Savings, Work, Keynes and Policy Realism

Guest Author: Karl Smith is Assistant Professor of Public Economics and Government at the School of Government at The University of North Carolina at Chapel Hill. He works primarily in the areas of Public Finance and Public Revenue and Expenditure forecasting. Prior to joining the School he was a graduate fellow at the Institute for Emerging Issues, where his work was focused on state and local tax reform. Smith holds a BA and a PhD in economics from North Carolina State University.  He writes at the blog Modeled Behavior at Seeking AlphaVita.

I will engage in some grandiose philosophizing before moving on to economics. Feel free to skip ahead.

Realism is an overused term and no one can be faulted for failing to know what it means in any particular context. Regardless, I am going to push that trend because no other English word conveys its power and simplicity.

Under my definition of the term, this from Mark A. Calabria is nearly the antithesis of policy realism:

If Beckworth wants to preach “conservative” values and principles, he might start with the observation that it is savings and work that provide wealth, and reject the Keynesian notions that we can spend or debase our way to prosperity.

Either savings and work produce wealth or they do not. Either Keynesian notions are correct or they are not. Whether one is a conservative, a liberal, purple or orange should have nothing to do with it.

Either we accept that there is a real world whose primal laws are independent of our hopes, dreams and values or we reject that in favor of some form of magic. That magic might operate through Voodoo, divine revelation, or the suggestion that ideology is a guide to fact. If we accept realism, our values become meaningless to the determination of truth.

For those who respond better to poetic pronunciations I offer Eliezer Yudkowsky

That which can be destroyed by the truth should be . . Relinquish the emotion which rests upon a mistaken belief, and seek to feel fully that emotion which fits the facts. . . .  Let yourself say: “If the iron is hot, I desire to believe it is hot, and if it is cool, I desire to believe it is cool.”

Somethings are true. Our mission is to find out what those things are. Are we biased – of course. Should we track down and fight those biases  – of course. Is open debate among the best methods for exposing biases – undoubtedly.

But, we begin with this premise:  At the heart of it all there is a fact of the matter. Our goal is to find it. We may fail, but we should not be unclear about what our mission is.

Now, on to Calabria’s larger statement

First, the good professor argues that spending is far below trend. That is true enough as it goes, but this trend includes a massive housing bubble, where imaginary wealth fueled spending, aided by massive borrowing from abroad. The objective of our economic policies should not be to get back to the top of the previous bubble. It was this desire to replace the lost wealth of the dot-com crash that contributed to the Fed’s juicing of the housing market. All that said, consumption today is higher than at any time during the recent bubble. The primary problem facing our economy is not a lack of demand.

The core question that I believe needs to be answered is: Why are people working less?

The nearly constant source of confusion is two fold

  1. The belief that a recession is a period in which people have to do with less. This is completely wrong. A recession is a period in which people produce less. Suppose the US were suddenly cut off from all world trade and we instantly and seamlessly reorganized our economy. On average everyone would have less but there would be no recession.
  2. That spending is equivalent to consumption. Investment is perfectly good spending and contributes to final demand. Whether they are consuming more or less is interesting and of proximate importance but ultimately irrelevant to whether there is a recession.

So, if the problem were simply that there was a massive spending bubble and people borrowed from abroad to consume more then the natural response would be to lower consumption, increase net exports to repay those from abroad and possibly increase investment so that we will be wealthier tomorrow.

Calabria says that savings is the key to wealth but I assume he means investment. Suppose I saved my money in the belly of whale? Should I expect to become wealthier? Suppose I used that money to create powerful and useful machines? Should I then expect to become wealthier?

It is investment that makes us wealthier, preferably investment in useful things. So if we feel that we are too poor we should be looking to spend our resources on investing in useful things. Instead our resources are sitting idle.

Here is capacity utilization and the employment ratio – that is the percentage of our machines and of our men that are working.

FRED Graph

As you can see they both collapsed during the recession and have not recovered. That is we are using fewer machines and we are employing fewer people.

We are not working and hence not producing. Calabria notes that consumption is back up. True, but several population has risen and productivity has risen. Consumption has not kept up with our ability to produce. This would be fine if investment or net exports had taken its place.

Again, to review net exports is how we repay foreigners. They sent us stuff during the bubble, now we repay them by sending them stuff. Lets look at net exports.

FRED Graph

It rose sharply during the recession but not all the way to the positive. See that’s still a –300 Billion at the top. That was good in more ways than one. It increased demand. Net exports are a part of Aggregate Demand and it helped repay our debts. However, net exports is now falling, hence it is subtracting from Aggregate Demand.

Again, remember, “spending” is not consumption and its certainly not US consumption. If we sell a bunch of bulldozers to China then that is money that is spent on US goods and services.

How about investment. Again, there would be no problem with the collapse in consumption if it was replaced by investment. Lets look at that:

FRED Graph

Investment has fallen from the peak and not recovered. This is a part of spending. Spending on anything that will help build a more productive tomorrow is spending. However, it is low.

I would love to see investment soaring. Unfortunately that’s not how recessions work. Consumption and Investment go down at the same time. Sometimes net exports goes up and that can only happen in a big way if our currency declines in value.

The reason why China persistently undervalues its currency is not because the Chinese government wants to weaken its economy but because the Chinese government understands that a weaker currency contributes to higher spending on Chinese made goods. Again they are looking for spending.

So to recap Spending is not the same as Consumption. Savings does not instantly transform into wealth, it has to be Invested. Both consumption and investment are below trend. Net exports has not altered enough to make up the difference. This implies that total private spending is below trend and this why people are working less. It is also why fewer machines are employed.

One potential remedy would be to increase government spending. If one is worried that this will lead to poor spending choices then one must endevaour to increase private spending. This could be done be done several ways

  1. Increasing net exports, which would mean lowering the value of the dollar.
  2. Increasing consumption which mean putting more money into the hand of liquidity constrained consumers.
  3. Increasing investment which would mean lowering the real interest rate.

Quantitative Easing directly goes after the 1st and the 3rd. It could be used to address the second if major lower income tax cuts were combined.

Related Article

Inflation and Jobs:  The Big Picture by Karl Smith

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