The naked stimulus: Why savings stimulate more than spendingSeptember 9, 2010: 1:25 PM ET
The Obama administration's stimulus package may have boosted spending in the short-term, but savings have a more lasting impact on the broader economy.
Despite the struggling economy, President Obama keeps arguing that his stimulus package is producing GDP growth that's far better than the disaster that would have ensued without the $862 billion in emergency spending. The reason, he and his advisors maintain, is that what really counts is spending -- the more the better, at least for now.
The sole thrust of the administration's policy is to boost consumer and government spending by borrowing heavily, and then recycling those dollars to people who are most likely to spend them on restaurant meals, PCs or toys. At the same time, it's vastly lifting federal outlays on everything from auto fleets to subsidies for solar panels.
All that "new" spending supposedly saved the economy. As Obama stated in December, "When you lose a trillion dollars in demand, you need to have a big enough recovery package to make up for the lost demand." In August, Treasury Secretary Timothy Geithner used the "consumption is king" rationale to champion keeping the Bush tax cuts for middle-income Americans who typically spend the cash, and ending them for high-earners, who save most of it.
But the administration's policy has a fundamental flaw. By basic economic math, it's impossible to raise GDP by borrowing from one group of people who would otherwise save that money, and transferring it to another group of people, and to the government, to spend. Savings, in the short term, have precisely the same impact on national income as spending.
The reason couldn't be simpler: All savings are spent. Let's look at the big picture. GDP measures all spending on all the goods and services that America produces. Savings translate, dollar for dollar, into a major component of that total spending: investment. All the money that the administration successfully moves from savings to consumption simply channels one type of spending to another, in precisely offsetting amounts. It's like filling a swimming pool from one end, and draining it from the other end. The level doesn't change. Nor does GDP change when the government drains investment to lift consumption.
We've all heard the argument that since consumer spending accounts for around two-thirds of GDP, a pro-growth policy must overwhelmingly concentrate on raising that number. But remember, GDP is composed of three other components, including government outlays, the surplus of exports over imports, and private investment. It's indeed possible to raise consumer spending by a significant amount, say from 65% to 75% of GDP, by reducing both private investment and net exports––in fact, that's what's happening right now. That's real legacy of Obamanomics.
What savings will finance
Over long periods, it's savings––not consumer spending––that finance the investments in mainframes, robots and other capital equipment that enhance productivity and drive economic growth. "President Obama keeps saying that only consumption counts," says Allan Meltzer, the distinguished economist at Carnegie Mellon. "It's foolish. Of course the money that people save doesn't go under the mattress. It goes to individuals to buy a house, or to businesses to build a plant."
Let's examine how savings translate into investments, and hence into a crucial source of spending––for the future, the most crucial. When people save, they either purchase stocks or bonds, or they deposit the cash in the banking system. When they buy newly-issued securities, those savers provide companies with the cash to purchase equipment, or buy factories and call centers via acquisitions. When they buy CDs or deposit money in savings accounts, the bank typically lends that money either to corporate customers that spend it to expand, or to the government by purchasing treasuries––and once again, the funds are quickly spent.
Indeed, the very purpose of the banking system is to guide savings into new spending. "If someone spends $20,000 on a new car, the money goes right into GDP," says John Cochrane of the Booth School of Business at the University of Chicago. "If the same person puts it in the bank, it's loaned to a company that buys a forklift. The savings go straight to investment spending, and lift GDP by the same amount."
What if the government borrows most of the money from foreign investors, as America does today? Unfortunately, luring cash in from China and Japan doesn't change the economics. To buy our Treasuries, foreign investors must first sell us far more of their products than we sell them, forcing the U.S. to maintain a trade deficit year after year. That gap between exports and imports lowers GDP by precisely the same amount that the money they loan us raises GDP. The result, as with sapping savings to raise consumer spending, is a wash.
In one theoretical case, government borrowing could actually raise total GDP. It's worth mentioning because this scenario was essential to the theories of John Maynard Keynes, whose prescriptions are extremely influential in the Obama administration. If lots of cash sits on the sidelines, outside the banking system, then the government can add to national income by enticing the people hoarding it to buy Treasuries. Indeed, when Keynes formulated his theories in the Great Depression, consumers mistrusted banks, and kept loads of cash in safes and safety deposit boxes. His solution was to get that idle money moving again.
Cash balances, or accounting entries?
Now, it's a different world. Only tiny amounts of cash generated from selling cars, say, or collecting interest, sits idle. While households have virtually no funds outside the banking system, the banks themselves are holding lots of idle money, or rather, potential money. Those funds have nothing to do with what constitutes GDP, the production of goods and services. They are an accounting entry generated by the Federal Reserve to increase the money supply. Banks keep that money on deposit with the Fed, and only draw it down––in other words, translate it into real money––when demand for loans increases.
Right now, demand for credit is so weak that a gigantic $1 trillion in excess reserves are now on deposit at the Fed. "The Fed is simply giving the system the oil it needs to run smoothly," says J.D. Foster of the conservative Heritage Foundation and a former George W. Bush budget official. "That money doesn't provide any horsepower to the economy." As Foster points out, those reserves are so oversized that while they're unlikely to generate more growth, they can produce high levels of inflation.
So what is the real result of Obama's "stimulus?" The plan has surely shifted money from savings to consumption, although the amounts are impossible to determine. For example, the Making Work Pay program last year gave $800 in cash to middle-class families. It's probable that they spent more of that money than the folks who bought the bonds, who typically have higher incomes, would have spent. The grants to the states to maintain government jobs made those workers feel more comfortable about their futures, and doubtless gave them the money and confidence to spend more of their incomes. The government also spent tens of billions directly on goods and services.
So what would have happened if we'd had no stimulus at all? By economic law, all of the money that was borrowed and redirected to consumption would have gone somewhere else. Two other components of GDP would have to be larger to offset the almost $900 billion in spending and borrowing. First, private investment would be higher, because of the bigger pool of savings, a great sign for the future. "It's big increases in private investment that always drive a recovery," says Cochrane.
Second, the U.S. wouldn't have to borrow nearly as much from abroad. As a result, the dollar would be lower versus other currencies, reflecting its true value. Hence, imports would be more expensive, and our exports far more competitive on the world markets. The rise in exports would help offset the hit to GDP caused by lower consumer spending. Bigger investment and exports on a tear? That's certainly a good alternative to the results of the stimulus.
To be fair, GDP might not be any stronger than it is right now, and it certainly wouldn't be any worse, either. And our economic future would look at lot brighter.