Sense And Nonsense About Fiscal Stimulus

by: Shareholders Unite

We rarely see articles that provide a balanced view about the effects of the stimulus, and when Daryl Montgomery wrote his a week ago here, that was no exception. The article simply needs a response.

The need for stimulus
Fiscal stimulus is helpful stabilizing and economic downturn, especially when other policy measures (that is, monetary policy) have largely been exhausted. With interest rates essentially at zero, the latter is undoubtedly the case.

That is, monetary policy has a habit of losing much of its traction, and this is exactly what happened in the aftermath of the financial crisis. In the famous words of Richard Koo from Nomura, if central banks cut interest rates to zero and nothing happens, it's not an ordinary world. This world is in a liquidity trap (described here).

The ineffectiveness of monetary policy in the aftermath of a financial crisis isn't that hard to understand. Balance sheets of households are ravished because their assets (mainly housing) have reduced in value while the debt remains. They're repairing their balance sheets by spending less and saving more, irrespective of interest rates. That is, the private sector (savings minus investment) moves into huge surplus (see figure below).

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That is, the private sector generates excess savings. The reduced spending is liable to feed on itself:

  • Less demand for products and services, hence a fall in production, employment and inflation. Actual production falls way short of potential production (the production that would result if all labor and capital would be employed), that is, there is an output gap.
  • Less tax revenues and more Government outlays (the economic crisis itself is the single biggest factor in blowing up the deficit).
  • More dangerously still, the economic downturn can easily trigger a Fisherian debt-deflationary spiral (after Irving Fisher who warned against this in the 1930s). In a Fisherian debt-deflationary spiral ever more banks and households enter into trouble, having to sell assets, which lowers asset prices further and puts others in problems, leads to further cutbacks in spending, bank failures, you get the picture. Before you know it, one finds oneself in a 1930s style economic slump from which it's very difficult to escape.
  • The increase in saving does something else, it reduces interest rates. This is reinforced as business investment also falls (as a reaction to falling demand and more idle existing capacity) and banks are less willing to lend because of their own problematic balance sheets.

In order to stop the risk of a Fisherian debt-deflationary spiral that would take us into a 1930s style depression simply something had to be done, and with monetary policy pretty powerless, fiscal policy is basically the only recourse.

Output gap and benefits
While the idea of fiscal stimulus is simply to fill an output gap, critics often point to empty Chinese shopping malls, bridges to nowhere, or (in the US) Solyndra. Indeed, not every dollar of stimulus is wisely spend. However, needless to say, not all private sector investments are always successful either.

An output gap occurs when the economy produces well below capacity, to employ people who would otherwise be unemployed, earning an income that will be spend. Employing an unemployed construction worker in a public infrastructure building program would create additional jobs, income and a ripple effect in the economy (the famous 'multiplier') as that income is spend.

Higher demand also stimulates private sector investment (there is little reason to increase production capacity if there is considerable spare capacity and demand is not likely to pick up anytime soon).

A second effect is that the bridges, roads, and airports (that is, infrastructure) build by otherwise unemployed workers from the construction industry improve the economic structure, future production is also enhanced, something even the conservative The Telegraph is clamoring for in the UK.

A third beneficial effect is that keeping production closer to capacity combats that the production capacity itself deteriorates. Idle plant deteriorates in quality over time, idle workers lose skills, motivation, habits, and employability. Hence the longer plant and workers remain idle, the more are effectively withdrawn from the market as supply factors, an effect known as 'hysteresis.'

Leaving an output gap linger for years is doing real damage to the supply side of the economy as well (apart from the human misery of the idle workers involved).

Chinese stimulus
Now, Montgomery points out side effects of the Chinese stimulus (housing bubbles and infrastructure waste). First, his characterization of the Chinese stimulus program is particularly unfortunate.

At $586B, the package was more than three times that of the US (relative to the size of the economy), although not the 14% of GDP that Montgomery claims (he likely included the local lending to arrive at such figure). The Chinese economy was hit hard by the 2008 financial crisis as it's much more dependent on exports compared to the US or the EU.

Most of it was spend on infrastructure and affordable housing. For sure, there were side effects, albeit not the housing boom which was the result of easy credit to developers together with the fact that households have high savings but little in the way of assets to put them in, not the stimulus. But to name only these negative side effects and failing to even mention the revival of economic growth is particularly one-sided.

It is also not terribly relevant for the US. Unlike the US, China suffered from the 2008 financial crisis exclusively through a fall for its exports, not a domestic demand slump. The best way to react to that would have been a currency devaluation, not a domestic demand boost, although the world economy was better off by China boosting domestic demand.

Since domestic demand was already very high, boosting it further was always going to generate diminishing returns on investments. But none of this holds for the US, which really needed a boost to domestic demand in 2009. None of the Chinese 'side effects' of its (much larger) stimulus are therefore visible in the US.

Montgomery had this to say about Japan:

Japan has been economically troubled for 22 years and despite zero percent interest rates and an unending number of stimulus measures its economy remains in the doldrums. While all the stimulus hasn't solved Japan's economic problems, it has led to a debt to GDP ratio of over 200% (worse than Greece's).

That really is wide off the mark. A number of observations:

  • Japan has done much better economically during those 'lost' decades than almost anybody seem to assume, Japanese GDP per capita actually grew a little faster than that in the US or EU
  • Put that in perspective with the magnitude of the problems: the Japanese bubble was 3x the relative size of those in the US in 1929 and 2007, the financial bubbles and subsequent implosion truly was of epic proportions. It's already a miracle they haven't experienced anything like a 1930s style depression
  • Expansionary fiscal policy is what made the difference. According to the leading expert of the Japanese situation, Richard Koo of Nomura, Japan's GDP would have fallen 40-50% in the absence of fiscal stimulus. Indeed, the one year they tried that (1997) the economy quickly turned into recession.
  • Yes, the Japanese public debt is very high, but whether it would have been any lower (relative to GDP) without fiscal stimulus remains very much to be seen and there are ways the debt can be contained.

Authors writing negatively about the stimulus have a habit to not consider the economic evidence, or be rather selective in quoting it. We don't know whether Montgomery is familiar with the economic literature on the stimulus topic as he doesn't mention any of it. A summary of these is available here, and there is another one by Christina Romer. Here is Michael Grunwald, who wrote a book (The New New Deal) on the US stimulus:

But at its peak, the Recovery Act directly employed more than 700,000 Americans on construction projects, research grants and other contracts. That number doesn't include the jobs saved or created through its unemployment benefits, food stamps and other aid to struggling families likely to spend it; its fiscal relief for cash-strapped state governments; or its tax cuts for more than 95 percent of workers. Top economic forecasters estimate that the stimulus produced about 2.5 million jobs and added between 2.1 percent and 3.8 percent to our gross domestic product.

But, as I detail in my new book on the stimulus, "The New New Deal," the bill helped stop that free fall. Job losses peaked the month before it passed. The jobs numbers that spring, while grim, marked the biggest quarterly improvement in almost 30 years. The Recovery Act launched a weak recovery, but even a weak recovery beats a depression.

The overwhelming majority of these studies point to positive effects. Montgomery fails to consider these studies, or try to answer what would have happened in the absence of the stimulus, or entertain the possibility that the stimulus was too small, as the downturn in the economy turned out to be much worse than at the time the stimulus was drawn up:

The Bureau of Economic Analysis, the agency charged with measuring the size and growth of the U.S. economy, initially projected that the economy shrank at an annual rate of 3.8 percent in the last quarter of 2008. Months later, the bureau almost doubled that estimate, saying the number was 6.2 percent. Then it was revised to 6.3 percent. But it wasn't until this year that the actual number was revealed: 8.9 percent. That makes it one of the worst quarters in American history. [Ezra Klein]

Economist like Stiglitz, Krugman, and Romer argued at the time that the stimulus was too small.

Tax cuts
A little appreciated item by the stimulus critics is the fact that the stimulus was one of the largest single tax cuts in the US history:

Ninety-five percent of all Americans got a tax cut under the plan. Small businesses and working families received a tax cut. First-time received a tax credit. Parents caring for their young children received a tax credit. Some 8 million people received tax credits and financial assistance to help pay for their college education.

It's actually debatable how effective tax cuts are under the circumstances of the time, as people embarking on repairing their balance sheet even with interest rates at zero are likely to save at least a substantial part of these.

Government retreat
After the Recovery Act measures waned, public spending in the US has become a net drag on the economy, a negative stimulus. This is unlike any other post-recession period in recent US economic history. Even the Wall Street Journal acknowledged that "Government cutbacks separate this expansion from others." It's therefore fair to say that the "Obama spending binge never happened."

Increased deficits and debts
It is simply a misconception that the economic stimulus is the main, or even an important factor in producing unsustainable public debt levels in the US.

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Running even large deficits for a couple of years is near irrelevant to the long-term sustainability of public finances, and even the deficits in the last couple of years were largely not the effect of the stimulus:

The Congressional Budget Office forecast a $1.2 trillion deficit before the Obama administration even came into office. The stimulus added only around $250 billion a year, and more than one-third of that came from tax cuts, especially the tax credit in the stimulus bill's "Making Work Pay" provision. [WSJ]

Apart from the Bush tax cuts and the two wars, the most of the deficits in recent years are the result of the economic downturn, which depresses tax receipts and boost spending automatically:

The nonpartisan Tax Policy Center's data predict that in 2011 taxes will have fallen more as a share of national income than during almost any other comparable period in U.S. history (including under Ronald Reagan) and may hit their lowest level since World War II: 14.4% of GDP, compared with the more than 18% average of the last 30 years. Individual income taxes may hit their lowest level as a share of income since 1950 and corporate income taxes the lowest since 1936. [WSJ]

The public sector can borrow at negative real interest rates. It's difficult to imagine there are no public investments (education, science, infrastructure, etc.) project that couldn't meet such a low ROI.

Brad DeLong and Lawrence Summers have calculated that when the economy has a large output gap and experiencing a liquidity trap (with interest rates effectively zero) it's even possible for public spending to pay for itself if one includes modest hysteresis effects (see above for explanation) because:

  • Public spending doesn't crowd out private sector spending as there are idle resources and excess savings which prevent interest rates from going up. Indeed, this is exactly what happened. Despite numerous alarmist warnings of the latter the last three years at least, the US public sector can still borrow at record low interest rates despite record public sector debts and deficits
  • Including some long-term damage from idle resources (hysteresis).

The jury is out on that one and there is little doubt that the public finances in the US need reforming, but this is a longer-term project requiring structural measures, not panic today. There is a large world savings glut, the idea that the US would face an imminent Greek style funding strike is based on very little, if anything.

The difference between Greece and the US, apart from having a much smaller public sector, is that the US still issues its own currency and US investors cannot, like Greek ones, take their bank deposits and investment funds elsewhere at no exchange rate risk.

We don't think the Montgomery article, which featured prominently on Seeking Alpha, was balanced with regard to fiscal stimulus. It was light on facts and substantiation, didn't consider what would have happened in the absence of stimulus, didn't consider the possibility that it was too small, and it didn't even mention a host of economic research on the topic, most of it positive.

It made curious analogies with China (only considering supposed negative effects which haven't happened in the US, but failing to even mentioned how it revived Chinese growth), it has made even more ludicrous claims about Japan. He confuses QE with money printing and makes inappropriate analogies with Weimar and Zimbabwe (see here for an in-depth treatment of these issues). We have no problem with his opinion, but we simply found his article lacking in the substantiation of it.

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