The virtuous circle of economic recovery

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By FERNANDO NOGUEIRA DA COSTA*

The increase in production will cause an increase in the demand for money in circulation and will require tolerance on the part of the Central Bank

Michal Kalecki (1899-1970), Polish economist, avant-garde in his dynamic Macroeconomics in the essay Mechanism of Economic Recovery, published in 1935, analyzes the following sequence. “Entrepreneurs, by engaging in additional investment, push profits equal to their investments into the pockets of other capitalists – and become debtors to those capitalists in equal amounts through the banks.”

Before, the problem was whether the profits resulting from the reduction in salary costs would be invested. Now, paradoxically, profits are invested before they even exist! It occurs through the anticipation provided by credit (trust) to entrepreneurs.

If profits are not invested, they cannot be maintained, because they are eliminated by the subsequent fall in production and prices. The creation of purchasing power to finance additional investment raises production from the low level reached during the depression and thus creates profits equal to that investment.

The increase in production will cause an increase in the demand for money in circulation and will require tolerance on the part of the Central Bank. It will be worse to react, automatically, thinking about “unanchored expectations” (before la lettre), regarding achieving the inflation target, and raising the basic interest rate to an exaggerated level.

It will cause total investment to decline by an amount equal to the additional investment caused, for example, by technological innovation. As a result, there will be no subsequent increase in investment and improvement in the economic situation.

Therefore, the condition for economic recovery, including during a long stagflation, such as that experienced in the Brazilian economy since the 1980s, is the basic reference interest rate, over which there is an increase of spread to determine interest rates on loans, not be raised automatically in response to a greater demand for money. The Central Bank of Brazil does this regardless of whether it is demand for credit to consumers or credit to investors.

When technological innovation becomes widespread and the investment stimulus dissipates, depression will not be inevitable. In the meantime, the greater profitability in the economy as a whole will have resulted in a sustained increase in investment. This, due to the expectation of greater profitability, will enter the scene, while the effect of the new invention or disruptive innovation will leave the scene.

If the economy stabilizes at the bottom of the depression, at a very low level of economic activity, investment may have fallen to the point of not even allowing for the replacement of old capital equipment. Only after the destruction of much equipment due to obsolescence, in the long term, will the recovery movement begin.

Due to the elimination of obsolete equipment, the same demand will be met by fewer establishments, increasing the level of use of available production capacity. This will increase the profitability of the remaining capital equipment and with this stimulus the level of investment will also rise.

The financial resources for this will be provided, either by creating additional purchasing power in circulation, or by deposits into debtors' current accounts by creditor banks. Expected demand for consumer goods from newly employed workers will cause greater employment in popular consumer goods industries in a virtuous circle.

This cumulative process will cause a firm, sustained recovery over the long term. If investment begins to exceed that level of necessary replacement of fixed capital, then the brakes on economic expansion will appear again.

During the depression, the removal of depreciated or obsolete capital equipment was the beginning of recovery. In the case of excessive expansion of equipment, idleness ends up causing economic expansion to be interrupted and the downward phase to begin.

“The process of stopping expansion is the reverse of the process of initiating recovery from the bottom of the depression,” stated Michal Kalecki. When demand is met by an increasing number of establishments, as a result, the degree of utilization of less competitive establishments will decrease, will be accompanied by a decline in investment and will result in lower overall profitability.

Just as the increase in investment, at the bottom of the depression, meant the beginning of the recovery in production and employment, otherwise, there will be a drop in production and an increase in unemployment. This “downward” movement (vicious circle) will accelerate in the same way as in the recovery period the upward trends were cumulative.

Michal Kalecki pointed out: “the aim of this essay [in 1935] is not to present a complete theory of economic fluctuations. The aim here is to give a general idea of ​​the mechanism of natural recovery and, particularly, to clarify one of its aspects.”

Investment has a favorable effect on the economic situation only at the time of its implementation when it provides an outlet for additional purchasing power. The productive character of investment contributes to weakening and recovery and ultimately stagnation, because the expansion of capital equipment causes the collapse of economic expansion.

A notable paradox of the capitalist system is: “the expansion of capital equipment, that is, the increase in national wealth, contains the seed of a depression in the course of which additional wealth proves to be only potential. As a considerable part of the capital remains idle, it only becomes useful in the next recovery.”

Hence Michal Kalecki addresses the problem of antidepressant government intervention through public investment.

After studying the mechanism of the economic cycle, an analogy is made with the case in which the recovery begins with a new technological innovation that encourages some entrepreneurs to embark on investments for technical updating. With this objective, after making use of additional purchasing power, via credit, they set the recovery mechanism in motion.

This case is very similar to that of antidepressant government intervention. To exchange case studies, simply replace businesspeople encouraged to invest because of innovation with the government making infrastructure investments, for example. It is also financed through the creation of additional purchasing power, via public debt, with the countercyclical objective.

Just as occurs in the private sector, in the case of the public sector what Richard Kahn (Keynes's disciple) later called the job and income multiplier effect occurs. This new money, in the same way, when it is not in industrial circulation, is deposited in banks for financial circulation.

On the bank assets side, government debt grows in the form of a portfolio of public debt securities. On the liabilities side, there is an increase in deposits equal to the additional profits arising in the economic system.

Thus, the government becomes a debtor to the capitalists, through the banks, in an amount equal to the value of the public investment made. There is a complete analogy between the case of government intervention and the case of recovery resulting from a disruptive innovation.

“In both cases, the greater profitability of the industry as a whole will stimulate investment and thus sustain the recovery even if the government then gradually reduces its productive investment activity. Likewise, a recovery initiated by an innovation continues despite the initial impact being diluted.”

The adopted pattern of public investment, whether in productive spending or social spending, is not essential for the effect of government intervention. The important thing is that this investment is financed by additional purchasing power.

The creation of purchasing power to finance the budget deficit, regardless of the cause, causes a similar effect. The difference consists only in the transmission mechanism for this additional purchasing power to initially flow to other industries – and then to others through the income multiplier effect.

Increased investment activity, financed by the creation of purchasing power by the financial system, will sustain the economic recovery – and it will continue even after budget deficits disappear. This occurs thanks to the increase in tax revenue resulting from the increase in income and sales.

“After some time, private investment takes over public investment. 'Artificial' prosperity is replaced by 'natural' prosperity. Sooner or later it will end as a result of the expansion of capital equipment.” This is the oscillatory cycle around, it is expected, a long-term growth trend, according to Michal Kalecki.

*Fernando Nogueira da Costa He is a full professor at the Institute of Economics at Unicamp. Author, among other books, of Brazil of banks (EDUSP). [https://amzn.to/3r9xVNh]


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