THE BEAR'S
LAIR Stimulus fix to the
death By Martin Hutchinson
Since 2008, economic policies throughout
the rich world have boiled down to one word:
stimulus. Interest rates in most countries have
been held down well below the level of inflation,
while spending programs have pushed national
budgets far out of balance.
As in Europe
calls rise for further doses of "fiscal stimulus"
in spite of that continent's precarious budget
position, while in the United States both fiscal
and monetary stimulus is widely canvassed, the
global economy languishes. It must surely now be
becoming clear: as with most pernicious drugs,
repeated usage of stimulus is lessening the
stimulative effect while exacerbating the adverse
long-term side-effects. As this recession drags on
into its
fifth year, it is
becoming one of diminishing marginal returns.
From the various semi-controlled
experiments that have been conducted around the
world in the past five years, the efficacy of
fiscal and monetary stimulus can be assessed.
Public spending itself almost always has a
multiplier of less than 1; in other words, when
the effect of borrowing the money is factored in,
it is generally moderately economically damaging,
albeit possibly with a lag. There are exceptions
to this, but they are fairly scarce.
If as
in Germany after World War II, public spending is
used to rebuild damaged infrastructure, it may be
devoted to projects of sufficient economic return
as to "pay for itself". If a financial shock such
as that of 2008 has damaged the banking system
sufficiently as to increase the cost of borrowing
for the private sector above its normal levels,
then public spending on projects with even a
modest positive economic return may also be
economically beneficial.
Much of China's
2008-09 stimulus, implemented very quickly, may
well have been beneficial, although it's clear
that a high percentage of it was so worthless as
to be damaging. This does not however justify the
Barack Obama "stimulus" of 2009 in the United
States, for two reasons. First, much of it was
used for uneconomic subsidies to featherbedded
unions, for investments in economically foolish
green energy projects and for other uses where the
potential return was either negative or far below
those in the private sector.
Second, and
crucially, the markets turned around in early
March 2009, two months before the Obama stimulus
moneys began to be spent; hence by the time the
money was disbursed the banking system was
functioning normally. By grossly increasing the
volume of public debt issued, the "stimulus"
simply steepened the yield curve, enabling the
banks to play silly "gapping" games of borrowing
short-term and investing in Treasury and housing
agency bonds, thereby artificially depriving small
business of finance, since the banks couldn't be
bothered to lend to it.
Stimulus might
have slowed the economic decline if applied in
late 2008; by the late spring of 2009 it could
have no beneficial effect. Moreover, much of the
stimulus actually applied consisted of items that
were hard to remove in subsequent years; the
permanent increase in public spending caused
further damage because of its effect on debt
levels.
In Britain and southern Europe,
the public spending "stimulus" had an even more
pernicious effect; it strained the capacity of the
local capital markets and put in doubt the
credibility of the state credit. In Britain, this
was solved by a Weimar Republic-like policy of
selling almost all new government debt to the
central bank, thus solving the funding problem at
the expense of producing an inflation problem. In
the European Union, this solution was not
generally available, hence the extraordinary
difficulties of southern European governments,
which have had a depressing effect throughout the
EU far in excess of any short-term benefit brought
by their previous fiscal stimulus.
Monetary stimulus was rendered less
effective in 2008-12 because in most countries
real interest rates had been excessively low since
2002, with US money supply growing too fast since
early 1995. Liquidity needed to be injected into
the system after the banking crash of 2008.
However, as Walter Bagehot remarked in his 1873
Lombard Street, it should have been done at
penally high rates, not at the ultra-low rates
favored by Federal Reserve chairman Ben Bernanke,
Bank of England governor Mervyn King and most
other central bankers.
Monetary policy was
successful in preventing the post-2008 recession
turning into a repeat of 1929-33; by March 2009
the banks were already out of danger and liquidity
was returning to the system. At that point
interest rates should have been raised to more
normal levels of perhaps 3-4% on the federal funds
rate. That would have forced the banks to resume
lending to small business, since they would no
longer have been able to make risk-free profits by
"gapping" between short-term and long-term rates.
At the same time, the recovery in US
savings rates which we briefly saw after the 2008
crash would have strengthened, limiting the
deterioration in the balance of payments that has
de-capitalized the US economy and made US workers
uncompetitive against those of emerging markets.
Unemployment would have declined at the brisk rate
of 1982-84, instead of the painfully slow rate of
the past three years.
After two rounds of
quantitative easing and a year of "Operation
Twist" purchases of long-term bonds, monetary
policy's efficacy in producing even brief stimulus
appears to have disappeared. Notably, on June 20,
after the Fed announced another US$267 billion of
resources thrown into the monetary stimulus pit,
the stock market as measured by the S&P 500
Index closed down on the day, while long-term
Treasury bond yields closed up. If Bernanke's
billions cannot produce a market bounce that lasts
even two hours, the curtain in the Emerald City
has finally been drawn away and the feeble
magician has been shown up as the charlatan he is.
Similarly in Europe, the two three-year
loans to the European banking system by the
European Central Bank, totaling over $1 trillion,
produced remarkably little effect for that amount
of money. Spanish and Italian banks bought their
local government bonds, locking in a substantial
profit, but by June the Spanish banks required a
100-billion euro (US$125 billion) bailout, while
Italian and Spanish borrowing costs were hovering
around record levels. As for Britain, monetary
stimulus there has brought only inflation and the
impoverishment of the nation's savers, faced with
real returns of as low as minus 5% on their money.
At this point, neither monetary nor fiscal
stimulus is likely to have any significant further
positive effect. President Francois Hollande's
attempt at further fiscal stimulus will almost
certainly land France in the same boat as Spain
and Italy, fighting desperately to finance the
government's borrowing program, at ever higher
rates. While this can be regarded as proper
retribution for French socialist moral superiority
over the last 30 years, it will make the full
break-up of the eurozone inevitable.
The
added market turmoil that this will produce will
make borrowing very expensive in real terms for
all southern European countries, including France
- which in turn will cause major recessions in
those countries. That's the irony of the eurozone
crisis - once a country has lost the confidence of
the capital markets, its interest rates rise far
enough to make borrowing costly for its industry
and recession thus inevitable, worsening the state
deficit still further. Only by leaving the euro,
undergoing the pain of devaluation, and
experiencing an export-led recovery can southern
Europe recover.
As for the United States,
the safe haven status of the dollar may allow
monetary and fiscal authorities to double down on
stimulus, certainly if President Obama is
re-elected with stronger Democrat representation
in Congress. At last New York columnist Paul
Krugman's dream policy of perhaps $2 trillion in
wasteful public spending financed by $2 trillion
of "quantitative easing" Fed purchases of Treasury
bonds will be tried once and for all. The result
should be spectacular - spectacularly awful, that
is. The dollar will collapse, as will US credit,
and US unemployment will be prevented from rising
to Greek levels only by reducing its inhabitants'
living standards to those of China.
In an
ideal world this would produce a return to a gold
standard, combined with a balanced budget
amendment and an effective line-item veto. In the
world we inhabit, that is most unlikely - quacks,
charlatans and populists will ensure that voices
of economic sanity are entirely drowned out. After
all, Krugman has received an economics Nobel and
Ludwig von Mises never did. (And make no mistake
about it, if Nobels were voted on by the public,
perhaps in a reality show "Celebrity Economist",
the results would be even worse than they are.)
There is an alternative, and one can only
hope it will eventually be tried. Interest rates
need to be raised to the 4-5% level, above the
level of inflation, while public spending needs to
be reduced and tax loopholes (housing, charitable
contributions) need to be closed, to reduce the
Federal budget deficit to manageable levels.
The rise in interest rates will cause
bankruptcies in the US banking system, not least
that of the Fed, which will suffer huge losses on
its massive "Operation Twist" portfolio of
long-term low-yield Treasuries. For a year, as in
1982 in the United States or 1981 in Britain, it
will appear the policy has failed, and massive
wailings will go up to reverse it. Then economic
growth will resume, on the basis of high savings,
tight money and balanced international trade - the
only true foundation for economic success.
Martin Hutchinson is the author
of Great Conservatives (Academica Press,
2005) - details can be found on the website
www.greatconservatives.com - and co-author with
Professor Kevin Dowd of Alchemists of Loss
(Wiley, 2010). Both are now available on
Amazon.com, Great Conservatives only in a
Kindle edition, Alchemists of Loss in both
Kindle and print editions.
(Republished
with permission from PrudentBear.com.
Copyright 2005-12 David W Tice &
Associates.)
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