Let the dollar circulate

"Unemployment on the rise, rent being paid late,
please, let the dollar circulate"

No, Young Jeezy is not qouting Keynes. He is however saying the same things many economists are.


In The Economist from November 5th there is a very interesting article from their Buttonwood column that covers the financial markets. It also ties in with my previous remarks on the crisis. In addition, the author behind the column writes interesting, smaller posts in her/his blog.

There the author writes repeatedly that governments may have saved the financial markets but they have done a worse job with the real economy. Stimulus packages and the takeover of banks probably rescued the financial markets, but it has not got the engine of our economy, consumption and investment, going again. What looks like a recovery by many companies is the result of downsizing, cost reduction and higher efficiency, not increased sales. The latest round of quarterly reports in Sweden looked better than expected, but there may be a good idea to see what lies behind the results. There is a limit to how much you can cut costs and pressure your workers. Sooner or later the turnover has to increase, otherwise we will see increased losses again.

In the previous post I wrote that people do not consume more despite the stimulus package and lower interest rates. The multiplier effect that governments and central banks are looking for has largely been absent. Some people told me that retail sales in Sweden have been persistent. So may be, but Sweden is a very export-dependent country, and exports fell by 17.2% in September compared to 2008 and the trade surplus was 44.4% (!) lower than September 2008.

Does this mean that the propensity to consume (c1) has fallen in John Maynard Keynes demand function C = c1 + c0(Y-T)? I think so. If that is the case it means that incentives to increase income (Y) or tax relieves to reduce T do not have the desired effect. The Economist writes that many believe this is due to people’s fear for future budget deficits that sooner or later must lead to higher taxes in the future (exactly what is happening in Spain right now). This phenomenon is also called Ricardian equivalence. John Maynard Keynes believed that higher public spending was the way out of a crisis when there was no normal demand. Ricardian equivalence contradicts this and says that the more increased public spending affects state finances, the less effect it will have. This might be interesting to keep in mind when you look at the U.S. TARP of 700 billion since they also have a national debt of 12 trillion dollars.

For Ricardian equivalence to be valid though, it requires that people are rational and have all the information needed. So are people rational? I discussed my previous post with a friend during dinner last week. My friend’s response to what I wrote concerning everybody not being affected by the crisis was:
"But, everybody knows that!"

I would say: No, everybody does not. Some are not informed, and some do not care and simply relies on what is said by politicians and the media. If people are not quite as rational as many theories imply, Ricardian equivalence does not apply in the same way, i.e. its impact on the economy is not the same. For those responsible for the public finances it does however, of course, hold. Either they raise taxes now to pay for spending today, or they borrow to pay for spending today and raise taxes later to pay off the debt. The question is how does this affect consumption today? Since people are irrational a tax increase today has greater negative effect on consumption than to raise debt, which does mean higher costs for future generations. A large cost today simply feels worse than an even larger cost in the future.

That is unfortunately how we are. For even if we feel solidarity with our next generations, it seems like the solidarity usually ends at the grandchildren. It is perhaps not surprising that we do not feel as much solidarity with family members that we will never see in life than those who are close to us. I do think however, it is one of humanity's biggest problems. It makes it extremely difficult for all policies and measures that could improve the lives of all people in the future but which currently affect us negatively, to get approved. Politicians who have such ambitions cannot exercise them because they know that they will not be either elected or re-elected. Projects with enormous potential in the future do not get funding. Companies will not invest in products, which can make a huge difference for the world if it does not pay back tomorrow.

Back to the Ricardian equivalence. There must be however a limit to how much a state can get into debt before the people start to react the same way as to a sharp tax increase. The Economist writes that this may depend on the size of the ratio of debt to GDP. I think this sounds very logical. Even a person without the slightest interest in economics will understand that 12 trillion dollar is an extremely large sum that someone (the people) at some point have to start paying back.

So, is Keynes correct that increased public spending is the best option even if it increases the debt burden in the future? Since people are not rational, it seems that way, especially in times of crisis. People believe that the state is helping them and do not think about the fact that it is actually themselves or probably their children or grandchildren who are footing the bill later. There must however be a limit on how big to the debt can become before people start seeing it as a threat. The mountains of debt that some countries have accumulated are likely to be a problem in the future. The U.S. and UK also fund some parts of the debt by QE. They therefore increase the debt by simply printing new money and buying treasury bills, at the same time also keeping interest rates low. Countries with large government debt tend otherwise to be punished with high interest rates. The question is, what will happen to these countries after the crisis is over, that is, when the real economy starts to recover?