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

[Imperialism Inc.]

From my blog. It is too tedious to transfer over the formatting, links and the chart so if you want those go to the original. Governemnt spending next time!

You can't cut your way to growth. Part 1b: A night at the theater?
Previous Parts: Part 1
Later Parts: (None Yet)

In this series of posts I'm looking at the relationships between various entities in an economy. Partly I'm trying to document, for myself, the information I have gleaned from the like of Paul Krugman, Dean Baker, Mark Thoma, and Brad DeLong. All of these guys have devoted a lot of time to explaining the foundations of macroeconomics at a layman's level, but often that information is spread out over many blogs and many months. I'm trying to pull it all together and put it in my own words.

In the first part we saw how a person who wants to save or pay down a debt may be thwarted by the fact that no other part of the economy wants to pick up the slack from the saver's reduced consumption. The desire for investment funds is low so the saver ends up with a pay cut and less saving than they had hoped. The key take aways were that when one variable changes in the GDP equation, one or more of the others must change as well, and how they do so will be determined by what mechanisms are available and plausible. If consumption goes down then either investment will go up, through the interest rate mechanism, or GDP will go down.

Morality Play?

Some people want the results of these adjustments to be some kind of morality play. People in debt are bad people. After all, they are probably poor and we all know being poor is a sure sign of lax morals. They may not care that the person in our example last time saw his income go down. After all, he was in debt, he had it coming. Unfortunately for the people with this POV (not me by the way) the economy cares not for such things.

I want to look at the reason why by breaking down further our equation from last time. We'll do this by breaking down our consumers in to 2 groups. The first group is our slovenly, indebted people and the second group is our virtuous debt free folks.
We start where we left off with this,

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

and break it down into our two groups

Total Income = (Indebted Income - Indebted Saving) + (Debtfree Income - Debtfree Saving) + (Investment)

Lets use some numbers.

$20,000 = ($10,000 - $0) + ($10,000 - $0) + $0

As we saw last time, when our indebted person tries to pay down his debt by $1000, only $500 of it got picked up as new investment and so total income went down by $500. In this case that would mean,

Total Income = $19,500 = (? - $500) + (? - $0) + $500

But who takes the income cut? There is no mechanism in the economy that makes sure the guy that is in debt will take the hit. In our example the person paying down debt decided to get the money to do so by cutting out his morning trip to Starbucks. It could be the case that our virtuous debt free guy works there. It might be the case that he is the one who takes all of the hit and it could look like this,
$19,500 = ($10,000 - $500) + ($9,500 - 0) + $500

If we could get our virtuous person to spend more by taking on some debt himself (have a negative saving rate) then we would be OK and Total Income would never have to fall in the first place:
$20,000 = ($10,000 - $500) + ($10,000 - (-$500)) + $500

Unfortunately this mechanism is blocked for the same reason the investment mechanism was blocked. The interest rate is already at zero and can't move any lower. So the economy will shrink and it doesn't care how virtuous the recipient of this pain is.
Does the Interest Rate need to be negative right now?

I thought I should back up my claim about the interest rate needing to be negative. This is from about a year and a half ago but it is a good example of what I'm talking about. I, unfortunately don't have a more recent number but we can infer the Fed thinks the number is still negative from their actions. There is no talk of raising rates any time soon, in fact they have embarked on a new measure intended to emulate negative interest rates, quantitative easing.

April 27 2009
The ideal interest rate for the US economy in current conditions would be minus 5 per cent, according to internal analysis prepared for the Federal Reserve's last policy meeting.

The analysis was based on a so-called Taylor-rule approach that estimates an appropriate interest rate based on unemployment and inflation.

A central bank cannot cut interest rates below zero. However, the staff research suggests the Fed should maintain unconventional policies that provide stimulus roughly equivalent to an interest rate of minus 5 per cent.

People are saving?

Remember, we are defining saving as anything not spent on consumption. So you can be in debt and be saving at the same time. All we care about for determining Total Income is how much of their personal income people are spending on purchases. Unfortunately the term "saving" gets used in a lot of different ways in the press. Sometimes an article is just referring to how much people are putting in a savings accounts so it can be confusing. I'll use a graph from the Fed that is defining saving the way we are using it.



As you can see, saving is indeed way up since the collapse.

Go Investors Go

Investment has been picking up some of the slack fortunately. Taking a look at this GDP table we can see that it increased at a pretty steep pace earlier this year, it just hasn't been enough to take up all the extra saving.