For years I passed a billboard that proclaimed, “Where will you spend eternity? That is the crucial question!” Change it to “How will you spend your fiscal stimulus payment?” and you have the crucial question for the U.S. economy right now.
My wife and I are doing what we can to help the economy. Two weeks ago, when proposals for a fiscal stimulus package first emerged, we acted. Feeling flush with the prospect of a rebate, we went out and bought a new toilet to replace a 4-year-old one that simply was not up to the job. So we increased consumer spending by $238 even before President Bush and Congress agreed on a specific bill. With the “multiplier effects” outlined by Keynesian economists, Victoria and I may have boosted U.S. gross domestic product by $1,000 or more.
Then again, maybe we didn’t. The degree to which people will spend one-time income and the extent to which such spending increases economic activity are uncertain at best. As usual, differences among economists on the usefulness of fiscal stimulus depend on different assumptions about fundamental human behavior.
John Maynard Keynes, the father of the idea that governments should actively intervene to boost slowing economies, assumed consumer spending depends on current income, regardless of source. If someone has a “marginal propensity to consume”- measuring what portion they’ll spend out of the last dollars earned – of 0.9, then they will spend $540 out of $600 received from a government stimulus package.
Franco Modigliani, a 1985 Nobel laureate, and collaborators, saw consumers making spend-save decisions as part of a life cycle. For example, college students spend more than they earn, covering the difference with student loans. After graduation, they spend less than they earn, setting money aside to pay student loans, buy a house and build savings. As they move through their prime earning years, the proportion they save tends to grow. After retirement, however, they again spend more than they earn, covering the difference from accumulated savings.
To Modigliani, the question of how much I will spend out of my $600 stimulus depends on where I am in my life cycle. At 57, I probably would save quite a bit. My college-age son probably would spend it all.
Milton Friedman, one of Keynes’ most impassioned critics, seized on what he saw as a naive assumption of automatic, predictable consumer spending increases as a key weakness of Keynes’ prescription for government economic micromanagement.
Friedman thought people were shrewd and able to distinguish long-term reliable income from one-time windfalls. People base spending decisions on what they see as their “permanent income.” A one-time $600 payment would constitute “transitory income.” Not expecting it to persist, they would spend some but save much, using the windfall to increase their permanent income over a long period rather than immediately blowing it all at the mall.
These three views all dealt with income increases in general. Some 140 years earlier, British economist David Ricardo had evaluated what would happen in the specific case of taxpayers getting a boost from lower taxes while the government did not cut spending. How much of their tax cut would people spend?
Ricardo argued that a rational man would spend none because he would know that, without a spending cut, the government would just run up debt that inevitably would come due. A rational person would save the whole tax cut to be able to pay higher taxes later.
All these theories paid little attention to the economic conditions people expected in the months and years immediately following some unanticipated extra income.
Such expectations, however, often are the key to the question. We bought our toilet on the mere expectation that some stimulus payment eventually would hit our bank account. We personally have few worries about any impending economic slowdown. Both of us have relatively recession-proof jobs and retirement accounts. We have equity in a house and farm. I’ll soon get Army Reserve retirement.
We feel quite safe even as storm clouds gather. Hence, buying a new biffy with impressive flushing action is not risky. But even we don’t plan to spend the rest of our payment when it eventually arrives. It seems like a good time to be careful.
The same is probably true for many households. Yes, many highly stretched families will use their little windfall to buy needed clothes or fix a dying vehicle. But many others will pay down credit-card debt or simply maintain a little higher bank balance than usual.
The more households save payments rather than spend them, the less effective the whole effort will be in bolstering output and employment. Given all the other emerging news about the nation’s economic problems, I do not place too much hope on any impressive success.
© 2008 Edward Lotterman
Chanarambie Consulting, Inc.