The trouble with Stimulus

The stimulus package has been passed and Australia will be stimulating our economy as much as other economies around the world. Will it work?

There is an assumption about the need for this type of prolific action to either prevent or dampen a recession or worse, a depression in the global economy.

The cure may be worse than the disease. We have been led to believe that stimulation packages and free Government handouts are the only solution to the problems we find ourselves faced with. Investors need to be aware of the potential consequences of this type of action.

There is a formula in economics that states that in any given year private investment must equal the sum of private savings, corporate savings (by way of retained earnings) and government savings (or deficits). In our globalised economy this formula applies to the world as a whole but imbalances can build up and countries can become dangerously out of kilter.

For example, over the last few years, private investment in the US has been far greater than the sum of private, corporate and government savings, so the US has had to import savings from the rest of the world by selling US Treasuries primarily to China, Japan and the Middle East. The US deficit is equal and opposite to the surpluses elsewhere.

Government bailouts and stimulus packages are being promoted as a cure for heavily indebted countries. They are funded by issuing more government debt but the problem is the money must come from somewhere.

It seems to be very popular, particularly with the recipients of the bailouts and cash giveaways.

The problem is that the added debt absorbs savings that would otherwise go to private investment. In the end bailouts and stimulus plans do not add to current resources in use. They simply move resources from one use to another.

The reason we find ourselves in the problem we are today is because we have been spending money we haven’t yet earnt. In order to fund current lifestyle we have been borrowing money that must be repaid at some point in the future.

The solution being offered in Australia, the US and elsewhere is to have the government give us still more money we haven’t earnt by borrowing it from the rest of the world (going into government deficit).

If the economic situation worsens in a year or two we will be in a far less flexible position to weather the storm if we are burdened by billions of dollars of debt. Bailouts and stimulus packages only enhance future incomes when the activities they favor are more productive than the activities they displace.

Most politicians will favor bailouts as they fear the voter backlash if thousands lose their jobs. Bailouts will be financed with government debt. The government deficit gets larger; government savings become more negative. If private and other corporate savers do not save more in response to additional government debt, the bailout displaces productive investments elsewhere.

If private and other corporate savers do save more in response to additional government debt, private consumption must go down by the same amount. This lost consumption and investment, and the incomes they would create, are the real unseen costs of a bailout.

We are all caught up by the very visible prospect of lost jobs in the industries that cry out for a government bailout like the auto industry. We tend to forget the unnamed people who lose jobs or don’t get jobs, the businesses that close or the new businesses that don’t start, because the bailout displaces productive activities elsewhere.

Even when there are lots of idle workers, government bailouts and stimulus plans are not likely to add to employment. The reason is that bailouts and stimulus plans must be financed. The additional government debt means that existing current resources just move from one use to another, from private investment to government investment or from investment to consumption, with no effect on total current resources in the system or on total employment.

Stimulus packages only enhance future incomes when they move current resources from less productive private uses to more productive government uses. Government has not had a good track record for efficiency when compared to the private sector.

If Government was more efficient at allocating capital than private investors, North Korea would be booming and South Korea would be a basket case. The Soviet Union would have been the richest country in the world by the late 1980’s! This is patently not the case. Small business has always been the real driver of employment growth. Policy must be directed towards the support and encouragement of enterprise.

Kevin Bailey

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19 Responses

  1. “If Government was more efficient at allocating capital than private investors, North Korea would be booming and South Korea would be a basket case. The Soviet Union would have been the richest country in the world by the late 1980’s! This is patently not the case. Small business has always been the real driver of employment growth. Policy must be directed towards the support and encouragement of enterprise.”

    Excellent thread Kev.

    On this point I agree, however the problem with a system that is heavily reliant on financial innovation is that it’s it let increasingly towards fragility and is patently flawed and has led to many inequalities. As TB would say “we live in a society not an economy”. Soros expresses it well.

    “Markets are not perfect. They can only cater to individual needs; taking care of social needs is beyond their scope. And even as the allocation of resources they are less than perfect: financial markets are inherently unstable. That does not mean we should abolish capitalism; rather we should endeavor to correct its shortcomings.

    Communism sought to abolish the market mechanism and to impose collective control over all economic activities. Market fundamentalism seeks to abolish collective decision-making and to impose the supremacy of market values over all political and social values. Both extremes are wrong. We need to recognise that all human constructs are flawed. Perfection is beyond our reach. We must content ourselves with the second-best; an imperfect society that opens itself open to improvement. Global capitalism is badly in need of improvement.”

    And the central point about economies and economic management still “History shows that people who save and invest grow and prosper, and the others deteriorate and collapse.”

    Yes, countries like the US, UK and Australia are not very well prepared at all, and this comes after years of increasing deregulation and financial innovation that has spread throughout the global financial system and is now impacting on real economies everywhere. And this has occurred because governments (especially the US) decided long ago to take a hands off approach to the private sectors (especially banking) activities.

    The two options we have in the current climate is (1) to attempt to reduce the impact of the global downturn on jobs, and most of all the level of shrinkage in our economy. Or, (2) Allow the crisis to run it’s course with very little or no interventions.

    I don’t think anyone really wants to test the second option.

  2. …I guess what we’re seeing at the moment from many governments who are attempting to stimulate their economies is, sadly, a process of trial and error based on previous experience. However, this crisis is far worse and unpredictable than all preceding crises .

    How prepared are we, well our problem hasn’t been huge deficits, but our level private debt has skyrocketed. As Mark Davis explains:

    “Australia’s ˜age of prosperity’, as Peter Costello calls it in his memoirs, has been underwritten by the mining boom (even as manufactured exports stagnated during his tenure) and massive increases in household debt (now more than $1 trillion ” about the same as the annual national output), even as the government has wound down its own debt. The national debt has in effect been privatised while, at the same time, risk has been shifted away from government and business onto the shoulders of ordinary people, in the shape of long working hours, casualisation, and the sort of uncertainty that is written in the fact that Australians take the least holidays of any western nation.”

    It just doesn’t get anymore succinct and to the point than this. In fact it was reported last year that our “economy is even more vulnerable to an economic downturn than the struggling US, leaving us facing the spectre of soaring unemployment, falling house prices and a long-drawn out economic slump.

    Experts said the only way to head off a crisis is to quickly cut interest rates and improve household finances decisively.

    The bleak picture is painted by economists who point to a series of data showing how we compare to the US.

    Australia has some of the most expensive property in the world, relative to incomes, according to the Demographia International Housing Affordability Survey.

    It says the median Australian house price is 6.3 times median household income, higher than the US, Canada, New Zealand, Ireland and Britain. A median Sydney property will cost nine times the average Sydney income.

    Australia also has more debt per household than the US, with Australians owing 177 per cent of household income in mortgage and other debts compared to 138 per cent in the US.

    This is coupled with the fact Australians save an average of 0.5 per cent of their income compared to 2.6 per cent in the US.”

  3. Sorry Kevin but I can’t agree with a lot of this.

    What you are suggesting is that Government’s (and presumably the private sector) should save and then spend rather than use use well capitalised debt. There are a host of problems with this on the Government side of things, not least issues of intergenerational equity problems where future genertations receive the benefits of past takpayers savings (in otherwords, the current generation bears an unreasonablecost to the benfit of future taxpayers). If infrastructure is funded through debt, those people using it (ie future taxpayers) are the people who actually pay for it.

    Australia, with the exception of the car industry, has bailed out any business so far as a result of the GFC. They have guaranteed bank deposits but this was necessary to prevent a run on the banks in favour of other countries where there was a guarantee; further, the chance of this guarantee being realised is extremely low – if it is, we are in much deeper sh!t than the $700Bn in resulting Government debt. As for the car industry ‘bailout”/ package, this has been linked to productivity improvements and private investment. Accordingly this would seem to satisfy your requirement that bailouts only go to sectors which are more productive.

    Your argument also assumes that bdebt and investment are mutually exclussive concepts. They are not. If debt is used to pay for productive infrastructure and or generate employment that would reduce the burden on Government in the future, the debt is actually an investment in the future, but only if the return on that investment in the long run is sufficient to pay for the debt.

    One final point, the cash payments are focussed on stimulating retail spending – much of this will be returned to the Government in the form of GST (10%) and taxes (company and personal) so an actual expenditure of $10Bn in payments is rally only equivalent to around %5bn in actual cost to the Government. Given that the 2 cash payments so far are less than the forcast surplusses in this financial year (particularly when tax feedbacks and reduced unemployment benefit payments are taken into account), all that is occuring is the Government is returning to people their own money (to use a conservative’s phrase). The future Government debt then is attributable to infrastructure and other productive uses – this would seem to satisfy what you see as the key requirements for Government (and private) expenditure. Accordingly, I fail to see the criticisms in you post as being applicable to the situation in Australia.

  4. The problem will be resolved easily, by extinguishing the debt through massive inflation. Pity that the value of savings will also be wiped out and ordinary wage earners will be pauperised but them’s the breaks of living under majoritarian rule. I’m afraid political/economic developments will remain in the hands of those who benefited from the debt binge and they will see inflation as the way to avoid being called to account.

  5. As an example of my comments above, I give you the Sydney Harbour Bridge. Funded entirely through debt and payed off by tolls over 50 odd years. The construction of the bridge kept thousands of people in jobs in NSW during the depression and probably prevented NSW from being a complete basket case. It did not send the State broke (it was the interest repayments on the war debts that England required repayed which caused the sacking of Lang) and provided a fantastic piece of infrastructure for not only NSW but the State and one can only speculate what it contributes to the economy in terms of tourism even now. This would never have been built by the private sector.

  6. Really good post Kevin. Thanks. If I may “rant”:

    If Government was more efficient at allocating capital than private investors, North Korea would be booming and South Korea would be a basket case. The Soviet Union would have been the richest country in the world by the late 1980’s! This is patently not the case. Small business has always been the real driver of employment growth. Policy must be directed towards the support and encouragement of enterprise.

    North Korea – is run by a despotic dictator with no understanding of much at all and especially economics – its a failure…

    South Korea – is run by a “democratic” government propped up by the west and particularly the USA – remove the props – its a failure…

    The USSR was a victim of its own internal corruption – it is now a free market “democracy” still full of the same corrupt officials who now run the government, rig elections, still assassinate voices seeking truth, or are “self made” (given by the previous government) multi millionaires who now milk the Russian “free market” as either “legitimate” businessmen, in the pocket of a corrupt government or as part of the Russian Mafia (who pay off the corrupt officials) – many Russians long for the days when things didn’t work well but they had a job, a roof and some care for their kids – another “free market” AND “command system” failure…

    Small business IS the answer – problem is the world and particularly the west is owned by big business – also a FAILURE…of free market ideology…

    Neither complete command, nor absolute free market systems work…

    …I would also question the “efficiency” of free enterprise over well managed government enterprise…

    …simply put a government enterprise need only sell say electricity to cover costs plus future maintenance – if “efficient” private enterprise take over they have to make a proffit for the company, for shareholders and for marketing – how can this possibly be “cheaper” – my electricity bills have increased over 18% since the “efficient” private billers have been engaged – ludicrous…its about efficient and effective management not making a quid out of an essential service…most private takeovers have not been efficient nor effective but they have been bloody expensive!

    …my purpose in life is not make some hard nosed, self centred, arsehole rich at my expense and/or breed more automatons for the grist mill…

    …roses need smelling – life needs sharing – we have lost the plot – it is not about who will be the richest person in the cemetary – its about living and about 10% of the worlds population just don’t get it…they are making the rest of us suffer for wealth and power…

    …they are no better than Reichfuhrer Hitler and his mob…they gave us the Beetle and autobahns, misery and death…another failure…because of EXTREMES…

    …how many times must these greedy experiments fail before ordinary people say enough is enough?

    Where are all the “leaders” of commerce and industry now? In court? In jail?

    Nup! Preparing to do it to us all again…

    By all means encourage free markets for small business (tightly controlled now, BTW) but The Robber Barons too have to be controlled…but they control the controllers…

    Disclaimer: I am a capitalist I ran my own business for 16 years – however I believe in socialist ideals (because not everyone has the opportunity to work for themselves). My mantra – provide the service and the dollars will folla…
    ———————————————————-
    Prosperity With Integrity!

  7. You make alot of sense to me TB.
    N’

  8. Ken Lovell, on February 18th, 2009 at 4:51 pm Said:

    The problem will be resolved easily, by extinguishing the debt through massive inflation. Pity that the value of savings will also be wiped out and ordinary wage earners will be pauperised but them’s the breaks of living under majoritarian rule. I’m afraid political/economic developments will remain in the hands of those who benefited from the debt binge and they will see inflation as the way to avoid being called to account.”

    Herein lies the major drawback KL.

    There are a number of potential and very challenging factors that will need to be addressed.

    1. Personal debt and poor savings record: It’s claimed that AUSTRALIANS are the world’s worst when it comes to saving, an Investment and Financial Services Association report said.

    The IFSA report, released last year, showed that on average Australian households have $160 in debt for every $100 they earn.

    In fact, only recently it has been reported that bad debt and household interest servicing levels have reached historic records, even before the major banks raised their lending rates independently of the RBA.

    2. . Ben Simpfendorfer, China strategist for the Royal Bank of Scotland, puts it succinctly: Where China was a deflationary influence over the last 10 years, it will be an inflationary influence over the next 10 years.

    3. Is our financial sector as solid as it claim to be?: Our banks assure us that we are in a stronger position than the US to cope with any fallout, I tend to be more skeptical. Our banks have surely been aided in earning record profits off the back of complex and risky debt arrangements with other lending institutions, businesses, and individuals in recent years? This has been a global issue not just one relating to the US alone.

    Whichever way you look at it we’ll all end up paying through the teeth.

  9. “The IFSA report, released last year, showed that on average Australian households have $160 in debt for every $100 they earn.”

    I take it that doesn’t include compulsory Super John?

    N’

  10. nasking, on February 18th, 2009 at 7:11 pm

    That’s a bit of a cheeky question, N’.

    Wonder what the ratio would have been if PJK had got his way and the CS had made it to 15%…but then other things might have made it a lot better too…

    No John Howard & The Private School Bullies to start with! 😀

  11. “No John Howard & The Private School Bullies to start with! ”

    Well, hopefully TB the voters have learnt their lesson…plenty still haven’t…and obviously some benefitted from the funneling of taxpayers money into the monopoly-dominated CHOSEN private sphere at the expense of the health of the nation.

    People can be BLINDED by the media light, that sick putrid light that shines on “no-core personality” celebrities and ever “whining & dining” corporate aristocrats selling their shonky ideas. Whoring themselves for a moment of fame & a lifetime of luxury…selling to the “dazed and confused” pathways to easy living…that are in fact nought but pathways to enslavement and poisonous living, as the manitou of debt grows ever larger & more menacing on the armchair imperialist’s back…& the toxic sludge creeps like a malignant tumour into every aspect of our lives…including our food, water…children’s lungs…our very DNA.

    N’

  12. nasking, on February 18th, 2009 at 8:01 pm

    Personally I’m sick of constantly paying off every sycophants debt…

  13. John McPhilbin, on February 18th, 2009 at 6:50 pm

    Going global in The Great Game…U.S. stimulus-related debt “could hurt investors,” China warns.

  14. Legion

    “Increased borrowing by the United States to fund its massive stimulus package could cause the depreciation of U.S. dollar-denominated assets, Chinese economists have told Xinhua.

    Being the largest holder of U.S. Treasury securities, China had reason to be concerned about that possible depreciation, the economists said. ”

    DANGER! DANGER!

    In the last few years, Japan and China have bought more than $1.8 trillion worth of U.S. dollars. Why? To keep the value of the dollar high so the US can continue buying lots of their exports. What would the dollar be worth if they were not propping it up? What will it be worth when they can buy no more?

    Well pointed out Legion

    Japan have gone to the wall and if China pulls it’s investment in Treasuries that spells MAJOR danger for the value of the $US

  15. John McPhilbin, on February 19th, 2009 at 7:53 am

    JMc would be a lot easier to REGULATE and reduce the SPECULATION (“…money for nothing…”) with a World Currency…

    If G20 is serious that’s one of the changes they should discuss – The Robber Barons successfully destroyed the gold standard, now’s the time to strike deep with a World Standard Currency.

    I’d suggest a McPhilbin but its too long …a TB would be much simpler 😆

  16. “Japan have gone to the wall and if China pulls it’s investment in Treasuries that spells MAJOR danger for the value of the $US”

    Oh goodie. That should make my overseas holidays more affordable!

  17. John McPhilbin, on February 19th, 2009 at 7:53 am

    Japan have gone to the wall and if China pulls it’s investment in Treasuries that spells MAJOR danger for the value of the $US

    In the last few years, Japan and China have bought more than $1.8 trillion worth of U.S. dollars. Why?

    Ken Lovell, on February 18th, 2009 at 4:51 pm

    Pity that the value of savings will also be wiped out.

  18. Legion, on February 19th, 2009 at 11:37 am

    Don’t tell me we lost the War that easily – Sheesh!

  19. TB Queensland, on February 19th, 2009 at 1:26 pm

    What War? And who are ‘we’? And how do you think a War is won or lost in a holistic system of flows?

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