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.