Monday, February 16, 2009

For the Greater Good: Frugality vs. Stimulus, T.A.R.P. and Foreclosure Relief

In this Sunday’s New York Times, Cornell Professor Robert H. Frank wrote an article entitled “Go Ahead and Save. Let The Government Spend,” in which he discussed whether taxpayers should resist spending their last dollar and let the government spend through the stimulus package, TARP and similar programs including the expected foreclosure relief package. In the article, Professor Frank referred to the John Maynard Keynes essay, the “Paradox of Thrift,” which argued that increasing individuals’ savings rates has the effect of reducing aggregate demand, and because of the negative multiplier effect, actually reduces personal income. Over the past seventy years many academics and politicians have used this analysis to conclude that government should stimulate a declining economy with grants. Keynes would individually have us spend our last dollar to lift the economy. In the Times article, Prof. Frank disagrees, “Taxpayers shouldn’t feel bad for putting their own savings first.” He stresses that personal savings find their way into the financial system, usually through some form of deposits. These deposits will force banks to compete for good loans by lowering interest rates which helps some existing borrowers as well as new borrowers.

I agree with the thesis that we should let the Government spend our money first, whether it provides optimum benefit to the economy or not. However, there are two stronger arguments that Professor Frank could have made. The first has to do with the contrast between the multiplier on consumer goods and services purchases as opposed to the multiplier on capital goods purchases. The largest part of consumer spending is for immediate or near-term consumption, which pays for the human labor already expended. Compare this impact to spending on capital-producing investments, such as mining or manufacturing, which may produce much larger revenues and earnings in the future. Those who favor immediate satisfaction by spending today are following the same pattern of over-spending and under-saving that is one of the causes of our current calamity. In effect, this is a consumption based philosophy that does not look to the needs of the future. In contrast, savings that support capital production does grow the size of the pie.

In order to make wise capital expenditures, business people assume various contingencies when building their calculations for cost of capital and expected returns on their capital, including sweat equity. I believe that from an economic measure, the return on private capital spending is materially higher than consumption expenditures. Thus, we should all be increasing our savings for the long-term benefit of the economy.

The second reason we should encourage savings is that frugality has its own reward. In my recent book Money Wise, I suggest that the second most important way to convert riches into wealth is by controlling expenditures. If your goal is to increase your savings from the current 5% to 9%, you will need to find the other 4%. You will do this by either expanding your gross income or finding some expenses you can do without, or can delay. In other words you will become a much more efficient purchaser. This more efficient mind set will stay with you for a much longer period of time than will the pleasure of consumption, and thus will have a more lasting benefit to you, yours and your charitable endeavors.

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