Economic Policy in a Nutshell

In a previous post (Economics in a Nutshell) we established a conceptual framework for reducing economics to the simple decision of when to consume (now or in the future?). We expressed this through the following equation, calling it the Inter-temporal Consumption Ratio (ICR):

Cfuture < divided by > Cpresent   < or >  Cf / Cp

The changes in this ratio will help determine the level of savings, investment, production and economic growth. However, before we can apply policy to our analysis we need to address two important factors that will affect the ICR over time. Economists have documented recurrent patterns in the ebb and flow of consumption, savings, investment, and production. One is the “lifecycle hypothesis” that shows greater consumption and lower savings at the beginning and end of life, among the young and the old. Saving and producing is maximized during the middle “working” phase of our lives. So, the consumption pattern of the entire population will be influenced by the demographic distribution of that population. In the U.S., this has been most noticeable with the economic boom associated with the postwar baby boom generation during its most productive middle-aged years.

Another natural pattern is associated with innovation waves in technology. Consider the impacts of the industrial revolution, the development of such technologies as the railroads, steel production, electricity, the automobile, telegraph and telephone, airplane transportation and, more recently, the development of the microchip, the personal computer, and the Internet. During periods of technological advancement, consumption is deferred as investment is poured into new productive opportunities. This is facilitated by rising interest rates, increased saving, increased productivity and economic growth.

These two cyclical patterns of demographics—or population growth—and technological progress are the true determinants of economic growth rates. If the population is growing and new technologies are being developed, economic growth takes care of itself. The problems arise when either population growth or technology or both fall into periods of retrenchment or stagnation. For example, the productive baby-boomers are entering their retirement years, so we can expect their consumption levels will increase, depressing savings and investment and economic growth. At other times technological innovation will stall. But neither innovation nor population demographics are really responsive to short-term government policies, and there lies the rub for the politicians and policy professionals. What to do when economic growth stagnates?

The economy stagnates when present consumption demand is inadequate or investment collapses, (both of these economic variables actually depend on each other in a feedback cycle over time – remember, everything economic derives from the ICR). The policy response has been to pull consumption toward the present and jumpstart productive investment. By our simple ICR, we can see how lower interest rates and government spending stimulus would promote these results. One problem is that increasing present consumption will reduce savings needed for investment, so the policies would seem to be contradictory. We overcome the problem of financing both consumption and investment at the same time by borrowing. This explains the explosion of debt over the past twenty years, and especially the explosion of public debt since 2008.

Now we can see the source of the true problem we face today. For thirty years we’ve been “stealing” consumption from the future by borrowing against the present. (What do you think all those re-fis are?) The borrowing initially went into the information technology revolution, but when that slowed the excess demand went into asset speculation—in commodities, in financial assets and in housing. When the bubbles in these markets popped, credit for investment dried up completely. Consumption collapsed as people feel the need to pay down their debts as their assets lose value. The economic downturn then threatens incomes, which fail to support the service of the debt. In other words, houses and financial assets lose value, people lose jobs and the economy falls into a downward spiral. There is no easy solution to this problem, short of a magical new technology wave. Unfortunately, they can’t conjure this up in Washington D.C.

In addition, our vain attempts to reflate a bubble are distorting all the price signals in the economy that would tell us how we should be allocating our consumption, saving and investment in order to grow again, at whatever pace. The added uncertainty and misallocation hampers the economy as we struggle, but fail to get up off the mat. (Remember, the economy is really us. No people, no economy.)

The foregoing is meant to help us understand what is happening and how to make sense of the gobbledygook coming out of Washington. There is no painless elixir that can set everything straight again, and if we think policymakers in Washington have some magic solution then we’re merely smoking fairy dust. But the important lesson to take away is that we can understand what the ultimate economic effect of policy will be if we understand how it will affect our desire or propensity to consume now or later. Economic disequilibria (a fancy word meaning imbalances) occur when the balance between the present and the future gets skewed too much either way.

For a more thorough exposition refer to Common Cent$: A Citizen’s Survival Guide.