Krugman & Kalecki, “injecting” to escape from a sub-optimal reality

Paul Krugman today wrote that we are in a “Keynesian crisis that calls for Keynesian policies”. Keynesian policies are monetary and fiscal policy to increase demand in the economy.

I wrote a response earlier today about an article from Mark Thoma who called for the same Keynesian policies of monetary and fiscal policies to increase demand. My view is that in normal times, those policies would take us back to a normal real GDP, but since labor share has fallen, the true and natural real GDP now sits at a lower level. If we then use Keynesian policies to push toward a higher real GDP that is above this new lower natural level, we will create an imbalance that could only be maintained by continued “injections” of Keynesian policy. The injections are deficit spending and expansionary monetary policy.

The title of this post implies that the injections are like a drug that lifts us to a “high” in order to escape the dreary, disappointing sub-optimal reality that we live. Economically, we now live in a sub-optimal reality due to a lower labor share of income. (see circular flow model) In order to maintain that “high”, the injections would have to be continued and never stopped. Because if they were to stop, the economy would come down to its true reality. This would cause a recession… like withdrawals from an addiction.

Krugman in his article noted that Michael Kalecki, the famed contemporary of Keynes, “had the answer“. If you mention Kalecki, you know you are going to read something about effective demand. Kalecki worked harder on the idea of effective demand than Keynes in my opinion. My work in economics focuses on effective demand, so I have something to say.

In the Kalecki article that Krugman linked to, we find this written.

“If the government undertakes public investment (e.g. builds schools, hospitals, and highways) or subsidizes mass consumption (by family allowances, reduction of indirect taxation, or subsidies to keep down the prices of necessities), and if, moreover, this expenditure is financed by borrowing and not by taxation (which could affect adversely private investment and consumption), the effective demand for goods and services may be increased up to a point where full employment is achieved.” (source)

This quote  is a basic argument for a Keynesian policy of deficit spending to inject demand into the economy. It is important that the government receive its money by borrowing, because an increase in taxes would be a withdrawal from the economy. The increase in taxes would offset or neutralize the effect of the deficit-spending injection.

Does effective demand actually increase with added injections of deficit spending? Yes, as long as it is within the effective demand limit, where effective labor share is still above the product of labor and capital utilization. Can increased injections push the economy beyond the effective demand limit? Yes… but …

Kalecki writes in the link offered by Krugman …

“It may be objected that government expenditure financed by borrowing will cause inflation.  To this it may be replied that the effective demand created by the government acts like any other increase in demand.  If labour, plants, and foreign raw materials are in ample supply, the increase in demand is met by an increase in production.  But if the point of full employment of resources is reached and effective demand continues to increase, prices will rise so as to equilibrate the demand for and the supply of goods and services.  (In the state of over-employment of resources such as we witness at present in the war economy, an inflationary rise in prices has been avoided only to the extent to which effective demand for consumer goods has been curtailed by rationing and direct taxation.)  It follows that if the government intervention aims at achieving full employment but stops short of increasing effective demand over the full employment mark, there is no need to be afraid of inflation.

The bolded sentences basically say that if the economy finds full-employment at or under the effective demand limit, prices will equilibrate between supply and demand and inflation will not be a problem. The implication is this… If government expenditure pushes production over the effective demand limit, there will be inflation.

I am here to say that the effective demand limit sits at a real GDP of $16.1 trillion (2009 dollars). That level is dependent upon an effective labor share close to 74%. By my calculations, at that level of real GDP, unemployment will come down to between 6.7% and 7.0%, which is not full-employment in the eyes of Krugman, Thoma and many others. They will want to push real GDP beyond $16.1 trillion with more injections… toward the CBO potential real GDP near $17 trillion. The result will be lower unemployment with inflation. Then everyone on the right in economics will accuse them of causing inflation just like “typical” Keynesians. The right will accuse them of taking the economy back to the 1960s. Hippie drugs and all.

Even if there is no inflation from pushing real GDP over the effective demand limit, which is a possibility, the economy would still want to lower real GDP back down to the effective demand limit. There are mechanisms of the profit rate that make that happen. Kalecki and Keynes wrote about that. Thus to maintain the induced “high” of a higher real GDP, the injections would have to be maintained and probably even increased over time. At some point in time, the pressure to stop the injections would mount, the injections would decrease and the economy not being able to maintain the artifical “high” real GDP on its own, would fall into recession.

Kalecki had an advantage over Krugman, Thoma and others. He was keenly focusing his awareness on the effective demand limit, even though he did not have a clear way to predict it. I work on an equation that can predict the effective demand limit. Krugman, Thoma and others need to be aware of the effective demand limit. Without this awareness, their policies will create a drug-induced high that will only lead to a harsher crash back to reality in the future.

They really should be talking about ways to increase the effective demand limit to protect us from inflation and other problems. The only way to do this is to raise labor’s share of income. I don’t see them giving any ideas on this over the past 2 days.