Tuesday, January 15, 2013

Spendthrift Sam and Judicious Janet

Recently, I bemoaned the bipartisan agreement that the government needs to "tighten its belt." This conventional wisdom is just plain wrong. I pointed to a column by economist Paul Krugman to explain why.

Apparently, some readers had trouble understanding how inflation and debt can sometimes work to our advantage (and by some readers I mean one in particular). Admittedly, it's counter-intuitive. If government debt contributed to our economic stagnation, how can more government debt get us going again?

After the jump, my attempt at paraphrasing Krugman's argument.

First, a recap. Krugman asks us to imagine a world in which there are only two kinds of people: Spendthrift Sams and Judicious Janets. Sam is in debt and Janet is a saver. But because of, say, a collapse of a housing bubble, Sam has to quit borrowing, quit spending, and start paying down his debt.

Sound familiar? Krugman explains how the usual solution to this is for interest rates to fall, thus encouraging Janet to begin spending instead of saving, thus making up for the drop in spending by Sam. But the usual solution doesn't work when interest rates are already so close to zero that they can't fall any more. Some other tool is needed.

Krugman explains how inflation can be a tool to get the economy going again when interest rates are up against this "zero lower bound." Inflation erodes both assets and debt, but, as Krugman explains, "the Sams are balance-sheet constrained, while the Janets aren’t, so this is a net positive for aggregate demand."

What's in it for Judicious Janet, whose assets are eroded? It allows her assets to be productive. If Janet has her assets invested in, say, a factory, that factory is currently idle, or at least under utilized, because Spendthrift Sam is deep in debt and unable to purchase the output of Janet's factory. Anything that helps Sam erode his debt and begin spending again hastens the day when Janet's factory can resume full production and start making more money for Janet.

If you have moral objections to using inflation to hasten this process, Krugman offers a different tool. The government can borrow money and use it to help Sam find a job. With a paycheck again, Sam can pay off his debt and start buying output from Janet's factory again. The economy grows -- not by inflation but by an increase in total economic activity. There's no need for the government to "overspend indefinitely," as our reader puts it. As the economy grows, the need for government borrowing lessens, and the debt to GDP ratio stabilizes and even shrinks.

If, on the other hand, the government "tightens its belt," Sam stays jobless longer, others join him on the unemployment line, their collective debt remains a drag on the economy, and the cycle gets worse. Janet's factory remains idle, so she loses, too.

By the way, if you wonder what makes the most recent recession different from the previous three, well, besides being deeper, it was also the only one where government employment dropped. In the previous three recessions, government employment rose, helping pull the country out of recession. Not this time.
Government employment in last four recessions
Source: Ezra Klein.
Note that the one spike in government employment during the recent recession was temporary hiring for the census. That didn't last long and even at its peak, government employment still didn't help to pull us out of recession as it did during the recession of 2001. By laying off teachers, policemen and firemen, we're shooting ourselves in our foot, folks.

As Krugman says, "The bottom line, then, is that the plausible-sounding argument that debt can’t cure debt is just wrong. On the contrary, it can -- and the alternative is a prolonged period of economic weakness that actually makes the debt problem harder to resolve."


Sassy Texan said...

Does that mean Mark Steger is for bigger government because it keeps Janet using up her assets to pay for Sam, who gets you cannot save your way to prosperity?

What I get from Krugman's is the use of debt for liquidity in the hopes the economy abounds. My point was more of a solvency issue. And probably the same problem Janet has is his example.

We all get the Federal Reserve has taken on the 'responsibility' so try and solve this little bitty problem with the economy by adding a little more liquidity to the problem. So here is the "pause and ponder" of that methodology. Since 2007, the Federal Reserve bailed out the banks and socialized their losses to the responsibility of the taxpayers. Did you say thank you? They said QE, QE2 and now QE3, all infusions of increased money supply to keep liquidity in the flow, with sizable increase to GDP that is justifiable to the levels of inflation it has created.

And I posted the link to the Federal Reserve's money flow report. The first half of 2012, by their own analysts assessment, reported a $50b deflationary action every month. So what did the Fed do? Infused $40b a month of new money into the market. What market, you ask? Wall Street! That infusion has now grown to $85B a month and appears to continue to grow. And Bernanke says he will continue to infuse dollars.

The other really big problem is all the exotics created out there. We should all say thank you to JPM for creating them. Some $600T holding some real risk to the macro global economy as noted by the IMF Research report published last month. Where do you cover $600T in derivatives with a GDP of only $16T? Who will get bailed out next?

So maybe you are right Mark. If we can just keep creating more debt to cover the illiquidity problem, then maybe we might grow our way out of this problem. But I think insolvency will win the race.

Cheri Duncan-Hubert

Mark Steger said...

Cheri: "So maybe you are right Mark. If we can just keep creating more debt to cover the illiquidity problem, then maybe we might grow our way out of this problem. But I think insolvency will win the race."

Using debt to stimulate the economy to grow our way out of problem is Krugman's point. His last point is worth repeating. Austerity, which I infer is your own preferred approach, paradoxically increases debt, prolongs the weakness, and hastens the insolvency you fear.

Sassy Texan said...

I get that Mark. But thus far it is really not working. People are not really spending to save their own arses. We are now to 50m people on Food Stamps to survive. And if that is what survival is, it's only $65 a month. 11 states are now insolvent with more people on benefits and Food Stamps than there are working people. Really now, how much printing will it take to "spend our way out of it"? Destruction of the middle class has been the burning fear turned into reality since the 1980's.

If the Federal Reserve, the IMF, GAO are all warning of insolvency of the US, why are some not listening? The biggest issue I see is that with globalization and the Bretton Woods taking the world to US standards years ago, ie a global economy is some regards, the US will draw down the rest of the world with it.

So I return with what I said the first time. If you spend more than you make YoY, eventually there is no balance sheet. Our government has a balance sheet in jeopardy of holding more debt than assets. And that is insolvency.

It has taken 40 years to get here! Liquidity cannot fix insolvency and China with several other countries are proving it by NOT buying our fiat paper. The Federal Reserve bought 75% of it in 2011 and 90% in 2012. That is a trend!

One last point. Could it be the central banks are insolvent and not the country?

Cheri Duncan-Hubert

Mark Steger said...

Cheri: "I get that Mark. But thus far it is really not working."

Actually, it has been working, to the extent that it's been tried. It kept the Great Recession from turning into another Great Depression. It's kept the US from experiencing Europe's new recession, which was caused by austerity. And it would work even better if Obama would do more of it and the GOP would let him.

Despite your claim otherwise, the US is not insolvent. The US can borrow money at historically low interest rates. That simply would not be possible if the US were insolvent.

I get that some people have a moral aversion to debt. I get that some people yearn for smaller government. But that's not the topic of this blog post. The topic here is whether debt can help pull the economy out of recession. And the answer is yes, whereas austerity will lead to another recession (as it's doing in Europe.)

Sassy Texan said...

Mark: Actually, it has been working, to the extent that it's been tried. It kept the Great Recession from turning into another Great Depression.

I get that you believe this and that is basically the media story told. But I have sent you links to the Federal Reserve's site with links to actual data.

Here is one more. From the IMF. The global derivatives markets in the post Lehman period… are unstable and they can bring about catastrophic failure,” according to a new IMF paper. The author summarizes why the derivatives market still has the entire system a breath away from yet another crisis:

Quite simply, a threat of failure to any of the systemically important financial institutions (SIFIs) is an immediate threat to the others.
The network topology where the very high percentage of exposures is concentrated among a few highly interconnected banks [JP Morgan, Bank of America] implies that they will stand and fall together....
Structurally, as will be seen, the interconnected hubs often suffer self-annihilation and thereby [not] spread[ing] contagion to the extremities—a matter of considerable significance [when considering] saving a species from epidemics.

Here is the direct link. http://www.imf.org/external/pubs/ft/wp/2012/wp12282.pdf

If you recall, the IMF promised $2.1T to bail out the Euro with taxpayer money. So Europe is not out of the woods yet.

Why would these reports be generated for circulation if they are untrue?

And here is one more on Shadow Banking and the instability of 5 top banks.


If you don't want to read it, then there is nothing to talk about. I want to understand it so I continue to study.

Cheri Duncan-Hubert

Mark Steger said...

Cheri, I agree that the unregulated derivatives market was a contributor to the recent economic collapse. But that's off topic. The topic here is whether debt can be an effective tool to bring the economy out of collapse. I contend it can.

I also agree that Europe is not out of the woods yet. Europe is still infatuated with austerity, although the IMF seems to be coming around to the realization that austerity has been "causing far more economic damage than experts had assumed."

Mark Steger said...

Another angle to the "debt can be good" story: "borrowing money and spending it on sound projects of long-duration is the best way we have to 'save' for the future even though it technically adds debt." -- Matthew Yglesias

Sassy Texan said...

Depends on the definition of "sounds projects of long duration". I have no idea what that means.

One question further. How much does the economy need to grow to beat the inflation created by the printing to bring this long term value? And how does that increase purchasing power?


Mark Steger said...

Sound projects of long duration are roads and railroads and bridges and ports and dams. The country's infrastructure is falling apart, we have unemployed workers, and we can borrow for negative real interest rates. We are fools for not making investments in infrastructure now.

Inflation isn't a problem now and won't be as long as growth is weak. That's the problem we're suffering from, not inflation. Government borrowing and spending (i.e., more debt) can help spur growth. Austerity won't.

Sassy Texan said...

Time will tell. But I will say without a middle class to keep money in motion many things could happen. Let's hope you are right.

And I totally agree on the infrastructure issue. Government has taken it upon themselves to overlook core needs to pay themselves way too much.