Last week, I received an email from a 28-year old aerospace engineer on the West Coast that included a list of thoughtful questions about a story I wrote on September 9, “The Naked Stimulus: Why Savings Stimulate More than Spending.” “A group of co-workers and I read the article and debated it over lunch,” writes Chris, the engineer. “We couldn’t figure out the answers. I’ve tried throwing it past my buddies in finance over the weekend, but they don’t seem to get it either.”
He concludes with a gentlemanly request: “Help us lay people with an interest in economics!”
Chris is a scientist trying to grasp the science of the $862 billion stimulus plan in terms he and his friends in the lab can understand. For these sophisticated folks, the President’s formula -- boosting consumer spending when companies are scared to invest in new plants and computers -- seemed to make perfect sense. Then they read “The Naked Stimulus,” which argues that by basic economics, the “stimulus” doesn’t raise growth at all. It simply shifts the same dollars from one category of GDP to another, leaving the total precisely the same for now. Over time, it actually harms our future by robbing from private investment.<!-- more -->
The story led Chris and his friends to question the basics of the Obama plan. But these masters of quantum physics and differential calculus weren’t totally convinced. They wanted more rigor. Fortunately, Chris’s questions aren’t arcane or wonkish at all. They reflect things millions of Americans would like to understand better about how the stimulus works, and why it appears to be failing.
I can think of no better way of explaining the giant flaw in the Obama plan than answering Chris’s excellent questions.
Doesn’t the premise of your article hold true only if banks are willing to reinvest savings deposits back into the economy? Doesn’t it make more sense to have the working class spend the money directly? If no one else is lending money, isn’t the only alternative to spur revenues by giving money to consumers?
Before we get started, it’s important to distinguish between two, extremely different results of the fiscal program. The first is what we’ll call “Static Impact,” which measures what the stimulus adds to GDP if it merely shifts money from one category of GDP to another, and doesn’t include incentives to raise profits for companies or permanently lift incomes for consumers. Though the administration would object, that’s pretty much the case with the Obama plan. The second is “Roll-On Effect,” which comes in two parts: First, the jolt from policies that ease regulations and lower government outlays, and hence future taxes. Those incentives can spur investment spending and growth almost immediately. They’re sorely missing right now. Second, though the money shifted from consumption to savings doesn't help lift GDP right now, the extra investment yields a harvest of far higher growth in future years by increasing productivity.
As we’ll see, the “Static Impact” of the stimulus is a wash. And the “Roll-On Effect” is decidedly negative.
The foundation of the Obama stimulus plan is easy to understand, and to Chris and lots of smart people, it appears to make sense. Once again, its goal is all about raising growth right now by shifting money around, without durable incentives for expansion -- what we call "Static Impact." It seeks to shift hundreds of billions of dollars in U.S. and foreign savings to government and consumer spending. The Treasury is borrowing $862 billion in funds that families and governments don’t need to use now, and hence are saving. The federal government is then spending part of it quickly and returning the rest, through programs like the “Making Work Pay” tax rebates, to consumers most likely to spend it. The rationale is that all the extra outlays in these two categories will raise GDP far more than if all of that money had flowed to places where savings go, into corporate bonds, stock offerings, CDs, or bank deposits.
But the plan contains a gaping hole. The rub is that savings, just like the dollars government channels into salaries and auto fleets -- and that consumers lavish on restaurants, tourism and computers -- are all spent. They’re simply spent on different things, namely corporate investment for research, robots and software. Hence, a dollar transferred from savings to consumption doesn’t add to total spending, or to GDP, at all.
So let’s answer Chris’ question directly. Let’s assume that the government never borrowed that $862 billion and that the money stayed in the hands of American families and foreign governments. Remember, all of that $862 billion is being spent under the stimulus by our government or consumers. If the savers simply kept the money, all of it would remain as savings. So those dollars would flow into the banks in savings accounts and CDs. That money would then be available for the banks to lend, chiefly to large and small businesses.
Chris’ point is well-taken: In this sluggish economy, would companies actually borrow those extra savings, and then spend the money on such investments as R&D or computer systems?
The answer is that banks are in the business of collecting interest, and would indeed lend the extra deposits. “Money never sleeps,” says J.D. Foster, an economist at the conservative Heritage Foundation, borrowing a line from the title of the new movie “Wall Street II.” How would that money make its way to private investments in a market where demand for capital is extremely weak?
It would happen in two ways. First, the supply of savings would surge, and government borrowing would be far lower. So the pool of funds available for companies would increase, and the competition for those funds would fall. As a result, interest rates would drop even below today’s bargain levels. Lower rates would reduce financing costs for companies, making it more attractive to buy everything from forklifts to new systems for logistics.
It's not that America would produce more goods and services. It's simply that a larger slice of the same pie would go to investment, and hence capital equipment. Once again, Obama is simply transferring the same dollars from cars to, say, forklifts.
Indeed, the lower rates would help. But rates are already low. In today's tough economic environment, U.S. companies might not buy enough new machinery to compensate for the drop in consumer spending. Even so, the banks would deploy every dollar of those deposits in ways that would raise GDP.
By answering Chris’ second question, we’ll explain where the banks, or other savers, would loan the money that American companies are unwilling to invest here at home.
You say in your story: “To buy our Treasuries, foreign investors must first sell us far more of their products than we sell them, forcing the U.S. to maintain a trade deficit year after year.” I don’t understand this sentence. Can’t any foreign entity purchase Treasury notes at any time?
Today, America is borrowing a big portion of the $862 billion stimulus from foreign nations, notably China and Japan. Put simply, we’re importing a huge portion of the savings necessary to fund all the government and consumer spending that’s the core of the plan. Their governments like our Treasuries because they view the world economy as highly volatile right now, and still prize the dollar as the world’s safest currency. To get the dollars to buy our Treasuries, those countries must sell us far more of their goods than we sell them. Indeed, all the new borrowing requires that the U.S. reduce its exports, raise its imports, or do some combination of the two.
Let’s address Chris’ question: the Japanese government can indeed use yen to buy our Treasuries on the open market, adding to its central bank reserves. That’s strictly a monetary transaction, a way for the Japanese to raise the value of the dollar, and make their exports more competitive. But those purchases have no immediate effect on growth in either country, because no goods or services are being exchanged.
So what is the “Roll-On Effect” of running the gigantic trade deficit required to finance all of our borrowing? The more goods U.S. companies sell abroad––and the amount we sell is the inverse of what we borrow––the higher the earnings they ship back to the U.S. Those extra dollars represent corporate savings that get plowed back into R&D and capital investment here at home. As companies add more and more capital equipment per worker, employment, incomes and GDP all rise.
You wrote: “Right now, demand for credit is so weak that a gigantic $1 trillion in excess reserves are now on deposit at the Fed.” Confused again. I thought businesses were screaming for loans? How is demand for loans weak?
Demand for loans is indeed extremely weak. The businesses “screaming for credit” fall into one of two categories. First, borrowers who are facing severe financial problems due to the recession, and are no longer creditworthy. Second, small companies typically had a single bank that knew their credit, and trusted their leaders. Many of those banks disappeared during the financial crisis. Hence, a number of healthy companies can’t persuade one of the remaining banks to establish a fresh relationship, and start lending them money.
But for most companies, the problem isn’t the availability of loans at all. It’s their reluctance to invest for the future. Right now, most companies are borrowing simply to finance their inventories and replace worn-out equipment. Any plans for expansion are now on hold.
To ignite a strong recovery, the U.S. needs a surge in both consumer spending and private investment. In a good recovery, consumer spending contributes around 2% to GDP growth and investment gives the extra juice by adding another two points or so, bringing the total to 3.5% or 4%. Consumer spending is already near the levels needed for a decent rebound. The problem is investment. Once again, simply reducing government spending and borrowing will not add to GDP right away. It will simply subtract the same amount from consumption, leaving national income the same. So the “Static Impact” would be zero.
What matters is raising consumer spending above current levels, and adding the tonic of an investment boom. To do that, we need a fiscal plan that makes both families and businesses far more confident about the future. Remember, part of the Roll-On Effect is the jolt, call it Sudden Impact, from a dramatic improvement in incentives.
A convincing plan to reduce spending would give corporate America a shot of confidence. It would banish fears that taxes will rise sharply and sap earnings. Companies also fret that interest rates will rise dramatically as the government absorbs most of the pool of private savings, forcing manufacturers and retailers to pay dearly for what’s left over. Those high rates, in turn, will raise the threshold for what qualifies as a profitable investment. Less borrowing and more savings would do the exact opposite, and open a galaxy of lucrative opportunities.
“If incentives change, growth can pick up in about ten minutes,” says John Cochrane, an economist at the Booth School of Business the University of Chicago. The reason is simple: As a leap of faith, companies start to produce more products, confident they'll be able to sell them to consumers who work more hours and companies that keep more of their revenues. The important thing, says Cochrane, is that families and companies feel that the changes aren’t a one-time gimmick, but will lead to durable increases in their incomes. “Investment rises first,” he says. “Then people work longer hours. Then families have more money to spend, and consumer spending rises along with investment.”
Despite his skeptical questions, Chris understood the basic argument that savings don’t disappear, as the Obama plan implies, but are spent, and add to GDP, just like government salaries or families’ purchases of SUVs. “In physics, it’s a law that ‘All mass and all energy are conserved,’” says Chris. “It appears to be the same concept with savings.”
Indeed, the financial system exists to transform savings into investment. Money isn’t left on the table, and that’s a concept that Chris and all Americans can understand. The laws of physics don’t change, nor do the rules of the science Chris and the rest of America show such an interest in understanding -- rules that determine our incomes, our wealth, and our optimism about the future.