Tuesday, October 27, 2009

Does spending == stimulus

The New York Times is demanding yet another round (the third at last count) of stimulus spending. The question, other than what's the definition of insanity, is why did they think it would work before? The rationale for spending as a means of stimulating consumption is succinctly summed up by the Times:
The Senate could take a step in the right direction by extending unemployment benefits without further delay. That is the single most effective way to boost consumption — which, in turn, preserves jobs — because it creates spending that would otherwise not occur.
The key to the entire Keynesian argument is that the government can induce a shift in behavior through spending. While I admit to being no expert on Keynes and his economic philosophy, let's examine this implicit assertion.

Let's look at the simplest economy imaginable, canonically speaking, Robinson Crusoe on a desert island. Examining all economic activity there is easy. It consists of whatever Mr. Crusoe wishes to produce. There is no trading or anything else going on. In this simple example, production consists of, well...what he produces, but what is the equivalent of spending? Generally, we think of spending as buying something, but in this case there is nothing to buy. The reality is that there is no such thing as spending for Mr. Crusoe or for the rest of us. What Mr. Crusoe can do is make something and use it (known as consumption). What we think of as spending is really a synonym for trading (more on that later).

Later. Now let's complicate life a bit and introduce Mrs. Crusoe to this formerly idyllic island. Now the economy consists of both what Mr. Crusoe produces and what Mrs. Crusoe produces. Each can now trade with the other (or not). The catch is that in order for them to trade, they must value what the other produces more than what they produce. When they do trade, they are essentially spending one good for another good. Mr. Crusoe spends apples in order to get oranges from Mrs. Crusoe. Note that all the apples and oranges are still there. It isn't until Mr. Crusoe eats an apple that consumption takes place. Spending is trading, consumption is using up what has been produced.

Would you believe that even on a deserted island we have problems with the economy. In fact, we had problems even before Mr. Crusoe's better half showed up. The problem is that value is fickle, it can change at any point in time and for no reason. Value is in the eye of the beholder and only in the eye of the beholder. Value has no meaning outside of Mr. Crusoe. In other words, what Mr. Crusoe thinks is valuable defines what is valuable and he can destroy value simply by thinking something is not valuable. This may sound obvious, and it is on a desert island with only Mr. Crusoe. But today, in a not so deserted island, the same holds true for all of us.

Imagine that on Monday Mr. Crusoe really wants a coconut hat. He sets forth to make it and on Tuesday he realizes that he really doesn't want a coconut hat. On Monday the coconut hat was worth something, on Tuesday it is worth squat. Is this irrational, yes, but so are we. We are not concerned with rationality, only with value. The reality is that something that had value on Monday to Mr. Crusoe no longer has any value on Tuesday. You see, even in this exceptionally contrived example there is always a risk that our preferences change and value is destroyed.

Now when we introduce other actors into the economy such as Mrs. Crusoe this risk of our preferences changing and value disappearing grows. Imagine that Mr. Crusoe produces an orange in anticipation of spending it (trading it to Mrs. Crusoe) so that he can get an apple. Notice how he risks not only his preferences for apples changing but also he risks Mrs. Crusoe's preference for oranges changing. Either one of those destroys the value of what has been produced. As more and more people join our island, the risks increase. Of course, there are a myriad of benefits to compensate us for those risks, but they are there.

But back to the basics again. When our wants are based on habitual wants and desires, the risk of our preferences changing is small. Food, shelter, and sex are some of the most basic of all desires and it should be no wonder why one is the oldest profession. But when we get richer and our wants are for things not so habitual, say watching a football game, then the risk of our preferences changing is high. A starving man will not accept a football game as payment.

We are a very rich society and most of the things we value are arbitrary in nature. Video games, huge houses, fancy cars, ipods, etc. These things have value for sure, but that value is subject to a lot of risk because they aren't tied to survival, the most basic and consistent desire of all. In the hierarchy of things, secondary items have value only once our basic needs are met.

So this brings us back to the New York Times:
The Senate could take a step in the right direction by extending unemployment benefits without further delay. That is the single most effective way to boost consumption — which, in turn, preserves jobs — because it creates spending that would otherwise not occur.
First, the New York Times confuses consumption with spending. Consuming things that have been produced doesn't create anything. What they mean is that when I eat an apple (consumption) that I will want another one and I will produce an orange (production) and trade (spend) to get another apple. Implicitly there is the notion that people are not trading but nowhere is it explained why. Well, the answer is that in response to real conditions of the economy and uncertainty about the future, people's preferences have actually changed and the real value of certain products has been destroyed.

The assumption is that by printing funny money we can change back the preferences of people to what they were before. I do not believe this is true. The first goal of our economic policy ought to be to restore confidence in the economy and in people's lives. I believe that as a result of people's fear they have shifted what they value from secondary niceties to putting money in the bank for a rainy day. Only when people do not fear the future will the value for secondary items go back up in real value, which is completely arbitrary. The New York Times solution doesn't address the cause of the problem (uncertainty leading to a shift in value throughout the economy) and only looks to address the effect (lack of trade of certain items). Like the many stimulus packages we have had so far, another one via the extension of unemployment benefits will not work.


Post a Comment