The Sensible Public Sector

by: Shareholders Unite

We've often explained that when households are repairing balance sheets and the economy suffers from a balance sheet recession, households are saving more and borrowing and spending less. In order to keep the economy going, somebody has to borrow and spend more.

If this doesn't happen and everybody saves more and spends less, we're all ending up worse off. This is the "paradox of thrift" and one of the reasons why the economy at large is most definitely not like a household.

We also explained how, as a result of such a balance sheet recession, the economy gets into a liquidity trap, in which monetary policy isn't effective. It could even experience a deflationary-debt spiral in which lower prices and GDP rise the real debt burden.

We're not advocates of higher public spending because we are in one way or another wedded to a bigger public sector. It is simply the result of the fact that it is by far the most effective tool to get us out of this very special type of economic crisis.

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With interest rates so low and households repairing balance sheets producing excess saving over investment (see figure above, and this is reinforced because there is a world savings glut), there are plenty of funds for the public sector to invest sensibly. Yes, invest. At just over 2% for 10 year yields, it is difficult to imagine there aren't any projects for the public sector to invest in that don't produce a bigger return than that.

To do so would accomplish two things simultaneously:

  1. In the short-term, it would prevent the economy from backsliding while households are deleveraging, that is, reducing borrowing and spending, increasing savings and pay off debt
  2. In the longer-term, it reinforces the economic structure, increasing the future supply

Stimulus is necessary to counter the fact that after being idle for some time, a certain percentage of productive factors like plant, equipment and labor effectively withdraws from markets as plant and equipment becomes obsolete and labor becomes demoralized, losing skills and habits, and becomes discriminated against.

Government Finances

Avoiding this so called "hysteresis" effect might even be responsible for sensible public spending to pay for itself. Even if that is not the case sensible public investment is the cheapest stimulus there is in a balance sheet recession, where deleveraging households make the recovery weaker than normal, the public sector should do "maintenance and training" for the whole economy.

While we had rather grand and spectacular bail-out programs to save the financial system from imploding and there was one stimulus program, the truth is that public spending hasn't gotten "through the roof" as some have it. In a recession or weak growth, tax income suffers while some automatic spending (social security, food stamps, etc.) increases, creating the large deficit. But one look at the figure below and the doom of an "encroaching" public sector turns out to be an illusion.

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Where to Spend?

Japanese firms have developed a very sensible habit. When demand is slack, they don't normally fire workers. This is costly, as valuable knowledge is lost and selecting, rehiring and training new workers when demand returns only makes it more so. What they do is they engage in maintenance and training, in addition to (reduced) production and reduced bonuses.

In the very peculiar situation of a balance sheet recession, where households borrow and spend less and save more, the U.S. economy as a whole should do something similar. Necessary maintenance and investment in skills. That is, we propose public investment in three categories: Infrastructure, education and research and development.


Investing in infrastructure is simply necessary "maintenance." It has to take place sometime and now is as good as any. In fact, now is much better than anytime as it creates demand for laid-off construction workers, a left over from the housing boom as well as upgrading U.S. infrastructure and giving the economy a spending boost while households are deleveraging.


Investing in education can't be a surprise either. In a knowledge economy, it produces large returns. The U.S. used to enjoy the best overall education standards in the world for a long time, underpinning its economic dominance. But the last decades, much of the U.S. education system has fallen behind many other developed, and even poorer countries.

While the U.S. still boasts many of the best universities in the world, even these depend to a growing degree on foreign students and faculty. And the U.S. secondary education system has fallen behind that of many other countries, as results in international skills test continue to show.

This is quite important. If the U.S. wants to regain some of the manufacturing might of former days, good secondary and technical training is essential.

Although we are not of the opinion that money is the only determinant of educational success, lessons from education powerhouses like Finland suggest that the pay, education and status of teachers is very important, and this does have a monetary component. When whole countries, like South Korea, have extracted themselves from abject poverty mainly on the basis of improving education we're pretty sure that there is a lot of low-hanging fruit in the U.S. still.

Research and Development

There is a wide consensus in economics that investment in research and development has large returns, some three to eight times for every dollar invested. It's no surprise that ...

Empirical studies across time and countries confirm that innovation is the primary source of technological change and productivity growth. And investments in research and development, as well as in the scientific and engineering workforce on which they depend, are critical drivers of innovation and national competitiveness. (Laura Tyson)

It might not be so terrible:

The U.S. remains the global leader in R&D investment, spending an estimated $400 billion in 2009 - a total boosted by President Barack Obama's stimulus package, and higher than China, Japan, and Germany combined. (Laura Tyson)

However, R&D spending as a percentage of GDP, the U.S. ranks only eight and no less than just over half (52%) of U.S> R&D spending is geared toward defense. R&D spending in China is increasing at a rather torrid pace, 20% per year. Even Europe, amidst all the financial turmoil, seems to recognize the importance of fundamental research with its "Horizon 2000" program and individual countries like Germany, Sweden and Finland increase their spending on R&D.


With a private debt overhang and increased savings still in play, low interest rates and ineffective monetary policy, sensible public investment is not only the only real short-term stimulus that can be provided. It produces long-term pay-offs that are several times the initial lay-outs.

Secondary education especially is a field where the U.S. has fallen behind and in need of much repair work and in R&D, much of the rest of the world is increasing its effort, sometimes dramatically so. Improving infrastructure simply is a necessity that has to happen anyway and now is a very good time to do that to get the short-term spending boost for that and employ workers laid-off from construction.

Some Investment Ideas

Should rationality come back to the political discourse, some infrastructure stocks could do well like Sterling Construction Company, Inc. (STRL), MDU Resources Group, Inc. (MDU), Vulcan Materials Company (VMC), United States Lime & Minerals, Inc. (USLM), Sherwin-Williams Company (SHW), American Woodmark Corporation (AMWD), Lowe's Companies, Inc. (LOW) and The Home Depot, Inc. (HD), Martin Marietta Materials, Inc. (MLM), Granite Construction, Inc. (GVA), Chicago Bridge & Iron (CBI), Jacobs Engineering (JEC), Foster Wheeler (FWLT), and Manitowoc (MTW). Steel stocks like U.S. Steel (X), AK Steel (AKS), Nuecor (NUE) and ArcelorMittal (MT) would also do well.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.