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Stimuli - They Are Not All The Same

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Old Glory

“The government that stimulates least stimulates best.”
                                                        Anonymous

Stimulus—First Let’s Clear Up the Linguistics

Stimulus, noun, plural stimuli

Definition: “something that arouses or incents to activity” (Merriam-Webster’s Online Dictionary)
Question: Why do we have to use the second declension Latin plural stimuli when speaking English? What is wrong with stimuluses? Wall Street says (or used to say) bonuses. Lots of words come into English from lots of other languages and English does not use their plurals. For example the word guru comes from Hindi. Depending on its use, there are apparently two ways in Hindi to pluralize guru - guru and guruo. (Check it out—Wilkibooks, Hindi Lessons, Lesson 7) But we do not say “We can blame the current economic situation on guruo like Alan Greenspan.”

Stimuluses, Stimuli – It Does Matter What Kind

To the above the most readers will probably say “who cares.” And most investors, politicians and voters would also say “who cares” to what kind of stimulus a government undertakes. Just so long as the government responds to the drop in private sector demand with an increase in its own spending. Any kind of government spending will do and the sooner the better.  Pure Keynes. Keynes famously said “Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist” Little did he know that, defunct as he would be in 2009, literally billions of people and governments would be his intellectual slaves.

They might have picked the wrong master. There is considerable theoretical and empirical support for the view that it does matter what kind of stimulus governments embark upon. Let’s start with some theory. The Austrian school would argue that bubbles have a monetary origin and result in a major misallocation of resources. The inevitable bust corrects this misallocation of resources and enables the economy to be put on sound footing to grow again. Government stimulus efforts to delay or prevent this correction of resource misallocation will only lengthen the bust period. Propping up inefficient bankrupt companies in particular is a major misallocation of resources and a mistake.

An Austrian interpretation of the current situation might be that a global bubble has built up over many years which showed up as the overinvestment in manufacturing and export oriented capacity in China and an overinvestment in real estate and import oriented consumer spending in the United States. The bubble is now being unwound. Two sides of the same coin. Government stimulus programs will only lengthen the adjustment process, i.e., lengthen the current global recession/depression.

OK, that is intellectual speculation. But investors should become aware of some interesting empirical work performed by economists Gonzalo Fernandez de Cordoba and Timothy J Kehoe, an abstract of which is available from the Federal Reserve Bank of Minneapolis. Fernandez and Kehoe have concluded that “massive public interventions in the economy to maintain employment and investment during a financial crisis can, if they distort incentives enough, lead (italics mine) to a great depression.”

Since 2000, Fernandez and Kehoe, with the cooperation of a team of 24 other economists, have been studying the great depressions that occurred during the twentieth century. Their work, unfortunately a little arcane by layman’s standards, is conducted in the context of what the economics profession calls the general equilibrium growth model. Productivity plays a crucial role in this model. Fernandez and Kehoe have concluded that “overreaction by the government can prolong and deepen the downturn, turning it into a depression.”  They find that “a large drop in productivity always plays a large role in accounting for the depression.” In other words, the government wasting money to replace private spending is a mistake. Building canals and bridges to nowhere , as Japan did in its lost decade post its bubble bursting in 1990, does nothing for an economy’s total factor productivity(TFP) and therefore nothing for its economic recovery. Fernandez and Kehoe conclude that “we need to avoid implementing policies that stifle productivity by providing bad incentives to the private sector… Unproductive firms need to die. This is true for the automobile industry as it is for the banking system. Bailouts and other financial efforts to keep unproductive firms in operation depress productivity.”

The Chinese vs. the American Stimuli

I would say at the outset that the Chinese stimulus, for all of its opaqueness and other faults, is a better plan than the American. The Chinese program, aimed in part at needed infrastructure improvements, has a chance at being a net plus for productivity, whereas the American does not. And the mantra for China is still Deng Xiaoping’s “To be rich is glorious” rather than what appears to be the new American mantra, “To be rich is to be a source of funds for the taxman.” China will recover before the US, although in my opinion neither will recover in 2009.

The American stimulus plan, including the myriad Fed attempts to bail out the banking system, is a hastily thrown together combination of support for inefficient money losing companies, wasteful spending on all kinds of earmarks, some fifty billion on high cost alternative energy, socialized medicine, higher taxes and billions for deadbeat home owners who cannot pay mortgages they never should have taken out. Fiscal responsibility be damned. It doesn’t matter how the government spends the money so long as it spends it quickly. Long live moral hazard. The President and Congress decry Wall Street junkets as excess. Yet the stimulus bill provides for an $8 billion Maglev high speed train from Los Angeles to Las Vegas. The Federal deficit will run close to some two trillion dollars for fiscal 2009, undermining the dollar and crowding out the private sector for funds. Productivity? Forget it.

Of course you will not get this point of view from the American media where unrestrained Keynesianism is the ruling doctrine. CNBC, for example, cheers the American government on to ever larger spending programs. (Actually CNBC embraces the Auditory School of Economics – If you yell something loud enough it must be true. But that is another matter.) The media is full of paeans to what it views as the marvel of American exceptionalism. Under this view, fast moving Americans are way ahead of group-think Japanese and the sclerotic Europeans. One wonders. Whatever happened to that old American adage, “haste makes waste?”

Compared to the American plan, the Chinese stimulus appears to be a model of sobriety. For starters, the Chinese so far anyway don’t have to bail out their banking system. Chinese and other Asian banks did not balloon their balance sheets with nonperforming real estate loans and related toxic assets as did the American banks. At the National Peoples’ Congress, Chinese Premier Wen Jiabao disappointed the world stock markets by refusing to increase the Chinese stimulus plan of $485 billion. But I think the reaction of the world stock markets was misplaced. Most observers already expressed doubts on the Chinese ability to spend the $485 billion and noted that many of these projects had been planned anyway. So much the better as far as I am concerned. Premier Wen was basically acknowledging that if China couldn’t spend the money wisely, then it wouldn’t spend the money.

One area of concern with the Chinese program. The banks, which are basically under government control, have been ordered to step up lending. And Chinese bank loans have jumped in the last two months. No one knows where the money is going although some of it may be finding its way into Shanghai A shares which have been rallying recently. But the same rules apply to China as to the US. Bank lending forced on banks regardless of credit criteria will misdirect capital, lower productivity and lead to rises in nonperforming loans later.

For China, the export model is dead as growth model. The Western consumer – particularly the American – is up to his/her eyeballs in debt and is deleveraging. No American mortgage restructuring program or misguided political pressure for banks to lend more is going to change that. Any US plan which wants to force banks to loan more money to people who have already borrowed too much is doomed to fail.

China’s long run growth on the other hand will depend on a growing domestic consumer spending and infrastructure.  Governments can stimulate infrastructure growth but these projects cannot be rushed if the money is going to be wisely spent and a productivity boost for the economy. One of the greatest infrastructure boosts to American productivity was the launching of the interstate highway system under President Eisenhower. That was not a hastily thrown together stimulus but a well thought out program, probably the most important public works program in American history since the Erie Canal. As far as Chinese consumer spending goes, yes putting in a social spending net particularly in health care may help. Chinese consumers have to save for their own health care right now. But this is a long run proposition. Near term China has to adjust to what now appears to be massive overcapacity in manufacturing particularly for export.

How Not to Bail Out a Financial System

The American “plan” for rescuing its financial system is turning into a nightmare. Leaving out a lot of details and allowing for a few exceptions, the American plan is something like this.

First, classify all banks into one of two categories: 1. not too big to fail and 2. too big to fail. If a bank is in Cat 1, like IndyMac, all non-government insured stakeholders, including common and preferred shareholders and bondholders, get wiped out and the government steps in and sells off the remaining valuable assets. If a bank is in Cat 2, aka a zombie bank, then government money poured into the institution in the form of phony preferred shares, all kinds of guarantees for the bad assets on these institutions’ books and all kinds of guarantees on many of their previously uninsured liabilities. Non-government insured stakeholders like bondholders are to be in effect rescued and therefore rewarded for their excessive risk taking. A government supported and subsidized Cat 2 like Citibank can therefore compete against its nonsubsidized global competitor, HSBC, which is now accessing the public markets for equity capital and is not asking for government capital. And to think once upon a time the Americans complained about European subsidies to Airbus.

But that’s not the end of things. Somehow with Cat 2 zombies, Congress, reacting to public outrage, instinctively senses that the bad guys are being rewarded. But rather than treat Cat 2 zombies like the Cat 1 dead, Congress is laying all kinds of political conditions and “punishments” on the Cat 2 banks. Political punishments are therefore substituted for market ones. This is not exactly an optimal solution. Thus keep the managements in place but tax their bonuses (should we say boni ?) at a ninety percent rate. Force these banks to make all kinds of stupid loans to keep the economy going. If Fernandez and Kehoe and the Austrians are right this is a strategy that will prolong the economic downturn and make sure that the Cat 2 banks will remain government wards and a drain on the public purse. And it will ensure that in the long run non-government supported banks like HSBC will outperform their Cat 2 competitors.

As I said there are all kinds of exceptions. Poor Lehman, although it was not a commercial bank and it was pretty big, got the Cat 1 treatment. Lehman’s demise left a lot of bitterness around the world, particularly in Hong Kong where small investors got stuck with a lot of defaulted Lehman bonds. But funny thing. The good Lehman assets did get sold off. The world hasn’t ended with the fall of Lehman. Resources were efficiently reallocated.

As this paper was written, Secretary Geithner’s new toxic asset plan was being rolled out. For sure the toxic assets have to be removed from the banking system. That is a given. But at whose expense? Stay tuned. Will the bad guys be rewarded again?

 

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