Seven Myths. Nay: Seven Follies. (I)

1 gennaio 2009 michele boldrin

I find the ongoing public debate on the "crisis" and its "solutions" misguided. It is a "100-times larger" replica of the one that took place in 2001-2003 (and gave us the policies the effects of which we are all currently enjoying) and of the never-ending 1990s lamentation over the "Japanese Depression" (in which all the policies now being advocated were adopted, with the known results).

Well aware of being part of a minuscule minority of dissenters, I dare to dissent.

1. More Consumption, Less Saving!

In some sense this is the foundational myth of all bad economic policies and, in fact, of the seven myths I will be discussing. I should therefore dedicate it a somewhat longer discussion than the one reserved to the other six.

The foundational myth is based on the idea that a magical “multiplier” (Keynesian, obviously) exists such that the larger is the share of its own income the average person consumes, the higher will the aggregate income of the nation be. It is often justified through common- (but incomplete) sense arguments such as “demand creates its own supply” (yes, but from whom?) or “firms will produce only if they expect goods to be sold” (indeed, but firms need to sell at profitable prices) which, as we will see, imply pretty much the opposite.

Believers in the existence of a consumption multiplier never pause to consider that, even in the abstract world of models, the more we consume the less we save and invest; hence, either, or both, of the following consequences must eventually follow. The higher is the share of our income we consume the more we must be borrowing from someone else, hence the more in debt we end up being. Unless we go completely for the second consequence, that is: consume our accumulated wealth until it is gone. In a closed economy the second must always be the case, whereas in an open economy one may go into debt for quite a while (possibly through the figment of borrowing from future generations via public debt) until foreign investors start pulling back their savings as we, the indebted Keynesian consumers, become less and less credit-worthy. How on earth high and sustained income growth may possibly be the outcome of such a mechanism, only believers in this myth understand.

Their confusion seems twofold. On the one hand, they do not understand that, saving being where investment funds come from, and investment consisting in demand for goods and services that are as much produced as are sandwiches and haircuts, saving also has its “multiplier”, hence it also generates employment and value added according to the rule that “demand creates its own supply”. That is to say: there are firms and workers whose comparative advantage is to produce investment goods, hence saving provides “effective demand” for such workers and firms. On the other hand, they do not understand that what economists call the “inter-temporal budget constraint” must hold in the aggregate and not just for single individuals. Meaning that, when we borrow heavily to consume today, lenders are expecting we make it up with future savings and investments. Otherwise, how can the accumulated debt ever be repaid? Put it differently: the inter-temporal budget constraint requires a proper and (inter-temporally, at least) balanced mix of consumption and saving. When one has saved little and borrowed a lot for a while, consuming less and saving more is the correct thing to do. In fact, it is pretty much the only thing to do: anything else will lead, sooner or later, to an even worse situation.

Which brings us to our current predicaments: a number of countries, the USA first and by far the foremost, have been consuming more than their current income would have allowed and they have financed such consumption by two means. First, by offering their accumulated wealth (be it houses or the stock of capital) as collateral against which to borrow; to the extent the collateral was valued highly and its valuation kept rising, such behavior appeared reasonable. Second, by “promising” (meaning: both borrowers and lenders “expected”) a high growth rate of income in the future, out of which repayments of borrowed principal and interest should have come. Just to be clear: the case of Spain is not as extreme as that of the USA because a large chunk of the borrowing financed internal investment and because, but I may be awfully wrong here, the assets over-evaluation was more contained. But more about Spain some other time, let me stick to the USA here.

As it is by now painfully clear, the households that are saving (be them in the USA or abroad) are no longer willing to lend to the “Keynesianly consuming” American households at the same pace they had been doing for the last decade or so. In part, this depends from the situation in which the intermediaries (i.e. the banks) find themselves but it stems also, and more importantly, from the fact that (i) the “Keynesian consumers” are too deeply in debt, (ii) their assets are worth a lot less than expected and, (iii) their incomes may not grow as fast as many had dreamed of. I will get to the banks later but, as far as the American consumers are concerned, there is only one reasonable thing they can do: start saving a higher percentage of their income and pay back a sizable chunk of their outstanding debt. Only once this ‘de-leveraging’ process will have taken place (meaning that not only debt will have decreased, but USA investment will have grown) it will be reasonable to expect consumption to pick up again and, possibly, consumption borrowing to resume.

That this should (and will, eventually) be so no matter what misguided economic policies will try to accomplish, follows from the obvious fact that this is a credit crisis at the origin of which there are ... a large number of households unable to repay their debts! Alternatively: the obvious (and recognized by everyone) cause of the crisis is that we have a lot less wealth we thought we had (either in the form of houses or of stocks) hence our consumption levels are not sustainable, firms and productive investments cannot be financed for lack of resources (read: savings), and we are defaulting on our debt commitments thereby trashing financial markets’ trust.

More consumption and less saving in a situation like this is only a receipt for further and worse future disasters.

Fortunately for us, in spite of the obsessive campaign for "more consumption demand", the American households seem to have decided to do the right thing: save more.

5 commenti (espandi tutti)

even in the abstract world of models, the more we consume the less we save and invest

only if income is exogeneously given...

only if income is exogeneously given...

No, always: Yt ≤ Ct +St

As it is by now painfully clear, the households that are saving (be them in the USA or abroad) are no longer willing to lend to the “Keynesianly consuming” American households at the same pace they had been doing for the last decade or so.

Which is why the Keynesian theorists say that the now Government has to take their place: and the latter, especially in the US where it exclusively borrows in its own currency, can always bail itself out by printing money. Of course this is going to cause inflation, and that in turn will benefit the private debtors as well; not to mention the banks, by reflating the nominal price of the real assets used as collateral for mortgages, MBS's etc.

Of course, the creditors will be screwed, and they should start thinking seriously about strategies to protect their interests. This should be easier in the present globalized era than in 1933, when Roosevelt confiscated privately-owned gold paying it $20.6/oz, and then devalued the dollar to $35/oz. Instead, a lot of people are rushing to buy long Treasuries, not even inflation-indexed!

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From a highly theoretical standpoint, and even on such troubled times, wouldn't it be also reasonable for American consumers to invest part of their income on something capable to produce extra revenues on a reasonable amount of time, (being this company shares or just a vegetable plot) instead of rushing up to pay back their debt all the way?

From a highly theoretical standpoint, and even on such troubled times, wouldn't it be also reasonable for American consumers to invest part of their income on something capable to produce extra revenues on a reasonable amount of time, (being this company shares or just a vegetable plot) instead of rushing up to pay back their debt all the way?

Sure it would: do you have a time machine to bring them back to the past, so that they can erase having borrowed for consumption in first place? If you don't, the issue is pretty moot... If they just stop servicing their debt now, the cash flow they interrupt will not be used for productive investment by someone else downstream, thus cancelling the benefit of their own investment.

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