June 28, 2009

Fairy Tale Economics - Part 1

Politicians would have you believe most anything. They'll say anything to get elected. They themselves might absolutely believe the words they are saying when they say them. But when it comes to governing, they are often confronted with the realities of the situation that cause their promises to become forgotten promises. In that light, the GOP being regarded as the party of 'No.', on the surface appearing to be simply obstructionist, is in reality a good position to be in. It's a lot easier to promise NOT to do something, NOT to spend money and then deliver on that promise, than it is to promise to do something that turns out to be unwise or impossible to deliver upon after being elected. In that case you've got to go back on your word, or plow ahead with a bad idea that will do more harm than good in the long run.

It's one thing to believe that your solutions are smart ones when the aren't, it's entirely another and far more sinister when politicians are deliberately misleading the public into believing in a set of principles that are patently flawed. The United States as a nation finds itself in one of those situations right now. The recessionary meltdown currently being navigated by the economy is the problem, and believe it or not, the solution as it stands is a big part of the problem too. There are three distinct culprits in getting us to this crisis point: (1) President Obama (2) The mainstream news media and (3) the inattentive, gullible and naive American public. The truth is that the culpability is pretty evenly spread between those three.

The Problem

The economy is in rough shape but it can't be cured by Fairy Tale Economics. Those following the economy will look at things like unemployment rates and the stock market and draw their conclusions about the nation's health based on them (or similar indicators). But that's taking a microscopic look at an economy that has a macroscopic problem. The unemployment rate is the symptom of the problem, not the problem.

You don't solve the economic problems by solving the unemployment rate issue. That's like thinking you'll cure your cold by taking cough syrup. If it was as simple as creating jobs then as someone pointed out (source unknown), then the government could take the stimulus money and hire workers, and handing out shovels to 2 groups of people - one to dig holes and one to fill the holes back in. And why not pay them $200,000 each to do it? Surely that would be more stimulating than $35,000 each, no?

The fairy tale economics yarn that the Democrats are spinning is that the government will create jobs and demand for goods and services by creating projects and spending money on them. The politicians will argue that consumers are not demanding goods and services so the government has to step in to fill the void until consumers appetite for buying returns. The government may indeed need to fix roads, build more Hoover Dams etc., but that's not the issue here. The economy is the issue, and their solution does not work. It's pretty a simple matter to figure out why.

In the simplest context, the government has to get that money from somewhere. They have 3 options available to them (i) they can raise taxes on consumers and/or businesses (ii) they can borrow money from domestic and/or foreign lenders (banks or governments) and then pay it back later or (iii) print more money and use it for the government spending. Of course the politicians could also decide to do a combination of some of all three of those options. The result would then be a mix of the results of each option taken in isolation.

Here's where the fairy tale breaks down into three distinct lessons to be learned.


Let's look at our hole digging example above. If the government raises taxes to pay those diggers, it means it has to raise taxes on other workers or businesses to get that money. If 10 workers are paid $200,000 each that costs $2 million for the government to pay them. That means it has to pull that $2 million out of other's pockets. On the surface, the government has added no new value to the economy, just moved it from personal areas of spending to paying for holes to be dug and filled back up.

But, the politicians argue, the economy is in recession - those people wouldn't have spent that money otherwise. They would have just paid off credit card debt, or saved it in case they are worried about becoming unemployed and they need it later. While there's no certainty that that would be the case, let's assume it's true.

If those who kept that money paid off their credit card debts, it would mean they are in fact spending the money - spending it on purchases they previously made. True it's not new spending but the payments do have an economic impact. The financial institutions, at the crux of the economic mess, become more solvent because they don't need to worry as much about potential bad debt. If they never got paid back for the credit they extended, they might collapse causing a much bigger drain on the economy. Even if they don't collapse, without the flow of being paid back, they would continue to be stingy with their new lending, thus acting as a brake on the economy.

Banks do not need to keep one dollar for every dollar they lend. They can lend $10 for every dollar they have on deposit. That means they can lend out $90 dollars. That means in our simple scenario the banks could lend out $1.8 million. If the hole diggers who got the $2 million put 50% of it (unlikely) into the bank then the bank would have $1 million more on deposit and could effectively lend out $900,000.

If the borrowers then writes a check to someone else who deposits the $1,800,000, the bank receiving that deposit can lend out again - $1,620,0001, and so on. The net effect is the potential amount of money in the system is increase by $20 million if the government does not tax it, and $10 million if the government does tax it, gives it to these workers and they save half.

That is, if the assumption that the assumptions about the ditch diggers depositing half of their pay into the bank holds true. In reality it would be much less. On the other hand we could assume that the newly hired ditch diggers and the other workers who are being taxed to pay for them all behave in the exact same way - they spend as much and deposit as much as each other. In that case there is no change in economic effect because $1 of those taxed and $1 of those paid would be applied the same way. In tat case, we are looking at a transfer of wealth, and not a stimulus because no matter where that dollar is - it will deposited or spent the same way.

The other reality is the psychological impact of a new level of taxation. If you are going to be taxed more, you are likely to spend less as a result. That has a negative, but not precisely measurable impact on the economy.

The economy requires that people spend. The economy therefore requires that people sell. The economy requires that people save so that banks can lend and multiply the value of every dollar in the economy. Lending leads to spending which leads to new things being built or made. That is wealth creation. Simple Supply and Demand dictate that the money will ultimately flow to where the economy most needs it. If we are short golf balls, more end up produced without any government bureaucrat saying let's produce more. When the government steps in to alter that system, it impedes the natural flow of the economy. The real argument about digging the holes is this - does digging and then fill in a hole do more for the economy, more for the country, or more for society than allowing that money to be used to manufacture computer chips for sale in laptop computers? Obviously not.

So the real question is - what does the government have planned for all this stimulus money? What can we compare private industry production against to see if we are all benefiting more by what the government wants to do than what the unimpeded economy will produce. The problem is all this money about to flow into the economy isn't precisely directed anywhere. It's such a mish-mash that being able to judge it fairly is impossible.

And that, is exactly what the Democrats want.

NEXT UP: Of course taxation isn't the only alternative for getting money into government's hands to be spent. Democrats would rather have you believe you are getting something for nothing. It's painless and therefore seems like a free lunch. They way that is achieved is to borrow money for the government to spend. In Part 2 - the borrowing option.

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