Keynesian economics emphasises the primacy of aggregate demand or expenditure in driving the growth of output and employment. More mainstream neoclassical Keynesians, and the New Keynesians, tend to argue that inadequate demand is a short run phenomenon. The more radical post-Keynesians argue that it can be a problem in the long run too.
To varying degrees, these economists make the case for demand management via some combination of monetary, fiscal and exchange rate policy. The more radically minded have also long argued for incomes policies to manage wage and price inflation, and reform to the international monetary system in order to allow national governments the space to manage demand and promote full employment while preventing excessive and destabilising current account imbalances.
While Keynesian economics focuses on demand and, traditionally, macroeconomics, industrial policy aims to impact more on the supply-side of the economy and draws on microeconomics.
I have posted on industrial policy quite a number of times, so now is not the place to argue over its definition. Instead I want to draw a link between some of the insights and implications of Keynesian economics in an economy open to international trade, and the need for industrial policy in its broadest sense.
With the (uneven and somewhat temporary) revival of interest in state intervention in the wake of the Great Financial Crisis, it is helpful to explore topics such as demand management and industrial policy, and their role in improving economic performance.
Influential post-Keynesians such as Nicholas Kaldor argued that economic growth can be export-led: it can be driven by the expansion of net exports, or the excess of exports over imports. Via the so-called foreign trade multiplier, this injection of demand can have a multiplied effect on aggregate spending, boosting domestic consumption and investment.
It may also boost productivity via the Verdoorn effect, in which faster output growth in sectors subject to increasing returns to scale leads to faster productivity growth, in a virtuous circle. Increasing demand raises output, which raises productivity, which raises competitiveness, which raises demand, and so on.
If these processes work as described, then policies which encourage export-led growth are important to economic performance and, in the Keynesian system, to maintaining a high rate of employment and low unemployment.
Policies which promote the competitiveness and growth of exports include industrial policy. This could take the form of horizontal policies, which aim to support the competitiveness of industry as a whole. It could include improving infrastructure and skills, and the overall business environment.
Vertical policies are what most people think of as traditional industrial polices. These focus on promoting individual sectors or even particular firms within an industry, one justification being that this will generate positive spillovers or externalities for the economy as a whole. Intervention could take the form of encouraging upstream or downstream linkages between firms and sectors, support for industrial clusters and forms of managed trade such as tariffs and quotas, or export subsidies.
Free market economists tend to be skeptical about vertical policies and more supportive of horizontal policies. They worry more about government failure than market failure, arguing that policies which try to ‘pick winners’ are more likely to result in social welfare losses.
Economists with more statist or interventionist leanings do not deny the potential for welfare losses, but argue that the historical record demonstrates the potential for successful industrial policies in particular contexts. If such policies do prove successful, the dynamic gains in terms of growth in productivity, competitiveness and incomes can more than compensate for the costs of particular interventions.
So if industrial policies in a particular country are successful, and result in a more competitive export sector with a high income elasticity of demand, then in an environment of growing world trade this can lead to improved economic performance.
Export-led growth requires an internationally competitive export sector which responds sufficiently to growing demand from its trading partners, and a sufficiently high multiplier effect from the injection of demand from positive net exports.
The level of the multiplier is determined by the amount of spending out of additional income. In this case, income first accrues as sales revenue to successful exporting firms. Wages are paid to employees, who will spend a particular portion on goods and services, whether domestic or foreign. Additional costs such as dividends and taxes leave profits, which could be spent on investment goods if future sales are expected to rise beyond current capacity.
If expected future sales are not expected to rise beyond capacity, income could be spent on higher wages or dividends, or accrue as savings in the financial sector. For Keynesians, savings represent a withdrawal from the circular flow of income and lower the multiplier, weakening aggregate demand.
The multiplier process works as the various economic agents, whether entrepreneurs, workers, rentiers etc., spend or save additional income. As already described, workers will spend a proportion of this income on goods and services, while the rest is saved or paid as tax. This spent proportion becomes additional income to the producers of these goods and services, who in turn spend a proportion of it, and so on, in a recursive process.
The larger the proportion of additional income that is spent by economic agents on domestic output, known as the marginal propensity to spend, the larger the multiplier and the larger the final ‘multiplied’ increase in income and output in the model. The factors that affect the propensities to spend, whether on consumption or investment, such as expectations about the future, mean that the multiplier can vary somewhat.
In our example of export-led growth, a highly successful exporting sector with a rapid growth of sales abroad may not necessarily create a rapidly growing overall economy if the domestic propensity to save is relatively high and the multiplier relatively low. Such an economy could end up with an excess of exports over imports and a current account surplus.
A good example of this is Germany in recent years, which has a current account surplus of over 8% of GDP and what is generally regarded as successful manufacturing exporters. Wage growth there has been low since the early 2000s, keeping consumption growth weak and national savings high.
These savings were lent by banks in Germany to the US and peripheral Europe in the buildup to the financial crisis, generally finding their way into speculative rather than productive investments, and fueling borrowing for consumption and housing.
So successful exporting need not lead to export-led growth if much of the additional income is saved rather than spent. An industrial policy which aims to promote the growth of exports may not be enough to accelerate overall growth.
Growth in domestic demand requires an expanding home market for goods and services, which in turn requires rising wages and consumption, as well as profits and investment. Imbalances between these categories can lead to economic and financial crises. This is nothing new historically, but it seems that each new generation of economists and policymakers has to rediscover such lessons as the memory of previous depressions fades.
Thus a Keynesian analysis of net exports as a determinant of aggregate demand can lead to an argument for an industrial policy. But this may not be enough to generate rising, widely-shared and sustained prosperity in the overall economy.
The Political Economy of Development 