Economic Policies for an Incoming Labour Government – Part 5

Economic Policies for an Incoming Labour Government

By Bryan Gould and George Tait Edwards

Part 5 of 9 – The Two Great Traditions in Western Economic Thinking

In studying what actually happened to the Japanese economy and then testing various explanations

for consistency with the observed data, Professor Richard Werner of

Southampton University has placed himself firmly in the first of the two great traditions in

Western economic thought. That first tradition, dating from the time of

Adam Smith, derives economic conclusions from detailed observation and

inductive reasoning based upon the observed facts and data analysis. The

second tradition, most highly developed in the 20th century with the

development of mathematical economic models and more lately computers,

develops a body of deductive reasoning based upon stated theoretical

propositions.

The “bottom up” tradition of observing what is happening, building

economic understanding on the foundation of the observed circumstances

or measured data, and arguing from the observations or the data to the

economic theory is exemplified by Adam Smith’s, The Wealth of Nations.

An example of his technique is his reference to the productive power of

specialisation, which he illustrates by referring to the workers in a pin

factory, and demonstrating how, by breaking down the elements of

production into their constituent parts, a few specialised workers can

create thousands of pins a day when one man could hardly produce one pin

per day on his own. Smith’s book is a major illustration of the major

scientific principle – revived in the Renaissance – of learning by observation,

extracting the particular principle from the general, and basing theory upon

precise, real-world, observation.

The one common factor in the work of Adam Smith, and of John Maynard

Keynes, Osamu Shimomura, Kenneth Kurihara and Richard Werner is that

they all belong to the first tradition in economics, the derivation of valid

theory from detailed observation. Smith in the pin factory; Keynes in his

observation that labour markets, left to market forces, do not produce full

employment; Shimomura deriving the economic model for Japan from his

observation of the productive force of credit creation in the USA from

1938-44; the Japanese-American Kurihara – examining and discussing the

Japanese economic miracle in close-up while acting as the Fulbright

Professor to Tokyo University in 1965; the German-born and Japanese-fluent

Werner in Tokyo, working from the Bank of Japan financial data about

credit creation in Japan, and analysing it into its three key functions of

investment credit, financial credit and the presence (or lack of)

consumption credit, and then proving the predictive linkages using Granger

causative analysis – the work of all these economists is located in the great

inductive tradition of economics.

The second and more recent tradition in Western economics is the “topdown”

approach. This starts from explicitly stated but theoretical

assumptions and then proceeds logically from these to policy

recommendations, using deductive reasoning and highly developed

mathematics. A number of assumptions are made – that consumers and

investors act within perfect markets, with access to perfect information, in

a world in which perfect information has levelled out local differences. On

this basis, deductive logic arrives at economic models which appear to have

great logical validity but which – as Keynes asserted – may bear little

relation to reality. In view of the imperfect outcomes of this second

approach, as evidenced by the declining fortunes of many western

economies, there is much to be said for a return to the methods used by

Adam Smith and his great successors.

Three Practical Illustrations of the Use of Credit Creation

As we have seen, if credit creation is left to the tender mercies of self-interested

commercial banks, credit will be largely devoted to gambling on

property creating a housing and other asset bubbles so as to maximize

profits for private shareholders while the real economy languishes for want

of adequate liquidity and investment capital, and the economy as a whole is

handicapped by a shortfall in effective demand.

An incoming Labour government, however, fully understanding the use of

credit creation in the public interest, could resolve many outstanding

problems. We provide three examples of the way in which this would work

to achieve quite different kinds of objectives.

The Acceleration of British Economic Growth Through Higher Investment

This aspect of central bank credit creation is by far the most potent policy

within a government’s control. It would allow the government to create

earmarked investment credits, cost-free, for use by SMEs and other private

companies to ensure the fulfilment of the Government’s economic, social

and environmental policies.

The provision of these funds would be directed by the Bank of England,

reflecting advice from the Treasury – a technique described as “Window

Guidance” when used by the Bank of Japan in using similar mechanisms in

the 1960s and 1970s. There would need to be a bank which was, or ideally a

number of banks which were, prepared to use its local branches as taps for

local investment (as the Sparkassen in Germany are) and not just – as

currently occurs – as drains to collect local saving, taking it away for

whatever fashionable policy use the London HQ decides.

The initial creation of credit could be at the level of about 10% of GDP, that

is about £150 bn a year; multiplier effects might create an eventual new

level of commercial and industrial funding of about £300 billion. We would

expect these funds to be initially used to provide an improvement of about

£100 billion in business liquidity, about £100 billion in early new plant and

equipment investment and about £100 billion in funding higher levels of raw

materials, working capital and work in progress. If the usual level of tax

take of 42% applies to the new investment and to work in progress,

government revenue receipts could increase by about £84 billion – an

excellent return to government in addition to the overall benefit to the

economy as a whole. Furthermore, that new investment would produce a

permanent increase in output of about an extra £100 billion a year, equal to

a permanent increase in GDP of about 6.7%, and a permanent rise in

government revenue of about £42 billion a year. We think these changes

would occur within about two years.

Some economists have traditionally argued that, because an extra job in

manufacturing industry has historically created another job in the service

industries, the final effect could be twice the initial stimulus. It is indeed

likely that placing the economy on a higher growth path will enable the

under-performing assets and spare capacity in our industries to respond to

the higher levels of demand created by this stimulus.

The experience of other countries shows that investment credit economics

works by creating wealth in the productive sector of the economy. The

loans made are almost completely repaid (the failure rate is typically about

2.5%) out of the growth of the economy resulting from the additional

investment. The failure rate of these loans matters little in any case

because the loans cost nothing to create; their consequences matter,

however, because they produce their targeted effect in reducing poverty,

stabilising the banking system, and creating widespread prosperity through

many flourishing private industries in all the areas of the country.

The increase in output would obviously negate the risk that a substantial

increase in the money supply could be inflationary, as Keynes recognized

and as the Japanese experience in particular demonstrates. The

consequence of the increased money supply could well be a fall in the

international value of the pound, which could only be helpful in

ameliorating the competitiveness problem of British industry and in

ensuring readily available markets for increased British production.

Unemployment will fall to a low level. Social security payments will

automatically reduce as fuller employment becomes the norm and

Government income will cease to be disappointing, ending the need for

austerity in government expenditure and bringing to an end all of its ill

effects for our people.

© Bryan Gould and George Tait Edwards 2015