As the recession continues, economists like Laura D’Andrea Tyson, the Chair of the Council of Economic Advisors under President Clinton, advocates spending as the pathway out of our economic banana. In her latest post on the New York Times economics blog, Tyson tells us that in order for the economy to recover we need an increase in “aggregate demand.” This basically just means that you, me, and the government should spend, spend, spend.
The fallacy here is due to the fact that in order to spend and consume things, we must first produce them. In order to produce goods we must first save and invest the funds necessary to bring those goods to market. Without savings, all the machines and other capital goods used in production will wear out, leaving production vastly less efficient. In fact, if everybody stopped saving anything they earned and consumed it all in the present, the economy would slowly but surely start operating with the efficiency of the Stone Age. This illustrates the importance of savings in an economy. With this in mind, why would anybody advocate spending more and saving less as a means to end the recession?
Keynesian economists and talking heads alike advocate spending in a recession because they believe there are “idle resources.” These idle resources supposedly indicate that the output of the economy is greater than the demand for that output. Thus, without asking too many more questions, they advocate spending more. This means an increase aggregate demand which will put to use all those idle resources.
The key problem with this theory is that the explanation for why so many resources become idle all at the same time is dubious at best. They try various explanations such as animal spirits and price rigidity, but these fall short upon further examination (saving this for a later post).
What they are really trying to do is refute Say’s Law. This is the concept that production opens up, or permits, demand. In other words, people produce certain things because they demand other things. If you make shoes, it is your production and sale of shoes that allows you to buy (demand) other goods produced by other people. Other people’s production of various goods allows them to demand your shoes. In order to demand any goods for yourself, you must first engage in production. Without production there are no goods to be demanded. Unless you produce, you will have no income with which to purchase goods.
The production and demand for goods is then equilibrated via the adjustment of prices upwards and downwards. If prices (including the interest rate) are manipulated by the government resources will be misallocated and may appear “idle”. In addition we have the observation that people always want to consume more (other things equal). This desire to consume more is limited by a person’s ability to produce (and thus generate income). It is also limited by the production of others. Generally stated, consumption is limited by production.
Keynesian economists deny Say’s Law and allege that the free market has a tendency to over invest. For the Keynesian, animal spirits and a follow-the-group mentality lead to this over investment at random. The mismatch this creates between the productive capacity of the economy and aggregate demand leads to unemployment. They believe the only way to solve the unemployment problem (created by the animal spirits) is to spend. Indeed, Keynes thought the existence of unemployment refuted Say’s Law. The Keynesian economist then prescribes increased consumption spending and government make-work projects to employ the unemployed and until the economy recovers. Without these policies, the Keynesian believes the unemployment problem will persist indefinitely. This is because they ignore Say’s Law which explains why, through supply and demand, the price of labor would adjust to new demand structures. The readjustment of the price leads to employment of all seeking work (the equalization of supply and demand in the labor market). Say’s Law is foundational to understanding the market economy. Ignoring it makes Keynesians merely deceptive shadows of economists.
In reality, there is a perfectly logical, cause-and-effect explanation for recessions and unemployment. The Austrian Business Cycle Theory explains how the housing bubble was an example of malinvestment, not over investment. There is a major theoretical distinction between the two. General over investment is not possible unless you ignore Say’s Law like the Keynesians do. This is because prices will adjust to equilibrate the new supply of capital goods that the investment has brought about. It is one of the conclusions of Say’s Law that you can never have too many capital goods as they just make labor more efficient.
Austrian economists ascribe the malinvestment that occurred in the housing market of the early 2000’s to artificially low interest rates that were the result of credit expansion. Credit expansion occurs when banks are permitted to engage in fractional reserve banking. This means that they create loans literally out of thin air. They just make a data entry on a computer and voila, new loan. Then they get to earn the interest on it.
In order to continue expanding credit, they must lower the price of borrowing. The price of borrowing is known as the interest rate. This is the price manipulation I referenced above. The consequence of cheaper loans and a lower interest rate is that investment projects which once appeared unprofitable suddenly appear profitable (like the housing market). Resources are misallocated into these projects. Unfortunately, consumers haven’t saved the funds to demand all of these new projects when they are completed. This is the boom as occurred in the housing market recently. It ends when investors eventually realize the mistake they made and begin to liquidate. The first investors to get out of the market get out at the top and make a killing. The vast majority end up bankrupt. When this happens, the resources that were misallocated into the housing market, for example, must be reallocated. The reallocation process is the recession. This involves unemployment as labor resources must transition out of construction jobs and into areas where they are demanded.
The reallocation process is where unemployment comes from. If the government does not interfere with the reallocation process, it will occur smoothly and quickly. The labor market will equilibrate and unemployment will vanish. Increasing savings helps to reallocate resources by supplying entrepreneurs with the funds to do so. Increasing consumption spending prolongs the distortion by bidding resources away from investors. Government spending is even worse because it doesn’t demonstrably add to welfare of anyone. It also bids resources away from entrepreneurs trying to reallocate resources to satisfy actual consumer preferences (see my discussion of Pareto Optimality here). As you can see, unemployment, as well as the housing bubble are clearly explained by the Austrian Business Cycle. For more information on this indispensable theory see Mises.org.
Moving on, it is ironic that just as Tyson peddles the trite, Keynesian explanation of economic downturns, she also worries about the household savings rate falling. She also worries that in order to maintain this decrease in savings households are borrowing more. Tyson accurately refers to this trend as “neither healthy nor sustainable.” But how are we supposed to increase aggregate demand while simultaneously saving more? I mean, which is it? Are we supposed to save more or spend more? Please Dr. Tyson, tell me which to do!
Tyson would likely respond to this plea by saying that people should spend more in the short run to get us out of the slump, but save more in the long run out of common sense. As this post explained, saving more in the short run helps to reallocate resources that credit expansion has led entrepreneurs to misallocate in the boom period of the business cycle. So get out there and save!