You Can’t Cut Your Way to Growth Part 2 Government and Exports

Previous Parts: Part 1 and Part 1b

The take away for this last part is that if someone is against a budget deficit and against a falling dollar, then they are for a smaller economy and more unemployment.

For this last part I’m going to skip using phrases instead of equations. It would just be too long to write things out that way. The main point of these blogs is to point out the silliness of much that we hear in the media and from politicians. Somehow a worldwide financial crisis and the busting of the biggest real estate bubble in history has turned into an effort to cut the US budget.

That the proponents of these cuts are arguing that 2+2 doesn’t equal 4 doesn’t seem to bother them. Some have proposed that it is a feature not bug. The Republicans know what they are arguing will kill the economy but they see that as a way to wrest the Presidency from Obama. The other option is that they just don’t realize what they are saying is a war against basic arithmetic. I tend to throw my lot in with the first group. Clearly nothing the GOP has done, or refused to due, like allow the Senate to vote, has had anything to do with helping the country and everything to do with harming Obama.

We are all familiar with the Gross Domestic Product (GDP) measurement of the economy. It measures the value of all goods and services created in the economy during a set time period. Equivalently, it also measures the amount of income people have received in the economy. To understand why the two ways are equivalent we just need to realize that every dollar someone earns as income has to come out of the pocket of someone else as spending.

So lets look at the different components of GDP.

GDP = C + I + G + (Exp – Imp)

C is personal consumption. I is investment by firms. G is government spending. (Exp – Imp) is exports minus imports.

Just to help clear the cobwebs lets imagine for a moment that all the variables on the right side of the equation are independent. That is , if one variable changes that doesn’t imply any particular change in the other variables. The other variables stay the same. Hopefully it is clear that, in that case, when a particular variable goes down then GDP goes down. Consumption goes down, everything else stays the same, so GDP goes down. It may seem odd to argue for basic arithmetic but, as we shall see, those taking certain positions are essentially arguing against it.

On this basis it should be clear that anyone arguing one component of GDP can go down without the economy shrinking must be arguing there is some mechanism that makes another component go up. So what are the mechanisms and how do they apply to current conditions?

Consumption, Investment and the Interest Rate
Today the rate of consumption has dropped from previous levels. Mostly this is due to people realizing the the owe more than there stuff is worth. Housing prices have crashed and people now want to pay down their debt. The private savings rate has swung from -3% before the crash to +5% now.

In normal times a drop in consumption is not such a big deal. As the amount of money being saved goes up the interest rate drops and businesses borrow that saved money to invest. While that is happening now, it is not happening at a rate to make up for the lost consumption (increased saving). Back in Feb 2009 the Fed estimated that the interest rate would have to be -5% in order to induce businesses to invest enough to make up for the drop in consumption. But, banks don’t pay people to borrow money so the actual interest rate is 0% and can’t go any lower.

Crowding Out and Future Taxes
Now we have people who say they want to see G go down too. Even President Obama has said the government needs to tighten its belt too. As we’ve seen, if G is going down, then we have to have a mechanism for something else to go up or GDP itself will shrink.

Crowding out is a phrase most often thrown around by the right but all economists admit there is at least something to it. Imagine a healthy economy where the interest rate is just right to get firms to invest all the money people are saving. Now, imagine the government comes along and wants to borrow some of that money too. The increased demand for loanable funds will cause the interest rate to rise. Because of this rise, some firms will decide not to borrow in order to invest. So in this case G going up has made I go down.

There is debate about how important the crowding out effect is even during normal times. Some of the things government borrows for are not things the private world buys. Roads and education would be two good examples that are known to have very high returns in terms of growing GDP. So there is debate on how much of a government spending increase just raises GDP and how much of the additional spending are eaten up by decreased investing (crowding out).

These aren’t normal times however. We’ve already seen that investment isn’t keeping pace with decreased consumption even. It is hard to imagine that the government increasing saving even more would somehow spur more investment. Another way to say this is , if interest rates want to be at -5% now and government spending, in effect, pushes that up to “only” -2% we are still at a desired negative interest rate. The actual rate will stay at 0% and there will be no crowding out.

Since there is no crowding out presently, the reverse case where we actually decrease government spending will cause GDP to shrink. There is no pent up, crowded out investment waiting to take over from the government. In fact, right now we should expect higher government spending to have a crowding in effect. Since all of the spending will go to propping up or increasing GDP firms should be slightly more willing to invest at any given interest rate.

Future taxes is another mechanism sometimes proposed for how cutting government spending might help. The idea is that by looking at the deficit people get so afraid of future tax increases that they stop spending or even drop out of the workforce because why work if it is just all taxed away. The problem is there is very little evidence that such an effect exists. There are many reasons for it but the bottom line is that most economists consider future taxes concerns as a disproved idea. See here for more.

So, it’s 2 strikes for deficit reduction. Now on to international trade.

The Exchange Rate
So, consumption is down, investment is not up enough, and the pain caucus wants to cut the deficit. That only leaves us with the trade portion of the GDP equation. Right now our Exports – Imports is negative, we import more than we export. Still this portion of GDP is actually pretty small. I forget the actual number but international trade (exports and imports) is only about the size of 10%-15% of GDP.
So there doesn’t seem to be a lot of hope to get to where we want with using trade. Still lets look at how we might go about growing exports.

The number one thing that drives the trade balance is the value of the currency. Let’s see how it works. Let’s say our currency goes up from a given level (becomes stronger). In that case it becomes more expensive for other countries to buy the dollars that they need to have to purchase American goods. On the flip side it becomes less expensive for us to buy the foreign currency we need to buy their goods. In this case our trade deficit would become larger. I.e. Exports – Imports becomes more negative. If the opposite happens we get the opposite results. It becomes less expensive for other countries to buy the dollars they need to buy American goods so they buy more. It also becomes more expensive for us to buy the foreign currency that we need to buy foreign goods so we buy less of them. In that case the trade deficit goes down.

This is the only short term mechanism known for changing the trade portion of GDP. If you are against the dollar falling then you are against the trade portion of GDP adjusting to make up for the shortfall in consumption (if it can even change that much realistically anyway).

Strike 3 you’re out
This is strike 3 for our group against deficits and strong dollar advocates. Consumption is down due to people paying off debts. Investment is not picking up all the slack due to a unpleasant economic outlook and interest rates not being able to adjust to negative values. But the pain caucus is ideologically opposed to keeping government spending elevated and to the dollar falling (they call it debasing the currency). So they have come out against the only two possible means to make up for the Consumption+Investment shortfall. There is only one conclusion. Whether they know it or not they are arguing for the GDP to fall and therefore for more people to be out of work. This conclusion has very little to do with any particular economic theory. It is a result of basic arithmetic.

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