The $787 billion stimulus bill has been signed by President Obama, and the $275 billion help for homeowners has been announced and generally well received, but still the stock markets keep dropping. Worldwide, daily new plans for stimulus and rescue are met with daily declines in stock prices and gloomy economic figures. There’s a reason for this: the markets have figured out that the deepest economic hole out of which the global economy will need to climb is the one that the world’s governments have dug.
The relationship between public sector stimulus packages and output is fairly simple, but it is non-linear and Maynard Keynes was no mathematician. It basically appears to depend on four factors: (i) the share of public spending in GDP, (ii) the public sector deficit as a percentage of GDP, (iii) the composition of the stimulus package itself – its split between tax cuts, “digging holes and filling them in” unproductive spending and “TVA/Interstate highways” productive spending – and (iv) the level of slack in the economy.
US deficit spending during the Great Depression was thus fairly productive. The share of public spending in GDP was low, so increasing it did not greatly impact the private sector. The public sector deficit was low, so the spending was easily financed, without too much “crowding out” of private sector needs. At least some of the spending, the Tennessee Valley Authority, was productive. And the level of slack in the economy in 1933-40 was enormous. Thus if Keynesian stimulus was ever going to work, it should have worked then.
In reality, it didn’t work all that well; unemployment remained above 10% until the US entered World War II in 1941. Part of that failure was due to foolish non-Keynesian policies that dragged the economy down – the Glass-Steagall Act (which de-capitalized investment banks, thus almost closing the capital markets to new issues) and the NRA and unionization policies which raised prices and wages above market levels. Herbert Hoover’s 1932 tax increase, the Smoot-Hawley Tariff and the introduction of Social Security (heavily cash-flow-negative to taxpayers in its early years) also weakened the economy, as did unduly restrictive monetary policy in 1930-33. Conversely the introduction of bank deposit insurance strengthened it.
Still, even in the Great Depression, the Keynesian case is a difficult one to make, judging by results alone. After all Britain, managed economically by the anti-Keynesian Neville Chamberlain, cut back public spending and emerged from the depression much more quickly and successfully than the United States.
Much though President Obama may not wish to admit it, his stimulus plans are not original. In 2001-02, a combination of a tax cut of 2% of GDP and spending increases of another 4% of GDP (partly the War on Terror, partly the No Child Left Behind Act and partly cyclical) provided fiscal stimulus of about 6% of GDP between the fiscal years (ending in September) 2001 and 2002. Monetary policy was also exceptionally stimulative, with short-term interest rates declining from 6% to 1% within a 2-year period while inflation remained positive.
Judging by results, the George W. Bush stimulus worked rather better than the New Deal. It was begun from a position of fiscal surplus, lessening the strain placed on the debt markets by its borrowing, while inflation during the period was suppressed by the deflationary effects of globalization and the Internet. However it distorted the economy, leading to an undue concentration in the unproductive sectors of housing and speculative finance, while manufacturing and much of the high-skill service sector was outsourced to Asia. Notoriously, the subsequent expansion led to very meager gains in living standards, except for the very rich, while inflation crept up and the federal budget deficit remained in substantial deficit, even at the top of the 2002-07 expansion.
This time around, the conditions for stimulus were much less propitious than in either the Great Depression or 2001-02. Public spending, including state and local spending, was far higher as a percentage of GDP than in the 1930s. In Europe, particularly Scandinavia and in Japan since 1990 we have seen the adverse effect on growth exerted by high public spending. The increase in global public spending through stimulus plans is thus likely to be substantially growth-destroying in its own right.
Second, an exceptionally large stimulus (including bank and mortgage bailouts) has been combined with a public sector deficit that was already excessive to produce a likely Federal budget deficit in fiscal 2009 and 2010 of more than 10% of GDP in each year. The difficulties of financing these deficits will unquestionably be very serious, and the adverse effect on the US Treasury’s ability to borrow resulting from their probable persistence will be equally severe. Outside the United States, Britain and Japan are notable among other countries that were already in a difficult fiscal position before the downturn hit, and will be in impossible positions as a result of their misguided stimuli.
Third the Obama stimulus package, having been largely dictated by Senate majority leader Harry Reid (D.-NV) and House speaker Nancy Pelosi (D.-CA) consists largely of short term state budget palliatives or handouts to favored constituencies, with very little TVA-type long-term beneficial spending.
Even in areas where true economic benefits might be expected, such as the $8 billion subsidy to high speed rail, the package has not been designed to favor rail projects in the country’s main centers of population and economic activity, which could hugely benefit from their rail systems being brought up to current international norms. Instead it favors the utterly frivolous project to run a maglev train, the most expensive and least tested technology available, to the isolated casino result of Las Vegas. Politically, that project may be very attractive to Reid, but it is economically almost worthless because of Las Vegas’ geographic isolation. It would also be socially highly damaging, forcing the destructive forces of gambling even more deeply into the fabric of American society.
Finally, at the time stimulus began with the bank bailouts last October, there was very little slack in the US economy, with unemployment only around 6%, the Dow Jones index at bubble levels over 10,000, house prices still sharply overvalued and the US savings rate still disgracefully moored at around zero. To re-stabilize the US economy after its years of imbalance, the savings rate needed to be brought back to its historical level of around 8%, or rather more to make up for the years of nil saving, while the US balance of payments deficit also needed to decline by 5-6% of GDP. In such circumstances, injecting yet more wasteful spending into the economy was a wholly perverse approach to the problem.
Going forward, we are now presented with an annual fiscal deficit of 10% of GDP that will be very difficult to finance or to eradicate (and that’s without taking account of further costs of any more bank bailouts that the erratic US Treasury or the Fed may consider necessary.) President Obama’s Fiscal Responsibility Summit will find significant cuts in public spending impossible, given the political orientation of the decision-makers and the expectations of their followers. The only approach that will appear feasible is thus one of massive tax increases, delayed sufficiently as to allow recovery from the recession before they take effect.
Substantial tax increases are already scheduled, with the December 2010 repeal of the Bush tax cuts. At less than $200 billion per annum however, this repeal will go nowhere near far enough. To correct the budget imbalance, it will be necessary to schedule tax increases of at least 4-5% of GDP ($600-800 billion) unless public spending can be cut commensurately. Even those draconian increases would only bring the budget deficit down within historically precedented levels, rather than eliminating it altogether.
Not only will such tax increases have an appalling economic effect, they will also be very difficult to fit into Obama’s political timetable. Tax increases that took effect in 2009 or 2010 would be disastrously counterproductive, reproducing almost precisely Hoover’s blunder of 1932. However massive tax increases that took effect in 2011 or 2012 would have an equally massive adverse effect on Obama’s re-election chances, particularly if they caused even a minor relapse in the US economy.
Hence all but modest tax increases are likely to be delayed until 2013 or later, and the US budget deficit is likely to remain at least well above 5% of GDP until then. That will increase US public debt to around 100% of GDP by the 2012 election. It will also cause a massive increase in interest rates, which will be doubtless be resisted a l’outrance by the Ben Bernanke Fed. That in turn will cause a resurgence in inflation, probably at a speed and to a level that will make the late 1970s seem like child’s play.
Already the Producer and Consumer Price Indexes have continued increasing in January, demonstrating that the specter of deflation is no more than a Bernanke fantasy. Once inflation reappears in earnest, accompanied by higher interest rates caused by the excessive budget deficits, Bernanke will not rein in money supply immediately, as he currently claims he would; the unexpected (to him) resurgence in inflation will cause hysterical denial and delay in necessary tightening for at least a 6-12 month period.
The Bernanke problem can only be solved by replacing him when his 4-year term is up next January, but it is not clear whether Obama has either the understanding or the bottle to bring in a Paul Volcker clone to the Fed to do what is necessary.
Internationally, the stimulus expenditures of Japan and Britain are likely to prove equally damaging to those countries’ recovery possibilities. Japan will have an election this year, from which an anti-stimulus opposition government may emerge; if so it will face an uphill fiscal battle more strenuous than that facing Junichiro Koizumi in 2001. In Britain the election need not be held until June 2010, and even after it the feeble David Cameron and George Osborne team seems unlikely to provide much policy improvement.
It’s already certain that 2009 will be a thoroughly unpleasant year, and many commentators are coming to realize that 2010 will not be much better. Thanks to stimulus, it now seems likely that 2011 and 2012 will also be years one would rather not experience and only in 2013 and after may some kind of feeble economic recovery emerge.
Gee, thanks Maynard!
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)