Why targeted government spending and tax concessions are preferable to outright tax cuts

Fiscal policy has become the subject of an intense ideological warfare among economists.

Over the long term – i.e. over the business cycle as a whole – economists do not agree on whether the structural budget should aim for a surplus or a deficit. This is understandable as several issues arise, such as whether governments can at times be more efficient than private enterprise, whether it is sound public finance for governments not to borrow, whether higher taxes are bad for economic growth, the equity premium puzzle etc.

But, until today, we thought we had wide agreement on whether governments should seek to smooth the effects of short-term fluctuations. It was generally accepted that we should be trying to iron out cyclical differences – through fiscal stabilizers (such as automatic changes in unemployment payments or in tax revenues) or through discretionary counter-cyclical fiscal measures (such as deliberate changes in tax rates or new expenditure initiatives). We have no such agreement.

One group of economists mostly libertarians like Robert Lucas, John Cochrane, Robert Barro and John Taylor argue that the Government should go for tax cuts. Malcolm Turnbull in many ways a social progressive on issues like abortion, gay rights, republic etc. – has now lined up with the economic libertarians, even though his views were mostly favorable to the $10.4 billion economic stimulus launched in October.

On the other hand, egalitarian economists like Paul Samuelson, Joseph Stiglitz, Robert Solow, Paul Krugman etc. want to use all relevant fiscal measures to minimize investment risk, ensure steadier income and avoid an increase in core unemployment rate the rate consistent with inflation. This is also the view of some conservatives such as Martin Feldstein.

I find myself in the latter camp. Our argument is that supply-side models are adequate models of the long run but they do not explain demand-side short-term economic fluctuations very well. Libertarian economic analysis is largely based on longer term models (e.g. 1955-2006 in the case of Makiw and earlier still by Barro), which allow for supply-side responses. This analysis does not apply to near-depressions.

On the other hand, models which include wage and price rigidities, such as New Keynesian models, do have a greater ability to explain short term fluctuations in a severe recession and can best address these macro-economic fluctuations.

This is particularly so when we are facing the prospect of a near-depression. In such a climate, monetary policy cannot work effectively where there is a break-down of trust among key players in the financial system and extreme risk aversion. It needs to be supplemented by fiscal policy.

The IMF is now urging its members to devise packages that provide maximum fiscal boost to demand very soon. If we relied on general tax cuts, it is clear that much of the tax savings would be saved in the short run. Public spending can provide much more bang for the buck than tax cuts. Moreover, tax benefits, especially if they are permanent, pervasive and predictable, cannot be later reversed once the depression is over. What we will then hear is how raising taxes will tend to kill growth and cost us jobs. Libertarians are justified to make an argument against public spending in general – but not at this point of the cycle.

What we need are selective, easily reversible spending measures such as
– bricks and mortar investments in shovel ready (no long lead times) infrastructure;
– improved time-specific jobless (unemployment) benefits;
– temporary tax benefits for low-income (genuinely low-income) persons to limit demands for wage increases;
– some assistance to people providing welfare benefits;
– through the states, assistance for all specific industries or regions that will bear the brunt of job losses;
– a boost in education and training benefits (health may need to proceed more slowly because it takes time to retrain medical trainees); and
– temporary tax benefits to encourage new investments and new technology (such as reducing energy or water consumption).

Such measures will only crowd out private investment and net imports if:

– there is pressure on productive resources;
– direct interest rate responses are likely to be very large, despite an accommodating monetary policy;
– exchange rate movements are correspondingly large; and
– there is significant forward looking consumption smoothing by private agents (Ricardian equivalence effects where people are smart enough to recognize that higher deficit spending will lead to higher taxes later).

The first only applies when the economy is operating close to full employment.

The second and third are crucial. The effectiveness of fiscal policy is only seriously damaged where (a) the smallest rise in investment and housing demand sharply pushes up rates of interest or (b) if the demand for real money is very insensitive to interest rate changes. But such extreme circumstances and their effects on exchange rate movements, especially if other countries are doing the same thing – are unrealistic and unsupported by the evidence.

As for Ricardian effects, past experience suggests that any effects tend to be long term and then only dampen the initial impact by a third to one half.

We are also blessed with a stronger banking system and sounder government balance sheets than in other countries. This too is an important issue to consider.


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36 Responses to Why targeted government spending and tax concessions are preferable to outright tax cuts

  1. Damian Jeffree says:

    These times almost need another book. For a title, how about “Australia at the ‘Wrong Way Go Back’ Signpost”?

  2. observa says:

    Can’t see fiscal stimulus doing the trick any better than liquidity measures to date because this is no ordinary economic slump. It’s really the beginning of the fading and aging of the baby boomers, after their ‘Great Moderation’ period and before that their unprecedented youthful stagflation. Officially the last of the baby boomers is 47 while the forerunners are 64 and that’s no great age cohort to be pouring fiscal stimulus into now their nominal savings have been burned badly. That’s a bottomless pit for fiscal stimulus and a recipe for disastrous deficits to be funded by their offspring. That cannot be allowed to happen although electorally I fear it will and Rudd is their man for that now.

    Guaranteeing bank deposits was really to guarantee all baby boomer savings and investments, because it is largely the old that lend to the young. Those savings are really fools gold and should be brought out into the sunlight and identified as such. Instead we see rearguard actions like propping up commercial proprty developments in order to prevent that happening. The 100% bank guarantee should be scrapped for a 50% or perhaps 60% maxm gurantee for all deposits and relax mark to market rules and let banks trade until insolvency or a run, with depositors fully aware of the risks. Youth has little to fear with its meagre deposits and high spend rates relative to income. With falling asset prices at least that would encourage spending and investment again, if only to pick up cheap assets and put a real floor under them. Naturally regulation of all all labour rates and terms of employment would need to be abandoned in a deflationary environment, but that would always favour youth in the long run. None of this will happen as baby boomers are all a sorry lot of self interested Keynesians now. They’ll wrap that self interest in concern for the battler of course and Rudd is their perfect man for that.

  3. Fred Argy says:

    Observa, the Governments aim is only to cushion the economy until the private sector resumes borrowing.

    Just ask yourself: how bad would our economy look if the old fiscal package (the $14.b injection) had not been initiated? How bad would it now look without this week’s fiscal package?

    Be thankful for small mercies.

  4. Tel_ says:

    The IMF is now urging its members to …

    Ask Boliva and Ecuador about the quality of advice they get from the IMF. The South Americans discovered that all the foreigners actually wanted was cheap resources and the investment never got spent on developing the people, nor any infrastructure beyond mining. This was all backed up by trade in small arms and back-door support for Authoritarian governments.

    We will see how Iceland enjoys their dose of IMF advice sitting on 18% interest rates. To think how the ALP was hammered over their track record of high interest rates during the Keating years and here is the IMF pushing up Iceland’s interest rates to crippling levels. I could describe my feelings but not in any words this blog would tolerate.

    The IMF have managed to give a bad name to the idea of free markets, and they have done it (like any loan shark) by searching for those weakest and then pretending to help while turning them into debt slaves. Then they scratch their heads in confusion when the people of these countries get violent and push towards socialism.

    I call myself a Libertarian, but my respect for the IMF or its advice is just about zero.

  5. Tel_ says:

    Bah! need coffee… someone please fixup the broken quote tags above.

  6. observa says:

    Here’s Spengler nailing the history of the current problem in a moment of superb clarity-
    and for the big cahuna US you can also substitute the EU or Oz and he points out the obvious that Japan is our road map for any futile attempts to live in lever lever land now. The Great Stagflation followed by the Great Moderation and now the Great Geriatrification, except that the last phase has begun with a bloody great bang rather than a whimper. The plethora of Gordon Geckos and Louis Leeches the intermediate phase spawned would ultimately make sure of that. Until we all accept that ‘moment of clarity’ and what it means for policy, it’s all just Groundhog 1930s stuff.

    And in May 2008 in another superb moment of clarity-
    ‘There is nothing complicated about finance. It is based on old people lending to young people. Young people invest in homes and businesses; aging people save to acquire assets on which to retire. The new generation supports the old one, and retirement systems simply apportion rights to income between the generations. Never before in human history, though, has a new generation simply failed to appear’

    which boiled down means there’s no way baby boomers have a snowball’s chance in hell of selling out those levered up assets at their inflated prices, to their dwindling offspring, in order to fund their retirement in the manner to which they feel they are entitled. Immutable laws of supply and demand say it just can’t happen and it’s not.

  7. observa says:

    ‘Be thankful for small mercies.’
    Depends how we like our medicine. Long, slow and very painful or short, sharp and bloody horrible. Apparently ir’s to be the former.

  8. observa says:

    As for ‘Why targeted government spending and tax concessions are preferable to outright tax cuts’, that’s because baby boomers vote in baby boomers to run the show and they’re not stupid when it comes to where their bread is buttered in future.

  9. Fred,

    like you, I thought stimulus spending was not really in doubt as an article of faith amongst policy oriented economists, so your claim of a punch-up amongst economists intruiges me. Where can I find the tax-cut advocates though? I tried to track down the recent opinions of the first on your list, i.e. Robert Lucas. I found him being bashed at a libertarian website (http://mises.org/story/3305) for defending big government in the form of a virtually all-powerful fed. Robert Lucas his op-ed (http://online.wsj.com/article/SB122999959052129273.html) on the recession doesnt read like advocating tax cuts at all. Rather, it reads like he believes in printing money and irresponsible lending by the fed. Indeed, it reads pretty badly for him, but that’s another matter. My point is that I cant find him advocating tax cuts as the appropriate response. He seems to believe in big borrowing by government, but then simply in the forms of blank cheques to firms rather than spending on particular programs favoured by the government. It’s not the same as tax cuts though.

    I bet I am missing an easy link to a declaration by the ones you mention. Can you point me to one?

    I think you are advocating an increase in welfare generosity. Can’t see it happening.

  10. Fred Argy says:

    Paul, thanks.

    On our own doorstep, we have Henry Ergas, Malcolm Turnbull and Julie Bishop.

    They are arguing about the overseas evidence for across the board tax cuts – taking the lead from John Taylor, who argues for permanent, pervasive and predictable tax cuts.

    Just look at Mankiw’s blog, http://gregmankiw.blogspot.com/2009/01/is-joe-biden-disingenuous-or.html

    where you will see a large list of similar people to Taylor.

    Look also at the economist’s view (“It’s in the water”) http://economistsview.typepad.com/

    Perhaps I have included one or two too many (not sure about Lucas).

  11. JC says:


    Are there any empirical studies showing where a spending program has worked?

  12. Fred,

    thanks. I followed the links. Barro definitely advocates tax cuts, and Thoman Sargent and several others also argue the tax cut ilk. Several others like Gary Becker seem to have misgivings about the particular spending proposals (which doesnt mean advocating tax cuts). I gues there is a bit of a punch-up between those who do not believe it is possible that production factors can be idle (those who basically believe market frictions are small even in the short-run) and those who do believe production factors can be idle (which is all the neo-Keynesians). If one takes the possibility of involuntarily idle production factors seriously though, nearly all current structural macro-models would be inadequate.

  13. Fred Argy says:

    JC, I have not done any work myself but if you look up Paul Krugman (the Nobel prize winner) you will see plenty of useful references. But remember what Paul has to say about “current structural macro-models”. In the end we must all rely on judgment.

  14. JC says:


    The latest evidence I’ve seen which was the Japanese attempt to spend their way of a similar problem in the 90’s had about zero effect and left Japan with a debt to GDP ratio of 175%.

    Furthermore work done by Roma & Roma (one 1/2 is now a senior economic adviser to Obama) has done some serious scholarly work to suggest spending has almost no effect and in some cases could actually have negative consequences.

    Krugman’s Nobel was on the very good work he did in trade theory not this area, so I wouldn’t cite him as having enough expertise.

    Harry, if we rely on judgment we could would also use the 70’s UK to show that spending simply doesn’t work.

  15. Fred Argy says:

    JC, let me just quote a recent piece by Susan Woodward and Robert Hall:

    “We have followed this area of macroeconomics carefully for many years. All macro-models agree that increases in government purchases increase real GDP. That multiplier is probably around one but we would not rule out 1.5. Most macro-models place the tax cut multiplier quite a bit lower and we agree. Here we are referring to tax cuts that hand families more purchasing power. Later we discuss tax changes that give focused incentives for immediate spending where the effect could be much larger”

    There, if you don’t like Krugman, maybe you will accept this assessment.

  16. NPOV says:

    Krugman doesn’t seem to think that much of Woodward et al’s analysis however, at least in the case of WWII spending. But it’s not clear that he’s made a particularly compelling case that government spending would have a high multiplier effect in the current circumstances. Then again, nor does he need to – he only needs to make the case that it’s an efficient way to trigger the right sort of economic activity to speed up the natural recovery process. Given there’s so much infrastructure in the U.S. that needs upgrading anyway, that’s not a particularly hard case to make.

    A question – if the prime concern re tax cuts and/or direct handouts is the amount that would be saved, is there a reason governments couldn’t issue vouchers that retailers etc. would be required to treat as equivalent as cash (i.e., the government would be required to buy the vouchers back from retailers at face value) but that cannot be converted directly to currency by consumers, and have a specific expiry date so they can’t simply be hoarded?

  17. JC,

    the problem with analysing historical data is that most of the recessions are believed to be of a different form, i.e. not a wave of pessimism but rather a policy-induced ‘correction’, a restructuring necessary after a war (1945), a price shift (such as oil), etc. The wave of pessimism variety is believed to be a very different animal to the other ones, making it almost irrelevant what spending and taxes have or have not effectuated in the 70 years since the last bout of great gloom.
    The simplest way I can explain the case for spending versus reductions in taxes is to liken this recession to a dance at the town hall where everyone is hit by a bout of pessimism and sits on their chair waiting for the others to move, making all movement stop because everyone is afraid there will not be a partner for them when they abandon their chair. A government can, for a while, bribe some section to dance (=spending). If successful, the dance gets moving again. Tax cuts on the other hand just make everyone feel more comfortable on their chairs but doesnt necessarily entice anyone to dance.
    Japan is a complicated case, though not entirely an irrelevant example. Many of the things money was spent on were reportedly of the truly useless variety.

  18. JC says:


    I don’t disagree that recessions have different pedigrees. However this one seems like a classic bank panic of the 1800’s combined with a good dose of monetary expansion causing mal-investments (with US housing being ground zero). In actual point of fact a recession is by definition a form of debt repudiation in that if you look at most recessions debt is always hiding around in the background.

    I’m truly buggered if I know what anyone can do to solve the US problem other than letting time act as the cleaning agent while ensuring no large bank failure.

    Spending your way out of it seems to me to be totally counter intuitive when we have a situation where the US budget deficit is already in dire straits. Adding another layer of spending will bring the deficit to 10% of GDP. How this figures in a country’s that running a current account deficit is yet to be tested and we’ll soon know.

    Japan’s cause wasn’t altogether different as it too can be taken back to an over extended real estate market and an equity market financed by a great deal of debt. The difference in Japan was that they were self financing in that they were running sizable current account surpluses which meant that they didn’t require foreigners to take foreign exchange risk like the US will have to. However spend they did like drunken sailors. They started the recession with a pretty decent budget situation and ended up with 175% debt to GDP and even then they were foundering around at the bottom.

    We’re about to get into the same boat as the US with a tax shortfall of $115 billion meaning we too could be running a domestic deficit of 10% of GDP. However unlike the US we don’t have the luxury of a reserve currency.

    Here’s my simply solution. If your going to do something eliminate corporate tax and freeze spending in nominal terms for a decade. Then hope like crazy the rest of the world reflates.


    Fred.. sorry I meant you… I wrongly referred to you as Harry Clarke.

  19. Tel_ says:

    … to liken this recession to a dance at the town hall where everyone is hit by a bout of pessimism and sits on their chair waiting for the others to move …

    So you are saying that what we are seeing here is purely illogical behaviour and that nothing whatsoever has changed in the physical world. In other words, not only is “rational economic man” completely irrational, but people in general are too stupid to consider their own interests. Quite frankly I don’t buy it, I don’t even half buy it. Yes, I agree that people can be stupid, and will get carried away with short-term hedonism when they get the chance, but generally they understand their own business pretty well.

    If humans really are so foolish that they can’t make basic decisions, why bother with an economic system at all? We should just give up on Democracy too. So what method do we have left to figure out who the new overlord is going to be… hmmm, maybe pit fighting? Na, that would be too intellectual. How about a beauty contest? Given that you obviously don’t trust anyone to figure out how much they should spend, what decisions are you going to trust them to make?

    Please, I’m an over such shallow analysis, go back and try harder. Come up with at least one thing that relates to real physical objects and the movement of such (which is after all, they fundamentals of any economy).

  20. observa says:

    That’s my whole point JC, that if demographics will persistently defy all reasonable reflation, then that only leaves deflation but noone wants to see it that way. Just like the 1930s.

  21. Tel_ says:

    Japans cause wasnt altogether different as it too can be taken back to an over extended real estate market and an equity market financed by a great deal of debt.

    May I propose a more fundamental theory.

    After the war, Japan’s economy had a clear purpose and a clear path to get there. They were rebuilding, adopting Western technology, and taking the position of the manufacturing powerhouse of the world. Having achieved these objectives they ran into the problem of where to go next. They had China and SE Asia coming up behind them eating up the market for mass manufacture of cheap goods so the logical step was to move up the technological and economic ladder.

    They faced a number of obstacles in doing this. Software is one of the important rungs on the ladder, but software requires a certain human and cultural investment. In my belief, it probably requires several generations of such investment to actually get good at it and that Anglo world just happened to strike it lucky at the right time and place. Military research is another important rung on the ladder (just look at how many technological breakthroughs had their origin in wartime) and Japan is still essentially an occupied country, massive military investment isn’t an option. Japan can’t expand, their land is finite and their population density is high. They tried investing in China so they could own the factories that were putting them out of work, to some extent it was successful, but helping China become productive doesn’t solve the problem of finding jobs for Japanese workers.

    The other problem that Japan faced is that the next rung up from them was already occupied by the USA and the European technological leaders. Japan would have to move from being an adopter of other people’s technology to a builder of new technology, that’s a tricky step, it requires a whole different point of view. Although the Japanese are brilliant at taking a good idea and polishing it up into a great product, can you name a single technological design that is uniquely Japanese and exported to the rest of the world (other than sushi, and jujitsu, which don’t make good earners) ?

    Japan has also invested massively in basic research. This is certainly what they need, but the payoff is slow by any timeframe that an economist would use. They need to build a culture of research, which is a culture of people who do odd things, and who don’t spend their lives trying to blend in with the crowd. You can fiddle with macroeconomic policy until the percentages come out your ears but this is a ship that just doesn’t turn on a dime, under any circumstance. Also, the population is aging, old people are set in their ways, unwilling to comprehend that after making one long leap they must now shift weight to the other foot in order to leap again.

    I’m always astounded by how quickly the economists will abstract themselves away from all the confusing details of tangible things and float on a sea of indicators and aggregates then point out some decade as being “lost” pretending like they have any idea of what might have happened during that time.

  22. JC says:

    Although the Japanese are brilliant at taking a good idea and polishing it up into a great product, can you name a single technological design that is uniquely Japanese and exported to the rest of the world (other than sushi, and jujitsu, which dont make good earners) ?

    Wasn’t the Sony Walkman a Japanese ‘invention”. I thought the ghetto blaster or boom box whatever its called was theirs too.

    No but seriously machines tools are also their bag goo.

  23. JC says:

    Sorry, meant to add before I rudely cut myself off………..

    Look the really big serious innovations for a good part of last century were actually European at least up to the early-mid part of the century. Think jet plans, rocketry etc. Even atomic discovery was basically done by transplanted Europeans. The US had a knack of making all these sorts of things available to the mass market except splitting the atom obviously. If the Euros were still doing planes the way they were only the very rich would be flying (as well as cars)

    So you can’t really say it’s important to be the first out with technology as I don’t think that is the most important factor. Consumers aren’t concerned that you were the first, they’re only concerned with value for money which is why Toyota is the biggest carmaker in the world now.

    (Some day I’ll start proof reading.)

  24. observa says:

    Speaking of Toyota try ‘Kanban’, apart from absolute quality control meaning the 1st to the 100,000th car off the line contained no lemons or Monday morning specials. Why car companies like Mitsubishi can offer a 5yr/100k overall warranty and a 10yr/160k power train warranty(engine and transmission) With that ethos they conquered the world commercially. You might also like to try and find a 1.5litre, 4door, CVT auto, aircon, power windows & mirrors, ABS, EBD runabout that can beat 5.6L/100km for $18k AUD in the marketplace with Mitsi’s warranty. Good luck!

  25. Tel_ says:

    The boom box was just a bigger, better radio set. As I said, take an existing design and make incremental improvements. No real breakthrough.

    The Walkman, yeah I guess I can give some credit there. Radios and tape players came with optional headphones in many shapes and sizes long before the Walkman, but Sony hit it right with the product package and the placement, plus they delivered the smallest unit to date. Sony have always stood just a little to one side of the rest of Japan.

    I was more thinking something along the lines of inventing digital optical data storage, or object oriented programming, or the transition from circuit-switched communications to packet-switched networks or one of those conceptual-level breakthroughs.

    So you cant really say its important to be the first out with technology as I dont think that is the most important factor. Consumers arent concerned that you were the first, theyre only concerned with value for money which is why Toyota is the biggest carmaker in the world now.

    Of course it is critical not just to prove the concept but also get it into a production-line product. And yes, eventually any given technology will propagate until everyone knows how to do it (like the motorcar) at which point the most efficient and consistent producer will take over. Being on the top of the technology ladder isn’t about value for money, it’s about being the guy everyone looks to for the NEXT big thing. There’s a time lag while everyone else plays catchup and by that time something else is the big breakthrough. You get a big bonus from being able to do things that no one else can do (both in the marketplace, and on the battlefield).

    Yes I agree that a big part of the US lead in the late 20th century was a combination of the highly skilled European immigrants, meeting up with the product-oriented American mindset and having the available physical and financial resources, plus a relatively liberal environment that encouraged people to try new ideas. Many of these factors have faded, and at the same time the US technological lead is also fading (and the competition for top place is heating up, the Asians might be slow to get their act together but they are very determined).

    I see the Western world keeping a lead in software for maybe another 20 years, not much longer. In robots we are probably behind w.r.t. the electromechanical devices, but still ahead for overall machine intelligence and problem solving, this is going to be a big deciding factor.

  26. James A says:

    NPOV: What you describe sounds a lot like stamp script which was used to some success in the 1930s depression in the US.

  27. Fred Argy says:

    NPOV, I don’t follow. Why can’t a better off person cash the vouchers and simply spend less from his normal incomes? It could apply to very low income people. Is that what you mean?

  28. Tel_,

    well, if you are not content with the kids’ version and seriously want to get your teeth into this matter, may I suggest the following link where you will find about 5 background papers on the micro-economics of the production factors destroyed during these kinds of recessions. I also have a more recent piece with Nemanja Antic (April 2008, very timely) which is titled ‘the missing production factor in economic downturns’ which I can send you (I dont want it freely on the web quite yet). The main point to make is that you do not need irrationality for waves of pessimism hence the straw man you put up has no clothes on.

    I will also turn the tables on you though and say that your pop-science story on Japan cuts no mustard. Even if you are right that Japan is somehow culturally constrained in becoming a leading technological country, that still wouldnt stop it lagging behind the technological leaders at a fixed ratio, hence with constant normal growth rates. You provide a pop-science explanation for why they havent overtaken the US, not why growth was so low in the 90s.

  29. NPOV says:

    Sure, but if you had a choice between handing someone on a $50K income $1000 in cash vs $1000 worth of vouchers, surely the latter is likely to generate more spending than the former? There would inevitably be a percentage of recipients that would simply switch to using the vouchers for all their regular spending (i.e., not increase their spending) and save more income, but it would surely be smaller than the percentage of recipients that would simply save any cash given to them directly.
    And I’m not suggesting that such vouchers should be given to those on above-average incomes.

  30. pedro says:

    “Sure, but if you had a choice between handing someone on a $50K income $1000 in cash vs $1000 worth of vouchers, surely the latter is likely to generate more spending than the former?”

    Even if no money is being saved out of the original $50k, the new “income” can be saved or spent. This is because $1k from the original $50k can be saved while the vouchers are spent.

    Given that this recession is likely to be sustained, I can’t really see the value in one-off payments like the first $10bil and the new $12bil. Nobody can base forward plans on them.

    The real problem is bank liquidity and lending uncertainty and so even in the land of Oz we need the air to clear on values so that the banks can lend again at reasonable LVRs.

  31. NPOV says:

    Pedro, of course it’s more or less mathematically equivalent, but human behaviour isn’t 100% rational. I’d be willing to bet that most consumers would be more likely to increase spending with quick-expiry non-saveable vouchers than with cash, because either way they have to change how they manage their money.
    For instance, my wife recently received a $500 Coles gift card. It arguably would have made the most economical sense to simply use this to purchase groceries, and save the income that would be normally spent at the supermarket. But she didn’t – she used it almost entirely to buy more expensive christmas presents than she would have otherwise.

    As for whether one-off payments have much economic value in a sustained recession, presumably the point is to prevent such a thing from happening. If we knew for sure the downturn would last years, then there’d be no point trying to do anything other than support those worst affected by it.
    Of course the payments aren’t just about economic value – they’re as much about maintaining political support as anything.

  32. Tel_ says:

    thanks for the link, I’ve had a look through some of it. I can see how your idea of ” Relational Capital” or just RC creates a coupling between individual outlooks so that a crash in one sector drags down other sectors, and also how the destruction of RC can create positive feedback:

    The cycles are not unique and are self-fulfilling expectations. They emerge because it is unpro…table to invest in extra contacts when other firms are destroying old contacts: the expected life of an extra contact is higher in periods with low creative destruction. This leads firms to coordinate their Dt and their Nt

    (from the Nov 2003 paper)

    I wouldn’t argue against any of that, and it does explain one of the things that makes a recession worse once the momentum gets going. To say that this is the primary CAUSE of the recession is rather far fetched. You coupling mechanism is not the only coupling mechanism in the system — anyone who just buys shares instantly couples their fortune to all the other owners of the same shares (and the whims and desires of those owners), buying shares does not require any great labour of searching (although one might argue that a bit of research might be a good idea). The banking industry is even more tightly coupled with constant interbank loans and a wide range of risk reselling instruments.

    Furthermore, let us consider the situation once the recessionary momentum does get underway, we have the so called “creative destruction” happening and relationships are being both broken down and rebuilt. You claim a time-lag between the time new RC comes into existence and the time when the new RC becomes productive (delay adopting new technology, refits, retraining, etc). I can accept this time lag, and this becomes a fundamental parameter in the shape of the bottom side of the bounce curve. What I can’t accept is the logic that throwing further spending into this downside bounce will reduce the lag (given that the lag is linked to physical transitions that must be performed), nor do I see why the additional spending changes any of your driving forces — new RC needs to be put into place, and doing so takes time.

  33. Hi Tel_,

    you flatter me by actually following through the link. Yes, the whole point of the research project is to capture the notion of market frictions between buyers and sellers into a production input termed relational capital. That is the thing that gets destroyed in bankrupcies and recessions. If input and output relations do not exhibite this kind of value-through-friction then there is effectively no reason to fear bankrupcies because they simply free-up the production factors for others the use. The reality is that these production factors are specific to the relations in which they were build and cannot immediately be used for something else. New networks and relations need to be built before they can be used.
    The translation of this kind of theoretical work to actual policies is always a bit tenuous (the real world is always so more complicated than the model world in which you can ‘solve’ things), and all the inadequacies you mention are valid. The main link between spending and the recession though is a) that the government prevent the mass-breakup of links in various sectors by effectively decoupling one part of the economy from the other parts, simply by talking over the role as the demander of the output of that quarantined sectors, and b) that the government becomes a direct link-maker. Within the model world maintaining high levels of links has dynamic benefits in that higher levels of networks make it easier for the market participants to find more links of their own next period. This thick-market externality is not incorporated by profit-motivated parties and hence is a job for government. There is no actual role for taxes in the models, but taxes would not change the nature of the externalities and hence the case for network formation at particular times.

    I you drop me a mail I will send you the later paper.

  34. AdrienSword says:

    If humans really are so foolish that they cant make basic decisions, why bother with an economic system at all?

    As in stop eating?

  35. Tel_ says:

    This thick-market externality is not incorporated by profit-motivated parties and hence is a job for government.

    Is this realistic?

    The classic tech example I can think of is IBM making the “PC” and deciding to base it around an inteL chip (actually they based it around an entire inteL application note for a bunch of their chips). IBM could logically have just signed an exclusive deal then and there, but they instead insisted that a second-source existed and managed to broker a deal with AMD getting access to some of the basic i386 design documents under inteL license. The rest is history with AMD and inteL at each other’s throats to this day, but competition has been very healthy for the industry (for completeness I should note that a third source exists which was Cyrix who did the rounds including collaboration with IBM themselves, and getting bought by Natsemi then onsold to VIA where the technology became the core of VIA’s current embedded systems design (and why has VIA never stepped into the laptop industry?)

    So back to the theory: IBM’s motive was obviously not to optimise any market externality, but they did have good reason to mitigate risk on what they were planning would be a long-term product. IBM thought it was important enough that they created a second-source where none previously existed. Indeed, pretty much any company has good reason to ensure second source and third source supply for their components. Similarly, any supplier has good reason to diversify their customer base. Possibly it might result in fractionally lower profits, but substantially lower risk. Not only does it lower the risk of a supplier going broke and leaving their customers in the cold, but it avoids putting oneself in a very poor negotiating position with someone who knows you have no other options.

    Handing responsibility of risk mitigation over to government results in private operators compensating by taking bigger risks and depending on government to bail them out. Worse because everyone must take bigger risks just to keep up with the competition, and the whole industry just gets crazier. That’s the thing about taking risks, it’s risky, and the only way private business is going to be sensible about it is if they understand that it really is risky, for them.

  36. _Tel,

    firms do not concern themselves with their search externalities and the situation you describe is just one where a firm makes its own optimising decision even though it didnt turn out optimal in the long-run. Yet it illustrates the value companies put on their networks. The externality I am talking about is that it is easier for the likes of AMD to find new partners if there are large networks in their industry already. Simply a greater chance of coming across a suitable partner because there is more information in the current network regarding the others. That is the externality on which government action is justified, not the individual trade-offs of individual firms.

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