Sunday, November 28, 2010

Why Governmental Stimulus Fails

Conventional demand-side Keynesian economic theory claims that when the economy is depressed, government spending will get multiplied into several times more increase in output. It is economic magic, like creating matter out of nothing.
There is one economic asset that can be created out of nothing, and that is fiat money. So the demand side policy is to create $100 billion of new money, spend it, and then, abracadabra! there magically appears $1 trillion of extra output and income. The new money has become multiplied by ten times thanks to the spending multiplier! Many economists, including Nobel-prize winners, believe in this magic. Here is how it works.
We start with the consumption function, which is private consumption as a function of income. Income is either spent for consumption or else saved, and the increase in consumption is less than the increase in savings as income grows, so savings gets ever bigger with greater income. Mathematically, C = b(Y - T), where C is private consumption, Y is income, T is taxes, and b (between zero and one) is the fraction of after-tax income used for consumption.
In an economy closed to foreign trade, output equals income, and total output Y equals the sum of consumption C, economic investment I, and government spending G, economic investment being an increase in the stock of capital goods. In the equation Y = C + I + G, substitute the consumption function for C. We derive an equation for income determination:
Y = b(Y - T) + I + G
Y = bY - bT + I + G
Y-bY = I + G -bT
Y(1-b) = I + G - bT
Y = (I + G - bT) / (1-b)
The spending multiplier is 1/(1-b). More consumption and less spending, thus greater b, makes (1-b) smaller and increases the multiplier. So if people save less and spend more, I and G will get multiplied into a much greater Y. For example, suppose b is .8, with folks saving a fifth of their income. Suppose I is $1 trillion, G is $1 trillion, and T is $1 trillion. Then
Y = (1 + 1 - .8) / .2 = 1.2 / .2 = $6 trillion of output and income.
Now increase b to .9, reducing savings to one tenth of income. We get:
Y = (1 + 1 - .9) / .1 = 1.1 / .1 = $11 trillion of output and income.
Wow! We got an increase in output of $5 trillion by reducing savings from 20 percent to 10 percent. Cut savings in half and we almost double the output! Isn’t economic magic wonderful!
But with the recession, people are saving more, not less. They are paying back debts and not spending as much. Those naughty consumers are not spending their money! The money is just sitting idle in the banks! Help! Ah, here comes government to the rescue!
Demand siders say that there is a lack of demand, and if private people are not spending enough, then government can step in to do the spending. What a wonderful doctrine for politicians! Government can spend lots of money, and the representatives can boast that they are stimulating the economy. The government borrows money and also creates money, so they can increase G without increasing T. The multiplier will then increase their spending several-fold.
But this has not happened. The US federal government spent $1 trillion for economic stimulus, and unemployment has hardly budged, and economic growth is only a couple percent annually, not the quantum leap up prescribed by the spending multiplier. Indeed, the multiplier has been less than one. Each dollar of extra government spending increases output by less than a dollar. When the government stops spending, this feeble stimulus also stops.
How do the demand-siders respond? They say that the stimulus was not big enough. But if the spending multiplier exists, it should have had a significant effect whatever its size. It’s just wrong. Can you find the flaw in the spending multiplier doctrine? Stop reading and think about it....
OK, did you figure it out? The flaw is that investment (I) is not an independent variable. Investment comes from savings. So more consumption implies less savings. If we put in an investment function as I = (1-b)(Y - T), then
Y = b(Y - T) + (1-b)(Y-T) + G
Y = bY - bT + Y - T - bY + bT + G
which gets reduced to G = T
With investment as a function of savings, there is no multiplier and no determination of income from a change in savings. Greater consumption and greater government spending do not stimulate. Yet the doctrine of demand-side stimulus is believed by most economists and by government officials. Stimulus spending did not work in Japan, and is not working in the USA.
What does work to stimulate the economy? The supply-side policy of reducing taxes on enterprise works in theory and did work in practice when presidents Kennedy and Reagan applied it. But economic growth following a tax cut can be misdirected into a real estate bubble, as happened during the presidency of George W. Bush.
The ultimate supply-side policy is to shift taxes off of labor and enterprise, and onto land value. That also prevents real estate bubbles. Only a shift to land-value taxation will promote a sustainable economic stimulus.
But spending is more popular than a tax shift, because the people are like small children who believe in the magic of a combination Big Brother and Santa Claus. Economists get government positions and columns in the New York Times by saying what the public and politicians wish to hear, that economic magic will bring us something for nothing.

Sunday, November 14, 2010

The Federal Reserve’s Stimulus Bill

The U.S. federal government’s one-trillion-dollar stimulus spending failed to jump-start the economy, contrary to demand-side doctrine. The demand-side policy believed by many economists, journalists, and politicians, says that when government spends an extra dollar, national output leaps up by several dollars.
The demand-side doctrine presented by the British economist John Maynard Keynes says that people use less of their income for consumption as their income rises; this is the “consumption function”. With less consumption there is less demand for output, so we get less production and less future income. So to increase output and employment, if folks don’t spend because they are saving instead, the government can step in, create or borrow funds, and spend the money. Those who sell the extra goods use the revenue to buy other goods, and so the initial government spending gets multiplied into much greater output.
The flaw in this argument is that economic investment, in more capital goods, comes from savings, so normally greater savings gets put to use in greater investment. But now in November 2010, Americans are saving more, yet industry is not investing enough. In 2011, with the Tea-Party-influenced Republicans in control of the House of Representatives, there will not be any new federal demand-side spending, although some infrastructure programs will likely be passed, as this will please the Republicans who now control more state governments.
Since Congress will do nothing to restore the economy, the chiefs of the Federal Reserve System are stepping in with a plan to buy treasury bonds with $600 billion of new dollars. The purpose of the bond purchase is to keep long-term interest rates low. This helps the federal government finance its big deficit, and puts funds into the banking system. The extra funds act like more savings to keep interest rates low. Low price inflation and low interest rates should create a favorable environment for business, and this policy has already boosted the stock market. American companies are also getting a boost from more exports as the rest of the world economy is recovering swiftly, while the U.S. lags behind.
So why is unemployment still high, and why is the economy recovering so slowly? Because even though interest rates are low, other costs will be rising. Taxes are scheduled to rise sharply in 2011. New regulations such as more 1099 tax forms have increased the costs of business. New medical insurance mandates have made labor more expensive. There was also “regime uncertainty,” as entrepreneurs have faced turbulent policy changes. The possibility of ever greater taxes and restrictions, combined with continuing governmentally-imposed credit constraints, have limited new economic investment.
What is needed to jump-start the economy is the supply-side policy of reducing the costs of enterprise. Government has imposed costs by restricting and taxing enterprise. Government subsidies also impose a cost on the economy, as the loss from taxation is greater than the gain to consumers. Supply-side policy cuts taxes and eliminates arbitrary restrictions.
The tea-party Republicans now in Congress will initiate legislation to reduce government intervention, but the Senate will block these acts, and those acts that do get passed will get a veto from the president. So don’t expect much supply-side policy.
The chiefs of the Fed are well aware that their $600 billion money expansion will have a future bill, increased price inflation, and that is actually intended. They think that higher inflation will get people to spend more today as prices will be higher tomorrow. But higher inflation will also increase nominal interest rates, as measured in the quoted rate or the money paid. Higher nominal interest rates will increase the cost of servicing the federal debt, increasing the federal budget deficit.
The new money could spark much higher price inflation, and indeed commodity prices have been rising. The Fed heads say they will unwind the money creation later, selling the bonds, but that too could have bad consequences, such as higher interest rates.
The reality is that greater output comes from production, and output increases when costs fall. Higher tax costs offset lower interest rate costs. Tax cuts will increase the budget deficit, but a tax shift will reduce tax costs without adding to federal debt. Everybody is talking about tax increases and tax cuts, but almost nobody is talking about tax shifts. The economy needs an “efficiency tax shift,” sharply cutting income taxes, shifting public revenue to land value. A tax on land value does not hurt production, since land is not being produced, and it does not increase rent, since higher rent creates vacancies and zero income for landlords.
Only an efficiency tax shift will create a swift and lasting recovery, and perhaps, by paradox, that is why nobody is talking about it.