Stimulate what?

Most economics experts, including Reagan administration veteran Martin Feldstein, are telling us we need to stimulate the economy in a big way. I agree.

It's not unanimous, though. There's still a small minority who think the option of doing nothing will sort things out more effectively in the long run. Unfortunately, none of them can say for sure how long the "long run" will take to arrive; maybe nine months, maybe two years, maybe more. To me, that's like asking Uncle Sam to do a bungee jump from a 200-foot tower using bungee cords that "might be" as long as 220 feet.

So yes, I'm with the stimulus crowd. But that begs the question, Stimulate what? I was thumbing through my favorite textbook on basic economics (Brad Schiller's), which I always keep close at hand, and came across an appropriate cartoon from the 1991 recession (it's on page 324):

I've noticed that economists in the Keynesian camp imply (predictably) that consumer spending, not saving, is the thing we need to stimulate; to them, saving is merely stuffing money into a mattress where it doesn't do the sluggish economy any good. Saving is "leakage." The solution to hard times is to stimulate consumers with tax cuts and rebates, stimulate business payrolls with more government spending, and hope the stimulus money gets spent instead of saved. In my judgment, that view is oversimplified; but here it is:

[By the way, opponents of this view don't do themselves any favors when they attempt to fight tax rebates by pointing out that last summer's rebate "didn't stimulate anything, because the recipients just saved it."]

Anyway, can you spot what's missing, and what's oversimplified? Hints: What's missing is the economic activity that transforms banks from mere fancy mattresses into true financial intermediaries. What's oversimplified is the business side of the diagram. Here's a more-complete picture; for a really big hint, look for the additional red star:

"Spending" doesn't just happen when consumers consume; it also happens when entrepreneurs invest in new businesses, or expand existing businesses. But investing doesn't happen as readily when banks are reluctant to lend money, or when entrepreneurs are reluctant to borrow. So, to provide a complete stimulus package for the economy, Congress and the new administration should stimulate investing as readily as consuming. That's what was missing from the first diagram.

One way for government to shoot itself in the foot is to discourage investing by keeping obsolete business firms alive, under the false pretense of "protecting jobs." When government keeps obsolete businesses such as General Motors afloat, it discourages healthy businesses from investing in expansions, and discourages entrepreneurs from investing in new startups. Protecting obsolete jobs prevents newer, more productive jobs from appearing on the scene. That's why the first diagram was oversimplified: it failed to depict the dynamic nature of the business side of the economy.

What would stimulate investment? Well, to stimulate lending, banks need to start feeling better about their ability to take on the risk, and in this environment, the prerequisites are (1) a larger cushion of capital on their balance sheets, and (2) cleaner assets. That's why the Fed and Treasury are (in theory) working to shore up the viable banks, and why the TARP was (in theory) set up in the first place.

As for business firms, existing and future, the stimulus ideas include more government purchases of today's products and services (...the proposed infrastructure spending is why I bought a few shares of the Shaw Group by the way), but it shouldn't stop there. Other incentives include a lower corporate tax rate, lower capital gains tax, and elimination of the double taxation of dividends. Those measures would increase the potential reward for entrepreneurs to start new businesses — for example, the guy who has a better idea for a fleet of hot dog stands, and the guy who thinks he has the superbattery problem solved.

Government won't just be stimulating consumption; it will be doing a lot of its own investing in infrastructure projects intended to yield benefits not immediately, but in the future. So why not give as much attention to stimulating private sector investing, too?

I'd like to see the private sector's creative destruction process get back into full swing — for our grandkids sake. That will require revitalized lending, borrowing, and investing, but for some reason those aren't getting nearly as much attention on Capitol Hill as is the stimulus of "consumption" spending.

Comments

[Leigh Caldwell]

Absolutely right. I have been thinking a lot recently about how to boost private investment as well as consumption - my arguments on it are here: http://www.knowingandmaking.com/2009/01/stimulus-spend-invest-or-incentivise.html

Your graphics are a nice contribution to explaining the issue - my article has some similar reasoning but perhaps less clearly because it's all text!

I have also tried to explore some specific conditions that we would put on a stimulus package if we wanted to encourage investment.

One final point, though - although the classical equation is Savings = Investment, this only applies to net savings across the whole economy. It's possible for consumers to save money which the banks then deposit at the Fed or invest in Treasuries, meaning that total net savings are zero (because public borrowing increases). In this case, no investment takes place.

So it's worth distinguishing between net and gross saving, or equivalently looking at how to encourage banks (or the Fed itself!) to invest in productive assets.

[inf4mia]

"Unfortunately, none of them can say for sure how long the "long run" will take to arrive; maybe nine months, maybe two years, maybe more. To me, that's like asking Uncle Sam to do a bungee jump from a 200-foot tower using bungee cords that "might be" as long as 220 feet."

It's worth noting that the crowd advocating stimulus are equally as blind regarding our future prospects. None of these advocates will tell you when or even if their plan will actually fix the problem. Over a short period of time these plans have shifted over time. I simply think that no one is smart enough to competently tinker with the economy without incurring a lot of unintended consequences.

The lack of investment we're seeing can in part be blamed on uncertainty. A portion of this uncertainty is natural and expected during hard times. People don't want to make large investments until they feel better about the future.

I wonder if you would allow that another part of the uncertainty in the market is due to government action (or inaction in some cases)? All of this unpredictable intervention creates quite a bit of uncertainty in the marketplace and makes people even less prone to take investment risks than they otherwise would be. Additionally, all of this intervention has substantially distorted our financial markets which makes companies (and people) behave very unnaturally.

[painlord2k]

So why not give as much attention to stimulating private sector investing, too?

Because, when government interfere in the economy, it do it for its own good not for the good of the people.

But investing doesn't happen as readily when banks are reluctant to lend money, or when entrepreneurs are reluctant to borrow.

We are in this mess because the bank (some bank but not all) and the entrepreneurs (some but not all) were not enough reluctant to lend and borrow. This is a reaction to the discovery that they actions were wrong.

If the government stay out of this mess, the banks will start to lend again taking from granted that they must be wise or pay for their mistake. If the government continue to "stimulate" them and cover their mistakes they will continue to be reckless.

The real problem is that reality states that you can not invest what were not saved before.
So must be incentives to save and invest, not to consume and invest.
Going away with fractional system would help much to link the saving to the investments.
Services like ZOPA solve the problem of fractional reserve. And, as you can note, the rate are better for savers and borrowers than the bank ones.

Higher interest rates will incentive people to save more, consume less or delay the consumption and invest in the more profitable projects only.

The concept is the same of compounded interests.
Consume less than you produce and reinvest the saving to enlarge your production; you will not be able to consume more immediately, but will be able to consume more than the last year.

but for some reason those aren't getting nearly as much attention on Capitol Hill as is the stimulus of "consumption" spending.

Because politicians are interested in fast returns (2-4 years) and not in longer terms sustainability. They know, or hope, to have someone else to foot the bill. It is better, for them , to tout consumption than investment (working hard and taking risks).

[Bret]

Yes, but (or is that yes and no :-).

"Savings: A source of "leakage" from current consumption?"

Yes, it is. With a fiat currency, there is an infinite pool of unallocated money. When people save, it simply joins that pool. It's the Fed's job to balance that "leakage" (the arrow can go the other way too, of course).

In this situation, if people save the rebates, it would be far more effective to just have the Fed take action instead.

"One way for government to shoot itself in the foot is to..."

There are nearly an infinite number of ways the government can shoot itself in the foot. Fortunately, the government has a lot of feet so we may still be able to limp ahead even if a few million toes get blown off.

Being an entrepreneur who is extremely dependent on wealthy investors and long term projects, the biggest problem is the short term focus of everything. For example, the current understanding of Obama's tax plan is something like, "Well, we won't raise taxes until things get better." Unfortunately, that's not very motivational to investors. If the economy stays crappy they'll do poorly on their investment. If the economy gets better, they'll have the sh*t taxed out of them. It's a lose-lose situation for them.

I've had a majority of my investors inform me that they are not going to follow through on their investment "commitments" for reasons such as these. Too bad for me, too bad for the employees I'm laying off, too bad for the companies who products and services they might've used, etc.

[Jerry McInvale]

The "stimulus" package as partially outlined by the President Elect as well as the actions of the Congress and the current Presdient are a major expansion of government size and power as well as debt. I am a retired Chief Financial Officer, not an economist, so my views are a bit short on theory. However, I have been responsible for quite a few billion dollars of capital investment and participated in new business startups. I can not remember a time in my working life that would be worse for investment than now. Every indication we get from government is that transfer payments will increase so that more than 50% of our population is dependent on government; taxes will increase on the wealthier segments of society thereby reducing investment funds, environmental regulation will increase dramatically making the U.S. less competitive, unionization will be sponsored, healthcare will be nationalized, etc. etc. Whatever your personal view of any or all of these predictions - they do not support a climate that will be conducive to investment. Business risk is increasing dramatically, and the people in government service show no signs of understanding the consequences of their actions.

Unfortunately, the issues we face and the solutions proposed are far more likely to be driven by politics and pressure groups than by thinking of best alternatives for longer term resumption of growth.

If I had a majic wand, I would immediately reduce small and large business tax rates and leave the current capital gains and dividend tax rates in place. I would not consider any increase in government size or spending with the exception of defense. I would increase the size (personnel) of the armed forces and coast guard.

As I view my own investments, and talk to others - the current political environment makes investment much riskier than usual and the returns given likely taxation and inflation are unacceptable. So - money stays on the sideline, and the more extreme the government "stimulus", the more private money will likely sit it out and wait for a better environment. That's also what my bank is doing with their TARP $.

[Optimist123]

Jerry,

I'm with you on the increasing business risk and uncertainty. One of the reasons the Great Depression lasted a decade was uncertainty on the part of the business community as to what the government would do or not do subsequent to any potential investment in a new business or expansion of an existing business -- so they simply held back from investing.

The same, government-induced uncertainty is in play today; TARP funds were originally approved for the purpose of cleansing toxic assets, then shifted to shoring up banks capital, then directed towards bailing out failed auto manufacturers to keep uncompetitive union jobs from moving to more productive but nonunion companies. Now, unsurprisingly, industry after industry has joined the TARP-fund conga line (indlucing the porn industry, desperately in need of $4 billion).

That said, deficits and the size of the debt are not inflationary; the culprit would be too-rapid credit expansion fueled by the deluge of base money the Fed has already put out there. So far, reluctance to lend is causing deflation, not inflation, but there's a huge overhang threatening future inflation if it turns out the Fed isn't able to sell assets back to the public at a rate sufficient to keep inflation in check. That's down the road a year or so, but it's there. For the time being, a deflationary spiral (which would bring on even more government intervention and uncertainty).

[beancounter]

Economists like to say that their theories are based on mathematics and fact, and they are. But investment is very much social engineering, based on fear. Are banks too afraid to lend in this climate? Is the only way to decrease fear to raise military spending, cut government spending and so on? Fear is *not* easily quantified, and even if you manage to do it it's easily turned around by hope.

That's why I am optimistic about the economy, and why I think Obama's administration will surprise the so-called investor class. At least those investors who think it is a bad time to invest and are worried about taxation.

1. Government mandated healthcare (this is not universal healthcare) means that companies can cut down on healthcare costs by pointing employees to government funded healthcare.

2. Increased taxation is a non-sequitur, precisely because government can carry debt and deficits far into the future, far longer than corporations can. *Already Obama is reneging on his campaign promise to repeal the Bush taxes*.

3. Decreased military spending means more money for domestic purposes. Helping Iraq does not help America except by preventing suicide bombings, and does anybody really think that terrorists are competent? They are uneducated, poorly trained dependent on low technology methods, and 9/11 will never happen again.

Here is my prediction. People like Mr. McInvale will lose out when America's economy begins booming again and wish they had invested. Fear is easily turned into hope, and this President is uniquely suited to inspire hope and confidence in the American people. Heavy government regulation, not European regulation but American Post-WWII style regulation will reassure investors and create a new economic boom during the conversion from a fossil fuel economy to a nuclear economy.

All this will require heavy investment in long-term projects such as nuclear power plants and alternative energy -- government investment. Private investors who are smart will get in on it. Those who aren't will wish they had.

We have hit rock bottom people. It can't go any worse than this unless you think GDII is on the way like Republicans believe. Nevermind that their own man G.W. Bush increased the debt by record amounts for pointless reasons such as Iraq and foreign aid to African warlords.

The only way to go from here is up.