Saturday, February 14, 2009

What will the stimulus bill accomplish?

The financial crisis does not yield easily to stimulus because it's primary cause is an overhang of debt built up over several decades. How this occurred is explained in a previous post on this blog, My Short Explanation of the Financial Crisis. Consumers are no longer spending on discretionary purchases and businesses are not investing because demand is declining. As the government pumps money into the system to replace that previously supplied by consumers and businesses, only that which is given to consumers that are just getting by will be spent to sustain demand. Consumers that are meeting their basic needs will use the money to pay off debt or save it. Businesses that are burdened with debt will use it to pay off debt, which may be due to bad investing or a result of the crisis. Those that are not will pay it out in dividends or bonuses, since opportunities for expansion are limited due to reduced demand for their products. The primary useful effect of the stimulus will be to keep workers in productive jobs rather than just pay them to be unproductive. In this sense it is not really a stimulus program, but a program to reduce the severity of the consequences of the crisis and shorten the recovery time, as the debt overhang is worked off. To not have any government spending could worsen the consequences and possibly lead to a deflationary spiral that could lead to a depression.

The key to how the stimulus should be used relates to who should be helped and who should not. Banks and investors that invested unwisely should suffer the losses. Right now this segment is sitting on the sidelines with their money in treasuries making little or nothing. They are not investing, because demand is dying and investing would be unproductive. But, they have reaped large rewards over the last several decades through leveraging, which caused the crisis, and should now be willing to now take their losses. Reducing capital gains and dividend taxes, especially retroactively, would just be a windfall for banks and other large investors that have reaped the gains, but now want to socialize the losses. Income tax rebates for wealthy investors will not stimulate the economy. They will be used to pay down debt from leveraging bad investments. Consumers are already paying the consequences for their spending euphoria over the last several decades. They are not being bailed out. And they will continue to suffer the consequences, for as long as the recovery takes.

So, is the stimulus package configured right? To the extent that tax cuts are going to investors who made bad decisions, it's not. To the extent that the cuts are going to people just getting by, it is stimulative. There appears to be an argument over specific spending projects in the package and how quickly the money is spent. Since the primary effect of the program will not be to stimulate the economy, but to reduce the severity of the consequences while debt is being worked off, any programs that keep people employed productively are worthwhile. If the money is spent so quickly that it becomes inefficient and wasteful, it will be counterproductive. If is spent so slowly that people are not employed productively, it will be inefficient, cause more pain, and lengthen the recovery period. Since it will take considerable time to work off the debt, the most important consideration is to keep the spending at a pace that keeps people employed productively without waste or undue hardship.

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