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Why borrowing for investment is correct – John McDonnell is right & Osborne is wrong
By John Ross

An earlier article ‘Why John McDonnell is correct to borrow for investment – an elementary economics lesson for Osborne’ analysed in the ‘family’ and ‘common sense’ vocabulary Osborne likes to present the distinction between state borrowing for investment and state borrowing for current expenditure – a key economic distinction Osborne’s Fiscal Charter deliberately tries to obscure. It also showed how sections of the media deliberately attempt to aid Osborne in this by talking of budget ‘deficits’ and ‘borrowing’ without distinguishing between borrowing for investment and borrowing for consumption.

The following article, an excerpt from a longer analysis of Western responses to the Great Recession, analyses the issue in more formal economic terms. It shows that John McDonnell is very far from being an ‘extremist radical’ in supporting state borrowing for investment. Among those holding the same logical position are fellow ‘extremists’ Ben Bernanke. Larry Summer and Martin Wolf!

An answer that may be immediately rejected in explaining the failure of response to the Great Recession, and the ‘new mediocre’ slow economic growth following it, was that no Western expert understood the situation. To the contrary, eminent Western economic figures well understood that the problem in the US and other Western economies was that the mechanism translating company income into investment was not functioning adequately, and that the solution was for the state to step in and invest these funds – as in Roosevelt’s 1930s response to the Great Depression. Merely a representative few of those arguing for this response will therefore be quoted – to show the accurate, indeed comprehensive, character of their analyses.

Ben Bernanke, almost immediately he could speak openly after ceasing to be Chair of the US Federal Reserve, called for:

‘a well-structured program of public infrastructure development, which would support growth in the near term by creating jobs and in the longer term by making our economy more productive.’¹

Lawrence Summers, former US Treasury Secretary, argued:

‘We may… be in a period of ‘secular stagnation’ in which sluggish growth and output, and employment levels well below potential, might coincide for some time to come with problematically low real interest rates…

‘The… approach… that holds most promise – is a commitment to raising the level of demand at any given level of interest rates… This means ending the disastrous trend towards ever less government spending and employment each year – and taking advantage of the current period of economic slack to renew and build up our infrastructure. If the government had invested more over the past five years, our debt burden relative to our incomes would be lower: allowing slackening in the economy has hurt its potential in the long run.’²

Martin Wolf, chief economics commentator of the Financial Times, and one of the world’s most influential economic journalists, argued:

‘In brief, the world economy has been generating more savings than businesses wish to use, even at very low interest rates. This is true not just in the US, but also in most significant high-income economies.

‘The glut of savings, then, has become a constraint on current demand. But since it is connected to weak investment, it also implies slow growth of prospective supply…

‘So what is to be done? One response to an excess of desired savings over investment would be even more negative real rates of interest. That is why some economists have argued for higher inflation. But that would be hard to achieve, even if it were politically acceptable….

‘Yet another possibility… supported by many economists (including myself), is to use today’s glut of savings to finance a surge in public investment.

‘The best response… is measures aimed at raising productive private and public investment. Yes, mistakes will be made. But it will be better to risk mistakes than accept the costs of an impoverished future.’³

Wolf analysed this situation in the UK, which faced the same problem as the US, citing similar views by other influential commentators:

‘With real interest rates close to zero… it is impossible to believe that the government cannot find investments to make itself, or investments it can make with the private sector, or private investments whose tail risks it can insure that do not earn more than the real cost of funds. If that were not true, the UK would be finished. Not only the economy, but the government itself is virtually certain to be better off if it undertook such investments and if it were to do its accounting in a rational way…

‘This does not even deserve the label primitive. It is simply ridiculous.’

Wolf clearly pointed to the consequences:

‘The results… are not at all ridiculous. They are extremely costly to both the economy and society. Yet, instead of taking advantage of the opportunity of a lifetime to repair and upgrade the capital stock, as Mr Portes [of the UK National Institute for Economic and Social Research] notes: “Public sector net investment – spending on building roads, schools and hospitals – has been cut by about half over the past three years, and will be cut even further over the next two.”’

Wolf concluded, endorsing such analysis:

‘He [Portes] recommends a £30bn investment programme (about 2 per cent of GDP). I would go for far more. Note that the impact on the government’s debt stock would be trivial even if it brought no longer-term gains…

‘the government… is refusing to take advantage of the borrowing opportunities of a lifetime…. It is determined to persist with its course, regardless of the unexpectedly adverse changes in the external environment. The result is likely to be a permanent reduction in the output of the UK.’ ⁴

Richard Yamarone, of Bloomberg Economics Brief, caustically noted:

‘Instead of adopting an economic solution such as matching idled and unemployed agents (millions of manufacturing and construction workers) with necessary improvements to the electrical grid, dilapidated highways, high-speed trains, outdated bridges, tunnels, ports, and water pipes, America received the political response of extended unemployment benefits and a whopping food stamp programme – safety nets for those who have fallen, not ‘stimulative’ measures.

‘Unlike during the Great Depression, which left a dazzling infrastructure legacy including a swath of bridges, tunnels, highways, art, dams and power generation, the only remnant from the 2007-09 depression is an underemployed labour force, earning a fraction of previous incomes, diminished skill sets and little or no promise for recent college graduates.’⁵

References

1. Bernanke, B. (2015, April 30). WSJ Editorial Page Watch: The Slow-Growth Fed? Retrieved May 2, 2015, from Brookings: http://www.brookings.edu/blogs/ben-bernanke/posts/2015/04/30-wsj-editorial-slow-growth-fed?cid=00900015020089101US0001-05011

2. Summers, L. (2014, January 5). Washington must not settle for secular stagnation. Financial Times.

3. Wolf, M. (2013a, November 19). Why the future looks sluggish. Financial Times.

4. Wolf, M. (2012, May 17). Cameron is consigning the UK to stagnation. Financial Times.

5. Yamarone, R. (2014, January 8). Summers’ remedy is years out of date. Financial Times.John Rosshttps://www.blogger.com/profile/08908982031768337864noreply@blogger.com0

Why John McDonnell is correct to borrow for investment – an elementary economics lesson for OsborneBy John Ross

If Osborne’s Charter for Budget Responsibility, which seeks to ban all government borrowing over the business cycle, was read naively you would assume it was written by an economic ignoramus who does not understand the difference between investment and current expenditure. But of course its economic howlers do not flow from ignorance but from a deliberate attempt to obscure issues which is driven by an ideological agenda to prevent the effective way for the economy to grow – by the state investing when the private sector does not.

In this deliberate attempt to obscure elementary economic realities Osborne is aided by sections of the media, such as the @bbcnickrobinson or @JohnRentoul, who equally talk about the budget ‘deficit’ without distinguishing between investment and current expenditure – although in their cases pure economic ignorance cannot be ruled out. However as other journalists such as @afneil (Andrew Neil) are capable of perfectly correctly understanding and expressing the issue, whatever their differences on other questions, it is more likely that some media comment follows Osborne’s deliberate attempts at confusion. As Osborne claims to explain things in homely ‘family terms,’ and as ‘common sense,’ we will do so equally – a second article will give a more formal economic statement related to present economic conditions.

The nation’s credit card and the nation’s house purchase mortgage

Virtually every family in the country in fact understands the difference between borrowing for investment and borrowing for current expenditure because that it how they organise their finances. To take Osborne’s analogy of the ‘credit card’ anyone who simply continues to run up debts to buy groceries on their credit card (current expenditure) without being concerned about whether they can repay them is heading for financial trouble. But no rational person decides to buy a house (investment) by first saving up the money and then buying the house – they take out a mortgage to do so.

This difference is even expressed formally in a balance sheet. If money is spent on food or other current expenditure there is an expenditure item and no corresponding asset – the expenditure has just been consumed, both literally and in economic terms. But the expenditure on the house has a corresponding asset – the house. This is a reason the borrowing for the house is entirely rational while ever increasing borrowing for current expenditure is not.

Osborne’s ‘Charter for Fiscal Responsibility’ is an attempt not only to limit expenditure on the credit card but to make it illegal to take out a mortgage to buy a house.

How factory machinery is financed

Another analogy, in this case from business, makes the situation equally clear. A company does not finance purchase of machinery, for example to build cars, out of its cash flow. It borrows the money, buys the machinery, and then repays the loan from the production. If it did not do so, and waited until it had saved the money for the machinery from current cash flow, that company would be totally outcompeted by companies which had borrowed the money, purchased the machinery, could now produce more efficiently, and had therefore gained a competitive advantage. That is why borrowing for investment is not merely economically rational but necessary.

George Osborne tries to obscure these elementary economic truths for his ideological purposes – he prefers the economy not to grow rapidly, and people to be poorer, unless it is done by the private sector. Sections of the media, by talking about the ‘budget deficit’ and borrowing without distinguishing between investment and current expenditure either are economically illiterate or themselves attempt to deliberately obscure elementary economic realities.

John McDonnell’s position has so far been correct. There is a clear economic difference between consumption and investment. The government should not borrow for consumption over the course of the business cycle. The government should borrow for investment. Osborne’s  ‘Charter for Budget Responsibility’ should be amended to allow borrowing for investment. If it is not permitted to amend it, the Charter should be voted against. That has become Labour’s position and it is the correct one.

John Rosshttps://www.blogger.com/profile/08908982031768337864noreply@blogger.com1

‘Butskellism’ versus Keynes and MarxBy Michael Burke

Economics of budget deficits

The debate is continuing on the purpose of government borrowing and the role of ‘balanced budgets’ – which was started by John McDonnell’s position of balancing the budget on current expenditure but borrowing for investment. This is not surprising given that economic policy has to be the core of the programme for a Labour government.

A thoughtful addition to the debate is this piece by Jo Michell in the Guardian, who asks for a real alternative to Osborne, which SEB has provided in relation to the Fiscal Responsibility Act. But an important misunderstanding should be clarified. That article argues that advocacy of a balanced current budget over the business cycle would be to ’emulate Ed Balls and austerity lite.’ That is incorrect. It would only be the case if the level of government investment were maintained at current miserably low levels. Instead what is proposed here is a transformational increase in public investment, sufficient to foster a sustained recovery led by public investment. Far from this being ‘austerity lite’ it makes state driven investment a key to economic policy – entirely unlike the policy of Ed Balls.

The piece below examines this attachment to persistent government budget deficits, which have been combined with a simultaneous long-run decline in public investment.

The position on Osborne’s proposals that a Labour government should balance the budget on current expenditure over the business cycle but borrow for investment is set out in an earlier article here. It follows from the fact that the purpose of economic policy is, or should be, to optimise the growth in the sustainable living standards of the population. Increasing living standards requires growth – internationally over 80% of increases in consumption are due to economic growth. Since it is not possible to increase the fundamental productive capacity of the economy without investment, investment is the decisive factor in producing growth (in an overall framework of increasing the division/socialisation of labour). Therefore economic policy, including fiscal policy, should aim at increasing investment and gradually enhancing the proportion of output devoted to investment. This is the precondition for more rapid growth – ‘growing the economy out of the crisis’ as John McDonnell and Jeremy Corbyn put it. Borrowing should primarily be confined to investment, only resorting to support consumption in specific exceptional circumstances – such as to maintain living standards of the least well off sections of the population during economic downturns. Social protection should be financed via taxation – levied in a disproportionate way on the richer sections of the population.

However, permanent or structural budget deficits have become a shibboleth for many ‘Keynesians’. This has almost nothing to do with Keynes, who himself responded to critics by arguing that the General Theory was primarily focused on the ‘regulation of the investment function’ (and barely mentioned budget deficits)*. Instead, the attachment to budget deficits is a product of the post-World War II economic consensus. In Britain this was known as Butskellism, the Tory/Labour bipartisan approach to policy which ended in spectacular economic failure by the early 1970s.

This consensus failed because it was based on a myth. The reality is that at the beginning of ‘Butskellism’ Britain and the US had experienced war-related booms. In four years of World War II the US economy doubled in real terms, and was to take another 22 years before it doubled again. In Britain the economy expanded by 55% in 10 years to 1943 and it was to take another 25 years before it increased by another 55%.

The false economic consensus was that the ‘post-WWII boom’, which some even dubbed the Golden Age of capitalism simply required expert ‘demand management’, where every sign of downturn was met with more government borrowing to finance day-to-day spending (and government-run industries were starved of investment). The true position is that this was the dwindling of the war boom, when government investment and direction of the dominant sectors of the economy had predominated. The attachment to persistent or structural budget deficits, on current expenditure and not for investment, arises from this post-WWII economic failure. The success was state-led and directed investment of the war and war preparation years.

It is a rather strange feature of the debate that many ‘Keynesians’ also regard themselves as scourges of the finance sector in general and its dominance in British society in particular. Yet as both Adam Smith and Karl Marx noted, the material power of the finance sector derives largely from its parasitic relationship to government. The interest which fattens the finance sector comes significantly in the first instance from the government, and the taxes it levies on the productive economy. As for Keynes, it is the opposite of his ‘euthanasia of the rentier’, to continually hand state assets to the finance sector. When, briefly, the Thatcher and Blair governments each had budget surpluses, there were howls of protest form the City about the ‘death of the gilts market’.

If there are deficits on current expenditure, including all the very valuable functions that can or should be performed by government, these should be met with progressive taxation. As the burden of taxation has shifted from big business and the rich to workers and the poor over time, it is clearly imperative that the former should bear the burden of increased taxation. In just one example, Thatcher inherited a Corporation Tax rate of 60% and Osborne will bequeath a rate of 18%. That trend should be reversed. To the argument that this undermines private sector investment, this has been in sharp decline even as taxes have been cut (Fig.1 below, which originally appeared on the PWC website).

Fig.1 Investment as a proportion of GDP

The British economy is participating in an investment crisis of the Western economies. It also has its own structural investment crisis, as the chart above shows. It is this twin problem that Corbynomics can address, and so raise living standards through growth led by investment – including the creation of a National Investment Bank.

There is strong opposition to this policy from capital. If the state increases its rate of investment, necessarily a greater proportion of the means of production will accumulate in state hands not those of the private sector. The entire Reagan/Thatcher era was designed to do the opposite and we are still living in that era. Attempting to accelerate the gradual run-down of the role of the state in the productive economy their programme was to attempt to remove it altogether – the policy Osborne is continuing.

But we should be clear the advocates of the ‘small state’ confine this to investment – because it means an interference in the means of production. They have had far less difficulty, and in many cases no difficulty, in increasing Government consumption as Fig.2 below shows. The Thatcherites were really primarily advocates of ‘small state investment’.

Fig.2 US Government consumption rises as Government investment falls

Osborne seems set on turning that into ‘no state investment’. But this curtailing of state investment is directly counterposed to the needs of the great majority of the population. This is why Labour, by setting out the goal of growth created by investment, including creation of an National Investment Bank, aligns its policy with that of the population. By taking the position of a balanced budget over the cycle on current expenditure but borrowing for investment John McDonnell has adopted the correct position in terms of economic theory and simultaneously, and for that reason, restores public credibility to Labour’s economic policy.

By setting out clearly that the there is an alternative to Tory policies, and that the opposite of austerity is investment, the Labour leadership team can demonstrate that its policies are superior and can deliver prosperity for the overwhelming majority.

*Keynes, Quarterly Economic Journal, OUP, February 1938.

How Labour should deal with the Fiscal Responsibility Act By Michael Burke

Jeremy Corbyn and John McDonnell are frequently in advance of many of their supporters on economic matters, including their supporters in academia and economic commentators. They are correct to argue against permanent budget deficits and in favour of the central role of public investment as the path out of the crisis, identify People’s Quantitative Easing as a useful policy tool, and to question the ‘independence’ of the Bank of England. They have faced unwarranted and confused criticism on all of these from some on ‘the left’.

The recent indicators point to a slower pace of economic activity and the Tory government is about to embark on Austerity Mark II, in nominal terms exactly the same level of cuts and tax increases as the £37 billion George Osborne announced in 2010. As the Tories have little popularity (the second lowest popular share of the vote for any government) it has been necessary for this project that there is a pretence that this not a return to austerity, after the boost to consumption that helped the Tories get re-elected. So, there was the fiction that recently there was a ‘One Nation’ Tory Budget, that Osborne was ‘stealing Labour’s ideas’ and similar nonsense.

Politically it is crucial for the Tories that there is no opposition to the latest version of cuts, as this would show the blantant falsity of the claim that the Tories have a commanding parliamentary majority and that There Is No Alternative. This necessity explains why the other Labour leadership candidates were so wrong to give the Tories a free pass on welfare cuts.

However the election of Jeremy Corbyn and the appointment of John McDonnell as Shadow Chancellor changes the previous situation in which Labour did not in fact challenge the Tories’ central economic policies. Now the Tory tactic is to set a series of political traps for the new team in the hope of detaching them from either, or both, the majority of the population or their base of supporters. This is taking place primarily on the area of foreign affairs and the military. But on the economic front this will be the introduction of an amendment to the Fiscal Responsibility Act. This proposed Act precludes borrowing in normal circumstances/over the course of the cycle not only for current government expenditure but also for investment. It also commits future governments to run budget surpluses when the economy is growing, to be overseen by the Office for Budget Responsibility.

Labour’s response

Initially, George Osborne hoped that by announcing the new law and holding it over to the autumn that it would dominate the Labour leadership campaign. That has failed spectacularly. Instead it is possible to turn the tables on Osborne and use the debate and vote to set out clear differences with him.

To achieve this it is necessary to approach these questions soberly and intelligently. To paraphrase a remark by Trotsky, the appropriate economic policy is not at all automatically derived from the policies of George Osborne, simply bearing only the opposite sign to him – this would make every madcap pundit an economics guru. It is necessary for Labour to put forward a positive economic policy based on a correct economic theory.

Labour should formulate its own policy and pose that sharply in contrast Osborne’s. It must be based on a clear understanding of the difference between consumption and investment. Investment is the chief motor of economic growth, with the latter in turn being the chief determinant of the population’s living standard. Therefore the way to ‘grow the economy out of the crisis’, as Jeremy Corbyn and John McDonnell have correctly put it, is to increase the economy’s level of investment. As the private sector has failed to do this the state should step in. This should be expressed in a policy to increase state investment, and to create National Investment Bank – which should finance both state and private investment.

The key question is where the savings equivalent to such investment should come from, and this in turn relates to the current expenditure in the budget. Current expenditure can be financed in one of two fundamental says. It can be financed by borrowing, but in that case this reduces the proportion of the economy devoted to savings/investment, which is undesirable as it will slow economic growth and therefore the increase in living standards. Or consumption can be financed by taxation, in which case it merely means privately financed consumption is being replaced by government financed consumption (either government final expenditure or transfer payments) in which case the level of investment is not being reduced and growth will not be reduced.

It therefore follows that for a coherent and sustainable policy current government expenditure should be financed out of taxation, in particular on higher incomes and luxury consumption, and not out of borrowing.

Expressed in terms of budget deficits and borrowing his means that the aim should be for a balanced current budget over the business cycle, but reserving the right to borrow for state investment. This is the correct position expressed by John McDonnell. This therefore means that an amendment to Osborne’s Bill expressing that position, of no deficit over the cycle for current expenditure but permitting borrowing for investment, should be moved by Labour. This will establish its position clearly.

But, in the likelihood an amendment of this type were to fall, although some other parties may vote for it, then Labour should vote against the entire bill – as it excludes borrowing for investment. (In fact the level of state borrowing for investment currently should be considerable, up approximately 3-5% of GDP). Labour should explain its position of voting against the bill as a whole because of the defeat of its amendment.

In this way, Labour’s approach would be very clear. It is not in favour of public borrowing to fund current expenditure and is in favour of borrowing to fund investment. As a balanced budget law does not allow that investment, Labour would be opposed to the Tory policy.

Labour should not support the Bill without this amendment as this would preclude borrowing to invest and leave the economy at the mercy of a private sector which has achieved only chronic under-investment. Neither should it simply oppose the Bill without offering an alternative, especially not on the spurious grounds that any public sector surplus should be ruled out because it ‘obliges the private sector to run a deficit’. Sometimes the private sector, or at least the business component should be obliged to run down its savings, if it is hoarding cash and refusing to invest. Many countries accumulate budget surpluses in their sovereign wealth funds, to be used for investment at a later date. This is what should have occurred with the windfall of North Sea oil, rather than wasting it on consumption in the ‘Lawson Boom.’

In taking a clearly different approach, Labour’s new leadership will be able to demonstrate it has an entirely different policy to the Tories based on increasing investment to increase prosperity.

The debate on ‘deficit spending’: The framework for Corbynomics

Crisis hasn’t gone away. Corbynomics will be increasingly necessary By Michael Burke

One of the most widely repeated falsehoods about the British economy is the assertion that it is growing strongly and that the crisis is over. This is not borne out by even a perfunctory economic analysis but it serves a political purpose. In the first instance the assertion was important in order to blunt any criticism of renewed Tory austerity policies, which will begin again earnest with the Comprehensive Spending Review in December. Now that Jeremy Corbyn has won the leadership of the Labour Party the same falsehood is pressed into slightly different service- with the idea that his policies represent a threat to the current recovery, or are at least unnecessary.

In reality, the extremely limited upturn in output is already giving way to renewed weakness. UK industrial production and manufacturing fell in July. Monthly data can be erratic but this is the second consecutive fall for industrial production and manufacturing peaked in March, shown in Fig. 1 below.
 

Fig.1 Industrial production and manufacturing index from April 2013 to July 2015

Source: ONS

 

This is not the boom that is repeatedly claimed. The recovery to date is primarily based on consumption not investment. Since the beginning of the recession to the 2^nd quarter of 2015 consumption has risen by £70bn, a modest rise of 5%. But investment has risen by just £4bn, a cumulative rise of just 1.3% over 7 years, less than 0.2% annually.

In terms of output and investment, the notion of a boom amid austerity is entirely misplaced. There is only stagnation. In fact, the levels of industrial production and manufacturing are effectively unchanged since the Coalition took office in May 2010, despite inheriting a mild recovery. In May 2010 the index levels of industrial production and manufacturing were 100.2 and 97.6 respectively. In the most recent data they were 99.2 and 100.6. The trends in output are shown in Fig.2 below. They clearly show that under austerity production has stagnated.

 

Fig.2 Output trends from January 2008 to July 2015

Far from a boom the current economic situation is best characterised as stagnation. In one form or another this also characterises the Western economies as a whole. Since the recession began in the OECD as a whole, the average annual level of GDP growth has been under 1%. Consumption has risen by US$2.5 trillion over that time. But Gross Fixed Capital Formation has declined by $200bn over the same period.

For the British economy, this continued reliance on consumption holds a particular threat. The relative weakness of investment and hence the relative weakness of productivity is a chronic one in Britain. The current crisis has deepened these severe long-term problems. Output has fallen back to levels last seen in the 1980s, as shown in Fig.3 below. This represents a combination of both the long-term weakness of manufacturing and the decline in the output of North sea oil, a financial windfall that has been almost entirely wasted.  

 

Fig. 3 Industrial production over the long-term

As it is not possible to consume that which is not already in existence, consumption must follow output. It cannot lead it. As the output of the British economy is experiencing both a structural and a cyclical decline, its increased consumption has been funded by its surplus on ‘financial services’, the money British banks extort from the rest of the world, and on increasing indebtedness.

As the revenue from financial services has now also gone into decline, so the resources for consuming without producing are increasingly through borrowing. The broadest measure of Britain’s overseas borrowing requirement is the balance on the current account. The current account includes both the trade balance and the balance on all current payments , primarily company dividends and interest payments by borrowers. Any deficit on the total current account must be met by increased borrowing from overseas (or asset sales to overseas). The latest 3 quarters have seen the worst current account deficits as a proportion of GDP since records began, as shown in Fig.4 below.  

 

Fig.4 Current account blance as a proportion lof GDP

The financing of this deficit depends on the willingness of overseas investors to buy UK assets. It is impossible to predict the precise point or catalyst for them to stop doing so. But what is known is that the British economy has faced a number ‘balance of payments’ crises before when the relative level of overseas borrowing was far lower. One possible way of reducing the current account deficit is to impose higher savings rates on the household sector, raising the taxes and reducing the wlefare transfers to them from government, which is one effect of renewed austerity. But even austerity Mark II will be unable to close the current account gap of this magnitude entirely.

Therefore the British economy is facing a series of interrelated crises, of production, slow growth and unsustainable borrowing. In reality they are key products of a single crisis- the crisis of weak investment. Contrary to the Tory propagandists, the supporters of austerity and their apologists, the crisis of the British economy has not at all gone away. As a result Corbynonics, a state-led increase in investment, is vital to end it.

 

The need to clarify the left on budget deficits – confusions of so called ‘Keynesianism’

By John Ross

Economics textbooks, particularly when discussing Keynes, frequently contain an elementary economic confusion – it should be made explicit this is a confusion in the textbooks and is not stated by Keynes. A typical example may be taken as Mankiw’s Principles of Economics, but numerous other examples could be cited as the confusion is widespread.¹ This elementary economic  confusion is expressed in the following formula

In this widely used formulation Y = GDP, C is private consumption, I is private investment, G is government spending, and NX is net exports. For a closed economy, which can be considered here as trade is not relevant to the issues analysed, this becomes.

From this it is typically argued that if there is a shortfall in private consumption C, private investment I, or both, then this can, or should, be compensated for by an increase in government spending G. This allegedly constitutes a ‘Keynesian’ policy. The fundamental confusion is that there exists no category ‘government spending’ G which is neither consumption nor investment – government spending is necessarily used for either investment or consumption. In short the correct formula is expressed as

Where C_p is private consumption, C_g is government consumption, I_p is private investment and I_g is government investment.

Keynes himself is clear on the distinction writing:
‘loan expenditure’ is a convenient expression for the net borrowing of public authorities on all accounts, whether on capital account or to meet a budgetary deficit. The one form of loan expenditure operates by increasing investment and the other by increasing the propensity to consume.²

This formula clearly distinguishes C_g and I_g as indicated above_.

For Marxists it should be noted that this distinction is also made clear in Marx’s categorisation of the economy into Department I (investment goods and services) and Department II (consumption goods and services).

The attempt in economics textbooks to introduce a third category G which is neither used for consumption nor investment is a piece of economic nonsense which should be stopped.

A key reason the lack of clarity created by introducing the confused term G is practically economically significant is the consequence for the structure of the economy when is there is unspent private saving, including non-invested company saving – i.e. private saving is not being transformed into private investment, and the government steps in to maintain demand. There are then two possibilities.

• If non-invested private saving is used by the government for investment, that is I_g increases, there is no change in the economy’s overall level of investment – private investment is simply replaced by government investment.
• If, however, the non-invested private savings is instead used by the government to fund consumption, that is C_g increases, then the percentage of consumption in the economy rises and the percentage of investment falls.

The use of an economically confused term G therefore obscures the choice being made for the economy’s overall investment level by whether there is an increase in government investment I_g or an increase in government consumption C_g.

The practical significance of this confusion is that modern econometrics shows that capital investment is the quantitatively most important factor in economic growth. Therefore reducing the proportion of the economy used for investment, other things being equal, will reduce the economic growth rate.

Both economic economic theory and practical results show that in a capitalist economy, not necessarily an economy such as China’s, there is greater resistance to government spending on investment than on consumption – as state investment involves an incursion into the means of production, which in a capitalist economy by definition must be predominantly privately owned. This theoretical point is confirmed by the fact that state expenditure on consumption has historically risen as a proportion of GDP in most capitalist economies since the economic period following World War II while state expenditure on investment has in general fallen in the same period.

The acceptance of government expansion of consumption, but opposition to government investment, therefore has the consequence that when so called ‘Keynesian’ methods of running government budget deficits are used, and G rises, what in practice happens is that C_g rises but I_g does not. As the government is transferring non-invested private savings into consumption such so called ‘Keynesian’ intervention therefore has the effect of reducing the economy’s investment level – and therefore reducing the economic growth rate. This process is concealed by using the confused term G instead of its proper components C_g and I_g .

However, as already noted, it should be made clear that this confusion is in textbooks and not in Keynes himself. But followers of Keynes should point out this elementary and damaging confusion contained in many economic textbooks.


Notes
1. Mankiw, Principles of Economics 6th edition p562.

2. Keynes, The General Theory of Employment Interest and Money, MacMillan edition 1983 p128.