The Idea of the Day

The idea of the day appears to be investment. Writing in the New York Times economist Edmund S. Phelps writes on the need for a different strategy for boosting economic growth:

The steps being taken by government officials to help the economy are based on a faulty premise. The diagnosis is that the economy is “constrained” by a deficiency of aggregate demand, the total demand for American goods and services. The officials’ prescription is to stimulate that demand, for as long as it takes, to facilitate the recovery of an otherwise undamaged economy — as if the task were to help an uninjured skater get up after a bad fall.

The prescription will fail because the diagnosis is wrong. There are no symptoms of deficient demand, like deflation, and no signs of anything like a huge liquidity shortage that could cause a deficiency. Rather, our economy is damaged by deep structural faults that no stimulus package will address — our skater has broken some bones and needs real attention.

His prescription? Increased long-term investment:

The worst effect of focusing on supposedly deficient demand is that it lulls us into failing to “think structural” in dealing with long-term problems. To achieve a full recovery, we have to understand the framework on which our broad prosperity has always been based.

First, high employment depends on a high level of investment activity — business expenditures on tangibles like offices and equipment, and also training for new or existing employees, and development of new products.

Sustained business investment, in turn, rests on innovation. Business cannot wait for discoveries in science or the rare successes in state-run labs. Without cutting-edge products and business methods, rates of return on a great many investments will sag. Furthermore, innovation creates jobs across the economy, for entrepreneurs, marketers and buyers. State-led technology projects do not.

High business investment also depends on companies having confidence in the future. A company might be afraid to invest in research or product lines if it fears the rest of the economy is not doing the same — or if it fears the government might become hostile to its goals. During the Depression, John Maynard Keynes warned President Franklin D. Roosevelt not to damage business confidence with anti-profit rhetoric — to treat titans of business “not as wolves or tigers, but as domestic animals by nature.”

He follows this with several policy prescriptions, all of which I’m afraid are likely to fail for a variety of different reasons.

Arnold Kling fleshes out his view that we’re in the process of what he terms a “recalculation”:

Much of today’s American workforce is engaged in roundabout production [ed. “roundabout production” refers to processes which don’t make end products, e.g. corn, but make products which are ultimately used to make end products, e.g. tractors, weather reports], which Böhm-Bawerk equated with capital. There is no longer a meaningful distinction between labor and capital. Labor is capital.

Arnold continues by explaining how the policy approaches that have been deployed to date in responding to the current (or past, depending) recession have been rooted in supporting an economy that doesn’t exist any more.

If any of the above sounds at all familiar, the lack of long-term business investment as a source of our economic woes has been a theme at this blog since its inception and something I’ve been articulating in other fora long before. My interpretation, for example, of the legitimate technology boom of the middle Clinton years, succeeded by the unsustainable dot com bubble of the later Clinton years, is that it was the result of decades of capital investment which had finally borne fruit. This contrasts with the competing theories (the tax increases of the early Clinton years were responsible for the growth; the fiscal prudence of the later Clinton years was responsible for the growth) in being founded on things that actually happened and supported by actual theories of economics. I know of no theory of economics under which tax increases lead to increased growth. It is certainly not a Keynesian view—tax reductions are fiscal stimulus and should result in reduced growth. Further, pro-cyclical tax increases were recommended by Keynes for reasons of sustainability not to stimulate growth. And federal spending never decreased during the Clinton years. The balanced budgets were a consequence of increased revenue not its cause.

To some degree whether long-term capital investment is the cause of economic expansion or a result of economic expansion is a “chicken or the egg” proposition. However, the pro-egg factions of both political parties, differing only in whether we should spend beyond our means to produce growth or reduce taxes below our needs to produce growth, have had their sway for a very long time—at least six decades by my count. It might be worth giving a pro-chicken policy a chance for a change.

8 comments… add one
  • steve Link

    ” I know of no theory of economics under which tax increases lead to increased growth.”

    I fail to understand the obsession with taxes and growth. When you look at our long term growth, there is just not that much correlation between tax rates and growth. There are clearly other factors which are more important. To be clear, taxes can be a factor, they just arent the only factor.


  • Sam Link

    I have a question for the economists here – if a deficit financed tax cut isn’t effective because of Ricardian equivalence, then similarly if during the Clinton years they raised taxes but also cut spending (thus lowering the overall deficit+ tax total) shouldn’t that be more of a stimulus than raising the deficit via tax cuts and no cuts to spending even though there was a tax hike?

  • I fail to understand the obsession with taxes and growth. When you look at our long term growth, there is just not that much correlation between tax rates and growth.

    Christina Romer and Paul Romer would disagree.

    The only time that tax increases seem to be pro-growth is when the increases are to reduce an inherited budget deficit–e.g. Clinton’s tax increases. Thing is with Clinton he was almost 2 years into an expansion when he did that, IIRC, and the recession that preceded that increase was not a financial crisis like we’ve seen recently (see the work of Rogoff and Reinhart on how these differ from your garden variety recession).

    However, all that being said our fiscal outlook is a nightmare. Deficits as far as the eye can see, Social Security and Medicare in serious fiscal imbalance. New commitments by the government to get in even deeper in the health care sector with damn little to slow the rate of cost growth.

    And for someone who wants to say, “Damn that Bush!” please pull your head out of your fourth point of contact before you suffocate. It wasn’t just Bush. It has been all of them for a damn long time. We’ve set up programs and policies that simply were not sustainable. This should have been seen back when we realized we had that demographic bulge Dave has mentioned. Under a wise set of leaders we’d have adjusted policies and made changes to ensure sustainability early on and minimize pain down the road.

    Problem is we don’t have wise leaders. We have normal people for whom we tend to construct cult-like beliefs in their ability to do things. Factor in that our government runs via voting and when you look at all the problems and pitfalls that entails it isn’t a surprise. Some people were getting rich off of the way things worked. They didn’t want to jeopardize it so they used their growing wealth to support candidates who would continue the status quo.

    Add on that people just love to piddle around in other people’s business all the time. They see somebody doing something that they wouldn’t do and they just can’t help trying to meddle. And that has carried over into our government. Oh, look those guys aren’t doing it quite right lets make them do it right…or what we think is right. Oh snap! That didn’t work so well did it. We all joke with sayings like, “I’m from the government and I’m here to help you.” But at the same time we keep giving them more and more control over decision making….the same government which is influenced by the rich and powerful; it is like rent seeking is just some myth.


    The requirements for Ricardian equivalence are rather stringent and are unlikely to be meet–e.g. capital markets are complete, households are infinitely lived dynasties where the utility of some future nth-generation is discounted back just like your own utility 10 years from now, etc. However, yes, such offsetting changes would likely be more pro-growth in the Ricardian model.

    In fact, part of the expansion during Clinton has been credited to the deficit reduction that we saw–it reduced interest rates thus spurring economic growth. Of course, we also had a bubble then too, so not sure how much of it was due to deficit reduction.

    And wow…Kling going back to Böhm-Bawerk, that’s actually quite cool IMO.

  • Increased long term investment, huh? I can guarantee that his prescription looks a lot different than mine.

    JIT manufacturing which involve international trade flows is heavily dependent on government procedure, operation of ports, transportation linkages, etc. If government is subsidizing the expansion of sea ports, airports, trade development zones linked to ports, etc then it is, in effect, subsidizing the export of jobs by making foreign suppliers more competitive vis-à-vis domestic suppliers. Port operations, roads linking to ports, trade zones attached to ports, customs operations to clear imported goods, shouldn’t be subsidized. Let them operate on a for-profit basis, or in the case of customs operations, on a fee recovery basis.

    With this one example we see that government involvement distorts commercial processes. Long term investment should take the form of rationalizing business and government processes so that they have minimal distorting effect on business decisions.

  • With this one example we see that government involvement distorts commercial processes. Long term investment should take the form of rationalizing business and government processes so that they have minimal distorting effect on business decisions.

    It’s funny you should mention this in connection with JIT. I’ve had the draft of a post on the subject sitting around for more than the year which makes precisely that point. JIT has also been primary in giving capital an advantage over labor in the contemporary economy.

  • We’d probably agree that there is no need to implement policies which impose tariffs on international trade flows involved in JIT manufacturing, just stop subsidizing them and direct that those who participate in JIT manufacturing flows fully pay their way.

    We can even put our thumb on the scale, in favor of domestic sourcing, by mandating full security screening of all incoming cargo with full costs of screening paid for by shippers. There is a legitimate argument to be made for full cargo screening but the affected parties, shippers, have been screaming bloody murder that this imposes costs and delays on them. How we trade off security against economic efficiency is a subjective/political calculation, not one in which economic theory has much to say. Regulations which inconvenience shippers and international manufacturers will conversely benefit domestic sources for the affected products which don’t have to be security screened and don’t have to be fully inspected in a customs inspection.

    These transaction costs (costs of port operations, cost of security screening, cost of transport itself) do have influence on total cost of manufacture. We can still have free trade and implement these policies because free trade shouldn’t mean government subsidization of international trade at the expense of domestic manufacture.

    As for the curse of half-written posts, I’ve got tons of them too. Too bad that we can’t just publish them in half-written form with the proviso that they’ll be fleshed out in the debate that follows in comments section.

  • Now that we’re on the topic of JIT why not publish your thoughts and then refine the thesis in the debate that follows?

  • Here’s another idea for long-term investment – change the employment law on disparate impact. There is a huge wealth and productivity black hole in contemporary society that is making us poorer – credentialism. Revamp hiring procedures so that employers can find applicant qualities that they seek without needing the shield of educational information. Let employers find the best people for the jobs they have available by using the best methods at their disposal even if the result create disparate impact.

    Finding better qualified people via a more direct method and being able to hire them for less (because a.) the hiring process is streamlined and b.) the applicant is in the work force sooner by skipping a full college experience or has more salary flexibility because their education was acquired more cost effectively because institutional status was not a primary concern) will result in national productivity enhancements.

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