The consumption / production distinction with regard to stimulus plans

Today, the House Appropriations Committee announced details of the largest economic stimulus legislation ever proposed by the federal government.

Many believe that in a financial crisis, the best way to get the economy moving is for the government to "prime the pump" by putting money in the hands of consumers. In his remarks from last Thursday, President-elect Obama articulated the opinion that "Only government can break the vicious cycles that are crippling our economy – where a lack of spending leads to lost jobs which leads to even less spending; where an inability to lend and borrow stops growth and leads to even less credit."

The plan calls for government "priority investments" (with an unprecedented level of accountability built in, the House Appropriations Committee notes) into a variety of worthwhile causes amounting to $550 billion, as well as an additional $275 billion in "tax cuts."

These tax cuts are not actually tax rate cuts, however, and they are specifically targeting an increase in consumption, rather than production. This is an all-important distinction.

The tax cuts in the current legislature are described by President-elect Obama as tax-cuts "to get people spending again." In other words, to increase consumption. As he explained it, "95% of working families will receive a $1,000 tax cut - the first stage of a middle-class tax cut that I promised during the campaign."

As nice as a $1,000 tax cut might be, it is correct that it will mainly be effective in increasing "spending again" -- consumption rather than production. It is our firm conviction that increasing production is what actually helps the economy, and in turn leads to more jobs and to increased consumption, as well as to improved standards of living to more members of society at all income levels. The important distinction between production and consumption is perhaps best explained in this article by Pepperdine Professor Emeritus of Economics George Reisman entitled "Production versus Consumption."

What would really help the economy would be a decrease in the marginal tax rate as well as a decrease in the corporate tax rate. This action would be far more likely to increase business activity by existing businesses, the creation of new businesses, and the allocation of capital to investment, all of which increase production.

In the video linked above, Dan Mitchell explains the problems with "stimulus" plans designed to improve the economy from the consumption side, using clear visual diagrams and plenty of evidence from American history.

Regardless of the path that the federal government takes in responding to the current economic conditions, investors have an opportunity to take the opposite approach. While it may seem that consumption-oriented mistakes will doom all future growth, the counter is that there are seismic shifts going on now which can be tremendous opportunities for investors.

As we explained in our previous post, there are some paradigm shifts which government mistakes simply cannot hold back. This was also true during previous eras of government economic mistakes, including the 1970s and even the 1930s. Now is also an opportune time, albeit a difficult time, to allocate capital to well-run businesses (through investment in both equity instruments and debt instruments) at very attractive prices.

Determining which businesses are well-run, and are positioned in front of potentially fertile fields of growth, requires some research and due diligence -- not all businesses with apparently attractive prices are wise allocations of capital right now. But for those who understand the distinction between consumption and production, the start of 2009 could represent the kind of opportunity that does not come along many times in an investment lifetime.

For later posts dealing with this same subject, see also:

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