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.