Greece situation is politically overwhelming for not only Europe but for the entire world. I remember reading a lot on Euro crisis, Drachma, QE, Greek issue, neo-classical economy, fiscal policy, Keynesian economy, Milton Friedman, Philips curve etc..during my MBA @ University Of Glasgow.
Greece has around $600M due next week to pay as a result of debt, but speculation is that they might default. However, their prime minister Alexis Tsipras denied any such speculation and assured that they have money to repay the debt this time. Many are saying that Greece is playing chicken game, they started to borrow first, they defaulted first, they are responsible, but they cannot be punished by offsetting them from Euro zone for Geo-political reason. They had enough defaults and help through austerities. It is also to be considered that Greece currently contributes <1% in world’s economy.
Greece is suffering highest unemployment at the moment, going to neo-classical economical theory that suggests reduce wages can help minimizing unemployment, I am sure Greece would’ve administrated this positively.
The classical solution to tackle unemployment, in whatever form they conceived it, is totally inadequate and unsatisfactory. They have relied entirely on a cut in the rate of interest and wage rates. These are self-defeating polices. Any cut in wage rates will result in widening the gap of unemployment instead of correcting it in modern times. This is because of the fact that any attempt to cut wage rates at the bottom of the depression period will cause a considerable portion of the aggregate or effective demand to reduce further causing a more severe unemployment situation. This can be illustrated with the help of a simple example:
Let’s assume that a small fruit seller sells 20kg of fruit at a market price of $10 on a daily basis. Thus his daily turnover is $200 (20 ´ 10) of which the only cost of production is in the form of wage rate. If he employs 10 laborers at a daily rate of $15, then the total wage payment is $150 (10 ´ 15). The fruit seller therefore earns a daily profit of $50 (200 – 150). If for some reason the demand for fruit that he sells reduces, then he will have to reduce the price say from $10 to $8. In this new situation his total daily turnover goes down to $160 and at the old cost of production, his profit margin declines to $10 (160-150). The fruit seller is not satisfied with this. Therefore he may reduce the number of his workers from 10 to 8 and bring down the cost of production from $150 to $120 (8 ´ 15). The two workers are then rendered unemployed. If the unemployed laborers insist on their re-employment, the producer will lay down the condition that wage rate of all the workers will be reduced from $15 to $11. If the workers accept this then the total wage bill will be $110 (10 ´ 11) which restores the seller’s profit of $50 (160 – 110) as before. It appears that even with reduced demand and fall in the price of fruit, unemployment of workers has been avoided with the help of a cut in the wage rate. But this in only a momentary and superficial solution. The workers’ total income has now reduced from $150 to $110 as a result of which they can spend less and reduce demand for every other commodity that they consume. Therefore initially the problem of depressed demand and unemployment which was faced by a single seller will eventually become a general and wider problem faced by all other dealers. Instead of curbing it, the wage cut solution will therefore increase the problem of unemployment. Though this example is oversimplified and hypothetical yet it helps to bring out gist of the Keynes’ Criticism of Classical theory.
Keynesian theory opposes this reduce wages, and suggests that it has adverse effect on economy reducing MPS (marginal propensity to save) and MPC (marginal propensity to consume). It will in-turn decreases multiplier factor that Keynes described in his book The General Theory of Employment, Interest and Money that was published in 1936. Keynes emphasized on Fiscal policy and tax reduction during recession. He also emphasized on investments in industries to produce more to meet demands, or to spend more to innovate and create demand, supporting as long as there is an active demand unemployment can be controlled.
Milton Friedman Argued Keynesian theory that why would industries would enhance investments if there is no profit. Why to enhance Fiscal policy, and government expenditure in recession?
The Good Society by Galbraith covers a concise description of the process of stabilization of the flow of aggregate demand which is the vital factor in the Keynesian economy.
Aggregate demand has three decisive components: consumer expenditure, expenditure for private investment and expenditure from the fiscal operations of the state – from government spending that exceeds or falls short of tax receipts. If the flow of purchasing power – of aggregate demand – is insufficient to sustain a high level of economic activity and growth, it is commonly believed that certain readily available and greatly benign measures will restore consumer and business confidence. There are three substantive lines of corrective action that will increase the flow of aggregate demand as required. First, taxes can be lowered, thus releasing to the consuming public more revenue to be expended on private consumption. Second, interest rates can be reduced by central bank action, thus encouraging business and consumer borrowing and investment or expenditure, which add to the flow of aggregate demand.
Third, the government can contribute directly to the flow of demand by new expenditure in excess of tax receipts – by a deliberately accepted or deliberately increased deficit. By one or a combination of these steps aggregate demand can, or so it held or hoped, be kept at a level that will cause business and the government to reach out for all available workers.There is, unfortunately, a wide difference in the effectiveness of these several public actions. There is also the problem of inflation. Action on interest rates, commonly referred to as monetary policy, has the highest establishment approval as an effective measure against stagnation and unemployment; it must, accordingly by the first for consideration. The serious flaw in monetary policy is that it may have little or no effect on the flow of aggregate demand. When times are poor and unemployment is high, lower interest rates do not reliably inspire consumer expenditure; depressive attitudes, including those which are the product of unemployment or uncertain employment, are in control. Tax reduction is also celebrated as a way to sustain aggregate demand during recession. Here again the hope is at odds with the reality; there is no certainty that the funds released by tax reduction will be invested or spent for the most good. As a way to stimulate demand in times of negative growth or stagnation, there remains only direct and active intervention by the state to create employment. In an ideal world this last would not be necessary. In the real world of recurrent and prolonged stagnation there can be no effective alternative. To intervene, the government must borrow and accept the reality of a larger deficit in the public accounts. Improvements to the public infrastructure – roads, schools, airports, housing – that are effected by the work of those newly employed also add to public wealth and income. Public borrowing can, over time, be a fiscally conservative act. When the economy recovers and public revenues rise, there must then be the discipline that brings simulative expenditure to an end. In brief, Keynesian doctrine suggests that the government should, in times of serious unemployment, run deficits to support the flow of aggregate demand7 and a wise government could stabilize the economy close to full employment and avoid fluctuations.
Rest later….Structuring needed