You can't cut your way to growth. Part 1a & Part 1b

[Imperialism Inc.]

I've written a couple blog entries on basic macro economics. I haven't had a lot of luck with them in GD. That's fine I'm partly doing it for myself to help synthesize what I've learned from various economist bloggers but in more plain language. I think the main problem is that it dry and boring stuff, and that many here probably already know the approach I'm using. That approach is to understand the various elements of GDP, how they relate to each other, and what mechanisms cause them to change. What I'm working up to is a model that includes government spending and imports and exports. With the goal of being able to do critiques like this: The defict hawks' war on algebra

Anyway, I thought I'd put up the links to what I have so far in this slower moving forum. Would love to hear any suggestions on what I could improve or how I could make it less boring. Or if maybe it is a waste of time because people already know this stuff.


You can't cut your way to growth. Part 1
You can't cut your way to growth. Part 1b: A night at the theater?

[flor-de-jasmim]

1. I'll read it, but your color scheme is a bit hard on sensitive eyes.

[Imperialism Inc.]

2. Ok. I changed the theme. Thanks.

At the time I set it up they didn't have many themes and the only non-flashy one looked like crap.

[flor-de-jasmim]

3. I got a bit lost here... where does this $500 come from? (Part 1)

Lets start with someone who wants to save a certain amount but that amount is flexible. He used to spend every dime they made but he has decided he really doesn't need that coffee from Starbucks every morning. He might as well sock that money away. He starts by making and spending a fixed $10,000 every month. He decides to cut his expenditures down to a fixed $9,000 a month and save the rest.

We start here,

Total Income = (Individual Income - Individual Saving) + (Investment)

$10,000 = ($10,000 - $0) + $0

Now he tries to save,

? = ($10,000 - $1,000) + $500

= $9500

(it is supposedly after this point that his salary is reduced).

[Imperialism Inc.]

4. Investment

As people save the interest rate goes down. Firms borrow this saved money. If the interest rate is low enough they may borrow all of it. A couple paragraphs up I was talking about how right now the interest rate is zero but that is not low enough to induce firms to borrow all of the savings. The $500 is just picking an arbitrary example of that situation. He tries to save $1000 but the interest rate, even at zero, can only induce businesses to borrow half of it. That is the situation the real world is in right now.

[Imperialism Inc.]

5. Maybe I need to be more explicit here.

In the real world what probably happens is that the first month he tries to save $1000 he is successful. But then businesses notice they have stuff left on the shelves (inventory levels go up). There is $500 less stuff being bought overall. Seeing this they cut our saver's hours.

[DoctorK]

6. how does that move goods off the shelf?

"But then businesses notice they have stuff left on the shelves (inventory levels go up). There is $500 less stuff being bought overall. Seeing this they cut our saver's hours."

In a market economy the business has to cut prices to find the new market clearing price for their goods.
Some firms will still be profitable at this new price level, others won't.

Entrepreneurs will borrow the saver's funds to start new ventures and establish new forms of employment.

Declining prices are a bogeyman to individuals and governments who borrow too much, and no one else.

[jtuck004]

7. Some workers who finds themselves in a business cutting prices and wages

to find a clearing price will meet the bogeyman as well. Regardless of whether that business borrowed too much or not.

[Imperialism Inc.]

8. You are proposing another mechanism and that's good.

You propose that prices will adjust until someone else is induced to to buy the goods. In fact, you propose, the number of people buying will increase enough that even at the lower price sales will go up enough to cover the amount of the saving-investment shortfall. This is not different from my main point that in order for one group to save another group must spend more. However, a look at consumption growth in actual GDP will show you quite clearly what you propose is not happening. There has been a swing from private savings before the crash at -3% to +5% now; growth in consumption is anemic. You may not like that savings was negative before the crash but that doesn't change anything about what the results will be right now.

What's more, as prices decline firms have less incentive to borrow money. If there is disinflation (a lower and lower inflation rate) or outright deflation, firms will be paying back any investment with dollars worth more than the ones they borrowed. This will shift their desire to invest downward.

It seems like you might have got the point that someone has to spend more. Where you seem to have gone wrong is assuming that changing the price will always bring things back in to balance. If a firm sells 30 items at $5 there is no guarantee they will sell 50 items at $3. There is no guarantee there will be any price they can get back $150 total and still be able to make money. You also seem to have missed the fact that , in order to spend more, some people may have to borrow, but deflation pressures remove the desire to do so.

As far as how inventories go down by cutting a worker's hours that seems pretty obvious. If they are selling say 1000 items too few every month, then cutting back hours would cause 1000 less items to be produced.

[DoctorK]

9. a few points

"This is not different from my main point that in order for one group to save another group must spend more."

In order for someone to save they must produce more than is consumed.
If you grow 5 bushels of corn and eat 4, you have saved. No one else has to 'spend more', you just have to spend less.

"What's more, as prices decline firms have less incentive to borrow money. If there is disinflation (a lower and lower inflation rate) or outright deflation, firms will be paying back any investment with dollars worth more than the ones they borrowed. This will shift their desire to invest downward."

It will shift the desire away from borrowing to _consume_, but the incentive to borrow for investment will still be to seek returns higher than the borrowing cost.

"As far as how inventories go down by cutting a worker's hours that seems pretty obvious. If they are selling say 1000 items too few every month, then cutting back hours would cause 1000 less items to be produced."

But if the goods aren't moving _off the shelf_ you have to cut prices to move them. Not making more of them won't sell the ones that are already made.
Extreme example to make the point. I produce a jug of whiskey and offer to sell it for 1 million dollars. If it doesn't sell my decision to produce less whiskey next week won't induce anyone to pay 1 million dollars for the jug I already produced.
When I find the market clearing price then I also know how much whiskey people want labor devoted to making.

"There has been a swing from private savings before the crash at -3% to +5% now; growth in consumption is anemic."

Indeed, the previous growth in consumption was built on misapprehension of the true pool of savings. The Fed lowered rates and convinced people that savings were abundant, when in reality they were being hollowed out.

"You may not like that savings was negative before the crash but that doesn't change anything about what the results will be right now."

Correct, the 'bust' is the response by people to get back to the situation they thought they were in all along during the boom. People saw rising home prices, etc. and mistook that for growth in real wealth. With this false understanding they engaged in a level of consumption they thought their earnings/savings could support.
Bernanke is trying to override the desire of hundreds of millions of people to improve their situation (reducing what they can earn on savings and encouraging utilization of credit to fund consumption).

[Imperialism Inc.]

10. Sorry but you are arguing that 2+2 doesn't equal 4.

Maybe a different approach will help.

GDP = C + I + G + (Exp - Imp)

If C, consumption, goes down GDP goes down, unless someone else (I, G or trade balance) spends more. That is arithmetic. If you find yourself arguing against arithmetic you need to start doing some rethinking. It is also basic economics. I haven't said anything controversial.

If you don't want some aspect of GDP to go up as consumption goes down then you are saying you don't want the economy to grow. Your last paragraph seems to indicate that is what you want. That's fine as long as you are honest about it. What I am concerned about is people who don't want anything done to make up for the consumption shortfall but pretend that it doesn't mean people will stay unemployed or employed but with lower incomes.