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Mainstream economists and the mainstream media continue to embrace John Maynard
Keynes' notion of the "paradox of thrift." While most economists subscribe to the
view that the pace of long-run economic growth is a function of productivity and
thrift (saving), short-run growth can be retarded by too much thrift. According
to this view, if households in the aggregate decide to cut back on their current
spending, i.e., save more, aggregate economic demand will be negatively affected.
Hence, the paradox of thrift. A little later in this commentary, I will try to dispel
the notion that thrift retards growth in aggregate demand in the short run.
But before getting into this aspect of economic myth-busting, I want to call your
attention to a February 19th WSJ opinion article by a member of the paper's
editorial staff, Daniel Henninger, entitled "Obama's 'Hair of
the Dog' Stimulus." Henninger essentially buys into the paradox-of-thrift
argument. He cites the "Making Work Pay" element of the new fiscal stimulus plan
as a way of giving a tax rebate to households with a lower probability that the
tax reduction will be saved. Again, according to Henninger, an increase in saving
would mute the stimulative effects of the new fiscal program. Is Henninger actually
endorsing an economic plan that does not include reductions in marginal tax rates?
Not to worry. He falls into line with The Journal's monolithic editorial
view that any stimulus plan devoid of marginal tax rate reductions is bound to fail
in igniting aggregate demand because American households have rediscovered the virtue
of thrift. To buttress his case, Mr. Henninger cites an authority on the subject
of women's marginal propensity to consume/save, Anna Wintour, the editor of Vogue.
Ms. Wintour's sampling, scientific, no doubt, suggests that ladies of leisure will
be cutting back on their current spending. (To be complete, perhaps Mr. Henninger
should have consulted Playboy's octogenarian playboy, Hugh Hefner, as to
what we men will be doing with our extra eight dollars a paycheck.) Moreover, Mr.
Henninger says that President Obama has met the enemy of household spending and
it is the president himself. You see, President Obama has an "austere persona" that
evidently promotes household austerity! I found it paradoxical that anyone on the
editorial board of The Journal would embrace anything Keynesian such as the
paradox of thrift. Hence the title of this commentary, "Paradox Squared."
Let's get economically objective. Thrift or saving does not necessarily mute aggregate
demand in the short run or the long run. As any economist of the Austrian school
will tell you, saving simply implies one economic agent cutting back on its current
spending and transferring its spending power to another economic entity.
For example, suppose a household decides to cut back on its current spending in
order to purchase an about-to-be issued corporate bond. The household is transferring
its purchasing power to the corporation. Presumably, the corporation does not intend
to simply sit on the proceeds of its bond sale. Rather, the corporation likely borrowed
funds in order to spend now on some capital equipment or R&D. So, the
act of increasing its saving on the part of the household does not lead to
a reduction in aggregate spending in the economy, just a redistribution of
spending.
There is, however, a special case in which an increase in thrift will result in
a fall in aggregate spending. This is the case of "hoarding" money - currency and
bank deposits. Hoarding in this sense is the term classical economists used to describe
what hip-hop economists refer to as an increase in the demand for money to hold,
or a decrease in the velocity of money. If more and more households wish
to curtail their current spending and increase their money balances, this will lead
to a decline in aggregate spending in the short run if the supply of money
is not increased commensurate with the increased demand for it to hold. The supply
of money is created by the new lending actions of banks in cooperation with
the central bank, the Fed in the U.S. case. An increased demand for money
to hold does not automatically elicit an increase in the supply of
money. Let's say that an employee of XYZ Company decides to save a larger portion
of her paycheck in the form of increased money balances. On payday, XYZ transfers
into the employee's bank account the employee's salary. So, XYZ's bank account is
debited by the same amount that the employee's bank account is credited. No new
money is created in this process. All that has happened is that the ownership
of money has changed. No net new bank credit is created in this process.
Although the employee's bank has gained some additional reserves in the process
that would enable it to create some new credit, XYZ's bank has lost reserves, requiring
it to extinguish credit, all else the same. Aggregate spending does decrease
because the employee cuts back on her spending in order to increase her money balances.
So, the paradox of thrift, which mainstream economists and Mr. Henninger so readily
embrace, is only paradoxical in the special case in which the public's demand for
money to hold increases. How do these economists and Mr. Henninger know ahead of
time that tax rebates will be accompanied by an increased demand for money to hold
on the part of households? Even if the demand for money to hold does increase, I
can make an argument that the supply of money available to be held is likely
to increase. The Treasury is going to issue securities to finance its new
spending and tax rebate programs. If, which is likely, banks and the Fed purchase
a large quantity of these Treasury securities, then the supply of money will increase.
An increased demand for money to hold matched by an increased supply will not
lead to a decrease in aggregate spending.
There is one other tangential economic myth that I would like to bust - that the
U.S. economy cannot grow rapidly unless there is a high level of consumer spending.
I would ask you to turn your attention to the chart below. The line in the chart
is the five-year moving average of the ratio (in percentage terms) of real personal
consumption expenditures to real GDP. The bars are the five-year compound annual
rates of growth in real GDP excluding federal government expenditures. Notice that
in recent years, the consumption ratio has moved up significantly. Notice also that
the real GDP growth rate has moved down significantly. The most rapid real
GDP growth we experienced in the 1951 through 2008 period occurred in the 1960s,
a period when the consumption ratio was relatively low. My bet is that when
we come out of this current deep recession (Q4:2009?), the recovery and expansion
will be accompanied by a much lower consumption ratio than we have experienced in
recent years and higher export and business capital spending ratios than we have
experienced in recent years. But most importantly, I expect that these changing
ratios will be accompanied by higher growth in real GDP ex federal government than
we have experienced in recent years. Why? Because, as I stated at the outset, the
pace of economic growth is a function of productivity and thrift. And no less an
authority than the editor of Vogue says that thrift is in vogue again!
Chart 1
Paul Kasriel is the recipient of the 2006 Lawrence R. Klein
Award for Blue Chip Forecasting Accuracy
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