May 13 2009
The Theory Behind Stimulus Packages
So people are still talking about the old stimulus package, some are talking about a new stimulus package, and as usual I don’t think people really understand the debate about it. As I’ve understood it, the public understanding of the debate was between those who think the government is better stimulated by tax cuts or by public works projects, and people project upon this debate questions of whether people believe in government or in the market (presumably those that are on the side of tax cuts believe in the market and those on the side of public works are on the side of government) failing to realize that realistically, by arguing for either side one already cedes the exact same level of governmental intervention.
What’s important is that it’s a stimulus package. If you want a stimulus, either from tax cuts or from increased spending, you are stating that you want the government to manipulate the economy. And it goes even further down the road of governmental intervention in the economy than Keynes ever went to suggest that we should’ve had a stimulus when we had it.
It’s important to understand what the classical theory behind stimulus packages are. When the free market progresses it goes through what’s called the business cycle. Businesses are interconnected, when firms are making money, so are other firms, and vise versa. So the economy grows, people invest, things become overvalued, people figure out its overvalued, people lose money, they economy shrinks, it gets undervalued, people invest, etc. It looks kind of like this:
Now the theory behind the stimulus package is that, through taking advantage of a delayed response time to monetary fluctuations you can smooth out the cycle.
The idea is that you can trick people into thinking things are better than they are, and that if you do it right they’ll figure that out at just about the same time that things have naturally improved to that point anyway.
And yes, there are a number of different ways to stimulate an economy, but they’re all just different means of doing the same thing, manipulating inflation. Supply-siders cut taxes without cutting spending, borrowing money to spend domestically. This means, briefly, there is an influx of cash into the economy without the economy doing anything to merit it. People are temporarily more wealthy because of this, but eventually the economy returns to equilibrium through the process of currency inflation (the currency losing value to match the amount of money spent on deficit). Demand siders instead think government spending does this better, that instead of borrowing money to pay for tax cuts, they borrow money to allow the government to spend more without tax increases. Monetarists, like Milton Friedman, believe that a federal reserve, where interest rates are manipulated to control how much money people in the economy are borrowing, thereby manipulating the money supply (controling inflation). All of these theories all fit with general Keynesian theory, which, if done responsibly, isn’t necessarily all that bad.
Keynes argued that fiscal policy needed to be dictated by technocrats, that these decisions had to be made by those best able to read the economy and motivated purely by those facts, which says to me that he recognized how important it was to use these tools responsibly. Unfortunately, what Keynes failed to take into account (being an economist and not a political scientist) was the fact that an inherent byproduct of democracy is that the decisions are always ultimately made by politicians.
For stimulus packages, either in fiscal or monetary form, to do what they’re supposed to do, they have to be targeted and temporary. The stimulation from the package is not permanent, it’s the impact of increasing the money supply. To sustain the impact of a stimulus package you have to sustain the level of deficit spending. For the stimulus to work as it’s supposed to work, it has to still function within the constraints of the free market, when the effect is had, the deficit has to go away, and when the economy is growing a surplus is needed to cover the deficit when the economy is going back down again.
They say that the 1970’s was the decade when Keynesian economics were discredited. Realistically they weren’t, because they weren’t really using Keynesian economics. There were politicians filling the roles that Keynes said needed to be technocrats. They weren’t making purely economic decisions, they were making political decisions. They were using moral hazard because they wanted to allow the poor access to more money, they were using price controls to help the poor afford more of what they wanted, they regulated the economy into oblivion, and they spent at perpetual deficits (there were maybe 3 or 4 years of surplus between the 1930’s and the 1970’s, the deficits were smaller than they are now, but they were perpetual). And so what happened was the economy would go into recessions while there was deficit spending, meaning the natural recessions were exacerbated by the recessions, and we’d attempt to solve the problem with more deficit spending, but since manipulation has become the norm, the natural business cycle doesn’t play itself out, and so when the impact of these stimuli wears off, the recession just gets worse. The culmination of the 1970’s stagflation (when rates of unemployment and inflation are increasing simultaneously) was that Ronald Reagan had to stand behind his fed chair as he raised rates to 22% (right now they’re close to 0), causing a huge recession that wore off after a year or two. Then Reagan went about running up huge deficits, which put us back in the same situation in the early 90’s.
The only medicine in recessions exacerbated by growth period deficit spending is to return sovereignty to the free market. Our economy took off in the mid to late 90’s when the Gingrich congress and the Clinton administration canceled each other out, eventually leading to a budget surplus. What needed to happen was that government obstructionism was stopped by partisan gridlock, and the market returned.
The recession we’re experiencing now is far from just a normal part of the business cycle. It was caused by unregulated moral hazard, and deeply exacerbated by massive deficit spending and below-market fed rates. And so right now any stimulus is an extension of the idea that the government has to run the economy, because the fundamental choice is whether we allow the market to return by decreasing governmental obfuscation or whether we’re going to leave everything up to the government. Just for historical reference, John Meynard Keynes, the father of the economic philosophy of stimulus packages, was on the side of the market. He recognized that the role of the government in the market had to be within the market, that governmental intervention is solely for the sake of smoothing over the rough edges of the market. When we had the stimulus debate in January and February, both parties were on the side of keeping the market out of it. If you want to do it through tax cuts or through public works, it doesn’t matter, right now the question is whether we’re a market economy or not, and the two parties were just arguing which kind of “not” is better. Which kind of cancer would better compliment the cancer we’re trying to cure with cancer.
I can understand removing the toxic assets. I’m pretty sure I’m still against it, but from some I’ve heard the reality of those is they were structured in a way that their damage would last for decades. It’s a pill we’ve gotta take, but it requires more significant action to destroy the moral hazard in our economy. Stop all bailouts. We’d also have to regulate and role them back over time as it becomes understood that we will not bail anyone out ever again. Still, the only way to take a real step against what caused this to happen and would cause more stuff that’s much worse in the future is to let people sleep in the beds they made for themselves.
Our current rebound was inevitable. We’ve pumped billions and commited to pump billions more into the economy. The question is whether the market economy will be there at the end of this stimulus’s effect. It’s important to recognize that we tried this last year, President Bush had a $300 billion stimulus package, and it worked in the short term then too. And then the DOW went on to shed half of its value. Manipulations won’t cure these problems. We have constructed things which stand in the way of the market, and the only way to get past them is to let the market improve the way it improves - through creative destruction.
The mistake is thinking that monetarism or Keynesian economics should be utilized exclusively. The US has a pretty good system in place with the Executive handling fiscal policy and the FED handling monetary policy. To strict an adherance to any policy will exacerbate problems inherent in the business cycle. I dispute any claim that states these tools, (monetary or fiscal policy) subvert the free market economy. Demand replacement or monetary infusion only stand to help flagging markets and long term concerns such as inflation or rising interest rates will have to be addressed at the time. In the end deflation and unemployments are the truly harmful fundamentals that have to be addressed. The rest of the arguments put forth seem largely moral or ideological rather than objectively economic.
Deflation and unemployment are harmful, but the problem with the logic that these tools should be used to curtail the damaging impacts of monetary fluctuations and unemployment is that it’s premised upon it being reasonable to expect these tools to be used responsibly. Keynesian economics are premised upon the decisions of how and when to use these tools being made by people who both know and care about their correct application, which is to a great extent quite naive.
If these decisions weren’t up to politicians, I’d have no problem with using Keynesian tools, and I agree that when correctly applied these tools aid market function rather than subverting them. We saw in Japan in the period between the start of the Korean War and the East Asian financial crisis, they developed a market economy that threatened to wrest global economic dominance from the United States, but even then, reliance on governmental intervention left them ill able to deal with the dynamism of the new economic issues which arrived as a product of more sophisticated interventionism in domestic economies and globalization.
There is no excuse for an economist to fail to take into account the realities of political decision making in governments. They take into account the potential impact of governments in economies, so ultimately you’ve got to do it. If markets are people coming together to satisfy needs, it’s important to take into account what those making the decisions need and how that is made available to them. They are politicians. They are in the power market, meaning those that want power have competitive advantage over those that aren’t particularly concerned with power, so you have a market of those who are in search of power. How do you get power? Ultimately, the ways are all derived from appearing as if you’re doing stuff they like, which is quite distinct from even doing stuff they like, let alone doing what’s in their best interest. So expecting politicians to apply these tools responsibly fundamentally requires one to ignore the nature of political markets.