Grading the Stimulus

Some readers of this blog and the reposts on the Seeking Alpha site have asked for elaboration on some of my earlier posts on the stimulus package.  I’ll try to do so here:

Is fiscal  stimulus a good idea?  There are several problems with using fiscal stimulus as an economic tool.   The primary issue is that fiscal policy is driven by politics, and budget issues in particular are driven largely by the House of Representative which lives on a 2-year election cycle.  In practice, this means that it is relatively easy to implement a stimulative policy, raising expenditures and cutting taxes.  However, it is very politically difficult to create fiscal restraint: cutting spending and raising taxes.  In other words, fiscal policy has an inherent stimulative bias, which is detrimental in the long run.  

Is monetary stimulus the better choice?  Monetary policy, because it is managed by an independent Federal Reserve, is a better “all-weather” tool.  Unfortunately, monetary policy has its limitations as well.  Monetary policy is ineffective in three instances: 1) when rates are already so low that further cutting of interest rates has no impact, and 2) when the “channels” by which monetary policy impacts the economy are broken, and 3) when inflationary expectations become a primary concern and monetary stimulus serves to devalue the dollar, stoke inflation, and increase nominal bond yields.  

In terms of our present situation, we are at point #1 with regard to the Fed Funds rates — there’s effectively nothing left to cut.  The Fed is not entirely powerless as it still has room to influence rates through purchase of securities with longer maturities, which they have already been doing (part of the the much discussed “expansion of the Fed’s balance sheet”).  With regard to point #2, right now there are some real structural problems that are impeding the effectiveness of monetary policy.  When you consider that the traditional mechanism for monetary policy is that the steeper yield curve inspires banks to lend, and low interest rates spur the economy largely through the housing sector, you get a sense of the problem.  Many banks are too wounded to be growing their loan portfolios regardless of the yield curve, and we have such a huge inventory of existing homes, so new construction is simply not needed regardless of mortgage rates.  The debt securitization markets that facilitate so much lending in the economy have also been severely damaged.  That being said, the lowering of rates substantially benefits consumers and corporations with floating rate debt, so there is definitely some positive impact.   Households with conforming mortgages have also been able to refinance.  Corporate borrowers and jumbo mortgage holders have not yet received much benefit since those rates have not declined substantially, but those rates have been improving, so benefit may be coming down the road.

Should we have even sought a fiscal stimulus now?  These are unusual times.  Given the above limitations to monetary policy, it seems prudent to implement some level of fiscal stimulus.  This is analogous to the fiscal stimulus of the 2003 tax cuts — following 9/11 and the very sluggish growth in subsequent years, and the rising unemployment at the time, a fiscal stimulus seemed like a reasonable precaution of last resort.  If you thought 2003’s fiscal stimulus was a bad idea in concept, you should also think the current stimulus is a bad concept.  The real issue, then and now, is probably not so much conceptual, but boils down to the specifics of the legislation. 

What makes better stimulative fiscal policy, spending or tax cuts?  The traditional view has been that spending has a greater stimulative impact since some tax cuts ultimately go toward savings rather than consumption.  In recent years, this has been challenged by some academic studies which have surprisingly shown that tax cuts may have a higher multiplier effect (i.e., how much additional economic activity a dollar generates).  This is an ongoing debate which really goes to the specifics of spending proposals.  Government spending for fiscal stimulus is often compared to employing someone to dig a hole in the ground.  If it is just  an empty hole, you’ve just wasted money.  If on the other hand, you dig a well, that water can now irrigate crops and sustain other productive activities and growth.  The recent studies which show that tax cuts have been more effective suggest that government programs for fiscal stimulus end up digging a lot of dry wells.  The jury is still out on whether tax cuts or spending is better — conceptually spending is better, but in practice tax cuts may be more effective. 

What are the risks and costs of any fiscal stimulus package  There are two main concerns with a stimulative fiscal policy: the general costs of increased deficits  and the risks of inflation.   The general costs of increased deficits include rising interest rates, the costs of debt servicing, the political risks of dependence on foreign borrowers, devaluation pressures on the dollar, and a general loss of economic maneuverability over time.   Inflationary pressures can be exerted by the generic “too many dollars chasing too few goods” paradigm.  

How good is the new fiscal stimulus bill?   The current package, when viewed as a mechanism to create jobs and boost the economy, is highly inefficient.   The fact that job creation costs are higher than the “Bridge to Nowhere”certainly gives a sense of just how ineffective the legislation will be as a fiscal stimulus tool.  If you judge it purely as a stimulus policy bill, it’s pretty poor legislation, although I believe it is better than doing nothing.

I think it is  more productive to think of this as not one but two bills: a fiscal stimulus bill, and a government spending package (this also explains why the bill is so inefficient at job creation).  The fiscal stimulus portion of the bill is okay but not great.  The positives are an attempt to focus on “shovel ready” projects and  a decent mix of tax cutting and spending.  The government spending package is really a political choice concerning the role and responsibilities of government.  We just had an election — the winning side should be expected to submit a policy and spending agenda in line with its political philosophy.  

What are the biggest problems with legislation?  Considering for a moment, stimulus side of the legislation (not the generic spending bill), the devil is definitely in the details.  The problems are best summed up as leading us down a slippery slope of excessive government intervention in the economy, with populist sentiments overriding good economic policy.  One example was the addition of further restrictions in executive pay for TARP recipients.  This is a highly controversial, but as I outlined elsewhere, some of these pay excesses are the result of government intervention in the first place — more intervention is not the cure and will likely lead to unintended negative consequences.   An area of greater concern is the creation of some protectionist barriers in the spending — although the strongest “Buy American” provisions have been diluted, there still appears to be some room for discrimination against certain imported goods.  Certainly, at least some trading partners are publicly decrying protectionist elements in the legislation.

To the large degree that this is not a stimulus bill, but is rather a spendingbill, I’m not going to comment on the policy choices imbedded (those are political preferences).  However, I think it is worth noting that the expansion of the deficit to this degree is a matter of real concern.  It is too early to tell whether this will result in higher borrowing costs and the crowding out of corporate borrowers: non-governmental issuance is practically non-existent right  now, so there’s no one to crowd out.  It is also premature to judge the inflationary impact.  Historically, the supply/demand factor in pricing within the taxable bond market has always taken back seat to inflationary concerns, so the “crowding out” argument has not played out.   Although the size of these deficits relative to GDP is extreme, so too is the deleveraging of the financial sector.  The inflation concern is more troubling — but difficult to gauge in a time of such economic slack — any adverse impact likely will not be visible for another year.

The real concerns I have are related to lumping the fiscal stimulus with a traditional spending bill.  While this was certainly a politically astute strategy, there are risks associated with this.  Because we get little “bang for the buck” with the legislation from an economic standpoint, I fear that a follow-up package, if needed, will be politically impossible.  The spending package undoubtedly will lead to larger structural deficits which ultimately erode our  ability to respond to future crises.  Whether the spending package supports worthy activities is a political question — the economic question is whether we can afford to add non-stimulative  funding responsibilities at this time.  I fear the answer is, “no.”

What “grade” would you give the stimulus legislation?  If this package were judged as a stimulus package alone, it would probably merit a failing grade for the incredible inefficiency of job creation for the total cost of the legislation.  However, as discussed above, it is really 2 initiatives in one, so an overall rating is very reliant on what one thinks of the worthiness of the spending initiatives.  Assuming a neutral view of those beneficiaries, I think the overall legislation still probably merits only a C or C-.   It will certainly have a positive economic impact, but hastily constructed guidelines and  large outlays in a short period of time virtually guarantee that a significant portion of the employment will be “digging holes,” and not “digging wells.”   Meanwhile, the expansion of non-stimulative Federal spending and the deficit comes at a time when it would be better to preserve our policy flexibility.  Finally, elements of the legislation leads us along particularly unproductive paths, whether through feeding protectionist impulses or the illusion of  government being able to “fine-tune” the economy. 

A passing grade, but hardly deserving of honors.

One Response to “Grading the Stimulus”

  1. More Unintended Compensation Consequences « (in)efficient frontiers Says:

    […] More Unintended Compensation Consequences By Jeff Korzenik There is no surer way to create unintended economic consequences than to regulate compensation plans.   Connecticut’s Senator Dodd made a last minute contribution to the stimulus bill that places severe restrictions on executive pay for TARP recipients.    As reported in the NY Times Dealbook Blog, one compensation consultant noted, “Any smart executive will (a) pay back TARP money ASAP or (b) get another job.”   These new pay rules may well be the single worst part of the flawed stimulus package. […]

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