Part I
Mainstream Macro-Economic Discourse
CHAPTER 1
Economics and Macroeconomics
Delineating the Scope of Economics
To make this book self-contained, I begin with my take on what economics is and what makes macroeconomics distinct from the other, microeconomics. A compulsive start to any question today begins with Google. When I keyed in âeconomicsâ two meanings appeared:
- The branch of knowledge concerned with the production, consumption, and transfer of wealth.
- The condition of a region or group as regards material prosperity.
These definitions are rather vague. Everything and anything seems to be a part of economics. Let me therefore articulate a more precise definition of economics.
People (and many animals too) live in groups and with this, division of labour amongst members of the group becomes inevitable, bringing with it specialization and higher standards of living. Imagine a life where you had to do everything yourself from growing tea to building your own house, let alone putting together an air-conditioner. Note that I have not said assembling because you would also have to make the tubes and wires, the blades and fasteners! What about mining and smelting? And who will design the air-conditioner and provide electricity? It is obvious that without division of labour we would never have progressed beyond hunter-gatherers.
Perhaps it was the need to facilitate the division of labour that people chose to live in groups. Whatever may have been the case, the division of labour generated the need for organization of production of goods and services as well as distribution of produced goods and services among members of the group. The economy, or the organization of production and distribution of goods, then becomes essential so that all tasks that have to be done get done and all members of a group get an appropriate share of the produced output. But who organizes this production and distribution of goods and services?
Consider, for instance, a tribal society where tasks and responsibilities are allocated according to traditional social and cultural norms. Distribution or who gets what share of the produced goods is also decided on a similar basis. The chief of the tribe is entrusted with ensuring that norms and customs are adhered to so that rules are not broken arbitrarily. Enforcement has to be strict because breaking rules could mean that some jobs never get done, which may even impact the tribe's survival. Or consider a feudal society as it prevailed in India where the caste system âassignedâ occupations by birth and also decided who got what and how much of the output. While these allocations may not be socially just, it did ensure that all tasks that had to get done got done. Finally, central planning as it existed in erstwhile Soviet Union (USSR) was also considered a viable and rational way to solve the economic problem of organizing production and distribution. Economics, at least the mainstream version, however, does not delve into a study of such economic systems where traditional norms and customs, politics and compulsion or a central plan directed the allocation of resources and distribution of the produced goods amongst members of a society.
Defining Economics
So what is economics in the modern sense of the word then? To me, economics is the study of the economy, i.e. how the economy is organized or, in other words, how society decides on who produces what and how much and who gets what and how much of the produced output of goods and services. But here comes the crucial point; economics studies how a market system goes about doing this, not other economic systems. We are really not interested in how production and distribution is organized in a tribal community, a feudal society or a centrally planned economy. I, therefore, propose the following definition of economics:
Economics is the study of production and distribution of goods and services in a market system:
- (i) how the market system works,
- (ii) how âwell'1 it works,
- (iii) when/why does it fail to work well, and
- (iv) what can be done to set the failures right and by whom.
The market system comprises markets or institutions that bridge demand and supply across place and time through exchanges that take place by bringing together buyers and sellers under a âsingle roofâ and generating price signals from the cumulative desires and abilities of all consumers and producers. Individual consumers and producers then react to these signals which either work as an incentive/disincentive to buy and sell more or less. A market system is a network of these interconnected markets that encompasses the entire economy or the entire sphere of production and distribution of goods and services. It goes beyond individual markets like those for automobiles and toothpastes. Thousands if not millions of markets develop for every conceivable good and service including labour, which are then interconnected with all other markets through price signals that impact consumer decisions, sales, inventories and profits and thereby regulate the allocation of resources to each market, the quantum of output that is produced as well as who gets what share of that output.
Adam Smith, some 250 years ago, used the expression âInvisible Handâ...a hand (that could be interpreted as the hand of God) that guides us in our actions but something which is not seen. This Invisible Hand is the market system, a system in which economic activities of society are organized through mutually beneficial voluntary exchanges between buyers and sellers on the basis of information transmitted in the form of price signals or prices. It is price that tells us, individually and collectively, what society wants us to do and how the total output is to be divided amongst us. The market system guides exchange, making the division of labour possible and smooth, allowing specialization, increasing productivity and consequently enhancing our standards of living.
While economists have devoted a lot of time to understanding how and how well the market system works, the study of market failure is equally if not of greater importance. Do price signals always encapsulate all information on scarcity or surpluses? If they do not, we end up with an inefficient or sub-optimal allocation of resources or market failure. âMicroeconomicsâ studies market failure in individual markets and finding solutions for such failures. In general, the reasons for market failure (and their solution given in brackets) include market structure reasons like monopoly or oligopoly (regulation) and non-market structure reasons like asymmetric information (screening and signaling), risk and uncertainty (insurance or hedging) and externalities (taxes or creating markets by assigning property rights). For instance, the cause of climate change is considered to be the inability of, say, the market for coal-based thermal energy to price greenhouse gas emissions resulting in too much pollution or what is called a negative externality. Assigning property rights over pollution and enforcing caps on the quantum of pollution permissible can create a market for carbon and generate a price at which exchanges or carbon trading can take place.
Macroeconomics
Sometimes market-system failure takes place not just in specific markets but across most markets of the economy, all at the same time; this is market failure on a grand scale which leads to a contraction of aggregate output of the economy (Gross Domestic Product or GDP) and rising unemployment, or what are called recessions or depressions. The approach to understand such instances of market failure is the subject matter of macroeconomics. In other words, macroeconomics restricts itself to the study situations where there is simultaneous failure in broad categories of the market for goods and services, the labour market as well as in financial or credit markets. At an even deeper level macroeconomics questions whether the causes of market system failure on a grand scale are mere âimperfectionsâ of a microeconomic kind or whether there is a fundamental problem with market capitalism; one that does not guarantee full employment as the natural outcome of free market interactions even when microeconomic imperfections do not exist.
It is important to reiterate that economics (or what is sometimes called microeconomics) as well as macroeconomics are both concerned with the same questions pertaining to the market system. Microeconomics is not restricted to delving into problems of individuals or individual firms as the term might suggest. The âmicroâ actually refers to its foundations; it begins from an understanding of an optimizing consumer and a firmâs behaviour. Furthermore, microeconomics does deal with issues that have âmacroâ-level significance. For instance, market failure in financial markets because of asymmetric information could have nation-wide or even global repercussions. Similarly the impact of climate change arising from externalities in the energy market may have important implications for human civilization itself. Unlike their early predecessors, present-day mainstream macroeconomists argue that market failure on a grand scale ultimately arises from micro-level failures in specific markets. For instance, unemployment may be on account of inefficiencies in the labour market; minimum wage laws, asymmetric information, and so on. It is argued that the need for a âdifferent approachâ developed by early macroeconomists (Keynes and the neo-Keynesians) may actually be a weak one. But Keynesians, especially post-Keynesians and MMTers, believe in the inevitability of crisis in and the intrinsic limitation of self-acting market capitalism in ensuring full employment.
The scope of macroeconomics goes beyond the study of market failure on a grand scale to the devising of instruments and the institutional apparatus to set it rightâstabilization policy. Here the emphasis is on taming the business cycle, containing unemployment and inflation, rather than engaging with issues pertaining to improvements in standards of living. The latter facet of macroeconomics falls in the domain of economic growth and development. While growth is easily measured as the rate of change of GDP, development is more social in nature than either stability or growth. It includes issues like regional inequalities and inequalities in distribution of incomes and wealth, gender discrimination, the environment, health and education. Economists have proposed measures of development like the Human Development Index (HDI) to track the performance of countries in relative terms over a period of time.
There is another question that macroeconomic discourses in developing countries like India must address; can we use the theories developed in the West relevant to their own economic conditions be âappliedâ to issues facing us? Or do we need an alternative paradigm with fundamental differences in macroeconomic theory? The answer is that although the economic environment that developing countries operate in may be different from their Western counterparts, the macroeconomic principles as well as certain institutions (like the Ministry of Finance/Treasury, central banks, modern banking sector, etc.) are not really unique to warrant a distinct theory. To cope with structural differences (like trade and exchange rate policies, role of public sector, informal sector, financial markets and volatility issues, etc.) models do need modifications, but this can be done with the existing tools of economic analysis.
CHAPTER 2
The Classical and Keynesian Macroeconomic Paradigms
Macroeconomic Schools of Thought
Broadly speaking, there are three schools of thought in economics from the left to the right; Marxist, Keynesian and classical. The difference between these schools of thought essentially boils down to one major issueâthe role of the state in a capitalist market system. While Marxism saw the ultimate demise of capitalism and the market system for their exploitative nature, the Keynesians and classical schools believe in the overall ability of the capitalist market system to organize the production and distribution of goods and services. Although Marxist analysis does provide deep insights into capitalism, I do not think a discussion that rejects the capitalist market system in toto is particularly relevant at present. I therefore exclude Marxist thinking from the present discourse.1 The reader may or may not agree with this proposition.
It is important to elucidate that Keynesâ ideas are not really in sync with those of the radical left. He was a believer in the overall efficacy of the free markets system except that state intervention was necessary when aggregate demand was inadequate to sustain full employment. Unlike Marx, Keynes was not in favour of central planning as a substitute for a competitive market system. Many believed that through his theory, Keynes was able to resurrect the market system from its collapse on a grand scale during the Great Depression of the 1930s, which may have, left to its own, been the basis for a communist revolution in the 1930s. It is a coincidence and an interesting bit of trivia that Keynes was born just days after Marx died, in 1883.
In the context of market capitalism, the two dominant and relevant schools of thought driving mainstream macroeconomic discourse today are therefore the Keynesian and the classical. Within the Keynesian paradigm there are sub-schools of thought that are considered mainstream (neo-Keynesian and new Keynesian) whereas some are kept out of the mainstream (post-Keynesian). While this book focuses on MMT that draws upon post-Keynesianism, we present in this chapter some mainstream Keynesian ideas that influence popular macroeconomics discourse. To the right of the Keynesians are the classical economists who believe that the role of the state should primarily be confined to the provision of public goods like street lighting, policing and defence services, education and health where market failure is inevitable. The government, however, must not manage the business cycle since the market system can correct itself even in case of market failure on a grand scale. The classical school too has evolved over time into many different paradigms, each with its own set of idiosyncratic assumptions and policy proposals. In many ways we are driven to favouring the propositions of these schools of thought by our own life experiences and world view. At the same time, the popular discourse (drawing directly or indirectly from academia) does influence our world view and in a democratic country, the policy responses of the political establishment too.
Classical Macroeconomics
Macroeconomics as a distinct field of enquiry began with the Great Depression of the 1930s when several markets were drawn into a crisis, simultaneously; the markets for goods with large unsold inventories, the labour market with high rates of unemployment and even financial markets with multiple bank failures. As sales fell, companies cut back production that led to a vicious circle of falling output and rising unemployment. This was a definitive case of market system failure; how could one ever justify 25...