Across the globe, politicians from Manmohan Singh to Barack Obama plan to boost government spending to revive flagging economies. Especially popular are big infrastructure projects, widely seen as an excellent way to give a Keynesian boost to economies. Yet this represents a misunderstanding of Keynes.
In a recession, many things fall together—production, employment, prices and business profits. Businesses go bust, and this can lead to runs on banks and a crisis in the financial system. Keynes emphasized that the root cause of a depression was a vicious downward spiral of consumption. Tackle that, he said, and a flagging economy can revive.
Andrew Mellon, US Treasury Secretary in 1929-33, viewed the Great Depression as moral retribution for wicked over-spenders, and a recipe for increasing prudence and savings. By contrast, Keynes realized that a recession was caused by excess saving, which drove down demand and GDP in a vicious downward spiral. To escape the spiral, Keynes proposed government action to boost consumption and end over-saving. The government could boost its own spending through public works. Or else it could cut taxes to boost private consumption.
Keynes did not advocate building infrastructure. Instead, he suggested that governments should pay people to dig ditches and then fill them up again. This would not create infrastructure. But it would put money into the pockets of people, and that was the aim of the exercise.
Why, then is infrastructure creation so widely equated with Keynesian economics? Because of public misunderstanding of the history of the Great Depression. US President Roosevelt launched the New Deal to combat the 25% unemployment he faced on being elected in 1932. The New Deal created jobs in projects to build roads, dams and electric systems. It was a huge political success, and aided his re-election in 1936 and 1940. Yet economists remain sharply divided on its economic impact.
The economy revived from 1932 to 1936, but then plunged into a fresh depression in 1938, wiping out most earlier gains. So, the New Deal created jobs quickly, but not sustainably. It failed to address the financial collapse and deflation that many economists believe turned a mere recession into a Great Depression. T he downturn was finally cured not by the New Deal but by World War II: the wartime economy needed all the manpower available.
In the middle of the Great Depression, Keynes produced his seminal General Theory, explaining the interaction of production, wages and employment. During the New Deal, Roosevelt swore by balanced budgets, the ruling economic orthodoxy. But Keynes’ General Theory argued that this was a mistake, and that governments should run large fiscal deficits during a recession to pump more demand into the economy. Roosevelt’s budget-balancing efforts typically failed, and he often ended up with budget deficits without meaning to. So he was a Keynesian by accident more than intention.
Yet the public remembers Roosevelt as the first leader to try to spend his way out of a recession, exactly what Keynes advocated. After World War II, Keynesian demand management became the new economic orthodoxy. Governments everywhere began pumping money into flagging economies to stimulate growth.
Hubris followed. In the 1970s, constant pumping of money led in many countries to inflation rather than growth. Clearly, Keynesian spending did not boost GDP in all situations. But it retained its reputation as a useful tool, though not a panacea, in recessions.
Global experience showed that Keynesian demand management did not require infrastructure spending. The simplest, quickest way to increase purchasing power was to cut taxes. This increased demand instantly.
However, it also had drawbacks. When consumers were given additional purchasing power, they did not necessarily buy domestic goods: they also bought imported goods. Thus the Keynesian stimulus could leak out of the domestic economy through imports, and boost foreign economies instead.
Public spending on infrastructure stood out as a way to minimise such leakages. In most countries, infrastructure utilized mostly domestic equipment and labour. So, the stimulus remained mainly within the country and did not leak out through imports.
Besides, infrastructure projects were popular with politicians keen to channel projects into their constituencies. Politicians hated Keynes’ idea of paying people to dig and fill up ditches. They preferred job creation to build infrastructure, creating a base for future growth.
Manmohan Singh thinks this is the best way to combat the recession. So do many economists. But I have reservations.
In Rooosevelt’s time, road building was labour intensive. But today, it is highly mechanised, using little labour. Dams are no longer built by armies of workers. Power plants, ports and airports are hugely capital-intensive. With today’s technology, infrastructure is not a massive job creator, unless we insist on obsolete, inefficient techniques.
This is exactly what we do in the National Rural Employment Guarantee Scheme. This mandates that 60% of the cost must be in wages. But such labour-intensive techniques yield low-quality roads that disappear after every monsoon. Decades of rural employment schemes have failed to create permanent assets. This approach cannot create good infrastructure.
Keynes would not have been surprised. He would have said that creating jobs should not be confused with creating infrastructure. He would have opted for digging and filling ditches.
Building infrastructure is time-consuming. Every big project requires a lengthy environmental impact assessment, with public hearings. Land acquisition disputes can hold up projects for years. So infrastructure projects disburse money slowly, and cannot provide a quick Keynesian boost.
Now, India badly needs infrastructure. But this requires massive long-term spending. Don’t confuse this worthy aim with providing a rapid Keynesian boost.
The fastest, most effective boost comes from slashing slash taxes. In the West, cutting income tax is a popular Keynesian nostrum. But in India only a tiny fraction of people pay income tax. So the right taxes to slash are excise duty and sales tax. These are paid by everybody (notwithstanding substantial tax evasion), and will immediately boost purchasing power. There will be no time lag, as in project spending. That is the Keynesian way to go.