In today's Finshots we talk about Keynes, the great Depression and government spending

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The Story

Yesterday, we summarized the budget and in it, we wrote — “The government intends to spend big on capital assets (roads, bridges and dams) to spur the economy back into life.”

One reader wrote back asking — “How?”

Well, that’s a complicated question and the answer may be beyond the scope of this article. But we thought we could offer more context on how this idea gained mass appeal i.e. When did people begin to recognize that government spending (even when financed by large amounts of debt) could in fact reverse “economic decline?”

Okay! To understand this bit we need to go back in time.

Back in the 1930s, the world was in crisis. The Great Depression was in full swing. A quarter of the US workforce was unemployed. And those that still remained employed saw their wages cut. It was an economic recession like no other. The popular consensus at the time was to leave the economy to its own device. Let it be, they said.

And despite the nonchalant approach, this idea has some intuitive appeal. Think about it — In a competitive marketplace, a mismatch in demand and supply can’t last forever. Market forces will correct it sooner or later. If oranges are selling for Rs. 1000 a kilo, more farmers will grow oranges next season. The ensuing supply will precipitate an equilibrium. Demand will match supply — someday.

And economists reasoned — that this would transpire in any rational universe if we simply let people act on their own accord.

— That someday demand will spontaneously bounce back and incentivize companies to produce more.

— That prosperity is just around the corner.

But one economist, a certain John Maynard Keynes argued that this was madness. He didn’t think the government should just sit back and wait for the economy to rebound. Instead, he advocated for active intervention. He believed that the state had an important role in reversing the economic slump and he batted for massive government spending.

In fact, he had some pretty radical ideas. At one point he confessed — “The government should pay people to dig holes in the ground and then fill them up.”

The critics would reply — “That’s stupid, why not pay people to build roads and schools”

Keynes would respond by saying — “Fine, pay them to build schools. The point is it doesn’t matter what they do as long as the government is creating jobs”

Paul Krugman, the Nobel Prize-winning economist offered another analogous metaphor advocating government spending after the 2008 global financial crisis. This is how he put it —

If we discovered that, you know, space aliens were planning to attack and we needed a massive buildup to counter the space alien threat and really inflation and budget deficits took secondary place to that, this slump would be over in 18 months. And then if we discovered, oops, we made a mistake, there aren’t any aliens, we’d be better. . . .

The idea being that government spending can spur the economy back into life even if such spending is misdirected, or in this case, directed against an alien invasion that never comes to fruition. There’s an assumption that such spending can often stimulate the private sector to get in on the act as well. A multiplier effect could kick in — aiding economic growth even though there may be some wasteful spending in the mix.

At first, not many people were convinced that this would work. But when US President Franklin D. Roosevelt embarked on a government spending mission in the 1930s, everything changed. As we wrote in one of our articles —

“At the height of the Great Depression, US President Franklin D. Roosevelt’s Public Works Administration (PWA) paid private construction firms $7 billion to build airports, dams, bridges, roads, schools, zoos, tennis courts, theatres, dormitories, and hospitals. It was a desperate act of rebellion against the faltering economic engine. A Hail Mary pass, if you will.

The hope was that this spending would rejuvenate demand — more jobs, more spending, more economic activity and a virtuous cycle of growth. But there was another angle here. Roosevelt wanted the PWA to provide local jobs directly to the unemployed. And although new jobs couldn’t outpace unemployment levels in the country, it put 8.5 million Americans to work, who went on to erect 600,000 miles of new roads, build 100,000 bridges and construct 35,000 buildings.

Some believe that this helped turn the tide for the American economy back in the day.

But others are not so convinced. They believe many factors were at play and they argue that wasteful spending has costs associated with it —Costs that governments seldom take into account. So yeah, there’s little consensus on whether government spending on capital assets can in fact spur the economy back into life. But governments across the world, including India, commit to these programs nonetheless.

As proponents of Keynes would argue — “Sometimes doing something is better than doing nothing.”

So let’s build roads, bridges and dams now, shall we?

Until next time…

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