important issue. In those models, all the decisions of agents are taken at time zero and the effects of these decisions are simply added up. In this situation, the order in which the transitions take place are of no importance. However, the period of transition from one equilibrium to another neglects the effects of the path between these two points (the traverse). This transition can have a considerable effect on the new equilibrium, or even generate many equilibriums. If there are several points of equilibrium, the supposed optimization effects of markets no longer hold. As demonstrated by Nicolas Kaldor (1985), because the real economy is dynamic (rather than static), the adjustment process to reach a new equilibrium point directly affects it. Cumulative causation and path dependency do not guarantee that the same operation in the opposite direction would produce the same result. The adjustment process can produce different equilibrium points, via hysteresis effects (Henry, 2012, p. 530). 3. Are prices determined by competition or established by firms? Central concept of mainstream economics, the principle of supply and demand is but one element among others to understand how prices are determined in the goods and services markets. The strategies and behavior of firms play a decisive role. Some issues with the marginalist theory of prices The marginalist theory of prices is quite simple: entrepreneurship, strategy, decision, and even risks are unnecessary to consider for firms because prices dictate their behavior. Competing firms determine the quantities of goods and services to produce according to their marginal costs and market prices. For the oligopolistic firm, two simple rules dictate its actions: equate marginal revenue to marginal costs and sell products as long as there is demand. In both cases, prices are fixed in an optimal manner by the market. Everything that is produced is bought and prices reflect their scarcity. An increase in the production generates an increase in the marginal cost, hence higher prices. Since prices rise when demand increases, yields are decreasing. (Lavoie, 2001, p. 21) The mainstream (marginalist) price theory hypothesizes that the marginal costs of production of a firm are positive in the short term (their cost per unit of output increase for each additional unit) because the amount of capital (and land) is limited. This uniform 6 treatment of capital carries several problems. For example, if four people use four axes to cut trees, the use of a fifth person would transform these four axes in five smaller and less effective axes. However, employed capital must usually be increased if the number of workers increases, forcing the use of unused capital or the purchase of additional capital (in our example, the purchase and use of an additional ax). This assumption is problematic when an economy has several different industries (i.e. capital which is not interchangeable from one industry to another); capital is not putty, although this approach is tempting to model its use. Workers and capital are more often than not used together; a cook without an oven or a taxi cab without a driver is of little use. This is why firms generally keep a surplus production capacity if they to increase production in the short term, an essential flexibility allowing a firm to survive in a modern economy. Capacity utilization of productive resources is never fully utilized, whereby suboptimal. Thus, firms have constant or increasing, rather than diminishing, returns. Constant or declining production costs Assuming constant or increasing returns finds important support in the literature. Keen (2011) lists 150 empirical surveys where firms reported mostly constant or declining costs of production. Blinder et al. (1998) conducted a similar survey of 200 firms in the United States, representative of the American industrial structure. The study reported that 89% of respondents indicated that their average variable costs had either declined or remained constant when production increased. Only 2% of the firms surveyed reported a combination of elastic demand curves and increasing marginal costs, two central premises to marginalist theories of prices. Moreover, more than 50% of respondents indicated that they did not increase their prices when demand increased, for fear of losing customers. These firms therefore do not maximize their profits because they have other objectives than maximizing short-term profits. According to Downward and Lee (2001), these empirical findings confirm postKeynesians theories of prices. Alternative theories of price and the firm In a world marked by complexity and uncertainty, firms adopt simple rules based on accessible data to manage their strategic and financial goals. Even if firms wish to maximize their profits, their knowledge of the demand curve is at best an approximation. As to their knowledge of consumers, their preferences (which cannot be simply summed up with market prices) are uncertain, sometimes irrational, expensive to obtain, and subject to sudden change. In addition, firms evolve in a context of oligopolistic competition and monopolies, which considerably alters their strategies and objectives: The environment is one of interdependencies; at any time rivals, actual or potential, may change their behavior and employ new strategies. In such an environment, short-run profit maximisation is not possible to achieve. Moreover, profit maximisation is an inappropriate goal for firms that strive to survive and want some market power over their economic environment. Finally, the goals of firms and of their managers are multidimensional; as circumstances change, the weight given to various goals is revised and some goals need to be modified. (Lavoie, 2001, p. 21) 7 Rather than resort to marginalist considerations, most firms use the method of cost plus, or markup, pricing; they add an extra cost (the target profit rate) to the average price of their products. They adopt rule-of-thumb and trial-and-error approaches to set their prices: ‘Cost plus pricing means that firms fix prices based on some measure of costs, rather than as a response to demand fluctuation.’ (ibid.) Markup pricing is present in most industries. The only exceptions are those where production is manufactured by lot (such as agriculture), those where production is limited by access to some limited resources (such as natural resources or land) or those where production is not easily reproducible (such as art). Firms adopt this method because it is easy to apply and control. It has several advantages, notably because it is simple to calculate and therefore inexpensive to implement (most firms do not have an economist at their disposal). These prices are not determined on markets but established by firms at the stage of production. Central concept for postKeynesians, fundamental uncertainty is an important issue: In an uncertain world, prices are set in advance of trade. [...] A markup is added to direct average costs, as a manifestation of an organizational process of coping with uncertainty, to cover both overheads and profit. [...] Prices are more likely to change from cost changes than demand changes. (Downward and Lee, op. cit., p. 474) These conventions allow prices to adjust to changes in the cost of production rather than to changes in demand. Post Keynesian pricing theory accepts that average total costs will decline and that both overhead and direct costs will affect pricing decisions. As calculations of average fixed costs – for example, to determine overhead recovery rates – will involve planning over pricing periods, then individual transactions may not affect prices, other than in a preplanned way through, for example, discounts. (ibid., p. 475) The cost-plus method depends on several variables such as conventions, shareholders’ expectations, the firm’s history and its market power. The markup may even be set arbitrarily (for example, by choosing a round number). In addition, it guarantees a profit margin (useful for forecasting and long term planning). Knowledge of the marginal cost and future income are difficult, if not impossible to know, particularly because markets constantly change. However, contrarily to flex-prices (set in the market), fix-prices (prices set by firms) are not fully rigid, as they change according to the conditions of the pricing process. Thus, the firm cannot necessarily set the price that it wants and it should not be too high: The pricing power of the enterprise is a matter of degree. It is limited by the competition in the market for the product, and while the firm can mark up the product’s price, the mark-up on the product’s cost cannot be too high. The firm has to consider the sales effects of the mark-up’s level, for higher mark-ups 8 means higher prices; and when the firm’s price is above that of its competitors, sales are lost, and the revenue from the product can drop. (Shapiro and Mott, 1995, p. 38) Firms adjust to demand by the quantities put up for sale and by marketing strategies rather than prices, driven by costs and therefore by supply factors. Because of their market power, firms set prices that suit them; they are not 'price follower'. If they do not have sufficient market power, they will follow market prices, driven by large firms. Thus, prices can be rigid not because of market failures or psychological barriers, but rather because firms prefer to reduce the fundamental uncertainty of markets, ensuring to obtain the desired level of income they yearn. Imperfect competition is the norm, not the exception. The result of the market’s discipline will not be the improvement of the enterprise but its demise. Survival in the market requires market power; the enterprises that survive the market are the ones that can affect its outcomes. They are the firms with the size and financial strength needed to wait out the market and stabilize its results. (ibid.) Prices rarely have the capacity to attain equilibrium (market clearing), but that is not their primary function; markup profits obtained by firms provide them with the degree of flexibility necessary to respond to changes in demand and to ensure their survival in the longer term. The objective of the firm is not the maximization of profits, but the maximization of growth ‘and the requisites of firm growth determined the mark-up on the product.’ The maximization of the company's growth requires investment, which can be guaranteed by a level of adequate profit: ‘While profit is needed for the expansion of the enterprise, growth is needed for survival’. If prices are similar or identical in a market, unit costs are not; firms therefore do not have the same cost-plus or the same return on investment for similar products, which depends on market power and the size of the firm: ‘There must be some price leader, or a group of leading firms, that set the prices of the industry. [...] The price set by an individual firm depends both on its unit costs and on the prices of other firms. [F]oreign firms fix their prices based on the prices set by domestic firms’. (Lavoie, 2001, p. 22). However, the financialization of the economy has somewhat partly limited these principles, shareholders imposing when they can the maximization of short-term profits. The priority given by some firms to share buybacks instead of investment in the productive capacities of the firm testify of this growing trend. 4. Are consumers simple optimizer? Are consumers omniscient and welfare-optimizing agents? Are their purchases calculated with an internalized super computer taking into account all available information, as implied by mainstream economics? Post-Keynesians consider this theory disconnected 9 from reality and of little use for economic analysis. They have developed a more realistic alternative theory, based on empirically-observed behavior. The consumer, a rational and omniscient optimizer? Mainstream economics portray the consumer as a rational optimizer that maximizes its well-being through his choices and purchases, a concept that is modeled by a utility function. He makes his choices at the margin, in a logic of substitution, as there would always be a price at which a good will be substituted for another. This approach presupposes that all choices are comparable (as measured by the same unit of measure, i.e. utility), without allowing neither indecision nor complexity for the decision-making process. In addition to being impossible to empirically calculate, this approach is static, leaving no room for changes in preferences. However, consumers (sometimes rapidly) change ideas about what constitutes their constellation of preferences. This approach makes it difficult to predict the behavior of consumers since several other factors come into account. For example, the manner and the order in which choices are presented have a significant impact on their decisions. The post-Keynesian theory of the consumer Rather than calculating the optimal value of a basket of goods (which is impossible to estimate and even less to aggregate), post-Keynesians conceive the consumer as an individual who will use rule-of-thumb and emulation to determine its consumption and behavior. He will confine his decisions to a limited number of choices, mostly determined by social norms and routines. The post-Keynesian approach is inspired by several schools of thought and contributions, including the work of institutionalists, psychologists, sociologists, marketing specialists and heterodox economists such as Nicholas Georgescu-Roegen and Herbert Simon. PostKeynesian theory presents the consumer as a human with limited capacity and patience: It has been shown that the vast majority of consumer decisions are spontaneous and arise out of routines and choices weighted on the basis of one or two criteria. For example, when buying a chair, the choice of colors could be offset by the quality of leather he desires. Households do not weigh all possible options, except for significant purchases. This allows them to take the necessary decisions of everyday life. (Lavoie, 2004, p. 29, loose translation) This approach allows the consumer to simplify his daily decisions. He doesn’t optimize, he practices satisficing. This neologism of the words satisfy and suffice is a concept developed by the behavioral economist Herbert Simon. As explained by Lavoie: ‘individuals set aspirational levels, so that the search for alternatives is brought to an end when the aspiration level is achieved’ (2014, p. 90). In defining what is acceptable and what is not, the consumer avoids considering all possible options, juggling only with those considered suitable. 10 Hierarchical needs Contrarily to mainstream theories of the consumer, post-Keynesians make the distinction between a need and a desire. For example, eating is a need; the choice between a pizza and a filet mignon is a choice. Also, the consumer’s decision-making process should be simple and fast, because his cognitive abilities and his time are limited. In real life, he has no time to make the precise calculations necessary to determine what are the optimum choices of shampoos or biscuits. The possibilities become much more limited, whereby manageable: If the consumer attempted to allocate his income by taking into account all prices and all possible goods, the task would be impossible. To alleviate this complexity, consumers take a series of decisions that simplify and subdivide the task. They allocate different budgets to various items of expenditure (food, clothing, services, entertainment, accommodation, transport), and within each expense item and every need, they evaluate different subcategories or their desires, regardless of the other items of expenditure. (Lavoie, 2004, p. 30, loose translation) The consumer will allocate his available income by dividing his needs according to specific categories of goods and services. His choice will be relatively isolated and hierarchical, an obvious parallel with Maslow’s pyramid. Basic necessities (housing, food) will be probably be determined first. When a category of need is satisfied, he will pass on to the next category. This hierarchy of preferences indicates that income effects prevail over substitution effects. The level and the type of demand will outweigh relative prices. Macroeconomic effects become more decisive than microeconomic effects. This observation is consistent with post-Keynesian macroeconomics, economic growth being determined by demand, which is composed mainly of wages. Unlike mainstream theories, consumers empirically behave as predicted by the post-Keynesian perspective: Only an increase in the overall cost of goods can have an impact on the allocation to other major items of expenditure (a global increase of the cost of food can lead to a drop in food expenditures). Indeed, empirical studies clearly demonstrate that the major items of expenditure have [...] extremely low price elasticities and cross-price elasticities close to zero. [...] In other words, effects of substitution between major items of expenditure are almost zero [and] are useless when similar products are implicated (in the case of fruit juices and soft drinks, for example). (ibid., emphasis in original, loose translation) In this perspective, largely influenced by the social environment, advertising takes on its full meaning. Needs can be created before the consumer is 'aware' that he 'needs' an iPad. For a consumer, acquiring needs is mostly a social phenomenon, determined by its environment. Consumers adapt. Social consumption relative to that of others is better explained in this perspective. In addition, past choices have an influence on the current decisions of the consumer; the purchase of an Apple computer can be motivated by the possession of software and habits inherited from the possession of a similar computer in an earlier period. Table 1 lists the seven principles of the post-Keynesian theory of the consumer. 11 Table 1: The seven principles of the post-Keynesian theory of the consumer Lavoie, 2004, p. 28, loose translation. Evidently, this theory is more complex to model than a utility function. It has the advantage of being much more representative of the real world, the complexity of the latter being rather difficult to reduce to its simplest expression. Economic theory has to adapt to the real world, rather than the other way around. 5. Demand, main determinant of economic growth Economic growth is a recurring issue in public debates. Why has it been so low since the Great Recession? How can we generate more (for all)? Modern societies depend (too much?) on growth to function and strive. How is it determined? The post-Keynesian school of thought provides relevant and empirically-grounded theories, based on the central role of aggregate demand, rather than supply factors, main components of mainstream growth theories. Mainstream theories of growth For heterodox macroeconomists, Solow’s canonical model (1956) and the theory of endogenous growth developed in the 1980s fail to convincingly explain the formation and changes of economic growth2. For Solow’s model, the evolution of savings and labor are exogenously given. The only remaining explanatory factor is the growth of productivity (total-factor productivity), which is measured as what remains when subtracting the effects of savings and the labor force. Thus, the sole determinant of growth is a residual (what we fail to explain). In the words of Stanford economist Moses Abramovitz, it is a measure of our ignorance. According to 2 The assumptions of diminishing marginal returns, the neutrality of money, the use of logical time rather than historical time, the substitutability between capital and labor, the production function, the absence of uncertainty and the causal relationship implying that savings produce investment (Say’s law) are strongly disputed by post-Keynesians. 12 Schlefer: ‘Productivity growth does tend to parallel economic growth, but economic growth often seems to be the horse, and productivity growth, the cart.’ (2012, p. 177) As for endogenous growth models, they have a number of significant shortcomings, including a large number of ad hoc assumptions added ex post, the search for empirical validation rather than theoretical falsification, the idea that technological innovation comes almost exclusively from the competitive process of markets (evacuating nonmarket institutions from the analysis), the failure to take into account the distribution of income, as well as the Cambridge critic, whereby capital cannot be aggregated. Also, an important shortcoming is the hypothesis that Say’s law holds, even in the long run because savings would generate investment and money would be neutral (the subject of the next section). Of course, saving does equal investment, but this is only an accounting identity and unsold goods are recorded as inventory at the end of a period, which is classified as an investment. For post-Keynesians, savings does not determine investment: ‘there is no reason why an increase, say, in the saving rate should lead to the adoption of more capital intensive techniques, thus casting doubt on the mere theoretical existence of a stable neoclassical growth path.’ (Cesaratto, 2010) According to Lavoie, [there] are an infinity of possible long-term equilibria, which depend on constraints imposed by demand and institutions. Supply side factors will adjust to demand. (2004, p. 17, loose translation) Growth is demand-driven For Post-Keynesians, the principle of effective demand is the main determinant of economic growth: ‘in a situation of unused capacities and unemployment, an increase in aggregate demand will increase output and employment without changing the price level.’ (Herr, 2013, p. 12) Supply factors determine the maximum productive capacity of the economy but effective demand rarely reaches this limit, beyond which only inflation is produced. The economy only rarely reaches full capacity of physical capital and full employment of workers available on the labor market. For example, the rate of capacity utilization3 of firms in Canada ranged between 70% and 90% from 1987 to 2014, rather than being close to 100% (Statistics Canada, 2015). When it comes close to full utilization, firms will simply acquire new productive capacity to preserve the flexibility necessary to adapt to rapidly changing markets. According to post-Keynesians, overall demand is driven by autonomous demand 4, mainly investment, which depends on a multitude of factors, ‘including the state of present and prospective demand, profitability and 'animal spirits' and technological factors.’ (Arestis and Sawyer, 2009, p. 22) Investment and net exports determine the current level of production and the employment rate since firms base their decisions on the value of goods and services that they think they can sell (expectations), in a context of Defined by Statistics Canada as being ‘the ratio between the actual production and theoretical production’. Non-autonomous demand refers to consumer spending, which vary depending on the distribution of income, i.e. the marginal propensity to consume, which declines when an individual’s income increases. Savings are a residual (what remains after consumption), rather than a consciously predetermined level. It should be noted that a large portion of the population does not save because their income is too low. 3 4 13 fundamental uncertainty. Firms invest and take risks according to the state of effective demand and future expectations. This is why post-Keynesian models usually have an independent investment function. Unlike the neoclassical, neo-Keynesian and Marxist postulates, post-Keynesians argue that supply factors (productivity, technological innovation, size of the labor force) are largely determined by effective demand, even in the long term, via its effects on the structure of the economy (the distribution between sectors, i.e. manufacturing, services, etc), immigration and the participation rate of the labor force. It is a serious defect in mainstream economics to have reduced all long-term issues to matters of the supply side. Lack of demand destroys capacity and technology, and conversely demand is a key stimulus for innovation and investment in Post Keynesian theory. (Hayes, 2010, p. 2) Investments determine savings, due to its multiplier effect on growth: The analogy between the individual (or household) and the economy does not hold, due to the circular flow between expenditure and income in the macroeconomy, where, in a double-entry national accounting format, my expenditure becomes your income. As a result, expenditure injected into the circular flow (as autonomous investment) can generate a matching amount of saving by raising income via the multiplier effect. In this framework, higher saving is the consequence of higher investment, and the maximizing principle of the individual agent deciding between present and future consumption (or saving) is, to say the least, an inessential detail. (Bhaduri, 2014, p. 4) This short demonstration casts serious doubts on the analytical priority granted to supply side factors by mainstream economics and reaffirms the importance of demand as the main driver of growth. 6. Money, created by commercial banks Unlike most mainstream schools of thought, post-Keynesians consider money to be endogenously determined, even in the long term. The evolution of the money supply is the product of the economic system, the decisions of agents and economic growth. Liquidity preference in the context of fundamental uncertainty plays a vital role. The creation and the fluctuations of money are therefore not an exogenously given neutral phenomena. The central bank only has a peripheral influence on the quantity of money. The post-Keynesian theory of endogenous money Credit is a central component of our modern economies. For post-Keynesians, commercial banks play an important role that goes beyond the allocation of savings; they create money; not bank notes per se but the money supply in circulation. Monetary policies only exert an indirect influence on the money supply, by the use of interest rates and by fixing the level of reserves required to guarantee deposits. But these factors do not 14 limit the capacity of banks to create deposits, and thereby money, almost literally out of thin air. For commercial banks to grant credit and create deposits, no prior reserves are necessary. The creation of credit and of bank deposits (money) in based solely on the basis of the credibility of the borrower and the guarantees he offers. (Lavoie, 2004, p. 55, loose translation) According to post-Keynesians, the demand for money is the leading constraint for the amount of money in circulation. Speculation and an inflationary spiral (driven by a conflict between wages and prices) are among the factors that influence the demand for money, but the main factor is the increase in aggregate income, i.e. GDP growth, via the Keynesian multiplier. It is investment decided by firms and the interest rate fixed by the central bank that determines the amount of savings, via economic growth. Conversely, if all households wish to save more, they will fail at this task; the aggregate result of a decline in consumption will be an equivalent loss of income for the firms that employ them, which will affect the level of investment and in the end, their own salaries. Higher desired savings leads to lower aggregate income, not higher savings. This is the paradox of thrift. Whenever they grant loans, commercial banks create money by crediting the account of the borrower. Credits make deposits, not vice versa. The money supply is determined endogenously by the demand for loans (and the willingness of banks to lend): ‘banks create credit and deposits, and they then procure the bank notes issued by the central bank when requested by their customers, as well as minimum reserves required by law.’ (ibid., loose translation) In a closed economy, the scarcity of funding is conventional: ‘as long as only the resources of a national economy are mobilized, financing economic activity depends only on the credibility of the borrower and the existing financial standards.’ By using double-entry bookkeeping, banks create money in the form of credit and most transactions simply transfer money between the accounts of their customers. When a loan is granted, M1 grows, and when it is repaid, M1 shrinks at an equivalent level. This means that the money supply is adjusted to the level of economic activity. Empirically, M1 is procyclical. The preference for liquidity John Maynard Keynes advanced the idea of liquidity preference to illustrate the motives for demanding money. It is preferred to other types of less mobile assets, satisfying the need for available and liquid funds to attain the preferred level of flexibility of agents in a context of fundamental uncertainty, an essential characteristic of the real economy. The preference for liquidity can be found in three distinct motives. First, transactions require a quantity of money to meet anticipated expenditure. Also, to respond to unanticipated needs, consumers and firms will keep in reserve a determined quantity of money in a precautionary fashion because revenues could not be available at the appropriate time. In both cases, the demand for money increases when income increases. Finally, speculation requires flexibility of financial resources that allows liquidity of 15 assets, a flexibility that is granted by the possession of money in a situation of fundamental uncertainty. However, unlike the transactional and precautionary motives, an individual’s desire to hold money to satisfy the speculative motive is a function of anticipated movements in a range of asset prices rather than changes in the level of income. [...] The money balances that are held to satisfy these motives reflect the individual’s degree of liquidity preference. (Kelton, 2012, p. 373) According to Keynes, the interest rate is the price to depart from liquidity. Thus, commercial banks offer credit according to their own preference for liquidity, and borrowers demand credit according their own preference. This is reflected by the composition of their portfolio of assets, determined by their state of confidence in the prices of all financial and non-financial assets, according to their anticipations: Money is created and made available to nonbank agents as a result of the portfolio decisions of banks. The responsiveness of banks to demands from the public depends on the preferences that orient those portfolio decisions. (Dow, 1995, p. 1) If uncertainty or pessimism about economic perspectives in the short or medium term increases, liquidity preference will be higher: ‘Shifting liquidity preference influences the supply of and demand for credit, as well as output and employment’ (ibid.) By hoarding money, individuals and firms withdraw money from circulation, which would otherwise be dedicated to consumption or investment. A higher preference for liquidity will increase the rate of interest at too high a level, undermining the investment potential, and thereby economic growth and unemployment: ‘When liquidity is high, there may be no preference rate of interest that will induce investment in illiquid capital - and even if the overnight interest falls, this may not lower the long-term rate.’ (Wray, 2012, p. 408) If investors and borrowers do not have access to all information and are not perfectly rational, they cannot allocate the 'correct' price, i.e. the exact price of risk (notably because they do not know the future), with the exception of the guaranteed rate of interest offered by the central bank. Due to the preference for liquidity, uncertain expectations and emotional factors prevail. The real economy has a real influence on monetary factors. Table 2 identifies the fundamental characteristics of money for post-Keynesian and neoclassical schools of thought. 16 Table 2: Characteristics of money for post-Keynesian and neoclassical schools of thought Source: Lavoie, 2004, p. 54, loose translation. This approach may seem counter-intuitive, especially if the theories learned at the undergraduate and graduate levels advocate mainly (if not only) an exogenous approach to money. Yet the facts remain. 7. An alternative approach to international trade Based on comparative advantages, mainstream economic theories of international trade assume that the production of a country will be determined by supply-side factors, such as technology, consumer preferences and availability of 'substitutable' productive resources (capital, labor). If there are no constraints to trade, the prices of resources and products will adjust to an optimal situation of full employment in the long term. The previous sections addressing mainstream approaches of the firm, growth and prices have shown the limits of these assumptions. Effective demand and trade equilibrium In a world characterized by involuntary unemployment and insufficient effective demand, countries often try to obtain a surplus of their current account to increase their economic growth and their employment rate. Their comparative advantages (low currency and low costs) basically allow them to 'import demand'. Since all countries cannot be in a situation of surplus at the same time, this surplus is gained at the expense of their trading partners, producing a deficit in their current account, whereby reducing their economic growth and increasing their unemployment rate. This export-based policy was described by Joan Robinson as a 'beggar-thy-neighbor policy'. This phenomenon was and still is largely overlooked by mainstream economists: ‘in the 1980s mainstream economists waxed enthusiastic about the export-led economic miracle of Japan, Germany and the Pacific rim NICs, without noting that these miraculous performance were at the expense of the rest of the world.’ (Davidson, 1999, p. 10). Demand constraints must therefore be considered. Important post-Keynesian contribution, the balance of payment growth theory argues that in the long term, a trade equilibrium deficit is not indefinitely sustainable and affected countries will need to balance their current account. In other words, national economies 17 could grow faster if they were not constrained by their balance of trade. This necessity to adjust in the long run must be made through changes of the quantities produced (level of income) or changes to the growth rate, rather than by changes in the level of relative prices (real exchange rates). This external constraint limits the growth of supply and demand factors. Here is how Thirlwall describes the process: If a country gets into balance of payment difficulties as it expands demand before the short term capacity growth rate is reached, then demand must be curtailed; supply is never fully utilised; investment is discouraged; technological progress is slowed down, and a country’s goods compared to foreign goods become less desirable so worsening the balance of payments still further, and so on. A vicious circle is started. By contrast, if a country is able to expand demand up to the level of existing productive capacity, without balance of payment difficulties arising, the pressure of demand upon capacity may well raise the capacity growth rate. (Thirlwall, 2011, p. 430) Balance constrained growth is defined as the growth rate of domestic exports divided by the rate of elasticity of income relative to the demand for imports. In other words, a country will have significant economic growth by exporting goods and services with a high elasticity relatively to global demand, while importing goods which have a low elasticity: ‘The key to long-run growth is to make one's exports more attractive to the rest of the world relative to import, in the non-price dimensions.’ (Razmi, 2012, p. 197) Obviously, trade deficits can be ‘offset by the influx of foreign capital, but for all countries except the United States, whose dollar is the international currency, this situation cannot be temporary, because interests and dividends must be paid on accumulated debt and investments from abroad.’ (Lavoie, 2004, p. 110, loose translation) Capital flows, essential determinant of international trade Since the 1970s, deregulation and the amplification of capital flows have caused many problems to countries engaged in international trade, in terms of trade imbalances, volatility and instability: It has changed the very nature of the market and provides an excellent example of the folly of what Keynes called the ‘fetish of liquidity’. In addition to the payments imbalances, resource misallocations, and trade and investment diversion this may cause, it reduces government policy autonomy and represents a waste of entrepreneurial talent. This is a problem in all market-based economies, but is even more problematic in the developing world. (ibid., p 210) Central element of the post-Keynesian theory of international trade, capital flows finance trade deficits: ‘As long as countries with trade surpluses run offsetting capital account deficits (that is, become net lenders) and countries with trade deficits run offsetting capital account surpluses (that is, become net borrower), overall balance-of-payments equilibrium can be sustained without eliminating trade imbalances.’ (ibid., p. 306) Net capital flows determine the balance of trade. The implications of this phenomenon are sometimes misunderstood. Some may support that low real wages, superior technology or similar factors are responsible for surplus or trade deficits of a monetary regions. 18 However, a deficit account in the national accounts must be identical to net capital inflow, as well as a current account surplus with net capital outflow. The causal link clearly flows from capital imports to current account imbalances. Productivity, the preferences of consumers, the availability of natural resources, tariffs, monopoly situations in certain sectors of production, and so forth only determine the structure of international trade (McCombie and Thirlwall, 1999, p. 41). Developing countries in particular benefit in the short term of an influx of foreign direct investment, which most often take the form of credit (loans). These debts are generally contracted in foreign currencies by firms and local governments. When countries (especially developing countries) undergo a rapid depreciation of their national currency, a high level of debt marked in foreign currency leads to serious problems of liquidity and solvency. These additional investments, initially bringing growth and jobs, can quickly become cumbersome, destabilizing their economies and fuelling financial crises, like those experienced by Asian countries, Mexico and Russia during the 1990s. Short term gains do not compensate for these problems in the long term. Unfortunately, there is no automatic correction mechanism to bring these countries to equilibrium: Debt, once contracted, cannot be dealt with through deflation and ‘decumulation’, as in neoclassical and Austrian business cycle theory – that is by ‘getting prices right’ internally – since the underlying problem is not one of a temporary inefficient allocation of existing resources, or even of the endogenous instabilities of self-sustaining capitalist accumulation paths, but one of structural socio-economic obstacles to industrialization. (Blankenburg and Palma, op. cit., p. 139) Without a mechanism to force countries with trade surpluses to increase their domestic demand (excluding international political pressures), the adjustment process lay on countries with current account deficits. Without capital controls that ensures this objective, countries with high levels of demand must restrict their growth. Global aggregate demand is therefore pulled down, reducing the potential economic growth and unnecessarily increasing unemployment. The free movement of large capital flows can create serious balance of payment problems for countries that would otherwise have an approximately balanced current account. Unfortunately, in a system of deregulated capital markets, fund being invested to develop the planet’s resources are indistinguishable from money laundering of flows of illegal funds, speculative capital flows continually in search for short-term profits, funds that are kept for precautionary motives or simply hiding from the tax collector. According to Davidson, these capital movements can be dangerous: The international movement of speculative, precautionary, or illegal funds (hot money), if it becomes significantly large, can be so disruptive to the global economy as to impoverish most, if not all, nations who organise production and exchange processes on an entrepreneurial basis. Keynes warned: ‘Loose funds may sweep round the world disorganizing all steady business. Nothing is more certain than that the movement of capital funds must be regulated’. (op. cit., p. 13) 19 Without control of capital flows or binding mechanism for countries with export-led policies based on high trade surpluses (like Germany and Japan), the current global trading system will keep its deflationary bias, limiting the opportunities for employment and growth. Exchange rates as adjustment variable? Mainstream trade economics argue that flexible exchange rates will correct these imbalances of international trade; a country’s currency is expected to increase when it accumulates surpluses, while those with deficits should see their currency depreciate, restoring the trade equilibrium. However, trade imbalances have greatly increased since the Bretton Woods fixed exchange rate system (under which the world has known few financial and economic crises) gave way to the current flexible exchange rate system. Post-Keynesians consider that flexible exchange rates are driven primarily by financial capital flows and asset market speculation, and hence need not move in the ‘right’ direction for balancing trade and, even when they do adjust, exchange rate changes may not generate the desired improvement in the trade balance due to low price elasticities or offsetting price changes. [The] implication that imbalanced trade will not follow comparative advantages is emphasized only by Post Keynesians. (Blecker, 2012, p. 306) Since the 1970s, the deregulation of capital flows and the adoption of flexible exchange rates resulted in a large increase of capital flows across countries, representing up to 50 times the amounts exchanged strictly for commercial purposes. Such changes produced a surge of exchange-rate volatility, a significant increase in current account imbalances and financial crises (mainly in developing countries). This fueled fundamental uncertainty, thereby reducing potential economic growth. In a system with multiple currencies, flexible exchange rate markets function like stock markets, i.e. based on the expectations of agents and financial speculation. Without any reality-based anchor (markets can be quite irrational), this phenomenon does not allow foreign exchange markets to benefit from the mainstream-attributed tendency to equilibrium by the price mechanism. Since prices are not a reliable measure of true economic scarcity and economic agents do not act solely as choice-theoretic automatons but also as members of social groups, comparative advantage is not a reliable driver of international integration. (Blankenburg and Palma, 2012, p. 139) Flexible exchange rates are thus determined by the expectations of exchange rates. They are driven by financial investors, which explains their volatility since the end of the Bretton Woods fixed exchange rate system. Why do these expectations change so quickly? Post-Keynesians identifies six causes: 20 the speculative nature of the currency market; the lack of a true anchor to currency values; the subculture of foreign currency dealers; the particular manner in which people make decisions; the environment of uncertainty in which decisions are made; and bandwagon effects. (Harvey, 1999, p. 206) Capital flows are crucial to understand international trade. Absolute advantages, rather than comparative advantages, determine international exchanges. Relative versus absolute advantage For a country playing the game of free trade and who has a lower productivity than its trading partners, it will simply suffer a decline of its domestic demand. There will be no automatic adjustment mechanism in the long term to correct it’s current account imbalances. Capital flows, rather than the flow of goods and services, determine international trade. These capital flows, most often of speculative origin, seek higher yields. The absolute benefit of a country will therefore be decisive, rather than it’s comparative advantage. ‘The law of comparative advantage is only applicable after all nations have domestic demand management policies assuring full employment.’ (Davidson, op. cit., p. 11) Trade equilibrium will not automatically adjust. If capital flows, rather than the current account, dominate the development of the balance of payment, then there is no reason to believe that the balance of payment is self-adjusting. This implies that the imposition of capital controls is essential for full employment policies to be sustainable. (Vernengo, 2001, p. 182) Post-Keynesians reject the assumption of the neutrality of money and the preeminence accorded to 'real' trade instead of financial factors. Absolute advantages outweigh comparative advantages. The argument that free trade benefits all countries falls flat as soon as are discarded the unrealistic assumptions on which it is based: The conventional argument for mutual benefits to all countries from free trade, based on the theory of comparative advantages, is rooted in the 'pure' trade models that assume balanced trade and full employment as well as capital immobility. If any of these assumptions are dropped, the theory of comparative advantage breaks down, and it can no longer be presumed that free trade policies are always in a nation’s best interest. (Blecker, op. cit., p. 305) 8. Conclusion Modern economies that leave markets unchecked are unstable, produce economic and financial crises, as well as a chronic underutilization of resources, resulting in rising inequality and high unemployment. Firms and individuals undergo high levels of detrimental uncertainty and only a minority benefits from unfettered markets. 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