Booms and Slumps

Booms and Slumps

If only it was always like that. The fact is that there are times when
economic events do not work out as market theorists maintain and,
in such times, it is very difficult to give an explanation as to what is
going on and what is the best that should be done.
The 1930s Great Depression was just such a time – when millions
were thrown out of work in all developed countries around the world –
and similar fears have been expressed recently in Japan and, to a
lesser extent, in Germany and the USA. Depression, or recession, is a
time of rising unemployment and – in the extreme – DEFLATION
(falling prices). When prices are falling, though it seems welcome to
the individual consumer, for the economy as a whole it is dangerous
because people will stop spending. This is another example of the
fallacy of composition. For you and I, if we can buy certain goods
The rate of

later at lower prices than today then it makes sense: we make money
by delaying purchases. But if everyone stops spending then the
circular flow of money, consumption and incomes in the country will
inevitably fall. The national income goes down and unemployment
will certainly rise. Ouch!
In Japan today (see Box 4.2), like in North America during the
Great Depression, leakages and injections to the circular flow have
not been balanced by the movement in rates of interest, as market
economics dictates. In deflationary circumstances, net leakages from
the economy are still positive even though rates of interest are at
rock bottom.
As was said at the opening of this chapter, free market theory
has a powerful hold over the mindset of many economists. The
dominant PARADIGM, or worldview, so influences thinking that it is
a struggle to see the phenomena in any other terms. It takes genius,
plus the accumulation of lots of other evidence, to shift received
perceptions. In 1936, the Great Depression provided the evidence;
Keynes provided the genius.
Re-read some of the circular flow analysis earlier – especially
related to how savings differ for low, as opposed to high, income countries.
This implies a different way to model savings and investment in
an economy than neoclassical market economics.
Keynes argued that the main determinant of the volume of
savings in an economy is not the market price of money (the rate
of interest) but the level of income. That is, if rates of interest rise
by a relatively large amount, people will still not save more in their
bank accounts. But if people’s incomes rise substantially then they
will put money aside. (It can thus be argued that savings are
price-inelastic but income-elastic in supply.)
Keynesian macroeconomics holds that savings are a leakage from
the circular flow and that they are primarily a function of income,
rising from some negative amount at very low income levels but
then increasing more steeply as incomes rise (see Figure 4.4).
In contrast, the demand for funds for investment – the key stimulus
to the economy – is neither primarily determined by rates of
interest nor levels of national income. The most potent influence on
investment is business EXPECTATIONS of future profits. If the outlook
is profitable then even high rates of interest on borrowing will not
dissuade the eager investor, and equally if future expectations are
© 2004 Tony Cleaver
Box 4.2 Japan: a modern case of Keynesian demand deficiency
Japan has recently been stuck in a Keynesian recession – the first
of its kind, some would argue, since the Great Depression held
the USA in its grip.
AGGREGATE DEMAND in Japan is well below that necessary to
generate full employment, the rate of inflation is close to zero
and so are interest rates. US economist Paul Krugman noted
that the 10-year bond rate in 1998 was less than 0.7 per cent, that
is, financial markets were then betting that recession would last
for at least ten years.
Savings ratios in Japan have always been high and well above
those in the USA and so a contemporary fall in consumer
spending cannot be the cause of the recession. Krugman attributes
the problem to low investment and even lower expectations:
a typical Keynesian explanation of aggregate demand deficiency.
Why should investment be so low? There are a number of
contributory causes. First a speculative boom (particularly in
property prices) burst at the end of the 1980s, which provoked a
recession as people then saw their assets tumble in value.
Misguided government monetary policy in the early 1990s
pushed up interest rates and prolonged the squeeze on spending
still further. Several banking and financial scandals eroded public
confidence, as did the government’s slow and inadequate
response. And beneath it all, the ageing population and slow
productivity growth have created a less innovative culture.
Business expectations are poor and pessimism is self-reinforcing:
things are bad because they have been bad for so long.
Krugman estimated that Japan suffers an output gap below its
potential full employment level of between 7 and 8 per cent of
GDP. There is sizeable room for expansion, but how to fill this
demand deficiency or output gap?
The government cannot help. The amount of public spending
that would be needed to plug the void that the private sector has
created is simply too great. Such a conservative ruling elite that
fills Japanese public office would anyway not countenance
anything like the sort of excessive spending needed, even if the
finances could be found.
© 2004 Tony Cleaver
gloomy then it is likely that even very cheap loanable funds will
not change the entrepreneur’s pessimistic mood.
Investment is thus exogenously given by a factor other than
income. It is assumed fixed at Q, by forces (expectations) outside
this simple model.
Simple though it is, Figure 4.4 carries a very powerful message.
Look what happens at low income levels, that is below the level Y*
illustrated. Over this range of incomes – from 0 to Y* – the level of
savings or leakages in the national economy is less than Q, less than
the level of exogenous investment. So long as more money is being
injected into the system than is being taken out, the circular flow of
incomes and spending must therefore grow.
Conversely, at levels of national income greater than Y* the
amount of savings leaking out of the circular flow is greater than
the level of injections. National income must decline. Either way,
the economy moves to a unique equilibrium at Y* – through
a movement of income levels.
The Japanese financial sector cannot help. Banks have been
guilty of over-lending, making too many bad and corrupt loans
and thereby fomenting the crisis in confidence. Outside
observers have argued the whole mess needs to be cleared up
and this implies tightening money controls – not a recipe for
economic stimulus.
If nothing else can be done then the only solution is somehow
to encourage an exogenous increase in consumer spending.
Since deflation – falling prices – gives the incentive for the
Japanese to withhold all household purchases (in anticipation of
lower prices later) so Krugman argues for the opposite. If people
were convinced that inflation will rise, they would go out and
spend more immediately, rather than wait and have the real
value of their money reduced by higher future prices. His recommendation
– for the Japanese Central Bank to create inflation:
‘How about a 4% inflation target for 15 years?’, he asks.
Source: Krugman, P. (1998) ‘It’s Baaack: Japan’s Slump and the Return
of the Liquidity Trap’ Brookings Papers on Economic Activity, No. 2.
© 2004 Tony Cleaver
This needs emphasising. According to the Keynesian macroeconomic
model any imbalance of savings and investment, leakages
and injections, in the economy is not matched up by a mere movement
of interest rates in financial markets but by a relentless
movement up or grinding down of all income levels in an economy.
What are the implications of this? It means that if, for some
reason, business confidence in aggregate is low and there is thus a
fall in the general level of investment in the country then, despite
financiers’ temptations to lower interest rates and practically give
money away, there will be a net flow of un-recycled money piling
up in banks and finance houses. Aggregate spending will fall, profits
will fall, industrial production will either fall or result in increasing
stocks of unsold inventory, unemployment will eventually rise and
the country’s level of income will slowly, relentlessly fall. The
economy will enter a slump, which will be prolonged until incomes
fall low enough for the level of aggregate savings to decline to the
already low level of autonomous investment. We can call this the
LOW-LEVEL EQUILIBRIUM TRAP.
The opposite scenario is now easy to predict: if business confidence
and investment rises then, at the existing level of national
income, injections will exceed withdrawals from the system and so
Savings
(leakages)
Q Investment
(injections)
0 Y ∗ National income
Quantity of savings
and investment
Figure 4.4 Savings and investment functions.
© 2004 Tony Cleaver
the circular flow will increase. Income levels will continue to
rise until the new equilibrium is reached, as illustrated at Y** in
Figure 4.5.
Investment rises from Q to Q1. At original income level Y*, the
amount of investment/injections (the distance 0 to Q1) is now much
higher than savings/leakages (0 to Q). National income grows therefore
from Y* to Y** where the two flows are again equal.
Note that how far income grows, given an increase in investment,
depends on the slope of the savings function (see Figure 4.5).
The steeper this line, the less income will grow; conversely the
more slowly savings rises with income, the more any given stimulus
to the economy will cause greater growth of income (Box 4.3).
An important implication of this Keynesian model is that a
country’s income level need not be stable over time. Contrary to the
market paradigm, it suggests that there are no guarantees that the
movement of prices will always keep the economy in some happy
balance. The variable flows of savings and investment may bring
the economy to rest at some level of aggregate spending too low to
secure employment for everyone or, conversely, spending may be
greater than domestic production can satisfy – in which case a surge
in inflation (continually rising prices) may be the result. Neither
outcome is particularly pleasant.
Quantity of savings
and investment