The Anti-Stimulus

[Bono]

http://econlog.econlib.org/archives/2009/05/the_anti-stimul.html


The Anti-Stimulus
Arnold Kling

Greg Mankiw reports that the yield curve is steep, meaning that long-term interest rates have risen. In my view, this is perfectly rational, and it shows that the short-run effect of the fiscal stimulus is negative, as Jeff Sachs predicted.

This is all based on a Keynesian type of macro analysis. As we know, most of the stimulus spending does not take place until next year and beyond, so the short-run gains are puny. On the other hand, the big increase in the projected deficit creates the expectation of higher interest rates, which raises interest rates now. These higher interest rates serve to weaken the economy.

According to this standard analysis, the stimulus is going to hurt GDP now, when we could use the most help. Much of the spending will kick in a year or more from now, with multiplier effects following afterward, when the economy will need little, if any, stimulus.

This is the flaw with using spending rather than tax cuts as a stimulus. The lags are longer when you use spending.

Of course, if the real goal is to promote government at the expense of civil society and to create a one-party state in which business success is based on political favoritism, then the stimulus is working exactly as intended.

[UPDATE] It is important not to confuse the outlook for economic activity with the effect of the stimulus. Even if the stimulus has a negative impact, the outlook for economic activity could be positive, and this could cause an upward-sloping yield curve. But I'm not sure that the outlook is necessarily positive. Bond investors could simply be taking the view that with or without a strong recovery in real output, the deficit spending is going to be monetized at some point, leading to inflation and higher interest rates.
CATEGORIES: Fiscal Polic

[Associate Justice PiT]

     So we get to wait a year before our economy enters a perpetual recession, Japan-style? I want fiscally conservative governance.

[Beet]

Japan never went into a perpetual recession. As I've posted before, their economy actually grew throughout the 1990s, with only two years (1998 and 1999) of contraction, which was caused more by the Asian financial crisis than its own bubble bursting in 1990. Also, it's unemployment rate during this time never exceeded 6%, while the economy grew by over 30% cumulatively. Japan only seemed bad because asset prices in Japan never recovered. But that depends on whether you judge an economy by its real output and income or its asset prices. I prefer the former myself.

We, on the other hand, may be entering a 'perpetual recession', or at least what it will seem like from today's perspective (which has very little to do with this analysis, by the way). Simply put, we are in a debt deflation. As the consumer cuts back on his over-leveraged balance sheet, demand falls and unemployment rises; this in turn increases the consumer's uncertainty level and causes him to further increase his savings rate. This in turn causes more demand contraction and more job loss. And so on and so on, in a vicious cycle.
What happened to the banks in the 1930s is now happening to consumers. Instead of people making runs on banks, banks are now making runs on people (as their confidence in a consumer's ability to repay their loans falls, each bank wants to be the first to withdraw their credit lines).

The result is a 25% to 35% contraction in GDP. The only way to fix this would have been a massive socialization of the economy, and traditionally a currency devaluation while the US exports its way to growth while simultaneously increasing savings. This would allow output growth without increases in the total debt level to GDP. Unfortunately, the only places in the world that could potentially absorb US demand, Europe and Japan, are in a similar predicament. Japan itself has been following the export method for the last 10 years. Only developing countries are still able to absorb demand at this point.

The 'other' hope would be that the $700 billion bank bailout and the other actions taken by the Federal Reserve put the genie back in the bottle and turn this into a regular business cycle downturn. Then jmfcst's leading indicators numbers and other instincts that he honed watching the markets in the last 30 years owuld mean something. The financial recovery would cause recovery in consumer spending, which traditionally leads the economy out of a downturn. So I have been watching the PCE and unemployment numbers very carefully over the past few months. Unfortunately, the savings rate is skyrocketing and the evidence is against PCE recovery. Therefore we are in for the long collapse. So long guys.

[Swing low, sweet chariot. Comin' for to carry me home.]

The 'other' hope would be that the $700 billion bank bailout and the other actions taken by the Federal Reserve put the genie back in the bottle and turn this into a regular business cycle downturn. Then jmfcst's leading indicators numbers and other instincts that he honed watching the markets in the last 30 years would mean something. The financial recovery would cause recovery in consumer spending, which traditionally leads the economy out of a downturn. So I have been watching the PCE and unemployment numbers very carefully over the past few months. Unfortunately, the savings rate is skyrocketing and the evidence is against PCE recovery. Therefore we are in for the long collapse. So long guys.

First, 30 years of watching the markets only helps judge inflections in investor perception (i.e. emotion).  It doesn't necessarily help predict economic cycles.  Instead, detecting inflections in the business is best done by REMOVING emotional instincts.

you can't look at a downward technical chart and draw a straight line perpetually downward.  if that were the historical case, then the business cycle would not have ever existed.  purely relying on technical analysis ignores the fact that fundaments tend to change over time.

IMO, for judging changes in fundaments, you have to disconnect your emotions, disregard current sentiment, and look at leading indicators that have a proven track record at predicting inflections in the business cycle.

So, me citing the ECRI leading indicators, as I have done throughout my 7 years on this board, is simply my way of removing my emotions (and my ideology) from the equation.  If anyone knows of a bucket of statistics that have a better track record of predicting the economic cycle than ECRI’s, then I more than willing to consider it.

Could the ECRI index be wrong this time?  Of course.  But I haven’t seen an argument that attempts to explain why that will be wrong this time.  Are we facing a situation where these indices could grow in a way that doesn’t lead to growth?  If so, I haven’t heard that argument made yet.

Every economic cycle is unique.  But if the argument is going to be made that we will not bounce back this time, then that argument has to explain how the current environment will allow the current business cycle to languish in a downturn while these leading indicators continue to advance.  Since these leading indicators predicted every economic cycle change over the last 100 years, including the current recession, why would they be useless in predicting the next upturn?    

IMO, I am asking a fair question.

[opebo]

     So we get to wait a year before our economy enters a perpetual recession, Japan-style? I want fiscally conservative governance.

Why on earth would you want that?  It gaurantees long-term depression.

[Associate Justice PiT]

     So we get to wait a year before our economy enters a perpetual recession, Japan-style? I want fiscally conservative governance.

Why on earth would you want that?  It gaurantees long-term depression.

     Excuse me for being skeptical of that.