*When* should consumers cut their spending?

by on November 1, 2008 at 10:56 am in Economics | Permalink

Paul Krugman argues:

Sooner or later, then, consumers were going to have to pull in their
belts. But the timing of the new sobriety is deeply unfortunate. One is
tempted to echo St. Augustine’s plea: “Grant me chastity and
continence, but not yet.” For consumers are cutting back just as the
U.S. economy has fallen into a liquidity trap – a situation in which
the Federal Reserve has lost its grip on the economy.

….The capitulation of the American consumer, then, is coming at a
particularly bad time. But it’s no use whining. What we need is a
policy response.

Krugman then calls for fiscal stimulus, as has Martin Feldstein.  I am more inclined to think that consumers need to cut their spending now.  It is widely understood that consumers have been living beyond their means.  Let us say instead that consumers maintain their spending (say through fiscal stimulus, a cut in sales taxes, or sheer exhortation) but that everyone knows consumer spending will fall in three years time.  In three years time, the "liquidity trap" (not exactly how I think of it) will be over, but in the meantime investment commitments will be lackluster, given that people will be waiting for the economy to digest the forthcoming change.  Maybe we need to spend less now and get the adjustment over with more quickly, even though that will be painful.  Or say we don’t know when the spending decline will come — markets often dislike uncertainty most of all.

I view the goal as hurrying up needed sectoral adjustments and minimizing unneeded or temporary sectoral adjustments.  That suggests any "stimulus" funds, whatever their magnitude, should go to preserving expenditure patterns of state and local governments.  Such an allocation also ensures that the money will be spent, if indeed that is the goal.  Greg Mankiw offers a related idea.

The St. Augustine quotation in Krugman’s column is apt.  Do many people in fact use temporary sex as a successful path to abstinence?  Some do, yes, or at least so I have heard.  But it would be odd to accept such histories as the default view of how to get there.

Addendum: Excellent comments from Interfluidity.

odograph November 1, 2008 at 11:16 am

That seems well-argued. The thing is, as a man on the Clapham omnibus, I somewhat turn in the wind as big-gun economists tell me need, or don’t need, this stimulus or that bailout. Can I (we?) ever know?

ScottB November 1, 2008 at 11:54 am

Mankiw’s idea, to allow the governors to choose whether to give money directly to citizens or fund infrastructure projects, won’t work. It won’t work for the same obvious reason that self-management of risk by financial institutions didn’t work – it ignores the incentives for the people in charge. How many governors are going to tell their voters to do without a government handout, in favor of infrastructure projects?

Nathan Smith November 1, 2008 at 12:28 pm

If the economy still has a lot of capacity to produce consumer goods, and, meanwhile, consumers reduce their consumption, shouldn’t prices fall pretty steeply and create deflation. And shouldn’t the Fed be anticipating this and cutting interest rates desperately?

Maybe not. Maybe consumer-goods deflation is less bad than investment-goods deflation, and if consumers start saving more and the money is channeled into investment, this will create price pressures on investment goods, which the Fed shouldn’t exacerbate.

There’s a problem here: We believe price instability is bad, but we don’t know exactly *why.* So we don’t know how to respond to changes in relative prices. Is it damaging when stock prices rise too fast? Housing prices? Investment goods prices? Consumer goods prices? Natural resource prices? What is the weight we should put on the stability of different kinds of prices?

David Wright November 1, 2008 at 1:01 pm

It’s nice to see this question put so starkly. But Paul’s assertion that we should favor spending over savings now isn’t backed by any quantitiative analysis.

All growth models, from Solow on, predict that an increase in savings causes a short-term drop in consumption, but a long-term increase. Presumably if we had a reliable consumption-vs-time curve for a given savings rate, we could “objectively” determine its NPV by interest-rate-discounting the predicted consumption. Are there any predictions of consumption-vs-time for the current stimulus and no-stimulus scenarios?

Is there some simpler objective argument as to why now is the wrong time for increased savings? In my experience, politicians and policymakers appear to believe that no time is the right time for increased savings.

MattYoung November 1, 2008 at 2:11 pm

Who said that I + C + G = Y?

The equation is wrong. Even assuming we added the integration limits, or as De Long says, after everything is settled, it is still wrong.

Keynes implies by this equation that there are successive levels of aggregation, that is why he broke out the G separately. (Even being a Royalist he must have know that G obeys the same laws as the other economic sectors, inefficiently as a monopoly, but the same laws apply) Keynes was wrong in assuming the capital value can be accurately counted by decomposition.

I + C + G < Y is the truth, there is a missing cost to a monetary standard.

The reason is that economic agents will invest in the bond system so as to make G non-inverted by term shifting. G is naturally cyclic, or has an inverted yield curve (its term structure).

The less than sign occurs because of that quantization error that allows short term traders to drain wealth from Y by term allocation, making G non-inverted and earning short term funds.

G is inverted for the reason that G is an aggregation of weighted proportions of the economic components under it. Each of these economic components have their own term structure, which is also maintained by term allocation to keep it from being inverted.
So far, so good, but here is the missing catch.

One cannot mathematically compose a non-inverted economic aggregate from non-inverted sub-aggregates; hence there is always a arbitrage opportunity whenever we aggregate economic sectors. Aggregate economies are not composable from semi-orthogonal sets after all.

The Japanese carry trade is likely an example of this affect, as is the equity premium puzzle.

The collapse is the accumulation of the arbitrage accounts which have no where to go. The solution is to rebuild a new monetary standard, or rebuild the term structures starting at the bottom. That implies that we should spend our government bubble money at the lowest economic quanta we can find, the taxpayer himself, via handouts directly or by congressional district.

It also implies that the new term structure has a definite time limit to its validity, and external shocks can shorten the time limit.

In other words, the economy is a definite integral, which has never been accepted by planners. There is no continuous economy.

joan November 1, 2008 at 3:46 pm

Households are not spending because they are uncertain about keeping their jobs and their income. Money spent on a temporary increase in benefits for people who lose their jobs would relieve the some of the anxiety and probably produce a larger increase in consumption than the program cost the government.

Tom Hanna November 1, 2008 at 4:22 pm

If we move to actually having a positive savings rate (we have), that’s going to hurt Chinese exporters and mean cheaper capital for US companies. How painful is that even in the short term? Extend unemployment benefits for those in industries that are affected and otherwise enjoy the positive benefits.

Alan Brown November 1, 2008 at 5:32 pm

Aren’t we in this mess because of stimulus? Isn’t that what all those those years of super low interest rates were about, keeping Bush from having a recession after 9/11?

We really need to rethink this whole acceptance of Keynesian economics. Stimulus and the consumption it creates only borrow from the future. And we are borrowing like there is no tomorrow.

Frankly, we don’t need stimulus. We need a stable dollar. Its value has been rising of late and banks wisely are holding them rather than loaning them out.

We ought to peg the value of the dollar to gold or a mix of stable commodities, rather than letting it deflate like this.

The Fed should stop deciding what to do based on the CPI. The CPI is a trailing indicator of inflation and tells us little about inflation and deflation in real assets, which is where everybody is getting whiplashed by the dollar’s behavior.

With a stable dollar, banks can lend again without the almost certain loss they would experience with more deflation.

jhh November 1, 2008 at 6:15 pm

Deflation…

ZBicyclist November 1, 2008 at 6:36 pm

We’re in a hole because we’ve been spending beyond our means on Iraq, tax cuts, houses we can’t afford, junk at the mall we don’t need, cars bigger than our first apartments [etc.]

Krugman’s solution is to buy more stuff we don’t need???

This is like giving an alcoholic another drink.

Donald A. Coffin November 1, 2008 at 9:13 pm

Of course, Krugman is advocating additional direct
government spending, particularly on infrastructure.
This is not a direct stimulus to consumption, and will
only indirecly affect it, as people’s incomes rise.
The most likely direct source of stimulus for
immediate consumption spending is likely to come
through extended unemployment insurance benefits,
not something like a tax cut.

Andrew November 2, 2008 at 8:59 am

A: before they have to.

Isn’t “a policy response” kind of an oxymoron? Policy would be a rule, not arbitrary, that is followed to keep you out of the ditch. We are in the ditch, Krugman wants to blast us out with fiscal dynamite.

All Krugman is saying is that since we consumers are too silly, the government needs to spend our money because we won’t.

“Let’s hope, then, that Congress gets to work on a package to rescue the economy as soon as the election is behind us.”

As in, when we can’t kick the bums out for their deception and

So, now, since the consumer is overextended, it is because the chickens come home to roost at an incovenient time that Krugman believes the government needs to bring out more punch bowls. As if the consumer would stop spending in boom times.

Krugman admits that checks sent to consumers won’t get spent on what consumers had been spending on before. I don’t understand why increased government spending on things other than things consumers had been buying will do anything other than create patronage.

Liberal, yes, but that’s some conscience. I agree, a dork.

Bob Murphy November 2, 2008 at 10:12 am

Ah Tyler. Believe it or not, I was getting all ready to compliment you on a great analysis. But then you said this:

That suggests any “stimulus” funds, whatever their magnitude, should go to preserving expenditure patterns of state and local governments.

I “get” the argument you used to arrive at this conclusion, but it constantly amazes me how frequently you call for (or at least say “this wouldn’t be so bad”) measures to bolster governments.

K T Cat November 2, 2008 at 3:20 pm

From Europe you think we should start saving for a rainy day?!? What part of Europe would this be, the weed smoke bong parlors of Europe? Have you taken a look at your own national debts and unfunded future financial commitments lately?

As for cutting defense spending, that’s a good idea. After all, your armies of hair stylists and interior decorators did such a bang-up job in Bosnia and for so much less money, too!

JSK November 2, 2008 at 6:20 pm

With a stable dollar, banks can lend again without the almost certain loss they would experience with more deflation.

Call me shortsighted but i would recon that expected deflation raises the expected return on lending cq any debt denominated in nominal terms would gain in real value.

Bill Woolsey November 2, 2008 at 8:01 pm

Saving fell at a 200% annual rate in the third quarter.

Consumption spending rose slightly, but because of a spike in inflation, real consumption fell. The reason that both saving and real consumption fell is because disposable income fell.

All elements personal income rose, except farm income and dividends. However, taxes rose at a 25% annual rate and transfer payments fell substantially.

So, disposable personal income fell. The saving rate fell in half. Nominal consumption expenditure failed to rise enough to cover inflation.

Federal government spending rose at a 14% annual rate.

Perhaps households should increase their saving. But they haven’t. Check out the data from time to time.

Russell Nelson November 3, 2008 at 2:13 am

Hey, Paul, you can post as yourself. You don’t need to post as “mike”.

Tim Fowler November 3, 2008 at 11:34 am

ZBicyclist – “We’re in a hole because we’ve been spending beyond our means on Iraq, tax cuts, houses we can’t afford, junk at the mall…”

Iraq, houses, junk at the mall etc. That’s all spending.

Tax cuts are not spending.

Michael November 4, 2008 at 4:55 pm

I suggest that consumers should adjust their spending to areas of positive returns rather than luxury items. It will cause certain sectors of the market to shrink (luxury goods) but could get us more rapidly towards a green economy, for example. Examples of positive returns include:

1. Insulation – typical full payback of investment is 2-3 years, lowers energy costs, creates positive cash flow including interest (remember, money is cheap right now) immediately.

2. Power efficient light bulbs, appliances, etc. Same as above, but payback is 4-5 years (replace the 40-year old furnace, replace incandescent with CFLs/LEDs, etc).

This is an area where the government could provide positive investment, through underwritten green loans, and it would have further, positive impact on the economy by reducing foreign energy dependence.

The ‘Green’ investing is just one example, I’m certain there are others people could come up with.

used bucket trucks February 4, 2011 at 12:03 pm

Consumers should cut their spending when their budget or income changes. It’s that simple. If you are on the scheduled path of a sound budget, you change when it changes… job loss, medical emergency, etc.

It’s not a hard concept to grasp.

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