Market Reaction to Stimulus Programs Largely Undeserved

by: Taesik Yoon, CFA

Wednesday’s stronger-than-expected new home sales data was encouraging. But the stock markets barely reacted to it. Perhaps, more investors are becoming as skeptical as I am of any sales data that is currently benefiting from some form of federal subsidy.

In this case, I’m referring to the $8,000 tax credit for first time home buyers the government is providing. That, in and of itself, is a strong motivator for any potential home buyer still on the fence. But there’s also the added benefit of alleviating the initial cash burden of ownership. This is because the FHA has allowed qualifying homebuyers to monetize the credit and apply it towards the down payment. This last point should not be minimized, especially now with many buyers required to put up a down payment of at least 20%.

This would also apply to the strong sales enjoyed by automakers in recent months, which has benefited from the highly visible cash-for-clunkers program. In fact, I’m even more skeptical of these numbers due to the magnitude of the incentive. A credit of $3,500-4,500 is nothing to balk at. Coupled with additional incentives and promotional offers by automakers and dealerships, the actual savings to the consumers were far greater.

While the stock markets have reacted mostly favorably to the performance of these programs so far, I don’t believe this reaction is deserved. One of my concerns pertains to just how much stimulus (if any) these programs will actually create.

Economist and Noble Laureate Gary Becker and respected judge, economist and law professor Richard Posner recently posted highly critical opinions on the cash-for-clunkers program on their coauthored blog. Of all the comments, I found this statement by Posner to be the most compelling and concerning:

"It is true that people who participated in the "cash for clunkers" program couldn't pocket rather than spend the money they received from the government, as they could with the other transfer payments included in the stimulus program; they had to use it to help them buy a new car. But that is different from paying a road contractor to build a new highway. The contractor as I said has to go out and hire people to build it, so unemployment falls (on the assumption, correct with regard to construction, that there is a high rate of unemployment in the industry). The purchase of a new car merely reduces a dealer's inventory, and whether the reduction leads to new production will depend on estimates of future demand."

What makes me even more skeptical are the lackluster results stemming from other tax credit/rebate programs implemented in recent memory designed to stimulate consumer spending—specifically, the tax rebate checks that were sent out last year. Like the current programs, these checks boosted consumer spending levels over the near-term. But the benefits over the longer-term were minimal.

This is not to say these tax credit programs won’t work. As my colleague, Sam Ro, pointed out in a recent post, many consumers used the tax rebate checks to pay down debt. But these programs reward only those who spend. As his post implies, a key benefit of cash for clunkers (or any program that encourages spending) is the multiplier effect that spending has on the economy. I agree that these programs will be more effective than the stimulus checks at creating more overall spending over the near term. My concern is what it will do to future demand.

As Becker writes:

“Unfortunately, that the subsidies are popular is no measure of its public value, and I am afraid there is little to be said at any level in defense of a cash-for-clunkers program. Hundreds of thousands [of] new cars will be purchased under the program, but many of these purchases would have occurred later in 2009 or in 2010 instead of during the five week window of the clunkers program. There is little value to the economy in subsidizing consumers to buy cars a few months earlier than they would have bought them anyway.”

If Becker and Posner are correct in their assessment that these programs will simply pull potential sales forward—that is, induce those would have bought eventually into buying sooner—then you’re just sacrificing future growth for growth today. As such, there is a real risk that the programs could actually retard the current economic recovery efforts in future years.

There are beneficiaries of these programs to be sure—car buyers, automakers and dealers, home buyers, homebuilders, and even the environment. But I wouldn't put the economy on that list quite yet.