Keynesian theory. Classical economists. Basis of the Keynesian theory.

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1 1 Keynesian theory Classical economists Before Keynes, the classical economists considered that full employment was always ensured. Their conviction was based the following points: households have money; with this money, they buy either consumer goods, or bonds issued by firms; bonds are issued by firms to finance their acquisitions of investment goods, the purchase of bonds by households thus corresponds to an indirect purchase of investment goods; thus, with their money, households buy directly or indirectly, either consumer goods or investment goods; the market ensure balance between the supply and the demand of goods by fixing the price level; the supply of goods by firms also corresponds to a labor demand which is satisfied by the household labor supply; on this market balance is ensured by the level of the wages; since the money earned by firms thanks to their production is distributed to households in the form of income, i.e. of wages, interests and dividends, the purchases of bonds by households correspond to the part of their income that they do not consume, that is their saving; on the bond market, the supply corresponds to the firm investment and the demand to the household saving, balance on this market is ensured by the price of bonds, i.e. the interest rate. Thus, if markets correctly work, unemployment is impossible, it can only be the consequence of an imperfection of the markets and particularly of the refusal of employees to accept a fall of their wages. In this reasoning, money does not play practically any role, any change of the money supply resulting only in a corresponding change in the general level of the prices. This view still remains very widespread today. Basis of the Keynesian theory The classical theory rests on the implicit assumption that households want to keep the minimum of money since it does not yield any profit to them and they cannot consume it. According to them, households keep money only for two reasons, firstly the time-lag between the money entries and the payments, i.e. the transaction motive, secondly the possibility to face unforeseen expenses, i.e. the precautionary motive. Keynes challenges this assumption by introducing a new motive for holding money: the speculation motive. Since the prices of bonds fluctuate, households may find interesting to keep money to benefit from good opportunities, i.e. to buy bonds when they think that their prices will increase. Francis Malherbe 1

2 2 Since households can keep money, the basis of the classical theory collapses, households necessarily do not want to buy all the goods produced, unemployment becomes possible. The households being able to keep money, their choice is not reduced to an arbitrage between purchases of consumer goods and purchases of bonds. Keynes considers that the households must make two fundamental decisions: to decide the use of their income between consumption, i.e. a destruction of value, and saving, i.e. an increase in their wealth; to decide the distribution of their wealth between money and bonds. According to Keynes, the household consumption mainly depends on their income and the distribution of their wealth mainly depends of the interest rate. The stronger the income is and the higher consumption is, the higher the interest rate is high and the higher the share of the bonds in the wealth is important. But the individual decisions of households are subjected to global constraints, the first one being the equality between saving and investment. The equality between saving and investment The money earned by a firm thanks to its production is distributed as income to the various stakeholders: employees who receive wages; the natural resource owners who receive rent; the business owners who receive the profit in the form of dividends. Saving In the following, we assume for simplicity that firms distribute all they earn. Output = income Households are not obliged to spend all the money they receive, they can keep some part. Keynesian theory, such as national accounts, uses the concept of saving. Its definition is very simple: saving is the difference between income and consumption: Saving = Income consumption But the simplicity of this definition is dangerous! The concept of saving is so common that we no longer feel the need to think about it, yet it is used here in a very specific sense, different from that in which it is sometimes used in everyday life and even by economists. It is therefore useful to clarify a few points: Saving is a flow, that is to say, it refers to a specific period, such as a year or a month, and not a moment as January 28, 2010 at 10:32. Thus, for this simple fact, Francis Malherbe 2

3 3 saving cannot be classified in the same category as assets, such as, for example, saving accounts. The consequence is that we can use savings, but not saving, to buy something. At the beginning of the reference period saving does not exist, or rather it is zero, since income and consumption only occur gradually and are zero at the beginning of the period; the concept of consumption is not equivalent to spending because some expenses are not consumption expenditure. For example, interest payments are not consumption expenditure but a transfer that is deducted from income. Consumption refers only to acquisitions by households for produced goods and services. Conversely, a land purchase is not consumption expenditure, firstly because land cannot be produced by humans, secondly because its purchase does not correspond to a destruction of wealth; one can as well save by paying off his debts than by placing money in a savings bank or buying shares. In fact, the money spent to repay loans cannot be used for consumption. The income of a household is the wealth it received during a period; its consumption is the wealth that it destroyed and saving is the increase in its wealth during this period. The equality between saving and investment To demonstrate the equality between saving and investment, just consider that: First, income is equal to output; On the other hand, output is equal to consumption plus investment. We deduce that income is equal to consumption plus investment. This also means that the difference between income and consumption is equal to investment. As the difference between income and consumption is nothing but saving, we can deduce the fundamental equality: Saving = investment What is remarkable in this equality is that it is always true, for any period and whatever the economic conditions, including whatever the level of interest rates. It is therefore difficult to interpret it as an equilibrium relation that determines the interest rate. Once business investment realized, households no longer have the power to determine their saving, it is strictly determined by the investment decided by the firms. Indeed, the household income is equal to output, that is to say the sum of investment and consumption. If households want to reduce their saving, they will increase their consumption, but by increasing their consumption they will also increase output and, therefore, income. Saving remains unchanged! The equality between saving and investment means that the increase in the wealth of collectivity is strictly determined by the firm investment, the household saving desire having influence only on the output level. Francis Malherbe 3

4 4 The Keynesian multiplier Keynes makes a fundamental assumption: households mainly determine their consumption on the basis of their income and want to save part of it. Suppose, for example, that households want to consume four-fifths of their income and save a fifth. At the macroeconomic level, household income is determined by output, which is the sum of consumption and investment. Suppose that, initially, the firms decide to produce consumption goods for a value of 200 and investment goods for 100 Total output is 300, it is redistributed to households as income. Households want to consume 4/5 of their income, that is 300 * 4/5 = 240. But this household demand is greater than the supply of firms that is 200. Therefore, firms will increase their output, which will generate an increase in household income and thus their demand. Since households save a fifth of their income, the situation will stabilize when the level of household income will be equal to five times the level of their saving. Household saving being equal to firm investment, household behavior will bring the level of their income, and thus output, five times the level of investment. This mechanism takes the name of Keynesian multiplier, it shows that the firm investment will determine the output level and hence employment. This small model shows why equality between saving and investment is important. Indeed, by deciding their level of investment, firms also fix the level of household saving. What is remarkable in the Keynesian model is that in trying to change their saving, households, in fact, change the level of their income. In our example, households find that their saving is too strong and, to decrease it, they increase their consumption. But by increasing their consumption, they also increase by the same amount the level of their income, so that their saving does not change. The process continues until the household income has reached a level compatible with the level of saving fixed by firms. An insufficient level of investment generates unemployment The Keynesian multiplier shows that the value of output and nominal income, that is to say, the income expressed in monetary units, depend on the value of the investment. But a decline in the value of output induced by a lower level of investment can come both from lower prices as a decline in activity. So suppose a situation where the level of investment ensures full employment and that, due to pessimistic expectations of entrepreneurs, the level of investment falls to zero. To take account of the time lag between the moment when entrepreneurs must incur costs to produce and the moment when they can sell their products, we can introduce time periods. At the beginning of each period, entrepreneurs must decide the level of their production. They base their decision on the price of labor they can find on the market and on a forecast of the price of their products when they become available on the market. They anticipate an output they can compare to the labor cost of production. If their expected profit seems satisfactory, they start their production. At the beginning of the period, firms pay wages; the expected value of output is equal to the income actually paid in wages plus profit corresponding to anticipated income. At the end of the period, the products are for sale. Employees will determine their Francis Malherbe 4

5 5 consumption on the basis of the wages they received and entrepreneurs decide it on the basis of their expected profits. But, because of their desire of saving, their consumption is lower than the paid or anticipated income, that is to say less than the value of the supplied products. Following this lack of demand, firms have the choice between lowering their prices in order to sell all of their products or to store part of them. In both cases, entrepreneurs do not realize their profit forecasts. In the next period, firms tend to reduce their production to match demand. However, they may also seek to restore their profits by exerting downward pressure on wages. If they do indeed fall, firms revise their profit forecasts upward, and if they are deemed satisfactory, they start their production. But if investment remains zero at the end of the period, we are in exactly the same situation because of the household desire of saving, demand is lower than supply. The firm response would then be to reduce the quantities produced. If firms reduce the quantities produced, they also reduce their demand for labor. This results in a decrease in the price of labor, that is to say, the hourly wage. Faced with this decline, employees can react in two ways, either they can reduce their offer because the work is less attractive compared to leisure, or they can increase their supply to maintain their purchasing power. Lower income is and stronger the second effect is, so that if production and thus the demand for labor continue to decline, it necessarily comes a time when the income of employees will be so low that the labor supply will increase. It will eventually exceed the demand for labor, that is to say that unemployment will appear. Gross value and net values It is necessary to introduce here in the analysis the depreciation of the physical capital of the firms (national accountants call it fixed capital) and to distinguish between gross investment and net investment. In fact, the physical capital of the firms deteriorates over time and must be replaced to maintain production capacity. Part of output is to be dedicated to replace fixed capital; this part is what national accountants call consumption of fixed capital. The part of output used to increase or maintain fixed capital is gross investment; the effective increase in fixed capital is net investment, it is equal to the difference between gross investment and consumption of fixed capital. Note that net investment may be negative. Indeed, consumption of fixed capital measures the effort that would be required to maintain fixed capital and not the effort actually performed. Since firms are not obliged to maintain in all their machines or all their buildings, it is possible that gross investment is lower than consumption of fixed capital, so that net investment is negative. This corresponds to a reduction in fixed capital. Consumption of fixed capital has two dimensions: 1 a physical dimension corresponding to the deterioration of fixed capital; 2 a dimension in terms of income since it corresponds to the concept of provision for depreciation in private accounts. In fact, firms do not distribute the part of their income corresponding to their provision for depreciation. Francis Malherbe 5

6 6 So, when we say that firms distribute all their income to households, we must understand that they distribute to households the value of their output minus their consumption of fixed capital. Output corresponds to gross income and the difference between gross income and consumption of fixed capital is called net income. In fact, firms distribute their net income and not their gross income to households. For example, if output is 500 and consumption of fixed capital is 100, firms distribute to households 400 and not 500. Assuming that households have no production and therefore no fixed assets, they have no consumption of fixed capital, and their net income is equal to their gross income. Saving can also be calculated gross and net. For households, net saving is equal to gross saving. The equality between saving and investment is also equality between the net investment of firms and household saving. Net investment = household saving This equality is very important because the net investment of firms measure the increase in fixed capital and saving measures the increase in household wealth. Equality between the net investment and savings means that, as a whole, the increase in household wealth is necessarily equal to the increase in fixed capital. Net saving and investment are two sides of the same coin, accumulation. Net investment is the measure of the increase in wealth from the viewpoint of accumulation of goods; saving is the measure of the value of the new property rights over these goods, that is to say, accumulation expressed in terms of rights. It is possible to summarize the Keynesian theory in very simple terms: 1 as households destroy goods they buy, their accumulation of wealth can only be the counterpart of the accumulation of goods by firms, that is to say, the counterpart of net investment; 2 households do not determine total accumulation, they can at best only influence it; in fact, only firms, through their net investment, can decide accumulation of goods and thus also its counterpart in terms of rights, that is to say, household saving; 3 households want, but when they reach a threshold of extreme poverty, to devote part of their income to accumulation, in other words they do not choose between consumption and saving, but both want consumption and saving, which means that they link their consumption to the increase in their wealth, the more important it is and the more households will consume; 4 if firms have no more incentive to invest or if they cannot do it, so household saving is zero, which leads them to reduce their consumption that will fall to its minimum level, resulting in the fall of production and income, it is the crisis. Therefore, according to Keynesian theory, the increase in household wealth is the real engine of the economy, it makes possible full employment. This engine is normally powered by net investment, but when this fuel runs out, alternative fuels have been proposed, the most famous of them being government deficit. Francis Malherbe 6

7 7 Deficits: miracle cure or time bomb? Net investment determines the total accumulation; if firms and households are the only economic agents, the increase in household wealth is necessarily determined by net investment, but if there is another economic agent, the situation changes. Indeed, the total accumulation will be shared between households and the new agent. Keynesian policies make government this new agent. Thus, the net investment of firms determines the total increase in wealth to be shared between households and government. The idea behind Keynesian stimulus policies is this: when the net investment of firms is insufficient to generate an increase in the wealth of households consistent with full employment, it is possible to compensate for the weakness of the total accumulation by a negative accumulation of government, that is to say, by a decrease in its wealth. Indeed, equality between saving and investment becomes: Increase in household wealth = net investment + decrease in government wealth Or, in more economic terms: Household saving = net private investment + government deficit We assume here that the net saving of firms is zero. The decrease in government wealth is obtained by a budget deficit, that is to say when government spending exceeds its revenue. Government spending increases household income, either directly when government pays wages, or indirectly through production when government buys goods and services. Main government revenues are taxes; they are deducted from household income. Therefore, the budget deficit corresponds to an increase in household income resulting from opposing spending and revenue effects, it plays a similar role to net investment in the mechanism of the Keynesian multiplier. This capacity of the budget deficit to boost the economy is the basis of the Keynesian policies. However, the analysis should be refined because the impact of the budget deficit on the economy differs depending on the method of financing. There are two basic methods of financing the budget deficit: 1 borrowing money from the central bank; 2 borrowing funds from financial markets in the form of bonds (treasury bonds). When the deficit is financed by the central bank, that is to say by money creation, the decrease in the wealth of government is expressed by the increase of its debt to the central bank; the increase in household wealth is an increase in their holdings of money, that is to say an increase in claims on the banking industry. Since the banking industry itself has a claim against government, the decrease in wealth of government takes the form of an indirect debt to all households that own money. Francis Malherbe 7

8 8 When the deficit is financed by issuing bonds, the increase of these bonds corresponds both to a decrease in the government wealth and in an increase in the household wealth. In this case, government is indebted to households that have purchased bonds. The main difference between a debt in the form of money and a debt in the form of bonds is that it is not possible to claim back the money issued. By choosing to finance its deficit by the central bank, government indirectly requires all households to finance it. If households consider they have too much money in comparison with bonds, they have no choice to reduce the liquidity of their assets but to acquire bonds issued by firms. The supply of bonds being limited, their price will increase and thus their yield will decrease. The increase in bond price encourages companies to issue new ones, that is to say, to invest. This is the second effect of money creation to finance the budget deficit, in addition to its direct impact on demand, it stimulates the firm investment. Its main disadvantage is the risk of inflation that creates growth in the money supply when the country is close to full employment. In a way, by choosing to finance its deficit by issuing bonds, government requests permission to households having money. It offers an alternative to acquisition of bonds issued by firms, allowing households to continue to increase their wealth in the form of bonds when the firm supply is insufficient. In this case, government competes with firms in the bond market, so the price of bonds drops and their yield increases. The decline in prices will result in a decrease in the supply of bonds by firms, that is to say, in a decrease in investment. But the main drawback to finance the budget deficit by issuing bonds is the increase in the government debt. The two ways of financing the budget deficit therefore correspond to different objectives; the goal of an economic policy based on the financing of the budget deficit by money creation is only to boost the economy; the objective of an economic policy based on the financing of the budget deficit by issuing bonds is also to maintain the yield of bonds. The problem is that none of these methods of funding can be continued for long without serious consequences, especially when it results in an increase in public debt. The public debt generates interest payable by government, this interest increases the deficit if it is not offset by higher taxes, the deficit is added to the debt and interest is growing again. At a certain level, the system becomes explosive and leads inevitably to the collapse of government. Zero growth Thus, if the budget deficit can stimulate the economy during a temporary weakness of investment and smooth out economic cycles, it is not a solution to unemployment when net investment remains on a long-term basis at very low levels. Two questions arise: Are there any situations where net investment could permanently remain at levels insufficient to maintain full employment? Are there any solutions to deal with situations like this? Net investment aims to increase fixed capital, for it takes place, it must be both desired by firms and physically possible. Francis Malherbe 8

9 9 A firm wants to invest only when it expects a benefit, that is to say, generally, to face growing demand, either to improve its productivity and thus increase its profit. The growth in demand is the result both of population growth and growth in per capita consumption. When population growth is low, the demand growth can only come from the growth in per capita consumption. If there was only one product in the economy, it is clear that growth in consumption will necessarily encounter, from a certain point, a saturation level that would constitute a ceiling impossible to exceed. For example, a household may buy a television every year, if the prices of televisions fall, it may buy two a year, if prices fall again maybe he will buy three a year, but even if televisions were free, would he go to buy a thousand a year? This reasoning is valid for all products. Thus, consumption growth cannot continue without introducing new products. However, if new products just replace the old ones, there is no guarantee that they will require more fixed capital and therefore that they will generate sufficient net investment to ensure full employment. Indeed, if the lifetime of a product is predictable, amortization of capital, that is to say consumption of fixed capital, offsets the positive impact of new investments on net investment. Only products satisfying really new needs, and able to generate such enthusiasm that households sustainably accept to devote to their purchase a significant portion of their income, can generate important profit expectations and therefore a significant net investment for long periods. Unfortunately, the invention of such products cannot be decreed. However, net investment should not only be desired, it should be possible. The problem is that, in an economy without population growth or productivity gains, it necessarily comes a time when net investment is zero. Indeed, capital depreciation is approximately proportional to the fixed capital installed while, from period to period, gross investment is approximately constant. Thus, for a given investment effort, consumption of fixed capital will steadily grow along with the fixed capital; the higher fixed capital will be and the lower net investment, which is equal to the difference between a constant gross investment and an increasing consumption of fixed capital, will be. Necessarily comes a time when the growth of fixed capital almost stops and when net investment becomes negligible. This remains true even if all resources of the country were exclusively devoted to investment. At this point of time, any new investment can, at best, only offset the deterioration in fixed capital. This situation corresponds to that described by Keynes, that is to say a situation in which the economic activity will result in a succession of phases of growth and depressions. In countries where population growth is close to zero, only productivity gains allow to escape this scenario. But, again, productivity gains cannot be decreed. Another cause of impossibility to maintain net investment at a level sufficient to ensure full employment is the depletion of natural resources. Indeed, natural resources are limited and, for a given level of technology, only can stand a limited activity. In addition, constraints related to the protection of the environment impose a ceiling on economic activity that cannot be overcome without serious consequences for future generations. This ceiling on economic activity is also a ceiling on fixed capital, that is to say, a level of activity at which net investment becomes impossible. Francis Malherbe 9

10 10 It is sufficient that one of the conditions listed above is satisfied for net investment jams and plunges the economy into recession. So, we see that there are circumstances where growth may permanently jam; this is the case with the depletion of natural resources, which is likely to be the main source of concern for decades to come. Thus, it is not because the world has experienced long periods of growth that this is the normal situation of an economy. Since zero growth is only compatible with a zero net investment, is the world condemned to live an uninterrupted succession of phases of growth and recession? To permanently eliminate economic crises, Keynes proposed, not to increase budget deficits, but to maintain the rate of profit to a level close to zero by moving fixed capital at a very high level. Under this condition, the household financial investment would no more be profitable and they would no longer really be interested in accumulating wealth. On the contrary, households would be encouraged to spend during their old age the wealth they have accumulated during their working lives. In other words, Keynes saw in the falling rate of profit a way to encourage households to voluntarily stabilize their wealth, that is to say, a way to maintain their increase in wealth at zero, which is the only level compatible with the zero net investment that characterizes a stationary economy. However, one can doubt that the method proposed by Keynes is sufficient because even though financial investments do not yield anything, households still continue to try to save throughout their lives, firstly because they do not know when they will die, so that an excessive dissaving could plunge them into poverty before they died, secondly because many households want to leave a legacy to their children. The problem is the following: households want to save for accumulating wealth throughout their lives; zero growth is not compatible with any increase in household wealth. This problem is not insoluble if we accept to introduce, as do national accountants, a distinction between current and capital transactions. Keynesian theory rests on a strong link between income and consumption, but this link really exists only if income is defined exclusively from current transactions. Capital transactions are mainly characterized by their exceptional character. Because of this character, their impact on consumption is relatively limited. For example, a household that usually consumes 80% of its income is not going to consume 80% of a legacy when it receives it. It is more likely that its consumption will increase mainly due to the increase in its income that will generate its legacy. Conversely, a household that suffers an extraordinary loss generally will not reduce its consumption unless its loss has a negative impact on its income. Therefore, national accountants define income only from current transactions, that is to say: Income = output + current transfers receivable current transfers payable The main current transfers are wages, property income and current taxes. Francis Malherbe 10

11 11 The definition of saving has not changed, it follows that saving is the increase in household wealth only due to current transactions, what we might call the current increase in household wealth. The increase in household wealth can be decomposed into two components, the current increase in household wealth and the exceptional one. The link between consumption and saving is thus a link between consumption and only the current increase in household wealth. Therefore, it becomes possible to preserve the current increase in household wealth that generates consumption while maintaining a total increase in household wealth equal to zero. To do that, it is sufficient to offset the required current increase in household wealth by an exceptional loss. Since this loss cannot be voluntary, government must impose it. In this case, the lost will be caused, not by a destruction of wealth, but by capital transfers from households to government. In practice, the only significant capital transfers from households to the state are inheritance taxes. In this case, the exceptional loss of households is offset by an exceptional increase in the wealth of government. If the total increase in wealth is zero for the whole economy and zero for households, it must also necessarily be zero for government. Thus, the increase in wealth of government coming from inheritance taxes must be offset by a current decrease, i.e. by a current budget deficit. Therefore, the solution to the problem of zero growth is, in the framework of a demand-side policy, to fill current deficits by capital transfers rather than to finance them by an increase in the government debt. In principle, this solution is very simple to understand. When net investment is permanently nil, the problem is the desire of households to increase their wealth that cannot be met sustainably. If households had the opportunity to increase their wealth throughout their lives and if, when they die, this increased wealth was transferred to government through inheritance tax, the desire of each household to get rich would not be incompatible with maintaining a constant level of wealth held by all households. Note here that it is not necessary that all the wealth accumulated by households for their lives to be taken, just the tax rate must be high enough to stabilize quickly the total wealth of households. Another possibility is to introduce taxes on property prohibiting its growth beyond a certain limit. However, the disadvantage of this solution is the risk of killing any incentive to engage in those that reach the ceiling. Keynesian policies in an open economy Strictly speaking, Keynesian theory is valid only in the context of a closed economy, i.e. without external relations. It is valid for the global economy as a whole but not for each individual country. We assume here, for simplicity, that there is no transfer of income between countries. If we also assume that firms distribute all their income to households in each country, household income is equal to output. Keynesian theory rests on the idea that, if Francis Malherbe 11

12 12 household income is equal to output, households are not forced to spend all their income to buy output, they can use some part to acquire financial assets, that is to say, money and securities. In an open economy, households have more choices; they can buy products and financial assets not only in the country but also abroad. Conversely, foreign economic agents can purchase products and financial assets in the country. In a given country, domestic output is equal to the sum of domestic demand and external demand. Domestic demand comes from domestic firms and households; it is the share of investment and consumption that is aimed at domestic firms. As the demand for products from firms and households can also be satisfied by the foreign supply, that is to say by imports, domestic demand is equal to investment plus consumption minus imports. External demand is exports. Therefore, in an open economy, we have: Output = consumption + investment + exports imports The difference between exports and imports is the balance of trade. In a closed economy, an increase in investment results in increased production, so in increased household income and, consequently, in increased consumption. In turn, the growth of consumption generates an increase in production, it is the Keynesian multiplier. In an open economy where goods and capital can move freely, it is no longer necessarily the case. Indeed, an increase in investment may also result in deterioration of the balance of trade. To understand when this will happen, it is necessary to distinguish between free movement of goods and free movement of capital. In case of free movement of goods, the market for goods is global, so that the product prices expressed in an international currency tend to equalize in all countries. Countries can specialize, which increases global production; it is the Ricardo s theory of comparative advantage. However, the free movement of goods does not necessarily imply the emergence of surpluses or deficits in the balances of trade of countries. Indeed, if we assume that there is no income transfer between countries, the balance of trade is inextricably linked to the balance on financial account, a surplus in the balance of trade necessarily corresponds to a deficit in the financial account, and a deficit in the trade balance necessarily corresponds to a surplus in the financial account. This relationship stems from the fact that a country supplies and demands abroad for both goods and financial assets. In the absence of transfers, the total supply is necessarily equal to the total demand. That is to say: Exports + sales of financial assets = imports + purchases of financial assets Or: Exports imports = purchases of financial assets sales of financial assets The balance of trade is equal to the opposite of the balance on financial account. Francis Malherbe 12

13 13 If there are no capital flows, i.e. if there are no flows of financial assets, the balance on financial account is zero, so that the balance of trade, too, is necessarily zero. In other words, in the absence of capital flows, imports and exports are necessarily balanced. The consequences for the Keynesian theory are extremely important. Indeed, if the balance of trade is zero, the Keynesian theory is fully valid since an increase in investment and consumption can only lead to an increase in production. Thus, in the absence of capital flows between countries, the Keynesian theory is as valid as in a closed economy. If products and capital can move freely, economic agents can buy or sell products and financial assets to other economic agents regardless of their nationality; the equilibrium of the balance of trade and of the balance in financial account is no longer insured. Domestic production is no longer only determined by domestic demand but rather by its global market share. Under these conditions, Keynesian fiscal stimulus policies become less effective since an increase in domestic demand will result in a deterioration of the balance of trade and not in an increase in production. Since the liberalization of capital movements makes demand-side policies ineffective, countries can improve their situation by opting for supply-side policies, that is to say, by policies aiming to improve the competitiveness of their firms. However, the liberalization of capital movements has another important consequence, the trend towards equalization of rates of return on financial assets and, consequently, rates of profit on capital across countries. But, because of the equalization of the prices of fixed assets, a technology requires the same capital all over the world. The rate of profit being unique, it follows that capital income should be independent of countries. The value of output is also independent of countries, wages that are equal to the difference between output and capital income should be too. But, for a given technology and expertise level, the productivity of a worker is independent of his country. Therefore, the liberalization of capital movements implies the equalization of wage rates between countries. The world has experienced several periods of globalization; the present period has the specificity to connect capital-intensive countries with high wages and relatively small populations to countries with low capital intensity and vast reserves of underpaid workers. It therefore radically changes the relationship between capital and labour in favour of capital and involves lower wages in countries where they are above world levels. Therefore, high-wage countries that have opted for the free movement of goods and capital have only three options: to accept the fall of their wages; to accept the continued rise of unemployment; to abandon the free movement of capital. Liberal economists usually justify the free movement of capital by the search of an optimal allocation of scarce resources that are capital and labour. This argument would be valid if capital was actually a scarce resource, but the real scarcity is not the scarcity Francis Malherbe 13

14 14 of capital and labour but rather the scarcity of natural resources and labour, therefore it is the optimal allocation of natural resources and labour that should be sought. It is made difficult, if not impossible, by the existence of borders and policies that restrict free movement of labour. In the medium term, fixed capital is not given but largely results from interest rates. The lower interest rates are and the larger capital is. But one of the main results of the Keynesian theory is to show that, in a closed economy, the interest rate is determined by monetary policy. Therefore, the relative scarcity of capital is also the result of the various economic policies adopted by countries. So, the free movement of capital does not aim to optimally allocate scarce resources, but to make profit rates independent from monetary policy, that is to say, to make the relationship between capital and labour independent from government. Threats to global growth It is only at the global level that the equality between saving and investment is strictly verified. If we adopt the hypothesis that capital taxes are negligible, it can also be written: Private saving = net private investment + government deficits In its first phase, globalization has resulted in massive private investments in emerging markets that benefited from low labor cost. At the same time, developed countries have sought to maintain their business activity threatened by their new competitors by increasing their government deficits. The combination of these two actions strongly boosted global growth. But this situation is not sustainable. Private investment can only slow down with the inevitable saturation of demand. Similarly, government deficits have fueled debts that have reached unsustainable levels and impose restrictive fiscal policies. To these unfavorable elements, a third one should be added, the increase in income inequality. Indeed, the saving rate of upper class households is higher than the saving rate of middle and working class households. Thus, the average saving rate increases if the upper classes get a larger share of global income, which has a negative impact on growth. Currently, two factors are in line with an increase in social inequality. The first one comes from the scarcity of natural resources. Indeed, the exploitation of natural resources is an activity with a diminishing marginal productivity, so that the share of rent in the value added of industries increases with the level of GDP. Therefore, the fact that a significant share of natural resources, including oil, is owned by a small number of extremely rich people results in a global saving rate growing with GDP, which is an obstacle to growth. The second factor is the increasing financialization of the economy that was accompanied by the development of speculation. Francis Malherbe 14

15 15 Monetary system and financial speculation Financing the economy Firms that invest require long-term funding since, to produce, they must acquire fixed capital which may provide returns only after several years. To obtain financing they can appeal either to households or to the financial system. When firms directly appeal to households, households who acquire securities indirectly become the owners of firms capital goods. When firms use financing of the financial system two scenarios are possible: the financial system plays an intermediary role by borrowing households and lending to firms; in this case, households who acquired securities issued by the financial system indirectly own the firms investment goods; Banks issue money to lend to firms; that money finally arrives among households so that, in this case, households holding money indirectly own firms investment goods. When banks finance firm investment by money creation, they impose this investment to households because households do not have the option to request repayment of the money they hold. But banks also compete against households to purchase securities. The additional demand for securities has the effect of raising their price. According to Keynes, the rise in the price of securities has no impact on the income they generate, so it results in a decrease in their rate of return. This lower rate of return on securities, which is a lower cost for firms, encourages investment. The development of financial markets, however, profoundly changed this pattern. Indeed, the profit accruing to the purchaser of securities not only comes from the income they generate, but also from holding gains. It is useful to consider three categories of assets other than money: investment goods; securities issued by firms; land and natural resources. These three types of assets are competing; all three can generate both income and holding gains. Normally, securities issued by companies cannot yield more than investment goods they have funded but expectations for future holding gains may make securities more attractive than investment goods. When the economic outlook is unfavorable, the net investment of firms and their issue of securities are low. To stimulate investment, banks may intervene in issuing money to purchase securities. This policy may have the opposite effect to that intended. Indeed, demand from banks raises the price of securities and thus the expectation of holding gains; it may become more attractive to acquire securities than investment goods. The competition between securities and investment goods has resulted in a decline in Francis Malherbe 15

16 16 investment, and hence in the supply of securities, which further strengthens the phenomenon. Due to the existence of holding gains, the securities market, which owes its existence and its social utility to the financing of firm investment, can be an obstacle to it. This is particularly the case when banks massively intervene in this market by creating money. A similar effect occurs when the demand for assets is focused on land since land cannot be produced, so that an increase in demand can only result in higher prices and thus in expectations of holding gains, which can make the acquisition of investment goods less attractive. Thus, the growth of the money supply due to the financing of the acquisition of securities and land results, not in inflation, that is to say, in a continued rise in product prices, but in the rise of the prices of these assets. This increase in the prices of assets, which does not correspond to an increase in real wealth, penalizes productive investment by generating expectations of holding gains and has two additional effects: the redistribution of real wealth for the benefit of those who own these assets; the increasing difficulty for those who live by their labor to build wealth. This is further strengthened by the development of financial speculation. Financial speculation The principle of financial speculation is simple: the speculator buys a security when its price is low and sells it when its price is high; in this transaction, the speculator realizes a capital gain equal to the difference between the selling price and the purchase price. Speculation is a zero-sum game, that is to say, what is gained by one participant is necessarily lost by the other participants; it generates no overall increase in wealth. If all economic agents had the same information and the same fortune, it would be statistically impossible to make money by speculation and therefore, it would be very risky to do this job. But the real society is made of inequality both in the domain of information and in the domain of fortune. The role of inequalities of wealth is particularly important because in a zero-sum game, the winner is statistically the participant who can handle the greatest losses, that is to say generally the richest. Thus, firms that specialize in speculation could develop and take considerable importance. These firms are profoundly altering the functioning of the economy because they offer to financial investments an alternative to productive investment. We can therefore consider that the economy is composed of two competing sectors, the speculative sector and the productive sector, that is to say, the sector producing real wealth. With the globalization of financial markets, the development of mathematical tools and information technology, firms in the speculative sector reach very high levels of rate of return. In the productive sector, firms are obliged to reach these high rates of return because capital goes where it is better paid, a firm providing a lower rate of return would not be able to finance its investments. Therefore, firms in the speculative sector impose to the rates of profit of productive firms a floor below which it is impossible to go down. The problem is that this rate of Francis Malherbe 16

17 17 profit may be not compatible with a level of production sufficient to ensure full employment. The speculative sector is not very sensitive to monetary policy. Indeed, the gain from a speculative transaction of purchase and sale of an asset mainly depends on the fluctuation of its price, the rate of return is directly derived from the ratio between the purchase price and the sale price, and it is quite independent of the level of the price of the asset. Thus, a policy of creating money by buying securities tends to increase their prices but has no impact on the rate of profit of speculative activities. Since this rate is the floor below which the rate of profit in the productive sector cannot descend, an expansionary monetary policy can no longer promote the financing of the productive sector and stimulate its activity. By keeping rates of profit, that is to say the cost of capital, at very high level, financial speculation makes capital-intensive activities less competitive. Since these activities are the most productive, it results in a general decrease in wealth. At the international level, it promotes economies with low capital and low labor cost at the expense of capitalintensive countries with high wages. Thus, speculation has three major effects on the economy: it leads to a concentration of wealth, which not only influences aggregate demand, but also its structure, as well as that of supply: financial services, luxury goods industries and services that meet modern forms of domesticity are particularly favored by the development of financial speculation; It competes with other activities by the rate of profit it generates, so it tends to stifle productive activities; it keeps the cost of capital at a high level, which makes the capital-intensive activities less competitive and leads to a general decrease in wealth. Financial speculation also questions the legitimacy of the market economy. This legitimacy is based on the idea that whoever earns the most is also the most useful. This is true to some extent in the productive sector where production is a source of wealth and brings in the maximum profit to the most useful activities. In the case of speculative sector, gains are not related to any social utility, they come from an activity that is close, in many ways, to a simple predation. However, financial speculation would never have the scale that we know without the support of the banking system. The new power of finance Globalization has profoundly changed the functioning of the banking sector. Indeed, because of the free movement of capital and the existence of tax havens, it has become very difficult for central banks to control the system, so that most of the money creation comes from commercial banks. Francis Malherbe 17