Information Is Stimulus

by: Steve Waldman

Suppose that the Federal government were to offer sizable loan guarantees for any and all "green energy" companies. Any firm, including new entrants, would be eligible. The government would do some cursory due diligence, only to establish that the company in question would actually spend the capital it raised on real projects colorably linked to green energy (as opposed to, say, buying New Zealand dollars in a carry trade).

Wouldn't such a program constitute a stimulus to the economy? If sufficient leverage is allowed, it would lead in short order to a bunch of entrepreneurs founding companies on just a shoestring of equity and a whole lot of cheap, guaranteed debt. Firms with even a small likelihood of success would constitute real options worth more than the sliver of private capital at risk, so arbitrageurs would rush to create them.

Such a program would be a pretty direct form of fiscal stimulus. Although politicians and financiers enjoy pretending otherwise, contingent liabilities are still liabilities, and offering loan guarantees to all comers for risky projects is, ex ante, just a way of financing a government expenditure equivalent to the expected losses of the program. We shouldn't be surprised that an oddly financed stimulus would function as a stimulus.

But note that if, by good fortune, the artificially spurred new firms do surprisingly well and very few guarantees are actually paid, that wouldn't eliminate the ex ante stimulus effect of the program. It is not the actual transfer of Federal money that serves as the stimulus. The stimulus comes only and precisely form the certainty the program provides to investors that capital spent will be repaid, with interest.

So, suppose that the government does nothing, but "the market" becomes certain (correctly or not) that green energy companies are a sure thing. As long as the cost of capital to such firms falls sufficiently, precisely the same dynamic would take hold. We've just watched it happen, twice. When capital became very cheap to internet firms, entrepreneurs understood (and discussed quite openly) that there was an attractive lottery on offer, so why not get in? During the structured credit bubble, the market became convinced that some classes of debt yielding more than the "risk-free" interest rate were certain to be repaid. Entrepreneurs (both speculative borrowers and financial engineers) saw the arbitrage, and found ways of offering those classes of debt. In both cases, if the market had been right, everyone would have been happy. But when the market was wrong, it was someone else's cost. Many entrepreneurs walked away rich and happy. Others lost, but only a small amount relative to what they'd have made of things worked out differently. It was a good gamble for them ex ante.

Responding to Arnold Kling's "recalculation theory", Paul Krugman asks (as he has asked many times)

why [doesn't], say, a housing boom — which requires shifting resources into housing — ...produce the same kind of unemployment as a housing bust that shifts resources out of housing.

A housing boom, any kind of boom, is attended by an increase in certainty. Information is stimulus, confusion is contraction. A bust occurs when the market is unsure of everything, when market participants perceive better risk-adjusted return in holding government securities (or supply-inelastic commodities) than in financing real investment. Sectoral shifts per se have no clear implication with respect to variables like employment and output. But "hangovers" do happen, because powerful booms are periods when market participants make consequential decisions with great swagger and confidence, and busts are when we learn that despite their certainty, they were wrong. They are left not only impoverished and burdened by debt, but bereft of confidence in their ability to evaluate new opportunities. The best way to avoid the hangover is not to err so terribly in the first place. Easier said than done, perhaps, but that's no reason to cop out. We can build a better financial system, one in which degrees of certainty are attached and removed from economic propositions dexterously, rather than clinging like giddy leeches until a collapse.

Information is stimulus. As markets become more informed, money will be created and lent into the economy as surely as if the government printed and spent it. And stimulus is information, since governments do not spend randomly but do so in accordance with their own revealed certainties, which may or may not turn out to be wise. Poorly chosen stimulus and asset price bubbles are covert twins — only the identities of the people making bad decisions are different. Conversely good economic choices by governments can lead to outcomes as salutary as a healthy market. (See this very nice post by Bryan Caplan, and the articles cited.)

Information is a behavioral attribute, not an attribute of the external phenomena to which it may ostensibly refer. To say that an agent is informed means she behaves differently than an uninformed agent. Her behavior is less random, more predictable. To be informed does not imply ones information is accurate. (In general, accuracy is unknowable, both ex ante and ex post.) Information increases the volatility of outcomes, because it provokes larger and more concentrated bets than uncertain agents would take, creating large gains and losses depending on how adaptive the informed behavior turns out to be. It is often better, as a behavioral matter, to be uninformed than to be poorly informed.

But we do not always have the option of remaining uninformed. We cannot afford to hedge all of our bets. Whether via a great mis-recalculator in the sky or a political establishment largely captured by certain interests, new information will be manufactured. (I think it probable that government stimulus will substitute for market-generated information in the near term, as chastened capital market participants are more conscious of the hazards of certainty than policymakers are.) We will be spurred to take some actions and eschew others, and the structure of the economy will shift accordingly. Let's hope those choices are good, and do our best to help make them that way.

Update: While I was writing... Arnold Kling offers related and excellent "Thoughts on Probability and Uncertainty."