By Michael Roberts
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What’s wrong with the Keynesian answer to austerity?

This article is over 11 years, 1 months old
As austerity measures bite while the economy continues to flatline, arguments for a Keynesian response to the recession are gaining traction. Marxist economist Michael Roberts casts a critical eye over the Keynesian case, arguing that it misunderstands the causes of capitalist crisis
Issue 379

A new radical think-tank kicked off last year in the UK. It’s got a great name: Class: the Centre for Labour and Social Studies. Sounds socialist, even Marxist, doesn’t it? Unfortunately, at its first meeting the speakers, especially the economists, were all Keynesians. All the arguments against austerity were Keynesian. Apparently, a Marxist analysis has no contribution to make in explaining the Great Recession and the ensuing long depression – or what to do about it.

I think it is a serious deficiency for those fighting for labour against capital, and needing to find the right policies, to rely on Keynesian theory and policy.

Why do I say that? Well, let me start with the kernel of Keynes’s contribution to economics: his emphasis on the macro economy. Keynes wanted us to focus on the macro economy through his key national accounting “identities”. National income = national expenditure – that’s easy. National income can then be broken down to Profit + Wages; and national expenditure can be broken down to Investment + Consumption. So Profit + Wages = Investment + Consumption. Now if we assume that wages are all spent on consumption and not saved, then Profits = Investment.

But here is the rub. This identity does not tell us the causal direction that can help us develop a theory. For Keynes, the causal direction is simply that investment creates profit. But what causes investment? Well, the subjective decisions of individual entrepreneurs. What influences their decisions? Well, “animal spirits”, or varying expectations of a return on investment, etc. It is entirely subjective.

Back to front
In any case, the idea that profits depend on investment is back to front. For Marxists, it is the other way round: investment depends on profit – and profit depends on the exploitation of labour power and its appropriation by capital. Thus we have an objective causal analysis based on a specific form of class society, not based on some mystical psychoanalysis of individual human behaviour.

Now if investment in an economy depends on profits, and if profits are fixed in the equation and cannot be increased, then investment cannot be increased. So capitalist investment (ie investment for a profit) will now depend on reducing the siphoning off of profits into capitalist consumption and/or on restricting non-capitalist investment, namely government investment. So capitalism needs more government saving, not more spending. It is the opposite of the Keynesian policy conclusion. Government spending will not boost profits, but the opposite – and profits are what matters under capitalism. So government spending is a negative for capitalist investment.

But the Keynesians do not consider profit. They look at output. They argue that, for every change in government spending in an economy, there is a corresponding change in consumption and national output. So if government spending is cut, there will a reduction in Gross Domestic Product (GDP) of some amount. This is the so-called fiscal multiplier. And it is powerful, according to the Keynesians.

As the world’s leading Keynesian guru, Paul Krugman, put it in his blog, “I and others have been arguing for a while that the experience of austerity in the eurozone clearly suggests pretty big Keynesian effects.” The International Monetary Fund (IMF) agrees, according to the evidence of the graph below. It shows that the more government spending cuts are made by a government (Greece – 16%), the worse is the decline in real GDP (Greece – 19%).

Indeed, this idea has now been latched onto by the Trades Union Congress (TUC). The TUC calculates that the UK fiscal multiplier is as high as 1.3 – the middle of the IMF’s new range – so the government’s fiscal cuts have reduced UK real GDP by two percent since 2010

But hold on. Before we bow down before the Keynesian multiplier, consider a couple of issues. First, is the IMF evidence that conclusive?

Well, not according to a Financial Times (FT) analysis. As the paper put it, “An exercise by the Financial Times to replicate and evaluate the IMF’s work, however, showed that the results suggesting very large multipliers – the relationship between deficit reduction efforts and growth – do not easily stand up to a different choice of countries or time period.” The FT goes on, “For the countries where the full data are available on the IMF website, the results lose statistical significance if Greece and Germany are excluded. Moreover, the results were presented as general but are limited to the specific time period chosen. The 2010 forecasts of deficits were not good predictors of errors in growth forecasts for 2010 or 2011 when the years were analysed individually. Its 2011 forecasts were not good predictors of anything.”

And when we go back and analyse previous estimates of the Keynesian multipliers, we find that the fiscal multipliers vary widely if the time periods are altered. Indeed, the IMF notes in its report that “earlier analysis by the IMF staff suggests that on average fiscal multiplier were near 0.5 in advanced economies during the three decades leading up to 2009.” That means boosting or cutting government spending and taxes had little impact on growth during those years.

But then there is another issue: causation. These studies do not tell you what causes what. Did the recession cause deficits to rise and debt to increase and thus force governments into austerity, or the other way round? Surely, it was not fiscal austerity that caused the Great Recession, but the Great Recession that led to fiscal austerity. Krugman’s reply is rather unconvincing – namely that, as the IMF got it wrong and the impact of government spending cuts has been worse than expected, this shows that austerity must be the cause and slowing growth or contracting economies are the result.

Well, there has been a heap of studies that argue the contrary: that it is large budget deficits and high debt that will cause GDP growth to falter. The most famous one is by Reinhart and Rogoff. It shows that if public debt levels get to over 85 to 90 percent of GDP (as they now are in most advanced capitalist economies), then it can take years (five to seven years or more) to restore “normal” economic growth. The implication is that the quicker public debt ratios are reduced, the quicker the sustained growth can resume.

But the causation is not clear: 1) a recession causes high debt, so the only way to get debt down is to boost growth (Keynesian) or 2) high debt causes recessions, so the only way to restore growth is to cut debt (Austerian). The evidence one or way or another from all these studies is not there.

I did a little piece of statistical research on this issue comparing the average budget deficit to GDP for Japan, the US and the euro area against real GDP growth since 1998. 1998 is the date that most economists argue was the point when the Japanese authorities went for broke with Keynesian-type government spending policies designed to restore economic growth. Did it work?

Well, between 1998 and 2007 Japan’s average budget deficit was 6.9 percent of GDP, while real GDP growth averaged just 1 percent. In the same period the US budget deficit was just two percent of GDP, less than one third of that of Japan, but real GDP growth was three percent a year, or three times as fast as Japan. In the euro area the budget deficit was even lower at 1.9 percent of GDP, but real GDP growth still averaged 2.3 percent a year, or more than twice that of Japan. So the Keynesian multiplier did not seem to do its job in Japan over a ten-year period. Again, in the credit boom period of 2002-07, Japan’s average real GDP growth was the lowest even though its budget deficit was way higher than the US or the eurozone.

The Keynesian multiplier measures the impact of more or less spending (demand) on income (GDP). But there is a Marxist multiplier. Here the causation is from profits to capitalist investment and then from investment to employment, wages and consumption. Spending and growth in GDP are dependent variables on profitability of investment, not the other way round. The Marxist multiplier measures changes in profitability and thus their impact on investment and growth.

If the Marxist multiplier is the right way to view the modern economy, then what follows is that government spending and tax increases or cuts must be viewed from whether they boost or reduce profitability. If they do not, then any short-term boost to GDP from more government spending will only be at the expense of a lengthier period of low growth and an eventual return to recession.

If more government spending goes mainly into social transfers and welfare, that will cut profitability, as it is a cost to the capitalist sector and adds no new value to the economy. If it goes mainly into public services like education and health (human capital), it may help to raise the productivity of labour over time, but it won’t help profitability. If it goes mainly into government investment in infrastructure, it may boost profitability for those capitalist sectors getting the contracts, but if it is paid for by higher taxes on profits, there is no gain overall. And even if it is financed by taxes on wages or cuts in other spending it will only raise overall profitability if it goes into sectors with a lower ratio of capital to labour (not usual in infrastructure projects, and if it is financed by more borrowing, profitability will constrained by rising interest rates. So there is no assurance that more spending means more profitability – quite the contrary.

The Marxist forecast
Now let’s look at the same period that I covered above for the impact on growth of the Keynesian multiplier, from the point of view of the Marxist multiplier. After 1997 the rate of profit in most of the advanced capitalist world began to decline. The Marxist multiplier would then forecast that investment growth would start to slow and so would GDP growth. Well, in the four years from 1998 to the mild recession of 2001 US real investment growth averaged 6.1 percent a year, while the government ran a small budget surplus and real GDP growth was 3.6 percent a year. But after the recession of 2001, during the credit boom of 2002-7, US real investment growth slowed to 2.2 percent a year, but the government ran a budget deficit that averaged 3.6 percent of GDP and real GDP growth slowed to 2.6 percent a year. It was the same story for Europe.

Even more revealing is capitalist investment in the productive sectors of the economy (real non-residential private capital formation in Organisation for Economic Co-operation and Development (OECD) terms). Between 1998 and 2001, US real investment in productive sectors rose 7.2 percent a year, but from 2001 to 2007 it rose only 3.5 percent a year (half the rate). Again it was the same story for Europe.
There does not seem to be any evidence that bigger government spending or wider budget deficits will lead to faster investment or economic growth over time in capitalist economies. Indeed, the evidence is to the contrary much of the time. The Marxist multiplier of profitability and investment seems more convincing.

Don’t get me wrong. This does not mean austerity is the right policy. The recent suggestion by the IMF director general Christine Lagarde (salary $470,000 per year and no tax) that austerity has worked, by citing the likes of Latvia and Estonia, is so much bunkum. These very small capitalist states in Eastern Europe have done a little better because they received huge fiscal transfers, way more than Greece (see the comments of the IMF’s chief economist and semi-Keynesian, Olivier Planchard). Around 20 percent of Estonia’s budget is made up of EU funding. No banks were bailed out because they are owned by Sweden and other Nordic banks and their exports are heavily oriented towards Scandinavia, which has generally fared much better. And government debt was never high in the first place.

What really helped these economies turn around, such as they have done, was not fiscal austerity, but the destruction of labour rights to allow employers to boost profits and emigration. A sizeable proportion of the Baltic people have left their homelands to find work in the rest of Europe. Skilled workers have disappeared. Latvia has undergone a demographic collapse. Young Latvians have fled the country. In 1991 the population was 2.7 million. The most recent census shows the population has dropped to two million, but is probably lower because of continuing emigration.

The UK government is sticking with austerity and it is not working. But austerity is not the only, or even the main, cause of the UK’s stagnating economy. One recent study found that the relatively tougher fiscal adjustment in the UK compared to the US has contributed slightly less than half the 5 percent point difference in real GDP growth between the two countries over the last three years . The real cause is the failure of the “rentier” economy that is British capitalism. Productivity in productive sectors of the economy is stagnant and investment has collapsed. Holders of capital are accumulating cash, sending it abroad or buying financial assets. But they are not investing. So the real economy stagnates and the authorities can do nothing about it because the capitalist sector dominates.

Steady decline
The reason that UK companies are not investing at home is that corporate profitability is still well below its peak in 2007 and, even more significant, the rate of profit in the productive sector of the economy, manufacturing, continues its steady decline from 1997, and is now hitting lows not seen since the recession of the early 1990s.

Not surprisingly, UK companies are on an investment strike.

So what is the correct policy response to the long depression? A Marxist analysis, in my opinion, recognises that the underlying cause of the crisis in the first place is to be found in the failure of capitalist production to generate enough profit. Then, until capitalism can destroy enough old or “dead” capital (employees, old technology and unprofitable weaker capitalist enterprises) to restore profitability and start the whole thing again, it will languish. In this long depression I reckon this may well require another big slump.

Keynesian-style government spending programmes can alleviate some of the pain for labour and government investment can help create new jobs. This will not boost profitability, but instead will be at its expense. And as long as capitalism is the dominant form of social production, that will mean more government spending will delay the capitalist recovery, not speed it up. If we want to end the long depression and avoid another big slump, we need to end the capitalist mode of production and replace it with democratically controlled, planned social production.

Michael Roberts blogs at

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