So, the previous article in this series noted that our data shows that the stimulus tax cuts simply went right into the Federal Reserve as deposits, doing nothing to stimulate the economy. They did that because people viewed the future value of the money as being more valuable to them than the present value of the money, and thus saved it (or paid down debt with it) rather than spend it on goods or services. And the banks were not lending because they feared they were insolvent, so they put it into the Federal Reserve as deposits.
So anyhow, it happened. And we know it happened because people (and banks!) viewed the future value of the money as being greater than its current value, because that’s just how the models work. But *why* did they view the future value of the money as being greater than the current value? Especially since there is still inflation, which would tell them that the future value of the money will be *less* than the current value?
Let’s look at the hierarchy of needs. There are basically four kinds of needs:
- Needs for immediate survival. This is food, housing, basic utilities, and gasoline for your car to get to work and get groceries. If you don’t have these you are in a world of hurt.
- Needs for long term survival. This is investments in clothing, transportation, home repairs, etc. needed to maintain your ability to fill the needs of immediate survival.
- Needs for long term improvement of your situation: This is investments in education, better housing, etc. that will help you get further ahead over time.
- Entertainment and luxury. These aren’t really “needs” as such.
So basically let’s give $10 to someone. When will they spend that $10 — now, or six months from now?
Basically, you have to look at where they are on the needs hierarchy now, and where they believe they will be on that needs hierarchy in six months. If they are on level 1 (i.e. in a survival situation) now, they will spend the money now. Thus, e.g., money given out as unemployment insurance typically gets spent immediately. If, on the other hand, they are at a higher level on that needs hierarchy now, but see themselves as being on a lower level at some point in the future, they will save that money to be used at that point in the future.
Let’s look at a measurement that seems to have some possible predictive value as to what people might do with that money: the University of Michigan Consumer Sentiment Index. You would expect that when this index is low, people will believe that they’ll be at a lower level on the needs hierarchy at some point in the future, and thus will save the money. And when this index is high, people will believe they’ll be at the same or higher level on the needs hierarchy at some point in the future, and will be more likely to spend the money, especially if there is inflation that would make the money decline in value if they held on to it. So, does this index track consumer spending well? Hmm, let’s look at the index:
And let’s look at consumer spending as a percent change:
Hmm…. there may be some correlation there indeed. When people see things as looking good for them in the future, they do seem more inclined to spend. It is not, however, a perfect correlation. As you’d expect, since there’s also other factors involved — seasonal holidays that create spending spikes, inflation, and so forth.
So anyhow: Next time someone tells you that tax cuts (or expanding the EITC to give money away) will create economic activity, tell them “it depends”. And unfortunately, a down economy is exactly when “it depends” most often rolls the dice as “Nope, it won’t”, because a down economy is when people most often view their future level on the needs hierarchy above as being lower than their current level — and thus view any unexpected money as being more useful in the future, not in the now. Mattress money simply doesn’t do anything, other than make mattresses lumpy. Just sayin’. Which is most likely why Jazzbumpa’s graphs attempting to correlate tax cuts with increases in economic activity show nothing of the sort — tax cuts don’t seem to do diddly to improve economic activity. In fact, the trend line is exactly the opposite — tax cuts seem correlated with lower economic activity. Which proves nothing at all (correlation is not causation), but at least proves that tax cuts don’t increase economic activity. Why? Well, the above hypothesis (that tax cuts tend to correspond with economic downturns and thus any additional spending money from the tax cut just disappears under a mattress because people view their future position on the needs hierarchy as lower than today) is a reasonable starting point, and does appear to agree with the data thus far. To go further than that will require spending a lot of time grabbing data and feeding it into statistical analysis tools to see whether the correlation I’m eyeballing is real and how strong it is — something I have no intention of doing right now due to lack of time (unlike JzB, I am *not* retired, yo!).
– Badtux the Economics Penguin
It is the spending of money that stimulates the economy, not just putting money in peoples’ hands. In an economic downturn, it is government that must spend the money because the people will not.
LikeLike
Hey, Tux –
I like your approach here. Looks pretty thorough.
Just to clarify “Jazzbumpa’s graphs attempting to correlate tax cuts with increases in economic activity” – actually, my point was to graphically demonstrate that such correlation does NOT exist.
The idea that it does is one of the BIG lies perpetrated by conservatives.
Cheers!
JzB
LikeLike