Government Stimulus Programs: Not Always the Hoped-For Panacea

The British government this week unveiled a stimulus plan that will boost that country’s budget deficit to $181 billion (118 billion pounds), the equivalent of 8.0% of gross domestic product (GDP). U.S. President-elect Barack Obama’s stimulus plan, when combined with the recession, may raise the U.S. federal deficit to $1.2 trillion, or 8.0% of U.S. GDP.

This raises the question: If it’s so easy to stimulate an economy, why don’t we do it all the time? Don’t such large deficits cause problems?

The 4-1-1 on Stimulus Packages

There is no question economic stimulus is popular. Economist John Maynard Keynes originally proposed it to counter the Great Depression, and it is now used as a panacea every time the economy suffers even the mildest hiccup. The Economic Stimulus Act of 2008 – a $150 billion stimulus the Bush Administration unveiled last spring – is an example of this: It was proposed before the economy had suffered a negative quarter and it provided a modest short-term blip to consumer spending, making the second quarter of 2008 the best of the last four.

It also increased the federal deficit by an estimated $152 billion. And it did nothing, whatsoever, to solve the problems of housing finance failures, bank illiquidity and deep recession, though it may have postponed the actual onset of recession for about three months – the sharp downturn appears to have begun in July, the month after the stimulus package ended.

There are two reasons stimulus packages are popular:

• Politicians like excuses to spend more of our money.
• And, the public is made to think that they are bound to work, because politicians and the media promote it as a one-sided thing. So, it seems obvious that if government spends more money – or cuts taxes – the economy is bound to improve.

When One’s a “Crowd”

What people don’t realize is that the money has to come from somewhere. Take Spain, where the government had previously been running a budget surplus. In such a case, a stimulus package is unlikely to do much damage, because it will cause only a modest deficit.

If, as is normally the case, the capital market is flowing freely, with investors worldwide buying U.S. bonds, then borrowing money for a stimulus package would at least do little harm, because capital inflows into the United States will just increase commensurately, so worthwhile projects still will get financing.

However, if the capital markets are even moderately tight (and they are more than moderately tight at present), then a stimulus package can be very damaging – perhaps even doing more harm than good. If it consists of extra spending, then the borrowing that’s done to finance those expenditures will “crowd out” private sector spending or investment. The sponsors of the stimulus package had better be very sure that their spending is well directed.

Keynes’ favorite scheme – employing people to dig holes only to fill them in – would make matters worse, not better. In the world of government budgets, the “hole” is deficit spending. The deficit is filled in – financed – with borrowed money.

Unfortunately, the money borrowed to fill in the budgetary hole would make matters worse, not better, because the money the government borrows would result in less money being available to invest in the rest of the economy. The little bit of money that was left over for private sector players to access would, naturally, command a higher interest rate, making the additional investments much more costly.

With a government-spending stimulus, nobody can be sure what is optimal, because the market is not involved, and government, once increased, may be very difficult to rein back.

Last spring’s tax-rebate stimulus package probably made things somewhat worse.

The tax rebates were spent by the recipients, who devoted their resources in ways that, at least to them, seemed optimal. But there is no long-term increase in the size of savings because U.S. consumers already save too little for economic health. So, draining some large portion of $150 billion from the savings pool to feed additional consumption was not sensible.

One other point regarding the tax-rebate stimulus: There is a school of thought, espoused by the folks who produced the acclaimed documentary “I.O.U.S.A.” that these rebates, by significantly slashing the government’s revenue, badly exacerbated the country’s debt burden.

British Prime Minister Gordon Brown’s Nov. 24 stimulus package involves primarily a temporary reduction in Value Added Tax (equivalent to a sales tax). At first glance, that was a surprising move, since the British government is from the left-of-center Labour Party. However, the reality was that after 11 years of Labour Party leadership, the budget was way out of balance even at the top of a boom, and the public had grown very tired of Labour’s public spending excesses – hence a “stimulus” of yet more spending would have caused even the placid British to start throwing things.

Obamanomics 101

President-elect Obama’s economic advisor, Austan D. Goolsbee, stated on Sunday that the stimulus “had to be a big number in order to get people back on track and startle the thing into submission.”

That is a little alarming, because the resulting budget deficit could startle into submission the bond markets as well as the recession. That would cause a flight from U.S. government debt and the dollar, reducing U.S. living standards, raising interest rates and possibly even causing the rating agencies to downgrade U.S. government debt.

A stimulus package of $1 trillion, the high end of what has been mentioned, would almost certainly be too much – especially since it’d come after the Treasury Department’s $700 billion Troubled Assets Relief Program (TARP), which is fueling bank takeovers, and not expansionary lending, and the follow-on $800 billion credit-market stimulus unveiled yesterday (Tuesday). [Editor’s Note: For a more-detailed look at this latest stimulus plan, please click here to take a look at our news analysis story elsewhere in this issue of Money Morning.]

On the other hand, Obama plans a middle-class tax cut, which gives the money to those who have least-benefited from the boom of the past few years (prior to the financial crisis) and keeps it away from Congress’s profligate spending barons who would waste it on bridges to nowhere and other pork-barrel projects.

Furthermore, Obama’s healthcare plans and New Energy investment plans have both been blessed by the electorate, so presumably people actually want them. Moreover, he is talking of spreading the stimulus over a period of 2 years, which would presumably reduce the immediate borrowing requirement and ensure that the economy was genuinely into recovery before the stimulus ran out.

The market currently wants a stimulus package and trusts President-elect Obama. He thus has a major opportunity to implement some of the spending plans he favors, while keeping the market happy. That’s a rare opportunity, but he should be careful not to take for granted the market’s welcome.

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Comments

[Smarty_Pants:]

Obamanomics: The belief that borrowing even more money is the way to fix the problems caused by borrowing money.

2008 Nov 26 02:06 PM

[DollarTalk:]

I am very thankful for the blessings that I have in my life. Now, regarding the market, the power of optimism never ceases to amaze me. In fact, we are missing a very large component of our view on the market and the economy in larger view when we discount the role of perception. Most of this market volatility was brought on by increased uncertainty and the perception that our credit crisis and financial difficulties were beyond our ability to solve as a free market. This, of course, was exacerbated by the media and capitalized on by the media in order to accomplish the election of now President-elect Obama. Now, the media has their man and would do well to continue to promote positive, uplifting views on the future direction of the economy and the solutions and people proposed by President-elect Obama. Otherwise, they will find themselves in the company of the Republican party when the public develops a pessimistic or negative perception of the new President and his leadership team. That's all for now. More on my blog.

2008 Nov 27 01:55 AM

[Steven Hansen:]

Martin, Obama's stimulus packages are yet pie-in-the-sky. Bush's packages are similar to sandbags holding a levy in place. The realization may set in that the ultimate cost of the sandbags may be so massive, that Obama may be left with few stimulus options.

2008 Nov 27 10:50 PM