Stimulus Produces Stagnation

Treasury Official:  The Fed Bank will print lots of money for us to spend.
Assistant:  We will construct more federal buildings, and the people will feel rich. Then what?
Treasury Official:  We will collect all of that money back in higher taxes.
Assistant:  Will that dampen their enthusiasm?

A Deficit-Financed Stimulus Leads Only to Stagnation
09/29/10 - Investors.com by Jerry L. Jordan
- Via Cafe Hayek

Mr. Jordan is a past president of the Federal Reserve Bank of Cleveland and a member of President Reagan's Council of Economic Advisers.

Soviet Realism

Leonid Brezhnev was General Secretary of the Communist Party and leader of the Soviet Union from 1964 until his death in 1982. He spoke at the Soviet Union Communist Party Congress in 1972:

The fundamental problem we face is that we can only distribute and consume what is actually produced.

Imagine the grandeur of the event. Communist Party leaders from throughout the Soviet Union were seated before Brezhnev in a large convention hall. This was similar to a US national political convention, but somber and powerful. The Party controlled all aspects of Soviet life. They listened in deep respect to every word of their totalitarian ruler.

Brezhnev made the above statement. It was the equivalent of saying with heavy meaning, "Gentlemen, the fundamental problem we face is that
2 + 2 = 4".

Imagine the country-wide failure which required an all-powerful leader to emphasize such a simple fact. The simple fact that you can eat a hamburger which is on the plate in front of you, but that you cannot eat a picture of a hamburger, and you cannot benefit from the promise of a hamburger unless you can exchange that promise for a real hamburger on the grill.

I think Brezhnev faced the problem that we face now in the US. The wierd economic ideas followed by the Soviet government were not working and had produced a crisis. Brezhnev had to reset policy. The Soviet Union had to face simple reality, rather than follow abstract theory. And, that is what we must do in the US.

The article which I link above provides an economic description of simple reality, nicely written. I think you will understand a reasonable economic explanation when you see one. You should be skeptical of any economic statements that are superficial or disconnected. Be especially wary of appeals to elite authority such as, "My program has the support of all the economists who I respect and who I have talked to."

Remember that entire nations can be misled, to such an extent that the rulers need a reminder of the simplest facts.

Summary of the article and other links ...

Summary of the Article

This is a summary of Mr. Jordan's three page article, with some added explanation. The article is worth reading in full.

Permanent Income

Households must decide what goods they can enjoy today and how much they must save or invest for the future. They estimate their long-term "permanent" income, and decide to consume (spend) some part of it. They don't spend all of a temporary windfall (eg. a bonus), and they don't cut back by the full amount of a temporary loss (eg. losing work for a short time).

Estimates of permanent income are relatively steady, but long-term changes in the overall economy will raise or lower those estimates over time.

Prosperity

Long periods of steady employment, increasing salary, and steady investment gains (eg. increasing values in 401K plans and house prices) may convince people that they are permanently more wealthy, and can afford to spend more now and in the future.

People will borrow against a plush future, to immediately enjoy such things as a bigger home or a vacation. This produces a low or negative savings rate. This is rational, and not a problem to be changed by government economic policy.

Businesses see opportunities and want to use current resources to meet the needs of a prosperous future. Real interest rates rise as individuals borrow for current enjoyment and businesses borrow to build more production capacity.

Higher interest rates direct borrowing away from low-yield projects, keeping those resources available for more profitable (more desireable) projects. Higher rates allocate resources to the best uses in the competitive markets of a healthy economy. This is also not a problem to be changed by government policy.

Recession

Decreasing employment, lower investment income, and falling housing prices produce an estimate of lower permanent income. Unfunded government pensions, large budget deficits, and growing government debt all promise higher taxes and lower after-tax personal income.

Government budgets are always balanced in real terms. The true burden of taxation is whatever the government spends. Citizens will pay for that spending, either now or later, either through explicit taxes or the effects of inflation (see below).

Future paychecks will be smaller or they will buy less. After higher taxes and/or inflation, people expect to be less well off.

A lower estimate of permanent income prompts people to consume less, to pay down current debts, and not acquire new debt. They doubt that they will have enough future income to both pay off their debts and spend as much as before. People want to avoid ruining their credit rating in the future. Paying down debt and keeping more cash in savings accounts increases the national savings rate.

The prospect of higher taxes and increased regulation lower the expected real, after-tax returns from new business projects. Fewer projects can return the needed minimum, real profit. Lower numbers of projects require fewer workers, affecting the least skilled workers the most. The lowered demand for both personal and business borrowing lowers real interest rates.

AMG: Low interest rates are not usually a sign of opportunity. Government interference to lower rates does not spark a recovery. People and business reduce borrowing because of their rational view of the future, not because already low rates are not low enough.

Government efforts to stimulate the economy by deficit spending are utterly useless. Government spending maintains some employment. But, businessmen know that tax increases (or inflation) will be used to pay back higher government debt and interest. They estimate their future customers will have lower real income to spend. So, they cut back on new projects, investment, and employment. This rational response of business and individuals cancels out any positive effects of that government spending.

 

Taxes, Deficits, and Inflation

There are three choices.

• Tax Now. Limit government spending to the taxes being collected now, or raise taxes to cover increased spending. The US government for 40 years has almost always spent more than it has collected in taxes in any year.
• Deficit Spending. Borrow the money needed to support spending above the amount of current tax collections (the additional deficit). The government sells US Treasury bonds to raise the money needed. Those bonds are promises to pay back that money after say 1, 5, 10, or more years, depending on the bond. The government pays interest to the bondholders as the cost of borrowing the money.

  The government sells bonds every month to support new spending and to pay off older bonds that have come due. Taxes must be increased to pay interest on the bonds, and to eventually pay off the debt.

  Every bond sold by the government is a loan to the government by someone with cash looking to make an investment. The government gets to use (or misuse) those resources, instead of a business receiving those funds for startup or expansion. This is called "crowding out" private investments. Ironically, huge government borrowing creates the risky business outlook which encourages investment in the supposedly riskless government bonds.

• Inflation. The Federal Reserve Banks (the US central banks) create money by buying US Treasury bonds. This is a last resort by government to acquire more money to spend. This is typically done when the government does not want to pay increasing interest rates on the bonds it might sell to the public, or to avoid increases in those interest rates.

  This is a hidden tax. The government acquires real resources by being the first spender of that new money. Later spenders find that prices for everything rise slowly as the new money is traded for an unchanged supply of real goods. The last people to spend are those who have money in bank savings accounts. They find that their money buys less real goods when they eventually use that money to buy things, such as buying their food in retirement.

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Why Spending Stimulus Plans Fail
11/2008 - Easy Opinions

The money isn't free. It is taken from the people who plan and invest in productive organizations. This destroys jobs and lowers everyone's income. The money is then given to government agencies which increase budgets. This is a form of government consumption. Investment is turned into consumption, and job expansion is killed.

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A Tested Stimulus Plan
02/2009 - Easy Opinions

The economic crisis is the result of a giant six year stimulus provided by housing loans. As we now know, it worked for a while and ended in disaster. What will the current stimulus plans produce when the money runs out? We know the answer: an economy like the current one, but somewhat worse.

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Stimulus Does Not Cure a Recession
11/2008 - Easy Opinions

Jobs change when people change what they want to buy or can afford. It is possible to keep people at their low-value or unneeded jobs for a bit longer, only by wasting the savings that should be financing a real recovery.

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Daniel J. Mitchell  reports on a few cases where governments realize that stimulus doesn't work.

04/26/12

-   Switzerland caps spending

04/15/12

-   Sweden shifts to the right on spending

11/02/12

-   Germany decides not to be Keynesian

04/24/12

-   Portugal declares that stimulus didn't work