Fooled By Stimulus - By Eric Sprott & David Franklin
There are a number of studies we have come across that suggest stimulus is the wrong approach. The first is a 2005 Harvard study by Andrew Mountford and Harald Uhlig that discusses the effects of fiscal policy shocks on the underlying economy. Mountford and Uhlig explain that from the mid-1950’s to year 2000, the maximum economic impact of a two percent increase in government spending was an ensuing GDP growth of approximately three percent. A two percent spending increase inevitably requires an increase in taxes. Due to the nature of interest costs, however, the government would have to raise taxes by MORE than two percent in order to pay back the initial borrowing. According to their data, this increase in taxes would generally lead to a seven percent drop in GDP. As they state in their study: "This shows that when government spending is financed contemporaneously that the contractionary effects of the tax increases outweigh the expansionary effects of the increased expenditure after a very short time."2 Stated simply, ‘borrowing to stimulate’ has never worked as planned because the cost of paying back the borrowed funds surpassed the immediate benefits of the stimulus.
In a follow-on study, Harald Uhlig estimated that an approximate $3.40 of output is lost for every dollar spent on stimulus. Another study on the same subject by C’ordoba and Kehoe (2009) went so far as to say that, "massive public interventions in the economy to maintain employment and investment during a financial crisis can, if they distort incentives enough, lead to a great depression."
If the conclusions of these studies are even close to being correct, we are now in quite a predicament – not just in the US, but across the Western world. Remember that the 2007-08 meltdown was only two years ago, and as we highlighted in April 2009 in "The Elephant in the Room", the US government has spent more on stimulus and bailouts, in percentage of GDP terms, than it did in the Gulf War, Operation Iraqi Freedom, the Vietnam War, the Korean War and World War I combined. All that spending was justified by the understanding that it would generate sustainable underlying growth. If it turns out that that assumption was wrong, have the governments made a fatal mistake?
Another recently published Harvard study looked at stimulus at a micro-economic level and derived some surprising conclusions. Entitled "Do Powerful Politicians Cause Corporate Downsizing?", the authors compiled 232 occasions over the past 42 years when either a Senator or a Representative was voted into a controlling position over a big-budget congressional committee. Unsurprisingly, the ascendancy of the politicians resulted in extra spending in their respective districts – typically in the form of an extra US$200 million per year in federal funds. The researchers examined the economic effects of this increase in spending and found "strong and widespread evidence of corporate retrenchment in response to government spending shocks." The average firm cut back on capital investment by 15 percent and significantly reduced its R&D spending. Companies collectively operating in the affected state reduced capital investment by $39 million a year and R&D by $34 million per year. Other consequences included increases in unemployment and declines in sales growth. Yikes!! That is not the response we’re supposed to get from government spending!
- Cbo Report: Trends In The Distribution Of Household Income Between 1979 And 2007
From 1979 to 2007, real (inflation-adjusted) average household income, measured after government transfers and federal taxes, grew by 62 percent. During that period, the evolution of the nation’s economy and the tax and spending policies of the federal...
- Hussman Weekly Market Comment: Implications Of A Likely Economic Downturn
A week ago, we accumulated enough evidence to conclude that the U.S. economy is most probably headed into a second leg of recession. It is unclear whether this will be identified as a second recession or a continuation of an existing downturn. In either...
- Fpa Capital Fund Letter To Shareholders
Thanks to Steve F. for passing this along. The stock market has a much rosier outlook than we do at this time, and is discounting a significant recovery in earnings. We think such a recovery is unlikely with banks pulling back on their lending, the consumer...
- 2009 Chou Funds Annual Report
WAS THE GREAT STIMULUS A SILVER BULLET? - THINK AGAIN: It now appears that the great stimulus provided by almost all governments has averted the second Great Depression and the North American economy may well be on its way to recovery. However, looking...
- Greg Mankiw, Paul Krugman, And Fiscal Stimulus
From Greg Mankiw's Blog: - - "a strategy of desperation" - My favorite book by Paul Krugman is Peddling Prosperity, which I once assigned in a course and still often recommend to students. A reader recently reminded me what the book says about the...