Friday, January 2, 2009

Mind the psychology at work in crisis

Jan 2, 2009

By Tion Kwa

A GERMAN Social Democrat disagrees with the economic stimulus measures being put in place by a British Labour prime minister. Then, the German is cheered on by members of Britain's Conservative Party. Social Democrat against Labourite; British Conservatives back-slapping Germans. What a curious world this has become.

The German in question is Finance Minister Peer Steinbruck who, in an interview with Newsweek last month, poured scorn on Britain's stimulus plans. 'Our British friends are now cutting their value-added tax...The same people who would never touch deficit spending are now tossing around billions. The switch from decades of supply-side politics all the way to a crass Keynesianism is breathtaking,' Mr Steinbruck said. (Yes, 'crass Keynesianism', from a Social Democrat.)

In the spirit of the whole confusing thing, let's say they have a point. That is, Mr Steinbruck and British Prime Minister Gordon Brown.

Mr Brown is right to want government to be out front trying to push the economy back to health. Just as right as United States President George W. Bush who, although he comes from a party with a natural aversion to government interventionism, has been busy pump-priming and dishing out bailouts like a Democrat. His successor, Mr Barack Obama, who is indeed a Democrat, will turn on the spigot even more.

The psychology at work in this crisis is such that traditional means of influencing markets and consumer behaviour won't suffice. Banks don't want to lend despite a boatload of liquidity. People don't want to buy despite rock-bottom prices. Without government intervention, the private sector will continue to sit on its hands all the way down to an even deeper recession. Governments have to hold their noses and act, however ideologically distasteful state intervention might seem, because these aren't normal circumstances.

Of course, Mr Steinbruck can't be completely averse to fiscal stimulus. Germany is about to introduce a second package of measures this month, following a number of initiatives announced in November. Mr Steinbruck, however, advocates testing out each step to judge what works and what doesn't before moving further.

The problem with this Teutonic moderation is that measured steps aren't effective. Washington learnt this last year when it sent out 'stimulus cheques' to taxpayers, hoping that by spending the money they would give the economy a nice bump up. But US$300 (S$430) per taxpayer - more if they have a family - adding up to total bill of US$160 billion wasn't enough to set things in motion.

Sure, in normal times that's a lot of money. Today, we're trying to figure out just how much is a lot. (Is a billion the new 'million'?) As it turns out, what we need may be the kitchen sink and everything that comes before it. Already, in the span of a few weeks, the price tag on Mr Obama's own stimulus plan has ballooned to US$700 billion, and might top a trillion. (Is a trillion the new '100 billion'?)

The more interesting thing about Mr Steinbruck's comments is something else. His main issue with the British plan is the temporary reduction of the value-added tax (VAT) from 17.5 per cent to 15 per cent. The centrepiece of Mr Brown's &pound20 billion (S$42 billion) programme, the VAT cut will cost Britain an expected &pound12.5 billion in lower revenues.

Again, it is about psychology. Although higher VAT can reduce the motivation to spend - as it did in Japan in the late-1990s, when Tokyo raised sales taxes in the middle of a downturn - lowering VAT in recessionary times doesn't necessarily result in a reverse effect.

Perceptions involved in the cost of transactions are complicated. Take Mr Steinbruck's point: 'Are you really going to buy a DVD player because it now costs &pound39.10 instead of &pound39.90?' Probably not. The inducement to buy is too small.

Yet, even a small rise in price as a result of a higher sales tax can have a bigger effect in the opposite direction. A price rise can be perceived to be more significant than a price reduction, even though they may be identical in value. A consumer will be happy the total bill for filling up his car is less because of lower sales tax, but he's unlikely to be moved to buy a new car because of it. When transaction costs go down, people pocket the change. They take the benefit in the form of lower expenditures, rather than as an incentive to spend further.

What opens up the wallet is cutting income tax, because this creates increased wealth. When people are better off, they feel a greater willingness to spend. On the other hand, a lower sales tax's wealth effect is notional. You are more wealthy only if you don't spend more than you would normally.

Thus, although a cut in the sales tax and an income tax reduction might look like the same thing - a tax cut, pure and simple - the effects are opposite. Cutting income tax encourages spending and investment; cutting sales tax induces savings. Mr Steinbruck is right to see that the British plans to boost demand may reap no result.

So should we instead have wholesale income tax cuts? It'd be nice. But those economies that need large fiscal stimulus programmes also need to consider how to pay for them.

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