Yesterday I was discussing a model of aggregate demand and
supply with my students. It was basically an introduction to how growth happens
and how it can bring about increases in the general level of prices. We
discussed the differences in the view Neoclassical and Keynesian economists
have of the aggregate supply curve (the total amount of goods an economy
produces at different given price levels.) For the first group, markets always
adjust and operate efficiently, so nothing the government does to stimulate
demand will have real impact, save for an increase in the overall price level. For
the Keynesians, instead, in times when the demand is too depressed (as seems to
be the case now, with consumers not particularly euphoric and companies
hoarding up cash instead of investing) any action taken by governments to
stimulate it will reflect in higher levels of output at a very moderate cost in
price stability. This is not a difficult concept to grasp, especially when taking
into account the notion of circular flow of income: any extra dollar spent by
the government will go to someone’s pocket, who is likely to spend part of it
in something else, and part of that expenditure is likely to be spent again,
and so on and so forth. So, the Keynesian argument goes, demand increases more
than the original stimulus, and output increases accordingly.
Now, what is the battle horse of Neoclassicals? The idea
that unfortunately seems to be dominating the debate, at least in Europe, is that governments need to create “business confidence.” And that firms are
not going to be confident if they expect higher taxes in the future in order to
finance governments’ expenditure. But let’s get it right. Firms produce in
order to sell. Consumers are not able to afford buying much. And governments,
allegedly, should focus in balancing budgets, by increasing taxes (not
corporate taxes, as this could affect confidence) and reducing expenditure. How
is this meant to work? An economy produces for consumers, for the government,
for investors, and for the foreign sector. The first group is not buying, and
with an increase in taxes chances are that they are going to buy even less.
Governments have been asked to limit their expenditure. Firms will only invest
if they see prospects of selling (to, ehrm, consumers and eventually the
government). And unless we find a way to have the rest of the world demanding
more of our products (a very difficult thing to do for a country that cannot
depreciate its currency, as all Eurozone-troubled economies are,) production is
not going to increase by means of just letting markets operate.
I didn’t say all this to my students; I just proposed the
two models. Obviously, they found the Keynesian one far more convincing. When I
asked what should governments in Europe be doing these days, the answer was
obvious: reduce taxes and increase government expenditure. What are they doing
instead? Fussing all around about austerity measures, about the possibility of
an increase in inflation, when inflation rates are below 3%, more than one point
below the rate in mid-2008.
In less than an hour, my 16-year old students could
understand why Europe is so much in need of real action if it wants to get out
of its trouble and prevents its citizens, particularly the younger ones, from
having to go through unnecessary hardship. But unfortunately the political
arena seems to be dominated more by ideology than by an unbiased understanding
of how the market operates.
