The Wrong Analogy

I’m not an expert in economics, but I am trying to make heads or tails of the growing debate over what to do about our economy.  We’ve pulled back from the brink we were on early last year.  But now we’re stalled. There’s a non-trivial chance we’ll fall back for a double dip recession similar to what happened in 1937.  There’s also some chance the world confidence in the dollar will fall and we’ll go into full-blown collapse ala Greece.  Then there’s a large chance we’ll just languish with 10% unemployment and be dead in the water like the Japanese were through most of the 90’s.  Oh yeah, and there’s some small possibility we’ll actually get things humming along again so we can all see our 401k’s at 2007 levels and have lots of job prospects for us and our children.

Many are calling for fiscal austerity, arguing that large deficits are the road to ruin.  Many of those same folks are calling for the Fed to raise interest rates as a hedge against inflation.  On the flip side, others argue that more government stimulus is needed and that we need to spend our way back to prosperity.  Frankly it all makes my head hurt.

Let’s start with the common ground.  No one thinks deficits are a good idea.  Most can agree that there are times where you borrow money to make appropriate investments, but that running deficits year on year without ever seeing the plus side of the balance sheet is not a healthy thing.  As a minimum, I would very much like to see everyone remember this the next time we do have a thriving economy so that we actually raise taxes or cut spending such that we get to a debt neutral position.  But that’s water over the dam now.  The issue is figuring out how to get out of where we are.

The austerity folks are fond of making the analogy of the U.S. economy to your household.  That is, if you lose your job or otherwise are taking in less money, then you need to cut back your expenses such that you are also paying out less money.  Responding to a layoff notice with a spending spree at Best Buy would be pathologically stupid.  There’s additional rationale that if there isn’t a show of some fiscal discipline, creditors will lose faith in the ability to pay the debts and call the notes due.  This would effectively result in bankruptcy.

There’s an elegant simplicity to that analogy, but after careful consideration, I think it’s the wrong one.  The major missing element is that in the home analogy, your spending doesn’t have a relationship to your income.  But in the U.S. economy case, it does.  That is, if people are broke, if goods are not sold, then there are no tax revenues to collect.  But I think there’s a simple analogy that does reflect this relationship.

Consider a small family business, let’s say a local Bar & Grill.  The tavern falls on hard times because the factory up the road shut down and a lot of their regular customers no longer have lunch there or hang out there after work.  As the owner, you’re faced with a significant drop in revenue.  You have two basic choices.  You can try and restructure your business to fit within the revenue you’re making, or you can borrow and invest in things to attract new customers.  While there may be some things you can do to cut costs, many of the obvious things you might try will ultimately hurt your business.  Reduce the variety and quality of the food menu.  Reduce staff.  Reduce hours of operation.  Water down the drinks.  Sure, these things save you money, but they likely will also cost you revenue as additional customers will become disappointed and leave.  In general, this strategy is a death spiral.  Alternatively, you could gather a few local investors to finance adding a stage on the back and offering live music.  Do additional advertising.  Hire a top chef to create an exceptional menu.  These things have the opportunity to expand your business, and thus your revenue, which hopefully you’ll use to pay down your debt.

Yet even in this analogy, it’s important to recognize that there are no guarantees.  Yes, maybe in the austerity case you’ll get lucky and some new company will re-open the factory and your business will take off again.  Yes, in the investment scenario you might make lots of improvements, and still nobody comes to your establishment and you go under with additional debt.  The key difference for me is that the austerity case is entirely hanging your future on luck and prayer.  It’s outside of your control.  While the investment scenario gives you a path to drive your own success, or at least die trying.

Bringing this back to the U.S. economy, it means to me that the federal government needs to keep investing.  Not spending wildly, but investing smartly in things that have future upsides.  Green energy technology comes to mind as a great industry investment.  In general, loans to small businesses and start-ups.  Unemployment payments to keep people off the state welfare rolls such that they prop up consumer spending so that larger companies stop hoarding cash and go back to investing in their own businesses.  Not every program will work, but we need to keep trying.

There is a time to be frugal, but this isn’t it.  There is no indication this is a passing storm such that if we just hunker down we’ll be fine in a few months.  The storm has already ravaged the town.  We need to decide whether to rebuild or to decide to get used to living in the rubble.

6 thoughts on “The Wrong Analogy

  1. Here’s where I think the analogy falls through, or at least needs to be reexamined. Why do they want to save the family Bar and Grill? Because it is the family’s livelihood most likely. If they remodel then they would probably put their personal assets on the line. If business rebounds then the bar owner would reap the windfall. But the whole point of the economy is not to make the government (the bar owner) more wealthy, it is to serve the needs of the people. If the government borrows money, it’s not from the bank, it’s from the people. So in your analogy, the bar owner would have to borrow from his customers. OK, but then the customers have less money to spend at the bar and grill. By actively trying to save his business he could be dooming it by taking his customer’s disposable income. I think this analogy works because a lot of the economy’s problems are caused by the government. The government is a drag (through taxes) on the economy. The best thing for the economy may be to lower the tax burden. Would that equate to getting rid of the cover charge at the bar and grill? What about the customer’s point of view? If we don’t want to spend our money at the bar and grill, we shouldn’t have to, and we really shouldn’t have to float him a loan so he can remodel and risk bankruptcy. The bar owner should be looking at the needs of the customers. If the bar and grill isn’t needed any more, shut it down. Of course, that’s where the analogy really fails, because once a government agency is created, it never goes out of existence…

  2. Granted, all analogies break down at some point. This one is no different. The goal of government is not to make a profit.

    But I think your point about borrowing from customers such that they have less to spend is wrong. That would be equivalent to raising taxes to pay for stimulus funds. Both the bar owner and the government are borrowing from willing outside investors, and those loans are repaid with the increased revenues. I think that part holds.

    Your point about serving the needs of the people/customers being the goal is spot on. In the same way that gold-plating the bar rail would likely be a worthless investment because customers don’t care, frivolous government spending that doesn’t benefit the people is worthless and abusive to the investors.

    As for taxes being an inherent drag on the economy, I think that’s somewhat wrong. Not to defend taxes, but most tax dollars wind up getting respent in the economy. If you think of money as the blood of the economy, then it is only through the circulation of that blood that the organism (society) lives. Spending is circulation. Government is an enormous spender in our economy. I’m not defending that, but when the other hearts of the economy (private business) are not pumping is likely the wrong time to take the remaining pump offline. When the private sector is thriving would be a great time to reduce the flow in the government pump.

    But I guess now we’re on to a different analogy.


    key quote – “However, multiplier values less than one have been empirically measured, suggesting that certain types of government spending crowd out private investments and spending that would have otherwise happened.”

    And you can claim that the borrowing is from a third party, but ultimately it is paid by the taxpayer through taxes (and fees and whatever else they can think of to raise money.) So the customers might not be paying for this remodel yet, but they are probably still paying for the last one.

  4. I absolutely would prefer private sector investment over public sector investment. But right now the private sector is hoarding cash, not investing. And they aren’t hoarding because they fear taxes. They’re hoarding because they fear a continued loss of business/customers. If the public sector doesn’t spend, then we’re back to hope and prayer.

  5. I don’t want it to sound like I’m disagreeing with your conclusions. I agree with a lot you have to say. I would agree with this paragraph 100% if I can change “keep” to “start”.

    “Bringing this back to the U.S. economy, it means to me that the federal government needs to keep investing. Not spending wildly, but investing smartly in things that have future upsides. Green energy technology comes to mind as a great industry investment. In general, loans to small businesses and start-ups. Unemployment payments to keep people off the state welfare rolls such that they prop up consumer spending so that larger companies stop hoarding cash and go back to investing in their own businesses. Not every program will work, but we need to keep trying.”

    In Sunday’s Buffalo paper they had an article that said that the majority of the stimulus money in NYS was spent to postpone layoffs in public education for a year. How is that stimulus? So I don’t want government to stop spending, I just wish they’d quit eyeing that brass hand rail…

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