The Humbug of Finance

Apr 5th 2000, Prabhat Patnaik

I have chosen as the title of my lecture a phrase used by Professor Joan Robinson, who, in her book Economic Philosophy, talks of "the humbug of finance which Keynes had destroyed".[1] What she means by the phrase "the humbug of finance" is the view held by British finance capital, based in the City of London, in the late twenties, and propagated by the British Treasury (because of which this view came to be known as the "Treasury View") that in all circumstances the government's balancing its expenditure with its income, i.e. not resorting to any fiscal deficit, is the most desirable policy for an economy. The British colonial government in India, it may be recalled, had used precisely this argument for pursuing deflationary policies even during the years of the Great Depression because of the fall in its tax revenue. This had succeeded in worsening the impact of the Depression on our economy[2], had thwarted the industrialisation prospects which the policy of protection of the inter-war period had opened up[3], and had resulted in a wholesale running down of the economy's infrastructure.[4] This view in short was pervasive in the pre-Keynesian era. A slight variation of this view is that the fiscal deficit must under all circumstances never be allowed to exceed a certain small limit.
The theoretical articulation of the Treasury view was contained in a White Paper of the British Treasury in 1929, called "Memorandum On Certain Proposals Relating to Unemployment", and written in response to Lloyd George's suggestion that Britain should undertake public works for reducing unemployment which at that time stood at 10 percent (it was to reach 20 percent later). The White Paper argued that in any economy there is at any time only a certain pool of savings, and that if more of it is used for home investment then less becomes available for foreign investment, or if more of it is used for public works financed by government borrowing, then less is left over for private investment and foreign investment. It follows then that public works can never increase total employment in an economy since the increase in employment brought about by public works would be exactly counterbalanced by the reduction in employment arising from reduced private and foreign investment.
The fallacy of this argument was exposed by a young Cambridge economist and pupil of Keynes, Richard Kahn, in a classic paper published in 1931.[5] The argument was simple: total savings in an economy depend, among other things, on its total income. There is therefore no fixed pool of savings, unless we assume that income cannot be augmented, i.e. the economy is already at full employment, in which case the need for public works does not arise. The Treasury View in other words was arguing against proposals for reducing unemployment on the basis of a theory that implicitly assumed that unemployment did not exist at all. In an economy in which there is unemployment, in the sense of resources lying idle owing to lack of aggregate demand, if investment increases then these resources start getting used up directly and indirectly, through various rounds of the "multiplier". As a result, income rises and so do savings. Indeed, Kahn showed, the whole process of increase in income and employment would go on and on, until an amount of savings had been generated which exactly equalled the increase in home and foreign investment. Far from there being a predetermined pool of savings above which investment cannot increase, it is the total investment that determines the total savings: the direction of causation in other words is precisely the opposite of what pre-Keynesian theory believed. A corollary of Kahn's theorem was that if the government expanded public works for generating employment and financed these by borrowing, i.e. by enlarging the fiscal deficit, then an exactly equivalent amount of savings would accrue in private hands. A fiscal deficit in other words finances itself.
The argument advanced by Kahn in 1931 was central to Keynes' opus The General Theory of Employment, Interest and Money published in 1936. Keynes argued in a similar manner that in a situation of "involuntary unemployment", or "demand constraint", the government can enlarge employment and output by increasing its fiscal deficit; far from there being any adverse effects of this on any other stream of expenditure, such government action in fact would stimulate the total expenditure from these other streams via the "multiplier", and not even generate any significant inflationary pressures. Moreover, since the government can successfully pursue such a policy, it must do so, because, as Keynes put it, "it is certain that the world will not much longer tolerate the unemployment which, apart from brief intervals of excitement, is associated -- and, in my opinion, inevitably associated -- with present day capitalistic individualism."
[6] Even if the government used the fiscal deficit for no worthier purpose than "to dig holes in the ground", that is still preferable to letting unemployment persist, since "'to dig holes in the ground' paid for out of savings, will increase, not only employment, but the real national dividend of useful goods and services"[7] (again because of the "multiplier"). To argue against the mitigation to human suffering that an increased fiscal deficit can provide is therefore bad theory, the sheer "humbug of finance".
The reason for my reviving this old and familiar discussion is that today in India we are once again witnessing the parading as wisdom of this "humbug of finance", and there is even large-scale acceptance of this "humbug" as wisdom. What is more, the "humbug" that is being paraded as wisdom in our country is even more of "humbug" than what Kahn and Keynes had attacked. In other words the "humbug of finance" that we are being subjected to even "out-humbugs" the "humbug of finance" that the British Treasury was purveying during the Depression of the late twenties. Let me explain this last point first.

There were no public sector enterprises in Britain during the late-twenties. The government sector's transactions therefore were co-terminus with budgetary transactions, so that the term fiscal deficit corresponded to the deficit of the government sector. This deficit had necessarily to match, as an algebraic truism, the surplus of the rest of the world vis--vis the British economy plus the surplus of the British private sector. An increase in the fiscal deficit, assuming foreign transactions were unaffected, would necessarily correspond to an equivalent increase in the private sector's surplus of income over expenditure. What Keynesian theory argued is that an increase in the fiscal deficit in a demand-constrained system would cause an equivalent increase in private surplus (and hence finance itself) through an increase in the private sector's income (via larger employment and output through the demand stimulus obtained from the government) rather than through a reduction in private expenditure, in particular investment expenditure, which the Treasury View with its fantastic notion of a savings pool had claimed. As the government deficit goes up by Rs.100, employment, output and incomes go up until private savings have gone up by Rs.100 (assuming private investment remains unchanged), i.e. an extra Rs.100 of wealth has been put into private hands, which is held directly or indirectly in the form of claims on government.
Now, even though the use of fiscal deficit for increasing employment is perfectly legitimate, one may have reservations about this particular mode of raising employment, for three reasons: first, a fiscal deficit-financed expansion in activity, as just mentioned, does accentuate wealth inequalities compared to an equivalent tax-financed expansion of activity. In a society wishing to keep wealth inequalities in check, it is better to finance government expenditure by taxing capitalists than by borrowing from them. Secondly, there may be problems about knowing how much fiscal deficit is needed to get to "full employment" (which in a capitalist economy would never mean employment for everybody willing to work, but would only entail lowering unemployment to that level of the reserve army which is the minimum necessary for the avoidance of cumulative price instability). Suppose for instance that the owners of wealth increase their consumption as their wealth increases but with a time-lag. Then if, say, with Rs.100 of fiscal deficit the economy gets pushed to full employment before private consumption has responded to the increased wealth, then once it begins to respond, Rs.100 of fiscal deficit would turn out in retrospect to have been too large, since now there would be too much demand. Thirdly, even if private wealth has no effect on private consumption, if the economy gets taken to full employment through a fiscal deficit-financed expansion in activity, then at full employment there would be a large overhang of private wealth in liquid form (as direct or indirect claims upon government) and these, when resources are being fully utilised, can give rise to speculation-engendered inflation.

None of the above considerations justify the "humbug of finance". What they say is that while an increase in the fiscal deficit can increase employment, and should be used for doing so if necessary, there are other ways of increasing employment, through tax-financed increases in government expenditure for example, which might be even better for the purpose. Of course if the latter cannot be implemented easily then fiscal deficit should be resorted to rather than keeping unemployment going.
Even these residual objections to fiscal deficit however vanish when the result of the fiscal deficit is to increase not private savings and wealth but those of public sector enterprises. When this happens, there is in effect no increase in the government sector's deficit. What appears as an increase in the fiscal deficit is counterbalanced by a surplus in the rest of the government sector not reflected in the budget, so that the appearance of a fiscal deficit is entirely on account of the convention of making the budget reflect only a part of the government sector's transactions; it has no economic significance. To object to an increase in the fiscal deficit in such a situation is even more theoretically illegitimate than to do so in a situation where there is no public sector. If the objection even in the latter case is the sheer "humbug of finance", then in the former case the "humbug" is, if anything, compounded several-fold. And yet in India there is an objection to an increase in the fiscal deficit even when the consequences of such an increase would accrue as larger surpluses to the public sector, which is why the "humbug of finance" being purveyed in our country today "out-humbugs" the "humbug" attacked by Kahn and Keynes. I shall give three examples of such "supreme humbug" (if I may call it so).

[1] Joan Robinson, Economic Philosophy, C.A.Watts and Co., London, 1962, p.95.
[2] A.K.Bagchi, The Political Economy of Underdevelopment, CUP, Cambridge, 1982, p.123.
[3] ibid; see also his Private Investment in India 1900-1939, CUP, Cambridge, 1972.
[4] M.J.K.Thavaraj, "Public expenditure Trends in the Inter-War Period", in V.K.R.V.Rao ed. Papers on National Income and Allied Topics, Vol.1.
[5] "The relation of Home Investment to Unemployment" , Economic Journal, June 1931.
[6] The General Theory of Employment, Interest and Money, Macmillan, London, 1949 edition, p.381.
[7] op.cit., p.220.
[8] For a more elaborate discussion of this argument see my Accumulation and Stability Under capitalism, Clarendon Press, Oxford, 1997, Ch.5. The conclusion to be drawn from the fact of this overhang of liquidity is not that the "Treasury View" is right and that the fiscal deficit cannot raise employment, but that the full employment target would have to be somewhat lower for deficit-financed government spending than for tax-financed government spending.

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