Monday and Tuesday, I wrote as if an increase in investment
was always desirable. Sometimes it isn't.
One cause of recessions -- the generally-accepted cause of the Great Depression -- is that families
save more than firms plan to invest. If total savings (private savings + government savings) is
greater than planned investment, then firms undergo unplanned investment. (Remember that
private investment always equals total savings.) This is an increase in inventory larger than the one
they desire. Firms then cut back on production; workers are laid off and decrease their
consumption expenditures; firms, seeing demand decreasing, cut back even further on their
planned investment; the economy spirals downward.
In this case, we either have to increase planned private investment -- difficult for the government
to control -- or decrease total savings. After the jump. I'll discuss how that has been done in the
past and can be done in the future.
The effective way for the government to reduce total savings is to reduce it's own savings. Since
government savings is a signed quantity, running a larger deficit is reducing government savings.
This can be done by planned increases in expenditure, by planned decreases in taxation, and by
automatic increases in expenditure and decreases in tax receipts.
Let's take the last first. Cranks often complain that government revenues are quite sensitive to
business conditions and that government expenditures soar when the economy sours. Actually,
this is a quite desirable condition. When the economy stumbles and unemployment increases,
income tax withholding income sags while payouts of unemployment compensation increase. This
may well be enough to bridge a small tremor in demand. It will not be anywhere near enough to
deal with the present meltdown.
If government expenditures remain stable, tax cuts stimulate the economy by decreasing
government savings. They don't decrease total savings by as great an amount as they decrease
government savings because some of the money taxpayers receive is saved. (Just like government
savings, personal savings is a signed amount. To decrease your debts is to save; to decrease your
borrowing is to increase your saving.) During one of the presidential debates, Senator McCain
said that he was going to stimulate the economy by tax cuts but pay for them by spending cuts;
this would in fact restrain the economy instead of stimulating it. Economics was never
Senator McCain's strong point.
Government expenditures -- if tax rates remain the same -- stimulate the economy by decreasing
government savings. This reduces total savings by the same amount.
(In the terms discussed Monday, what we desire to restore the economy is not so much an
increase in consumption as an increase in consumer purchases.)
Marginal propensity to save
Marginal propensity to consume
Economists talk about the marginal propensity to consume. Smith's marginal propensity to
consume is how much of an increase in Smith's disposable personal income ( = after-tax income)
he will use to increase his consumption; this is expressed as a fraction. His marginal propensity to
save is how much of an increase in disposable personal income he will save. In actual economic
planning, as opposed to theoretical discussions, it is not one person's propensity but the
propensity of one class or the entire population which is discussed.
Remember that saving means not consuming; so
A) marginal propensity to consume + marginal propensity to save = 1.
When the country is seen to need more saving to stimulate investment in plant and equipment, the
right wing assumes that the rich have a negative marginal propensity to consume; this means that
a tax cut for them would induce enough saving to pay for their purchase of the treasury bonds to
supply the missing revenue plus new plant and equipment. When the country is seen to need less
total savings to dig itself out of a recession, the right wing assumes that the rich have a marginal
capacity to consume of 1 or greater; every dollar of a tax cut to them would result in stimulating
purchases. Milton Friedman got his first prominence arguing (true believers would say proving)
that the rich have the same marginal propensity to consume as the poor in the same stage of their
lives. Right wingers in other fields have argued that the rich are rich because they have superior
habits of thrift (and work) -- which would suggest that they retain the habit as a greater marginal
tendency to save. The right-wing pundits contradict each other; this does not lead to
disagreements, however, since each says that the rich have the tendency which is needed in the
situation he is addressing.
Probably, the common-sense estimate that the poor have a greater marginal propensity to
consume than the rich is accurate. A time horizon for the next decade is a luxury which is enjoyed
only by those who can afford it. (And not by all of them. Recent news reports have people buying
SUVs in response to the recent -- and clearly temporary -- drop in gas prices. SUV purchasers
cannot be numbered among the poor.)
So a tax cut for the rich is an inefficient way of decreasing total savings until it falls to the point
where it matches planned investment. A tax cut for the poor is probably a more efficient way;
direct government expenditures is even more efficient.