India’s new and first female finance minister Nirmala Sitharaman in an interview recently said ,
At this stage, what we are looking at is making sure that consumption is encouraged through various steps that we’re taking, actually get the money into the hands of people, rural, particularly. This whole DBT-based transfer of entitlements to those who need to get it and get it instantly, being enabled by technology, was one very big way in which we’re pushing money into the hands of people. As you are spending on infrastructure, in-situ promotion of labour is what is happening. Giving money they need in their hands instantly is what is needed. So if government’s expenditure is diverted to only prioritising on infrastructure, the ripple effect, I expect, will be on labour, everywhere rather than concentrated in one place…The virtuous cycle kicks in from there. Consumption increases, demand increases, investment increases, as a natural course.
Is Sitharaman right in saying that, consumption increases, demand increases, investment increases, as a natural course? Is this the natural course? Or just a figment of Sitharaman’s Keynesian ideas? Let’s see.
In the 19th century, and before the 1936 Keynes’s publication of The General Theory, John Stuart Mill’s Fourth Fundamental Proposition Respecting Capital used to be the litmus test of a good economist. What is this proposition? Here are all four propositions of Mill:
Mill’s first proposition states that “industry is limited by capital.” It states that the total output of an economy is held within limits set by the amount of capital available. There is only so much that can be produced, given the available resource base, and this resource base can either be applied to the production of consumption goods or used to add to the economy’s capital base. Capital, it should be further understood, was any and every available resource that was used by its owner to earn an income. Labor cannot be employed without capital: “There will not and cannot be more of that labour than the portion so allotted (which is the capital of the country) can feed, and provide with the materials and instruments of production ” (Mill 1921 , p. 64; italics added).
This is not wages fund. Mill means something more comprehensive than just the availability of food, shelter, and clothing for the working population, since, beyond merely feeding the population, Mill explicitly notes that it is also necessary to provide “materials and instruments of production.” Also included are foundries, power looms, and every other produced form of input into the production process. That this is Mill’s meaning for the term “capital” is clearly explained in the previous chapter (Book I, Chapter 4), simply titled “Of Capital,” in which Mill describes the particular kinds of items that might be included as part of the capital of a manufacturer. There he explicitly lists buildings, machinery, raw material inputs, food and clothing, and finished goods ready for sale as forms of capital (Mill 1921 , pp. 54–55). The productive efforts of an economy are limited by the supply of productive resources in all their different forms. The more capital there is, the more employment there can be. Leslie Stephen states on the page following his previously cited more famous quotation “that the capital employed constitutes the demand for labour” (1876, p. 298), a conclusion directly derived from Mill.
Mill’s second proposition states that “capital . . . is the result of saving” (Mill 1921 , p. 68). In Mill’s words, “To consume less than is produced, is saving; and that is the process by which capital is increased” (1921, p. 70). Saving is discussed in real terms. The source of resources with which to invest are made available only because some resources have been saved; that is, not used as current consumption.
Mill’s third proposition is that saving is not an abyss, a negative, an absence, but is instead an actual productive use of resources. Mill again: “Capital … although saved, and the result of saving, it is nevertheless consumed” (1921, p. 70). Consumed here is not in its modern sense of forming part of final consumer demand, but means that the goods and services in question are being put to use in some kind of productive activity by being converted into capital. The word consumed and its various derivatives in the following passage should be read in the sense of “put to use.” “The word saving does not imply that what is saved is not consumed, nor even that its consumption is deferred; but only that, if consumed immediately, it is not consumed by the person who saves it” (1921, p 70). Savings are part of an economy’s productive efforts. They are actual resources used to increase that economy’s capital base. They are productive capital items plus the various goods and services bought by wage earners, all of which are funded out of national saving.
Mill’s fourth fundamental theorem respecting capital is, however, where the “paradox” is found. It is this proposition—quoted here in full and not just restricted to its second sentence—that has been the puzzle since the 1870s: What supports and employs productive labour, is the capital expended in setting it to work, and not the demand of purchasers for the produce of the labour when completed. Demand for commodities is not demand for labour. (1921, p. 79).
In the continuation of this passage, Mill makes a statement that underscores the point he is trying to make: “Almost all others occasionally express themselves as if a person who buys commodities, the produce of labour, was an employer of labour, and created a demand for it as really, and in the same sense, as if he bought the labour directly, by the payment of wages” (1921, p. 80). …
It is this implicit assumption that to buy commodities is the same as to employ workers that Mill was attempting to deny. He was trying to demonstrate that to buy goods and services not only does not add to the demand for labor, such increases in the demand for commodities, if they reduce the supply of capital, can even cause the number of persons employed to fall.
To understand in simple words what Mill said let us take one example. One of the basic principles of economics is that, without prior production there can be no consumption. This is easy to understand (apparently not for the finance minister Sitharaman). Suppose I am on an island and alone. I am hungry and I need to eat. There are two types of foods available on the island 1) fish and 2) coconut. Before I can consume these goods, I need to produce them first i.e., I have to first catch fishes and bring down coconuts. Suppose my daily catch of fishes is 10 fishes when I am fishing for 10 hours a day using original factors of production of labor, land and time. My production of fish is low because I am only using my bare hands for fishing. There is no capital goods available right now to increase my total catch, which is my daily income. If I want to increase my future catch (income) then I need to increase my productivity and that needs the use of a capital good. The problem that I face is, there is no ready capital good, in this case a fishing net, available on this island. I have to produce this capital good first in order to use it later to increase my future income of fish. Now this production of capital good requires resources i.e., when I am making a net I will not be able to catch fish simultaneously so I need to make provision of resources for the days on which I will produce a fishing net. This provision comes from prior saving i.e., consuming less than what I have already produced. The next few days when I will get busy in making the fishing net I will invest the prior saving, providing myself few fish (my those days wage/income), in the production of fishing net. Only after this successful saving and investment activity I will be able to produce a fishing net. Once I have my fishing net ready, I will be able to catch more fishes in less hours of time increasing my future income i.e., economic growth.
Now this same process also goes on in our modern day indirect exchange money economy. The economic laws enunciated above stays the same in our modern economy also. As Mill and my example above show, demand and consumption is never a problem that an economy faces. As David Ricardo said, men err in their productions; there is no deficiency of demand. And men err in their productions because the government and the central bank is fooling them in making their production decisions by manipulating the rate of interest, which is a price of time that coordinates production activities between future and present, and other prices which work as a signal for producers to make their decisions of ‘what to produce, how to produce and for whom to produce’. The Austrian Business Cycle Theory as developed by Mises, Hayek and Rothbard demonstrates this amply.
Thus the finance minister Sitharaman is totally wrong when she said, Consumption increases, demand increases, investment increases, as a natural course. This is not at all a natural course. She got it all wrong and backwards. As Mill originally explained, increase in present consumption will actually decrease saving and investment and so future income i.e., economic growth! What Sitharaman is terming as a virtuous circle is actually a vicious cycle. Her efforts to boost consumption will undermine the very future economic growth that she is trying to boost. Her spending of money on various governmental infrastructure projects is just going to divert precious resources from the right channels of production. She is just going to waste India’s saved resources and that only means even more poor India in future.