Levy Economics Institute of Bard College Levy Economics Institute Public Policy Brief of Bard College No. 130, 2014 WHAT REMAINS OF THE THEORY OF DEMAND MANAGEMENT IN A GLOBALIZING WORLD? Contents 3 Prefac e Dimitri B. Papadimitriou 4 What Remains of the Theory of Demand Management in a Globalizing World? Amit Bhaduri 9 About the Author The Levy Economics Institute of Bard College, founded in 1986, is an autonomous research organization. It is nonpartisan, open to the examination of diverse points of view, and dedicated to public service. The Institute is publishing this research with the conviction that it is a constructive and positive contribution to discussions and debates on relevant policy issues. Neither the Institute’s Board of Governors nor its advisers necessarily endorse any proposal made by the authors. The Institute believes in the potential for the study of economics to improve the human condition. Through scholarship and research it gen - erates viable, effective public policy responses to important economic problems that profoundly affect the quality of life in the United States and abroad. The present research agenda includes such issues as financial instability, poverty, employment, gender, problems associated with the distribu - tion of income and wealth, and international trade and competitiveness. In all its endeavors, the Institute places heavy emphasis on the val - ues of personal freedom and justice. Editor: Michael Stephens Text Editor: Barbara Ross The Public Policy Brief Series is a publication of the Levy Economics Institute of Bard College, Blithewood, PO Box 5000, Annandale-on- Hudson, NY 12504-5000. For information about the Levy Institute, call 845-758-7700 or 202-887-8464 (in Washington, D.C.), e-mail [email protected], or visit www.levyinstitute.org. The Public Policy Brief Series is produced by the Bard Publications Office. Copyright © 2014 by the Levy Economics Institute. All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or any information-retrieval system, without permis - sion in writing from the publisher. ISSN 1063-5297 ISBN 978-1-936192-35-9 Preface In our era of global finance, the theory of aggregate demand financial investment, the perceived need to maintain a healthy management is alive and unwell, says Amit Bhaduri. In this pol - climate for finance and protect against the risk of capital flight icy brief, Bhaduri describes what he regards as a prevalent con - disciplines and constrains fiscal policy, while elevating the status temporary approach to demand management. Detached from of price-stability-focused monetary policy. Instead of public its Keynesian roots, this “vulgar” version of demand manage - investment aimed at full employment, policymakers pursue ment theory is being used to justify policies that stand in stark restrictions on government spending and a shifting of the tax contrast to those prescribed by the original Keynesian model. burden away from corporate profits and toward wages and Rising asset prices and private-debt-fueled consumption play the salaries. Bhaduri argues that such policies exacerbate inequality starring roles, while fiscal policy retreats into the background. and thereby suppress aggregate demand. To support demand, the Returning to foundations laid down by Keynes and Kalecki, “vulgar,” or “Great Moderation,” model hinges on the interplay Bhaduri sets out to clarify whether there is any place for tradi - between expectations of ever-rising asset prices and a consump - tional demand management policies—featuring an active role tion boom driven by private debt. for deficit spending and public investment—in the context of Bhaduri cautions, however, that a model centered on pri - financial globalization, and he concludes that such policies are vate credit creation is prone to instability. More and more finan - ultimately unavoidable if we are to revitalize the real economy cial investment is needed to produce greater returns and boost and achieve stability. asset prices, continually shifting the composition of investment This policy brief emphasizes not only that globalization has from the real to the financial and creating the conditions for a elevated the relative importance of the external market, but also delinking of finance from output and employment. When the that we are living through a period in which trade in financial paths of the financial and real sectors of the economy diverge, assets, enabled by multinational banks and other financial insti - when incomes stagnate while debt and asset prices continue to tutions, overwhelms, in terms of quantitative significance, trade rise, this creates the conditions for a financial crisis. At that point, in goods and services and foreign investment in physical assets. the government is called upon to inject liquidity into the finan - This era of financial globalization is marked by layers of private cial system. But this is not enough, says Bhaduri: it saves the debt contracts that are generated at will by financial institu - financial sector, but not the real economy. Ultimately, he suggests tions—a system of private credit creation that is increasingly cen - that a revival of traditional Keynesian demand management, tered on a shadow banking system that exists largely beyond including large-scale, deficit-financed public investment, is regulatory and supervisory control, and (at least formally) with - needed to return the real economy to a state of health and stabi - out the support of a lender of last resort. lize the system as a whole. While some might insist that the age of global finance leaves As always, I welcome your comments. little room for the idea of demand management, Bhaduri con - tends that the theory survives, but that it does so in a form that Dimitri B. Papadimitriou, President is nearly unrecognizable from the original. This contemporary January 2014 model of demand management receives its inspiration from the presuppositions of neoclassical economics, and its policy empha - sis is often the very opposite of the old Keynesian model. In the context of the mobile and short-term nature of contemporary Levy Economics Institute of Bard College 3 Even as societies change, powerful social theories can often sur - and the maximizing principle of the individual agent vive, not as a coherent body of reasoning, but in a “vulgar” form. deciding between present and future consumption (or The vulgar version is not mere simplification but more like saving) is, to say the least, an inessential detail. dogma without a foundation in reasoning. And when this vulgar version enters political discourse, it undergoes yet another muta - (2) In a recession, the generation of additional income tion. It can be used to justify policies that are the very opposite in response to higher expenditure is mostly brought of what was originally intended. about through increases in production, as quantities The vulgar version of Keynesian demand management the - respond more vigorously and with greater speed than ory—to which almost all politicians, irrespective of their politi - prices, even in the short run, to higher demand caused cal color, turn in times of recession—revolves around what one by higher autonomous expenditure. This inverts both might call the stimulus doctrine: that is, stimulating the econ - Marshallian and Walrasian presumptions that prices, omy with liquidity from the government and the central bank to rather than quantities, adjust in the short run. primarily save financial institutions. It is hoped that this will also revive aggregate demand sufficiently to save not only banks but (3) In this scheme, prices respond to money wages and also the real economy, which is suffering from unemployment the level of output responds to the level of demand and excess capacity. This Keynesian policy is pursued, however, (expenditure), allowing independent price and quan - without any appreciation of the fundamental foundations of the tity determination. More important, the real wage rate original theory—even in academia. Indeed, most mainstream becomes an endogenous outcome of the interaction academic economists, including those who believe themselves to between the price level and the money wage rate, which be “Keynesians,” continue, in their technical works, to theorize in makes the real wage rate an unsuitable policy instru - a neoclassical mode. This mode is characterized by assumptions ment. Since the wage bargain is in money terms, only like representative maximizing agent(s); long-run equilibrium the money wage rate can be changed, with indetermi - positions from which the problem of effective demand has been nate effects on the extent of change in the price level banished as a “short-term” issue; and perfect flexibility of prices and the real wage rate. and wages, with substitution between capital and labor induced by relative prices to reflect relative scarcity—the central mecha - The theory of demand management was deliberately set in nism for bringing the economy into equilibrium at full employ - the context of a closed economy without foreign trade, to avoid ment. The only deviations allowed in this neoclassical scheme unnecessary debates and detours about the unfortunate experi - are short-term failures of the price mechanism due to incom - ences of the “beggar-thy-neighbor,” competitive devaluation plete information. policies of the interwar years, which amounted to efforts