Implications for political economy

The foregoing discussion of labor markets and saving underscores the broader implications of Keynesian theory for political economy. The self-regulating market cannot be relied on to secure the livelihoods of those dependent on it, or to translate the community’s desire to save into the formation of the capital needed to make that saving bear fruit in the future.

Government stabilization policy focuses primarily on systemic conditions in three areas: (a) aggregate demand, (b) the financial sector, and (c) prices.

Figure 3. The circular flow with government

We will not attempt to summarize here the methods employed in these areas. We focus instead on the objectives of stabilization as they reveal important features of the understanding of the relation of state to economy.

To help understand the proximate objectives in stabilizing aggregate de­mand, we revise our diagram of the circular flow to take the government explicitly into account (see Figure 3). The state’s ability to affect the circular flow depends on the way it is connected to that flow. This connection consists of the following points:

1. Government spending. The government uses its revenues to acquire goods from the private sector, employ labor, and provide incomes to consumers (and to various corporate entities) independently of their employment or of their providing goods and services in exchange.

2. Government borrowing. One source of revenue for the spending indicated in point (1) is borrowing from the private sector. The government issues bonds, which can be held by individuals or firms. The purchase of gov­ernment bonds from the state provides revenues to fund the state budget.

3. Taxes. The state can fund its activities without borrowing either by print­ing money or by taxation. In the following, we ignore the former and concentrate on revenues resulting from taxes on the incomes of firms and consumers.

The proximate cause of instability in consumer demand is the link between income, employment, and consumption. This link translates fluctuations in investment into fluctuations in demand. To stabilize employment and output, the government seeks to modify this link. In order to stabilize demand, the government must compensate for fluctuations in output and employment originating in the private sector. In the following, we focus on efforts to support or maintain a level of demand and output.

Clearly, if the government, in taxing consumers, simply shifts demand from them to itself, the net effect cannot be to enhance output and employ­ment. To achieve this end, the government must do one of two things.

1. Tax incomes that would otherwise be saved rather than spent by their original recipients and (a) spend the tax revenue directly on goods and services or (b) transfer the tax revenue to agents who will consume it (or at least consume more of it than would have been consumed by those bearing the burden of the tax).

2. Spend more than it collects in taxes by borrowing the difference from agents who would not otherwise have spent it or even received it them­selves.

When the state does either of these things, it stimulates demand and employment. Either government spending directly offsets deficiencies caused by inadequate private investment (as emphasized by Baran and Sweezy, 1966) or government transfers income from employed to unemployed, either by borrowing from or taxing the former.

Assume that consumer A receives $50,000 per year income and spends 90 percent of it. He thus uses $45,000 to acquire goods and services, $5,000 to acquire a financial asset. Consumer B has no income. The overall income of the two consumers is $50,000, which generates demand of $45,000. Now assume that the government taxes consumer A $10,000 and transfers the money to consumer B who, having a low level of income, consumes the entire $10,000. After the transfer, consumer A spends $36,000 and saves $4,000, consumer B spends $10,000, so that total spending and demand out of the $50,000 rises from $45,000 to $46,000.

If the government commits itself to income supports, then it commits itself to assuring that fluctuations in investment will not multiply their effects. When employment falls as a result of a fall in investment, incomes will not fall (or will not fall proportionately) since incomes are not so tightly linked to demand for products. Stabilization thus tends to break the link first be­tween income and output, and ultimately between income and employment. Stabilization as pursued by firms tends to soften the impact on income from changes in current demand (see Okun, 1981; Schofield, 1978), making a larger part of the wages bill an overhead expense whose magnitude is relatively more stable in the face of fluctuations in output and investment. Stabilization as pursued by government weakens the link between income and employment (as emphasized by Offe, 1984). Stabilization modifies, and may implicitly or explicitly challenge, a central institution of private enterprise economy. It thus has profound political implications.

The pursuit of stability by government policy, if successful or even if only assumed to be successful (see Baily, 1978), changes the subjective environ­ment within which individual and firms’ decision making takes place. As we emphasized earlier, agents act differently in a stable environment; they form and act on plans oriented toward the long run. Their sensitivity to current conditions declines, and they are less likely to exacerbate short-period fluc­tuations by their responses to them. This fact also contributes to the stability of the economy, since it reduces the expectational component of cumulative processes. Stabilization breeds stability; but it is also perceived to breed its own set of political and economic problems. It has potentially profound political implications and thus stimulates a political agenda.