Friday, March 06, 2009

Martin Feldstein has the pieces, cannot put them together

I liked this oped by Marty Feldstein -- he has so many of the pieces, but just cannot put them together. Household balance sheets are interesting, because the assets tend not to provide the cash flows to finance the liabilities. For example, if you have a house with a mortgage, the house is your asset, the mortgage is your liability, but the income stream to fund that liability comes from your (easily disrupted) income. In the past, people would save cash to provide a buffer in case the income stream was disrupted, but in the 2000s, cash savings was replaced by home equity, and capital gains. Oops.
Previous recessions were often characterized by excess inventory accumulation and over-investment in business equipment. The economy could bounce back as those excesses were absorbed over time, making room for new investment. Those recoveries were also helped by interest rate reductions by the central bank.

This time, however, the fall in share prices and in home values has destroyed more than US$12 trillion of household wealth in the US, an amount equal to more than 75 percent of GDP. Previous reactions to declines in household wealth indicate that such a fall will cut consumer spending by about US$500 billion every year until the wealth is restored. While a higher household saving rate will help to rebuild wealth, it would take more than a decade of relatively high saving rates to restore what was lost.
Investments, whether in real estates or in stocks, are not savings, and conflating those two is a very dangerous mistake that many have now learned the hard way. Lesson learned, they are building up that cushion the old fashioned way, out of cash from their salary. So far so good. But then Marty turns weird:
So the US economy faces a US$750 billion shortfall of demand. Moreover, the usual automatic stabilizers of unemployment benefits and reduced income tax collections will do nothing to offset this fall in demand, because it is not caused by lower earnings or increased unemployment.
Huh? Don't we have an unemployment rate nearing 10%? In fact, given that the Obama "stimulus" will be completely un-stimulative, when it finally gets going in 2010/2011, automatic stabilizers are the only things that are working. Now Marty loses the plot entirely:
Although the recently enacted two-year stimulus package includes a total of US$800 billion of tax reductions and increased government spending, it would be wrong to think that this will add anything close to US$400 billion a year to GDP in each of the next two years. Most of the tax reductions will be saved by households, rather than used to finance additional spending....A second fiscal stimulus package is therefore likely. However, it will need to be much better targeted at increasing demand in order to avoid adding more to the national debt than the rise in domestic spending. Similarly, the tax changes in such a stimulus package should provide incentives to increase spending by households and businesses.
Households, having seen their balance sheets shrink, are working to build them up the old fashioned way -- by saving. After having spent more than they earned, they are now spending less than they earn. They will, for years, build up their balance sheets this way to replace what they have lost in the recession. But Marty decries that "tax reductions will be saved by households" instead of cheering that. Savings from lower taxes is better for aggregate demand than savings through lower consumption. Maybe Marty will cheer that fact that households only get a piddling $400?
Although long-term government interest rates are now very low, they are beginning to rise in response to the outlook for a sharply rising national debt. The national debt held by US and foreign investors totaled about 40 percent of GDP at the end of last year. It is likely to rise to more than 60 percent of GDP by the end of next year, with the debt-to-GDP ratio continuing to increase. The resulting increase in real long-term interest rates will reduce all forms of interest-sensitive spending, adding further to the economy’s weakness.
Marty, like most, gets this completely backwards. Government debt is the mirror image of household debt. Governments must run deficits so the non-Governmental sector can save. If the non-Governmental sector wants to save more, as it does now, the Government must step up and run larger deficits to fund that demand for savings. The alternative is falling aggregate demand, the world we are in now.


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