Monday, March 16, 2009

Keynesian Economics: Implications on India & US

The 'Keynesian Economics' was advocated by the British economist John Maynard Keynes in his book ‘The General Theory of Employment, Interest and Money’, after the world suffered the Great Depression of 1930. The seeds of the theory were sawed after experiencing mass unemployment in the times of the Great Depression. The theory works on the principle that higher demand growth on the back of stimulated policies & measures led by the public sector would consequently avert the long drawn recessionary period which would otherwise have been long-drawn-out and self-correcting policy in nature.

(1) Keynesian Approach basically targets 5 aspects:

1) Government Policy & Stimulus Packages
2) Infrastructure Spending to generate Employment opportunities
3) Circular relationship between Spending and Earnings
4) Aggregate Demand for Goods & Services
5) Revival of Economy from the worsening business cycle.

(2) Assumptions of the Keynesian Theory:

The theory works on the formula that a certain stimulation of spending trend would lead to multiplier effect in the growth of output. The theory connotes the role of importance to pump prime the poor economic state either by the way of increasing spending or enhancing flow of funds in the economy. The theory stressed on the fact that it is the public sector that is responsible for the smooth operation of business cycles which could be done by means of various policy measures. The theory emphasizes on the cause of economic fluctuations as divergence in the nature of circular money flow in the economy on the back of sudden jolts in consumer confidence levels.

(3) Stimulating Demand led by the Public Sector:

The theory was articulated on the basis of assumption that when the economy operates below its equilibrium growth levels, on the back of under-achievement in terms of its potential output, it needs stimulus and spur led by the government measures in order to stabilize the macro-economic indicators of the economy. The theory stressed on the role of active government policy in managing & controlling the economic factors.

(4) Averting Long-drawn Economic Downturn:

The Keynesian theory connotes that phenomenon of fall in demand during the times of economic downturns need not necessarily get corrected on its own and that it needs various policy measures & actions by the government such as cut in interest rates and increased spending towards infrastructure which would lead to enhanced public participation in building infrastructure projects and hence creation of employment & eventually more spending power in the hands of people. This could lead to more investment demand to fulfill growing needs in the course of a business cycle.

(5) Drawbacks of the Keynesian Theory:

(A) Rise in Inflation: The theory was not without its part of criticism & drawbacks from various quarters. Since the theory was led by the purpose of stimulating demand and growth, it was susceptible to inducing sharp rise in inflation under on the back of increased demand & money supply to stoke commodity prices over a period of time. However, the theory blatantly points out that change in aggregate demand would not have impact on prices but its output and employment levels.

(B) Increased Fiscal Deficit: Higher spending by the government would lead to increased deficit, especially, when such data already points at a negative tick in the recessionary situation. Thus, what forms as an act of stimulus package for the economy, at one side of the coin; would contradict as rising deficit on the other side of the coin, thus defeating the very purpose of the reviving economy.

(C) Rising Budget Deficits: The theory stresses on the use of Monetary & Fiscal policies to counteract the divergences in the aggregate demand scenario & spending capabilities of the public. This would imply lowering of taxes as a part of fiscal measure to disburse more money in the hands of general people & spur the aggregate demand. But, this lowering of taxes will further stop the source of income for the government & a measure to kill budget deficits. This would further slowdown the chances of revival of the economic problem at hand.

(D) Limited influcence of Private Sector: The theory is more prone to tilt towards central focus of governmental influence. The theory advocated more of government spending and less by private sector. This could also lead to more borrowing by government and to that extent extinction of funds from the public account. This borrowing of funds is usually in the form of divestment of governmental stakes or through issue of bonds. This would also eliminate the chances of private sector influence in the decision making process in shaping economy.

(6) Feasibility of Keynesian theory in US Crises:

We all know how it all started with sub prime crisis in US and spreading across most of the developed and emerging economies of the world. The sub prime crisis of US further worsened taking form of Credit crisis and spreading across the global economies. Further, the credit crisis gobbled the likes of few large Investment banks in the US which had their wings spread wide and far across the globe. This crisis slowly spread across the sectors among various industries affecting various business lines. Unemployment data started cropping up & rising sharply all over the world, especially US.

(A) Integrated approach to Monetary measures:

This led to an integrated approach by the central banks all over the world in order to correct & rectify the situation with the help of monetary & fiscal policies on basis of individual standing of various economies. US Fed led the slide in interest rates which were gradually lowered to as low as near zero levels. This was followed by various other economies – developed & emerging both – as it could be sensed that no economy could be spared by the torrent of downturn.

(B) Application of Keynesian theory:

Finally, as inflation fears started subsiding on the back general slowdown in the world & unemployment data showed skyrocketing figures, most of the economies indulged in various monetary & fiscal measures & increased spending by respective government authorities, which nothing but a form of Keynesian approach towards reviving economy prospects. Combating unemployment & generating demand for their goods assumed priority as worries of soaring inflation comes down.

(C) Will US Succeed in Bailing out its Economy by applying the Keynesian theory?

United States went all out with all possible monetary & fiscal measures, not to mention stimulus and bailout packages offered to various private Investment banks & other private majors from various industries. These measures were adopted on the back of combating worst recessionary trend witnessed after the Great Depression crises. Unemployment rate has soared to a record 8% levels in US, which spurred US Fed to undertake various approach of stimulus & bail-out packages.

(D) Seeds of Recession in US:

These are deep recessionary times in US led by a housing collapse & related sub prime mess. Spending among US consumers far exceeded their income levels. There is a fundamental issue in the economy which cannot be corrected by a mere use of Keynesian approach, though the applicability of this theory ought to be a part of the final rescue package. The current rot in the US economy has more devils in the detail than just minor problems involved with aspects like inflation, demand & growth potential.

The largest economy of the world is largely lying within the pool of deficit. The country needs to correct the situation by counteracting the situation with huge amount of exports from currently being an import dependent economy. For this, spending and findings from R&D will play a large role in the initial phase to produce new and improved products.

(E) Need to Stop 'Leveraged' Spending:

The economy which relied on excessive spending will have to turn in to 'Savings-led' economy. Savings will eventually lead into investments & spur the growth. Once these basic approaches are evolved into & new concepts of development are inculcated into the economy, gradually the country can also lead into application of Keynesian economics more aggressively. The country needs an integrated approach with a change in particular fundamental factors & application of the Keynesian economics together.

(F) US bail out of Finance Companies –
Is it a Right Approach?

US economy is currently spending most of its bailout funds in financing & improving credit lines of financial companies like large Investment banks, Insurance giant AIG & various other financial institutions. Whereas the requirement, on the other hand, is producing & supporting more and more of export-oriented units & businesses which would bring down the country’s deficit ratio & also aiming for domestic infrastructure projects which would create large employment opportunities & stimulating growth potential. The country needs more focus on appropriate funding of industries invovled in manufacturing of real output for the economy, something that is adding materially to the economic growth.

(G) Direct approach of killing US Recession:

One may argue that if these financial bigwigs were not supported it may have lead to sinking of giants; further delaying the revival of the economy & consequently making out a case for long-drawn recession, asking for a painful wait through. But, then the current flows of funds which are being pumped into these companies are getting extinguished on the back of severe credit crisis & are proving insufficient over a period of certain time limit.

Instead, the government can use it directly in spurring domestic infrastructure & other employment opportunities in the economy which may be involved in a rather conscious approach to compensate the hugely unemployed population and disbursing money in the hands of worst effected people of that horizon.

(7) Feasibility of Keynesian theory in Indian Slowdown:

On the other hand, a more resilient Indian economy, which largely relies on the domestic economy, has willfully approached the slowing mantra with sound monetary and fiscal measures. Indian economy has a low ratio of reliance on exports of around only 1/3rd of the economy. This has ensured that in the present growing recessionary environment, the world over, the country is not as reliable on exports to other countries as a major part of its over-all trade. The soaring growth has come to a halt with a slight slowdown in the growth figures.

Rising Infrastructure Spending in the Domestic economy:

Fundamentally, India has not gone wrong on any major aspects. But, the infrastructure spending continues to be lower side even till date. The Keynesian approach is more useful in case of Indian economy than US economy where there is faltering on certain fundamental factors which specifically needs a correction in initial phase. On the other hand, Indian economy which is still largely deprived from domestic infrastructure spending would specifically benefit on account of large government spending on infrastructures & industries along with cut in tax rates which may disburse more liquidity in the hands of people and thus enabling higher spending & consumption phenomenon.

So, possibly though not necessarily, India stands a better chance to gain recovery of economy on implementation of Keynesian approach than the prospects of the same for US economy. Though, any such domestic recovery may also depend to a great extent on global linkages & other domestic factors.


Conclusively, the implications of Keynesian theory are largely variable on the case to case basis for every other country depending on the various factors of reliance of their respective economies, demand-supply scenario, employment levels, infrastructure standing, foreign policies, and inflation levels among various other factors. The theory may work differently in different conditions and economies, dependent on the underlying fundamentals of the respective economy & it’s potential.

The theory has its own positive and negative aspects which need to be determined by the monetary authorities of the economies interested in implementing the policies of the law. Some economies may need integrated approach where various measures need to be blended to arrive at a right mix of actions & policies. While others may need a plain-vanilla approach of mere stimulus packages where the problem is more definite & clear in nature.

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Faisal said...

Hey Bulls this is a great post and the concept has been explained in a really nice way...

I believe that bailout would really not help and as you mentioned its better to use this money for maybe the taxpayers instead of using the tax payer money to help companies who have proved themselves worthless...

Jim Rogers came out with a comment today that bailouts will lead to depression inm the US...I agree with him cos of the simple reason that US is not adressing the problem of excess debt and overconsumption by them over the years...

Instead they are increasing their debt and trying to increase consumption again...

Lets c where they end up...surely they have not done great things post October 2007...

Mahesh said...

BULLS, your post requires a Whole day to imbibe and assimilate because your write from top to bottom which very very less ppl do. I liked you educating the ppl as i saw your comments on various blog and glad you are writing your own blog. Keep continuing blogging in your free time to inject knol in novice investors like me :).

Your Telecom post is really awesome as i am in that field only.

BULLS said...

Hello Mr Faisal & Mahesh,

Thank you for your nice & appreciating comments. It helps in gauging the way forward for the blog. Whether my thoughts & views are in sync with reader's expectations.

Next few articles, i plan to write on various aspects related to Portfolio building, Portfolio Diversification, Tackling bear markets, and so on.


mohit said...


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Shabu's said...

Superb and simple and comprehensive... eagerly expecting your future posts

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