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

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

Nov 28, 2014

- By Vivek Kaul

Vivek 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.

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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."

What do you think the United States, Europe and Japan should do in order to get sustainable growth going again? Post your comments or share your views in the Equitymaster Club.

Vivek Kaul is the Editor of the Diary and The Vivek Kaul Letter. Vivek is a writer who has worked at senior positions with the Daily News and Analysis (DNA) and The Economic Times, in the past. He is the author of the Easy Money trilogy. The latest book in the trilogy Easy Money: The Greatest Ponzi Scheme Ever and How It Is Set to Destroy the Global Financial System was published in March 2015. The books were bestsellers on Amazon. His writing has also appeared in The Times of India, The Hindu, The Hindu Business Line, Business World, Business Today, India Today, Business Standard, Forbes India, Deccan Chronicle, The Asian Age, Mutual Fund Insight, Wealth Insight, Swarajya, Bangalore Mirror among others.

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


Nov 29, 2014

Hi Vivek,

Zero% interest rates are a virtue than problem. It is wonderful for poor people born with empty hands and small companies that run on borrowed money. Individuals can get no cost money for their education. Small companies can compete against zero debt big companies. People who have competency to compete will not feel the lack of capital over a period of time. So, I see sensible central banks will keep the risk free rates at zero, so that all the other loans are priced lower. As there is no equality at birth in our world, at least this measure can be a helping hand for the destitute.

In the medium term, the rich who wants to live on money with no effort, are seeing zero returns or low returns. They will fight and run for yields("Search for yield"). It is silly in financial markets, especially stock markets to search for yield. If you search too much for yield in the stock market, it will get horribly expensive. Stock Market over a period is supposed to show the equity value of an enterprise close to its replacement value. But unfortunately, in the short term, the "Search of Yield" crowd looks the stock market in terms of P/E and Dividend Yield. A P/E change from 12 to 24 takes the market 100% up. A dividend yield change from 3% to 1%, takes the market to 200% up. Where as the replacement value of entire market hardly changes drastically anything more than GDP growth rates.

So, if you look at world markets today, all asset prices are at scarier levels. Once this search for yield tribe gets punished, you will see the real benefit of zero interest rates.

These zero rates will enable all developing countries(hard working people) to prosper. Because the yields will get down further in these countries.

Look at the kind of western money(ECB,FPI,FII etc.) that is flowing into emerging markets. It reduces the yield in developing countries. Look at china and india, the yields are hitting record lows every day!!. If India's central bank doesn't inflate(silent tax), we will be looking at a home loan rate of 4% very soon.

We should like zero inflation and zero rates. It is foolish to feel that inflation really helps growth. Look at china, with less than 5% inflation(now less than 2%) they achieved 10% growth for decades.

Instead of feeling higher inflation & interest rates are good for anybody, The new normal of "Zero interest rates and Zero Inflation" are simply super for hard working poor.

Unfortunately, for decades, India is following inflation tax, by printing excessive money than GDP growth. With inflation, whatever little money the poor saves will evaporate in no time.

Instead of this "Search for Yield" tribe push the markets up and up, they could invest something in brick and mortar businesses. Then the GDP will go up in a much better way. This will have happen, definitely once the yield disappears in the stock market as it has already disappeared in debt and commodity markets.

If all the world central banks pursue zero risk free interest rates and zero inflation for next 20 years, the world will be a much better place to live especially for the poor.

For encouraging investment, it should not be the job of monetary policy(inflation tax), instead fiscal policy should encourage investment and businesses to be set up.

The problem with developed countries is lack of demand. They should encourage immigration in droves.
The problem with developing countries is lack of investment, the countries should ease the way of business being conducted. At present,both are in reverse order.
All the money from western world is flowing to push stock prices higher, rather than open a new factory.



Nov 29, 2014

Extremely well written Vivek - must compliment you on this. Loved the statement - Supply Creates Its Own Demand! Would urge you to write your articles at 2 levels - initial summary for the uninitiated (like me), and then a more in-depth elaborate write up below it. Once again - thanks for a wonderful post.


Hasan Fazal

Nov 29, 2014

The relevance of currency is limited in the sense that the production of goods only carries forward the economic activity. Money is at best only a medium but not a trigger.



Nov 28, 2014

Just get rid of the Central Bank, allow companies and banks to fail and capitalism to do its job. The CBs think they have got all the answers despite the world knowing how addle brained our Big Ben was when the storm was gathering in 2005 to 2007. Just read his qoutes... subprime contained, house prices never go down (it won's while these clowns meddle!) etc.

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Nov 28, 2014


"MAKE in India"
is the Mantra of NaMo! Now, read the above article and I appreciate the Greatness of Namo's Vision....much more!

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