The Long-Awaited Conclusion

So to complete my economic post from last week, I'll take on the 500 lb gorilla in the room head on. Yes I am going to advocate government intervention. No, I don't think that makes me a socialist.

My rationale is based on my belief in Keynesian economics. Until Michael Jackson died, John Maynard Keynes was easily the most talked-about dead guy of the last year. Nevertheless, since there were a lot of people dropping his name in an effort to sound like they knew what they were talking about even if they didn't or if what they were advocating had nothing to do with the Keynesian model, I think a brief and extremely simplistic description is in order.

In a "normal" economy (we'll set aside what the exact definition of this is; just think of an economy humming along at about 2% real growth per year) you have high employment and everyone spends their money "normally". Your "normal" demand is defined as the sum of domestic consumer spending, business investment, and government expenditures. In other words, these are the "inputs" into the economy. Now you hit a recession (for the example, the reason is unimportant). One of the main hallmarks of a recession is higher unemployment. As unemployment rises, those left jobless have less disposable income and thus spend less, which causes aggregate consumer spending to fall. Even those who still hold jobs are now more uncertain (typically measured by consumer confidence) and thus begin to elect to save more of their earnings rather than invest. This further hits consumer demand. The fall in demand causes more companies to layoff more workers which further triggers a fall in consumer confidence and you get a vicious cycle of falling demand to unemployment to falling demand, etc. So the Keynesian argument is that when consumer demand falls the government must step in to plug the gap so that demand as a whole (consumer spending plus business investment plus government expenditures) can be normalized again.

It's important to realize that anything the government does in this situation is technically "government intervention"; even tax cuts. If taxes are at level A, and a Congressmen proposes changing them to level B in order to combat the recession, that's still government intervention! I hear the idea of lowering taxes presented as being synonymous with laissez-faire economics and that's simply not the case. True laissez-faire economics would say change absolutely nothing during a recession. Again, we are talking about specific steps to combat a recession, not changing the tax policies of the country in general (where a reduction in taxes and, presumably, government WOULD be a move towards a more laissez-faire style).

OK, so in my previous post I illustrated why I don't believe that personal tax cuts are effective in increasing consumer demand, so that leaves two options: increasing business investment or increasing government expenditures. Most often, you hear only about government expenditures while increased business investment gets short shrift. I think that's a mistake. First of all, anytime you tell Congress to "spend some money" you are just asking for trouble. Not all government expenditures are created equally. Some are just horrifically wasteful and serve no purpose other than to help the sponsoring Congressmen get re-elected. But even if they all are "good" expenses, you still have problems. Any temporary government expenditure has the inherent flaw that once the project is done so is its stimulative effect. Giving a million people a job for 2 months helps them for those 2 months but at the end they're back to being unemployed. A lot of times the government spending amounts to paying people as a temporary stop-gap and hoping (praying) that by the time the project is over the economy has magically recovered and everyone will now be able to find jobs again. Still, I think it's better than just straight tax cuts because here you are giving people that had no income (the unemployed) some income and thus you are more significantly increasing disposable income. Plus, you were going to be paying them unemployment anyway, so you might as well pay them for doing something (we'll leave the discussion of whether or not unemployment payments are a good idea for another day). Again though, you still have the fundamental problem that when these workers spends these wages so little of it is actually getting filtered back to the U.S. economy. If you are going to go this route, the best thing to do is spend it on infrastructure, because that's something that needs to be done anyway and the government will ultimately pay for regardless.

So with all that as a backdrop I think that the most effective way to combat a recession is to increase and encourage business investment. Encourage in the sense of offering more guaranteed loans for entrepreneurs, where the government and the private bank share in the interest for the successful loans and the government bears the brunt of the failed ones. And directly increasing investment by partnering with new or existing companies to establish new entities in cutting-edge industries. The key is that you want to create something that will be self-sufficient when the government involvement is over and thus any employees hired to start-up such an operation will still have the jobs when the government is no longer there. A good example for this would be partnering with someone like GE to build a plant to manufacture solar panels. Now you're providing temporary work to the construction industry, then when the plant is done you're providing permanent employment for the surrounding area, and you're starting to reduce the trade gap by bringing manufacturing back here and (hopefully) helping to keep more of the money spent in the U.S. cycling through the domestic economy. I would structure any such arrangement so that after a specified period of time (depending on the industry) the government will exit the business and retain only a minority, non-voting interest in it, to be divested as soon as it is possible to do so while recovering the initial investment (plus a reasonable amount of interest).

OK, so that's how I feel about the different elements of the Keynesian tools. Best is increasing business investment, worst is personal tax cuts, and straight government expenditures are in the middle. In reality though, I'm not advocating just one approach. I don't think that the government should do all business investment and nothing else. The fact of the matter is that traditional economic models are very sterile. They basically assume that we are all machines. But the truth is that we are emotional beings and economic models designed to address that (behavioral economics) are still in their infancy. The bottom line is that the economy not only has to get better; people have to feel like it's getting better. That's the only way to break the cycle of people feeling increasingly uncertain and spending progressively less. If you're a die-hard from the school of tax cuts and you see the government spending tons of cash, that's going to make you more uneasy about the economy and you're likely to continue to spend more conservatively. Similarly, if you're of the mindset that tax-cuts are worthless you're unlikely to go out and spend more when you receive one. Thus, a calculated balance of all 3 approaches seems to have the best chance of success. This, of course, is completely at odds with the bipolar nature of our government.

And just in case you're not yet utterly sick to death of this, one final note. Notice that you never hear too much about Keynesian economics during the times when the economy is expanding. The flip side to spending during a recession is higher taxes and interest rates during the good times in order to both combat inflation and to run surpluses so that when the inevitable bad times do hit you have money socked away to pay for the spending and reduced tax revenues during the recessions. But think hard about the last time you heard a politician proposing raising taxes during a boom. It seems that somewhere on the road to recovery, all these devout Keynesians jump off the bus.