Wednesday, March 11, 2009

Musings on transfer payments and money velocity

My sister-in-law recently asked for comments on what are basically becoming the right-wing talking points about Obama's economic policies. I shouldn't say talking points. It was far more sophisticated than that and was well above the intellectual capabilities of Rush Limbaugh. Still, it was fundamentally flawed. Here is what she sent me:

What is new is the unveiling of Mr. Obama's agenda and his approach to governance. Every new President has a finite stock of capital -- financial and political -- to deploy, and amid recession Mr. Obama has more than most.

But one negative revelation has been the way he has chosen to spend his scarce resources on income transfers rather than growth promotion. Most of his "stimulus" spending was devoted to social programs, rather than public works, and nearly all of the tax cuts were devoted to income maintenance rather than to improving incentives to work or invest.

His Treasury has been making a similar mistake with its financial bailout plans. The banking system needs to work through its losses, and one necessary use of public capital is to assist in burning down those bad assets as fast as possible. Yet most of Team Obama's ministrations so far have gone toward triage and life support, rather than repair and recovery.

AIG yesterday received its fourth "rescue," including $70 billion in Troubled Asset Relief Program cash, without any clear business direction. (See here .) Citigroup's
restructuring last week added not a dollar of new capital, and also no clear direction. Perhaps the imminent Treasury "stress tests" will clear the decks, but until they do the banks are all living in fear of becoming the next AIG. All of this squanders public money that could better go toward burning down bank debt.

The market has notably plunged since Mr. Obama introduced his budget last week, and that should be no surprise. The document was a declaration of hostility toward capitalists across the economy. Health-care stocks have dived on fears of new government mandates and price controls. Private lenders to students have been told they're no longer wanted. Anyone who uses carbon energy has been warned to expect a huge tax increase from cap and trade. And every risk-taker and investor now knows that another tax increase will slam the economy in 2011, unless Mr. Obama lets Speaker Nancy Pelosi impose one even earlier.

Meanwhile, Congress demands more bank lending even as it assails lenders and threatens to let judges rewrite mortgage contracts. The powers in Congress -- unrebuked by Mr. Obama -- are ridiculing and punishing the very capitalists who are essential to a sustainable recovery. The result has been a capital strike, and the return of the fear from last year that we could face a far deeper downturn. This is no way to nurture a wounded economy back to health.

Listening to Mr. Obama and his chief of staff, Rahm Emanuel, on the weekend, we couldn't help but wonder if they appreciate any of this. They seem preoccupied with going to the barricades against Republicans who wield little power, or picking a fight with Rush Limbaugh, as if this is the kind of economic leadership Americans want.

Perhaps they're reading the polls and figure they have two or three years before voters stop blaming Republicans and Mr. Bush for the economy. Even if that's right in the long run, in the meantime their assault on business and investors is delaying a recovery and ensuring that the expansion will be weaker than it should be when it finally does arrive.
There's really no detail on how any of Obama's policies are attacks on capitalists. It's just asserted a priori that any departure from the status quo is an attack on capitalists. Interestingly, the removal of a federal subsidy (that's what being paid for administering a federally guaranteed student loan is) is treated as an attack on capitalists. I generally disagree with a priori assertions on principle (though I don't do this a priori.) Anyway, any change in economic policy will have winners and losers. This article seems to say that the only way to a prosperous society is to continue the policies that have brought us to the current situation without regard as to whether they are sustainable or not.

There are currently several startling cases of market failure undermining our economy right now. In no particular order, health care spending can best be described as inefficient, poorly distributed and growing at an unsustainable rate. The efficient distribution of capital through the financial sector is moving at an unacceptably slow rate due to a variety of factors no one quite understands. Consumers and business are, en masse, slowing consumption and investment because the future is too uncertain, to improve balance sheets or because capital is unavailable. The capital markets are failing and the health care market is failing. One could make a credible case that the housing market is failing. The right's solution is to complain about "attacks on capitalists." Get a clue.

Anyway, all that is not the point of this post. The article starts with lament that Obama is using transfer payments rather than growth promotion. Basically, he's saying that transfer payments are not stimulative. Well, that seems rather simplistic.

Right now, we have a problem in that capital is not being moved into the economy. I don't know the figures, but I imagine gross investment has been declining precipitously. Consumption is also declining. Now, here's the thing, those with accumulated wealth (let's just say those with money,) spend less of their money on consumption than those who have less. Take me as an example. I am in solid financial condition. Give me $100 and I'll probably just put it in the bank and forget about it. Give $100 to an unemployed single mother and it will probably be spent by the end of the day. If the financial market was not failing, it might be better to give me the $100 because the bank would turn that into $1000 of loans that would get spent in the economy. Right now, though, the bank would not loan that money, but keep the cash to try and cover some of the bad loans it made in the past. So, if you give me $100, nothing will be spent and the economy is not stimulated at all. Give it to the single mom, though, and it will stimulate the economy by $100.

Normally, my money has a higher velocity than the single mom's. Giving me $100 results in $1000 of spending and so the velocity is 10. The single mom's velocity is 1 regardless of the situation. But right now, with the financial sector frozen, the velocity of money given to me is 0. Velocity is actually more complicated as it nests, but this example gives the basic example.

So, the next question is, what if the government takes $100 from me and gives it to the single mom? Well, the government can't really just take $100 from me. Instead they will take $100 from a future me (i.e. tax my future earnings higher.) In the current situation, that's not going to change the velocity of the money I have already. You see, I've already cut my consumption spending and as long as the future tax increase is not too big, I probably won't cut any more. So, taking $100 from a future me and giving it to someone now will stimulate the economy right now. The trick, though, is that you can't raise the taxes so high that I cut my current consumption even more. If you raise the taxes too high, I will cut more than the amount you raise from my spending.

The best way to build wealth in this country is to participate in capital formation activities. In other words, you consume less than you earn and invest the rest. In recent times, middle class Americans have saved very little and actually consumed more than they earned. It is very easy to say, "It's their own damn fault." Maybe it is. However, in recent times, middle class incomes have stagnated and while product inflation has been under control, service inflation has been high. Being able to send your kids to college is not usually considered an upper-class thing, but has been a hallmark of middle class achievement. I think college costs have increased 15% a year for at least a decade. It used to be that 10% was the standard for tipping at a restaurant. Now, 15% is considered cheap. Ticket prices to just about any event are at least 3x what they were twenty years ago. Meanwhile, wages have stagnated. So, just to live what was considered a middle class lifestyle twenty years ago -- sending the kids to college, going to shows and movies, eating at restaurants -- you need more income. That income hasn't grown, though. Some will downsize their lifestyle. Most will borrow to maintain it. They will not just fail to save, but actively go into debt. So, now they're not participating in the best wealth-building activity, saving and investing, but actually going into debt.

Meanwhile, those at the top continue to accumulate wealth and with inflation under control have more and more to spend on ever more extravagant consumption. The middle class is going into debt to stay even while the upper classes are engaging in conspicuous consumption. If you're a middle class person and you go into debt to maintain your middle class lifestyle does that signify moral weakness on your part? If a large portion of your country's middle class goes into debt to maintain a middle class lifestyle does that mean your middle class is morally weak? Or does it mean the situation has changed so that a middle class lifestyle is no longer possible on a middle class income? In other words, does a middle class lifestyle now require better than average willpower, discipline and talent to earn a better than average income? Is it now unlikely that the average person's endowments can provide a middle class lifestyle?

I believe the Obama administration believes the answer to the last question is yes. I say maybe, but the answer is ambiguous enough that we should act as if the answer is yes. I'm not a fan of nostalgia. What people think of middle class may have historically represented greater privilege than realized. You see, we have reduced the effects of birth circumstances on economic status in many ways. If you're born black, you're less likely to live in poverty now than ever in American history. Being born female deprives you of fewer opportunities than anytime in our history. It could be that the middle class lifestyle was never possible for the average person but only possible to members of a privileged, but majority class. Still, it doesn't take a genius to see that recent attitudes and policies are unsustainable.

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