Wednesday, March 5, 2014

For the Last Time: Why David is Wrong About Fiscal Stimulus (Dense)

I’ve written twice now on David’s misguided attempts to explain away fiscal stimulus. But David’s latest post just repeats the same fallacy over and over again as if it were some fundamental truth in economics: “all money in an economy is applied toward economic activity.”

To be fair, there is indeed an economic identity that says that all income is applied toward economic activity—that is, all income is spent. The problem is, there is no economic identity that says that all money is applied toward economic activity because banks convert savings into economic investment by making loans. So here's a somewhat denser version of why David is wrong.

First, some definitions.

Total spending in an economy must always equal total income. How do we know this?

Suppose the economy has no money. I produce ten bananas, you produce twenty apples, and once per day I sell you all of my bananas in exchange for all of your apples. What is total income—the value of goods and services bought and sold—at the end of the first day? Well, I sold my ten bananas to you and you sold your twenty apples to me, so total income is ten bananas and twenty apples. Total spending and total income are the same.

Now, consider that an economy can spend income in two different ways: individuals purchase goods and services (consumption) while businesses purchase physical entities like machinery, equipment, and software (investment). Since total spending equals total income, consumption and investment together must equal total income.

Some of you are wondering, what about saving?

Let's add money back into the equation. Economists define economic saving as “income not consumed.” That coincides with the conventional understanding of what makes up your income: the part you spend (consumption) combined with the part you don’t spend (saving) is equal to your income. We initially learned that income is equal to consumption plus investment, but I just showed that it’s also equal to consumption plus saving. It stands to reason, then, that economic saving and investment are equal.

This is the identity that David tries to satisfy by saying that banks must loan out savings to businesses to invest in new machinery and equipment. After all, saving has to equal investment, right?

But of course, it’s all wrong. What you put into your bank account doesn't equal  investments in things like machinery and equipment. That's because only investment can create saving, not the other way around. Let me explain.

We know that economic saving is “income not consumed.” But that means that you “save” the moment you get your paycheck. Eventually, you might purchase goods and services, which will reduce your saving. But as soon as you receive your paycheck, you “save.” Similarly, a business “saves” when it receives income.

A lot of saving, then, is simply transferred between us and nets out to zero. You save when you receive your paycheck, but your employer reduces saving the same amount. The same happens when you consume. When you buy groceries, you reduce your saving, but the grocery store saves the same amount.

Now, what happens when you put, say, $100 in the bank? Yes, the money in your account increases by $100. But this doesn't increase your economic saving (income not consumed); all you've done is taken $100 of saving from your pocket and transferred it to your bank account. Your “income not consumed” is the same no matter if it’s in the bank or under a mattress. This means that you can’t ever increase total economic saving yourself

How then, does saving equal investment?

Remember when you bought groceries, you reduced your saving because you were purchasing goods. But when businesses invest, there is no reduction in saving. Suppose Business X invests in new machinery from Business Y. What happens at X is that, instead of reducing saving, an asset is created to reflect the value of the new machinery. This represents an increase in investment. Simultaneously, X’s spending represents income for Y, so Y’s saving goes up. That’s the only way to increase investment, and hence, saving.

Unfortunately, it doesn’t work the other way around. You cannot guarantee more economic investment by putting money in banks, like David thinks. That's because you can't create more economic saving by putting money in banks. David’s argument that the money you have in bank accounts is equal to economic investment is false.

So, in a depressed economy, there’s no reason why government borrowing money inhibits the private sector from investing. David wants you to believe that because government is borrowing money from your savings accounts that it’s displacing economic investment that would have otherwise occurred. But as we just learned, that's not how the savings-investment identity really holds.

And that is why, for the last time, David is wrong about stimulus.

No comments:

Post a Comment