We don't need to stimulate consumption

Last week, President Obama rolled out the framework for his long-anticipated economic recovery and employment-improvement plan. Details of the plan are being sent to Congress today for their inspection. Mr. Obama says that the only reason anyone could be against this plan would be "political games," but from what we have seen of the plan so far, the economic approach of the plan is almost completely "demand-side" or "consumption" oriented, which is a reason to remain very skeptical.

We have written before about the difference between seeing our economic problem as one of boosting production versus boosting consumption. We would recommend all our readers understand this crucial distinction, and perhaps go back and review previous posts on the subject, including this one and this one, and this external article by the professor emeritus of economics at Pepperdine University, George Reisman, first published back in 1964.

The demand-side or "consumptionist" view of economics teaches that demand for goods and services is always in danger of growing too weak to consume what is being produced, leading to recessions and unemployment. Those who follow this view naturally believe that the way to improve the economy is to stimulate this demand in various ways.

The supply-side or "productionist" view of economics teaches that demand is a given -- it does not need to be stimulated. People will consume things -- in fact, if we do not consume food every day, we will soon die. Furthermore, left to themselves, people do not simply consume the minimum, but will naturally desire more and better goods and services. The desire to consume does not need to be stimulated, because it is built-in.

Each of the above approaches believes that the basic economic problem is very different. The consumptionist school takes supply for granted, believing that goods and services will naturally be produced, and that the problem is getting consumers to buy them. The productionist school takes demand for granted, believing that consumers always want to consume, but that producing enough for them is the problem.

We believe the productionist or supply-side school is much closer to the real situation experienced in the economy, and that this view of the world has demonstrated its worth over the demand-side/consumptionist theories that dominated the twentieth century (championed most famously by John Maynard Keynes and his followers and intellectual descendants).

The president's policies from the beginning have focused on stimulating demand and consumption, and last week's speech was no different. While the plan is ostensibly about creating jobs, the details it did contain centered around government spending on infrastructure (which will create temporary work for those involved, who will then spend and increase demand and consumption), lowering the interest rates on mortgages for homeowners (enabling them to spend more money, thereby increasing demand and consumption), and paying small businesses that have contracts with the federal government more quickly (enabling them to start spending sooner and thus boosting consumption and demand). These are all demand-side or consumptionist approaches.

We believe that the best way to increase economic growth and hiring is to remove obstacles to production, and the plan appears to do very little in that department. To be fair, there were some points about lowering payroll taxes for certain workers (such as those who have been unemployed for six months). However, these payroll tax reductions are always "targeted" (for certain employees only) and temporary -- which does not fool potential employers.

The speech also promised a review of government regulations in order to "cut away the red tape that prevents too many rapidly-growing start-up companies from raising capital and going public." We applaud any proposals that actually reduce obstacles to production, including reduction of government red tape, but must confess to being skeptical in light of the fact that this administration recently pushed for and signed into law a massive increase in red tape in the form of the Dodd-Frank bill, which dwarfs even the Sarbanes-Oxley Act in terms of red tape -- see the amazing graph posted by economics professor Mark Perry in his Carpe Diem blog here.

We also applaud the line in the speech about signing free-trade agreements, including the trade agreement with Colombia that has languished for years since being signed in 2006, and like the reduction of red tape will be more inclined to believe it when we see it.

However, the demand-side bias in the plan is revealed by the suggestion that any tax cuts in the plan be paid for by raising tax rates "on those who are most fortunate and can best afford it." This kind of statement ignores the simple truth that we have discussed in previous posts, that tax rates in the wealthiest brackets have a disproportionate impact on production because most of the capital used for business investment and backing for start-ups and new innovation comes from these brackets. Penalizing gains from such investments reduces the incentive for investors to risk that capital. If investors lose their capital, nobody pays them back, and if the government takes more of their gains when they invest in a winner, the risk-reward equation changes dramatically.

Finally, the plan does not reduce corporate tax rates in the US, which are among the highest in the developed world, a point that has been discussed by legislators from both political persuasions as a necessary ingredient to give US companies equal footing in the global markets. All he did was promise to eliminate loopholes and deductions that some companies receive. This reveals the fundamental demand-side bias of the plan, which was on display in this segment:
Should we keep tax loopholes for oil companies? Or should we use that money to give small business owners a tax credit when they hire new workers? Because we can’t afford to do both. Should we keep tax breaks for millionaires and billionaires? Or should we put teachers back to work so our kids can graduate ready for college and good jobs? Right now, we can’t afford to do both.
None of this is to suggest that consumption is not important -- it is obviously necessary to create demand for goods and services. However, it does not need to be stimulated. And when government reduces the obstacles to production, those producing companies end up expanding, hiring more workers, and creating more demand.

This fundamental distinction should be understood by all investors.