How Stimulus “Works”

There’s an interesting joke going around in email. I wanted to write a reply to it because even though it is a joke, a lot of people believe that this is how stimulus works, and even those that do take it as a joke may not fully understand why it is funny.

The joke:

The streets are quiet in Smalltown, USA, where times are tough and everyone is in debt. A tourist stops at the motel, lays a $100 bill on the counter, and proceeds to inspect the rooms upstairs to pick one for the night.

With cash in hand the hotel owner runs to pay his $100 bill debt to the butcher.

The butcher immediately pays his $100 debt to the pig farmer.

The pig farmer pays his $100 debt to the feed supplier.

The feed supplier pays his $100 debt to the town hooker.

She then quickly pays the hotel owner her $100 room debt.

Promptly, the hotel owner returns the $100 bill to the counter so the tourist will not suspect anything, and moments later the tourist returns stating that the rooms are not satisfactory, picks up the $100 bill and leaves.

No one produced anything, no one earned anything, but the whole town is now out of debt and looking to the future with a lot more optimism.

……..and that, ladies and gentlemen, is how a “stimulus package” can improve the economy.

The main problem with this example is that none of these people were in debt. They each owed $100 and were owed $100. In accounting terms, their assets and liabilities canceled each other out. At worst they may have been worried that they might not be paid back.

The secondary problem is that this isn’t really how stimulus works. Stimulus is about increasing, not reducing debt. Here is more like what really happens:

The Congress and President pass a giant spending bill to stimulate the economy.

The Treasury doesn’t have enough revenue coming in to pay for it all right now, so needs to borrow (issue bonds).

The borrowing would exceed the debt ceiling, so the Treasury has to ask Congress to increase their credit limit. (They are going to hit this limit sometime between March and May according to estimates.)

Congress and the President increase the debt ceiling.

The Treasury issues new bonds, but it turns out that there isn’t enough demand to buy bonds. If demand for bonds is low, the price for bonds will decline. When bond prices are low, their yield is high; effectively the borrowing cost (interest) is increased.

If the government’s borrowing cost is too high, they can’t spend as much on stimulus, or they would need to increase borrowing even more to make up for getting less for each bond they sell. This isn’t any good for them, so they go to the Federal Reserve to ask for help.

The Federal Reserve is happy to oblige by helping out buying up bonds, thereby increasing their demand, increasing bond prices, and reducing yield. However, the money used to buy these bonds is created out of thin air, and instead of buying from the Treasury directly, they buy from specialized Wall Street government bond dealers who earn a nice commission on the deal. This is Quantitative Easing.

The money raised is then spent on a lot of different things, many of which are inefficient and non-productive. As this money works its way through the economy, demand for certain goods is increased, and many people begin to believe that things are getting better.

But this isn’t the end of the story. The larger quantity of money in the economy increases demand and therefore also pushes up prices, causing inflation. It is the explicitly stated goal of the Federal Reserve to have inflation of 2% per year. Or to put it more bluntly, right when people are having trouble paying their bills, they want everything to get more expensive.

Next, the government has to figure out what to do about all this debt they’ve built up. They have to do some combination of three things: 1) roll over the debt, 2) hope that inflation makes the debt more manageable or 3) collect more in taxes.

Rolling over the debt just kicks the can down the street. Next time the problem will just be bigger. Actually what they are hoping is that the economy will improve and people will forget about the problem. Government debt rarely gets paid down in good times.

The only way inflation will help to ease the debt problem would also end up destroying people’s savings and de facto reducing their income, as wages rarely keep up with inflation.

And then we come to taxes. Don’t worry, it’s only the rich that’ll have to pay the bill! And guess what? It’s the hotel owner, butcher, pig farmer and feed supplier in the example who are the rich capitalists who are expected to pay the bill. (The hooker isn’t exactly paying taxes on her income.)

Maybe they made enough out of the stimulus to pay these taxes. But they also have to pay higher prices for their goods, their employees are clamoring for cost-of-living raises, their profits are being squeezed (if they aren’t losing money) and their other investment income is flat because interest rates are being held down. And how are they supposed to “expand the economy” when they know there’s going to be a big tax bill due?

Oh right, they could borrow money to expand because interest rates are so low. Debt, debt, and more debt. The government borrows more, companies borrow more, consumers add more and more to their credit card bills and mortgages, and everyone’s debt keeps climbing higher and higher. Eventually this needs to be paid back. How does this happen? It’s supposedly because the economy will spontaneously roar back into action, but all I see is steadily increasing debt.

Getting back to the original story, no one produced anything, and no one earned anything. Maybe they feel a little better now that they don’t have to worry if they will be paid back what they were owed. But they also have no efforts wasted on inefficient and non-productive government projects, they don’t have any inflation, they don’t have increased government debt, and they don’t have a big tax bill looming. The story correctly assumes that the people in it are—or at least feel—better off by not being in debt, but actual stimulus increases, not reduces overall debt.

Also in the story, let’s assume the worst case: everyone defaults on their debts. What is the result? Well, everyone will be pissed off at each other for a while for ripping them off, but in reality the result is exactly the same: each person no longer owes any money and is no longer owed any money. The $100 that enters the economy is also almost immediately withdrawn from the economy with no cost involved. In reality, the money supply is increased through expansion of lending, so there is always an interest cost, and decreasing the money supply is avoided at all costs for fear of causing deflation.

Back in the real world, I said above that government has three ways to handle this. There’s actually a fourth way, but nobody likes it. That way is to reduce spending and pay down the debt until things are more manageable. Yes, this is painful, but everyone gets out of it without a huge debt and big tax bill looming.

The history of trying to stimulate the economy is not an encouraging one. From the Great Depression to 1970s stagflation to Japan’s Lost Decade (now entering its third decade!), the track record of government stimulus is one of long drawn out periods of stagnation with some combination of high unemployment, inflation, and mounting debt levels. The only answer the stimulistas have to these failures is that there wasn’t enough stimulus, and in any case it would have been worse if nothing had been done.

Real economic growth happens when people produce good quality products that others want to buy, when clever people figure out ways to make things that are better and/or less expensive and when people invest in capital goods because there is a market for what they produce. But all of this has to be real activity without the extra hidden costs of stimulus.

The debate is really about two ways of dealing with an economic problem. You could stop doing what isn’t working, pay the bill and move on with the problem behind you. Or you can borrow and hope the problem eventually goes away, and meanwhile you have to keep paying more and more as the debt piles up around you.

Ron Paul on the bailout (part 3)

Another email from Ron Paul on the bailout rescue plan:

Dear Friends:

The financial meltdown the economists of the Austrian School predicted has arrived.

We are in this crisis because of an excess of artificially created credit at the hands of the Federal Reserve System. The solution being proposed? More artificial credit by the Federal Reserve. No liquidation of bad debt and malinvestment is to be allowed. By doing more of the same, we will only continue and intensify the distortions in our economy – all the capital misallocation, all the malinvestment – and prevent the market’s attempt to re-establish rational pricing of houses and other assets.

Last night the president addressed the nation about the financial crisis. There is no point in going through his remarks line by line, since I’d only be repeating what I’ve been saying over and over – not just for the past several days, but for years and even decades.

Still, at least a few observations are necessary.

The president assures us that his administration “is working with Congress to address the root cause behind much of the instability in our markets.” Care to take a guess at whether the Federal Reserve and its money creation spree were even mentioned?

We are told that “low interest rates” led to excessive borrowing, but we are not told how these low interest rates came about. They were a deliberate policy of the Federal Reserve. As always, artificially low interest rates distort the market. Entrepreneurs engage in malinvestments – investments that do not make sense in light of current resource availability, that occur in more temporally remote stages of the capital structure than the pattern of consumer demand can support, and that would not have been made at all if the interest rate had been permitted to tell the truth instead of being toyed with by the Fed.

Not a word about any of that, of course, because Americans might then discover how the great wise men in Washington caused this great debacle. Better to keep scapegoating the mortgage industry or “wildcat capitalism” (as if we actually have a pure free market!).

Speaking about Fannie Mae and Freddie Mac, the president said: “Because these companies were chartered by Congress, many believed they were guaranteed by the federal government. This allowed them to borrow enormous sums of money, fuel the market for questionable investments, and put our financial system at risk.”

Doesn’t that prove the foolishness of chartering Fannie and Freddie in the first place? Doesn’t that suggest that maybe, just maybe, government may have contributed to this mess? And of course, by bailing out Fannie and Freddie, hasn’t the federal government shown that the “many” who “believed they were guaranteed by the federal government” were in fact correct?

Then come the scare tactics. If we don’t give dictatorial powers to the Treasury Secretary “the stock market would drop even more, which would reduce the value of your retirement account. The value of your home could plummet.” Left unsaid, naturally, is that with the bailout and all the money and credit that must be produced out of thin air to fund it, the value of your retirement account will drop anyway, because the value of the dollar will suffer a precipitous decline. As for home prices, they are obviously much too high, and supply and demand cannot equilibrate if government insists on propping them up.

It’s the same destructive strategy that government tried during the Great Depression: prop up prices at all costs. The Depression went on for over a decade. On the other hand, when liquidation was allowed to occur in the equally devastating downturn of 1921, the economy recovered within less than a year.

The president also tells us that Senators McCain and Obama will join him at the White House today in order to figure out how to get the bipartisan bailout passed. The two senators would do their country much more good if they stayed on the campaign trail debating who the bigger celebrity is, or whatever it is that occupies their attention these days.

F.A. Hayek won the Nobel Prize for showing how central banks’ manipulation of interest rates creates the boom-bust cycle with which we are sadly familiar. In 1932, in the depths of the Great Depression, he described the foolish policies being pursued in his day – and which are being proposed, just as destructively, in our own:

Instead of furthering the inevitable liquidation of the maladjustments brought about by the boom during the last three years, all conceivable means have been used to prevent that readjustment from taking place; and one of these means, which has been repeatedly tried though without success, from the earliest to the most recent stages of depression, has been this deliberate policy of credit expansion.

To combat the depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about; because we are suffering from a misdirection of production, we want to create further misdirection – a procedure that can only lead to a much more severe crisis as soon as the credit expansion comes to an end… It is probably to this experiment, together with the attempts to prevent liquidation once the crisis had come, that we owe the exceptional severity and duration of the depression.

The only thing we learn from history, I am afraid, is that we do not learn from history.

The very people who have spent the past several years assuring us that the economy is fundamentally sound, and who themselves foolishly cheered the extension of all these novel kinds of mortgages, are the ones who now claim to be the experts who will restore prosperity! Just how spectacularly wrong, how utterly without a clue, does someone have to be before his expert status is called into question?

Oh, and did you notice that the bailout is now being called a “rescue plan”? I guess “bailout” wasn’t sitting too well with the American people.

The very people who with somber faces tell us of their deep concern for the spread of democracy around the world are the ones most insistent on forcing a bill through Congress that the American people overwhelmingly oppose. The very fact that some of you seem to think you’re supposed to have a voice in all this actually seems to annoy them.

I continue to urge you to contact your representatives and give them a piece of your mind. I myself am doing everything I can to promote the correct point of view on the crisis. Be sure also to educate yourselves on these subjects – the Campaign for Liberty blog is an excellent place to start. Read the posts, ask questions in the comment section, and learn.

H.G. Wells once said that civilization was in a race between education and catastrophe. Let us learn the truth and spread it as far and wide as our circumstances allow. For the truth is the greatest weapon we have.

In liberty,

Ron Paul

More Ron Paul on the bailout

Over on my twitter account I’ve been posting some links to interesting articles about the folly of the bailout plan. My opposition to it is based on economics and libertarianism but I’ve posted links that show why those who are Democrats or Republicans should be wary as well. I already posted one link commenting on the bailout by Ron Paul. I got another one by him in an email that I’m reposting below.

Wednesday, September 24, 2008

Dear Friends,

Whenever a Great Bipartisan Consensus is announced, and a compliant media assures everyone that the wondrous actions of our wise leaders are being taken for our own good, you can know with absolute certainty that disaster is about to strike.

The events of the past week are no exception.

The bailout package that is about to be rammed down Congress’ throat is not just economically foolish. It is downright sinister. It makes a mockery of our Constitution, which our leaders should never again bother pretending is still in effect. It promises the American people a never-ending nightmare of ever-greater debt liabilities they will have to shoulder. Two weeks ago, financial analyst Jim Rogers said the bailout of Fannie Mae and Freddie Mac made America more communist than China! “This is welfare for the rich,” he said. “This is socialism for the rich. It’s bailing out the financiers, the banks, the Wall Streeters.”

That describes the current bailout package to a T. And we’re being told it’s unavoidable.

The claim that the market caused all this is so staggeringly foolish that only politicians and the media could pretend to believe it. But that has become the conventional wisdom, with the desired result that those responsible for the credit bubble and its predictable consequences – predictable, that is, to those who understand sound, Austrian economics – are being let off the hook. The Federal Reserve System is actually positioning itself as the savior, rather than the culprit, in this mess!

• The Treasury Secretary is authorized to purchase up to $700 billion in mortgage-related assets at any one time. That means $700 billion is only the very beginning of what will hit us.

• Financial institutions are “designated as financial agents of the Government.” This is the New Deal to end all New Deals.

• Then there’s this: “Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.” Translation: the Secretary can buy up whatever junk debt he wants to, burden the American people with it, and be subject to no one in the process.

There goes your country.

Even some so-called free-market economists are calling all this “sadly necessary.” Sad, yes. Necessary? Don’t make me laugh.

Our one-party system is complicit in yet another crime against the American people. The two major party candidates for president themselves initially indicated their strong support for bailouts of this kind – another example of the big choice we’re supposedly presented with this November: yes or yes. Now, with a backlash brewing, they’re not quite sure what their views are. A sad display, really.

Although the present bailout package is almost certainly not the end of the political atrocities we’ll witness in connection with the crisis, time is short. Congress may vote as soon as tomorrow. With a Rasmussen poll finding support for the bailout at an anemic seven percent, some members of Congress are afraid to vote for it. Call them! Let them hear from you! Tell them you will never vote for anyone who supports this atrocity.

The issue boils down to this: do we care about freedom? Do we care about responsibility and accountability? Do we care that our government and media have been bought and paid for? Do we care that average Americans are about to be looted in order to subsidize the fattest of cats on Wall Street and in government? Do we care?

When the chips are down, will we stand up and fight, even if it means standing up against every stripe of fashionable opinion in politics and the media?

Times like these have a way of telling us what kind of a people we are, and what kind of country we shall be.

In liberty,

Ron Paul

YouTube: SUBWAY™天天6吋$69(97年夏天)

SUBWAYâ„¢ Taiwan offers the TW$69 Sub of the Day for a limited time at all participating restaurants. This is the new Summer 2008 TV advertisement used for this promotion.

The SUBWAYâ„¢ trademarks are owned by Doctor’s Associates Inc. and the independent franchised operator of this restaurant is a licensed user of such trademarks.

Sub of the Day

SUBWAYâ„¢ Taiwan offers the TW$69 Sub of the Day from 4/1/2008 to 5/31/2008 at all participating restaurants. This is the TV advertisement used for this promotion.

The SUBWAYâ„¢ trademarks are owned by Doctor’s Associates Inc. and the independent franchised operator of this restaurant is a licensed user of such trademarks.

New Subway Taiwan TV Ad

For January and February 2008 we are promoting the Chicken Teriyaki Sub in Taiwan with the following TV commercial:

When you buy a Chicken Teriyaki Meal you can win one of four prizes: 1) Trip for two to Las Vegas, 2) Coca Cola duffel bag, 3) Buy one get one free 6″ sub 4) Free small soda.

Pizza Now Available

Click For Larger Version

Personal Pizza is now available at select SUBWAYâ„¢ Taiwan Restaurants for $180 each: Cheese, Veggie, Sausage or Pepperoni, with extra topping options such as bacon, meatball, double meat or double cheese.

This is a test product which will be available at limited locations to test market response. The test stores are:

Available Now: SUBWAYâ„¢ Qingcheng Restaurant (Nanjing E. Rd. MRT)
Available This Week: SUBWAYâ„¢ Tianmu Taipei American School Restaurant, SUBWAYâ„¢ Minquan/Longjiang Restaurant
Available In Coming Weeks: SUBWAYâ„¢ Dunhua/Civic Restaurant, SUBWAYâ„¢ Xingtian Temple Restaurant

(Product availability may change without notice.)

2007 Baseball World Cup

Today SUBWAYâ„¢ Xingtian Temple restaurant is busy from the early morning preparing meals for the 2007 Baseball World Cup. We are supplying lunch for the noon games held in Xinzhuang (the games are also being held in Tianmu and two sites in Taizhong) from now through November 18. In Taiwan the games can be watched on TVBS or TVBS-G.