Tuesday, June 29, 2010

Getting Capitalists to Act Like Capitalists

There is a common argument against austerity and in favor of further fiscal stimulus going around resting on this equation:

Net Private Sector Financial Position - Net Government Deficit = Current Accounts Surplus (ie, net exports)

The idea is that, as a matter of arithmetic necessity, the balance sheet of the private sector must match that of the government sector, plus that of any external trade.

Martin Wolf, among others, have used this as a case for further government stimulus. The private sector, the argument goes, is deleveraging as a matter of necessity after a severe shock. The export channel may be a useful boost for certain countries, but cannot be helpful on a global scale since the exports of one country necessarily match the imports of another. Additional government borrowing remains the only way to sustain a proper global recovery.

Rob Paranteu, referenced by Steve Waldman, cautions us on this interpretation. As an arithmetic identity, this equation must necessarily be true. Yet nevertheless it elides certain distinctions within the private sector.

Paranteu reworks this equation to arrive at the following form:

Net Household Income = Current Account Surplus + Net Government Deficit + Change in Business Non-Financial Assets

The interpretation here is that the private sector can be divided up into households and firms. Rather than "the private sector getting rid of debt"; instead we should think about what is going on within the private sector. Are households gaining income? Or are businesses losing the value of their assets? This is a more complicated story than one involving only the private sector and government, but it brings out the fact that we really care about the income in the household sector as the final output, and that can come about through several channels.

Certainly, exports and government debt are two of these channels. But another, under-explored area lies in boosting the value of business assets.

Here, I think, we can draw a line to the fact that business are now hoarding record amounts of cash. Rather than re-investing profits, and thus driving economic recovery, firms remain cautious. The net effect of everyone remaining cautious is a damp economic recovery. Fiscal stimulus would work by putting unused capacity to work either directly or indirectly as a result of government intervention. But we can imagine alternate stimulus programs that boost the economy by raising firms propensity to invest and garner assets.

In other words--we need capitalists to act like capitalists. We need firms to invest capital to create productive investments.

Parenteau recommends that we impose taxes on firm earnings that go uninvested for long stretches of time, or else tax them for unproductive casino-finance style investments--ie, ways to force firms to invest more today. Steve Waldman calls for measures to improve the value of private sector assets, such as inflation or rising productivity.

I think this is the right way to think about it. Rather than merely shoveling money around, trusting that it will have an effect by way of hydraulics; or trying to retain a pre-crisis level of government which is clearly unsuitable for today's needs--it would be better to think of what sort of targeted interventions can bolster productivity and investment. I can think of a few ways to do so:

1) Monetary Stimulus: Waldman gives this a bad name, but as David Beckworth notes, reasonable measures of inflation show that monetary policy was unduly tight during the critical period from late 2008-2009, while expected inflation remains very low today. As long as money remains tight, firms and households are more likely to hoard money. Simple price level targeting, as Bernanke advised Japan, would have the effect of boosting aggregate demand, raising the value of firm assets, and raising the confidence level of firms so that they are willing to invest today.

2) Prioritize Investment in the Tax Code: Martin Wolf has an excellent proposal on this issue, which I'll reproduce here:

First, it would be extremely helpful to reform the taxation of companies, to promote investment. In an interesting discussion of this issue, Andrew Smithers of Smithers & Co argues that a radical reform of corporation tax, to end interest deductibility, offset by a lower rate of tax, would reduce indebtedness and lower the pre-tax return needed to achieve a given post-tax return on equity. The result should be a bigger capital stock. Such a measure could be combined with higher deductibility of investment, which would be helpful to manufacturing.

Though mentioned in a different context, I think it is very relavent here. The Lib Dem/Tory government, it should be noted, also have a related proposal: they are pushing a rise in the VAT forward, so as to increase consumer spending now; while cutting corporate taxes today, encouraging investment right now as well.

Even if you believe that government stimulus is all you need--it's worth thinking about multiple ways to boost growth. And if you are at all worried about the high levels of government debt, yet also think that 10% unemployment is unacceptable--this seems like the thing to do.

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