THE BEAR'S LAIR - The Snare of Stimulus

THE BEAR'S LAIR
The snare of stimulus
By Martin Hutchinson

President George W Bush, Fed chairman Ben Bernanke and the Democrats in both Congress and the presidential campaigns agree that a fiscal stimulus is essential. It now appears that such a stimulus, of around 1% of gross domestic product, US$145 billion, will be enacted, perhaps by means of a rebate of around $1,000 per taxpayer. This is a fairly small amount, so it may not do much harm. But does the theory underlying it make any economic sense at all - as distinct from political sense, clearly uppermost in a presidential election year?

It's good to know that the classics are still read, even at Yale in the 1960s and that the General Theory of Employment, Interest and Money was able to have such a formative influence on the mind of the young George W Bush. However he doesn't seem to have got beyond the Cliff Notes version. Keynesian economic stimulus, in the form of adding spending or providing a tax cut (something Keynes generally abhorred) to stimulate the economy, was intended to be used to stimulate a consumer demand that had become inadequate and had locked the economy into a suboptimal equilibrium with substantial unemployment.

Excessive savings was Keynes' bugbear; he believed that excessive saving had been the principal problem for Britain and the United States in the late 1920s, so that only a demand-side kick could re-stimulate the economy.

We now know that Keynes' remedy was basically wrong, even for the 1930s, although certainly the deflationary below-capacity 1930s was a decade in which it was both tempting and not very harmful. By the time Keynes wrote the General Theory, the British economy had recovered nicely entirely without the use of Keynesian stimulus. Indeed Neville Chamberlain, the Chancellor of the Exchequer who engineered the rapid recovery, had gone so far as to cut civil service salaries by 10% at the nadir of the Depression in 1931, thus reducing government spending, basically on the entirely correct grounds that the option value of civil servants' guaranteed job security was higher in an economic downturn.

The Great Depression was primarily caused not by the 1929 stock market crash but by the Smoot-Hawley tariff passed in 1930 (a failure that would have been recognized by Adam Smith in 1776), by the money supply contraction in 1931-33 (a failure that was not to be recognized until Milton Friedman and Anna Schwarz's magnum opus in 1963) and by a thumping income tax top marginal rate increase from 25% to 63% in 1932 (a failure that Keynes would have recognized, but which would appear much more salient to the supply-side economists of the 1980s.) It was overcome, in Britain though not in the United States, by a government of the utmost economic orthodoxy pursuing policies of which Calvin Coolidge and Andrew Mellon would have thoroughly approved.

However, even those who believe in Keynes can hardly suppose a Keynesian stimulus to be relevant now. Lack of consumer demand has not been the problem in the US economy since 1995, quite the opposite. Grossly excessive consumer demand, caused by an over-expansionary monetary policy over a period of 12 years, has produced record balance of payments deficits, a negative savings rate and the transfer to Asia and the Middle East of one of America’s most important comparative advantages: readily available capital at low cost.

At this point, the long-term need is for a radical upward re-orientation of interest rates, to a level that provides savers with at least a 3% real return over and above the current inflation rate of nominally 4%. That would reduce US consumer demand, close the payments deficit, increase US consumer saving and bring the US economy as a whole back into balance. It would also increase the worldwide cost of capital, making it less easy for emerging markets, most of which are still somewhat capital poor, to outsource US industries to their own lower-wage economies. It would also reduce the excessive US investment in housing and financial services, both of which sectors are in the early stages of a very unpleasant downsizing of their current bloated and carbuncular state.

A major rise in interest rates would also have the useful side effect of preventing a resurgence of inflation. Having remained quiescent over the past decade, in spite of excessive money creation in the US and worldwide, inflation is now making a comeback. Even by the heavily massaged numbers of the Bureau of Labor Statistics, US inflation is above 4% and likely to remain there. In China and India, two of the important sources of cheaper goods in recent years, which have kept prices down and US industries outsourcing, inflation is above 7% and shows no sign of returning to a more tolerable level. The Chinese and Indian governments are at their wits' end as to how to control it; not surprising because its origin is in the excessive money creation of the US and other Western economies.

However, a major rise in interest rates we are not going to get, quite the opposite. Instead the Fed, seeking as usual since 1995 to provide short-term palliatives to Wall Street at the expense of the long term health of the economy, clearly intends to cut the Federal Funds rate further at its meeting January 30th, probably by 0.50% to 3.75% (incidentally, it is interesting that while interest rates must be increased as slowly as possible, in increments of no more than 0.25%, cuts can apparently be as large as the Fed's whim dictates.) ...>

http://www.atimes.com/atimes/Global_Economy/JA23Dj01.html

Fed rate cut fails to slow stock slump
Taipei Times:


..."There was a snowball effect of selling, mainly due to falls on other world markets, fears that troubles on the US financial markets are spilling over into the wider economy and finally that Japanese authorities are unable to do anything about it," said Toshihiro Matsuno, market research head at SMBC Friend Securities.

"Stability needs to emanate from the US markets and there is little that Japan can or would want to do," he said.

But Matsuno said that the market expected US authorities to try to calm markets before next week's Federal Reserve meeting, which is widely expected to slash interest rates.

"Although there are few economic indicators this week, the market is expecting US authorities to say or do something to tackle this problem -- other than rate cuts -- that would calm down markets," Matsuno said.

The stock market volatility will continue as long as US and European markets are unstable, said Yutaka Miura, strategist at Shinko Securities.

"Investors are waiting to see if US and European policy makers will come up with new measures," Miura said.

"An inter-meeting rate cut by the Federal Reserve or the advanced implementation of Bush's stimulus plan or the introduction of a public fund could be effective in bringing stability to the markets," he said....>

http://www.taipeitimes.com/News/front/archives/2008/01/23/2003398411

when it's clear this guy is another "Let the market decide", the "government is bad" kind of ideologue. I'm sorry, but whenever I hear that the Smoot Hawley Tarriffs caused the Great Depression, or that "everyone" knows that Keynes was wrong, I just can't listen anymore. WHat does everyone else think of the article?

certainly didnt help matter any, but I do not think it caused the depression either. It had a negligible effect one way or the other

Smoot Hawley was a symptom.

Anyway that is why we have to push the mantra that the bankruptcy bill caused this problem (IMHO, it did exascerbate it!)

I've decided capitalism works great locally, but globally, and with concentration of power, it starts to break down. Didn't even Adam Smith realize this?

I don't remember that being a picnic