Monday, August 08, 2011

Why the Government has to Spend when the Private Sector decides to Save

What is necessary for a healthy, stable economy is a balance between savings to provide capital for new productive activity, and spending to sustain demand for goods and services. When these forces get out of balance instability happens.

If everyone decides to save more all at the same time, spending is reduced and economy goes into recession. If everyone decides save less at the same time, spending increases demand and prices go up. If the new spending is to buy assets rather than consumables, asset bubbles develop.

If the balance shifts to to0 much saving of capital, there is more capital chasing a limited number of investment opportunities, rates of return on capital drop, and owners of capital seek ways to stimulate demand for credit, or turn to leverage and speculation to increase returns. This is what happened prior to the current recession. Owners of capital turned to derivatives and leverage to increase returns. When that wasn’t enough, they turned to liar loans in the housing industry to stimulate demand for credit. As the housing bubble built, housing investors got the idea that the housing market could only continue to go up, and started using their home equity as a piggy bank for spending, driving themselves ever deeper in debt. This is what caused the housing bubble. When the loans could no longer be serviced as variable rates went up the bubble burst.

When the bubble burst, the piggy bank closed, the markets dropped, and the rush was on to deleverage and pay down debt. This required spending less and saving more by nearly everyone around the world. So we return to first scenario where there is too much saving and too little spending, and into recession we go.

The difference between this and milder recessions is that this time it happened to nearly everyone, even around the world, because of the strong linkage between financial institutions worldwide, due to the mitigation of risk through investment insurance like credit default swaps on collateralized debt sold as stock. Credit rating agencies were paid by the banks issuing the collateralized debt to give it a high rating so it could be easily sold around the world. All this was done to increase returns on capital because there was way too much capital for the investment opportunities that existed.

Instead of restructuring the banks that had issued the junk debt, allowing the owners and stock holders to take the hit, the government bailed out the banks and allowed them to keep the junk loans, now deeply devalued, on their books at face value rather than market value. So instead of destroying the junk debt, they put repayment in full on the backs of taxpayers. Now everyone is panicked, no one wants to spend, lend, or investment. This is what’s called a liquidity crisis.

Returning to the theme presented at the outset, when everyone in the private sector decides to save at the same time, the government is the only source of spending available to maintain the balance between spending and saving that is required to stabilize the economy. Instead, we now have a bunch of politicians who think they’re at a Tea Party and the government is just another private budget manager that needs to save like the rest of us. They don’t understand the basic need to balance spending and saving overall to stabilize the system. To make things even worse, they think that the wealthy capitalists who created the problem should be exempt from participating in the solution. In fact they think their taxes should be reduced even further. Until taxpayers and politicians understand the basics of how an economy functions, we will continue to be mired in the quagmire and things will only get worse.

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