James Wood's  Instablog

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 1930’s 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 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 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 (CMO’s) which there had to be buyer sufficiently sucker to buy the story of Credit Default Swaps (CDS’s) 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 1930’s 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 70’s, 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 Busch 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 and Freddie Mac.  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.