Preface by Dimitri B. Papadimitriou:
In our era of global finance, the theory of aggregate demand management is alive and unwell, says Amit Bhaduri. In this pol- icy brief, Bhaduri describes what he regards as a prevalent con- temporary approach to demand management. Detached from its Keynesian roots, this “vulgar” version of demand management theory is being used to justify policies that stand in stark contrast to those prescribed by the original Keynesian model. Rising asset prices and private-debt-fueled consumption play the starring roles, while fiscal policy retreats into the background.
Returning to foundations laid down by Keynes and Kalecki, Bhaduri sets out to clarify whether there is any place for traditional demand management policies—featuring an active role for deficit spending and public investment—in the context of financial globalization, and he concludes that such policies are ultimately unavoidable if we are to revitalize the real economy and achieve stability.
This policy brief emphasizes not only that globalization has elevated the relative importance of the external market, but also that we are living through a period in which trade in financial assets, enabled by multinational banks and other financial institutions, overwhelms, in terms of quantitative significance, trade in goods and services and foreign investment in physical assets. This era of financial globalization is marked by layers of private debt contracts that are generated at will by financial institutions—a system of private credit creation that is increasingly centered on a shadow banking system that exists largely beyond regulatory and supervisory control, and (at least formally) with- out the support of a lender of last resort.
While some might insist that the age of global finance leaves little room for the idea of demand management, Bhaduri con- tends that the theory survives, but that it does so in a form that is nearly unrecognizable from the original. This contemporary model of demand management receives its inspiration from the presuppositions of neoclassical economics, and its policy emphasis is often the very opposite of the old Keynesian model. In the context of the mobile and short-term nature of contemporary
financial investment, the perceived need to maintain a healthy climate for finance and protect against the risk of capital flight disciplines and constrains fiscal policy, while elevating the status of price-stability-focused monetary policy. Instead of public investment aimed at full employment, policymakers pursue restrictions on government spending and a shifting of the tax burden away from corporate profits and toward wages and salaries. Bhaduri argues that such policies exacerbate inequality and thereby suppress aggregate demand. To support demand, the “vulgar,” or “Great Moderation,” model hinges on the interplay between expectations of ever-rising asset prices and a consumption boom driven by private debt.
Bhaduri cautions, however, that a model centered on pri- vate credit creation is prone to instability. More and more financial investment is needed to produce greater returns and boost asset prices, continually shifting the composition of investment from the real to the financial and creating the conditions for a delinking of finance from output and employment. When the paths of the financial and real sectors of the economy diverge, when incomes stagnate while debt and asset prices continue to rise, this creates the conditions for a financial crisis. At that point, the government is called upon to inject liquidity into the finan- cial system. But this is not enough, says Bhaduri: it saves the financial sector, but not the real economy. Ultimately, he suggests that a revival of traditional Keynesian demand management, including large-scale, deficit-financed public investment, is needed to return the real economy to a state of health and stabilize the system as a whole.