It’s “recessiontime” in America. The sweet scent of bailout is in the air, the auto companies are performing their courtship rituals in Congress and the bears are frolicking in the marketplace. This is the time of year when a young economist’s fancy turns to thoughts of financial stimulus … BIG financial stimulus.
The lame duck Congress recently rejected a $100 billion stimulus bill, but the new Congress waiting in the wings and its Democratic leadership will be much less squeamish. Some Democratic advisors are recommending spending increases as large as $400 billion dollars.
The love-fest on January 6th will be epic as eager-to-spend politicians seemingly find themselves with a mandate to spend like there’s no tomorrow. While there’s still time left, let’s recheck the assumptions behind counter-cyclical government macro-intervention.
In the 1930’s, John Maynard Keynes (pronounced “Canes”) put forth a simple bit of logic that came to be called the Paradox of Thrift. It goes something like this: If everyone decides to save more money, consumer spending will fall; if consumer spending falls, then total demand will fall; if total demand falls, then total income will fall; and if total income falls, then people have less income to save.
The end result is that as consumers save a higher fraction of their income, the economy as a whole will have less saving. Using this neat counter-intuition, Keynes justified a counter-recessionary strategy of taxing people who save a lot (the rich) to fuel government spending that would boost aggregate demand.
Over the past couple decades, Washington has followed Keynes’ logic to its extreme. If saving is counter-productive, then why not cut saving to zero? Or better yet, why not save negative amounts and really boost the economy!
Over the Clinton years, the personal savings rate fell from 8 percent to 2 percent. Bush completed the descent, and the personal savings rate was actually negative in 2005. Today, there’s something of a panic as experts predict that the personal savings rate will claw its way back to 4.5 percent by the end of 2009.
Meanwhile this year the Chinese national savings rate (the combination of private and public saving) topped 50 percent. Judging from the growth rates of the two countries, the reports of death due to saving have been greatly exaggerated.
So what’s wrong with the Paradox of Thrift?
Let’s simplify the economy down to the production of two outputs: Current Goods (C) and Future Goods (F). All income is either consumed (used to purchase C) or saved (used to purchase F). Consumed income buys food, electronics, clothing, and other end-use products. Saved income is invested in new factories, machines, education, and other means of producing future goods.
With this simplification, the fault in the Paradox of Thrift becomes obvious; income that is saved doesn’t just disappear down a hole — it simply purchases a different type of good than consumption. Workers in consumer electronics might lose their jobs, but the loss to national income is offset by new hires of welders, construction workers, and teachers. Aggregate demand doesn’t fall — it merely changes in composition. In the long run, the paradox unravels.
In the short run however, the paradox still holds some water. This is because of time dynamics present in the economy; the current goods industry can shed workers in a matter of weeks — the only barrier is the contractual obligation to provide advance notice to the downsized.
The expansion of the future goods industry however can take months or years — laws and regulations need to be navigated, new projects need to be planned, businesses need to be started, and workers might even need to be retrained. In the meantime, the paradox rages on; every worker shed from the current goods industry is a worker idle (read unemployed).
Also, there are barriers to the proper transmission of price signals necessary to shift production from C to F. One price signal is wages; low wages incentivize employers to hire more, but minimum wage laws and downward wage stickiness often keep wages artificially high (this effect was especially pernicious during the Depression when unions were stronger and Hoover’s policy advisors confused the causal relationship between a strong economy and high wages).
Another obstructed signal is the interest rate, which determines the relative prices of C and F. A negative real interest rate would strongly incentivize the production of F over C, but the existence of non-productive stores of value (like gold and diamonds), prevent nominal interest rates from falling below 0 percent, and the high inflation necessary to make real interest rates negative is disruptive for its own reasons. Trying to increase investment in a recession with interest rate cuts alone is often likened to “pushing on a string.” The Fed can make funds available, but it can’t force them to be invested in new projects.
Because of the short-run validity to the Paradox of Thrift, it is necessary to carefully manage a rise in saving; too fast a rise and the future goods industry can’t keep up — the labor force would go under-utilized. Financial stimulus is necessary.
However, there is a big difference between smoothing out a rise in saving and trying to smother it entirely. Indeed, there is no question that American saving will have to increase; the only serious argument, which has been carried back and forth between the op-ed pages of the Wall Street Journal and Financial Times for years now, is whether there will be a “hard” landing or a “soft” landing, that is to say, whether consumption will fall precipitously and destructively, or slowly and safely. The long existing trade imbalance between the United States and the world ensures that at some point, Americans will have to produce more than they consume in order to pay off their international creditors. Ultimately, they must save.
Mr. Obama must not confuse his mission; the recession is not a call to kill saving, but merely to curb its excesses. And when good times return, his mission will not be to pressure down saving as Clinton did, but to oversee its gradual rise. This will be difficult for him to do with his current promises to tax the rich and their capital gains — it will be even more difficult however if he uses the political opportunity provided by the recession to launch a new New Deal and commit large fractions of future generations income to consumption.
During the campaign, Mr. Obama blamed the current recession on ideology, claiming that Republican’s blind allegiance to right-wing economics doomed the country to a subprime crisis. If Obama truly believes in a pragmatic “Ideology of No Ideology,” he must be willing to challenge the orthodoxy of the Left as well as that of the Right. The Keynesian Paradox of Thrift shouldn’t be ignored, but its lesson must be taken with the grain of salt that it richly deserves.