In a recent post, Eric Sprott argued that the "bailout and stimulate" model of economic policy has been a spectacular bust in the U.S., Europe, and the banking sector. We agree with the idea that bailout resources have been inequitably distributed in the U.S. and that rescue measures have been poorly designed in Europe. However, our position is based on a very different view of the system dynamics at work.
Here's Sprott's underlying thesis, which we essentially agree with:
'Bailout and Stimulate' has been the rallying call for governments and central banks since the beginning of this financial crisis - and it has certainly had its impact over the last two years, but not the type of impact we need to propel real, sustainable growth.
He then offers some evidence in support, which we've critiqued below.
U.S. DEFICITS & GDP
For the U.S., he uses the following table to argue that "dimes" of incremental GDP are being "bought" for "dollars" of new public sector debt. First, we would point out that for any investment, a dime on a dollar (or 10%) is not a bad annual return. Sprott mistakenly treats stimulus as analogous to a business expense. Properly done, it is an investment expense of the public sector. An up-front cash flow deficit is the definition of an investment, after all.
And even by Sprott's seemingly pessimistic analysis, a net impact of $215.6 B in marginal GDP on a net deficit of $2,481 B in deficit outlays produces a return of over 8% -- about where we would expect it to be, given some estimates of fiscal multipliers under pessimistic conditions and low nominal interest rates. That's nothing to sneeze at, and we're almost certain that it has resulted in a more optimal economic outcome than would have occurred without it. (Click to enlarge)
To get a better sense of the effects of ARRA and other 2009 measures, we might assume that their effects on GDP occurred with a lag, e.g., in 4Q09 and 1Q10. Comparing the change in GDP in Q1 2010 ($37 B) plus Q109 ($53 B) to the 2009 cash flow deficit figure of $1,471 B, we get a two quarter return of 6%. Admittedly, we're assuming that the fiscal stimulus of 2009 (and the financial system support measures starting in 2008) enabled the private sector activity that constituted most of 4Q09 and 1Q10 GDP, so it's crude and a bit aggressive.
Using a more conservative calculation of $90B of GDP on $2,481 B in deficit stimulus since 2008 gives us an estimate of 3.6% over two quarters. Even using the more stringent $3T figure mentioned in Sprott's article, from TARP's inspector general, still gives us 3% over two quarters -- and that's with less than half of committed ARRA funds spent.
If we extend that 3% figure over four quarters, we get an annual return of around 6%. Given that the Treasury currently pays a market rate of just over 3% per annum on its ten year debt securities, even straight debt financing looks like a no-brainer.
Again, this is admittedly crude arithmetic, but no more crude that that used by Sprott to trash the effects of stimulus.
COSTS OF vs. RETURNS ON JOB CREATION
Sprott also points to estimates of the net return on job creation via stimulus measures. The Obama Administration estimated that each job resulting from stimulus measures would cost $92,000 and result in a $105,000 increase of GDP. In other words, the estimated "multiplier effect" of stimulus was 105/92 = 1.14, or 14% on each dollar spent by the government.
Sprott then points to an empirical estimate for the actual cost of each new job created under ARRA as $117,933. If true, and if the Administration's estimate of a $105,000 increase in GDP is accurate, then the resulting multiplier is 105/118 = .89, meaning that for every dollar spent, only eighty nine cents are recovered. Robert Barro shouldn't start penning his Nobel acceptance speech yet though, as there are several problems with this analysis.
First and most obvious, Sprott has substituted for one Administration estimate (cost per job = $92K) without reassessing the other (marginal GDP per job = $105K).
Second, the figures for ARRA related job creation are as conservative as you can get. From the study cited by Sprott:
It is difficult to determine the number of jobs created from ARRA tax credits or higher levels of consumer spending from extended unemployment benefits. Jobs created or saved by direct contracts, grants and loans have been recorded each quarter, but the process has required a high level of judgment by those reporting on "jobs created or saved." In the fourth quarter of 2009, the reporting guidelines were changed to emphasize jobs directly funded by the Recovery Act. Employment figures are now linked to hours worked in positions funded by the Act.
...this includes only the jobs associated with contracts, grants and loan spending, about one-third of the total stimulus program. Jobs created by tax credits or consumer spending due to COBRA or extended unemployment benefits are not included in this tally.
Third and most important, the study provides an unweighted average of each state's cost per job. To a U.S. taxpayer, this is an utterly meaningless figure, unless each state received exactly 2% (1/50) of ARRA funds released. If you take the total ARRA dollars expended ($57.2 B) and divide it by the conservative number of jobs created (583,821), you get an average cost per job of $98,153 -- only 7% above the Administration's original estimates, and probably overstated given the conservative job counting method being used.
As we noted above, the Administration's use of a 1.14 multiplier is probably conservative given the underlying economic conditions against which fiscal stimulus is being carried out, as some studies would put the figure closer to two under current conditions, and as high as three or even four under the worst of conditions (conditions which remain on the table, as long as policymakers around the world continue to agree with Sprott's implicit view that the time for fiscal austerity is now at hand).
Of course, a multiplier of 1.14 is not reflected in the crude GDP numbers discussed above, which would need to be decomposed to get a better handle on the kind of multipliers that are actually at work.
The bottom line is that job costs appear to be in line with the Administration's initial estimates, and that fiscal multipliers are positive, with returns well above the federal government's cost of credit. In other words, there is absolutely nothing in Sprott's data indicating that stimulus is somehow "busted" -- quite the opposite, in fact.
We do like the last part of Sprott's take on federal spending:
Rather than maximize spending, why not maximize actual employment by finding a way to produce a job for less than $92,000? Surely some of the fifteen million unemployed workers in the US would appreciate some help in that area.
As we've noted elsewhere, an "employment buffer stock" or employer of last resort program, akin to the Civilian Conservation Corps under the New Deal, remains one of the most interesting and underexamined policy options for the federal government. It has also been touted in various forms by liberal, conservative, and heterodox economists, and might go a long way towards easing some of the populist anger being felt towards large and powerful sectors of the economy that have enjoyed federal government largesse, in what has been, thus far, the Democrats' version of "trickle down economics."
EUROPE & LEVERAGE
Sprott then turns his sights onto Europe, first on the recent "bailout" fund:
In a show of force designed to impress the world markets, the European Union pieced together an unprecedented loan fund worth almost €1 trillion. The fund’s capital was made available to rescue euro zone countries in financial trouble. The European Central Bank announced it was ready to buy euro zone government and private bonds “to ensure depth and liquidity.” The US Federal Reserve, the Bank of Canada, the Bank of England, the European Central Bank and the Swiss National Bank announced that temporary US dollar swap facilities would be opened to provide liquidity. Never have so many organizations coordinated and contributed so much to a single bailout effort!
So what was the ultimate effect of this shock and awe campaign? After enjoying a short-lived obligatory rally, the market for stocks, bonds, and the euro (in terms of USD) traded lower by the end of the week.
He's correct that the plan has had little if any positive impact, but overlooks the reasons. The key factor is the ECB's stated intention to sterilize all interventions under the plan (as well as their meager and declining rate of purchases). This means that there will in fact be no actual relief provided to debtor countries, and thus no backstopping of troubled sovereign debt prices in anything beyond the short run. Markets seem to understand this and are reacting accordingly.
As we've previously observed, the knee jerk reaction to this argument is that monetization = inflation. But when a debt spiral deflation is in effect, it's a long road between "disdeflation" and outright inflation. The real "shock and awe" of the eurozone plan is how shockingly incomplete its underlying assumptions are, and how awful its design and execution have been to date.
Sprott then fingers leverage in the banking system as the ultimate culprit, which we absolutely agree with, and his estimates of German bank leverage are far higher than the ones we recently sketched on the back of the envelope for the European banking system as a whole. His figures are IFRS based and thus more conservative than U.S. GAAP ratios, and one could argue that they are overstated to some degree. Nonetheless, their implication is clear: it will take only very small losses on highly levered banks' assets to cause systemic insolvency and a payments system and counter party crash of the kind that we now believe is headed our way:
The German banks are not alone. Most large banks around the globe are operating with too much leverage. The governments can keep the “Bailout and Stimulate” game going, but it won’t amount to much in the long term unless the leverage issue is wrung out of the banking system. Until that happens, bailing out the banks is akin to pouring money down a bottomless pit.
That's well said, and we do agree with the idea that concerted fiscal expansion must be accompanied by the implementation of sensible limits on global financial system leverage. There are simply no good reasons to allow high financial leverage -- it serves the transient interests of financial executives, trading desks, and speculators at the (sometimes drastic) expense of everyone else.
As with his take on fiscal stimulus, Sprott leaves a lot to be desired when he discusses the monetary aspects of government policy. He concludes with this gem (which to be fair, is how most people think about the subject):
The key point to remember with bailouts and stimulus is that it’s ultimately your money that the government is spending – and your children’s money.
The implication here is that the (non-bank) private sector produces money, which couldn't be more wrong. The private sector can only produce real goods and services, not money. Of those goods and services, government will demand some amount as a consumer, and some amount in taxes. Thus, money is simply an IOU -- or non-interest bearing debt -- created by the public sector, for which it agrees to extinguish private sector tax liabilities (it's important to note that in the eurozone, this nexus between monetary and fiscal policies is largely absent. In the U.S., it's as if there were a Federal Reserve, state and local governments, and no Treasury).
To the extent that the availability of those IOUs exceeds (falls short of) demand, they are inflationary (deflationary). In both cases, future economic outcomes are suboptimal. In our current situation, where tax receipts and incomes are coming up short, deflationary signs abound in everything but gold, and governments around the world are preparing to compete intensely with the private sector for those IOUs with fiscal austerity measures, it's inconceivable to us to think that flows of money -- the non-interest bearing debt of the public sector -- are not going to be in drastically short supply.
In this type of situation, with monetary policymakers constrained by the zero bound on interest rates, the fiscal lever becomes the clear and obvious choice for effective economic policy. Thus, concerted fiscal expansion, involving direct creation of money if necessary, is absolutely required if we are to avoid ten more years of muddling through or worse.
The bottom line is that against a backdrop of zero-bound monetary policy, well designed and executed fiscal expansion will leave us and our children better off, while fiscal retrenchment will leave us all worse off. Even Ben Bernanke* implied this in his Senate testimony yesterday, saying, despite his usual warnings about structural deficits, that "Right now is not the time to radically reduce our spending, or raise our taxes, because the economy is still in recovery mode and needs that support."
Is "Bailout and Stimulate" really busted? We don't think so. If anything, we need more of it, but we need to do it better -- more intelligently, more openly, and more equitably.
*On a side note, we're a bit concerned about the outlook for Bernanke's tenure at the Fed, given his stated belief yesterday that the European sovereign crisis is likely to be "contained." We just don't see how another global payments system crisis can be avoided under the current policy measures being undertaken in Europe, and that's an event that will have powerful impacts on the U.S. and global economies, and on global financial markets and asset prices. If he errs on this like he did with subprime mortgages, that'll be two strikes against him -- and it's not clear whether Fed chiefs are entitled to three.
Disclosure: Some clients long FXP, GLL, TLT, and/or TWM
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