Government Stimulus Programs Not Always the Hoped-For Panacea
By Martin Hutchinson
Contributing Editor
Money Morning
The British government this week unveiled a stimulus plan that will boost that country’s budget deficit to $181 billion (118 billion pounds), the equivalent of 8.0% of gross domestic product (GDP). U.S. President-elect Barack Obama’s stimulus plan, when combined with the recession, may raise the U.S. federal deficit to $1.2 trillion, or 8.0% of U.S. GDP.
This raises the question: If it’s so easy to stimulate an economy, why don’t we do it all the time? Don’t such large deficits cause problems?
The 4-1-1 on Stimulus Packages
There is no question economic stimulus is popular. Economist John Maynard Keynes originally proposed it to counter the Great Depression, and it is now used as a panacea every time the economy suffers even the mildest hiccup. The Economic Stimulus Act of 2008 – a $150 billion stimulus the Bush Administration unveiled last spring – is an example of this: It was proposed before the economy had suffered a negative quarter and it provided a modest short-term blip to consumer spending, making the second quarter of 2008 the best of the last four.
It also increased the federal deficit by an estimated $152 billion. And it did nothing, whatsoever, to solve the problems of housing finance failures, bank illiquidity and deep recession, though it may have postponed the actual onset of recession for about three months – the sharp downturn appears to have begun in July, the month after the stimulus package ended.
There are two reasons stimulus packages are popular:
- Politicians like excuses to spend more of our money.
- And the public is made to think that they are bound to work, because politicians and the media promote it as a one-sided thing. So, it seems obvious that if government spends more money – or cuts taxes – the economy is bound to improve.
When One’s a “Crowd”
What people don’t realize is that the money has to come from somewhere. Take Spain, where the government had previously been running a budget surplus. In such a case, a stimulus package is unlikely to do much damage, because it will cause only a modest deficit.
If, as is normally the case, the capital market is flowing freely, with investors worldwide buying U.S. bonds, then borrowing money for a stimulus package would at least do little harm, because capital inflows into the United States will just increase commensurately, so worthwhile projects still will get financing.
However, if the capital markets are even moderately tight (and they are more than moderately tight at present), then a stimulus package can be very damaging – perhaps even doing more harm than good. If it consists of extra spending, then the borrowing that’s done to finance those expenditures will “crowd out” private sector spending or investment. The sponsors of the stimulus package had better be very sure that their spending is well directed.
Keynes’ favorite scheme – employing people to dig holes only to fill them in – would make matters worse, not better. In the world of government budgets, the “hole” is deficit spending. The deficit is filled in – financed – with borrowed money.
Unfortunately, the money borrowed to fill in the budgetary hole would make matters worse, not better, because the money the government borrows would result in less money being available to invest in the rest of the economy. The little bit of money that was left over for private sector players to access would, naturally, command a higher interest rate, making the additional investments much more costly.
With a government-spending stimulus, nobody can be sure what is optimal, because the market is not involved, and government, once increased, may be very difficult to rein back.
Last spring’s tax-rebate stimulus package probably made things somewhat worse.
The tax rebates were spent by the recipients, who devoted their resources in ways that, at least to them, seemed optimal. But there is no long-term increase in the size of savings because U.S. consumers already save too little for economic health. So, draining some large portion of $150 billion from the savings pool to feed additional consumption was not sensible.
One other point regarding the tax-rebate stimulus: There is a school of thought – espoused by the folks who produced the acclaimed documentary “I.O.U.S.A.” that these rebates, by significantly slashing the government’s revenue, badly exacerbated the country’s debt burden.
British Prime Minister Gordon Brown’s Nov. 24 stimulus package involves primarily a temporary reduction in Value Added Tax (equivalent to a sales tax). At first glance, that was a surprising move, since the British government is from the left-of-center Labor Party. However, the reality was that after 11 years of Labor Party leadership, the budget was way out of balance even at the top of a boom, and the public had grown very tired of Labor’s public spending excesses – hence a “stimulus” of yet more spending would have caused even the placid British to start throwing things.
Obamanomics 101
President-elect Obama’s economic advisor, Austan D. Goolsbee, stated on Sunday that the stimulus “had to be a big number in order to get people back on track and startle the thing into submission.”
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That is a little alarming, because the resulting budget deficit could startle into submission the bond markets as well as the recession. That would cause a flight from U.S. government debt and the dollar, reducing U.S. living standards, raising interest rates and possibly even causing the rating agencies to downgrade U.S. government debt.
A stimulus package of $1 trillion, the high end of what has been mentioned, would almost certainly be too much – especially since it’d come after the Treasury Department’s $700 billion Troubled Assets Relief Program (TARP), which is fueling bank takeovers, and not expansionary lending, and the follow-on $800 billion credit-market stimulus unveiled yesterday (Tuesday). [Editor’s Note: For a more-detailed look at this latest stimulus plan, please click here to take a look at our news analysis story elsewhere in this issue of Money Morning.]
On the other hand, Obama plans a middle-class tax cut, which gives the money to those who have least benefited from boom of the past few years (prior to the financial crisis) and keeps it away from Congress’ profligate spending barons who would waste it on bridges to nowhere and other pork-barrel projects.
Furthermore, Obama’s healthcare plans and New Energy investment plans have both been blessed by the electorate, so presumably people actually want them. Moreover, he is talking of spreading the stimulus over a period of 2 years, which would presumably reduce the immediate borrowing requirement and ensure that the economy was genuinely into recovery before the stimulus ran out.
The market currently wants a stimulus package and trusts President-elect Obama. He thus has a major opportunity to implement some of the spending plans he favors, while keeping the market happy. That’s a rare opportunity, but he should be careful not to take for granted the market’s welcome.
News and Related Story Notes:
- Money Morning News Analysis:
A Trip Down the Road to Squanderville. - Wikipedia:
John Maynard Keynes. - Money Morning News Analysis:
Obama Unveils Economic Team, Plans 2009 Stimulus Package. - Wikipedia:
Great Depression. - Wikipedia:
Economic Stimulus Act of 2008. - Wikipedia:
Value Added Tax. - Money Morning News Analysis:
Sen. Dirksen: Let Me Introduce You to Standard & Poor’s. - Wikipedia:
Austan D. Goolsbee. - Money Morning Special Investigative Report:
Billions in Bank Rescue Funds are Fueling Buyout Deals, and not the Increase in Loans That Would Help Ease the Financial Crisis.
Comment by Omar on 26 November 2008:
I hope will larn more from u
thanks.
Comment by Subash K on 26 November 2008:
So what is the solution? We see do articles and critical evaluation of why the stimulus will not work. But the detractors do not state as to what the alternative/s is/are. By now most of us know about the problem. The issue is nobody knows or is sure of what the solution should be. Obvioulsy it is not sitting tight and hope the situation clears itself.
Yes, the stimulus might not work. But unless the detractors give some other viable alternative, they do not have a right at this time to analyse why it will not work.
Comment by Robert McDowell on 26 November 2008:
I read your essays because they are interesting by being forthright and strongly opinionated. I do not always agree, however. For example, why focus so strongly on Federal Debt when nearly half of it is not external to Government but internal. The remaining $6 trillion that is owing to private investors, including one third to banks, equates to less than hal of US household debt, less than half of US corporate debt and a fifth of US finance sector debt. All have to greater or lesser degrees counter-balancing assets. US Government bail-outs are stepping into the breach to restore confidence and allow the link-up between all these to function sensibly – and Government is doing so profitably for taxpayers all-round. Of course, deficit-spending makes less sense and may inflate rather than manage down asset bubbles if not judged cyclically. Why not try more balance across all the stocks and flows of business, households, banks and government assets and debts and then ask the question when Government squeezed or expanded its financial bellows at the right and wrong times, and whether a mistake was to accept household and corporate debt grow at much faster rates than government debt thereby financing the $trillion trade deficit? And then you have to ask whether the US easy credit economy that worsened the inevitable cycle bust was not in the interim a good thing for the US economy as well as for the rest of the world economy, that is if we can climb out of recession quickly enough for it to be relatively ok?
Comment by Christos on 26 November 2008:
The economic policy of G Bush made the same ,the opossite way ,instead of increasing expenses they reduced the taxes .The markets where happy despite the deficits .
Finally the judgment of what is good or bad for the economy seems to be subject of who is the beneficiary of the stimulus and not the real needs of the economy strength .
Christos
Comment by John Lounsbury on 26 November 2008:
Great analysis. I was interested in the surprisingly benign, even hopeful, outlook. Your implication is that Obama’s stimulus “spending” has an opportunity to be “investment”. I agree that it is possible that could happen. However, the effects on the economy will be slowly realized and will take years, not months (or even quarters). This will result in the consumption, not generation, of political capital in the next few years. Can this new “great communicator” keep the American citizenry on board if such a program is underway but not paying substantial dividends for more than the four years of his first term? If not, he might “do the right thing” and not get re-elected.
Comment by Web Smith on 26 November 2008:
Anything that puts money, not credit, in the hands of the people will provide temporary relief. FDR’s program, at a time when the banks had raised the interest rates and caused the depression, did this and the relief lasted for the 70 years that it took for the government and the banks to strip the population of its wealth again.
When too much of the population’s income goes towards paying interest, the money moves directly to the banks not remaining in circulation and generating commerce. As long as population is enticed to not live within its means, this will be a repetitive process. The population generates over 70% of the economy and throwing money t banks will have no effect until they have someone to loan the money to. When the population once again has money and the banks start releasing the cash that they were given, inflation will hit and slow the recovery.
http://ewebsmith.com/Finance/BankBailOut.html
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Comment by Mary Diane Dolan on 26 November 2008:
The comment of K made me laugh and laugh. A friend of mine just dies, K. What is “the solution”? A war breaks out, impoverishing and damaging thousands. What is “the solution”? What ought the government to do? REMEMBER that, according to yourself, you cannot recognize or reveal any negative or unfortunate situation without also revealing “the solution.”
As for the present topic, I cannot understand why, if deficits don’t matter, anyone should even KEEP TRACK OF what the US current accounts deficit IS. I cannot understand why such terms as “improvement” or “worsening” should be applied to deficit, if deficit is a meaningless figure. Also, someone mentioned that the money the US gov’t has borrowed has come largely from persons and entities living within USA. Why does it matter where creditors live or what their nationality is? Also, if I have lent money to USA & now hold US Treasurys, what is meant by the assertion that I have “counter-balancing assets”? What is meant by “counter-balancing assets” and why should it be assumed that I have any?
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Comment by Colin on 27 November 2008:
Sure the money has to come from somewhere and will put extra pressure on the money supply, possibly curtailing private sector spending but I think you’re missing the point, the reason why we are in recession is because private sector spending has been curtailed. No-one is buying ANYTHING! In Australia we aren’t getting someone to dig a hole to fill it in we are spending it on infrastructure which in difficult times is less expensive than when the economy is booming. Too much of that article sounded like Republican party scaremongering. The election’s over. Fear doesn’t work anymore.
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