Busting an Old Economic Myth

Thanks everyone for your suggestions. As I might have imagined, they were pretty much all across the board. That's bad in the sense that it doesn't really help me narrow down what I want to concentrate on but good in the sense that there doesn't seem to be any one thing I do that bores the living crap out of everyone.

As I sit here watching Mythbusters, I've decided that I want to take down a myth myself. In particular, I want to explode the oft-repeated myth that lowering individual taxes or sending people additional tax rebates has a stimulative effect on the economy. And for this I'll be returning to one of my favorite topics: economic theory. I can hear most of your groans from here, but fear not loyal reader! I am not going to use a lot of detailed stats and arcane theories. I'm going to lay this out in pretty simple language.

First of all I am not a communist, socialist, hacky-sack wielding hippy, or a left-wing ideologue. As a general tax policy I believe that the fairest tax would be one that is flat and low. But I am not talking about a good general tax policy, I'm talking about stimulating the economy.

So let's first go through the conventional argument about why lowering taxes has a stimulative effect. A person makes X amount of money per paycheck. This leads them to consume Y amount of goods. Thus if you increase X by 10% (through an income tax reduction or additional income) they should now go out and spend an amount greater than Y. Multiply this a couple million times and overall demand gets stimulated, which causes businesses to produce more goods, which means they need to hire more people, and pretty soon the economy is roaring again.

So what's wrong with this theory? Absolutely nothing, provided that you are reading this on dried, rolled-up parchment by the soft light of a hogs-fat candle. The problem is that this theory is several hundred years old, and it completely discounts the global economy. There's an old expression that the mistake generals always make is trying to fight a current war just like they did the last one. That's what is happening here too. We're trying to solve today's problem with yesterday's solution.

Allow me to illustrate. Back in the day there existed these things called "local businesses". And when the local townspeople received extra money they spent it at these businesses and all the magic of increased demand and stimulus described above really did apply.

But now when consumers get extra money, there's no guarantee that they'll spend it locally. In fact, there's a good chance that the bulk of your purchase may not even be spent in this country. We know this conclusively by the fact that we have a huge trade deficit ($574.7 billion over the last year - sorry; I know I promised no stats). You make a purchase on Amazon or at Wal-Mart, there's a real good chance that whatever you're buying was manufactured elsewhere. And, sure, Wal-Mart or Amazon do get a percentage from each sale but we're talking in the area of 1-5% (depending on the item). And given the scale of both operations it's unlikely that an increase in volume will cause them to make any significant hiring decisions.

So, in a sense, actually everything with this theory still does in fact hold. If all you care about is that the global economy is stimulated, then it absolutely still works. But I seriously doubt that most of the proponents of a tax cut are doing so because they believe it will help China's economy more than ours.

Here's another issue. There is always the assumption that an increase to a consumer's paycheck will automatically lead to an increase in their disposable income. That's simply not true. Someone who is in debt is actually already over-consuming and thus it's far more likely that they will just use the extra income to pay down debt. While that is better for the individual, it doesn't have any direct stimulative effect. Similarly, someone who has a wealth surplus already has the capacity to consumer more than they do and they have chosen not to. It's unlikely that they will decide to consume a great deal more given a small amount of extra income. Far more likely that they will decide to save or invest the extra cash. Now, both that and the consumer who pays down their credit cards will have net positive effects on the economy. Credit card companies getting paid back and savings accounts getting filled means banks can extend more credit to other consumers and increased investment leads to growth in the industrial and business sectors. But, again, these are long-term effects and not short-term boosts.

So what we are indeed looking for is someone whose income currently is in lock-step with their expenses; they have no net debt or wealth. Now this person is quite likely to spend any extra income on additional consumption. But I would hardly call it efficient to throw a lot of money at every consumer just to hit the 5% (max) in this position. It's like putting out a candle with a firehose.

So if tax cuts are not the answer, then what is? Do I have any thoughts on that? Well as a matter of fact I do.

To be continued . . .

Suggestions?

So I have very little today, and that's actually what I want to write about. I feel like no one really wants to read about my day to day activities but then it also seems like when I blog about politics or economics I can hear crickets chirping in the comments section. So, anyone got any suggestions for me on things I should blog about? Mainly I'm looking for things that I can express an opinion on (e.g. not "I've always wondered how maple syrup gets made. Can you explain that to me?"). And even if you don't have an idea for a topic, it'd be nice to know what kind of topics you've liked most/least that I've written about. Right now my only gauge for the interest level is the comments, but I also realize that's not always a good indicator. Should I just do political or economic posts? Should I axe both of them completely and just do humorous ones? Should I accept that no one cares about my thoughts and just post pictures of Anabelle? Any and all suggestions and comments are welcome. I've been pretty much meandering my way through this blog for the past couple years now writing about whatever I felt like, and I'd like to start to get a little more dialed in.

I also have become more open to the idea of having additional guest contributors, so if any of you are interested in writing something for me to post, please let me know.

Busy Everywhere

So a whole slew of things have kept me busy at work (12 meetings this week through Wednesday and 4 more tomorrow) and baby has been keeping Chrity and I busy at home and that has left my blog suffering. Things at work should slow down a bit after this week so hopefully I'll get back in the groove.

I have no doubt that I'll be talking a lot about Anabelle here, but in general I'm going to leave the weekly updates and the multitude of pictures and videos for Christy to post on her blog. Since we have 90% the same readership, I see no reason to post it at both places.

So just a couple thoughts I've had over the last week. First of all, the Olympics. Even before the announcement on Friday I was fairly indifferent to whether it came to Chicago or not. Although I have no immediate plans to change jobs or move, it would be a bit naive to just assume that they'll both be unchanged 7 years from now. Thus I found myself unable to get excited about getting to experience the Olympics firsthand nor could I muster any dread about how it would inconvenience my commute for a couple months. As for the decision itself, in my opinion it was always going to be Rio and, given that South America has never hosted the games, that's exactly where it should be going.

Given that, I frankly don't care that Chicago was eliminated first. The 2010 winter games will be held in Vancouver. Quick, can someone tell me the runner-up location? Didn't think so. There's no prize for 2nd or 3rd, so who cares? Plus, I was working from home on Friday and saw all the news coverage leading up to the announcement and on several occasions it was reported that the 1st round of voting often has a lot of surprises. Supposedly there are a lot of voters who say "ok, I'll vote for your city after mine's eliminated" so you can actually end up doing far better in subsequent votes than initial ones (similar to a run-off election reversing the popular vote from the initial election). Thus we were told that the 1st round was actually the most dangerous and that nothing would be a surprise. Well, apparently either the press didn't really believe that or they just meant that the acceptable surprise would be Rio getting eliminated, because suddenly once the vote was announced it was "an absolute shocker" and "something no one expected." I was sitting there going "I just sat here 5 minutes ago when you told me that anything could happen and nothing would surprise you." Gotta love spin.

In any case, I am also predictably displeased at the spinning of this into an Obama failure, but I'm not even going to waste much of my breath on that. Since he went to Copenhagen to pitch for it, it was his failure, and if he hadn't gone the knock would have been that he didn't try hard enough for it. For some people, the sun never shines during a Democratic presidency and every little thing is just further evidence that he's working hard every day to destroy our country.

To continue the happy topics, I am once again sounding an alarm bell on the economy. Actually, just on the stock market. I do believe that the recession is over and we will see overall positive GDP growth this year and next. The trouble is that the stock market seems to have priced in a very aggressive V-shaped turnaround whereas it's far more likely that we're going to see a more messy U-shaped one.

If you have a minute and care at all about financial stats, take a look at this chart. It show the price to earnings (P/E) ratio for the S&P 500. For the laymen, that's the ratio of a company's stock price to their latest earnings per share. Historically, a P/E of between 8 and 10 is a sign of a fairly stable economy. A level below that usually indicates that people are irrationally gloomy on the market, and once we get above 15 people are starting to get a little slap-happy (and the almost 45 we hit at the height of the dotcom boom was euphoria of a kind usually only acheived via high quality street drugs and proved to be just as fleeting). If we are truly just starting to pull out of one of the worst financial crises ever, why in the world are we sitting at almost 19 right now? That's the kind of number you should only see during a period of robust growth. It's an indicator that we are once again trying to buy our way out of the problem. People buy a stock today not because they believe it's actually worth what they're paying but because they believe that someone else will decide it's worth more tomorrow (the so-called "greater fools" theory). That's not creating value or rewarding profitable companies, it's just gambling. Not that there's anything wrong with that; the trouble is that eventually you run out of greater fools. Anyway, I'm just saying don't be surprised when we see another big slump in stock prices over the next year to 18 months. Of course, if we really do start seeing signs of strong GDP growth between now and then, then maybe these optimistic expectations will be justified. But I have a feeling that if that in fact does happen, we're going to see this P/E ratio get pushed even higher into silly territory again. Finally, I'd like to state once again that I am not a believer in trying to time the market so I wouldn't advise anyone to touch their 401ks and start unloading their stocks. The market deserves to be at this level; it just doesn't deserve to be there right now.