Thursday, June 17, 2010

Who spends a dollar more effectively--the Fed Govt or You?...Guess again!

     NewsFlash: We are/have been in a recession!  In this particular recession it is generally accepted by economists (relatively objective ones)  that it is because of sagging Aggregate Demand. This means our total demand for US made goods and services is LESS than our ability to supply US made goods and services (aka Aggregate Supply).  We don't necessarily have an excess supply of goods/services, but we have an excess supply of CAPACITY to produce goods/services---a gap between our actual production and our potential to produce good/services.   Because people are not buying "stuff" then businesses are not selling stuff and certainly not re-ordering stuff.  This in turn effects employment as employers shed employees as demand for their goods declines.  As more people become unemployed they buy less so businesses lay workers off or close entirely, so on and so forth.  It becomes an economic death spiral downward. 
    This means we need to get money into the hands of people/businesses so they can spend it to INCREASE or at least STABILIZE Aggregate Demand so businesses will sell/re-order more goods, and more people can keep there jobs, and hopefully more will be re-called as business picks up--Phew! That was hard work! How best to achieve this?  
     In general, we all think in terms of "bang for the buck" (hey, we are Americans, after all).  What transmission mechanism that originates from the Federal Govt is going most effective---Govt spends a dollar OR Individuals spend a dollar from a tax cut?  Oh, boy, here we go!
     Below is a chart that represents research into how much ONE DOLLAR spent (by govt or individuals) INCREASES GDP, which is the goal of congress/the President. This is called "The Multiplier Effect", or more specifically, "The Keynesian Multiplier Effect".

Mark Zandi via  Ezra Klein 
     Notice that one dollar spent can either yield a change in GDP of more than one dollar or less than one dollar.  How can this happen? 
     To simplify, lets assume we ALL behave the exact same way.  If I get a dollar in the form of a tax cut, research shows that I will save some portion of that dollar and spend the rest.  So if we all save 10% ($.10) of our dollar then we will spend the other 90% ($.90), thereby increasing GDP by $.90.   Economists would say we are acting "rationally" by saving some of our bounty.  However, government does not save ANY of that dollar because, well, why would they? So, on the face of it, which entity, the  individual OR the government, is going to have the BIGGEST impact on the purchase of GDP in that FIRST round of spending?  Why the government, of course (I just proved it to you mathematically!!).  Govt is going to buy $1.00 worth of "stuff" and I am going to buy only $.90. 
    However, as you look at the graph you will notice as you start from the top and move down you will see a transition from Tax Cuts/Rebates to more direct spending by the government then back to spending by individuals.  Does this not go against what I just said about government spending being king? Sort of...
    There IS going to be "leakage" from that federal dollar spent and not all of it will be spent directly on goods/services.  Some of that dollar will be subjected to what I call "WTF"---no it is not what you are thinking, but  it could be, I suppose.  For me, WTF is "Waste, Theft, Fraud".  Ultimately we want to look at who, an individual, business, or government entity is going to spend MORE of that initial dollar when it is received, hence affecting Aggregate Demand in the most impactful way.
   Looking at the graph, we see the group with the highest tendency to spend an additional dollar they receive is the unemployed and others receiving direct government transfers. This makes sense, doesn't it? These are people living at the margin, as economist put it. Or more simply, people who have little immediate need to save but the most incentive to spend right away.  They spend on necessities, one would suppose. Necessities, like food, rent, utilities and other basic staples, that are made in the US (mostly).  This allows businesses to stay open to sell stuff and re-order more stuff AND keep/hire employees.  Now Aggregate Demand is STABILIZED! Perhaps it inches forward to close the recessionary gap?
    This is important to understand because there is A LOT of politics that takes place between the gaps of all the groups in the above graph.  Who should get a tax cut, if anyone? Who should spend money in a recession:? The Federal Govt directly, or people who are most likely to spend it to get the economy stabilized?  What do YOU think????

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