Deficit Spending

In November 2008, Thomas Friedman wrote a column urging young people to save more:

I go into restaurants these days, look around at the tables often still crowded with young people, and I have this urge to go from table to table and say: "You don't know me, but I have to tell you that you shouldn't be here. You should be saving your money. You should be home eating tuna fish. This financial crisis is far from over. We are just at the end of the beginning. Please, wrap up that steak in a doggy bag and go home.

Is Thomas Friedman offering sound economic advice here? Certainly, the importance of saving seems to be the new mantra these days. Lots of emphasis on "bargain meals" and such. But, really, should everybody be saving? Should we all be hoarding money in preparation for financial endtimes?

Steven Levitt puts the question nicely in his blog entry, titled, "When it Comes to Saving, Who Would You Listen to: My Wife or Milton Friedman?" (Note that Levitt is speaking of Milton Friedman, the Nobel Prize-winning economist, and not Thomas Friedman, economic layperson and obviously in cahoots with Levitt's wife.)

A lot of people blame today's economic crisis on excessive borrowing. Loans were too often extended to people not worthy of the credit. A fair assessment. But does this mean that borrowing is necessarily a bad thing? No.

Enter probabilistic thinking. The US government currently operates at a deficit and all signs point towards this deficit increasing dramatically during Obama's first years as president. This is not a bad thing. Economists are generally in consensus that large fiscal stimulus (read: deficit spending) is required to get the economy back on its feet. But there is an important distinction to be made when talking about the deficit, the difference between structural deficit and actual deficit. The structural deficit can be thought of as a probabilistic deficit: do spending programs exceed expected tax revenues (which can be calculated using the economy's long-run probabilistic unemployment rate). So Obama's challenge is this: to simultaneously increase current actual deficit spending while eliminating Bush-era structural deficits.

How does this all relate to the initial question about the prudence of saving? Well, the same principles that apply to government deficit spending apply to personal finance, especially for young people with long time horizons to consider. It is okay to borrow and to spend so long as you are probabilistically-structurally sound. In fact, your spending patterns need change from what they were a year ago only if there has been an underlying, probabilistic shift in your expected, life-time income stream. Consumption-smoothing, after all, is one of the primary functions of financial markets.

As for Thomas Friedman's advice? He with his words is single-handedly responsible for a statistically significant drop in consumer confidence, and we should blame him at least partially for our current woes.

Of course, probabilistic thinking sometimes or oftentimes runs counter to emotional thinking. Thus the conflict between the coldly rational Milton Friedman and the surely sentimental wife of Steven Levitt (why she must surely be sentimental I have no idea).

Maybe I am just trying to rationalize my current spending habits.