Saturday, February 21, 2009

How to Correctly Fix the Economy

Apologies in advance if this is long and boring, but I figured since I've been thinking about it for a while, I should write down what I would do to smooth out the natural down-cycles of the economy, if I were so inclined, with the minimum amount of "bad" effects. This is not to say that I think it's necessarily what the government should be doing (although I'm getting inclined to think so), but assuming that it's the goal, here's the "correct" way to do it, as far as I can think of to date.

First, background on why I'm thinking the government should be doing something. Since roughly 2000, we have been in a worldwide credit bubble, which has inflated the valuation of virtually everything. Now that the bubble is correcting, asset values are returning to normal (and will probably overshoot normal), and personal spending has decreased substantially, probably below "normal" in a steady economy. Now, increasing the personal savings rate is good, and decreasing personal debt is good, however this does have a ripple effect through the economy, as businesses which would otherwise be healthy and viable with "normal" consumer spending may go under due to a prolonged period of "below normal" consumer spending. This then cascades through to other businesses as B2B purchases are reduced, and as each of these businesses fail, more people lose their jobs. More job losses lead to less spending and less well-being, and businesses closures lead to longer recover time. So, there is value in the government doing something to try to preserve businesses which would otherwise be healthy under a "normal" economic scenario, to help the system as a whole, even if it means borrowing from our future prosperity (by increasing the national debt, for example).

Given that, we should consider how best to do so. As we know from many historical lessons, one of the worst things the government can do to their economy is cause economic uncertainty, or inefficiencies in allocation of private resources. This is why a free market with minimal corruption, fixed and minimally-obtrusive laws, minimal government manipulation, and a solid-value currency is the most efficient system known for generating economic prosperity, and the US has taken advantage of this to various extents to become the most economically prosperous nation in the world. So, in injecting new borrowed government money into our economy, the "correct" course of action should involve something which minimizes the disruption to the factors which make the economy work well in the long-term. Let's examine the ideological proposals of both major parties in this context.

First, the Democrat proposal is ideologically to spend a lot of money having the government take-over the services lost through private business failure, and provide new services (like building infrastructure, investing in new politically-targeted technologies such as "green", and providing more welfare services). The prevailing thought is that spending the majority of the money quickly is of maximum benefit. This would cause:
- Private businesses will still fail (no support and no increase in private spending), causing cascading job losses
- Some jobs will be created in government or government-sponsored industries, but these are only funded for a year or two, after which they will be lost again (without additional borrowing and spending)
- The Democrat agenda is advanced with more government services, but these do nothing to help the economy
- Private resources are inefficiently allocated to meet changing government mandates and "special favors" (tax breaks, incentives, backdoor deals), which causes loss of economic efficiency
- No long-term benefit; prolongs the recession (same as response which created the Great Depression)

Now for the Republican proposal, which is ideologically to give tax breaks to all individuals, large tax breaks to businesses, and some spending on infrastructure (it's hard to discern if there's anything else they would propose, since they had virtually no input into the "stimulus" pork bill, but this seems at least ideologically fair). This would cause:
- Small businesses get very little help (no profits to tax), so they still fail, cascading. Large businesses and energy companies would be the big winners, but they don't generate jobs or help the economy, so no benefit.
- Individuals benefit, but they largely save the money or pay down debt (which is not incorrect, just not particularly helpful to the economy), which is not the purpose for the government support. Although they would be helped in the short-term, it does nothing to help the economy, just transfers wealth from the future to short-term help now.
- No long-term benefit; prolongs the recession (no severe disruptions or inefficiencies, so at least not negative, but not positive either)

Now for what I think is the "right" approach:

The goal is to keep private businesses which would be viable with "normal" consumer spending alive long enough for the economy to recover, without propping up businesses which should be allowed to fail, or causing severe economic disruption (eg: moving substantial capital allocations around chasing the next government handout). To that end, the government should devise a formula which calculates private business profits from operations (not investments) which is realized in the US (and thus subject to US taxes after costs). They should then allocate an amount for ongoing "economic support", on a per-year basis, to be funded with borrowing as necessary. This money should be given (tax-free) to every private company based on their percentage of the total gross revenue from operations realized in the US for every private business in the country, as real-time as possible (probably quarterly with estimated tax filings).

This would cause:
- Viable businesses would be able to survive, but only by continuing to produce meaningful profits in the same relative magnitude as would be required to survive "normally". If profits degrade because the business model is not viable, government support will degrade by the same percentage, leading to failure anyway (which is correct, since the business would have also failed with "normal" spending). Overall business levels (employment and production) are preserved.
- B2B business is preserved, which preserves the maximum amount of private jobs.
- No inefficiencies are introduced in capital allocations, because the support doesn't create special incentives of direct capital.
- When private savings have "caught up" to lost asset valuation and spending returns to normal, the government can uniformly reduce the amount of support causing minimal disruptions.
- No individuals are directly benefited (although all all benefited indirectly), and there's no subjective allocation, so the potential for corruption, manipulation, and special favors is minimized.
- The system can be codified as a "standard" support policy in dire times, removing the need for ad-hoc "solutions" which disrupt the economy further.

Anyway, for what it's worth, that would be the "correct" way for the government to support the economy without causing a prolonged recession or a depression. I'm sure there are many reasons we're doing all the other things instead, be them political, personal, or intellectually-deficient, but this would be the right way per the stated goals (as far as I can think of). Just wanted to write it down, since I can't resist trying to "solve" problems, and this seems like far closer to the "correct" solution than anyone else has proposed to date.


  1. Now, increasing the personal savings rate is good, and decreasing personal debt is bad

    Did you mean to say increasing personal debt is bad?

    I think you’re slightly underselling the Democratic approach, but not by much. I agree that the Democratic and Republican approaches are flawed. I like them about equally. (The Republicans didn’t have much role in it, so I may be filling in the blanks with what I wish they would support.)

    In your approach, would the money go to all businesses or only those affected by the slowdown? Would businesses doing well during the slowdown be eligible for the money? I guess the goal would be to get unbiased number crunchers to work out which industries are affected to what extent. Then business lawyers would be hired to argue that large portions of their clients’ businesses fall within the industries eligible for money.

    This plan is better than any other I’ve heard. I just won’t buy into any stimulus package, though, unless it is paired with changes to make the less recession more manageable. I want IRA-like or HSA-like accounts for people to save a family emergency fund and a large down payment for their house. This way the next recession won’t be a crisis for so many families.

  2. You are quite correct: I did reverse the polarity in that statement, and I've corrected it, thank you. :)

    In my approach, the money would go to all businesses which meet the criteria (ie: making gross profits from operations which would be taxable in the US). It's essential to a workable plan that the government support be as unbiased as possible, both to eliminate political corruption as much as possible, and to prevent influencing the allocation of capital, which leads to imbalances and inefficiencies. It's much more important that government spending not hurt the economy in the long-term than to try to make sure it's ideologically perfectly allocated.

    I, too, would love to have other government plans and systems in place to help mitigate or avert future recessions, but I disagree that they should be tied to government support programs (and thus negotiated with, and/or affected by). I think one of the fundamental failings of our current political system is the amount of "bundling" which happens with new laws and programs, which allows otherwise near-universally despised measures to get "snuck-in" to "must-pass" legislation. If it were up to me, we'd have much more separability in all of our laws, and only the provisions which were favored enough to get enough votes to pass on their own would become law... but that's a different debate.

    The goal of my plan would be to provide a framework by which the government could support the country during a recession, in a manner which causes the minimum damage to the long-term economy in the process. Optimally, it would be enacted stand-alone, and used without modification in any year in which Congress wanted to allocate money to support, per the objective rules (ie: no negotiation, buying votes, corruption, lobbying, payoffs, backroom deals, etc... all the normal things which accompany ad-hoc spending legislation in our Congress). Any other measures to spend additional money on agenda-related items, and/or measures to fix systemic problems in the country (eg: tax-protected savings accounts, fixing social security, etc.), should be debated openly and independently, and should not be incorrectly characterized as "support" or "stimulus" programs.

    That's my opinion, anyway.

  3. I'm not saying stimulus needs to be bundled with preventative measures in the legislative process. I'm just saying if we have to have a stimulus, I want it to be the last one. If most low to middle income families saved at least 20% down before buying a house and were at least working toward having a $20,000 cushion against hard times, these exact same economic conditions would not be a problem.

    The message politicians are promoting today encourages moral hazard. They're saying that these conditions are crazy and we need to "restore confidence" that recessions don't happen and that it's okay to go into a lot of debt.

    To me this failure of citizens (nowadays they like to call us "consumers") to plan for the ups and downs of the economic cycle is the key issue. The need for fiscal stimulus to soften this particular recession is minor, IMHO, compared to that.

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