Of Banks, Stimulus, and the Future--Part II


I want first to consider the following argument, made by a number of conservative economists, against the $787 billion stimulus enacted by Congress in February. The argument is that since savings equals investment, if the government borrows money to finance public investment (say in the form of a public-works program, such as highway construction or repair) this reduces by the identical amount the money available for private investment; and therefore only if the public investment is more valuable than a private investment of the same size is the public investment, and hence the stimulus, a worthwhile anti-depression measure. I disagree.

To begin with, not all savings are forms of investment in an illuminating sense. One form of savings, which is quite attractive in a depression especially if there is deflation (and, as I explained in a previous entry, we are experiencing a mild deflation at present), consists of putting cash in a safe or safe-deposit box, or even under the mattress. Such money is not invested, unless investment is defined as deferred consumption so that if I put money under my mattress I am in effect deciding to spend it sometime in the future, and knowing this firms will invest to create the productive capacity to meet my increased future consumption. But that is not a good definition of "investment." I may be refraining from spending not because I have any definite intention of spending the sum saved in the future but because I want cash on hand to meet a possible urgent need for it--a common concern during a depression and one that helps explain the surge in the personal savings rate since last fall. In fact the amount of currency in the economy has increased substantially since then and the sale of safes has increased as well.

Critics of Keynesian deficit spending as a depression remedy may reply that, setting the mattress example to one side, if I have decided to lend my savings in some form it will be borrowed by either a private investor or the government, and there is no reason to think the government will use the borrowed money more efficiently. That is, if I have $100 in a demand deposit account, meaning that I have lent the bank this amount (depositors do not own the money in their deposit accounts; they are merely creditors of the bank), the bank can lend it either to some business or to the government. The government will be interested in borrowing the money because, to finance a Keynesian public-works project, the government must borrow the cost of the project (unless it raises taxes--and at present it is reducing rather than raising them, in order to help fight the depression). One way it can do this is by selling a Treasury bond to the Federal Reserve.

But this picture is overdrawn. If the government does not borrow the money in the depositor's account from the bank, it does not follow that the bank will lend it; the bank may instead decide to add the money to its "excess reserves"--that is, to its cash hoard. Or the government may borrow the money to pay for the public-works program not from an American bank but instead from foreigners--foreigners finance a great deal of our public debt. And if the government follows that route it will not be withdrawing any cash from the American economy. In both cases, the expenditure of the $100 in my bank account on public works will be a net addition to investment and thus contribute to increasing output and employment.

Furthermore, the fact that there is money available to be invested doesn't mean that it will be invested even if banks are eager to lend money to entrepreneurs. If entrepreneurs are afraid to invest in a depression, as many are, because they are uncertain about what the business environment will be when any investment they make is completed, then even if the money is deposited not in a demand deposit but in a money market account it may not increase the amount of investment. The money be largely inert from the standpoint of stimulating economic activity.

What is true is that if any of the money that the government is borrowing to finance public works would have been invested privately, the withdrawal of that money from the private sector will raise interest rates, and in turn dampen private investment. But the negative effect on investment may be much less than if the money remained in the form of precautionary savings. It is also true, however, that heavy government borrowing to finance a Keynesian anti-depression program exacerbates the "depression aftershock" problem, of which more presently.

There is a further difference between private and public investment during a depression, a difference in timing as distinct from size. A well-designed Keynesian program (unfortunately the current program is not as well designed as it could be, because of political pressures) is geared toward channeling as much money as possible into investment and production as soon as possible, moreover in the industries hardest hit by unemployment. Private investment of the same money might proceed at a more leisurely pace, because it might be oriented not toward filling potholes (say) but instead toward building factories that might take years to be completed and employ few unemployed workers.

There is a further and decisive reason for a Keynesian anti-depression program, and that is to restore confidence. Fear of the economic environment in a depression causes both business and consumers to freeze and hoard, rather than invest and consume, and that freezing and hoarding cause output to fall and unemployment therefore to rise. Confidence (hope, optimism) could not be restored by monetary policy and bank bailouts alone during the present economic downturn because these measures were having only a limited effect in pulling the economy out of its hole. They no doubt made the depression somewhat less severe, but they were not arresting the downward spiral but merely slowing it down. The government had to show the public and business its resolve to beat the depression, and the enactment of an ambitious program of deficit spending was the key to showing that. The slight improvement in the economy in the last month may be due in part to a general feeling that the government is tackling the nation's economic situation vigorously, makiing it safe for business and consumers to loosen the purse strings slightly.

But what about the long-term effects of the anti-depression programs--the "aftershock" that I mentioned? The government has created a great deal of money, and borrowed a great deal of money, to finance the bailouts and the stimulus package and increase the amount of money in circulation (to help push down interest rates). If when demand rises the banks lend their $800-plus billion in excess reserves, the ratio of money in circulation to the output of goods and services is likely to rise--and this will mean inflation. The ratio will rise further if the government decides to finance some of the huge additional debt that it is incurring as a result of its anti-depression expenditures by increasing the money supply, that is, by inflation, which is a form of taxation--taxation of cash balances. A low rate of inflation is manageable and does little economic harm, but a high rate is very harmful, and can be broken usually only at the cost of a sharp recession (consequent upon a sharp rise in interest rates in order to reduce the amount of lending and hence the amount of money in circulation). And the recession might (as in 1937) disrupt a recovery from the depression. These costs have to balanced against the benefits of the anti-depression programs; unfortunately only guesses are possible.

Another long-run effect of a depression goes by the name of "moral hazard," a term best illustrated by the tendency to be less careful than otherwise if you are well insured against the consequences of your carelessness. If the government is expected to make vigorous efforts to dampen the consequences of a bust, investors and consumers will be less cautious in a boom. In particular, if the secured creditors of large financial institutions are confident that they will be insulated against default, they will not only lend more to such institutions but also make fewer efforts (which are costly) to police the conduct of their debtors. (Hence the shellacking that the secured creditors of Chrysler are taking is the silver lining of the cloud that that shellacking has placed over secured credit.)

Another possible long-term consequence (which may also be a short-term consequence) of the current depression is worth considering. There is recent speculation in the media that Americans will not return to their "free-spending," debt-financed ways. The personal savings rate bounces around a lot. It was 10 percent in 1980, declined pretty steadily after that, reaching negative territory in 2005, but since last fall it has risen from about 1 percent to more than 4 percent. The question is whether it will remain there or instead return to the 1980 level. I am skeptical that we are entering an era of thrift. Memories are short, and I argue in my book that the low savings rate is due in part to the impressive ability of the modern marketing profession to separate people from their money.

What seems more likely is that the composition of people's personal consumption expenditures will change. This depression has been marked not only by a shift from consumption to savings but also by a change in consumption. A wealthy friend of mine who owns three cars that he used to turn over every two years has decided, in reaction to the modest losses in his investment portfolio that he has experienced recently, to wait another year before buying a new car. Because modern cars are of high quality and durability, and design changes from year to year are modest, he may discover that changing cars every two years isn't worth the expense and bother. People who have reacted to their losses by moving a notch down the luxury-goods hierarchy from Nieman Marcus may discover to their surprise that they are quite happy with the switch. And the terrible decline of the newspapers may turn out to be permanent as people switching to free news on the Internet to avoid the cost of subscribing to a newspaper decide they prefer obtaining their news electronically.

Contrast the current depression with a recession or depression in which sales of every category of consumer product falls by the same percentage. Then when demand returns to its pre-recession level the sellers will rehire laid-off workers, and increase their purchases of supplies and materials, until they are back to their pre-recessions levels. But suppose that demand for the output of a major industry, such as automaking, does not return to its previous level. Then some of the laid-off workers in that industry will have to find jobs in other industries--jobs for which they are not trained--and those jobs may be in other parts of the country. And suppliers to the industry may have to retool. The need for such adjustments in labor and materials supply will delay recovery. This is one reason why the recovery from the current depression may be slow.

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Richard A. Posner

Richard Posner is an author and federal appeals court judge. He has written more than 2500 published judicial opinions and continues to teach at the University of Chicago Law School. More

Richard A. Posner worked for several years in Washington during the Kennedy and Johnson Administrations. He worked for Justice William J. Brennan, Jr, the Solicitor General of the U.S., Thurgood Marshall, and as general counsel of President Johnson's Task Force on Communications Policy. Posner entered law teaching in 1968 at Stanford and became professor of law at the University of Chicago Law School in 1969. He was appointed Judge of the U.S. Court of Appeals for the Seventh Circuit in 1981 and served as Chief Judge from 1993 to 2000. He has written more than 2500 published judicial opinions and continues to teach at the University of Chicago Law School. His academic work has covered a broad range, with particular emphasis on the application of economics to law. His most recent books are How Judges Think (2008), Law and Literature (3d ed. 2009), A Failure of Capitalism: The Crisis of '08 and the Descent into Depression (2009). He has received the Thomas C. Schelling Award for scholarly contributions that have had an impact on public policy from the John F. Kennedy School of Government at Harvard University, and the Henry J. Friendly Medal from the American Law Institute.
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