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- OPINION
- JANUARY 7, 2009
Boost Private Investment to Boost the Economy
Excessive spending is what got us into this mess in the first place.
By HAL VARIAN
These days it seems like it is our patriotic duty to consume more. And if we don't choose to spend more money ourselves, the government will do it for us.
But wait a minute. Isn't it excessive spending that got us into this mess in the first place? Spending more now seems like drinking Scotch to cure a hangover.
Despite this apparent paradox, there is some logic to providing a dose of economic stimulus. But it should be more like Alka-Seltzer than Scotch. To understand what sort of stimulus makes sense, consider the economic forces at work:
In the modern economy, there are four sources of demand (consumption, investment, government and exports) and two sources of supply (domestic production and imports). When a component of demand declines, supply will ultimately have to decline as well.
In an ideal world, an increase in savings would automatically lead to an increase in investment. When consumers put more of their money in their savings accounts, the funds would be lent out to finance the production of factories, machines, computers and other forms of physical capital. These capital investments make more consumption possible in the future which is, after all, why people choose to save.
It is not just investment in physical capital that matters. Savings can also be recycled as student loans, which allow for the accumulation of human capital by increasing the supply of doctors, engineers and skilled workers of all kinds.
Unfortunately, savings are currently not getting translated into investment for three reasons. First, one of the largest categories of physical capital is real estate, and we have already overinvested in that area. Second, businesses are reluctant to invest in new plant and equipment due to the weakening economy. Third, the sorry condition of bank balance sheets has made them reluctant to lend. The net result is that money is piling up in ultrasafe assets like Treasury bills, without being invested in ways that would build a more productive economy.
Federal Reserve Chairman Ben Bernanke and Treasury Secretary Hank Paulson have rightly concentrated on getting the financial sector functioning again, since lending is a critical ingredient for private-sector investment. The Obama administration now wants to shift from monetary policy to fiscal policy and provide direct stimulus of demand. But which component: consumption, investment, government expenditures or exports?
Increasing exports would be great, but it's not going to happen. The rest of the world is having its own problems, so we are unlikely to see a big boost in demand for American goods.
Direct stimulus of consumption is tricky. In this economic climate, most of the money returned to consumers from tax cuts would probably be saved, and rightly so, since it is the prudent thing to do. Rather than relying entirely on direct stimulus of consumption, it is better to put a floor under consumption by making sure that unemployment benefits and food stamps are adequately funded.
That brings us to government expenditure, which is getting most of the press. The danger with this form of stimulus is twofold: First, it takes too long for the government spending to kick in, and second, spending may easily focus on pork-barrel projects that have little inherent value.
There are worthwhile public infrastructure projects; the trick is to find them and fund them promptly. One possible plan is to set up an independent commission to prioritize public investment projects, and then subject the plan to a single up-or-down vote in Congress.
One further warning about government stimulus: It makes little sense for the federal government to spend more if the states are forced to spend less. A significant part of the increase in federal government spending should be transfers to the states in order to keep basic government services available at the state and local level.
That brings us to private investment, which hasn't been getting nearly as much attention as it deserves. This is unfortunate, since private investment is what makes possible future increases in production and consumption. Investment tax credits or other subsidies for private-sector investment are not as politically appealing as tax cuts for consumers or increases in government expenditure. But if private investment doesn't increase, where will the extra consumption come from in the future?
Ultimately, we want to end up with a significantly higher savings rate in the U.S. than we have seen recently. That means some other component of demand must increase to compensate for the reduced consumption. And the most attractive candidate by far is private investment.
Mr. Varian is professor of economics at the University of California, Berkeley, and chief economist at Google.
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