Moving away from stimulus happy talk to focus on malinvestment

For the period leading up to the panic last year, I had been warning of a rather severe recession. My view at the time was that what was needed was a realignment of America’s industrial organization away from finance and housing where serious overinvestment meant many firms would fail and asset prices would fall.This turned out to be an accurate view.

However, when Lehman Brothers collapsed in a heap, it was clear to me that we faced a stark choice.  One choice was a deflationary spiral and the associated economic dead weight loss of a non-equilibrating global economy in Depression.  The other choice was a soft depression cushioned by fiscal (and monetary) stimulus. About a year ago I wrote an ode to Keynesian economics called Confessions of an Austrian economist in which I said that I choose fiscal stimulus to cushion the downturn and prevent a depressionary spiral.

The thinking was this: if government buoys the economy, the effects of deleveraging and the bankruptcy of large systemic players need not create a deflationary spiral that leads to a deadweight loss, social unrest or the usurping of democracy by populist autocrats.

But, I am going to move away from the happy talk about fiscal stimulus and re-focus on malinvestment (I have never really talked much about monetary stimulus as a solution).  I am sure many of you saw this coming when I wrote “Stop the Madness now!” last month and I have been signaling my realignment with posts like “A few thoughts about the limitations of government.”

The reason is simple: in theory, fiscal stimulus can cushion the downturn and hasten real recovery by preventing a spiral into a non-equilibrating economic state.  However, in practice, stimulus has been used as an excuse to maintain the status quo, prop up zombie companies and forestall the inevitable.  This only lengthens the downturn, misallocating even more resources to less efficient uses. And all of the worries I had about social unrest, populism, and protectionism are coming true nonetheless.

To be honest, I always knew that the fiscal stimulus game was fraught with risk. Politicians will always use public money in part for their own devices.  However, perhaps I was naive enough to believe this time would be different. Cognizant of the risks of the policy response detailed in my stimulus post, I wrote a post detailing what economist Ludwig von Mises said about stimulus years ago. Here is what he said about the actual efficacy of stimulus as opposed to its theoretical application.

It has often been suggested to “stimulate”economic activity and to “prime the pump” by recourse to a new extension of credit which would allow the depression to be ended and bring about a recovery or at least a return to normal conditions; the advocates of this method forget, however, that even though it might overcome the difficulties of the moment, it will certainly produce a worse situation in a not too distant future.

What you should take away from this quote is exactly what I said earlier: Rather than use the period of fiscal stimulus to promote private-sector deleveraging and saving and to purge malinvestment, politicians will simply use this period as a way to continue business as usual, making the problem even bigger down the line.

Is this not what we have just seen with the too-big-to-fail bank bailouts? Is this not what we witnessed with the Chrysler and GM bailouts? Has my advocacy of fiscal stimulus not been proved wrong? It seems that Mises’ estimation of the likely consequences of stimulus are spot on.

What about monetary policy? Well, in a depression where the constraint is overinvestment, leverage, and debt, the question is not a monetary one.  As Marshall recently suggested, it appears Fed Chairman Bernanke doesn’t understand the basic economics of central banking. Throwing more money into the system will not make credit-worthy borrowers borrow more. Nor will it necessarily induce banks to lend when they fear that many of their prospective borrowers are not credit-worthy.

By lowering interest rates and expanding the money supply, central banks are not inducing more lending; they are trashing cash. You are not promoting saving with 0% rates; you are looking to re-create the asset-based status quo ante. And when there are insufficient lending opportunities, banks are either forced to sit on billions of cash earning nothing or try other ways of making money (proprietary trading, investment in Treasuries, maybe even lending to non-credit worthy borrowers).  Moreover, investors are earning next to nothing as well.  How many people have looked at their money market fund statements with the 0.00% interest staring them in the face and decided to switch into bond, equity or commodity funds? It’s what’s called liquidity seeking return – a major reason the stock market has been buoyed.

So, in future, you will see a lot less chatter about stimulus and the desire to avoid a downturn and a lot more chatter about malinvestment and the need to address the inevitable realignment of investment and resource allocation.

  1. dansecrest says

    I worry when we start to assume that government can’t do things properly, so we don’t even try. In fact, isn’t that a big reason we’re in the mess that we are in now? Because government failed to manage financial markets effectively?

    Being from Detroit, I’m not so sure that the bailout of GM was a big disaster. As far as Chrysler goes, didn’t the govt just facilitate a sale of the company to Fiat?

    I would advocate aid to state governments, allocated on a per capita basis. Also, some New Deal type programs — since they proved effective in the 30s — giving people gainful employment and doing a lot of good work. A payroll tax holiday would also be useful. All of these would be somewhat direct fiscal measures which would boost employment (badly needed for 15-25 million Americans).

    I agree with you in general that we need to fix the problems that caused this mess, and that that doesn’t seem to be happening. So I also advocate some stern regulation and letting the chips fall where they may for banks, homeowners, and stockholders. (GM did go bankrupt and its stock went to $0.)

    1. Edward Harrison says

      But Dan, GM now exists as a result of $60 billion in government aid money. Were it not for this money, the company would have been liquidated. The fact is it was propped up artificially by government to save jobs in a deep economic downturn and the consequences of this are overcapacity in the auto sector. The question is whether that aid is justified longer-term – a complicate subject.

      But in its totality – not just looking at isolated events – it is evident to me that the general aim of most of the aid, fiscal stimulus and monetary easing has been to return the economy to its pre-recession level as quickly as possible. There has been no thought about the need to re-calibrate in finance or elsewhere.

      1. dansecrest says

        I agree that the monetary stimulus hasn’t been well focused, and I’m sure that goes for the fiscal stimulus too, though to a lesser degree (since the fiscal stimulus is generally more focused by default).

        I see your point.

        On the other hand, I’m not one of those anti-government folks. Government seems to be necessary, since the only places without it are not faring very well. So it’s not a question of more or less government; it’s better or worse government. In recent years, we’ve concluded that less is better, but we’ve discovered that less can also be much worse…

        1. Edward Harrison says

          I can agree with that. Government always has a role to play and it can and should play a greater role in times of economic difficulty. The sad thing about what has transpired in the last year is the degree to which trust in government has been damaged. After 8 years of George W. Bush as President, I think it was appropriate for people to think a decent degree of change was forthcoming. However, there has been much less change than anticipated.

          This has discredited government (as an agent which does not act in good faith). Obama’s presidency to date has, thus, been more of a setback to any increased role of government than McCain’s would have been (as we are seeing played out in the healthcare debate). And I do agree that, unfortunately, this distrust is warranted.

      2. dansecrest says

        I’ve been very disappointed in McCain both before and after the election. The man doesn’t have the slightest idea what is going on in the economy…

      3. Anonymous says

        That is what stimulus is. It’s spending money. Low interest rates stimulates spending. If you wanted to promote savings, and deleveraging, you have to increase interest rates much higher than zero percent, but lower rates of course are considered stimulus. Inflationist want to inflate cure the problem with the wrong medicine. The government has to cut spending as well, trim down, so it can lower taxes, and aim for a balanced budget, or surplus. Let’s face it, the government can’t afford itself without debt. So the idea to continue spending to solve a spending problem is fallacious. Of course none of these things are considered stimulus, so I don’t understand your point here. All stimulus does is trade in short term pain for long term pain. Short term pain is very painful, but necessary.

        1. Edward Harrison says

          Let’s distinguish between fiscal and monetary stimulus, anarchist. Monetary stimulus in the form of quantitative easing doesn’t work in a debt deflationary environment. The Fed is pushing on a string. You correctly state that zero rates do not promote saving or deleveraging. So, monetary stimulus is an attempt to re-create the status quo ante.

          On the other hand, fiscal stimulus causes the public sector to deficit spend and, through the financial sector balance, it causes the private sector to net save. See here:

          The question is whether, over the longer-term, the specific stimulus policies lead to desirable outcomes, optimal allocation of scarce resources, a fair distribution of income, longer-term economic growth.

    2. Kirk Kinder says


      I am not sure I agree with your synopsis. The New Deal projects may have provided jobs, but it did nothing to pull the country out of the Depression. Even FDR’s folks admitted that after the war. Today, we have the safety nets in place through unemployment and food stamps so further government spending won’t help in that arena.

      I also think we should take into consideration that government doesn’t function properly when debating whether to continue with government spending. Your statement is essentially saying just because something doesn’t work it doesn’t mean we shouldn’t try it. Well, of course, we shouldn’t try it if we know it doesn’t work. Goes back to Einstein’s definition of insanity.

      You are right that the guv failed to manage financial markets. They caved to the financial special interests to keep derivatives off exchanges and overturn Glass-Steagall. And, they continue to cowtow to the bankers even after the mess last year. So why put more faith into them or give them more power. Again, Einstein’s definition of insanity fits here.

      1. dansecrest says

        Just to be clear– I’m only in favor of the government doing things that I think will work. These things include:
        -Fed money for states, so that states won’t have to lay off workers
        -Payroll tax holiday (would help employers as well as employees)
        -Public jobs for environmental management (worked in Great Depression to give people honest work and do a lot of good public works many of which last until today)

        Anyway, I share your concern about trying things that are not likely to work based upon past experience…

        1. Vangel says

          -Fed money for states, so that states won’t have to lay off workers

          Why should taxpayers be on the hook for the inflated salaries of unnecessary state employees? If you look at the data you seem many people being able to retire from state payrolls at full pensions after only 20-25 years on the job. Those people could not get such high compensation in the private sector, which is where true earnings and taxes come from. For most states the best solution is dumping overpriced employees from payrolls and renegotiating retirement liabilities.

          -Payroll tax holiday (would help employers as well as employees)

          This makes a lot of sense. Cut taxes on employment and you would see more economic activity.

          -Public jobs for environmental management (worked in Great Depression to give people honest work and do a lot of good public works many of which last until today)

          This is a net negative. Making goods and services more expensive for consumers is not a good thing. If environmental projects were economic without subsidies, the private sector would fund them. If not they should not be funded.

  2. MikeNY says

    One should never trust politicians to do the prudent thing…

  3. Matt Stiles says

    Welcome back to the liquidationist camp, Ed. It’s more comfortable over here anyway. No sleepless nights worrying of the innocents being maimed. No logical contradictions requiring mental gymnastics for justification. And no need to defend the indefensible who beg for a return to an undesirable status quo.

    Only justice and the unwavering knowledge of a better future.

    I know you never really left. You got scared – like all of us after seeing the totality of destruction we had set ourselves up for. Hoping not to experience that is only human. But realizing the impossibility of its avoidance is admirable.

    Again, thanks for your blog. And happy holidays.

  4. kynikos says

    “Only justice and the unwavering knowledge of a better future.”

    So the liquidationist camp promises that? Why do you say “unwavering knowledge?” At least Christians say they have faith that Jesus died for their sins and they will be saved from hell (after purgatory for Catholics) after they die. But instead of faith, you say you have “unwavering knowledge” about the future. Why cannot be liquidationist position be realistic? Why should the liquidationist be favored in this Kobayashi Maru scenario?

    1. Matt Stiles says

      I believe that human progress is a natural state of order in our world. Unimpeded, the human desire for profit (not necessarily monetary) will overwhelm any and all adversity.

      But such progress can be impeded by various exogenous forces – things like enormous debt overhangs that limit our ability to invest in the future. Or by despots who seek to misappropriate human progress for their own needs.

      Remove the unnatural impediments and sooner, rather than later, individual humans will better their situations. I have an “unwavering knowledge” of this a priori truth.

      Therefore, any short term pain that would accompany “liquidation” would soon be overcome by the innate human desire for individual betterment.

      After all, I’m not advocating the destruction of anything tangible. If every paper financial instrument were to disappear overnight, humans would wake up the following morning no less wealthy – our existing accumulated capital would still remain.

  5. Anonymous says

    I, too, am appalled at how the Obama Administration – and Congress – have been acting. They are all fiddling while Rome burns. Totally oblivious to the train wreck slowly unfolding right now, and the much worse one we will experience when foreign creditors realize we can’t/won’t repay our debts.

    Back during the Presidential primary season, I wondered how Obama became the “it” story so early in the campaign. Seemed to be a phenomenon driven by the money and the media. Now the cynic in me is once again interested to find out just how he got so much early media attention.

  6. Anonymous says

    Bernanke, advertised as the greatest expert on 1929 etc, seems not to have read much history. I was looking up something in Chernow’s big book on Morgan and found on pp.354-55 this great exchange in the summer of 1932 (before the election) between Leffingwell of Morgan and FDR: “…You and I know,” (wrote Leffingwell,) “that we cannot cure the present deflation and depression by punishing the villains, real or imaginary, of the first post war decade, and that when it comes down to the day of reckoning nobody gets very far with all this prohibition and regulation stuff.” To which FDR replied: “I wish we could get from the bankers themselves an admission that in the 1927 to 1929 period there were grave abuses and that the bankers themselves now support wholeheartedly methods to prevent recurrence thereof. Can’t bankers see their own advantage in such a course?” And then Leffingwell again: “The bankers were not in fact responsible for 1927-29 and the politicians were. Why then should the bankers make a false confession?”

  7. Anonymous says

    I don’t see how stimulus should be used for deleveraging, and savings. That’s the natural thing to do in a economy where massive leveraging, and spending bursts in a bubble. The opposite in the bust, which is the correction is to contract credit, and save money. If you haven’t noticed, the mainstream media, and government academia are very Keynesian in perspective. You will hear words like “animal spirits”, and “liquidity trap”, or “savings glut” in the mainstream media. Most of which these terms came from Keynes the man himself. Keynesianism is only there to keep the unproductiveness going in hopes that it will one day be productive on it’s own again. Stimulus only stimulates the problem. As far as savings, deleveraging, and economic readjustment, that’s something that the market economy can do on it’s own.

  8. Vangel says

    This is much better. The pro-stimulus position should be abandoned in favour of one that is moral, prudent, and defensible.

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