With a physical product, if the price of something goes up, the more suppliers will want to supply it and the less consumers will want to consume it. This is the premise behind the most famous graph in all of economics, what I like to call the Big X of an upward sloping supply curve and a downward sloping demand curve. Anyone who ever took Econ 101 probably came across that on the first day of class.

What happens if there is some external force that sets the price above the intersection of the supply and demand curves?  Well, suppliers will still want to supply a lot of the item, but consumers will not want to buy it, and you end up with a glut. Similarly, if the government imposes price controls on the item, suppliers will have no desire to make it and consumers will want to consume a lot of it, and you end up with a shortage.

The same basic process works for money. Remember that every dollar you spend is somebody else’s revenue. So if you earn $100,000 per year, but only spend $90,000, the overall income in the economy would fall by 10%. However, the $10,000 in savings does not disappear. It gets channeled through the financial system and becomes available for investment. Ideally it would eventually find its way into real physical investment — the building of new plants and equipment, or financing of inventories — not just forever traded around within the financial sector.

The “price” of money is the interest rate. If the interest rate is high, then people will decide that they can do without some additional consumption now, in return for much more consumption later. In other words, they will tend to save more, and thus make more money available for investment.

At the same time, a high interest rate will tend to make some investment projects unprofitable that would be profitable at lower rates. After all, investment means laying out money now (say, to build a factory) in return for more money later (when you sell the output of that factory). A dollar in the future is worth less than a dollar today. The difference between the value of a future dollar and a current dollar is the interest rate.

Shifting Toward More Investment

What happens if for some reason other than the interest rate if people all of a sudden decide that they no longer want to spend $90,000 out of the $10,000 of income, but instead spend only $80,000? If it was only a single individual, that would not be a problem. However, if everyone wants to do this at the same time, it is a problem. The supply of funds available for investment suddenly just shot up.

At the same time, with everyone now only spending $80,000 instead of $90,000, there are going to be a lot of physical goods that languish on the store shelves. That means that businesses are going to want to cut back on production. They certainly are not going to be in the mood to increase their productive capacity by building a new factory. Why should they when they have a perfectly good factory sitting idle? The interest rate will fall with the market trying to entice people to not save as much, and to persuade some producers that now is a good time to invest, because it will be cheaper to do so now than in the future.

Unfortunately, there is a “price control” of interest rates. They cannot fall below 0.00%. People would be better off simply burying their cash in a coffee can in the back yard if that were the case.

What could make millions of people all of a sudden decide that they want to spend $0.80 per $1.00 of their income rather than $0.90 as they were before? A financial crisis brought on by having too much debt. Paying down debt is the functional equivalent of saving.

If, for example, you own an asset worth $200,000 and have borrowed $150,000 against it, you are pretty comfortable with the situation, and feel that you can continue spending $0.90 of every dollar you earn. Now suppose that over the course of a few months, the value of that asset falls to $100,000. Well, the positive net worth of $50,000 has turned into a negative net worth of $50,000. You probably were counting the positive $50,000 as part of your overall nest egg. That money was going to be used to put your kids through college, or to retire on.

Assuming that you still want to send the kids to college, $10,000 a year in savings is not going to cut it. Thus you decide that you are going to save $20,000 a year. If everybody is doing so, that will push interest rates down and eventually you get to the 0% limit. However, since everyone is saving, it means less demand for currently produced goods, and hence less income. Remember, your spending is someone else’s income.

That results in companies laying off people and being reluctant to hire new people. Unemployed people find it very tough to save. That is one of the market’s mechanisms for bringing down the overall savings rate. Low interest rates also try to convince consumers to spend more now. That is why the car companies offer low-interest rate loans, to get you to buy more now.

But being able to send little Billy to your alma mater, or not having to work until you are 90 years old, is still more important to you than replacing a still serviceable car with a shiny new one, even with zero-percent financing.

“The Paradox of Thrift”

While an individual saving more is admirable, when everyone does it at the same time it can severely slow the economy and make everyone worse off. This is known as “The Paradox of Thrift.”

In such a situation, the natural clearing price for interest rates can fall below zero. Or put another way, even at zero-percent interest, there would be a glut of savings (and a shortage of savings instruments) and a shortage of profitable investment projects.

In case you hadn’t noticed, what I have been describing is the situation we are in now. The falling asset value in question is housing, and the borrowing against it is mortgages. Total demand is well below potential, particularly private-sector demand.

Let me stop here for a second and explain that demand is both the desire for something and the ability to pay for it. For any given product, there is usually a natural limit to our collective desire for it: no matter how cheap steak gets, at some point you are full.

However, when you are talking about the total demand for everything an economy produces, the desires are limitless. The controlling factor is thus the ability for the economy collectively to pay for its desires.

The proper response in such a situation is for the government to come in and help prop up the total demand in the economy, and to provide the extra savings vehicles for those who want to save. Those vehicles are better known as bonds. When the government runs a deficit, it is simultaneously creating more bonds, and increasing demand.

It can create more demand directly, say, by spending money building bridges or buying fighter jets. It can also create demand indirectly by making more cash available to the private sector. It does this either by transfer payments to people who will spend the money quickly (i.e. unemployment benefits) or by cutting taxes.

When Government Should Run a Deficit

In short, it is a good thing for the government to run a deficit when the economy is in a recession. The kitchen table analogy of “times are tough, so we have to tighten our belts” is simply wrong. It is exactly when the private sector is tightening its belt that the government needs to be loosening up its own. Cutting spending and raising taxes are both forms of fiscal anti-stimulus, or contraction. I suspect that most readers will agree that raising taxes in the middle of a recession, or in the very early stages of a recovery, is a bad thing to do.

The same is true for cutting spending. Depending on whose taxes are raised, and what spending is cut, it is often the case than cutting spending is even more damaging than raising taxes. The best government spending during a downturn is on projects that have a positive long-term return on investment (ROI). Those do exist, but represent only a small minority of government spending.

The classic example from the Depression would be the Hoover Dam. Spending on research also tends to have a very positive long-term ROI, although it is often very hard to identify which research project will lead to big returns. The classic example there is the government investment that lead to the creation of the Internet (it started out as a Pentagon project that would insure that computers were still working after WWIII was over).

Investments in human capital, also know as education, tend to have a positive ROI. Spending that is simply the equivalent of digging holes in the desert and then filling them up is less useful, but actually in a severe enough situation would be a positive for the overall economy.

This logic only holds when the economy is operating well below its potential capacity. If the economy is in good shape, then the extra demand from the government starts to bid up interest rates. That then crowds out private investment, which tends to have higher ROI’s than government spending. That is especially true since the bulk of government spending is on transfer payments that do not produce future returns.

Government Spending & Politics

So how do we know that we are in a situation where government deficits are a good thing or a bad thing? Look at interest rates. Despite budget deficits as a percent of GDP that have not been seen since WWII, the rate on the 10-year T-note is at historically low levels. Short-term interest rates are near zero and have been since December 2008. That is a clear indication that the desired level of savings by consumers still greatly exceeds the desired level of investment by businesses.

Right now, the government is “crowding out” idleness, not the private sector. The political debate in Washington has it all wrong. With unemployment still at 8.9% and manufacturing capacity utilization at just 73.7% (vs. a long-term average of 79.1%) the debate should not be about how much the government should be cutting domestic spending, but on how much we should be increasing government investment.

The current imperative to cut spending — and to cut it sharply, and now — is likely to be very damaging to the economy. It is also likely to be ineffective on its own terms. As the economy slows, tax revenues will fall (or grow less quickly than they otherwise would). The net result is that the spending cuts will deliver far less in deficit reduction than is advertised.
 
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