Mainstream macroeconomics' focus on individual choices overlooks how business investment, driven by profit expectations and uncertainty, shapes economic growth and instability; Keynesian economics shows why saving does not guarantee investment and why economic structure matters.
Robert Hall and Michael Woodford's work modelling macroeconomy based on individual agents' decisions has significant implications for monetary policy. Despite being hailed as providing rigorous foundation for stabilisation policies, focusing on individual blinds us to way macroeconomy actually works. It may seem paradoxical; John Maynard Keynes's insight was that aggregate economy cannot be understood simply as sum of individual actions. Heterodox economics, by focusing on structure of broader economy rather than its individual components, provides much better framework for understanding economy.
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Investment and interest rates -
Work of Keynes in wake of Great Depression led to development of study of aggregate economy, as opposed to studying demand and supply of individual commodities. Microeconomics focuses on optimising behaviour of individual, while macroeconomics focuses on statistical relationships to characterise aggregate behaviour. Hall and Woodford provided rigorous models that rooted study of macroeconomic aggregates such as consumption, investment and employment in behaviour of individual agents. Key contribution was linking consumption to interest rates and future. Individuals chose to smooth consumption over their lifetimes rather than base it solely on current needs. When interest rates high, savings yielded greater returns. Individuals therefore had incentive to defer some consumption to earn more and consume more in future. Higher interest rates could reduce current consumption and hence lower current demand, and vice versa. Macroeconomic dynamics could consequently be derived from rigorous formulations of how individuals responded to market signals and policy variables such as interest rates.
This provided framework within which Central Bankers could target interest rate that was neutral to real economy - one that neither excessively stimulated nor depressed aggregate demand - greatly aiding development of sophisticated stabilisation paradigms for monetary policy.
However, this approach collapsed distinction between consumption, savings and investment. By viewing consumption inter-temporally, and making it main component of demand, microfoundations methodology relegated importance of volatile investment expectations to background. Whatever not consumed currently was saved, and automatically translated into future consumption demand. This was framework followed by classical economics, which Keynes contested. He cautioned that not all saving is necessarily undertaken for future consumption. In contrast, investment is fuelled by expectations of business owners as to prospects of profit. There is no necessity for savings behaviour of individuals to always imply demand for future consumption, and hence investment, by businesses. How can businesses determine whether act of individual savings is to spend on house for future, or to ward against future health emergency that may or may not occur? In such situation, interest rate cannot serve as indicator of extent of future consumption.
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Keynes further suggested radical intervention. It was not interest rate that equated savings and investment, but income. Investment raised income, and generated equal amount of savings. This is not merely technical insight, but important way in which to view policy. It is not savings or inter-temporal consumption demand that affects output growth and employment, but business investment. To understand why economies are prone to instability, one must examine investment behaviour of companies rather than consumption demands of individuals.
Class and macroeconomic policy -
According to Keynes, investment being done for profit in environment of uncertainty is chief source of economic instability. In uncertain situations, rational for investors to follow herd, investing during boom for fear of missing out on speculative returns, and withdrawing investment in recession for fear of loss. This is reason why booms and recessions get amplified. Work of Keynesians such as Hyman Minsky and Jan Kregel offers great insight into how financial behaviour of firms brought about boom in housing construction and finance, as well as recession in 2008. Much of current stock market gains in US economy being driven by Al hyperscalers, giving rise to concerns of new bubble that might eventually burst. Such outcomes can be clearly discerned when viewed from Keynesian lens. Some might argue it does not matter how one views economy, if framework designed to bring about stability is effective. Moreover, in centering actions of individuals, so argument goes, framework takes into account reality of complex economy being driven by individual choices.
Keynes' genius was in going beyond what appeared at first glance. In capitalist economy, it is not individuals that drive economy, but decision of businesses to expand stock of productive machinery. Point stressed by Keynes is that individual welfare is harmed by economic system driven by subjective expectations of future made by businesses focused on profits rather than societal welfare.
Mainstream focus on individual-level microfoundations implicitly assumes every individual similarly placed in hierarchy of economy, differing only in values of few key parameters determining economic action. In dividing economy into two classes, heterodox economics does not reduce complexity or resort to ad hoc explanations. Instead, provides better analysis of why individual is often ill-served by prevailing models of unregulated capitalism where holding of capital and ability to make decisions regarding its investment is restricted to members of certain class. Structure of economy determines its dynamics, and nuances lost in framework that begins and ends with individual. For India, where core sector growth 7.9% driven by government capex not private investment, Keynesian insight relevant - saving in form of household financial savings 5.2% of GDP does not automatically become investment if businesses uncertain due to US tariffs, oil above $112, and SIR protests disrupting Delhi.
Tags: #KeynesianEconomics #HallWoodford #Investment #InterestRates #Minsky #Macroeconomics #HeterodoxEconomics #Saving #EconomicStructure #MinskyMoment