Saturday, June 20, 2009

It's far better for China to increase demand and net-imports through investment spending than consumption spending

Oliver Blanchard writes:

China has embarked on a major fiscal expansion, with a focus on investment rather than on consumption. This was the right policy given the need to increase spending quickly, but this increase in investment can only last for a while. The question is whether, as time passes, China will allow an increase in consumption.
Why is it constantly the case that we see calls for increases in consumption to stimulate demand and/or net-imports, even over longer run periods, when demand and net-imports can be increased with investment spending instead, which will create far more growth in wealth, science, technology, and medicine over the long run. Why are people constantly calling for China and other countries to spend more on big screen TVs, fashions, and eating out, when demand could be stimulated and net-imports could be increased just as much through investment in schools, universities (and student aid so a much greater percentage of young Chinese could go), infrastructure, health (mentioned briefly by Blanchard, but his focus was predominantly on increasing consumption) and safety, relatively clean power generation and conservation, provision of computers and internet access to the rural poor, etc., etc.
These things would make the people of China far wealthier over the long run, and advance science, technology, and medicine for the whole world far more than if instead demand and net-imports were stimulated through the purchase of big screen TVs, Nikes, Burger King, and SUVs.

Blanchard does give this reasoning:
China has embarked on a major fiscal expansion, with a focus on investment rather than on consumption. This was the right policy given the need to increase spending quickly, but this increase in investment can only last for a while.
and
...there will be heavy pressure on the US government to maintain a strong fiscal stimulus for as long as private demand is weak, and this may lead to larger and longer deficits than would be wise. While strong fiscal stimulus was and still is needed to fight the crisis, it cannot go on forever; at some stage, debt dynamics become unsustainable, markets react and fiscal deficits become counterproductive.
But a shift in the mix of a nation's spending away from consumption and towards investment can be maintained indefinitely without "at some stage, debt dynamics become unsustainable, markets react and fiscal deficits become counterproductive.", through the use of something called "increased taxes" to eliminate the deficit.
If a country, or the world, is in a demand-crunch, increased government spending of X on investment will stimulate demand more than increased taxes of X will decrease it. You can read the many excellent posts of Nobel Prize winning economist Paul Krugman explaining how increased government spending creates more stimulus per dollar than tax cuts, but the main idea is that a tax increase of X will cause a decrease in consumption of less than X. But all of the increased taxes of X will be spent by the government -- on high-return investments in this case.

As Krugman wrote:
Other things equal, public investment is a much better way to provide economic stimulus than tax cuts, for two reasons. First, if the government spends money, that money is spent, helping support demand, whereas tax cuts may be largely saved. So public investment offers more bang for the buck. Second, public investment leaves something of value behind when the stimulus is over.
To elaborate, some of the tax increase on consumers will result in them consuming less, but a large amount of it will result in them saving less. Essentially, when taxes are increased to pay for more government investment projects you are making consumers save less and spend more, but not on Nikes and TGI Fridays, instead on infrastructure, education, alternative energy, conservation, basic scientific and medical research, etc.

Moreover, increased government spending on high enough return investments (and there are plenty) can be maintained indefinitely even without tax increases (in rate) because the high enough returns over the long run allow the payoff of the government debt and much more (if that debt can be reasonably financed in the shorter run until the investments pay off. Nonetheless, tax increases, once the demand crunch recession ends, are desirable to eliminate deficits, and the public debt, much faster). As Berkeley Public Policy Professor Robert Reich recently wrote:
...That growth path, by the way, will be faster and stronger if the nation invests in our infrastructure, our schools, and our environment -- which is exactly what Obama aims to do. In this respect, national budgets are like family budgets. It’s dumb for an indebted family to borrow more money to take a world cruise. But it’s smart even for an indebted family to borrow money to send their kids to college. So too with the Obama budget. Public investments, just like family investments, build future wealth. They allow faster growth. They make the debt/GDP ratio even lower and more manageable over time.