Today (14 Nov 08) President Bush called for $25 Billion in loans to the automobile industry. If Mr. Bush really believed in his “market work best” philosophy he would not be asking for these loans. Instead, he would say that the companies should file for bankruptcy under chapter 11. Chapter 11 allows companies to continue in existence while they reorganize. However, the current leadership of the companies, the basic constituency of Mr. Bush, would not be protected. In addition, the golden parachutes of the corporate elite could be nullified by the bankruptcy courts. The President who personifies the politics of greed could never allow this to happen.
On top of the protection of the current management, we are faced with continuing the support of the very people who made the errors which drove the companies to the brink. For the most part, these are the people who decided that they should rely on vehicles that can only be sold when energy is cheap. They gave up on basic transportation and pushed brobdignagian vehicles where it was possible to joke that the best measure of efficiency was gallons per mile rather than miles per gallon. They took the attitude that they were too big to fail. This may have some truth in the financial sector. However, reorganization is often the best solution in the manufacturing sector. If we want to bail them out and minimize the consequences the government should say that they will supply the financing only after GM files for Chapter 11. This will allow for reorganization without the burden of the current incompetent management and will allow the firm to renegotiate some of its most onerous obligations.
Saturday, November 15, 2008
Monday, November 03, 2008
Why Government Spending Over Tax Cuts?
In my last blog I indicated that increasing government spending has a larger impact on the economy that tax cuts. A reader has asked me to explain this as a Part 2 to that blog and I will take this opportunity to do so.
The problem arises from something called the multiplier. Whenever income is spent it becomes income to someone else. People do not spend all of their income. Some is saved, some is used to pay down debt, and some is spent overseas (imports). The multiplier is 1 divided by the proportion of new income not going to spending. To get the total re-spending effect we multiply the initial spending by the multiplier. If on average people do not spend 10% of their new income then the multiplier would be 1/.10 = 10. Therefore, a tax refund of $100 million would result in initial new spending of $90 million and a total re-spending effect of $90 x 10 = $900 million.
On the other hand, if the government builds new roads equal to $100 million the initial new spending is the $100 million. The total re-pending effect would then be $100 million x 10 = $1 trillion. A little algebra indicates that getting a $1 trillion increase in economic activity would require $111 million in tax cuts. In this simple example tax cuts would cost the treasury 11% more than increases in public spending. Lets face it, this means 11% higher cost to us. Either way the government would be required to borrow. The issue is which leads to a lower debt?
The right wing says so what if tax cuts cost more; we know how to spend our money better than the government does. The question is: do we? Will we spend our tax cuts rebuilding our infrastructure? Will we install sewage treatment plants? Will we invest in clean coal research? All of these things need doing but the private sector returns for doing them are limited.
The problem arises from something called the multiplier. Whenever income is spent it becomes income to someone else. People do not spend all of their income. Some is saved, some is used to pay down debt, and some is spent overseas (imports). The multiplier is 1 divided by the proportion of new income not going to spending. To get the total re-spending effect we multiply the initial spending by the multiplier. If on average people do not spend 10% of their new income then the multiplier would be 1/.10 = 10. Therefore, a tax refund of $100 million would result in initial new spending of $90 million and a total re-spending effect of $90 x 10 = $900 million.
On the other hand, if the government builds new roads equal to $100 million the initial new spending is the $100 million. The total re-pending effect would then be $100 million x 10 = $1 trillion. A little algebra indicates that getting a $1 trillion increase in economic activity would require $111 million in tax cuts. In this simple example tax cuts would cost the treasury 11% more than increases in public spending. Lets face it, this means 11% higher cost to us. Either way the government would be required to borrow. The issue is which leads to a lower debt?
The right wing says so what if tax cuts cost more; we know how to spend our money better than the government does. The question is: do we? Will we spend our tax cuts rebuilding our infrastructure? Will we install sewage treatment plants? Will we invest in clean coal research? All of these things need doing but the private sector returns for doing them are limited.
Sunday, November 02, 2008
THE POTENTIAL FAILURE OF MONETARY POLICY
Writing in today’s (10/31/08) New York Times Paul Krugman labeled our current financial crisis a “Liquidity Trap.” This is a situation where attempts to lower the interest rate have no effect on investment spending by businesses. The USA hasn’t seen a Liquidity Trap since the great depression. Now, analysts are predicting that the Fed might lower the Fed Funds Rate, the rate at which banks lend to each other, to zero. The Japanese tried this during their economic malaise of the 90’s and it had almost no impact.
Although the current condition of the US economy is unlike that of the 90’s economy of Japan, we are faced with a similar question. That is: are banks willing to lend? The current answer in the US economy is NO! Banks are in panic mode. As the Fed pumps money into the system, the money supply will continue to shrink because the banks are unwilling to lend. On the other hand, businesses are only willing to borrow to meet working capital (short-term) needs rather than capital expansion. With consumers worried about their futures, they have reduced their discretionary spending. An absence of demand will lead to a reduction of businesses' plans for capital expansion even if they can borrow at minimal cost. This situation points up a flaw in Supply Side Economics. The Supply Side assumes that falling costs of capital will induce investment. It ignores the behavioral element which indicates that executives would be hard pressed to recommend expansion when they have excess capacity. In addition, market analyst would pillory executives trying to expand capacity during an economic down turn.
All of this indicates that McCain’s economic plan that is based upon increased saving leading to reduced costs of capital and Bernanke’s monetary expansion will have little or no effect upon an economic recovery. The great depression, and Keynes, has taught us that demand is still the primary determinant of economic activity. The Supply Side mantra of Say’s Law: “…supply creates its own demand…”works only in an economy that is already recovering. What the economy needs is a stimulus to demand. Given the deteriorating condition of our national infrastructure this would be best accomplished through an increase in government spending rather than tax cuts. In addition, it is well known that accomplishing a given increase in economic activity costs more with tax cuts than it does with an increase in government spending. Explaining the reasons for this would take too much space for a blog. However, Mr. Obama should take note of this problem if should he be elected.
Although the current condition of the US economy is unlike that of the 90’s economy of Japan, we are faced with a similar question. That is: are banks willing to lend? The current answer in the US economy is NO! Banks are in panic mode. As the Fed pumps money into the system, the money supply will continue to shrink because the banks are unwilling to lend. On the other hand, businesses are only willing to borrow to meet working capital (short-term) needs rather than capital expansion. With consumers worried about their futures, they have reduced their discretionary spending. An absence of demand will lead to a reduction of businesses' plans for capital expansion even if they can borrow at minimal cost. This situation points up a flaw in Supply Side Economics. The Supply Side assumes that falling costs of capital will induce investment. It ignores the behavioral element which indicates that executives would be hard pressed to recommend expansion when they have excess capacity. In addition, market analyst would pillory executives trying to expand capacity during an economic down turn.
All of this indicates that McCain’s economic plan that is based upon increased saving leading to reduced costs of capital and Bernanke’s monetary expansion will have little or no effect upon an economic recovery. The great depression, and Keynes, has taught us that demand is still the primary determinant of economic activity. The Supply Side mantra of Say’s Law: “…supply creates its own demand…”works only in an economy that is already recovering. What the economy needs is a stimulus to demand. Given the deteriorating condition of our national infrastructure this would be best accomplished through an increase in government spending rather than tax cuts. In addition, it is well known that accomplishing a given increase in economic activity costs more with tax cuts than it does with an increase in government spending. Explaining the reasons for this would take too much space for a blog. However, Mr. Obama should take note of this problem if should he be elected.
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