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*When* should consumers cut their spending?
Paul Krugman argues:
Sooner or later, then, consumers were going to have to pull in their belts. But the timing of the new sobriety is deeply unfortunate. One is tempted to echo St. Augustine’s plea: “Grant me chastity and continence, but not yet.” For consumers are cutting back just as the U.S. economy has fallen into a liquidity trap — a situation in which the Federal Reserve has lost its grip on the economy.
....The capitulation of the American consumer, then, is coming at a particularly bad time. But it’s no use whining. What we need is a policy response.
Krugman then calls for fiscal stimulus, as has Martin Feldstein. I am more inclined to think that consumers need to cut their spending now. It is widely understood that consumers have been living beyond their means. Let us say instead that consumers maintain their spending (say through fiscal stimulus, a cut in sales taxes, or sheer exhortation) but that everyone knows consumer spending will fall in three years time. In three years time, the "liquidity trap" (not exactly how I think of it) will be over, but in the meantime investment commitments will be lackluster, given that people will be waiting for the economy to digest the forthcoming change. Maybe we need to spend less now and get the adjustment over with more quickly, even though that will be painful. Or say we don't know when the spending decline will come -- markets often dislike uncertainty most of all.
I view the goal as hurrying up needed sectoral adjustments and minimizing unneeded or temporary sectoral adjustments. That suggests any "stimulus" funds, whatever their magnitude, should go to preserving expenditure patterns of state and local governments. Such an allocation also ensures that the money will be spent, if indeed that is the goal. Greg Mankiw offers a related idea.
The St. Augustine quotation in Krugman's column is apt. Do many people in fact use temporary sex as a successful path to abstinence? Some do, yes, or at least so I have heard. But it would be odd to accept such histories as the default view of how to get there.
Addendum: Excellent comments from Interfluidity.
Posted by Tyler Cowen on November 1, 2008 at 10:56 AM in Economics | Permalink
Comments
That seems well-argued. The thing is, as a man on the Clapham omnibus, I somewhat turn in the wind as big-gun economists tell me need, or don't need, this stimulus or that bailout. Can I (we?) ever know?
Posted by: odograph at Nov 1, 2008 11:16:27 AM
From the WSJ yesterday about the personal savings rate going up:
http://blogs.wsj.com/economics/2008/10/31/good-news-for-stability-bad-news-for-growth/
"It’s a bit early to say so, but the American consumer may have finally learned a lesson and is moving toward a more sustainable level of spending. However much this move may benefit individuals, it could prove difficult for the economy.
“Hopefully, this will be a measured, longer-term move which, while painful in many ways, would not be as disruptive as a complete collapse in spending that is maintained for several quarters,” said Shapiro. “Time will tell which it will be, but there seems no escaping the fact that the U.S. consumer will not be the world’s engine of growth for many years to come.” –Phil Izzo
I am for a stimulus targeted to infrastructure, since we had a tax rebate already and the lower price of fuel can be seen as a stimulus. I would also like the infrastructure stimulus to try and target areas with high unemployment. Other benefits, such as UI, I see as simply what we need to do in a recession.
However, since we are in a downturn and the savings rate is going up, I'm not for announcing a tax increase in the near future as Japan is considering, or going on a moral crusade against debt right now. I like the phrase "measured, longer-term move". We could still be underestimating the downturn, so the adjustment needs to be calibrated.
Posted by: Don the libertarian Democrat at Nov 1, 2008 11:33:28 AM
Mankiw's idea, to allow the governors to choose whether to give money directly to citizens or fund infrastructure projects, won't work. It won't work for the same obvious reason that self-management of risk by financial institutions didn't work - it ignores the incentives for the people in charge. How many governors are going to tell their voters to do without a government handout, in favor of infrastructure projects?
Posted by: ScottB at Nov 1, 2008 11:54:22 AM
The key statement in Tyler's post is I view the goal as hurrying up needed sectoral adjustments and minimizing unneeded or temporary sectoral adjustments. That suggests any "stimulus" funds, whatever their magnitude, should go to preserving expenditure patterns of state and local governments.
Many state governments are cutting back spending because they operate under annually balanced budget rules and their tax collections are shrinking with the economy. Whatever the wisdom of balanced budgets they do create inefficient on again off again spending and on the macro level they do just the opposite of what is needed. Cutting unrestricted grants to the states makes sense.
Posted by: John B. Chilton at Nov 1, 2008 12:21:57 PM
If the economy still has a lot of capacity to produce consumer goods, and, meanwhile, consumers reduce their consumption, shouldn't prices fall pretty steeply and create deflation. And shouldn't the Fed be anticipating this and cutting interest rates desperately?
Maybe not. Maybe consumer-goods deflation is less bad than investment-goods deflation, and if consumers start saving more and the money is channeled into investment, this will create price pressures on investment goods, which the Fed shouldn't exacerbate.
There's a problem here: We believe price instability is bad, but we don't know exactly *why.* So we don't know how to respond to changes in relative prices. Is it damaging when stock prices rise too fast? Housing prices? Investment goods prices? Consumer goods prices? Natural resource prices? What is the weight we should put on the stability of different kinds of prices?
Posted by: Nathan Smith at Nov 1, 2008 12:28:29 PM
If we're at all concerned about the state of the economy, we should definitely be spending on these: https://www.economylapelpin.com/.
Posted by: Nick at Nov 1, 2008 12:38:51 PM
It's nice to see this question put so starkly. But Paul's assertion that we should favor spending over savings now isn't backed by any quantitiative analysis.
All growth models, from Solow on, predict that an increase in savings causes a short-term drop in consumption, but a long-term increase. Presumably if we had a reliable consumption-vs-time curve for a given savings rate, we could "objectively" determine its NPV by interest-rate-discounting the predicted consumption. Are there any predictions of consumption-vs-time for the current stimulus and no-stimulus scenarios?
Is there some simpler objective argument as to why now is the wrong time for increased savings? In my experience, politicians and policymakers appear to believe that no time is the right time for increased savings.
Posted by: David Wright at Nov 1, 2008 1:01:19 PM
"But Paul's assertion that we should favor spending over savings now isn't backed by any quantitiative analysis."
My first instinct given Krugman's stunningly and overtly partisan behavior over the last many years is to suspect that at the moment he's more concerned about the potential impact of a tepid economy on an Obama presidency than actual economic improvements which my not be able to be easily (if at all) claimed during the next election cycle, and which may broadly impact the political fortunes of Democrats in general. I fully believe a man of Krugman's political ilk is fully willing to trade fundamental economic improvement for a little added growth zing and prettier numbers in order to foster political capital.
Posted by: MM at Nov 1, 2008 1:51:45 PM
Who said that I + C + G = Y?
The equation is wrong. Even assuming we added the integration limits, or as De Long says, after everything is settled, it is still wrong.
Keynes implies by this equation that there are successive levels of aggregation, that is why he broke out the G separately. (Even being a Royalist he must have know that G obeys the same laws as the other economic sectors, inefficiently as a monopoly, but the same laws apply) Keynes was wrong in assuming the capital value can be accurately counted by decomposition.
I + C + G < Y is the truth, there is a missing cost to a monetary standard.
The reason is that economic agents will invest in the bond system so as to make G non-inverted by term shifting. G is naturally cyclic, or has an inverted yield curve (its term structure).
The less than sign occurs because of that quantization error that allows short term traders to drain wealth from Y by term allocation, making G non-inverted and earning short term funds.
G is inverted for the reason that G is an aggregation of weighted proportions of the economic components under it. Each of these economic components have their own term structure, which is also maintained by term allocation to keep it from being inverted.
So far, so good, but here is the missing catch.
One cannot mathematically compose a non-inverted economic aggregate from non-inverted sub-aggregates; hence there is always a arbitrage opportunity whenever we aggregate economic sectors. Aggregate economies are not composable from semi-orthogonal sets after all.
The Japanese carry trade is likely an example of this affect, as is the equity premium puzzle.
The collapse is the accumulation of the arbitrage accounts which have no where to go. The solution is to rebuild a new monetary standard, or rebuild the term structures starting at the bottom. That implies that we should spend our government bubble money at the lowest economic quanta we can find, the taxpayer himself, via handouts directly or by congressional district.
It also implies that the new term structure has a definite time limit to its validity, and external shocks can shorten the time limit.
In other words, the economy is a definite integral, which has never been accepted by planners. There is no continuous economy.
Posted by: MattYoung at Nov 1, 2008 2:11:03 PM
"Nobody leads the cow
To the greenery cropped and dry
To the greenery without caresses,"
Applies to consumers too. No use trying to tell them to spend when they see a dry and parched economic landscape.
Accept the comsumers' behavior as the given it is. Adjust Government behaviour to compensate, when doing so looks better than the alternative..
Posted by: Diversity at Nov 1, 2008 3:14:22 PM
Households are not spending because they are uncertain about keeping their jobs and their income. Money spent on a temporary increase in benefits for people who lose their jobs would relieve the some of the anxiety and probably produce a larger increase in consumption than the program cost the government.
Posted by: joan at Nov 1, 2008 3:46:08 PM
Local and state block grants targeted to mass transit and education?
It's not as fast as helicopter cash-dumping, but it gets us off the keynesian skateboard, wildly veering from one side to the other while the rider departs up and forward, with an inevitable hard landing.
(Not dissing keynesianism--just knee-jerk, last-minute-reactive keynesianism.)
Posted by: Steve Roth at Nov 1, 2008 4:05:31 PM
If we move to actually having a positive savings rate (we have), that's going to hurt Chinese exporters and mean cheaper capital for US companies. How painful is that even in the short term? Extend unemployment benefits for those in industries that are affected and otherwise enjoy the positive benefits.
Posted by: Tom Hanna at Nov 1, 2008 4:22:08 PM
What we need is a policy response.
LOL!
We've had lots and lots and lots of policy responses, Paulie. Take a look at the tax code and the entire list of Federal laws and mandates.
What a dork.
Posted by: K T Cat at Nov 1, 2008 4:24:47 PM
Aren't we in this mess because of stimulus? Isn't that what all those those years of super low interest rates were about, keeping Bush from having a recession after 9/11?
We really need to rethink this whole acceptance of Keynesian economics. Stimulus and the consumption it creates only borrow from the future. And we are borrowing like there is no tomorrow.
Frankly, we don't need stimulus. We need a stable dollar. Its value has been rising of late and banks wisely are holding them rather than loaning them out.
We ought to peg the value of the dollar to gold or a mix of stable commodities, rather than letting it deflate like this.
The Fed should stop deciding what to do based on the CPI. The CPI is a trailing indicator of inflation and tells us little about inflation and deflation in real assets, which is where everybody is getting whiplashed by the dollar's behavior.
With a stable dollar, banks can lend again without the almost certain loss they would experience with more deflation.
Posted by: Alan Brown at Nov 1, 2008 5:32:46 PM
Is there some simpler objective argument as to why now is the wrong time for increased savings? In my experience, politicians and policymakers appear to believe that no time is the right time for increased savings.
Precisely. The last stimulus package produced a mere blip on the radar screen confirming the predictions of economists. Now, the senate and the house members are trying to outbid one another on a second stimulus and somehow, we are to imagine that the result will be different this time.
Consumers know that in a recession cash is king. They are trimming their debt loads, cutting non-essential spending, and reducing their consumption.
Unfortunately, Washington believes that it can simply throw money at this problem which will magically disappear. Japan tried the same thing to no avail with the result that it has one of the highest debt to GDP ratios in the world (160% of GDP in 2005). How many times does this approach have to fail before politicians get it?
Posted by: qt at Nov 1, 2008 5:36:37 PM
Deflation...
Posted by: jhh at Nov 1, 2008 6:15:00 PM
Unfortunately, Washington believes that it can simply throw money at this problem which will magically disappear. Japan tried the same thing to no avail with the result that it has one of the highest debt to GDP ratios in the world (160% of GDP in 2005). How many times does this approach have to fail before politicians get it?
Never? Politicians and bureaucrats like spending money, its sort of what they are there for. They will throw money, and people like Krugman will encourage them to throw more and more money while at the same time encouraging them to raise taxes. Its really a mess. We need a separation of state and economy, much the same way the world needed a separation of state and church a few centuries ago.
Posted by: Jorge Landivar at Nov 1, 2008 6:15:48 PM
We're in a hole because we've been spending beyond our means on Iraq, tax cuts, houses we can't afford, junk at the mall we don't need, cars bigger than our first apartments [etc.]
Krugman's solution is to buy more stuff we don't need???
This is like giving an alcoholic another drink.
Posted by: ZBicyclist at Nov 1, 2008 6:36:28 PM
We're in a hole because we've been spending beyond our means on Iraq, tax cuts, houses we can't afford, junk at the mall we don't need, cars bigger than our first apartments [etc.]
Krugman's solution is to buy more stuff we don't need???
Sheesh.
Most of the people I know like me in their mid-50s are trying to get as much of the junk out of their life as possible.
Birthdays, holidays, anniversaries, etc., I tell people, "Do NOT give me any tangible items - give me experiences and memories, like taking me to a ball game, a concert, a good meal, a play or a movie. I have everything I need and want, and I'm not interested in any more stuff in my life."
That statement seems to resonate with many people I know.
And that includes no yard to maintain. Being a renter is one of the most liberating things I have done in the last 10 years (although I am none too pleased that the government is using my tax money to attempt to prop up the inflated housing market...).
Also, more tax cuts, please. I can find better things to do with my money than the dim bulbs in DC.
Posted by: at Nov 1, 2008 7:52:01 PM
Of course, Krugman is advocating additional direct
government spending, particularly on infrastructure.
This is not a direct stimulus to consumption, and will
only indirecly affect it, as people's incomes rise.
The most likely direct source of stimulus for
immediate consumption spending is likely to come
through extended unemployment insurance benefits,
not something like a tax cut.
Posted by: Donald A. Coffin at Nov 1, 2008 9:13:50 PM
Presumably the hope is that consumers never tighten their spending - they merely grow it at a lower rate than income.
I'm all for structural adjustment, I just can't see how it's prompted from an aggregate demand collapse. And if we indeed have an infrastructure deficit, I'd rather spend the money on that now than during an economic boom.
Posted by: Measure for Measure at Nov 2, 2008 1:37:10 AM
A: before they have to.
Isn't "a policy response" kind of an oxymoron? Policy would be a rule, not arbitrary, that is followed to keep you out of the ditch. We are in the ditch, Krugman wants to blast us out with fiscal dynamite.
All Krugman is saying is that since we consumers are too silly, the government needs to spend our money because we won't.
"Let’s hope, then, that Congress gets to work on a package to rescue the economy as soon as the election is behind us."
As in, when we can't kick the bums out for their deception and
So, now, since the consumer is overextended, it is because the chickens come home to roost at an incovenient time that Krugman believes the government needs to bring out more punch bowls. As if the consumer would stop spending in boom times.
Krugman admits that checks sent to consumers won't get spent on what consumers had been spending on before. I don't understand why increased government spending on things other than things consumers had been buying will do anything other than create patronage.
Liberal, yes, but that's some conscience. I agree, a dork.
Posted by: Andrew at Nov 2, 2008 8:59:04 AM
Krugman is a perfect specimen of a looter from Atlas Shrugged.
Posted by: K T Cat at Nov 2, 2008 10:07:37 AM
Ah Tyler. Believe it or not, I was getting all ready to compliment you on a great analysis. But then you said this:
That suggests any "stimulus" funds, whatever their magnitude, should go to preserving expenditure patterns of state and local governments.
I "get" the argument you used to arrive at this conclusion, but it constantly amazes me how frequently you call for (or at least say "this wouldn't be so bad") measures to bolster governments.
Posted by: Bob Murphy at Nov 2, 2008 10:12:01 AM
