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Why Stimulus Harms the Economy

May 13, 2011 3:31 PM ET
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Seeking Alpha Analyst Since 2008

James F. Wood is a retired Country Manager for Citibank in three Latin American countries. Nearing 70, James is now devoted to analyzing markets and where our economy is going. He believes that the next few years will be some of the toughest we have had since the Depression which started in 1929.

Monetary Stimulus from the FED is supposed to help the economy.  This article shows why just the reverse has happened: in reality, stimulus is hurting the economy as it is now being used.

There are three powerful explanations why stimulus hurts the economy at this time.

  1. THE CONCEPTUAL ARGUMENT. Stimulus does not work at the conclusion of an economic cycle such as we are now at.  It only works at the beginning of the cycle when there new investment truly stimulates the economy, creating jobs and promoting growth.  There is no historical precedent to show that it works at the end of a major economic cycle such as we are in now.
  2. THE HISTORICAL RESULTS OF STIMULUS SHOW IT FAILS. When stimulus is used at the end of a major economic cycle, it only produces asset bubbles that eventually explode and make worse the economic situation of the country.  We will analyze the last three uses of stimulus, including the current asset bubble to demonstrate this case.
  3. 3)   THE ADVERSE UNINTENDED CONSEQUENCES OF STIMULUS. The worst consequence of stimulus at the end of the economic cycle is that it creates inflation that causes higher costs of living for all people.  This is now happening dramatically to the people of the United States, particularly in the cost of gas and food.

1)   Stimulus does not work at the end of a major economic cycle. 

Stimulus does work at the beginning of the economic cycle.  Stimulus does not work at the end of a long-term economic cycle such as we are currently experiencing.  The logic is simple: at the end of the economic cycle there are no worthwhile areas that create new jobs and new investment.  As a result, the money gets pumped into the stock market, financial derviatives, commodities, and corporate buyouts.  At the beginning of the economic cycle and even in the middle, there are places to invest that do create jobs and investment in machinery and other physical assets.  These investments in machinery and physical assets in turn create new jobs.  And this in turn creates real spending capability to advance the economy.  This simple distinction seems to have eluded most economists.

Modern history of economic stimulus begins with President Roosevelt using economic stimulus as a part of the solution to the Great Depression.  Stimulus money went for roads and bridges.  First, the investment in roads provided employment that helped stimulate the spending by the newly employed.  Secondly, the roads and bridges were valuable investments that provided returns to the economy for decades.  These investments were made at the beginning of the economic cycle and were “good investments” and “good economic stimulus”.

By the mid 90´s, the US was going into the end of a decades long economic cycle.  We had heard from former Fed Chairman William McChesney Martin who counseled the function of the Fed was to “take the punch bowl away just when the party really starts going”.  But this was the time that Alan Greenspan came to the leadership, ultimately as President of the Fed.  Greenspan´s views were categorically opposed to those of McChesney and disastrously wrong.

Greenspan believed in self-regulation of the private sector.  He could not believe that intelligent men running our largest banks would expose themselves to so much credit risk that they could go broke in a down turn of the economy. As a result, he promoted very low costs of funds and removal of critical legal limits that permitted vast increases in leverage and risk, with a resultant enormous increase in the effective monetary base. For a fascinating and in depth analysis of Greenspan, read Chapter 2 of the book “Griftopia” by Matt Taibbi.

During the decade of the 90’s, Greenspan promoted a bubble by excessively low rates of interest for money.  With the brief exception of his 1996 comment of “irrational exuberance”, his public comments were that there was no bubble.  However, in his private comments to the Fed Open Market committee he spoke of a bubble being existent from the mid 1990’s.  This bubble ended with the tech stock crash of 2000.  Many stocks became horribly overvalued in the market due to the easy money and the possibilities for increased financial leverage.  The crash of the NASDAQ was greater than 70% from the 2000 high to the 2002 low.

Now we started to double down in the sense that we had to get out of the tech stock crash so we had to keep stimulus going with low rates.  This led to the real estate bubble of 2007 that ended in 2009 with a 54% drop in stock market prices.  Average home prices are now down more than 25% from the 2006 high, a virtual wipeout of the savings of many people where their home was the principal savings.  The housing price increases were of course from the bubble, but that does not help the people who bought at the high or the people who were induced into financing they could not afford, particularly with the adjustable rate loans.  In concrete terms, Alan Green promoted the annulment of Glass Segal, loosening of the rules on credit default swaps, and foreign exchange swaps, all of which were primal causes of the collapse of 2008.  In short, mistaken government monetary policy is the primary cause of the problems we have today.

And our response as a nation was more stimulus starting in 2008, even bigger and more costly to the common citizen.  Now stimulus is in the trillions, not the billions of before.  The result is we have in 2011 another bubble: now in stocks, commodities and corporate buyouts.

Where are we today? Stimulus was to provide jobs that would get the economy moving again.  Nothing has really happened here.  We are very close to the job levels at the low of 2009.  The stimulus has moved stock market prices to double the prices of the low of 2009, but that has basically benefited the rich who have money to invest in the stock market.  Therefore, there is no benefit to 80% of the population who does not have stocks in any significant amount.  Corporate buyouts are all the rage and the elevated prices will in a few years look like crazy prices to have paid. Facebook is talked about as being worth $90 billion plus. These are clear signs of a bubble economy with too much low cost money.  It should be intuitively clear that these corporate buyouts are not really producing more jobs (in fact corporate buyouts almost always reduce jobs substantially).  Corporate buyouts make a very limited numbers of sellers very rich, but provide no help to the general population.

The only conclusion from these experiences is that when you do stimulus at the end of a major economic expansion, there is no worthwhile place to invest and the money goes to unworthy investments.  All the contrary to making improving things, stimulus worsens the economic position of the country in this case.  Look at the consequences of the 2000 bubble exploding.  Look at the consequences of the 2008 bubble exploding as well as the continuing problems (including probably more than $1 trillion of write-offs still to be taken on residential and commercial real estate).

2)   When stimulus is used at the end of a major economic cycle, it only produces asset bubbles that eventually explode and make worse the economic situation of the country.

We have cited four cases here: the early thirties coming out of the depression, the collapse of the market in 2000, the collapse of the markets in 2007 and 2008, and now the precarious position now in 2011 which this writer is convinced will end in another collapse.

We have seen that the investments in roads and bridges in the 1930’s had a beneficial result and that occurred at the beginning of a new economic cycle.

In 2000, the stimulus money ended up in the stock market.  We can see the stock market collapse of 2000 produced over a 70% loss at the bottom for NASDAQ investors.  The pain was very severe for the investors in the NASDAQ, but the 2000 market collapse did not truly affect broad parts of the economy for the simple reason that the lower classes generally do not invest in the stock market.  The easy money went into the market and much less to beneficial investment that creates jobs and national wealth.  Also this was towards the end of a decades long economic cycle.

After the collapse of 2000, the effects of stimulus become particularly insidious.  The government said we needed to recover from the collapse of 2000.  Rates were kept low and loans were easy.  This was coupled with mistaken ideas on improving home ownership, first with President Clinton and very strongly with President Bush.  Fannie Mae and Freddie Mac permitted lending polices that simply made no sense in retrospect because the borrowers could not pay their contractual obligations.  This incorrect policy application by the government led to a permissiveness about loan documentation that ranged from carelessness to being outright fraudulent.  Also the creation of Collateralized Loan Obligations which could be cut up and suddenly classified even by the ratings agencies as in large part triple A credit all helped create an environment that set the stage for the collapse of 2008.

Some may argue that fraudulent loan documentation, the creation by the private sector of CMO’s, and that excessive leverage by private sector banks is not direct stimulus.  Yet this author finds that virtually all the issues can be traced back to Alan Greenspan that were critical to the collapse of 2008. Greenspan approvals included letting Credit Default Swaps be approved as an unregulated instrument, banks putting large amounts of their assets in unregulated subsidiaries, the elimination of the Glass Segal through the Citibank merger with Travelers, etc.  Greenspan was widely revered because it took years for his policies to disclose their full, cataclysmic failure.  Until the effects of his stimulus policies collapsed, everyone was making money and happy with the Greenspan policies.  Now that disaster has struck, we must learn from the lesson of damaging stimulus. 

But now in 2011, it is worse.  The stimulus starting in 2008 has created a bubble in 2011. The bubble is in stock market prices, commodity prices and in corporate buyouts of companies.  However, the commodity bubble of 2011 has now created significant increases in the prices of gas and food for the average American.  Together with housing costs, these three cost elements represent the biggest use of all their spendable money.  This bubble will blow shortly creating the Economic Collapse of 2012, which is likely to be a horrific financial decline. 

Our contention is that stimulus is bad at the end of historic economic cycles.  We can now see that the relatively mild down turn caused by the mid 90’s stimulus, was modestly painful in 2001.  But it was the basis for the stimulus-induced bubble in housing that resulted in the collapse of 2008.  The 2008 collapse was profoundly painful and is continuing.  While it is speculation of the author, he believes there is a coming collapse in 2012 that is a result of the stimulus policies of 2009 through 2011.  The collapse of 2012 will be even worse than that of 2009.

3)   In addition to creating asset bubbles, stimulus at the end of long-term economic cycles creates inflation for the principal cost elements of citizens, infinitely worsening their life.

Let´s look at the Fed Chairman Bernanke’s statement on inflation in 2011.  There is clear and high inflation in the cost of many basic foodstuffs and the gas that goes into cars.  Chairman Bernanke says both oil and food costs are transitory and not controllable by the Fed.  Therefore he simply says he is going to disregard them in his analysis and policy actions.  Unfortunately, Chairman Bernanke’s statement is incorrect.  First of all, it is the government stimulus money that is the cause of the increase in commodity prices.  Secondly, it is not transitory if the government keeps on stimulating, particularly if there is Qualitative Easing 3.  The Fed seems sincere in its desire to stop QE 2 and not do QE3, but it is unclear what the Fed will do if the stock market starts to decline at the end of QE2 next month.

In the 20 years prior to 2008, the commodities markets were transformed from being primarily for physical traders to essentially allowing speculators, who were primarily buyers of long contracts. This had the practical effect of quintupling the amount of money trading commodities while there was no practical increase in the physical supply of commodities.  This can have only one result: raising the prices of all commodities.  A quintupling of the amount of money, most of it long, must force up the price of the thing being sold.  Since there is not more physical oil, more physical gold, more physical corn, but now there is 5 times the amount of money, higher prices is the obvious and logical result.

One clever argument of those saying these futures contracts do not affect prices is that there is a buyer for every seller of a future’s contract.  Implicitly, this argument suggests prices do not go up.  Think intuitively if that you have 4 speculators/buyers for every real physical buyer of a house, house prices are going to increase as they did in fact through the bubble of 2006.  Likewise, the fed induced stimulus of 2008 resulted in dramatically increased money supply, which increased prices of commodities, stocks and corporate buyouts.  It is a fact that the Fed induced stimulus is now raising the prices of the basic things American consume on a daily basis.  Oil and foodstuffs are particularly affected by the Fed stimulus policy.  The confusion with the public on oil is particularly illustrative.  The Democrats says people must use more fuel-efficient vehicles.  The Republicans say the problem is Democrats preventing costal oil drilling.  Yet clear-eyed review of the facts seems to show the problem is simply a large number of people wanted to bet on oil prices in recent years and they drove the prices up.  Too much low cost money with lots of leverage produces asset bubbles.

Another problem, rarely referred to, is the terrible consequence of the Fed’s stimulus on the elderly savers.  I am 70 living on my savings.  I expected to be able to live on the interest of my savings.  Now interest rates are zero so that we can stimulate the stock and commodity markets.  Most elderly now find they do not have enough to live on since they no longer earn interest on their savings, or worse, are being persuaded to invest in high risk bonds that will collapse in the coming crisis.

This is the conundrum for the government.  Stimulus does not work at the end of long economic cycles and it results in terrible consequences for many segments of society.  However, stimulus is the only monetary tool that economists have. The government is afraid to stop stimulus, even though there is now convincing evidence that it does not work at this stage of the economic cycle.  Very much like the alcoholic who takes a new drink in the morning to deal with the pain from the night before, renewed stimulus at the end of the economic cycle only produces more pain for the economy.  Just as the stimulus after 2000 brought the housing and banking collapse of 2008, the stimulus of 2009 and 2010 will bring us an even worse asset bubble and collapse in approximately 2012.


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