Topic: Finance, Banking & Monetary Policy

The Last Word on Fiscal Stimulus?

From “the best-selling Principles of Economics textbook [which] has been teaching students in a clear, unbiased way for 40 years.” Campbell R. McConnell, Economics: Principles, Problems, and Policies.  McGraw-Hill, 7th edition, 1978.

The Last Word: The Impotence of Fiscal Policy
Some economists feel that fiscal policy is an impotent and unpredictable stabilization tool.

Well, as I wrote in a 1977 Tax Review article (reprinted 1w permission of the Tax Foundation, Inc.):

The real question is whether or not conventional fiscal policy works as advertised. If fiscal policy works, and its impact is properly measured by the size of the full employment deficit, then it should be possible to find some correlation between either the level or direction of the full employment budget and some measure of current or subsequent economic activity. George Terborgh tried to find some such link back in 1968, in The New Economics, but found only a weak correlation that turned out to be perverse. That is, larger full employment surpluses were associated with faster economic growth. More rigorous tests by economists at the St. Louis Fed, and again at Citibank, had no more luck in uncovering the magical properties of the full employment budget. A sharp shift toward larger full employment deficits did not prevent the recession of’ 1953-54, for example, nor the mini-recession of 1967. In 1946, a $60 billion reduction of Federal spending (equivalent to $400 billion today) was followed by a vigorous boom, and a combination of tax cuts and higher spending in 1948 (the equivalent of S75 billion today) was followed by a sharp recession.

The theory of fiscal policy is almost as messy as the evidence. If deficit spending is financed by borrowing from the private sector, there is no obvious stimulus-even to that undifferentiated thing called “demand.” Whoever buys the government securities surrenders exactly as much purchasing power as is received by the beneficiaries of Federal largess. There would be a net fiscal stimulus only if there were no private demand for the funds needed to cover the added Treasury borrowing. Otherwise, lendable funds are just diverted from market-determined uses to politically determined uses.

There may be a stimulus in some circumstances if the deficit is financed by a more rapid increase in the money supply, but this is really a monetary stimulus, not a purely fiscal effect.

In the long run, resources allocated through the government must displace those allocated through markets, and growth of government spending must be at the expense of the private sector. The government has only three sources of revenue – taxes, borrowing, and printing money – and increasing any one of those must reduce the private sector’s command over real resources. Although deficit spending may at times be a short-run stimulus to nominal demand, it is also a long-run drag on real supply-siphoning resources from uses that would otherwise augment the economy’s productive capacity, and instead diverting those resources into hand-to-mouth consumption through government salaries, subsidies, and transfer payments.

So, the theory and evidence suggests that fiscal policy is essentially impotent, or at least unpredictable, except as a device to promote inflationary monetary policy and/or to reduce investment and growth.

Obama’s Shock Doctrine

At the Guardian, I argue that President Obama and Rahm Emanuel are carrying out just what Naomi Klein predicted in The Shock Doctrine. Except that, as usual, it’s not deregulation and budget cutting that governments turn to in times of crisis. It’s more money and more power:

Last year the US economy was hit with one shock after another: the Bear Stearns bail-out, the Indymac collapse, the implosion of Fannie Mae and Freddie Mac, the AIG nationalisation, the biggest stock market drop ever, the $700bn Wall Street bail-out and more — all accompanied by a steady drumbeat of apocalyptic language from political leaders.

And what happened? Did the Republican administration summon up the spirit of Milton Friedman and cut government spending? Did it deregulate and privatise?

No.

It did what governments actually do in a crisis — it seized new powers over the economy. It dramatically expanded the regulatory powers of the Federal Reserve and injected a trillion dollars of inflationary credit into the banking system. It partially nationalised the biggest banks. It appropriated $700bn with which to intervene in the economy. It made General Motors and Chrysler wards of the federal government. It wrote a bail-out bill giving the secretary of the treasury extraordinary powers that could not be reviewed by courts or other government agencies.

Now the Obama administration is continuing this drive toward centralisation and government domination of the economy. And its key players are explicitly referring to their own version of the shock doctrine. Rahm Emanuel, the White House chief of staff, said the economic crisis facing the country is “an opportunity for us”. After all, he said: “You never want a serious crisis to go to waste. And this crisis provides the opportunity for us to do things that you could not do before” such as taking control of the financial, energy, information and healthcare industries….

Occasionally, around the world, there have been instances where a crisis led to free-market reforms, such as the economic reforms in Britain and New Zealand in response to deteriorating economic conditions. Generally, though, governments seek to expand their power, and they take advantage of crises to do so. But they rarely spell their intentions out as clearly as Rahm Emanuel did.

Looking Back: Cato Scholars Critical of Bush’s Big Government Policies

In selling his big-spending ideas for reviving the U.S. economy, President Obama has chastised “the same policies that, for the last eight years, doubled our national debt, and threw our economy into a tail spin.”

We couldn’t agree more with the president.

Unfortunately, he seems unaware that exploding the size of government, as he is proposing to do with this stimulus package, is a remarkably Bush-esque ideal.

While Bush was in office, scholars at the Cato Institute were critical of his big government policies. In a new section on cato.org/fiscalreality, you can find some of our research and commentary throughout the Bush years, including:

Obama Truth Check

President Obama may have preempted the first hour of prime time Monday night, but he certainly did not fail to entertain with several pronouncements that require suspension of disbelief.

Here are four Obama statements that deserve closer scrutiny:

1.      “[I]f you delay acting on an economy of this severity, then you potentially create a negative spiral that becomes much more difficult for us to get out of. We saw this happen in Japan in the 1990s, where they did not act boldly and swiftly enough…”

The fact is that numerous presidents, including Obama’s immediate predecessor, have used desperation and fear to sell some of the truly awful policies to come out of the U.S. government in the last 50 years – the Gulf of Tonkin resolution and the Iraq War resolution, to name two.

2.      “What it does not contain, however, is a single pet project, not a single earmark, and it has been stripped of the projects members of both parties found most objectionable.”

This one severely strains credulity.  The president is right about one thing: many of the bill’s projects are online for all to see.  But could any reasonable person agree that these projects are stimulative and not aimed at special political interests?

3.      “Most economists, almost unanimously, recognize that…when you have the kind of problem we have right now…that government is an important element of introducing some additional demand into the economy.”

We’ve been over this, Mr. President.  The truth is that a huge and still-growing number of respected economists think that a massive government spending effort in our present circumstances is wasteful and foolhardy.

4.      “What I won’t do is return to the failed theories of the last eight years that got us into this fix in the first place…”

OK, so we actually agree with the president on that one.  But then why is he bound and determined to repeat the reckless spending habits of George W. Bush?  We thought the November campaign was all about “change.”

What the Stimulus Is All About

With the president adopting his predecessor’s strategy of attempting to scare Congress into approving a bad bill by warning of financial doom, it’s worth remembering that the proposed “stimulus” package is about politics, not economics. If the proposed spending was worthwhile, it would be silly to fuss about whether the total comes to $800 billion, $900 billion, or $1 trillion. If we really can’t afford $1 trillion, then how can we afford $900 billion or $800 billion? In fact, the basic goal for most legislators is just to spend as much money as feasible as quickly as possible.

Thus, in Washington today the most important issues are: who gets all of the wealth extracted from the American people and who gets political credit for giving everyone else’s money away. Just consider the local boondoggles being advanced for federal funding by cities around the country–dog parks, tennis courts, neon signs, Harley motorcycles, golf courses, “eco parks,” frisbee golf courses, skateboard ramps, and much, much more not considered worth constructing with funds from local taxpayers.

Eugene Robinson admitted as much in today’s Washington Post. In urging the president to “roll over the Republicans,” he observed:

The House of Representatives loaded up the bill like a Christmas tree as powerful Democrats found room for their pet projects. This was a good thing, not an outrage. Hundreds of millions of dollars for contraceptives? To the extent that those condoms or birth-control pills are made in the United States and sold in U.S. drugstores, that spending would be stimulative in more ways than one.

Also indicative of how the proposed spending is foremost a matter of politics is the role of lobbyists in divvying up the proceeds. The role of House Financial Services Committee Chairman Barney Frank already has been exposed. But he is not alone. Reports the Washington Post:

“Earlier today, Sen. Bingaman met with Treasury Secretary nominee, Timothy Geithner,” the staffer wrote. “The Senator raised concerns regarding New Mexico based Thornburgh Mortgage and their efforts to access TARP funding and convert to a savings and loan holding company.”

Thornburg had been fighting off bankruptcy, and its best chance at a piece of the $700 billion federal bailout known by its initials as TARP could hinge on transforming itself into a regulated thrift and persuading the OTS to recommend it as a candidate for rescue. Bingaman’s aide wanted to schedule a call between her boss and OTS Director John M. Reich.

That short Dec. 9 e-mail offers a glimpse of the flurry of activity involving lawmakers and federal regulators as firms have pursued hundreds of billions of dollars from the Troubled Assets Relief Program and waited for details of how the Obama administration will disperse even more. With so much money at stake and so much uncertainty about who will get it, beleaguered companies fearful of being left behind are scurrying from Capitol Hill to K Street, trying to find a way to the front of the line.

None of this is surprising, of course. But it does demonstrate that the president’s rhetoric bears no relationship with reality. Unfortunately, his proposed “stimulus” bill will stimulate big government, debt, and inflation, not economic growth, jobs, and prosperity.

Investors Bet against the Stimulus Plan and/or Tim Geithner

I rarely give investment advice unless asked.  But I’ve found that most people are unduly shy about using short sales to hedge and, yes, “speculate.”

If you were invested in, say, an S&P 500 index fund over the past two years, you were actually speculating that stocks of banks and homebuilders would go up.  Index funds are weighted by the value of shares, so financial firms in particular were much too heavily weighted (the market has fixed that).

Exchange-traded funds (ETFs) make it easy to hedge that sort of unwanted long position with shorts.  You buy them like stocks and they have similar trading symbols like SKF or TBT.   Since 2007 (but not lately), I was invested in SRS which shorts real estate, and SKF which shorts financial stocks.  Those are ultra-short funds, which means the rise about twice as fast as those stocks fall in a day (though not over time).  The gains from SKF sometimes topped 150%.

In a May 1 2008 blog, I revealed that “I am shorting oil through an exchange-traded fund (DUG), and shorting precious metals through a mutual fund (SPPIX). I’m also slightly long the dollar (UUP).”  Shorting energy stocks and going long the dollar were contrarian positions, but profitable.  Shorting precious metals (then, not now) was partly because platinum and silver have industrial uses; gold held up fairly well.

If you still hold any mutual fund or 401(k) that is invested in long-term Treasury bonds that shows admirable patriotism and courage but not much caution.

Two old friends, one at a hedge fund the other a California economist, told me they think the government will be borrowing too much, and that the Treasury and Fed are trying too hard to expand money and credit.  That sounds like an easy bet to me.  I suggested another Pro Shares Ultra Short fund called TBT.  It makes a strong, leveraged bet that the price of 30-year Treasury bonds will fall and long-term interest rates will rise.

Since the end of 2008, this bet that government borrowing will cease being so cheap has risen by 36% – from about $36 to $49.

And that happened even though the Fed has threatened to buy long-term Treasuries.

If the Obama team’s “stimulus” plans and “rescues” keep making it this lucrative to bet that long-term long-term interest rates are heading up, what sort of “stimulus” is that?