Stimulus 101

Two of my former professors from the University of Oregon, Mark Thoma and Tim Duy, were on KLCC the other day talking about the recession. You can listen to it here. They cover topics such as shadow banking, the great moderation, and a great explanation of what a toxic asset really is. They explain just why economists didn't see this coming and why government spending is better than tax cuts during a recession. There's even a diplomatic answer to a livid Eugene commie that calls up. Very entertaining!

Today I have posted my opinion on the Stimulus Package, the goods and the bads. As a Libertarian I have to say I don't like the government mucking around in markets but it seems to be necessary at this point.

I feel that the Stimulus Package is necessary, though the restrictions that have recently been added and the allocation of funds is incorrect. The Great Depression era was the time of little government intervention and a strong reliance on the market. The thought then was that the market always works and that government was superfluous. The solution then, to the Great Depression, was to do nothing. While banks failed, the FED sat idly by and allowed deflation and illiquidity to spiral out of control. The government waited 4 years before finally enacting large amounts of government spending in 1933. By this time, the economy had collapsed and getting out of the hole it dug for itself was near impossible. It was not until 1940 that the economy started to pick up again, 11 years later. Since then, many economists have changed their theories on how the market works through thorough theoretical and empirical research. The stimulus bill has very little theoretical backing other than we know what didn't work before. It is thought that government spending can stimulate the economy, but as to how those funds should be spent, when, and for how long, is all a mystery. I will try to explain why it is so hard to predict: Assume you put 1 million dollars into a small economy for stimulation purposes. Not only do you have to track each dollar of those million, but also the social welfare and surplus value (ie. does that money help individuals or businesses to get loans, does it create public goods, etc) created by each dollar. Then you must quantify this effect. What monetary value does a public good have to each person able to use it.

ex. A bridge is built from a San Francisco peninsula to Oakland (i.e. Bay Bridge). Assume that a combined 2 million people live in Oakland and San Francisco that might regularly use the bridge. Then you must ask, how much time does this save each person, what does each person value their time as (obviously, the wage they work for), and you can get the net benefit by multiplying each person's wage by the time they save using the bridge (instead of going around the mainland) less cost of constructing the bridge. But then there are also other things to consider. The cost of constructing the bridge is money that went to pay for wages and materials (supplied by people and companies) that stimulate the economy. So is this a cost or a benefit? Also, maybe the bridge increases traffic between San Francisco and Oakland from people that don't live in either area. It also might increase tourism. How do you quantify all of these factors? You cannot - and this is why it is so difficult to know exactly how government spending affects the economy.

The stimulus bill is going to put funds into banks, mortgage assistance, infrastructure programs, and energy conservation and alternative fuel research, among many other things. This is where I theoretically disagree with the stimulus package. I feel that infrastructure programs are the best way to stimulate the economy while creating the greatest net benefit. One of the largest negatively affected industry segments of the economy is contractors, construction companies, architectural firms, etc; infrastructure programs would target this labor market while also creating the largest social welfare by building public goods that could last the next 100+ years.

Allocating money to banks and mortgage assistance is a great idea. Many feel that banks should be punished for their belligerent loaning that has characterized the industry for the past 7 years; I am among those people. Unfortunately, it is economically inefficient and dangerous to let the banking sector fail.

ex. Let's take the case of Bank A who has lent long term the money that it has borrowed in the short term. Assume that something happens in the market to dramatically reduce consumer confidence (in this case, excessive consumer debt) and all of the bank's short term lenders (those with savings accounts, etc) come asking for their money back simultaneously. If the bank were inside the capitalist system, Bank A would not be able to pay everyone and it would fail. As soon as other short term lenders (consumers) to Bank B, C, D, etc saw the failing of this Bank A, they would quickly try to pull their money out as well - leading to a complete and devastating collapse of the entire financial sector.

This is why banks are government backed (FDIC) and outside the capitalist system. Since banks can only successfully operate with consumer confidence and trust, it is the government's job to maintain bank stability through regulation so that a troubled bank does not bring down the entire system. The argument for allocating funds to banks is to increase liquidity and therefore increase lending.

ex. To better understand liquidities role in the economy, think of liquidity as a faucet and money is the water that flows from that faucet. In good times, the water runs freely to individuals and firms. But when there is a shock to the system the water pressure supplied to the faucet drops and water cannot flow.

This is essentially what has happened. The shock that dropped the water pressure was the mass number of mortgage defaults and the short period in which they occurred. At the same time, the demand for water has increased and it cannot be supplied quickly enough. The increase in demand has been caused by a collapse of the commercial paper system in which individual investors in money market funds have simply stopped lending. This has put additional strain on banks. The hope is that by injecting money into failing banks, we can increase liquidity in the market and therefore, banks will feel freer to lend to reputable borrowers. Furthermore, the government has started to step in and lend money to firms directly as a stand in for the crippled commercial paper market, another favorable stimulus objective.

Unfortunately, Senator Dodd has added some last-minute restrictions to the stimulus package that disrupts certain economic theories. The restriction most pertinent is the bonus-cap for firms receiving aid. As was signed into the bill, bonuses awarded may not be greater than 1/2 of that person's salary. At first look, I completely agreed with this restriction and was appalled that Summers and Geithner could be against this. But this restriction goes against the theory of economic efficiency.

ex. When speaking of efficiency, past costs must be disregarded for they have already happened and this cannot be undone; we call this the 'sunk cost.' Therefore, since this cost is in the past, it should not effect future decisions. In our case, this 'sunk cost' is the money lost from irresponsible lending and mortgage defaults.

By trying to punish firms for their past behavior by creating a bonus-cap is inefficient and counter productive. Bonuses are incentives; do a good job, you will be rewarded. Unfortunately, in the last 20 years, bonuses have become more of an expectation than a measure of productivity. By interfering with incentive-based pay, the government is essentially creating an atmosphere where top executives will have no motivation to work harder to fix the firm's current economic problems. (It should be noted that an average Wall Street salary before bonuses is around 300-500 thousand dollars, with a handful making around 1 million dollars; average bonuses are upward of 10 million dollars). Further, Summers and Geithner argue that by creating bonus-caps, you are effectively funneling money from the middle class to the upper class.

ex. Let me explain this argument. The pay structure in firms has a very large lower/middle tier where you will find workers that make up the middle class. At the top tier you have relatively less people making about the same in non-bonus salary and receiving excessively large bonuses; this is where you will find upper class workers. If a bonus-cap is imposed then the thinking is that the firm will take money formerly given as salaries to the lower/middle tier workers and funnel it up to the top tier workers to increase base salaries for two purposes, to compensate for drastically reduced salaries due to bonus-cap and to allow larger bonuses to be given (since the bonus must be under 1/2 of non-perk salary).

As a taxpayer, it irks me to think that these people have been rewarded in the past for belligerent behavior but as an economist I feel that efficiency is the best policy. The only way that I could feel perfectly fine with large bonus structures is if there was a disincentive for bad and irresponsible behavior, something like shift in bonus curve so that a bonus at every level would be lower until they proved that they deserved a higher bonus curve.

The largest problem that I find with the stimulus package is the money being allocated to research and development of alternative fuel sources and energy conservation. My sentiments are completely independent of any political affiliation I might have and any feelings I have on energy and the environment. Instead, they rest on an analysis of the targeting and social benefit that can be supplied by R&D. First, R&D in general should never have to be financed by the government. R&D is the outcome of competition between firms in the search to supply a better, cheaper, and more innovative product to consumers. Additionally, government funded R&D projects go straight into the public domain for access by any company - what incentive is there for government funded scientists to produce a result since they will have no chance of obtaining a patent or copyright.

ex. Say the government wants to create a domestic market for hybrid technology. This is pointless because if GM and other US automakers had been forced to be competitive firms instead of relying on government assistance, this technology would already be in use. But because the government has subsidized US automakers with pension loans and through military expenditures, they have not needed to respond to market forces demanding hybrid cars.

Further, how many energy research scientists have become unemployed in the past year. I don't know this number but I have a hunch that this labor market segment has not been so readily affected by the economic downturn. Considering the mass amount of factory, construction, and real estate workers out in the labor market, energy research scientists are a small group comparatively. In the economy, there will always be winners and losers, but the hope is to maximize the net benefit of government action. Creating jobs for research scientists is not a way to maximize the net benefit of this stimulus package. Furthermore, to assume any benefit other than job creation for scientists would require the R&D funding to guarantee an outcome. What I mean by this is that R&D is a game of uncertainty, there is no guarantee that anything will come of it. So the government spends however many billions in R&D and in the end there is a good chance that no alternative energy will be found. It is essentially paying men to dig holes and fill them up, there is no assured social benefit from this.