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Sloppy use of terminology leads to sloppy analysis. One of the things that really drives me crazy is when people equate “spending” with consumption. Why does this matter? Consider whether you’ve ever heard the something like the following:

“Around the middle of the decade Americans went on an orgy of spending on new homes; it’s time to tighten our belts and cut back on consumption.”

There is an argument for cutting consumption, but it has nothing to do with building too much housing, and it’s probably wrong in any case.

1. Spending on new homes isn’t consumption, it’s investment. Period. End of story. Some commenters will insist that new homes are not capital goods. That’s crazy, I live in a 90 year old home. How many factories last for 90 years? How many trucks? How many jetliners? Homes aren’t just capital goods, they are super capital goods, the most capital-like of all capital goods. And no, the fact that they are often owner-occupied, and not rented out, makes no difference. If you insist homes are consumers goods I will regard you as economically illiterate. You’ve been warned.

2. Suppose we built way too many houses in an frenzy of irrational exuberance. What then? Let’s first consider a closed economy model. We should increase non-housing production. We should probably also increase total production, as poorer people generally want to work harder. But let’s suppose I’m wrong, and use the worst-case scenario for my argument. No extra work effort. In that case, if we decide to produce say $400 billion less in housing, we might decide to build another $400 billion in non-housing goods, i.e. consumer and non-housing capital goods (private or government.) It might be another $250 billion in business capital and another $150 billion in consumer goods.

3. Thus the optimal response to a spending frenzy on housing isn’t tightening our belts, it’s loosening our belts. The housing frenzy involved too much investment, and hence too much saving. Yes, saving really, really does equal investment. To make up for too much saving, we need to save less and spend more. We should have had a monetary policy that makes that happen, but of course we didn’t.

4. I’m sure by now you are screaming at the monitor that I forgot the current account deficit. That could change things, but I doubt it. It’s certainly true that if we made two mistakes, a housing orgy and an current account fiasco, then we should fix both problems. But what makes people think there was any big problem with our current account? I predict it will go back into large deficit as the economy recovers. Why shouldn’t it? As long as the US can run up massive debts, and yet face no net outflow of investment income, I’d expect us to keep doing that. For my entire life I’ve been told that the day of reckoning is coming for the current account, and it never happens. I’ll believe it when I see it.

5. If I’m wrong about the current account, we’ll want to re-allocate that $400 billion to business investment, exports, and consumption, in some combination. So the net effect on consumption is ambiguous. But if I’m right that the US current account will continue to be all talk and no action, and that we’ll keep running deficits, then my analysis in parts 1-3 still holds, with the proviso that the excess saving was done by both Americans and Chinese. But we’ll still want to loosen our belts by saving less.

Why does everyone else get this wrong? Perhaps it’s nothing more than confusing the terms ‘spending’ with ‘consumption.’ One can spend on either consumer or investment goods. When you spend on investment goods, it’s called saving.

There should be nothing controversial about this post–it’s all straight out of econ101. But then we know that our profession likes to abandon textbook economics whenever it conflicts with their prejudices. So I wouldn’t be surprised to get a bit of push-back in the comment section.

PS. Krugman’s right that we should not react to the housing bust by spending less. But this is not because the individual family is unrepresentative of the macroeconomy. What’s right for the individual is right for the overall economy.

PPS. I still think we save too little. But for tax distortion reasons, not because of the housing bubble.

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This entry was posted on March 14th, 2012 and is filed under Misc.. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response or Trackback from your own site.



