Monday, December 29, 2008


“Bailout” is the hottest word around the globe today. Governments around the world are following what Keynes, one of the founders of Macroeconomics, preached after the Great Depression of 1929 – trying to increase consumption. 2 primary things are being done.

1. They are pumping in tax payer’s money into saving large organizations from crashing down, eventually saving lots of jobs and preventing unemployment which will further lead to decrease in demand of different commodities in the market. And which will further lead to closing down of more industries, more job losses and so on. The basic aim of this step is to keep the demand of different products high in the market. That is, people should not get a reason of not consuming. For this, there can also be tax rates increase because the government wants more money to bail these companies out.

2. Reducing Interest rates artificially so it is easier for:
a. Industries to borrow money. Presently, as people are buying less, industries are getting lesser cash inflow. Due to this it is tough for them to carry on their operations and produce and sell their products.
b. People have less incentive to save and they consume more, hence keeping the demand high
So the basic mantra is to increase consumption. But ironically, the basic reason for the current crises was the same – tendency to consume was much higher than tendency to save.
So the solution is the problem itself.
Now what will happen when interest rates are reduced artificially and tax rates are increased.

As is evident from the figure, it will lead to further failure in the long term.

What does the Austrian school of thought, people like F.A Hayek say. According to them, the government should losen its control at junctures like these. Rather than tax increases, tax cuts would benefit in the longer run. Tax cuts would mean more money in the hands of people. Now with same level of consumption, people can save more. More savings will result in interest rates coming down naturally.( Banks have more money to lend when savings are more. Hence lowering the interest rates). Hence it will be a natural reduction in the rates unlike the artificial one at present. The government has to become efficient and come in cost cutting mode to reduce the fiscal deficit it will incur due to lower taxes.

Kaushik Das explains this in detail here.

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