Why Obama's Financial Stimulus Plan Will Fail

The Obama stimulus plan is based on providing massive amounts of money to banks and the general economy in an effort to return the economy to growth. While the private sector is deleveraging and reducing debt generally, the public sector is trying to provide economic stimulus with government funds. The intellectual origins of stimulus go back to Lord Keynes in the 1930s who first proposed this type of stimulus. Today, the leading advocates of the Obama stimulus program are Ben Bernanke, Larry Summers and Paul Krugman.

It should be noted that this article focuses on financial stimulus through the banking system and does not refer to job creation programs such as building roads or bridges.

To my mind, the first problem is that the advocates of this stimulus plan are looking at only one side of the balance sheet. While it may work for that one side of the balance sheet, it does not work for the other side. A national balance sheet for mortgage debt, home equity debt and credit card debt, shows the general public owing money to banks and banks being owed money by the borrowers. The government program has focused on getting more money out there into the hands of the public by getting more money in the hands of the banks, but there has been little or no discussion whether the public can beneficially use this extra money. And therein lies the fatal flaw.

First, let’s look at mortgage debt. To get to the levels of indebtedness we now have, the mortgage industry had to have liar loans with no or poor documentation. They had to have no down payment loans. There had to be the conviction that prices of houses would always go up and thus we could get many people trying to flip houses quickly and make a profit. To fund all this, you had to have Collateralized Mortgage Obligations (CMOs) which there had to be buyer sufficiently sucker to buy the story of Credit Default Swaps (CDSs) to guarantee the bonds they were buying and triple A credit rating that we now know are simply not true. In short, to get the mortgage market going again like it was, you would have to recreate all the stupid things that were done and that drove mortgage market to the unsustainable highs of 2006 and 2007. This makes no sense what so ever. Lending more money to people that cannot even repay what they currently owe is evidently not going to be a solution.

The Home Equity loans and the Credit Card Loans to the public are exactly the same situation. People already maxed out on rational borrowing cannot now go out and borrow more.

In summary, even if you put more money in the banking system, it is not going to end up with the consumer because he cannot rationally absorb more debt, and to do so will put the lending institution in greater risk of credit losses that risk destroying the lending institution. If the money does not end up with the consumer and the consumer actually spends the money, the whole concept of economic stimulus becomes very dubious.

Now let’s go a step further. The public has found out they owe too much and is cutting back. The banks have found out they have too much bad credit and are now very cautious about making new loans. I have recently reviewed most lending criteria that exist today. They have gone from extremely lenient to, generally speaking, extremely demanding so that only well qualified borrowers get money. In short, we are now in a situation where even if the money exists in the banks, it will probably be used to solve bank problems and strengthen capital ratios rather than take on a lot of new, high risk credit. I consider these “facts” to justify the conclusion that the economic stimulus program of the government will not work.

However, there is a second line of reasoning which also explains why the government stimulus program cannot work. We are at the peak of the mother of all financial bubbles. This is the largest bubble we have had since the Great Depression of the 1930s and this will probably be considered bigger than the bubble at 1929. This is true because this is the first worldwide financial and business crisis since that time. This bubble has already had the largest effect on the worldwide banking system since that time. While we did have a limited problem with the savings and loans in the 70s, this is a worldwide effect affecting all parts of the financial system and is now progressing to the consumer demand parts of the economy. I consider this a factually irrefutable statement today. However, it is the explanation of this that will be subject to some controversy.

I believe that economic stimulus can be beneficial at the beginning and middle of long term upward business cycles. But at the peak of long term cycles, economic stimulus cannot be beneficial because of the excesses, maxed out lending to the public and business, bad credit, and poor business investment decisions that are so dominant at the peak of any long term cycle. To my knowledge, this is a new economic view that I have not seen elsewhere and quite important to understanding business cycles and creating effective public policy, particularly relating to effective stimulus programs.

This view explains the famous “conundrum” of Alan Greenspan with respect to interest rates not working as expected in the dot.com bubble. It explains Paul Krugman’s puzzlement why economic stimulus sometimes works and sometimes does not work, as explained in most recent book “The Return of Depression Economics”. In an important respect, Paul Krugman’s support of the stimulus plan is puzzling. He blames Alan Greenspan, in his newest book, for the causing the 2006 housing bubble by putting in place his stimulus plan to solve the dot.com problem in 2002. The logical conclusion for Krugman should be that this year’s stimulus plan will have an equally deleterious effect on the future, in the dubious case that he does in fact short term reflate the economy.

I believe this above position is supported by the economic facts. However, historical economist’s and technical analyst’s give much more support to this theory. Economic historian Niall Ferguson in his “The Ascent of Money” describes business cycles and the events taking place within each phase of the business cycle. The Austrian School with their focus on the business cycle (but I am not referring to their view on gold which I do not support) and Bob Prechter of Elliot Wave Theory give much support to business cycles and what happens in the different phases of the business cycle (or “waves” as Bob Prechter describes them). Once one sees clearly the different circumstances occurring in each phase of the business cycle, one can see much more clearly why economic stimulus will work in one situation and not in another.

In a couple of years from now, we will look back to today and ask where our stimulus money went. A very large amount of stimulus money will then clearly be seen as wasteful, and primarily helpful to banks and bank equity investors from bailing them out of bad loans and bad investments. Much as there is a cry today about the retention payments to AIG officials and water boarding approved by Bush government officials, there will be a cry who did theses silly deals which had little or no benefit.

In summary, stimulus has a noble objective. However, without looking at both sides of the balance sheet to see whether the incentive money can be beneficially used, we ignore a critical element in forming effective government policy. Without understanding that we are at the peak of a historic bubble and the enormously bad economic conditions prevailing within this historic bubble, we cannot understand why indiscriminately pumping more money into the banks and the economy is doomed to failure.

We can put all the money we want into financial institutions, but we will not force the banks to lend nor the borrowers to borrow. Without a beneficial use for the funds, we may create inflation, and in an extreme case even hyperinflation, or find the money is lost through misuse. A more probable risk of the stimulus policy at this moment is that the US dollar will become discredited and foreign borrowers will no longer be willing to accept it, particularly at low interest rates. While this possibility is still of relatively low probability, we are already seeing China cut back on it exposure to US securities, particularly Fannie Mae (FNM) and Freddie Mac (FRE). We start to see growing support for using Special Drawing Rights as the world’s reserve currency. In a few years, we may look back and find this was the beginning of the end of the US dollar dominance and thus the ability for the world to fund the US deficits.

You can take a horse to water, but you cannot force him to drink. The government can pump money into the banks, but that will not cause it to be lent or to solve the current problems we have. I believe we have a strong case that the Obama government economic stimulus program will not be effective and that it may in fact create new, very harmful conditions for both the United States and the word in general.

Disclosure: No positions

Comments

[Jasper M:]

Good article. A fine conceptual antitoxin for the sophistry so popular in the economic community these days.

Now, for a rebuttal . . . cue the Goldilocks Zombie . . .

May 11 02:57 AM

[Daniel Luedtke:]

Mr. Wood,

Mr. Wood,

Thanks for another fine posting. This is a good, clean and clear discussion of why stimulus isn't going to work in its current form. The financial bailouts so far have the stink of blackmail to them. By not having the management of the misguided financial firms (whether instigators or the duped) pay the price for their failures (mostly disgrace and getting canned) we seem stuck in place.

I’m not a subscriber of any of the dominant economic models but rather a pragmatic convert to Fischer/Minskian viewpoints very much tempered by a historical viewpoint. I don’t spend much time peering into the Dismal Swamps of the Dismal Sciences. I came to Fischer/Minskian via Stephen Keen’s talks; see debtdeflation.com/.../ for an interesting recent discussion. Compared to the gobbledygook of Greenspan, Paulson and Geitner; Keen is a wonderfully clear voice. To me most economics popularly discussed seems more akin to parlour magic tricks or even spiritual séances than rational discourse, unfortunately with corresponding purposes: to distract and deceive. Our nation and world, as recent developments in finance and investing have shown are poorly serving the whole.

The FDR public works programs in the end seem like the safest stimulus as long as we build stuff we will need in the near and long term future. Just trying to get people to buy more cars or upgrade their houses isn't going to help the nation prepare for the future especially the long-term future. I fail also to see what encouraging personal or corporate leverage advances unless the future consequence is nil, in which case I’d like to know what is foreseen.

Now we concentrate on the psychological manipulation of our nations economic anxiety and security. We do this thru a very messy private sector, government and mob musical chairs dance that doesn't seem likely to solve anything or satisfy anyone (but the weakest always seem to have no place to sit when a round ends).

But likely something will change within the next year or two. I'm a student of the Strauss and Howe theories of History (get a copy of The Fourth Turning (1997)). First skim through it and than read it cover to cover.

Our history, since Jamestown, shows a strong pattern of generations and turnings. The important thing about now is that we're moving from not being able to adequately solve problems to solving them. That's good; the bad thing is that it has a high price, the beginning of a great Crisis period.

As with the Revolution of 1775, the Civil War of 1861 and WWII of very late 1942; Crisis turnings come at very regular intervals and are the culmination of a 4 turning progression called a Saeculum (which starts immediately after the previous Crisis-our current Saeculum started at the end of WWII). The crisis period doesn't begin with a great war. Rather it starts with an event called a Catalyst that gets the juices flowing (mostly by anxiety). This I think was what the 2008 Crash was and did. Hopefully soon, maybe in retrospect now, the next milestone will be reached, the Regeneracy. This is the point where entropy gives way to building a new order (having a plan, executing the plan and moving to a practical new state, which will be the basis for the following 80 years or so, i.e. the new Saeculum).

The other very scary bit is that indeed all of our Crisis periods have involved a great war. Great wars are big and they change the US. It is interesting the timings of the great wars seem to have even a tighter scheduling than the crisis itself, currently at around 71 to 74 years from the end of the previous Great War and the start of the next.

Over a long Anglo-American period since the late middle ages in England their has been a shortening of generation lengths and of turning lengths which naturally shortened Saeculum from over 110 years in length in our early Saecula to currently 80 years. I expect a great war to arrive as early as 2014 and perhaps as late as 2028, with 2017 being my best guess (based on the 71 year spacing, or "Peace Interval" as I call it).

I suspect this amazingly consistent interval reveals an important aspect of a Crisis, and sadly a lack of historical consciousness. If you fought in WWII even late in the war, say 1944 as a 19-year-old kid that means you were born in 1925 and now you'd be just about 90 years old. Your elder comrades are mostly dead. And you're not likely to be too active yourself! The hard won experience and gut level realization of what a Great War is has faded away from us, thus giving us another chance to repeat past folly (or at least try to make it rhyme).

But I can tell you from an economic standpoint, there has never been a very large Panic of any sort during one of our Anglo-American Great Wars. Which makes me wonder if economic interests view peace as an asset.

Please if you want to understand our history, read the Fourth Turning and an earlier book of Howe and Strauss: Generations. Their writings will open your eyes.

I chart the Strauss and Howe Saeculum, Turnings, Generations along with interesting (too me anyway) events in a free large PDF chart. A new one will be released before June. Send me an email at: [e-mail] and I'll include you in the next distribution, you can also request an opt-in for future free PDF charts.

Daniel Luedtke

May 11 06:15 AM

[John Bowman:]

We have lost our industrial base and it won't be coming back. The dotcom boom was somewhat of a phony boom, but it did make it possible to increase efficiencies in many industries, but mostly to our competitors.

The housing boom, as everyone knows was another phony boom and IMO was the last boom in this country. Houses are places where people live, not investment opportunities. Once the houses are built, people need real jobs to maintain their existence.

Greenspan called America's economy the casino economy in the mid-nineties. He was right and the horrific results are showing up today. The investment vehicles invented in the last ten years were nothing short of chemotherapy and quack cures given to a dying patient.

The bailouts will not work. They will just add debt to an already bankrupt nation, making us even less competitive. Stimulus packages are only cosmetic and won't work either. There are no tricks up anyone's sleeves, especially the government's.

We are in for seriously bad times, possibly worse than the depression. I believe some very older people and other rational thinkers realize this but don't want to admit it in their hearts because it is too scary to consider.

As to the stock market rebounding, it means absolutely nothing. It is a psychological rally not based on fundamentals. People are still losing jobs, banks are not lending, and credit card companies are losing money hand over fist.

The stimulus package was and still is a joke.

John Bowman

May 11 09:47 AM

[5142152-337:]

Good article, and John Bowman's post is a CLASSIC! Thank you both for writing.

We ARE in deep doo-doo. And, by the looks of things right now, we may NEVER recover. This nation, and the world will change dramatically going forward and the liberal left steering us now will drive us into the abyss.

Being an old fart, I won't HAVE to endure it much longer. The rest of you, Godspeed.

May 11 12:29 PM

[Old Rick:]

Cetin, You might consider removing your rosy glasses for a bit. The unemployment rate is still going up and while there are signs of progress, things can still be nipped in the bud with BHO tax increases as with FDR in 1937. As far as the stimulus package being a "good" thing, it was neither TIMELY (some spending allocated out as far as 2013), TARGETED (a scattergun of Democrat pork-barrel programs) or TEMPORARY (again, semi-permanent Dem wish list programs). We could have gotten out of the recession with $200B in TTT spending, but now we have built in double-digit inflation baked in starting in 2012 or so. You need to reread your Saul Alinsky to know what is going on.


On May 11 04:12 AM Cetin Hakimoglu wrote:
That would be me. I disagree, obviously. Obama is doing a good job evidenced by the economic and stock market recovery. Too mcuh foom and gloom regarding job loss, but what's being ignored is that 91% of the population is employed. Full employment in the USA is only 95%.

May 11 02:57 PM

[Old Rick:]

And I forgot to add that any stimulus spending has to pay wages at prevailing (read union scale) wage.

May 11 02:59 PM

[Jasper M:]

5142152-337
Trees do not grow to the sky. Pernicious trends tend to choke themselves off, in the long run.
So buck up, fella! Those who come after us oldsters will eventually set all this right, and better. And they will be able to look back at the wreck of our near future, and use it as a cautionary tale

May 11 07:07 PM

[5142152-337:]

Jasper M: Thank you for your comment! Without getting into a ranting thread that is endless, I just wish to say that what I was reflecting in my initial post was that in the past, radical changes WERE accomplished. And, as you suggest, would be positive in the long run. However, in this enviornment, with the ME attitiude alive and well, the PC world (not personal computer, eh), and the nanny state, this is just not going to happen, ever, period! The next time you go out of your house, shopping, etc, look at the young people. Look at their personna. These are the heart and soul of this country going forward. Its very scary, and that is a mild statement. Again, God help you all!

May 11 08:45 PM

[demosthenes:]

Hi all,

I am just starting off investing (so some may say speculating) but I would really like to get some feedback on a question that I have.

How are stocks such as JPM and WFC trading near prices that they were in 2005 and 2006 when they did not have so many problems? I know that there are more metrics than just the price of a stock but in this case it seems pretty clear cut. Why would the price of a financial stock during an economic boom be even close to where it is now after an economic disaster?

Sorry to put such a basic question out there but any input would be greatly appreciated.

May 12 02:18 AM

[ifuwish2:]

just another dummy non alpha payroll writting doom and gloom,,should be fired but if they get rid of one dummy another comes in,,my 12 year old knows more than he does,,he do damn old probably,,why dont you retire

May 12 05:58 AM

[Jasper M:]

514 etc
People indulge in bad habits, including bad mental habits, when they perceive they can get away with it. Those young folks whose state of mind you decry will come around. When the government promises to bail them out, and Fails, they will reassess.

demosthenes,
"Why would the price of a financial stock during an economic boom be even close to where it is now after an economic disaster?"
It shouldn't.
But all pricing is psychological. And great effort (not to mention taxpayer $$) has been expended to promote the notion that "Show's over, nothin' to see here". TARP, Mark-to-Myth, AIG bailout conduit, orphan month reporting. Also, the two banks you specifically cite are in relatively good shape compared to the walking dead C and BoA, and not near the scandal factory of GS.
It will not last.

May 13 05:55 PM

[Speedspirit:]

WWW.GOLDMANSACHS666.com my friend will shed some light and then you determine your own opinion. Best Wishes


On May 12 02:18 AM demosthenes wrote:

> Hi all,
>
> I am just starting off investing (so some may say speculating) but
> I would really like to get some feedback on a question that I have.
>
>
> How are stocks such as JPM and WFC trading near prices that they
> were in 2005 and 2006 when they did not have so many problems? I
> know that there are more metrics than just the price of a stock but
> in this case it seems pretty clear cut. Why would the price of a
> financial stock during an economic boom be even close to where it
> is now after an economic disaster?
>
> Sorry to put such a basic question out there but any input would
> be greatly appreciated.

May 13 08:21 PM