Friday, February 06, 2009

What's Wrong with Fiscal Stimulus?

“We’re all Keynesians now.” Nixon didn’t actually say this, but judging by what is being said these days by many politicians, news outlets, and economic pundits, this mythical assessment certainly seems to be true today. Many have jumped on the fiscal stimulus bandwagon. If we just spend a gazillion dollars we don’t have, we’ll create jobs and kick-start the economy back to life. But how much sense does this make, and why is it that no one seems to count the opportunity costs of such stimulus plans? What will we actually accomplish and will it be relevant? For now we’ll bypass the question of whether or not the government has the authority and responsibility to spend taxpayer money for economic stimulus and just address its consequences.

The first question we should be asking is, “Why are we in a recession in the first place?” This rarely seems to matter to Keynesians who just want to spend money in an attempt to prime the economic pump. References to animal spirits don’t explain anything or alternatively, such references could potentially explain everything (which is just as useless). But if a substantial cause or exacerbating factor of the recession was a prior inflationary bubble fueled by reckless borrowing and spending, it seems rather problematic to attempt to solve this problem with more borrowing and spending.

Moreover, Keynesians usually see deflation and recession as causes to be counteracted or as problems to be fixed. But what if a deflationary recession is the cure/fix? What if a recession were the market’s attempt to clear itself of credit-driven overproduction and rebalance misallocated resources? In this case, injecting more fiat money into the economy and/or trying to prime the pump with government spending would fall somewhere between irrelevant action and action that is diametrically opposed to the cure and that prolongs the problem.

In fact, all of this is the case. Easy credit, artificially low interest rates, and leverage helped propel large amounts of ill-advised borrowing/spending, and deflation is precisely what is needed for the market to rebalance after such an inflationary binge. A recession is simply the way in which the market purges itself of a general overproduction of goods and fixes the prior misallocation of resources. At best, fiscal stimulus is an irrelevant waste of money that will probably pump up a few consumption-dominated statistics (e.g., GDP) for a while. But more often than not, such stimulus also involves an attempt to fight a symptom and in so doing, it actually retards the cure.

We have been on a debt-fueled binge for years and it is no longer sustainable. The last thing we need is the government to step in where the private sector left off and continue the same binge with new debt of its own. People need to start saving money so that future investments will be backed by capital we have actually accumulated instead of being based on debt and leverage. The market needs to liquidate inflationary bubbles and re-balance misallocations. These aims are not furthered when the government tries to blow new bubbles thus creating new misallocations. As far as recessions are concerned, fiscal stimulus spending is a complete non sequitur.

There is also the general problem of what Jim Rogers refers to as transferring capital and assets “from the competent to the incompetent” and the inefficiencies and economic drag that this creates. Depressed sectors are depressed for a reason. Failing companies are failing for good reasons. When we take money from the economy at large (either through tax changes, borrowing, or inflation) and give in to the “troubled” parts of the economy, we are directly contravening an important and necessary aspect of capitalism: the liquidation of poor/failed ventures for the benefit of good/thriving ventures. This inversion of market forces adds a long-term depressive aspect to the economy instead of a stimulative one. We get more of what we subsidize and less of what we tax.

The second big question we should be asking ourselves is, “Where will the federal government get the stimulus money from?” What follows is an analysis of the alternative sources.

1. Raise taxes, borrow from loaned up banks, borrow from banks w/ excess reserves that they will not part with; borrow from the private sector

This simply takes money from circulation and redistributes it. It therefore adds no new spending/stimulus. The government simply redirects the money into investments that were less valued by the market (otherwise the market would have already spent the money on those investments). Investors would have directed the money towards other sectors and investments but the government stepped in and redistributed that money elsewhere. This lowers prices in the sectors where the money would have been spent thus depriving some sellers in these sectors while it bids up prices in the sectors where the money is actually spent thus pricing the marginal buyers in these sectors out of the market. This adds a layer of inefficiency and distorts the market. Such an effect is especially problematic in a recession because sectors need to rebalance (some more than others) in order to clear gluts and malinvestments. The bottom line here is that some sectors receive a short-term, debt-fueled boost, some sectors pay the price via a short term drag, and resources are poorly allocated.

In addition, money borrowed on the market will add a new and large bidder to the capital markets thus raising interest rates above what they would have been w/o this extra bidder. The private borrowers at the margin are priced out; they don’t get the funds they need and suffer economic loss because of this. Others will pay more to borrow funds thus increasing their costs (and leading to an increase in their prices) and lowering their return. Some people will get economic stimulus while others will pay the price. On the other hand, tax increases will add a new burden to the whole economy thus adding a depressive aspect to the useless redistributive aspect.

2. Monetize debt by borrowing from the Fed

This adds new money to the economy (i.e., inflation). This new money will bid up prices in the sectors to be stimulated. Marginal buyers of these sectors will be priced out of the market and suffer economic loss. As the new money flows throughout the economy, it pushes prices higher than they otherwise would have been (keep in mind that this could take the form of stable prices when, in the absence of the new money, prices would and should be falling). Those who get the new money early get the benefit of the pre-inflation prices while those who get the new money later will pay more for the goods/services they buy than they would have paid. Those on fixed incomes are victimized the most as their purchasing power is looted and redistributed. The economy eventually has more money but prices are also higher than they would have been.

This increase in prices includes the price of credit. When lenders find out that the government is monetizing debt, interest rates will rise (or fall less than they would have fallen in the absence of the new money) so that lenders can protect themselves from the anticipated inflation. The marginal private borrower will be priced out of the market while other borrowers will pay more for credit thus lowering their overall rate of return and pressuring them to raise prices. If the Fed tried to counteract upward pressure on interest rates by buying a significant amount of treasuries from the market, this would artificially balance the credit markets but it would create new problems (e.g., interest rates that are held lower than they would be based on non-manipulated credit market conditions and a manipulated money supply would further the same easy credit binge that brought us this mess). More manipulation doesn’t eliminate policy costs, it simply shifts them around so that they reemerge in a different place and/or form.

3. Borrowing from commercial banks w/ excess reserves where the banks allow reserves to fall

This would seem like a remote possibility. All other things being equal, new government borrowing should not induce banks to lower their reserves. If they have substantial excess reserves, they must have good reasons for it (like a financial crisis perhaps). Government borrowing shouldn’t change those reasons. Nevertheless, under this situation, new money would be added to the economy and the effects would be similar to those produced by government borrowing from the Fed.

4. Tax cuts as direct stimulus

This would be much less problematic than the previous options if done the right way. For example, rebates are no different from stimulus checks. They are one time or short-term payments that don’t provide the sustained improvement that is necessary. And because they are indiscriminate transfer payments, they don’t do what tax cuts are meant to do: lower the burden on productivity and encourage work. Tax reductions must therefore take the form of sustained marginal rate cuts on labor, capital, and business activity.

However, the Laffer curve not withstanding, this would still be no silver bullet. It would be helpful for removing some of the burden on the economy but tax cuts don’t and can’t address the cause of the problem: the prior inflationary boom which resulted in overproduction, debt accumulation, and misallocation of resources. Tax cuts lower one of the burdensome constants of the equation but they don’t address the variable part of the equation: the boom and bust cycle itself. Taxes in the US are far too high. They should be lowered, but this doesn’t have anything to do with the business cycle.

5. Sell federal land

This would require the sale of a massive number of acres – a move that would significantly depress land prices in an already depressed market (this assumes the government could even move enough of this “product” to raise a significant amount of funds). It would also take far too much time to implement. While a theoretical possibility, it is never a serious option.

Now that we’ve reviewed some important short and medium term effects of the various options that the government has for raising money, we should mention the primary long term effect that results from most of those options. Any borrowing along with tax cuts will add to the public debt, a burden that will eventually need to be repaid by someone. Since government debt is almost never repaid in short order (i.e., 1-5 years), this amounts to a tax on future taxpayers to pay for the indulgences and mistakes of current taxpayers. The two groups will have substantial overlap for a decade or two but some future taxpayers will be paying a bill they never helped run up. This is stealing from the future to pay for the present, and the longer the debt is held, the greater the amount of money that will be stolen from future victims to pay off the currently generated debt.

Moreover, these future payments on the debt will burden the economy by diverting resources. Instead of producing and buying useful goods/services, these future payments will go to pay down the glutinous national credit card bill.

This debt adds an additional cost in the form of interest. Some claim that the new debt we are now accruing is not much of a problem in this regard because current interest rates are so low. This is true now but the potential for a significant problem in the not too distant future is large. It is almost surely the case that the government will not run significant budget surpluses in the near future. This means the new debt, along with the old, will need to be rolled over. As interest rates rise, this will add billions of dollars to the cost of servicing the debt at the same time that entitlement costs will be rising substantially. If we have a $15 trillion debt that starts to roll over into bonds costing 8-12%, the phrase “international debt crisis of the 1980s” may start to show up in more and more news articles. If we think our budget is being mismanaged now, wait until yearly debt servicing payments push past $1 trillion.

The bottom line here is economics 101: there ain’t no such thing as a free lunch. In order to raise new money for a fiscal stimulus plan, the government can deficit finance by borrowing, deficit finance by cutting taxes, raise taxes, or inflate. All of these actions (with the partial exception of intelligent tax rate cuts) cause numerous market-distorting, debt-accumulating problems, have limited and questionable benefits, and are irrelevant or even exacerbating when it comes to the real problem. We got here by way of distorted credit markets, debt, leverage, and a lack of saving. Even if we manage to manipulate some consumption-dominated statistics for a while, we’re not going to solve the problem with more of the same.



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