Back To the Stimulus Debate

It was bound to happen sooner or later. There are growing rumblings that we will need another round of government stimulus, a.k.a. deficit spending, before we can be assured that the economy can reach a sustainable growth path.

The most recent source of the discontent from which those rumblings are emerging is last week’s poor unemployment statistics. With unemployment now at 9.8% and rising it is a certainty that we will go above the 10.0% mark in the next month or two, and there are few if any signs that the outlook for jobs will improve anytime soon.

So, perhaps, it is time to start thinking about adding more fuel to the fire in the hopes it doesn’t flicker out early next year.

There is no surprise in this story. None. It was fairly clear to many observers, including yours truly, that the stimulus package that eventually was passed into law earlier this year was not sufficient. By coming in at a little under $800 billion it was probably about 50% or $400 billion short of the level needed.

That’s an awful lot of money. So we should spend a moment to revise what a stimulus is and how we should calculate it. I realize this is boring, but with the economy hanging on a knife edge we all ought to have an idea of the issues as they start to re-appear in Washington.

The purpose of a government stimulus is to fill a gap that opens up in the private economy. The American economy is somewhere in the range of $14 trillion per year. During late 2007 and throughout 2008 the non-government part of the economy began to shrink rather than keeping on its ‘normal’ 3% per year growth path. The contraction, as we all know, was caused by the collapse of the real estate bubble and the knock-on failure of large financial institutions who had gambled on stupidly underwritten loans and even more insanely constructed financial instruments like Credit Default Swaps and other derivatives.

The cards came tumbling down and, more to the point, three decades of economic illusion suddenly were exposed as fraudulent. America was suddenly aware that its thirty year debt binge and denial about some critical imbalances in its economic system were totally unsustainable.

Three decades of economic neglect and erroneous thinking had allowed those massive imbalances to accumulate. We have lived through three insane binges: the dot-com boom that spawned IPO wealth on paper and little lasting effect, other than the infrastructure of the internet; the stock market inflation that was associated it; and latterly the equally ludicrous real estate price inflation.

None of these were dealt with competently at the national economic policy level. On the contrary, each problem seemed to be met with an urge to reduce the effectiveness of government and to increase reliance on the same private sector that was creating the problem. The era of ‘self-regulation’ and ‘government is the problem’ had a singular worldview and a singular policy option: reduce regulation, and somehow the market will solve all our economic woes.

It was John Keynes who said:

“The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly supposed. Indeed the world is ruled by little else.”

The problem of the past three decades has been that the ideas were wrong. So now we pay for it.

The collapse was dramatic. By the time the dust settled it became apparent that the economy will have shrunk so much that we will lose about $2 trillion in wealth over about a two year period. That’s big by any calculation.

We were facing the opening up of a vast hole in the private sector: demand was simply insufficient to soak up the available output, so businesses started the inevitable shrinking process that is needed to shift resources away from rotten activities towards the remaining profitable ones, and to eliminate idle capacity.

Jobs were cut.

7.6 million so far and counting.

The textbook tells us that the immediate response by a government when faced by the implosion of the private sector is to reduce interest rates. This should have the effect of making borrowing cheaper and thence stimulating demand. Lower interest rates usually does the trick: after a few months of adjustment cheap money creates an increase in demand and the private sector rebounds.

This was not an option this time.

Why?

Because we had already lowered interest rates close to zero in the early stages of the credit crisis and therefore had no ‘ammunition’ left to shoot as demand cratered. It is simply not possible to have negative interest rates. More precisely it is not possible to have negative ‘nominal’ interest rates. Remember that nominal in this context means unadjusted for the effects of inflation. In truth we have had negative ‘real’ [i.e. inflation adjusted] rates for a while.

Faced with this impotence of the normal ‘monetary’ policy, we have to dust off the Keynesian solution: huge Federal deficits. The idea being this: if private people and businesses are to afraid to spend, then the government should in order to get thing going again. This is that classic pre-1970’s prescription. It was discredited, wrongly, during the stagflation of that decade and replaced by the more modern monetarism of Milton Friedman and then Robert Lucas.

With the Friedman/Lucas school of thought now exposed as intellectually bankrupt – that fight is still raging – policy makers had to resort to the policies of an earlier era.

The big question then becomes how much stimulus is needed?

This is calculated by estimating the lost wealth that needs replacing – in this case that $2 trillion I mentioned earlier, and then adjusting it by the effects of way in which money flows through the economy.

This latter step is tricky.

It requires us to calculate how much impact a single dollar of deficit spending has. Keynes called this the ‘multiplier’ effect. A dollar spent creates an ability for its recipient to spend, which means that the original effect compounds on itself as it keeps on rippling through the economy. This ripple gradually fades away after the dollar has changed hands a few times. Typically the multiplier is thought to be between 1.2 and 1.5. This means that a single dollar of stimulus has the ultimate effect of creating between $1.2 and $1.5 of demand.

Returning to the stimulus earlier this year.

The administration’s experts calculated the lost demand as that $2 trillion and that the multiplier of any stimulus was likely to be about 1.5. Given some fine tuning that meant the stimulus should have been $1.2 trillion.

We didn’t get that.

In fact that number never even made it to the President’s desk for consideration. The reason was raw political calculation. The political side of the White House vetoed anything larger than $800 billion on the basis that they saw no way to get enough Congressional support for it. So we ended up with a stimulus that the experts knew was inadequate from the get go. They were hoping it would be sufficient to stave off disaster – which it has – but they knew it may not be up to the ultimate task of re-igniting self-sustaining growth in the private sector. That has also proven to be an accurate guess.

The economy is certainly no growing, the combined effects of the weak stimulus and an inventory correction have ended the recession, but few observers now think that continued growth is assured. In fact, as last week’s miserable unemployment figures indicated, there is a growing threat of a return to recession sometime in 2010.

The political calculus will extraordinarily difficult this time. Opposition to the Obama agenda has solidified. His popularity has fallen. The Republicans have nothing to gain by being cooperative. This is not Obama’s recession, but it is his to fix. The slow recovery has hobbled his claims that a stimulus works. Instead the Republicans are arguing for more of the policies that caused the problem: more market freedom. The resonance with the 1930’s is stunning: the original opposition to FDR came from exactly the same quarter and for exactly the same reason. Some very famous economists – Schumpeter not least – were vehement in their insistence that the market should be allowed to follow its natural course. We have the same today with people like Lucas arguing that any stimulus is wasted money.

It’s as if we hadn’t learned anything from the success of Keynesian economics in the later 1930’s.

So here we are back, not just to the debate of earlier this year, but to the debate of 1934.

That cannot be good.

And it could have been avoided had we had more courage and sense at the critical moment earlier this year.

Hopefully we can get that missing $400 billion stimulus enacted.

I doubt it.

And that tells me next year could be very rough – meanwhile unemployment keeps on mounting. Presumably those opposed to stimulus don’t care about unemployment.

Shame on them.