The U.S. economy is in a mess. The Dow Jones Industrial Average is down 40 percent from its peak in mid-2008. Unemployment in January 2009 was 7.6 percent, up from 7.2 percent in December 2008. Gross domestic product for the last quarter of 2008 was down 3.8 percent at an annualized rate and is estimated by the Economist to be down 2.0 percent in 2009. Industrial production in December 2008 was off 7.8 percent from the year before.
The economy in Europe is also depressed. The unemployment rate in the Euro area was 8.0 percent in December 2008. Gross domestic product for the last quarter of 2008 is off 0.7 percent at an annualized rate and is projected to be down 2.1 percent in 2009. Industrial production in November 2008 was down 7.7 percent from the year before.
Wrong Diagnosis, Wrong Cure
The first question that comes to mind is, what caused this mess? Was it an outbreak of greed on Wall Street? That seems to be the view of Democrats in Congress. However, the consensus among professional economists is that the housing boom went bust, leaving the major investment banks holding large amounts of toxic assets tied to mortgages.
According to John Taylor of Stanford University:
“Monetary excesses were the main cause of the boom. The Fed held its target interest rate, especially in 2003-2005, well below known monetary guidelines. … The effects of the boom and bust were amplified by … the use of subprime and adjustable-rate mortgages[;] … excessive risk taking was encouraged by excessively low interest rates[;] … [a]djustable-rate, and subprime and other mortgages were packed into mortgage-backed securities of great complexity[;] … [r]ating agencies underestimated the risk of these securities[;] … [t]he government-sponsored enterprises Fannie Mae and Freddie Mac were encouraged to expand and buy mortgage backed securities, including those formed with risky subprime mortgages.” [Wall Street Journal, February 9, 2009]
There were two policy alternatives facing government decision-makers. If the crisis was one of liquidity, then the solution was to make borrowing easier. If the crisis was due to counterparty risk reflected in the sudden increase in the spread between the three-month and overnight interest rates in August 2007, then a focus on the banks’ balance sheets would be appropriate. In Taylor’s opinion, the “policy makers misdiagnosed the crisis as one of liquidity, and prescribed the wrong treatment.”
Disposing of Troubled Assets
Cleaning up bank balance sheets is generally viewed as the task to be performed, but this is very difficult to accomplish. Former Treasury Secretary Henry Paulson discovered this to be the case, and it caused him to change policies during the first bailout stage.
When Treasury Secretary Timothy Geithner unveiled the nonspecific second bailout stage on February 10, the S&P 500 index fell 4.9 percent. It is obvious the market was not impressed. It is apparent the new Treasury Secretary is having as much trouble dealing with the toxic bank assets as the former Secretary did. It may be time to question whether the Treasury, Fed, or the Federal Deposit Insurance Corporation can arrive at a way to correctly assess and liquidate the toxic assets held by banks and other financial institutions.
Delays by the government in developing a troubled-asset policy, and denying a tax credit to a firm that buys a bank with losses (which is a part of the stimulus plan), will further complicate the adjustment, if not make it impossible. This seems to suggest the market alone should dispose of the troubled assets without interference by the government. While it is true the Treasury has committed $350 billion of the $700 billion authorized by Congress to accomplish this task, that is a sunk cost. The Treasury should admit it is in a deep hole and stop digging.
In the final analysis, resolution of the troubled assets should be between the principals–borrower and lender–and not be burdened by the presence of a third party, namely the government with a political agenda. Indeed, this adjustment has already begun.
Letting principals replace nonperforming loans also settles the problem of mark-to-market accounting, which some analysts claim undervalues the troubled assets. Principals can and will renegotiate the loans using a host of mutually beneficial adjustments to compensate for any evaluation errors, if they are free of the government presence that restricts their negotiating latitude.
Stimulus Hikes Deficits, Not Economy
The American Recovery and Reinvestment Act (enacted by Congress on Friday, February 13, 2009) saddled future generations of taxpayers, who will not vote for many years, with a $787 billion-plus bill.
There are serious questions to ask. The government green-eyeshades, working late at night, have estimated the stimulus plan will add to the federal deficit in future years $506 billion in federal government spending and $281 billion in tax breaks. All of this is subject to upward revision and additional legislation that will add to the deficit.
The basic rationale for most of the spending and tax breaks is that the initial dollar injection will reverberate through the economy. The effect, it is claimed, will be multiplied as the dollars are spent and spent again in a long series of transactions.
The key parameter is the value of the multiplier. Estimates vary greatly. Valerie Ramey found each additional dollar of government spending increased gross domestic product by $1.40. Susan Woodward and Robert Hall found a dollar-for-dollar effect of government military spending on GDP. And Robert Barro found one dollar of government military spending increased GDP by only 80 cents.
Thus, there is no guarantee the spending part of the stimulus plan will multiply. The tax cuts may produce more benefit if Christina Romer (now chair of the Council of Economic Advisors) and David Romer are right. They estimate a dollar of tax cuts raises GDP by about $3. (See Gerald W. Scully, Analysis No. 643, National Center for Policy Analysis, February 10, 2009.)
The multiplier effect of government spending or tax cuts was addressed a half-century ago by Nobel laureate Milton Friedman. In his 1957 book, A Theory of the Consumption Function, he found consumption choices made by consumers are determined by their long-term income expectations, not by current income. The key policy implication of Friedman’s model is that transitory, short-term changes in income have little effect on consumer spending behavior.
Even if the multiplier is greater than one, how will the spending pattern change after a tax increase or inflation is imposed to pay for the near-term stimulus? After all, if there is a multiplier for the recipient of the government spending, there must also be a multiplier for the present and future generations who have to pay for the stimulus.
Market Is Best Means to Reallocate Investment
The task to be performed is to facilitate the change in the capital stock from overbuilt housing to a new pattern of investment. This sounds simple, but new capital investment opportunities are difficult to identify and take a long time to put into place. Disinvestment, by comparison, can take place very quickly, as we have seen. In ordinary times, worthy investment projects can obtain financing fairly readily. However, in today’s credit environment, it will be a while before widespread financing becomes available.
Many will presume the government can help on the financing side, even though they are probably clueless about which investments will have the highest payoff economically. But interest rates are at all-time lows as a result of Fed distortions and the lack of credit availability. Soon nominal interest rates will rise to reflect the anticipated inflation. Investors will then have to cope with both the lack of credit and high interest rates caused by anticipated inflation. Who creates inflation? Milton Friedman tells us inflation is always and everywhere the result of the actions of the monetary authorities.
Where does this leave us? The answer is that only the market knows where to reallocate efficiently the investment funds. The only role for government is to get out of the way. And the government will benefit if it does so. As the economy grows, the tax revenue that pays for government services that are actually valuable also grows.
Stimulus Is Political, Not Economic
The mission of economists, besides maximizing their wealth, is to explain why the world is the way it is. The bad news is that explaining why government enacts stimulus plans is easy. Stimulus increases the demand for government. The party in power defines stimulus in a way that benefits its constituencies (thereby improving its chances of reelection) and raises the price to be paid by the opposition party and the interests it represents.
The good news is that there is a limit to how long the government abuses can continue. While it must be admitted it took 70 years for the correction to take place in the Soviet Union, it did happen eventually. The length of time for the correction in the Soviet Union was probably due to its being a police state. While the United State is not a police state, there are policies that delay the recovery. One of the most disturbing is the decision to bail out homeowners with mortgages that are underwater, especially those who did not qualify for their loans in the first place. One particularly onerous plan is to give judges the power to modify bankruptcy laws to favor borrowers even more than they do now.
In summary, the financial bailout and the stimulus bill are unlikely to be successful. But for a while they probably will make some politicians successful.
Jim Johnston ([email protected]) is a senior fellow of The Heartland Institute.