When Stimulus Does Not Stimulate (=govmt consumption and fewer goods for higher prices )

A majority of Americans now give President Obama's handling of the economy a negative rating and many economists and city officials are concerned that Obama's gargantuan stimulus effort has not given the expected quick boost to the economy. Some argue this is because funds have been slow in coming due to bureaucratic red tape meant to ensure that the money spent will not be wasted. Jared Bernstein, chief economist for the office of Vice President Joe Biden (who knew that the Vice President needed a chief economist?), is quoted as saying "We're hitting the right balance between speed and oversight." Unfortunately for the American public, sound economics teaches that, regardless of how fast the money is spent or how much oversight is provided by bureaucrats, the money doled out by the stimulus plan will be wasted and will have a detrimental impact on the economy in the long term, because that is the nature of profligate government spending.

From an economic perspective, Obama's stimulus plan is equivalent to a giant welfare scheme. Instead of the money going to lower income Americans, however, it is meant to go to municipal bureaucrats of various stripes. Instead of productive American citizens determining what to do with their own scarce resources, the state is stepping in and dictating how they will be used. Consequently, such spending is essentially government consumption, which is what vulgar Keynesians think we need now more than ever. Such economists are shocked — shocked! — to find out that Americans are now saving any increases in income instead of blowing it on even more consumer goods. Not to worry, however. If private citizens do not consume enough for official tastes, the government always can.

Certainly we can expect that when the government spends a trillion dollars this will provide a positive statistical boost to GDP, if for no other reason that government spending makes up a significant portion of GDP. Where, however, does the state get the money to spend? Ah, as Hamlet might say, there's the rub. There are only three ways the government can obtain funds to throw at all their shovel-ready projects and all three leave in their wake negative economic consequences.

The most obvious thing the government could do to raise the funds to spend on fiscal stimulus is to raise taxes. However, this method is the economic equivalent of robbing Peter to pay Paul. Taxation directly impinges on taxpayers' well-being because they are left with less income from their labors with which to provide for themselves and their families.

Additionally, taxation reduces prosperity in the long run, because it fosters capital consumption over time. Taxation reduces the ability to save and invest in capital, because savings come out of income and as people have less income at their disposal, they have less to save and invest. Taxation reduces the incentive to invest as well, because future rates of return on any investment will be reduced by taxes on positive income. A project that might have netted 10% without new taxes might only net 7% after taxes. If a 7% rate of return is not an acceptable rate for a specific capitalist, he will choose not to save and invest. If saving and investment decreases over time, capital will be consumed. Labor will become less productive, resulting in lower incomes and less prosperity. Not what you want to happen when trying to get out of a depression.

Because taxes are so politically unpopular, governments usually resort to additional ways to raise funds, one of which is borrowing. A good case can be made that government borrowing is more harmful for long-run economic progress than taxation. Although taxation reduces both consumption and investment spending, government borrowing comes entirely from the nation's pool of savings. The money that is lent to the government in Treasury bond purchases is entirely money that was saved and ready for investment. Instead of being invested in productive capital accumulation, however, it is being lent to the government to fund state consumption. When the government borrows, it becomes a major demander of loanable funds, so market interest rates increase, making it harder for private entrepreneurs to gain access to capital for their production. As private capital available for productive enterprise shrinks, our economy becomes less productive and less prosperous.

The other source of funding turned to by the government is monetary inflation. Governments can either create money and spend it outright or they can inject money into the economy through the banking system so that people and banks can use this new money to buy up government bonds, thereby monetizing the debt. This route is preferred by governments who want to borrow more money without all those nasty rate increases.

Monetary inflation produces another set of negative economic consequences. In the first place, when the government increases the money supply, in general people hold more money than they want to at prevailing overall prices. They relieve this excess supply by spending the excess money on consumer and producer goods. Increasing the money supply does not spontaneously increase the stock of these goods; it merely increases the amount of money being spent on the same quantity of goods. Because more money is spent, the demand for producer and consumer goods increases, so overall prices increase and the purchasing power of the dollar falls. There is, therefore, no general social benefit from inflation.

In fact, monetary inflation via credit expansion is the source of our present trouble. Artificial credit expansion — credit not funded by savings — creates the business cycle by spawning capital malinvestment. Artificial credit expansion makes many unwise investments (say, in residential and commercial real estate and financial derivatives) look profitable because of the accessibility of cheap credit, so business activity expands, manifesting itself in an inflationary boom. Bad investments, however, are not made economically sound merely because there is more money in existence. These bad investments eventually must be liquidated. The boom resolves itself in a bust whose twin children are capital consumption and unemployment. The moral of the story is that monetary inflation is not a way to sustainably generate economic prosperity.

One thing the government does do, however, by increasing the money supply is discourage saving. This is because, as prices rise, money saved becomes worth less and less, so people are more likely to spend it on present consumption while the spending is good. Promoting consumption is the last thing we need to build up a capital stock that has been woefully depleted thanks to malinvestment. The old economic saw cuts true: there is no such thing as a free lunch, and there is no costless way to fund government spending.

Given that Obama's $798 billion stimulus program is a done deal, the only question is which economic poison will the government pick to drink: taxation, borrowing, or inflation? It turns out that that answer is all three. The government's fiscal response to our current debacle is a near perfect example of what not to do when trying to regain solid economic footing.

While not wanting to be identified as the great tax assessor and, hence, promising to cut taxes for most citizens, Obama is actively seeking ways to increase taxes for a host of Americans. Imposition of a national sales tax is a very live option sitting atop the Obama Administration's policy table. The Administration is also presently considering raising taxes on health care expenditures by taxing employer-provided health care benefits and by decreasing the deductibility of medical expenses. It wants to raise taxes on cigarettes, adult beverages, and sugar-sweetened elixirs such as soda pop, fruit juices, iced teas, and sweetened coffee drinks. Obama has proposed raising corporate taxes by $190 billion over the next ten years. He wants to place heavier taxes on commodities and option traders. Obama even is favorably considering increasing taxes on intangible drilling, an important technique in oil and gas exploration. While taxing these specific groups may be politically doable, it cannot be good for capital accumulation and economic recovery.

It is already conventional wisdom that a huge part of the stimulus program will be funded by borrowing. Who would have thought that in his first year in office, Obama's thirst for red ink would make George W. Bush, himself no foe of government borrowing, look like the frugal presidenté. The U.S. government reported the first monthly budget deficit in an April in over 25 years and a record budget deficit in the month of May. The current year's official deficit is slated to be $1.85 trillion (that's right, trillion)! The good news is that the Obama administration has things under control. They project that next year's deficit will only be $1.25 trillion. When the U. S. Treasury spends over a trillion dollars more than it receives in taxes, it must borrow to fill the gap. In fact, the deluge of government debt has already begun. The national debt has increased by $804 billion in less than five months. Last week alone investors bought $65 billion in long-term Treasury debt.

Not surprisingly, interest rates on Treasury notes have begun to rise. Already this year interest rates on 10-year Treasury Bonds have increased 1.4%, and rates for 30-year fixed mortgages increased to 5.5%, the highest they have been since November 2008. Higher market interest rates indicate, of course, that loanable funds are becoming relatively more scarce and we know that they are being shunted to less productive uses perpetrated by the state. Even Ben Bernanke is publicly confessing concerns that fiscal deficits like the ones being projected for the near future will serve as a serious drag on the economy.

One thing that Bernanke is not concerned about is inflation. Increasing liquidity by expanding the money supply is his drug of choice to prescribe to an ailing economy. From the first quarter of 2008 to the first quarter of 2009, the monetary base increased from $96.2 billion to $820.8 billion, an inconceivable annual rate of 753%. Such a huge expansion understandably sows seeds of fear of hyperinflation. If banks, who are presently sitting on a mountain of excess reserves, began to feel things are closer to normal and begin making loans at pre-2008 quantities (something the government is encouraging) there will be a gigantic increase in the money supply.

Notwithstanding official worries about deflation, Federal Reserve money supply figures reveal that the money stock has already inflated at a noticeably higher rate. The Fed's measure of MZM, money of zero maturity, increased from $8356.8 billion in the first quarter of 2008 to $9385.5 billion in the first quarter of 2009. Additionally, as the table below indicates, the rate of growth in the monetary aggregates accelerated during the last quarter of last year and the first quarter of this year.

As discussed earlier, economic theory teaches us if the money stock increases, overall prices of goods will be higher than they would be without the increase, because demand for goods will be higher due to increased spending. While it is not always easy to distinguish between relative and overall price increases when price changes are occurring, it does appear that prices of many goods have resumed an upward trend. The national average of the price of regular gasoline has increased by 58 cents since the end of April. It has increased $1.01 since the end of last year. Agricultural crop prices have also been rising steadily this year while reserve grain inventories have shrunk to low levels. Robert Murphy has recently made us aware that the non-seasonally adjusted consumer price index increased at an annual rate of 4.3% last month. All of these trends are consistent with the above mentioned monetary inflation and suggests that, as sound economic analysis tells us, the recent monetary inflation has not provided any real help to the economy in general, but is merely serving to spur increased prices.

The moral of the story is that we are right to be concerned that the Obama stimulus plan will not stimulate economic progress and will not usher in the next age of prosperity. Government spending merely directs scarce factors of production away from their most productive uses. Taxation, government borrowing, and monetary inflation all produce negative economic consequences. Real economic expansion is the product of wise entrepreneurs using capital that is funded by real savings. Such economic progress results in more goods that can be purchased for lower prices. As we are seeing play out before our eyes, the only thing that government stimulus plans stimulate is capital consumption and fewer goods available for higher prices — not a recipe for economic recovery.

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Stimulus spending begats higher taxes + inflation begats weaker economy begats stimulus spending begats higher taxes + inflation begats weaker economy.....

I’m now ready for my Nobel Prize in economics.

” All of these trends are consistent with the above mentioned monetary inflation and suggests that, as sound economic analysis tells us, the recent monetary inflation has not provided any real help to the economy in general, but is merely serving to spur increased prices.”

Anybody who thinks that we are in a period of monetary inflation at this point simply has no idea of how a credit collapse plays out.

“I’m now ready for my Nobel Prize in economics”

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Consider running in 2010? You’ve got my vote!

Thanks for the basic economics class refresher... I needed that... had the basic idea, now I can elaborate to others more clearfully...

Bookmark (after renaming)

Obama, Reid and Pelosi did not intend to stimulate the economy. They wanted to materially weaken the economy by shackling it with mega-debt and slow growth. This will suppress the American economy for decades (just like the Japanese economy)and allow Europe, China and India to surpass the USA. And, by default, destroy its global power. THAT is the goal of the Internationalist Movement and they will continue to borrow and increase our national debt until America is no longer a threat to global interests...

Anybody who thinks that we are in a period of monetary inflation at this point simply has no idea of how a credit collapse plays out.

Its early. First the deflation and debt default. Then, the political panic as 2010 elections approach. Then, more government spending in a mad attempt to preserve Congresscritter jobs. Then, an ocean of money in the global economy as other countries try the same trick. Then, too much cash in a no growth economy (1970's anyone). Then, inflation pressures build. Then, the massive outstanding debt starts to lose value. Then, panic as investors unload debt and flee to tangible assets. Then inflation as tangibles (including housing prices) start to rise.

We are in for a rough ride and there are no clear answers because we can't predict the sick minds of the Democratic Quants and their lackies in government. So... good luck! Inflation with slow or zero growth cost Jimmah Kahta his job. Obama had better think about the 1980 election results.

"We all knew spending was planned for the 2010 election."

Yup. That's exactly why less than 10% of the allocated money has been spent.

It's to be used to get the POS Democrats in congress re-elected! They could care less about you, me or the country, SOB's!!

The stupid stimulus was based on the FACT than noone knew what they were doing and the FEAR that they had to do something to prevent greater calamity. Sound familiar? It’s the same crap your local school board pulls when money gets tight and they threaten to cut football and the band. Fear tactics. That’s why it didn’t matter whether anyone had time to read it, they just wanted to pour money into the economy as fast as possible because that’s what their screwed=up Keynesian philosophy told them to do.

Except it was all wrong, and won’t work. Never has and never will. Unless you believe that a crisis is a terrible thing to waste, and can use it to fulfill political dreams that never would otherwise ever see the light of day.

It won’t stimulate because it CAN’T stimulate.

I appreciate your argument and sometimes find that position convincing. What’s working against it is the sheer quantity of credit disappearing due to massive debt default, a process that is only going to get worse as default spreads from residential real estate to the commercial sector.

I’ve seen figures indicating that defaults are in the range of 40-50 trillion, which dwarfs the 2 trillion or so that the government and Fed are injecting. That liquidity could grow if, as you point out, other central banks join the game. But will that counter the huge amounts of credit vanishing? The Japanese tried fighting a credit collapse without much success.

I’m not sure how much of that new money will get into the hands of the public. Banks aren’t lending, which makes you wonder just how much worse their balance sheets may be than we already suspect. The American public has relearned the value of thrift and that lesson may stick. This all works against the velocity of money, and for a good inflation to take off the velocity will have to pick up.

Since you've posted this, I've come to learn that the Fed has stopped QE and never really injected much new money over the past 6 months. I'd like to think our relentless ranting had some effect. So...

Your credit shrink argument becomes all the more frightening as money is drying up. Deflation is now in full swing. Cash is King and dollars to repay debt are getting hard to find. Inflation does seem a long way off. The question becomes: What will the government do to try to stimulate the economy to stop the slide? It can't borrow and spend fast enough to turn it around at these rates. And the tax base is shrinking by the day.

That "gold" coin they were passing around at the G-8 was telling. If the dollar is dumped, we are the new Mexico! And... American lifestyles go down the drain...

“The question becomes: What will the government do to try to stimulate the economy to stop the slide?”

I don’t think it matters what they try. They won’t have any more success than the Japanese did. The deflation is going to continue as unemployment feeds on itself. I think we are going to see a greatly different economy emerge after this process plays itself out, with a lowered standard of living for most of America in the next up cycle.

” I’ve come to learn that the Fed has stopped QE and never really injected much new money over the past 6 months. “

A funny thing about QE - I saw someone make a case for the idea that the past credit boom was built on QE, with China being the force responsible for the long term quantitative easing. China recycled their dollar earnings into American debt instruments, holding long term rates low and fueling the credit bubble. Not that they did this by design, they aren’t necessarily all that economically sophisticated. It was a very intriguing article but right now I don’t recall who wrote it.

I'm pondering the problem of stagflation like we saw in the 1970s. We have negative growth right now, credit is shrinking so the Ms are falling, prices are flat to slight decline. All point to a long term deflation ala’ Japan. But, I sense inflation as the currency weakens. We import way too much and a weaker dollar means rising prices.

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