The Fallacy of Stimulus

Like many people, last year’s collapse of the financial system led me to take another look at the economics I learned in college. In earlier posts, I’ve mused about the notion that we’re all missing something—that there’s some subtlety that it takes a Keynes or a Krugman to figure out.

I’ve changed my mind. This plan is ridiculous, and it takes nothing more than common sense and experience to see that.

Over the last six months, the Obama administration and Congress have poured trillions into the economy in an attempt to avert more serious recession. The idea was that Roosevelt didn’t ‘spend enough, fast enough,’ and that was a major contributor to the Great Depression. My gut and my study of history told me that was wrong—it's pretty obvious that Roosevelt's tax policies prolonged the Great Depression, and only World War II pulled us out. Moreover, I’ve worked in government, and with government, so I was immediately suspicious of the concept of “shovel ready” projects. No one—no one—plans, designs, and approves a project knowing they don’t have money for it. Oh, sure, you can find the one exception, but even money says that “exception” is actually a project that was funded that lost its funding.

The crux of the problem came home last week when Vice President Biden made a comment that the government would have to reinvigorate its efforts to get the stimulus money spent—that only some $40 billion or so of the $787 billion authorized had actually been spent. For me, that was the alarm bell that finally made me realize all those (mostly conservative) pundits were right—most of this “stimulus” won’t be spent until 2010, well after it could do any good. In fact, it will be spent just in time to help with the 2010 elections, and if the incumbents are lucky, just before too much money in the system sparks inflation. (Although the President has a plan to curb inflation—he will be raising taxes in 2010, by letting the Bush tax cuts expire.)

The simple truth is that governments cannot spend billions extra in a matter of weeks. The system just doesn’t work that way. Even after the money is authorized by Congress, it takes months just to get it obligated on a contract. It takes more months to get it expended—and until it’s expended, it isn’t stimulating anything. And, while “months” is really, really fast when you’re building something, it’s far too slow to have any relevance to the business cycle.

I don’t know if the Keynesians just don’t understand the reality of bureaucracies, or if their faith in theory has simply blinded them to it. I do know that common sense tells me there are two ways to get money into the economy rapidly: 1) cut taxes, 2) hand out cash.

It has become popular to argue that this collapse has “proven” supply-side economics doesn’t work. I have yet to see anyone actually make that case with anything other than partisan talking points, and I don’t think they can. Instead, they rely on the populist argument that cutting income tax only helps the rich—because half of Americans pay no income tax at all. Um, okay—I thought we were talking economic stimulus? When did we switch to social policy? We can certainly have that discussion, but conflating the two issues suggests the redistributors have a not-so-hidden agenda.

But, if you’re worried about getting money into everyone’s hands, it isn’t just income tax that can be cut. Slash the corporate income tax, and 1) companies can cut prices; which 2) makes goods more affordable; which 3) increases demand; which 4) increases the need for labor. It isn’t just shareholders who benefit—everyone does. But, of course, that’s not popular to say in these populist times. (And shareholders benefiting just creates stimulus, too--because they either spend or invest their profit, and if they invest it, that just gives it to someone else to spend. Stimulus all around.)

This leads us to consider option two: handing out cash. That will certainly get money into everyone’s pockets, but there’s an obvious problem—for the 50% of Americans who pay no income tax, you’ve simply taken capital out of the system, because you have to borrow that money to pay them off. (And, please, spare me the argument that these folks pay Social Security taxes—they will get that back fivefold when they retire, and again, we aren't talking social policy here.) So, you may get a very short term stimulus from the demand, but you’re choking the engine that will ultimately create more jobs.

Finally, that brings us to the ultimate Keynesian argument—that deficit spending is okay in a recession, because the capital you’re borrowing isn’t being used, anyway. While that might be the case in some recessions, it certainly is not the case now—the major argument the populists are making against the banks is that they aren’t lending. Of course, they aren’t lending because they’re scared to death about what's next and what's really on their balance sheets, so they are keeping higher reserves. How, exactly, does government stripping those reserves out of the system improve confidence? It doesn’t, of course.

Which is why I am, just now, starting to worry about stagflation.

Good News About the Recession

This morning, I paid $1.89 a gallon for gas. Just five months ago, I was paying $4.02. More than anything else the government is likely to do, this is effectively a tax cut for millions of Americans—and specifically, it is targeted at lower and middle income families that both political parties claim to want to help. Set aside all the arguments about “progressive” tax policy, free market versus regulation, and everyone paying their “fair share,” and this is a tax cut that benefits everyone—fairly.

A question worth asking, then, is what the government might do to keep prices low. It’s too late for John McCain to argue it, but before Congressional Democrats start talking about raising gas taxes (oops, too late), they might want to think about what this means for a slowing economy. Barak Obama might even want to argue it.

The unfortunate aspect of these falling prices is that they are the direct result of reduced demand, first sparked by consumers reaching their personal tipping point at $4.00 a gallon; then further cratered by the collapsing financial markets. When America sneezes, the world catches a cold, and it was worldwide demand, as much as the United States’, that was causing the record prices earlier in 2008. The specter of extended recession has the whole world hesitant to buy anything—and if goods aren’t purchased, they don’t need to be transported, nor raw materials hauled to the factory.

But, as the saying goes, there’s good news and bad news. Or, more specifically, there’s good news, great news, bad news, and then more good news.

The good news is actually the very fact that the original high prices were caused by increasing demand—demand from countries such as China and India. Never mind whether or how much to regulate free markets. The Communist Chinese government needs capitalism to employ and feed its billion people, and it isn’t exactly a laissez faire organization. Globalism and the market are here to stay.

The great news is that those same markets, once we begin to climb out of the recession, will eventually earn a standard of living that makes them not just producers for the developed world, but consumers, as well. No longer are the Vietnamese content to ride bicycles or motorcycles—they want cars. Now, in my best William Shatner voice, imagine, if you will, a billion Chinese and a billion Indians wanting cars. And computers. And airplanes. Detroit, are you listening?

The bad news is that before we get to the great news, there’s going to be a recession—maybe a pretty deep and pretty long one. That will be painful. But, it will also keep those oil prices down, which will ease the pain a little. It will also buy us time.

The good news about all this is that we now have a breather. In June 2008, when gas was topping $4.00, every politician worth his or her salt was talking about what we needed to “do” vis-à-vis energy. Offshore drilling will take 5 years—or 7, or 10, or whatever. Wind will take 3 years—or 10, when people discover they don’t really like those loud turbines in their backyard (or even spoiling the view off their shore). Nuclear will take 10 years—or 50. Solar has been on the edge for 20 years. We don’t even talk about fusion anymore. So, nothing we can do will help for at least a couple years. But, we now have a couple years, if the government will do the right thing.

In this case, doing the right thing doesn’t even cost anything. It just means encouraging, and voting to permit, all those plans we liked when gas was $4.00 a gallon. At this moment, we have two choices—celebrate that prices have fallen, pretend the problem is gone, and react in shock 2 or 3 years ago when China decides to buy oil again or…or get busy with that program that sounded so good just a few months ago. Get busy offering long term incentives to develop all those things that will either bring us energy independence or a carbon-neutral life, depending on your politics. It’s one of the few areas that “why” doesn’t even matter.

There are a lot of specific things government actually can do, effectively. For starters, it can decide what things are going to be fast-tracked through the regulatory process. Until 2012, that will be President Obama’s responsibility to push, but if he plays his cards even reasonably centrist, he’ll have huge bipartisan support. There are even a few things that government can actually help get done. Compressed natural gas is an interesting technology, but without a nationwide infrastructure of CNG stations, most people aren’t going to buy one. So, Detroit won’t make them. So, no one will build a CNG gas station. See the problem? That is the sort of thing government can help with, just as governments sponsored exploration 500 years ago, and pushed space technology 50 years ago. Governments can incentivize gas stations to offer CNG (yes, it’s a subsidy), can incentivize purchase of CNG vehicles (because the more that are purchased, the sooner the price comes down), and while we’re at it, maybe should even subsidize the on-board nav system with a database of every CNG station in the country. As a free-marketeer, government involvement causes me shivers, but if we truly believe this is a social good, there are ways to bootstrap adoption without picking winners and losers.

Electric cars? Hey, I love technology, but I’m not paying $5000 extra for a car that only goes 75 miles on a charge, won’t last beyond 100,000 miles without replacing $10,000 worth of batteries, and will save me $3000 over its expected life. I leave it to electric proponents to come up with a logical incentive plan for that—but I bet it isn’t that difficult. As a crazy suggestion, how about all government buildings have electric plug-ins right next to the handicapped spots (i.e. close to the door) and the juice is free? (Let’s be clear—the juice is actually bought by the taxpayer, but that’s the whole point of social policy). If the plug-in spots are all full, then put in more. As adoption becomes more widespread, then some of them require payment. (An incentive for the suckers who have to show up at 6:30 a.m.)

While we’re at it, both the electric and CNG ideas require a build-out plan. Governments love build-out plans. Just as Amtrak only has Acela trains in the northeast corridor, perhaps these (and maybe California?) are the areas best suited to CNG stations and plug-ins. Only when sales warrant do we extend the infrastructure to the rural west. (Note to rural west: you don’t really want to pay for CNG stations every 100 miles along Nevada’s Highway 50, do you? Check a map.)

These are just two ideas picked randomly from items in the news. There are many more. The key is that, collectively, we have an opportunity to get ahead of our energy problem, a problem we all say we want to solve. We can do this, not by subsidizing foolish activity, but by thinking through the second and third order effects of every incentive, examining where a market jump-start offers a high payoff, and then acting swiftly to provide the incentives and cut through the bureaucratic red tape.

If there was ever a time to make lemonade from lemons, this is it.

Originally posted on my personal blog Nov 12.