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Economic and Market Commentary

A Responsible Word for Irresponsibility

Recessions are about an excessive desire to save. Note, I said “an excessive desire to save”, not “excessive savings.” These are two very different things. If you understand the difference, you know all you need to know about why the global economy is on the cusp of a recession. From a macroeconomic perspective, an excessive desire to save is one and the same as a deficient desire to spend.

In turn, deficient aggregate demand growth begets deficient income growth, the fount from which all savings flow. Thus, an excessive economy-wide desire to save actually undermines the economy-wide ability to save. Put differently, an excessive desire to save does not generate excessive savings, but rather a deficiency of savings!

This malady is not new and is not strange. It’s called the “paradox of thrift,” and is what recessions and depressions are all about. It’s also the soul of what macroeconomics is all about: what holds for the individual need not hold for a collection of individuals. As I’ve written before 1  , one need not resort to fancy labels such as the “paradox of thrift” to define the common sense of macroeconomics. Anybody who’s ever been to a crowded ball game has witnessed the difference between microeconomics and macroeconomics.

From an microeconomic perspective, it may be rational for an individual to stand up to get a better view, if such a view provides incremental utility greater than the dis-utility of sore feet (a Pareto efficient trade-off between your eyeballs and the balls of your feet, for fellow economist geeks amongst you). From a macroeconomic perspective, however, each individual acting rationally to stand up will produce the irrational collective outcome of everybody standing up with sore feet, but nobody having a better view.

Only Herbert Hoover and Andrew Mellon
Would Have a Problem With The Forecast

Figure 1 is a line graph showing the ex Social Security U.S. federal budget balance and the total federal balance from 1958 to 2000, with Congressional Budget Office projections through 2003. Both metrics track each other for most of the time period, but their divergence starts to grow in the late 1990s. Around 1992, both metrics are around negative $300 billion, with that of the total federal balance slightly higher. Both metrics rise steeply to 2000, but by then, the total federal balance is around $240 billion, while that of ex Social Security is around about $85 billion. Both are forecast to fall by 2002, to about $180 billion for the total federal balance, and just less than zero for the ex Social Security balance. At the start of the chart, in 1958, both metrics are around zero, and trend downward starting in the late 1960s to their lows in 1992.  

  Figure 1
Source: Bureau of Economic Analysis, Congressional Budget Office


Too Much Investment Begets Too Little Return
On Investment

Figure 2 is a line graph showing the rate of return on U.S. capital versus the amount of capital stock, from 1929 to 2001, according to the U.S. Bureau of Economic Analysis. The metrics, when superimposed, roughly track each other over the period. Recent years show a divergence, though: the rate of return on capital, scaled on the left-hand vertical axis, falls to about 6.5% by 2001, down from a recent peak of almost 9% in 1997. Yet over those same four years, the percentage year-over-year change in capital stock rises to greater than 4.5%, up from about 3.8% in 1997. Both metrics show a peak on the chart around 1965 of almost 11% for the rate of return on capital, and over 5% for percentage change in capital stock. Both metrics bottom in 1933 during the Great Depression, well below their typical ranges, with the rate of return on capital at around 0%, and capital stocking showing a 2% decrease.  

Figure 2
Source: Bureau of Economic Analysis


The Paradox Of Thrift In Action

Figure 3 is a line graph showing percent change vs. one year prior for U.S. non-farm payrolls and for real investment in equipment and software, from 1990 to mid-2001. Both metrics roughly track each other over the period, and are in sharp decline in recent years. Non-farm payrolls are expressed on the left-hand vertical axis, and the year-over-year change fell to about a 0.4% by mid-2001, down from a recent peak of about 2.7% in early 2000. Similarly, real investment in equipment and software, scaled on the right-hand side in terms of percentage change from a year ago, falls to negative 4%, down from about positive 13% in early 2000. Non-farm payrolls show a chart peak of around 3.5% in late 1994 and a trough of around negative 1.5% in 1991. Equipment and software peak in 1998 at around 17.5%, and have another low of about negative 0.75% in 1990.  

Figure 3
Source: Bureau of Economic Analysis, Bureau of Labor Statistics

In such a situation, the society of spectators at the ballgame needs a macroeconomist to stand up and bellow for everybody to sit down! And then sit down himself. Such a servant of humanity would, no doubt, be cursed, slandered and otherwise maligned, as was the father of macroeconomics, John Maynard Keynes, with his publication of the General Theory in 1936.  But that would not change the fact that the collectively rational outcome for all the belching bleacher bums would be to sit down.

Sometimes, A Cigar Simply Stinks

Such is the case in the stands of the global economic stadium at the moment. Corporate decision makers are individually increasing their desire to save, in the wake of both (1) wealth destruction at the hands of Mr. (Equity) Market, and (2) disappointing income from prior investments. These are not, of course, independent impulses: global equity markets have destructed wealth (a stock concept) because they have re-priced down the profits (a flow concept) that are likely to be generated by prior investments. After all, an equity claim on a company is nothing more than a claim on the profits generated by a company’s investment.

Corporate decision makers are discovering that the rate of return on investment just isn’t what they thought it would be, as shown in Figure 2. Yes, irrational exuberance did indeed infect capital spending budgets. And as men and women of action, and ostensible accountability to shareholders, corporate decision makers are doing something about their collective ex post discovery: they are ex ante slashing investment budgets and headcounts, as shown in Figure 3.

From a microeconomic perspective, there is nothing wrong with this. When you have paid a quarter for what turns out to be a two-for-a-nickel cigar, which smells like burning seat covers on your first used jalopy, you should pay attention to your spouse’s injunction to take it outside. And to quit buying the wretched things!

But from a macroeconomic perspective, if all corporate decision makers simultaneously get the urge to cut capital budgets and headcounts, they will undermine their collective ability to save more, ‘cause one company’s investment spending is another company’s income; and one company’s headcount is another company’s paying customer. This is the paradox of thrift. It is what recessions and depressions are all about. Not everybody can get thrifty at the same time, just like everybody can’t get a better view by standing up at the same time at the ball park.

Before Keynes, conventional wisdom held that there was nothing policy makers could do, or more importantly should do, to break the paradox of thrift. Indeed, recessions and depressions were viewed in a moralistic fashion, as just punishment for preceding sins. Or, as Treasury Secretary Mellon said to President Hoover in 1931:


“Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate. Purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people.”

That was macroeconomics before Keynes: let markets “purge the rottenness” out of the system. To wit, there was no macroeconomics before Keynes, merely microeconomics in drag. And such is still the case in the eyes of the Austrian economic church, which preaches that mal-investment must be punished, to teach sinners the evils of their sins and to prevent the chaste from ever being tempted to sin.

Too Much Responsibility Is Irresponsible

In contrast, Keynes had a simple and profound idea: when the private sector has a collective bout of morning-after spending regret, with everybody vowing to become more responsible, it is responsible for the public sector to have a bout of morning-after irresponsibility about its finances. If the private sector wants to increase its savings rate, the public sector should reduce its savings rate, turning it negative via borrowing if necessary, so as to provide a floor under aggregate demand growth and therefore aggregate income growth, the reservoir from which all savings flow.

Keynes was right when he preached that sermon during the Great Depression. He’s still right today. And nothing about the stagflationary 1970s in the United States or the stag-deflationary 1990s in Japan changes that proposition. Since Keynes’ time, we’ve learned that monetary policy is more powerful than fiscal policy, and that with bad monetary policy, bad economic outcomes happen, even if fiscal policy is responsible (which sometimes requires doing what the private sector would consider to be irresponsible!).

Loose fiscal policy was not the source of either accelerating inflation in the United States in 1970s, or accelerating deflation in Japan during the 1990s. In fact, fiscal policy actually tightened in the 1970s in the US, as accelerating inflation worked through an un-indexed tax code to raise real tax burdens. And fiscal policy eased in Japan during the 1990s, as deflation did the exact opposite to real tax receipts.

In both cases, fiscal policy didn’t “work,” even though it was appropriate. Inflation in the 1970s in America and deflation in Japan in the 1990s were all about monetary policy, not fiscal policy. Get monetary policy wrong, and there is little that fiscal policy can really do to help matters.

In contrast, fiscal policy does matter, and matters hugely, if monetary policy is about right, as is the case in the United States at the moment (but not Japan, where it is still blatantly deflationary). More specifically, prospects for renewed US economic growth – with low inflation! — would actually be quite favorable, given broadly appropriate monetary policy, if fiscal policy was also broadly appropriate. It is not. To the contrary, US fiscal policy is cyclically bone-headed.

Uncle Sam is running a huge cash flow surplus, sucking net purchasing power out of the private sector. This makes no macroeconomic sense at all. None. Uncle Sam’s balance sheet is in great shape, and any macroeconomist worthy of the label should be screaming for re-levering, not de-levering of the federal balance sheet.

Yet the macroeconomics community has itself wrapped ‘round Washington’s stupefying, and stupid political axle called “save Social Security first,” which limits fiscal stimulus to that portion of Uncle Sam’s cash flow surplus above and beyond that generated by taxes labeled Social Security (payroll) taxes. Such an outcome puts Uncle Sam in the position of brute forcing de-levering of his balance sheet, an absolutely idiotic outcome at a time when the private sector is in the gripes of the paradox of thrift.

Hooverite Democrats And Pro-Mellon Republicans

Three months ago2 , I declared this nutty “save Social Security first” axle to be the nation’s “ biggest macroeconomic policy problem .” Three months later, the matter is worse, with Democrats preaching Hoover economics of tax hikes and Republicans preaching Mellon economics of spending cuts, so as to “prevent” Uncle Sam’s huge surplus cash flow from dipping below that which is “earmarked” for Social Security.

I never thought I’d live to see the day when the macroeconomics community would sit silent in the face of such lunacy. Yet I read report after report from my old Wall Street brothers and sisters that there really isn’t any “room” for further fiscal stimulus, now that the ex-Social Security budget surplus has disappeared. Unless, of course, the economy goes into a real McCoy recession, in which case the political consensus to “save” the ex-Social Security surplus will break.

Well, excuse me. We need a recession to get cyclically-sensible fiscal policy, all because President Clinton got caught fishing off the Oval Office dock? Recall, “save Social Security first” was a policy coined and articulated by former President Clinton, in his first address to Congress following his public confession that he’d been lying through his teeth about “that woman.” The Republicans wanted to exact their political pound of flesh, not just by impeaching his wandering lust, but cutting income taxes for the rich, the object of their lust.

Clinton , in his most brilliant political maneuver ever, and there were lots of them, called the Republican’s bluff and said, “save Social Security first.” And the way to do that, he argued, with the full backing of the maestro Alan Greenspan, was to use payroll taxes in excess of current Social Security outlays to pay off (or buy back) marketable debt held by the public. Taxes should be cut, he preached, if and only if taxes labeled something else beside payroll taxes were generating an aggregate cash flow surplus for Uncle Sam.

It was a brilliant political maneuver, and the Republicans bought it. It still befuddles me that they did, because there was no macroeconomic or political reason to do so. Except, perhaps, the political risk associated with suggesting that Alan Greenspan could be wrong. And at the time, Washington thought Greenspan walked on water; unfrozen, of course.

Anyway and anyhow, Presidential candidate George W. Bush was handed this “save Social Security first” straightjacket by his party, and slipped it on comfortably. No problem, really, since he comfortably wears whatever clothes his elders hand him, since they politically bought and paid for them. If income tax cuts could be defended while “saving Social Security first,” then he would defend income tax cuts. And run on them, win on them, get them passed, and flip the political bird at the Democrats.

Even though I’m a Democrat, I must say I admire Mr. Bush’s skill as a politician. Politics is as politics does, and winning is what politics is about, as his predecessor proved in spades (and hearts, clubs and diamonds). President Bush is a good politician, a very good politician. That’s why he is where he is, and former Vice President Gore is listening to his whiskers grow. Mr. Bush ran on income tax cuts, and found enough Democrats to join with the Republicans to get them passed, all the while vowing fealty to the notion of “save Social Security first.” That’s called winning.

Earth to Krugman

Thus, I take major issue with fellow Democrat, Princeton University Economics Professor and New York Times columnist Paul Krugman, who uses his lofty position in that hallowed space to repeatedly call Mr. Bush a liar on his fiscal intentions. A liar is someone who knows the truth (as Mr. Clinton did) while explicitly saying something in contradiction to that known truth. Ten year budget projections have never, ever come under my definition of “truth.” They are political documents with politically-inspired economic assumptions. Politics change, and so do associated economic assumptions.

Indeed, up until Mr. Clinton got the Republicans to buy into creating a “lockbox” for that portion of the aggregate federal surplus stemming from “excess” Social Security taxes, neither party ever made an issue of “borrowing” from the Social Security “trust fund” to pay for non-Social Security outlays. In fact, the federal government had been doing that by design ever since 1984, when Social Security taxes were hiked explicitly to “grow” the Social Security trust funds, which hold exclusively non-marketable federal debt. There has never been anything nefarious about any of this, which has been plain for the world to see, as shown in Figure 1 on the cover.

Nobody was “raiding” Social Security after 1984, when payroll taxes started generating a cash flow surplus relative to Social Security outlays, which was used to fund a portion of Uncle Sam’s cash flow deficit being generated by non-Social Security outlays in excess of non-Social Security taxes. And nobody is “raiding” Social Security now. The Social Security trust funds have always been credited or debited with the precise difference between Social Security taxes and Social Security outlays, regardless of what Uncle Sam’s aggregate cash flow position may be.

The cash flow surplus or deficit on the Social Security ledger is mirrored by either an increase or decrease in the Social Security trust funds’ holdings of non-marketable debt. And the resulting stock of non-marketable federal debt held by the Social Security trust funds has always been credited interest at the market rate.

That process is functionally independent of whether Uncle Sam has an aggregate cash flow surplus or deficit, which determines whether he net retires or issues marketable federal debt. It’s not a matter of raiding or not raiding Social Security; it’s matter of book-keeping! Social Security liabilities are what they are, unless and until Congress changes the law determining the eligibility and terms of future Social Security benefits.

That’s a political issue, certainly, for which heavy words like “raiding” might, or might not apply. They wouldn’t for me, because I believe Social Security benefits should be cut, and Social Security taxes raised for the relatively well off. But that’s a personal value judgment, grounded in my own political perspective that Social Security should move back toward (but not to!) its roots as social insurance against abject poverty in old age. That personal axe has nothing to do, however, with professionally assessing the right fiscal policy for the here and now.

Existing book-keeping for existing Social Security liabilities should not be a macroeconomic issue. It’s a political issue only because politicians choose to make it a political issue, not because any of any known theory of business cycle macroeconomics. It is the duty of the macroeconomic profession to inform the public on this matter, not to try to find sex where there is no sex. But Mr. Krugman insists on calling Mr. Bush a liar, demanding that Democrats demand a repeal of some of Mr. Bush’s income tax cut, because Bush putatively always knew he was going to have to “raid” Social Security to pay for it.

Forgive me, dear readers, but I’ve had it with Mr. Krugman. He and I e-mail dialogue from time to time, and I’ve told him that he’s embarrassing himself, his party, and our profession by his ranting. But he doesn’t care. He simply does not want to accept that democracy involves losing sometimes, and sometimes you lose because the other guy has fuzzier, and better marketed, math. Not lies, but fuzzier, and better marketed, math. As Churchill intoned long ago, democracy is the worst political system extant, except for all others, and good “small-d” democrats – i.e., believers in democracy, regardless of whether they are Democrats or Republicans — should just be cool about it.

Bravo, Bartley and Reich

Now is such a time, as beautifully displayed by two other prominent columnists just this week — Mr. Bob Bartley, head of the Wall Street Journal’s editorial page and a Republican if there ever was one; and Mr. Bob Reich, head of the Labor Department under Mr. Clinton and a Democrat if there ever was one. Bartley 3   and Reich 4   wrote columns that the other could have signed, both highlighting the sheer lunacy of debating about whether Uncle Sam should avoid an “ex-Social Security deficit,” even while running a huge total cash flow surplus.

When the economy is in the grips of a cyclical paradox of thrift, which it manifestly is right now, the notion that Uncle Sam should resist a diminishing cash flow surplus – regardless of the label on the taxes – is macroeconomic nonsense, both men argued. And operating from opposite ends of the political spectrum, both men were exasperated and embarrassed at the rhetorical gymnastics to the contrary displayed by their parties.

It was a beautiful moment for all serious students of macroeconomics in a democratic society. There is hope that the politics of democracy can pull back from a James Dean game of macroeconomic chicken. And if Mr. Krugman had an ounce of objectivity and civility in his veins, he would quit using his special pulpit to call Mr. Bush a liar, and join the enlightened caucus led by Messrs. Bartley and Reich against cyclical fiscal policy madness.

There is, in fact, a secular case for scaling back Mr. Bush’s income tax cut on the distant horizon, as Mr. Krugman argues. As a Keynesian principled populist, I could make it. But it’s is a secular argument laden with political value judgments, not a cyclical macroeconomic argument related to breaking the grip of Keynes’ paradox of thrift. Mr. Krugman knows precisely how to make the same argument. Indeed, he acknowledged to me last week that cyclically, the economy needs more, not less, of what he accuses Mr. Bush of secularly lying about. He promised to come clean in future columns.

I'm Still Waiting, Paul

Krugman’s offering 5  in today’s New York Times did not pass the clean test. To the contrary, it smells like those burning seat covers. He acknowledges that the economy could use some good ole-fashioned fiscal pump-priming right now, but declares that the nation can’t “safely” pursue such a policy. He rests his case on the notion that additional fiscal stimulus is not “safe”, because the “grim long-term financial outlook” created by Mr. Bush’s secular income tax cuts are raising long-term interest rates, and “any further tax cuts would make the outlook even grimmer.”

Proper counter-cyclical Keynesian fiscal stimulus could be pursued, he argues, only if the Bush Administration were to do the “ responsible thing, making room for additional tax cuts now by canceling some of those big tax cuts scheduled for 2004 and later.” Therefore, he resignedly concludes, the entire burden of avoiding a recession must be placed on Alan Greenspan and monetary policy ease.

This is absolute poppycock
, and Krugman knows it. The last time I checked, the dominant determinants of long-term interest rates are actual and expected short-term interest rates, which the Fed controls. Professor Krugman no doubt routinely teaches this “expectations theory” of the term structure of interest rates.

Yes, long-term fiscal policy expectations do have some influence on the slope of the yield curve. But no econometric evidence exists to support the proposition that fiscal policy expectations dominate the level of long-term interest rates in the United States. Indeed, the long-term interest rate equation in the Fed’s own huge econometric model of the United States is dominated by the “expectations theory,” with Fed-controlled short-term interest rates the “anchoring” variable.

The truth of the matter, assuming Mr. Krugman is searching for the truth, is that there is plenty of room for the United States to “safely” pursue proper counter-cyclical fiscal stimulus right now, regardless of the efficacy of Mr. Bush’s secular income tax cuts. All that would be needed to make it “work” would be for the Fed to commit to resist any urge to hike short-term interest for a long, long time.

That’s the argument that Mr. Krugman should have made in today’s column. Fiscal policy is not impotent to the task of breaking the paradox of thrift. Mr. Krugman’s analysis is impotent. The responsible thing for fiscal policy makers to do right now is to show some irresponsibility (relative to orthodoxy).

Mr. Krugman knows that. But he can’t bring himself to admit it. He’s having too much fun calling Mr. Bush a liar.

Paul A. McCulley
Managing Director
August 31, 2001

1 See "Capitalism's Beast of Burden," Fed Focus, January 4, 2001.
2 "Prisoners Of Our Domain," Fed Focus, June 4, 2001.
3 "Debating Cockamamie Economics," Wall Street Journal, August 27, 2001.
4 "Surplus Silliness," Wall Street Journal, August 29, 2001.
5 "Greenspan Stands Alone," New York Times, August 31, 2001.


No part of this publication may be reproduced in any form, or referred to in any other publication, without express written permission.
This article contains the current opinions of the author but not necessarily Pacific Investment Management Company, and does not represent a recommendation of any particular security, strategy or investment product. 
The author's opinions are subject to change without notice. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
This article is distributed for educational purposes and should not be considered as investment advice or an offer of any security for sale. Past performance is not indicative of future results and no representation is made that the stated results will be replicated. Copyright ©1999-2003 Pacific Investment Management Company LLC. All rights reserved.

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