Monday, December 2, 2013

Economics for Challenged People

Economics is generally considered a Social Science.  That means that like Political Science it attempts to identify rationale thoughts and ideas which, because they involve people, must automatically include irrational actors.  While various economic schools of thoughts have mathematical models of what should happen, or what might happen, or what could happen, there are always stray situations that cause prediction errors.

However, like many other fields of human endeavor, there are players in this game that make predictions based upon questionable data and then cling to those predictions even after years of having been proven wrong.  Economists attempt to predict the future...or explain the present...using examples from the past, and it often seems that the past was somehow different....just enough to matter.

However, some people in positions of power, continue to believe that things that have never happened before will suddenly happen now, apparently because they would like them to happen.  So, let's look at a couple of ideas and see why they are fundamentally flawed.

The first thing we need to understand is that a government, and I'm speaking of the Federal Government, is not the same as a household or business.  Because people know the "rules" for their household they often attempt to apply them to the government, and it just doesn't work.

A household has a set amount of income.  It may vary from month to month, and it might even change dramatically as a wage earner gets a new job or loses a job, but it is a set amount.  They cannot conjure additional money, so they have what they have and can only supplement that by borrowing.

Borrowing is not necessarily a Bad Thing.  Borrowing makes it possible to purchase a home or perhaps an automobile that would otherwise be impossible.  However, borrowing is not without danger.  You are expected to pay back the borrowed amount plus some interest, and there are penalties if you don't.

The rules for the Federal Government are different.  The income (Revenue) is variable and can fluctuate wildly.  The overall state of the economy has a huge effect, and the Government has only limited ways to affect that.

The most direct control is through the establishment of tax rates, and clearly those are a political issue.  There is an element of Science involved, but politics will trump science every time in this discussion.  For example, history has demonstrated multiple times that our economy has operated well when tax rates on the rich were high, much higher than today.  That may seem counter-intuitive, but it's true.

In any case, the point I really want to discuss is something else, so for the moment I'll just leave that where it is and look at the most fundamental question.

In Bad Times government revenue falls.  Since the whole economy is faltering people don't buy as much, more people are unemployed, and therefore tax revenue falls.  As a result, the government is spending more than it takes in.

There are always two schools of thought about how to fix this.  The options are simple:

  • Cut spending to match the lower revenue available
  • Borrow to continue spending at the current level, or even expand spending to support recovery

This seems simple, especially if you're working with the household model.  If a wage earner loses their job they immediately cut all unnecessary spending.  No more eating out, no movies, no vacation, and such.  That's the household model.

However, the Government model works differently.

Let's suppose you like the first option.  It is certainly true the Government can cut spending, and probably should regardless.  However, the impacts are not as clear cut.

When the Government cuts spending it means that less product is being purchased and the Government has fewer employees.  While the costs for those things go down, so does the tax Revenue.  Every employee who was laid off is no longer paying taxes...because they have no income.  So...cutting spending also means cutting Revenue.  In addition, whatever products the government was buying supported more jobs, and those people will quickly be laid off also, compounding the effect.

That doesn't happen in the household model.  You have the same income, albeit smaller, regardless of how much spending you cut.

Now, not only does cutting spending have that revenue effect, it also, ironically, increases spending!  All those people who aren't working are now going to be showing up for unemployment benefits, food stamps, and perhaps even "welfare."  The Government is now paying more to keep people unemployed...but getting nothing for it.

So...when you cut some money from government spending, you don't realize all that cut.  You increase your other expenses and decrease your revenue.  The unemployment you created also impacts the entire economy meaning companies that make consumer goods are seeing softer demand and are less likely to hire new people or maintain current production levels.  Cutting government spending has a multiplier effect that ripples through the entire economy.

Okay, if cutting spending seems bad, it's easy to think that increasing spending would be worse.  The government is borrowing to spend money it does not have, and that can't possibly be good, right?

The answer is Yes...and No.  I'm going to over-simply a little, but the idea should remain clear.

First, borrowing is going to go up.  That's true.  For the moment we'll park that idea...but I promise to return to it.

Now, if spending is increased here's what happens.  The government gets "something."  During the Great Depression, unemployed people were put to work building public works projects.  Today the easiest place to have a big gain is in "infrastructure"...which means doing the maintenance we've put off since forever.  Replacing faulting and failing bridges, improving road surfaces, rebuilding crumbling buildings, and similar things are projects that put people back to work AND yield a tangible result.  We could also restore some funding for education and return more teachers to the classrooms.

All those people who are now working not only have money to spend...which helps the overall economy...but they're also paying taxes!  That means a portion of what the government is spending is coming back in revenue.  That same multiplier effect works here too, with people who now have jobs eating in restaurants, attending movies, and spending on consumer goods.  Other people get to keep their jobs and maybe some additional folks are hired, taking them off of unemployment and allowing them to pay taxes too!

So...things get better.  More people are working, more people are paying taxes, and the economy operates closer to capacity.  Life is better.

Now...what about that borrowing?

The time to pay down the accumulated debt is when you have a surplus, not when you're broke.  In 2000, the Federal Government actually was operating with a surplus.  The economy was stable and we were actually paying down the debt.  It wasn't growing, it was shrinking!

Since that time things have changed.  While the changes are many, complicated and interrelated, there are three things that stand out as the major issues.  Again, in no particular order:

  • The banking system collapsed, primarily due to risky business practices that were not regulated
  • We entered into two wars without bothering to provide money to pay for them
  • We cut the tax rates, especially for the rich

In short, we decided to collect less Revenue at the exact same time we decided to spend more, carefully keeping the war costs out of the budget so they wouldn't show what was really happening.

Like it or not, those are the FACTS.

Now, when you hear someone say the solution to the problem is to cut governmental spending, consider the truth about how that impacts the current situation.

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