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Monday, February 16, 2009

The Possibilities of this Stimulus: Bad Worse, and Worst

Those that support the stimulus would have us believe that our worst fate is the fate of this economic downturn itself. It was, however, the same type of thinking that got us here in the first place. During the period after September 11th, 2001, we were also looking into the abyss of economic downturn. As such, the Federal Reserve began a long and drawn out process of loose money policy. That policy culminated when the Federal Funds Rate was set to 1% and kept there for about a year and a half. It was that loose policy that began the ball rolling on the real estate boom, and ultimately it lead directly to the bubble that caused our current economic malaise. Looking back, I think all of us would have accepted a longer downturn with a slower economic expansion not to be facing the current crisis. Often our solutions lead to even bigger problems.

Those that support this stimulus have to answer one very important question. What are the consequences of out of control government borrowing? There are several answers and none of them are good. In fact, they can be classified in bad, worse and worst.

1) Bad

In this case, the economy begins to get stimulated. Then, the inflationary effect of out of control borrowing begins to be felt. It's impossible to know just how bad it could get. Inflation could merely be a problem or it could be out of control. Inflation occurs when too much money follows too many resources. Because this economy will be largely built on government spending, we aren't going to see a massive expansion in resources. Yet, we are about to pour several trillion new Dollars into the system. What we would have is a fairly slow growing economy (something less than 3% growth in GDP) at the same time that we have higher than appropriate inflation. Just how high will be anyone's guess. If we are lucky it will stay below 3.5% annual growth in inflation. If we are unlucky, it will spin out of control and approach double digits. We will see all lending rates: mortgages, car loans, and student loans, spin out of control into double digits. This of course is the bad outcome.

2) The worse outcome is that instead of seeing inflation we would create a bubble.

This is largely the same as the effect that we saw from far too loose a monetary policy in the beginning of the decade. Rather than seeing prices in general go up, we will see prices just in one sector go up. That will create a boom in that sector which soon enough will turn into a bubble. The worst part about this effect is that it will seem as though things are going great for a while. Things looked great for the economy all the way from 2003-2006. Housing prices were going up with no control. We saw record home ownership. We saw record multiple home ownership. We saw 3%+ GDP growth annually. We saw fairly low unemployment. Yet, we saw relatively no inflation. All of that inflation was centered specifically in housing. Once that busted, we see where we are. The results won't be realized for years to come. That happened because the allure of low interest rates created a phenomenon in which an overabundance of investment money went into one sector, real estate. If the stimulus begins to stimulate the economy in an uneven way, something similar could happen again. Money could become overweighted in one sector. That sector would heat and then spin out of control. What would follow would be a boom and then a bubble. Then, it would be a bust and this bust would be even worse since the stimulus this time is even greater than in 2001.

3) Deep Stagflation.

This is the nightmare scenario. In this scenario, all of this government spending has limited stimulating effect but we still have the inflationary effect of deep deficitis. In this case, unemployment remains high and at the same time we see higher than expected inflation. We would be stuck in economic abyss. To solve one would perpetuate the other. In order to slow down inflation, we would need to increase short term rates exponentially. If we did this, through raising the Prime Rate, it would slow down lending even more. We would see unemployment go into double digits. This would happen because the stimulus would be misspent, corrupted and wasted. It would go to programs with limited economic effects: long term research, non performing insurance, to prop up the non productive. (in other words many of the programs it is going to now)


Anonymous said...

Or perhaps America comes out of recession, the govt raises interest rates as inflation starts to come up, and thus controls it to a large extent.

But hey we wouldn't want t have anything good written about the Obama administration would we???

mike volpe said...

Yes, except America can't come out of the recession without spurring inflation. Raising interest rates would then be contractionary. As such, the economy either can't fully recover or we would be faced with high inflation when there is a full recovery.

You can't just borrow one trillion dollars without consequences. The consequence is high inflation.

As soon as the economy begins to recover it will set off inflation. The economy isn't going to just go from recession to boom overnight. In that time in between, inflation will rear its ugly head. Raising interest rates would contract the economy, which would immediately put us back into a recession. Do you think we will go from 9% unemployment to 4.5% unemployment overnight or will it happen gradually. As it happens, that is when inflation will spawn. To combat one, you perpetuate the other.

This isn't partisan. This is basic economics that I learned in my third week of high school economics.

Anonymous said...

It should also be noted that the government does not raise interest rates. The Federal Reserve Bank is in control of interest rates and is independent of the government.

xformed said...

"The Federal Reserve Bank is in control of interest rates and is independent of the government."

Been toking a bit today? On paper, yes, they are defined as independent. In reality...tell me that again, so I can laugh harder, particularity when Larry Summers becomes the next Chairman....