Friday, February 1, 2008

Stimulus Will Be Saved

How Much Of The Stimulus Will Be Saved? All Of It
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By John P. Hussman, Ph.D. | 31 January 2008
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One of the ways that analysts talk about the just-enacted "fiscal stimulus" is by asking the question "How much of the stimulus will be saved?" To some extent, this is the wrong question, because if you think about it from the standpoint of equilibrium, the answer is obvious: exactly all of it.

The reason is simple. In equilibrium, every security issued must be held. If the government issues $150 billion of new debt to finance its outlays, then by pure accounting identity, exactly $150 billion of savings must be absorbed from someone to purchase that debt.

The trivial way for saving to absorb the stimulus would be for the Treasury to offer $150 billion in bonds, and also issue people $150 billion specifically for the purpose of buying those bonds. That's an instant wash. But even if the dynamics are different, the end result must be the same— someone must end up holding the new debt.

One might counter that the Treasury could sell $150 billion in bonds and the Federal Reserve could purchase them, creating $150 billion in new base money. Unfortunately, the entire U.S. monetary base is only $847.6 billion, up from $837.7 billion a year ago. Far from the notion that the Fed has created oceans of liquidity in the past year, the fact is that the U.S. monetary base (which is the only monetary aggregate the Fed controls with its open market operations) has increased by less than $10 billion. There's no shortage of previous weekly comments on this website that explain the distinction between repo rollovers and true increases in Fed "liquidity." The simple fact is that $150 billion is far beyond the capacity of the Fed to monetize without provoking a currency crisis [[and full blown panic, world-wide: normxxx]].

Government itself is a zero sum game. The proposed "fiscal stimulus" amounts to the government issuing additional debt to some individuals in the economy, and allocating the proceeds to others. The only relevant issue is whether adding to the Federal debt in order to redistribute purchasing power will bring resources into use that otherwise would lay idle; whether the redistribution of purchasing power will relieve some constraint that would be binding in the absence of the program, in a way that ultimately increases economic activity.

The hope is that moving money from one pocket to another will make us wealthier [[anyways, some of us: normxxx]].

That's not a particularly "Keynesian" way to look at a fiscal stimulus, but Keynes didn't worry much about debt, much less productivity. Keynesian theory is fundamentally the study of economics without the assumption of scarcity. If you look at Keynesian models of recession, the operative assumption is that investment is fixed and "trapped." By virtue of the savings-investment identity, this implies that total national savings are also fixed, so that attempts to save a greater fraction of income are futile, and will only result in lower GDP. In that context, government spending solves a "coordination failure" that the economy can't solve on its own.

Algebraically (we'll ignore foreign trade and "autonomous" consumption here), Keynes' model basically looks like this:

Y = C + I + G (GDP equals consumption + investment + government spending)

C = cY (consumption is some fraction of income)

Which Can Be Rearranged To Give

Y = (I + G) / ( 1— c)

That last equation represents the full force of accumulated macroeconomic knowledge on the average politician and Wall Street analyst. It says that if government increases spending by $1, GDP will increase by a "multiplier" equal to 1/(1-c). That little "c" is the fraction of new income that people spend on consumption (their "marginal propensity to consume"). So for example, in Keynes' world, if c = 0.75, every dollar of new government spending will produce $4 of new GDP. It also produces 0.25 x $4 = $1 of new savings to automatically finance the deficit spending.

As I've said many times before, if economics is the study of how scarce resources are allocated, Keynesian theory is not economics. There are, of course, modifications that include taxes, IS-LM versions that include monetary policy, and so forth, but the basic structure is hardly different. Keynes essentially looked at recessions as points in time when people suddenly and irrationally decide to save more, so the automatic policy response is simply to get them to consume more. But while the naïve simplicity of Keynes' framework (and the ability to scribble it on a napkin) has made it a highly popular way of thinking about economics, it is not a realistic theory on which to base the policy decisions of the largest economy in the world.

Keynesian theory is challenged by a variety of well-established results in economics. Most important is that people choose their spending plans to achieve a relatively smooth path of future consumption. As a result, a temporary increase in income is generally spread over a long horizon, while permanent changes in income result more quickly in permanent changes in consumption.

This principle (due largely to Friedman and Modigliani) became something of a political football itself last week, as some used it to advocate for a permanent reduction in taxes as a way of temporarily stimulating spending. That effort didn't get very far. People understand that if the government runs a higher deficit today, it will eventually be offset by higher taxes or reduced purchasing power in the future, so even a "permanent" reduction in taxes will not be effective in boosting consumption if that reduction in taxes isn't offset by a reduction in expected future government spending.

If the government issues Treasury bonds and uses the proceeds to make tax rebates, it simply effects a transfer of savings from one party in the economy to another [[or, from Chinese 'savers' to U.S. consumers: normxxx]]. A "fiscal stimulus" is not new money, but a redistribution of resources that relies on the hope that the new recipients will direct the money more productively than those who did the saving. Remember, people don't save by stuffing their money under a mattress. Rather, they typically invest it, so the savings are ultimately intermediated to a spender— even if that spender is the Federal government. The real question is not how much of the "stimulus" will be saved, but the extent to which the redirected resources of the economy will be used more productively than they would have otherwise.

Before enacting a "stimulus package," it would be helpful for Washington to recognize that a policy that loosens a particular constraint is only effective if that constraint was previously binding on the behavior of individuals or companies. If the Keynesian problem is that people want to save but investment is stuck, then R&D subsidies with a tight sunset timeline would be a good way to directly promote productive investment and channel savings into economic activity. That said, I don't think the problem with the economy is a sudden desire to save. It's a shift in the composition of demand away from the mix of goods and services (particularly housing and debt origination) that was previously desired. There's not a whole lot fiscal policy can or should do to bring back the "good old days" of irresponsible lending and housing bubbles. Once a market becomes overvalued— in stocks, bonds, or housing— either falling prices or poor long-term returns become inevitable.

For most families, the most binding constraint right now is not the ability to spend out of current income, but the ability to service debt. A temporary boost to current income is likely to be spread out in a way that best allows that family to operate under its constraints, which means that the predominant use of this "stimulus" will be for debt service. This may very well provide the economy with a modest reduction in credit strains, but it certainly won't avoid delinquencies and foreclosures. Most mortgage obligations will swallow down the entire rebate in a single month. Outside of bailing out credit institutions and creating a huge moral hazard problem down the road, there's not a whole lot that will solve the problems except time and writeoffs.

Several years ago, Joel Slemrod and Matt Shapiro (former colleagues at the University of Michigan) estimated that only about 22% of the tax rebates provided during the last recession were directed to consumption, with the bulk going to savings and debt service. Given the much higher debt burdens today, I don't expect this instance to be much different. In the end, the U.S. economy will carry a larger amount of U.S. Treasury debt, and a somewhat smaller amount of mortgage and credit card debt than it would have in the absence of the fiscal stimulus.

Still, policy makers can only do so much given that the Federal government is already running enormous deficits and the U.S. has such a deep current account deficit that we are happily selling off our productive assets to foreigners (e.g. "sovereign wealth funds") to stay afloat. The piper does eventually get paid.

In any event, we can expect that however the "fiscal stimulus" is spent, we will observe an increase in the U.S. federal deficit, as well as an increase in the U.S. current account deficit (or at least a smaller decline than we typically observe during recessions) because the U.S. has for the past decade relied primarily on foreign capital inflows to finance growth in investment and government spending. To the extent that a portion of the rebate is spent on consumption goods, "consumption smoothing" will probably be a factor. Most likely we'll observe that by some amount of increased demand for durable items such as consumer electronics, computers, and home improvements.


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