Is Spending Or Saving The Answer?

The rush to hoard cash and pinch pennies is understandable, given that some $13 trillion in net worth evaporated between mid-2007 and the end of 2008.  But while it makes complete microeconomic sense for families and individual businesses, the spending freeze and collective shunning of nonguaranteed investments is macroeconomically troubling.

– Dan Gross, “Stop Saving Now!”, Newsweek, March 23, 2009

Dan Gross has a cover piece in the most recent Newsweek arguing that we need spending to get us out of this economic crisis.  But the natural inclination for all of us businesses and individuals is to cut back on spending in the wake of declining incomes, profit and wealth.  Could it be that what seems so naturally imperative to all of us at the microeconomic level is problematic at the macroeconomic level, as Gross posits?  This is one of the great misconceptions in contemporary economics and my guess is it is traceable to Keynes.

On the surface, this argument seems plausible.  After all, if we cut back our spending on clothes, restuarants, vacations, that means the loss of revenues and profits and therefore jobs for those businesses.  A decrease in jobs then leads to less spending and we have a vicious spiral.

What this account overlooks is that the current structure of production is irrational and inefficient.  Due to rising home and stock prices, all of us believed we were much wealthier than we actually were.  Based on that false premise, we spent money on all kinds of things resulting in growth in a variety of industries. 

What the crash has revealed is that it was all a bubble.  Our increase in wealth was mere appearance, not reality.  We do not in fact have the wealth and corresponding purchasing power we thought we did.  The increase in nominal prices for assets created the mirage of increased real wealth.

Now that all of this has become apparent, it makes great sense to cut back on our spending in proportion to our lower income and wealth.  This will lead to business failures and unemployment but it sows the seeds for a more rational allocation of capital and labor.  We don’t want so many people working in restaurants, stores and construction.  We don’t want so many people working in mortgage finance. 

There is always demand for work to be done.  It’s just a question of people finding work in areas of the economy where there is demand and at wages employers are willing to pay.  The adjustment process will be painful but it’s a necessary part of allocating our scarce capital and labor in the most efficient way to satisfy our collective needs and desires.  To promote spending is to perpetuate the current irrational structure of production and it’s inefficient allocation of resources.