demandside

Investment and Consumption are part of the recovery, not just government spending

Today, from a listener

Dear sir,

As we plow ahead and jack up the G by any means possible, we should also consider how to support C.

I still have some money in my 401k.  I would gladly use some of that to support my family in a time of hardship.  How about relieving the penalties for early withdrawal of 401k or IRA money?

I don’t know how much C that would generate - but I would be very inclined to use that cushion until things become more stable.

Thanks for thoughts.

Bob

By all means, Bob.  Thank you for this note.  I realized it at the time, and did not make a good enough acknowledgement of the situation of real people when I talked about the imperative of government demand.  The C is the point of the economy.

What Bob is talking about is C plus I plus G plus NX equals Y or total economic output.

It is not that the C is bad.  It is just that there is not going to be enough of it to float the economy.  And in C we are referring to private consumption.  The G is the government spending.

Let’s take this on a couple of levels.  First, directly to the question.  The 401(k).  Of course it is all right with me to eliminate the penalties on the use of savings.  Right now there are entirely too many incentives to save.  The paradox of thrift is in full flower, as everybody saves against the uncertainty, and consequently incomes drop from the absence of spending, and eventually everybody must use their savings to make up for flagging incomes.

Let everybody be aware that I am certainly not making any investment advice here.

It is unfortunate that the private, defined contribution scheme for pensions embodied in the 401(k) and IRA has blown up on us at this time.  And  the more I consider Bob’s note, the more directions it leads.

Let me confine myself today to a couple of more levels.

The C.  The C is not going to be strong enough to carry the economy.  Consumers are, as Nouriel Roubini says, “tapped out, debt burdened and saving less.”  But the C also has to be big enough to stimulate the I in order for any self-correcting mechanism to take place.

That is, the multiplier which we have applied to government spending, is originally, or at least in one early form, called the “Investment Multiplier.”  It is an exogenous spending that stimulates demand.  For private I to come back to a positive number, private C has to be big and growing and require increased investment to generate the goods and services clearly on the horizon.  For GM to be a positive force again, people have to not only buy enough GM cars to get their old plants up and running, but to cause GM to build or expand.

The Government does not need the prospect of profit to generate I, it can use the prospect of disaster.

And be sure there is a lot of I in G, in terms of roads, bridges, education, even some health care.  Likewise there is a lot of C in G.  Police and fire services are indistinguishable from and married to private insurance payments.  Private schools and public schools may be perfectly identical except for which side of the C or G they are accounted for.  Health care for the indigent or publicly insured is poorer, I suppose, but is it any different than health care for the privately insured?

What is in the stimulus package now proposed?  Well, there is lots of C, with the tax cuts that go to individuals.  Plenty of S there, too, which we should talk about, and will in a moment.  There is I in the G, as above, with the expenditures on facilities and services that build for the future and are not consumed in the current quarter.  There is other G, as with the support to state and local governments.  The cops and teachers, you might call it. (You know, I really need to get organized so I can go back and point out that this is the kind of thing, specifically, we were talking about in the first stimulus package.)  And there is the induced C when somebody working on an I or a G takes his paycheck to the grocery store.

Here is David Korten, publisher of Yes Magazine, talking about consumption on a recent edition of Democracy Now!.

KORTEN

David Korten.

So, consume, yes.  Let’s eliminate the penalties on using 401(k)s and IRAs to promote current consumption.  But let’s take a look at the other elementary equation in which C appears, and that is Consumption Plus Savings equals income.

Since total income equals total output,  this C + S = Y is often combined with the above C + I + G = Y and simplified to produce Savings = Investment.  You have to do things like assume away the trade deficit and assume G is paid for by C in the second case, but this Savings equals Investment equation is one of the great bludgeons used against profligate Americans.  Never mind we thought we were being prudent by buying stocks and houses, these are assets, so they don’t count in S.

But more to the point.  The equation is often, very often, almost universally used to force a causation.  Savings equals Investment.  Therefore Savings causes Investment.  This is backwards.  People save to invest.  They don’t invest because there is a pool of savings to be used up.  Aside from this, people invested in American houses with Japanese and Chinese dollars and in Chinese factories with American corporations retained earnings.

But back to this point.  Which is essential.  How about somebody other than Demand Side saying this.  Here, from the

According to classical theory, if unemployment were to rise, consumption would decline, but savings would increase. The increase in savings would lead to lower interest rates, which would lead to greater investment, which would lead to the restoration of jobs–in short, back to full employment. But Keynes rejected this logic. During a recession, lost jobs and wage cuts would lead to a reduction in consumer demand, which meant less incentive for businesses to invest and banks to loan. And, if businesses–skeptical about the rate of return from an investment–failed to invest, more workers would lose their jobs, consumption would decline even further, national income would go down, and any initial increase in savings would be wiped out. The economy would reach equilibrium with a high number of unemployed, which is exactly what happened in Great Britain in the 1920s and 1930s.

Keynes’s theory inverted the relationship between savings and investment. Instead of the amount of savings determining the amount of investment, the amount of investment determined the amount of savings. It also inverted the relationship between consumption and savings. If the inducement to invest was determined at least partly by consumer demand, then the greater the propensity to consume rather than save, the greater the inducement to invest. Consuming, in short, was preferable to saving.

These two inversions had radical implications for government policy. In the past, governments had advocated budget cuts and tax increases, along with wage cuts and lower interest rates, to escape recessions; Keynes was arguing that, except for lower interest rates, these measures made matters worse. And, in a severe recession or depression, when pessimism about future business profits made lenders reluctant to finance investment, even government attempts to lower interest rates wouldn’t help. What was needed instead? Budget deficits, rather than budget balancing, and public investment and income transfer programs designed to put money in the pockets of the poor–that is, the people most likely to spend, not save it.

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