Thursday, August 18, 2011

Saving the Economy

Jacques doesn't get savings and investment.  I've never seen him store a bone for later, and he doesn't seem to have any conception that he might want to save something up.  Which is fine, because he's a dog, he's not supposed to get how savings works.  But I realized that the concept of savings is something I don't think much about either. When I do, it is usually an issue of how much I have saved in the bank, but stopping to give it more thought, its actually a lot more interesting.

The reason it's interesting is that every single dollar that every single person has can either be consumed, or invested. Because dollars represent real wealth, some valuable service or product, it has to be somewhere.  If its a physical good, it can be sitting in a warehouse, or it can be a gizmo helping an assembly line run, but it has to be somewhere. If it's a service, for obvious reasons it has to be consumed on the spot. Because really, you can't "store up" an oil change or a manicure.  What this means is that every dollar's worth of wealth created must be either consumed or invested.

Another important way to look at it is this: every dollar that you save is really a dollar that you're lending to somebody else. Even if you're just stuffing dollars bills into the mattress, those are effectively IOUs for goods or services that you'll buy back later. The problem with this is that if I'm saving, somebody else has to be borrowing, which means that not everybody can save money at once. If my balance sheet gets another dollar into the black, that means somebody else's just got another dollar into the red.

Normally this is just fine. If people in general decide they want to save more, the supply of bonds goes up and banks have more money to loan, which means that the terms for saving get less favorable for the savers (you bank pays you less interest) and more favorable for the borrowers. This makes more people willing to borrow, since the rates are a bit nicer, and less people want to save, since the rates are a bit less nice. In other words, the interest rates are the price of money, and the price will shift until the supply of money equals the demand of money. Obviously, the situation is more complicated than this, but its really not that much more complicated. Your personal decision about how much money to save or borrow is influenced by interest rates, and the interest rates shift until there's exactly as much desire to save as there is to borrow.

Here's where it gets tricky though. Sometimes, everybody gets scared, and wants to save. Something happens, and everybody realizes all at once that they're not saving enough (maybe the house that they were counting on getting them through retirement just became worth less than their mortgage). In normal times, this would be accompanied by a downward shift of interest rates until somebody wanted to take their money and spend it, often by investing in a business. These are not, however, normal times.

Because very quickly, in 2008, we discovered that interest rates have an inherent lower bound. They cannot be significantly less than zero, because stuffing cash in your mattress is effectively saving money at a 0% interest rate. What this means is that, if a 0% interest rate is not enough to get people investing, then people just won't spend or invest everything they earn. Which cannot happen.

What can happen is that the total amount of wealth created drops (and people get laid off) until people once again spend everything they earn, but now because they have to (groceries and heating bills are pretty much unavoidable). This is what's called a liquidity trap—everybody wants safe, or "liquid" assets all at once, and the interest rates cannot go lower than zero, so they can't be convinced to put their assets into riskier investments. There is a shortage of liquidity, and this is what happened to Japan around 1990, after which they had a span of anemic growth and bad times for their people. When the economics textbook on my shelf was published, this was called their "lost decade," though as it continues into roughly year 18, its hard to know exactly what to call it.

What this means for our economy today is this: there is not nearly enough spending, we cannot ask individual households to spend, since they are already in risky fiscal positions, and without being able to lower the interest rate further, businesses are unlikely to invest either, given the terrible economy they face. So, to fix this, we need to do one of two things: All agree to invest at once, or find a way to lower the interest rates below zero.

If we all agreed to invest at once, it would work out great for everybody. We'd get the stuff that we bought (I suggest things like fire trucks, schools and water systems), and once the economy picked up again businesses would be more willing to invest and borrow, which would let consumers save, allowing us to go back to "normal times." This option is, of course, government spending, in which we all agree to borrow money at the fantastically low rates the government has available (2.17% for a 10 year loan as of Wednesday) and spend it on things that need fixing, like our abysmal school and elderly water distribution system.

The other option is to find a way to further lower interest rates. The reason that this is possible is that nobody really cares about the nominal interest rate, they care about the interest rate compared to inflation. What that means is that the real interest rate, that is the nominal rate less the rate of inflation, can be less than zero. So, if we had some solid inflation, perhaps 4%, we would have room to make real interest rates negative, which would encourage investment and spending, which would, at the very least, lead to full employment.

Either one of these options would help the economy. The government spending option has the huge advantage of leaving us with better roads, water systems, and schools, as well as avoiding the risk of another housing bubble style side effect of low interest rates.  However, as a young person with a bright red balance sheet myself (school was expensive), I'd be happy with either option, because both would make it much more likely for me to spend the next decade with a good job.

1 comment:

  1. This statement may not be accurate: "Because dollars represent real wealth, some valuable service or product, it has to be somewhere." I believe dollars are fiat money that can be created out of thin air, er, electrons. It seems the Fed has been doing that recently. I remember Ben bragged about creating dollars out of thin air two years ago. If you had said 'gold backed dollar' then that statement would make sense but our dollars are currently backed by a smile and a shrug of the shoulders, especially with the tax base shrinking in our financial malaise as more dollars are pumped into banks to shore up their balance sheets by letting them buy T-bills with the new dollars so taxpayers can pay them interest on the money we GIVE them to use for free. Wish I could do that. Of course, some of the free money goes to speculate but that's another story.

    But you are right about the velocity of money being reduced. It is a major problem and one of perception of financial weakness being pervasive in so many areas of our economy by the public. I wonder, however, if spending on public works would help increase that velocity when I look at 20 years of Japan's public works having done nothing for their economy even before the earthquake and, historically, whether the US in the 30's public works had any real impact on our economy then. If judged by market activity in the 30's, it was a roller coaster of unmet expectations, hope and fear of a yet deeper depression to come.