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

[Imperialism Inc.]

A lot of this probably seems blatantly obvious to many here. However, it seems clear that to many in politics and the media it isn't even known, let alone obvious.
(Mods: This is from my personal blog and I hearby give myself permission to post it in full ;-) )

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

Cutting budget deficits is all the rage. After all, everyone "knows" that being in debt is a sure sign of someone with lax morals. At least, that is how it is sold. It is claimed that, somehow, getting the US budget deficit under control will lead to growth and prosperity, i.e. jobs. What most people care about right now is the jobs part of the equation; getting new ones, keeping old ones, and making sure their income doesn't go down at the ones they keep. But, will cutting the budget deficit do the trick in the current environment? The answer is no, and not because of any particular economic theory. It isn't the result of a liberal theory, or a conservative theory. It starts from basic arithmetic followed by examining the actual situation we find on the ground in the economy today.



Many people hate math but my hope is that sticking to basic arithmetic will make this all more palatable to read. I plan to start with a simple model of the economy and work my way up. The point here is to learn how to reason about relationships in the economy and in later parts to specifically talk about government deficits. I'm using phrases in the equations instead of the typical variables but this all ties back to how economists calculate things like total output of the economy (GDP). Let's look at an economy that has producers and consumers with no government and no other countries and look at the size of the economy.

First we note that, for any given time period, it must be true that:

Total Income = Total Spending

This is not an economic theory, this is just basic double entry bookkeeping. A dollar that comes out of someone's pocket as spending, must show up in someone else's pocket as income or something has gone wrong with our record keeping. It should be noted that producers and consumers both show up on both sides of the equation. Producers can have income and can also spend by buying new equipment and the like from other producers.

It can be useful to break these quantities down in to different components so we can see how parts of the economy interact.

Total Income = (Individual Consumption) + (Investment)

Individual Consumption is what people buy for themselves and investment is spending by firms on equipment, buildings, etc.

Let's assume that Investment doesn't change but individuals would like to consume less (save more) and have income stay the same (i.e. have the economy not shrink). Can they do it? No. Obviously if Individual Consumption goes down and Investment stays the same Total Income must fall. If we want the size of the economy to stay the same we will have to get rid of our assumption that Investment doesn't change.

If we could somehow get the Investment to rise then we would be ok. It could just happen that firms want to invest more just at the right time that people want to consume less but it is not a given. In fact, seeing less spending(demand) for their goods may have exactly the opposite result. Fortunately, in normal times, there is a mechanism to encourage this increase in Investment. It is the interest rate. You can kind of think of the interest rate as related to supply and demand of loanable funds. As people spend less and have more to lend, the price of borrowing that money goes down.

This introduces the concept of a mechanism. If one of the variables changes then there are two other variables that change with them. Consumption changes so either Investment, Total Income, or both will have to change. The mechanism without an interest rate is that firms see less orders for their goods so they cut back on production , i.e. lay off workers, and the Total Income goes down. With an interest rate, the interest rate itself is the mechanism which brings things back to equilibrium , hopefully at the same Total Income level.

There can be several reasons why consumers as a whole may decide to cut back on spending. The most obvious are to put money away for the future or to pay down debt. We can break down our equation even further to look at how this desire to save interacts with the economy. First, lets look at a very special case where individuals spend everything they personally earn as income. In other words,

if, (Individual Consumption) = (Individual Income),

then Total Income = (Individual Income) + (Investment)

Now lets introduce the concept of saving. In that case we have,

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

It should be noted here that we are defining Saving as any income the individual isn't using for consumption. In the real world this could mean putting money in the bank. It could also mean paying down an old debt or buying a bond. None of those are consumption and would show up in our bookkeeping as investment once a firm borrows the money back out to buy something or uses the money you gave them for the bond to buy something.

Going back to our example of a person who wants to change their spending habits we can use our equations to look at a scenario. I think at this point it is best to use some numbers in the equations instead of asking people to imagine what happens when a variable is changed. In the example we will assume that changing the interest rate is not possible. This is not so far fetched. It is in fact the situation we are in right now in the real world. The rates banks can borrow from our central bank, the Fed, are as low as they can go. The rates banks give are of course higher but this is because they must account for administrative cost and the risks they perceive in the economy. There is nothing we can do to drive these rates lower because the central bank rates are already essentially at zero. In the examples we'll assume that some of what is saved is used for investment but not all of it.

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 they've decided they really don't need that coffee from Starbucks every morning. They 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 by firms)

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

Now he tries to save,

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

= $9500

Oops. Income went down because not all of his saving got picked up as investment. This guy is flexible though. He just wants to spend $9,000 a month and save the rest. He can just save less to bring things back in to balance at the new , smaller , total income (GDP) of the economy.

$9500 = ($9,500 - $500) + $500

He tried to save $1000 but instead he saved $500 and got a pay cut.

I'm going to stop at this point. The key idea to take away from this is that this result is not from any particular economic theory. It is a result required by basic bookkeeping . In order for one person to save more another person must spend more. Otherwise the person that wanted to save won't be able to save as much as they planned. The key fact to take away is that right now we are in a situation where the interest rate can't adjust anymore. There needs to be a negative interest rate for things to balance out but you can't have a negative interest rate. This discrepancy between rates is important for understanding why things that might normally have bad consequences don't right now. It is important to understand these bookkeeping relationships and demand from anyone that claims doing X will produce Y what mechanism they propose will be at work to make it happen.

I hope to be able to tackle the next part that includes the government this weekend. We'll see. I don't blog much and this is hard work when you have a 2 year old running around. In any case, consider what the government's role might be with respect to the missing $500 above. Also, consider what might be the case if government spending was a part of total income and was cut at the same time as people saved more. Finally, consider what might happen if the person saving is actually paying down a debt and can't reduce the amount they are trying to save. Our simple model implies this could lead to a downward spiral. Only half of the $1000 ever gets invested and so total income must keep falling to try to get back in equilibrium.

[Imperialism Inc.]

1. I guess I should have mentioned a mechanism myself.

When the producer sees $1000 less demand they cut back on production and therefore our saver's hours. Now, when he goes to save he finds out he doesn't have as much as he thought he did.

I know this is dry , boring stuff but I think it is important to understand the relationships and reasoning to evaluate claims made by people. Once this simple model is expanded to include government and imports and exports it becomes much more relevant. Relevant to budget deficits, relevant to currency exchange rates, and relevant to Fed policy. By knowing the relationships you can know what must go up when someone says they want something else to come down, and decide if there is a plausible mechanism for that to happen.

Anyway, obviously not very interesting to anyone. I'll probably write part 2 anyway since it is partly an exercise in making sure I understand it all myself.

[StarsInHerHair]

2. kick

nt

[TexasObserver]

3. recommend

If the president listens to the deficit hounds, he'll risk snuffing out the recovery in 2011 or 2012.

And that's probably what the GOP and the deficit hounds want.

[eridani]

4. My patience for longer articles required some effort to read--

--is determined by how much online time I have that day. I had enough time to read this--please start a journal if you don't have one. That way your related posts can be accessed in the future with minimal effort.