Stimulus spelled out
Amidst the dire predictions of imminent catastrophe if Obama's stimulus package were not passed by the Congress, and equally dismal prophecies of how the stimulus will extend what is looking like a doozy of a depression, there has been a near-complete failure on the media's part to explain the core principles behind the fiscal stimulus to the American people. This is due to the near-complete ignorance of economics on the part of the mainstream media; one can hardly expect them to explain what they do not understand. Some readers may find it useful, then, if I attempt to rectify the situation.
Hey, they just report the news! People certainly don't expect them to do some research and find out if what they are told is true or that their may be people that disagree with what they are being fed.
In 1987, the new Federal Reserve chairman, Alan Greenspan, averted a financial meltdown in the fall when he used a variety of aggressive monetary policies to inject liquidity into the financial system, temporarily driving down the overnight repo rate from 7.5 percent to 5.5 percent in a matter of days. Interest rates, as measured by the effective federal funds rate, were slashed from 8.5 percent in late September to 5.5 percent in mid-December. The success of his actions in stabilizing the financial system gave great credence to the Monetarist school of economics, epitomized by Nobel Prize-winner Milton Friedman, who had long asserted that management of the money supply was the key to preventing the economy from contracting.
Friedman had long blamed the Federal Reserve for failing to respond aggressively enough to the stock market crash of 1929, and in collaboration with his co-author Anna Schwartz, had claimed that a more aggressive lowering of interest rates would have prevented the Great Depression. Greenspan's successful navigation of the 1987 crisis appeared to prove conclusively that the monetarist thesis was correct, and in 2002 led to current Federal Reserve chairman Ben Bernanke making a humorous admission in his speech made in honor of Friedman's 90th birthday.
Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.
But then something odd happened:
Similar rate-cutting actions were begun in July 1990, February 1995, May 2000 and June 2006 when signs of economic contraction appeared. However, as the cuts came more often and the target rates fell lower, it began to become clear that these liquidity injections were no longer having the desired effect of propping up stock, real estate and commodity prices. Now that interest rates are effectively at zero but the economy is still in the process of shrinking, the failure of the monetarist theory has become obvious, especially given the continued failure of the Japanese economy to respond to extreme interest rate-cutting following its 1989 crash.
It slashing interest rates stopped working, plus we had the example of Japan's economy tanking using this principle, but nobody can put two and two together.
The failure of monetary policy has caused many economists and politicians to return to the Keynesian school, which primarily concerns itself with fiscal policy. Just as the Federal Reserve's control of the price of money – the interest rate – is the primary tool of the monetarists, government spending is the primary tool of the Keynesians, or more properly, Neo-Keynesians, since even the biggest fans of John Maynard Keynes have been forced to acknowledge at least some of the fundamental flaws in his economic theories. The core of the Keynesian theory of economic contraction is a failure of demand to meet supply, or to put it more simply, people are refusing to buy enough stuff to keep the economy growing. This is why Neo-Keynesians like Nobel Prize-winner Paul Krugman worry about "the looming hole in the U.S. economy," by which he means the difference between what could be produced by the economy and what will actually be bought.
So now we go back to the "semi" discredited system that didn't work.
This next quote is long, but explains it with an easy to understand example:
Consider a hypothetical example of an economy in which there are 100 cars. Because a car lasts for 10 years, every year 10 cars wear out and are replaced. But things have been going well and people are getting wealthier, so five of them buy second cars. The three car makers each sell five cars, and there are now 105 cars in the economy. However, in the second year, there is a stock market panic due to the failure of the Madagascar cashew harvest, so the central bank gets nervous and slashes interest rates. Ten cars wear out, and 10 are replaced, but thanks to the low interest rates, the automakers can offer zero percent leases and other creative forms of payment, which encourage 20 people to buy second cars. There are now 125 cars in the economy. Interest rates stay low for the next three years, and people continue to take advantage of the new car-financing deals, until there are 185 cars in an economy that only required 100 five years before.
Then, an Icelandic bank bets heavily on the Norwegian cod harvest and goes under. The global stock markets drop, people feel less wealthy, and car drivers decide to reduce their automotive consumption. Ten cars wear out, as always, but instead of being replaced by new cars, they are replaced by cars that still have seven good years on them sold by two-car owners who decide they really don't need their second car anymore. The car economy shrinks by 10 cars to 175 cars, but even worse, the annual gap between the demand and the supply capacity is 30 cars. So, what is the solution?
The monetarists would recommend cutting interest rates, but since they are already low, that's not a viable option. (And then, there is the fact that because low interest rates caused the problem in the first place, they cannot reasonably be expected to fix it.) The Keynesians would attempt to stimulate the economy by having the government fill in the demand gap by buying 30 cars, but this will only put off the problem for a year since there will be 30 more used cars available to the 10 people who will require replacement vehicles next year. The optimal solution is the Austrian one, which is to leave the economy alone and wait for the extra cars to wear out. This may be frustrating to the would-be hero politician who wishes to solve the problem through decisive legislation, but it is the only solution that will not make things materially worse in the future.
Hey, there are going to be a lot of fancy golf carts on the market next year.
Doing nothing is admittedly difficult in times of crisis. But it is always wise to keep in mind that there is no crisis so severe that government intervention cannot make it worse.
P.S.: See my new Debt Clock on the sidebar to find out what you owe.