ECONBLOG: The Stimulus Package (part 1)

Over the next two days I will be posting the opinions of two different teachers; one opposed to the stimulus, the other in support. Both opinions are of the authors and not the Georgia Council. Today we will hear from Marc Mayfield, a teacher at LaGrange High School.

The Stimulus Bill Will Not Work: A Free Market Perspective

To understand why the stimulus bill will fail, it is necessary to understand how the economy got into its current predicament. Our current recession began in December 2007, according to the National Bureau of Economic Research. It had become obvious to many economy watchers that the US economy was headed for a recession during the middle to latter part of 2007.

When the recession became official, it surprised a lot policymakers and politicians who do not understand monetary policy, fiscal policy, business cycles, or the role of the Fed. The stated purpose of the Federal Reserve is to promote economic growth and stability. The Federal Reserve’s Board of Governors is willing to do virtually anything to prevent an economic downturn from occurring. This includes preventing necessary market corrections and adjustments from taking place in a timely manner. The Fed has the ability to use the printing press to paper over a crisis and keep a bubble from popping in the short run. However, this only serves to make the unavoidable market correction longer and sharper than it otherwise would have been.

The roots of the current crisis are rooted in monetary policy decisions pursued by Greenspan’s Fed from November 2002 when rates were cut to 1.25%, followed by the June 2003 cut to 1.00% where it stayed until rates began rising in June 2004. These historically low rates led to a large amount of malinvestments by businesses that would have to be liquated at some point in the future.

New Federal Reserve Chairman Ben Bernanke began to sense a coming liquidation of the malinvestments in the summer of 2007. The Fed began slashing interest rates in September 2007 from 5.25% until they reached the new unheard of target level of 0.0% to 0.25% in December 2008. This was a failed attempt to prevent a necessary market correction from occurring. The Fed’s monetary policy failed to avert this recession and may have sown the seeds for the next recession in the process.

So in the summer of 2007, instead of allowing the market to correct, the Fed began pouring drinks. What we had was a classic Hayekian Hangover.[1] This is the opposite of what should have been done. A sharp, short recession could have cleared the economy of the malinvestments created during the period of November 2002 until June 2004. The necessary correction would have set the stage for a period of strong sustainable growth. Instead the Federal Reserve began slashing interest rates (more easy money) and set the stage for a far more severe recession.

Add to the mismanagement of interest rates by the Fed a financial crisis and a housing crisis and you have set the stage for one of the worst economic downturns in the post-World War II era. In March 2008, Bear Stearns collapsed. The Fed and JP Morgan step in to bailout an investment bank. Jim Rogers appeared as the voice of reason when he declared, “If you bail out every investment bank that gets in trouble, that's not capitalism, that's socialism for the rich.” Unfortunately, nobody was willing to take Rogers’ advice and allow bad firms to fail.

Bear Stearns failed because:

“of the poor judgment of their management: their aggressive risk taking, their positions in the mortgage back market, their apparent lack of risk controls, their leverage, lack of liquidity and reserves, and the enemies they made over the years.”[2]

Fannie Mae and Freddie Mac go under in the fall of 2008 as the housing bubble pops. Then Lehman Brothers falls in September. Apparently they were not worthy of a bailout. The Fed continued to cut interest rates in a vain attempt to stop the bleeding. In December, the National Bureau of Economic Research confirmed what everyone already knew, the economy was in a recession.

While the Fed was busy cutting rates, there was an election and we got a new president who promised change. For the Obama administration, since monetary policy had obviously failed to prevent the recession, or to moderate its severity, it seemed time to give fiscal policy a turn. In my opinion economic stimulus packages do not work. A country cannot spend itself into prosperity. Expansionary fiscal policy is the wrong solution for a recession for practical, historical, and theoretical reasons. Fiscal policy is ineffective in addressing a recession for the following reasons:

1. Fiscal Policy Time Lags

2. Fiscal Policy Ignores the Lessons of History

3. Fiscal Policy Ignores Budget Realities

4. Fiscal Policy Misdiagnoses the Problems

1. Fiscal Policy Time Lags

Even if you concede that a government can tax, spend, and borrow a nation into prosperity, expansionary fiscal policy remedies are too slow to have the intended consequences. By the time a recession is identified and “appropriate” legislation is drafted and debated, the crisis has generally passed.

Here I am being generous and assuming the current stimulus is well thought-out necessary spending. The current stimulus package is none of those things. It is a grab bag of pork projects and unrelated spending having little to do with building a solid foundation for future economic growth and prosperity. There is not time or space to devote to describing the pork-laden stimulus package.[3]

2. History: Depression of 1920-21 and Japan’s Lost Decade

The Recession of 1920-1921 was severe. GDP dropped 24%. Unemployment more than doubled to 4.9 million. However, Harding did not panic. He acted calmly and rationally to confront the problems.

Harding attacked the bloated federal budget: spending was cut from $6.3 billion in 1920 to $3.2 billion in 1922. There were also massive cuts in tax revenue. Tax revenue declined from $6.6 billion in 1920 to $4 billion in 1922. The massive reduction in the size and scope of government allowed the national debt to be cut significantly.

According to Richard Vedder and Lowell Galloway the roaring 1920s “were arguably the brightest period in the economic history of the United States. Virtually all the measures of economic well-being suggested that the economy had reached new heights in terms of prosperity and the achievement of improvements in human welfare.”[4]

Japan’s “Lost Decade” is also instructive. Japan engaged in a massive public works program in a effort to salvage their economy. “During those nearly two decades, Japan accumulated the largest public debt in the developed world — totaling 180 percent of its $5.5 trillion economy — while failing to generate a convincing recovery.”[5]

The massive amounts of spending failed to achieve the desired results. “This has led many to conclude that spending did little more than sink Japan deeply into debt, leaving an enormous tax burden for future generations.”[6]

3. Fiscal Policy Ignores Budget Realities

We have a national debt that will soon hit $11 trillion dollars.[7] We are going into debt at the rate of $3.71 billion dollars a day. This is not a sustainable trend. Our current Debt-to GDP ratio is 75% of our $14.3 trillion dollar economy. We need to reduce this figure, not increase it.

The media and the American public were shocked that Bush recorded the biggest budget deficit ever in FY 2008 at $455 billion. Very soon that number would seem small in comparison to future budget deficits. We have witnessed the projected FY 2010 budget deficit estimates grow from $160 billion in Bush’s final budget estimate to $1.2 trillion in January to finally $1.75 trillion in February. It is very likely the actual number will surpass $2 trillion. Even based on Obama’s rosy scenario projections, the federal budget may never drop below the $600 billion barrier again.

FY 2008 was a disaster from the stand point of fiscal responsibility. FY 2009 is the year we break the $3 trillion budget barrier. In all likelihood it will surpass $4 trillion. This fiscal insanity is going to saddle taxpayers with a tremendous burden and future generations with a national debt that can never be eliminated.

Some will notice the “cuts” in the FY 2010 budget. This is largely an illusion. Comparisons should not be made on the outlier FY 2009 budget, but to the pre-crisis FY 2008. This phenomenon is known as the “ratchet-effect.” Government spending increases in response to a “crisis” and spending explodes. After the crisis is over, spending is cut but never to the pre-crisis levels.

Why does this matter? Government creates nothing. Everything the government has is extracted from the private economy by taxing, borrowing, or inflating. All three sources have a negative impact on the economy.

According to Tim Geithner, “Failure to reduce deficits to this level would result in higher interest rates as government borrowing crowds out private investment, leading to slower growth and lower living standards for Americans.”

4. Fiscal Policy Misdiagnoses the Problems

The cause of a recession is not a lack of spending. It is malinvestments that occurred in the boom phase of the business cycle. It is a myth that we can spend ourselves into prosperity. Consumption does not create prosperity. Consumption is the result of prosperity. It is savings and investment that drive the economy and create economic growth.

The business cycle is just that a cycle. Once the boom occurs the bust is inevitable. A recession is simply a market correction, where businesses address mistakes and put their financial house back in order. Government intervention only delays the inevitable.

Hans Sennholz reminds us, “A recession is a time of readjustment and recovery when businessmen correct the mistakes made in the past and put their houses back in order. It is an integral part of a business cycle that begins with a boom, leads to a bust, and ends with recovery.”[8]

Conclusion

The current recession is the direct result of the interventions of the Federal Reserve under Alan Greenspan and Ben Bernanke. Rather than allow the for the necessary market corrections to occur in 2002-2003, they papered over the crisis and ensured that when the housing bubble finally popped, that it would be severe.

The recovery that will inevitably occur will be in spite of government inventions into the economy, not because of them. Unfortunately recovery will occur months if not years later than if should have because government intervention has prevented markets from adjusting.

Murray Rothbard identified the best course of action for dealing with a recession in his classic essay “Economic Depression: Their Cause and Cure”:

The depression is the process by which the market economy adjusts, throws off the excesses and distortions of the previous inflationary boom, and reestablishes a sound economic condition.

The depression is the unpleasant but necessary reaction to the distortions and excesses of the previous boom. The business cycle is brought about, not by any mysterious failings of the free market economy, but quite the opposite: By systematic intervention by government in the market process. Government intervention brings about bank expansion and inflation, and, when the inflation comes to an end, the subsequent depression-adjustment comes into play.

What the government should do, according to the Misesian analysis of the depression, is absolutely nothing. It should, from the point of view of economic health and ending the depression as quickly as possible, maintain a strict hands off, "laissez-faire" policy. Anything it does will delay and obstruct the adjustment process of the market; the less it does, the more rapidly will the market adjustment process do its work, and sound economic recovery ensue.[9]