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April 05, 2009

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Nato

If the precipitous fall in employment owes most heavily to the prolongation of tight business credit* (and I think this is likely) then stimulus is helpful. If it's due to sudden correction of long-overdue misallocations of labor, then stimulus redirects resources from a more efficient future to a less efficient present, resulting in what amounts to deadweight loss. By that idea, then, last year's bipartisan stimulus was probably a bipartisan mistake.


*And expectations that it will not let up soon, or at any rate, not soon enough for individual firms

Nathan Smith

re: "If the precipitous fall in employment owes most heavily to the prolongation of tight business credit* (and I think this is likely) then stimulus is helpful."

Why?

Suppose we employ a lot of people who would otherwise have been unemployed to dig holes and fill them up again. We borrow to do it. Investors anticipate higher future taxes; this reduces the return on investment; so they pull back on investment further.

Or maybe we end up hiring a lot of people who would have been employed anyway, and move them to less-productive public-sector jobs. That reduces GDP and may leave unemployment unchanged, or may reduce it, again through harming the government's fiscal position.

If I were to argue that the economic case for fiscal stimulus is theoretically weak and has no empirical support to speak of (except wars which are unusual in enough ways that they should not be taken as indicative of good peacetime policy), how would you argue against that?

Nathan Smith

Oh one more thing. I don't think the stimulus last year was a mistake. The reason is that it wasn't wasteful, at least not directly, and probably not indirectly in any important way. If the government spends a lot of money trying to create jobs directly, the result is probably to misallocate a lot of resources, putting labor and capital into projects with little social value. If the government gives bailouts to specific companies, it creates incentives for rent-seeking, that is, for firms to position themselves to seek such handouts in future. But if you just send every American a check none of these bad consequences occur. *That* kind of stimulus might actually be worth practicing on a much larger scale, even if what the economy really needs is a sectoral shift and not just a boost to aggregate demand. After all, people don't have to spend their rebate checks on the same things they used to spend money on.

nato

Employers want to retain their workers because they anticipate the return of the market sooner or later, and those that don't have to amputate much of themselves are in the best position to make use of the recovery. Most businesses that operate on a credit basis assume that if they can show their bank that their cashflow situation remains generally positive that they will continue to extend credit. This has not been true, recently, meaning that some firms have been scrambling to replace their lines of credit, or reduce their need for them or whatever, meaning that firms have been selected by the exigencies of their financing mechanisms rather than their current or historical profitability, much less future tax regimes. I suppose we could just wait for all credit-based businesses to either shrink until they can operate on cash or die completely, but that would be both disastrously inefficient and unnecessary.

Now, if a bank felt that the stimulus wouldn't prop up demand or generally reduce their short term downside exposure in some other way, then the fiscal stimulus would do little to loosen credit. If that's Nathan's position, then that's a discussion worth having. However, indications are that credit tightening has bottomed out and may even be loosening slowly.

Last year, by contrast, the credit markets hadn't tightened to the same levels. The stimulus might have helped us eat up some extra capacity, but it probably put us in a worse position for this year's disaster control. I'm not saying it was a stupid mistake; just that it seems likely that it was premature.

Nathan Smith

"Employers want to retain their workers because they anticipate the return of the market sooner or later, and those that don't have to amputate much of themselves are in the best position to make use of the recovery. Most businesses that operate on a credit basis assume that if they can show their bank that their cashflow situation remains generally positive that they will continue to extend credit. This has not been true, recently, meaning that some firms have been scrambling to replace their lines of credit, or reduce their need for them or whatever, meaning that firms have been selected by the exigencies of their financing mechanisms rather than their current or historical profitability..."

Yes, there is a credit crunch, and that's part of the problem. There has been a systematic mispricing of risk which was exposed in the course of the past couple of years. People and firms now want to deleverage.

"... much less future tax regimes..."

The way future tax regimes come in to it-- at least, this is what I think; I won't claim to have knock-down evidence for it-- is that higher future taxes penalize risk-taking. Tails you lose, heads, the government wins. It's riskier to lend to firms, even firms that seem to have pretty sound business models, than to buy T-bills. So by raising expected future tax rates, the government induces a capital strike.

"I suppose we could just wait for all credit-based businesses to either shrink until they can operate on cash or die completely, but that would be both disastrously inefficient and unnecessary."

I wonder if it would be a good idea to tax corporate and private debt so as to encourage capital structures in which equity plays a larger role... Of course, it probably would be nice if individuals shifted their earnings/consumption patterns in favor of save-in-advance rather than buy-now-pay-later. (I wish I had taken my own advice...)

"Now, if a bank felt that the stimulus wouldn't prop up demand or generally reduce their short term downside exposure in some other way, then the fiscal stimulus would do little to loosen credit. If that's Nathan's position, then that's a discussion worth having."

Well, that's part of it. Yes, I don't think many private banks or investors have much confidence that the *fiscal* stimulus (monetary is a totally different story) will prop up demand in the short run. One problem with distinguishing the short run and the long run is that the long-run-oriented parts of the economy are actually the *most* volatile, the ones that drive short-run fluctuations. Thus, right now, there's a collapse in demand for cars, while things like food and gasoline are still in demand. A car is a long-term investment, and people don't want to make it when the future is uncertain. The tsunami of government debt and the panicky overhaul of the US economic constitution through bailouts and guarantees only encourages a "wait and see" attitude. Thus "stimulus" can backfire even in the short run.

And don't forget that government stimulus and private businesses are competitors in the market for loanable funds.

"However, indications are that credit tightening has bottomed out and may even be loosening slowly."

Yes, but none of the policies that account for that are part of what I think of as "stimulus." Monetary policy has been shrewd, far-sighted, bold, and useful. That's the main reason credit is loosening. Bank bailouts and other interventions by Fed and Treasury in the financial markets, though they will likely do long-term institutional damage, have probably played an important role in loosening credit and preventing a deeper meltdown. The fiscal stimulus, with its assortment of tax cuts, infrastructure spending, and pork, most of which won't actually be released until 2010, is hard to link plausibly to any of the improvements.

"Last year, by contrast, the credit markets hadn't tightened to the same levels. The stimulus might have helped us eat up some extra capacity, but it probably put us in a worse position for this year's disaster control."

How so? Just because it put us a little bit deeper in debt? Actually, to the extent that the root cause of the crisis is that Americans' balance sheets show too much red, and considering that much of the stimulus checks seem to have been saved, the stimulus may have been getting to the heart of the problem. Maybe it would have been even more useful in December, or now, but it was a far superior policy to the junk that's been adopted recently.

nato

I think Nathan's assumptions about the ceteris paribus tendency for higher taxation rates to suppress economic activity are far more aggressive than mine. I agree that in cases where taxes begin take two out of three dollars or more that it really starts to demotivate people, but when we're discussing the difference between .32 and .36 on the dollar, I don't see the tax rate as having a noticeable impact on its own. Instead, it's all about 1) (as Nathan notes) the apportionment of activity between public and private activities and 2) competition from tax regimes offered by other polities. Considering that t-bill income and investment income have the same federal tax rates,* it seems like increased federal tax rates would mainly cause a small shift in investment to foreign firms less subject to federal taxes. Corporations can write off losses against taxes as well, so higher taxes doesn't materially change the risk return equation except in terms of flattening out the lines somewhat.

*As far as I know; perhaps there's some obscure difference?

Nathan Smith

"when we're discussing the difference between .32 and .36 on the dollar"

First of all, we're not. In the near future, it's true that we probably won't get big tax hikes. But since nobody has the faintest idea how we're going to pay for the ludicrously vast amounts of money we're spending, it's reasonable to fear that marginal tax rates on the incomes of those who are considering doing things that would put them in high tax brackets could rise to .50 or .60 or .80 on the dollar. That's what FDR did, and now left-wing pundits are citing him as a model. And even if taxes don't rise that high, the threat of increased regulations effectively confiscates more future value from investors. And the government's revenue problems make it more likely that it will use unfunded mandates and other substitutes which, while not taxes, have the same effect of confiscating value. All this gives investors a reason to keep their money as liquid as possible, and not park it in sitting-duck value-creating investments.

And yes, as Nato points out, capital is internationally mobile.

But what really puzzles me about Nato's case for a stimulus is that his main concern seems to be to alleviate a credit crunch. Again, aren't the government and business competitors in the market for loanable funds?

nato

"aren't the government and business competitors in the market for loanable funds?"

Sorta, except a portfolio with a lot of t-bills isn't considered heavily leveraged in the way one with corporate paper might, meaning that more paper can be counterbalanced by more t-bills. Thus, it's something of a license to print money (that must be paid back later, one way or another)

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