You are invited to read the latest commentary from the Free Enterprise Foundation. It will make you think!

“We are pleased to introduce Professor William Woolsey as a member of our editorial staff and senior writer on national economy reporting . Bill’s first article is in this special issue of our foundation news . We hope over time you will come to look for his periodic column as a reliable provider of accurate economic reporting and wise analysis on what it all means to you and your family. “

Inside The Economy, One Economist’s View

In a recent column in the New York Times, Nobel-prize winning economist, Paul Krugman used some simple Keynesian concepts to bolster his preference for “stimulus in the form of actual government spending.” He was commenting on the third quarter GDP report, which showed that the total production of goods and services in the U.S. dropped less than one-tenth of a percent. Total spending on U.S. final goods and services actually rose at an annual rate of 3.37%. That should be more than adequate to purchase all the additional output produced by our growing labor force, even accounting for historical rates of improvement in productivity - but only in the context of stable prices.

Unfortunately, the U.S. continued to suffer from inflation. In the third quarter, inflation spiked to a 4.2% annual rate, causing a reduction in the real volume of goods and services purchased. If current trends continue, total production of final goods and services would drop .3% of a percent after one year. Krugman, however, focuses on what he sees as bad news regarding consumer spending. According to Krugman, “American consumers almost never cut spending.”

Consumption spending in the third quarter was over $10 trillion, and increased more than $50 billion over the level of the second quarter. Why is Krugman complaining about a drop in consumer spending? Because consumer prices rose about 1.3%, so the increase in spending purchased fewer consumer goods and services The real volume of consumer goods and services purchased by households fell by about three quarters of one percent. If consumer price inflation continues at a 5.2% annual rate, and households continue to fall behind at the same rate for the entire year, then they would be purchasing 3.1% fewer goods and services in September 2009.

Krugman suggests that John Maynard Keynes’ concept of “the paradox of thrift” applies to the U.S. today. He explains that while it may be sensible for a household to save more, the resulting decrease in consumer spending can depress the economy. The purported “paradox” is that even though households might save a larger fraction of their income, because recession and unemployment reduce that income, their actual saving would be less. Krugman is concerned that the private virtue of saving has become a public vice. Was there a “paradox of thrift” during the third quarter? A further exploration of the statistics shows that households actually reduced their saving rate. In the second quarter, their saving rate was 2.7% and in the third quarter it fell to less than half of that, 1.3%. If saving is a vice, households were not guilty.

What happened? Personal income in the third quarter was $12,219.9 billion. That was an increase of $31 billion over the second quarter. Wage income was up $63 billion. Independent businessmen made $3 billion more. Rental income was up $4 billion. Interest collected by households was up $24 billion. But that $91 billion increase was partly offset by a $5 billion decrease in dividend income. So, households earned $86 billion more— an increase at a more than 3% annual rate. Unfortunately, it was too little to keep up with inflation.

Worse, households had to pay more taxes. Personal taxes went up $133 billion and social security taxes went up another $5 billion, so that taxes increased at a 25% annual rate. That left families about $47 billion less than in the second quarter. Further, the government reduced its transfer payments to households by another $55 billion. Disposable personal income dropped by $102 billion, to $10,732 billion. When faced with price increases, it should be no surprise that households cut back on personal saving as well as consumption. While consumer spending dropped at a 3.1% annual rate, personal saving dropped at a whopping 200% annual rate.

Krugman then appeals to another Keynesian concept to argue that the Federal Reserve will not be able to save us from the (imaginary) glut of savings. He asserts that the U.S. economy is in a liquidity trap. A liquidity trap is a hypothetical situation in which an increase in the money supply fails to lead to lower interest rates. The theory is that at some low level of interest, liquidity preference becomes absolute, so that no matter how much new money the Fed creates out of thin air, interest rates will go no lower.

There is no evidence that the U.S. is in a liquidity trap. As the Federal Reserve has lowered its target for the Federal Funds rate, its expansionary monetary policy has resulted in lower interest rates. The prime interest rate has fallen from 8.25% in September 2007 to 4% today. In fact, the Federal Reserve has begun paying interest on reserve balances in banks to keep interest rates from falling “too low.” During much of October, actual transactions in the Federal Funds market averaged less than 1%, below the Federal Reserves target of 1.5%.

It is true, of course that as long as the Federal Reserve supplies currency as demanded that interest rates can fall only slightly below zero. It can be no more negative than the cost of storing currency. However, convincing households to expand their consumption spending isn’t the sole pathway by which lower interest rates can expand spending in the economy. Dampening or reversing the contraction in investment expenditures, further expanding exports, and further reducing imports are all ways in which lower interest rates could expand spending even if households really did choose to increase saving. More importantly, a lower interest rate isn’t the only way in which an ample quantity of money supports spending. If production and income should fall, this will reduce the amount of money people can afford to hold, and as long as the quantity of money doesn’t fall, excess money balances will be spent.

For the last decade, government spending has increased at a record rate. This continued between the second and third quarters, with federal spending increasing at a 14% annual rate. Fiscal liberals, like Krugman, support new government programs as a matter of ideology. They believe that ever bigger government will do more to solve social problems. Those who take a more skeptical, libertarian view about the value of government programs would instead see new government spending programs as a last resort.

Since the current decrease in consumption was largely due to tax increases, reversing those tax hikes should be the first step to increase the public’s willingness to spend. Further, the market process that dampens and reverses price increases is for firms to sell less at higher prices. Reversing the inflation spike in the third quarter will allow for recovery in output and employment. Finally, lower interest rates only gradually stimulate increased spending.

It is certainly possible that even lower interests rates will be necessary for the economy to return to equilibrium. But rather than panicking due to a careless reading of the data, we have little option but to be patient. If the government has ceased draining off household income with higher tax collections, and interest rates are actually at their lower limit of slightly less than zero, and total spending is actually falling rather than only failing to accommodate rising inflation, then it might be time to call forth the old Keynesian concepts of the paradox of thrift and the liquidity trap. But at this time, it is premature to propose adding to the national debt in order to finance wasteful government spending on the grounds it is necessary to help the economy.

Dr. Woolsey is a distinguished Professor of Economics in the Citadel’s School of Business Administration and a former Libertarian candidate for Congress. We are pleased to welcome him to The Free Enterprise Foundation as one of our contributors to these pages.

Copyright © 2008 by William Woolsey and The Free Enterprise Foundation. All rights reserved

About the author: Professor William Woolsey as a member of The Free Enterprise Foundation's editorial staff and senior writer on national economy reporting. Dr. Woolsey is a distinguished Professor of Economics in the Citadel’s School of Business Administration and a former Libertarian candidate for Congress.

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