Tuesday, December 27, 2011

My response to Pablo

Recently I wrote a post about David Frum and criticized him for his view on the deficit. Frum argued that the deficit is not an urgent issue, but rather something we can deal with when we want to, when we happen to feel for it, sometime a few years from now or so.

First of all, I'm happy Pablo took the time to respond. I really want us to have more intellectual debates here at RightSpeak and I know that both him and I are trying to contribute to that. Pablo is a fellow conservative whom I respect a lot, in particular for the fact that he always expresses his views even when he knows that they are unpopular.

Now, to the subject:

Pablo assures me that government borrowing to invest in infrastructure would have a positive return, far above 2 %, but ignores one very important thing:

It is impossible to stimulate the economy by investing in infrastructure.

This is because infrastructure investments take so long time. You can't just build a bunch of airports in the middle of nowhere and think that that will somehow help the economy, you have to plan where to build them, how big they should be, how many terminals and gates they should have etc. If we decide to build an airport today, it may well take five years or more before it's actually finished and actually contributing to the economy. Since the point of stimulus is to help the economy NOW, not in five years when the economy might have recovered on its own and might be on its way to becoming overheated, it doesn't really work.

Yes, we'll create a few jobs for architects in the meantime, and after they've made the layout for the airport we'll create a few more jobs for construction workers, but the real contribution to the economy that an airport provides comes once it's finished - and like I said, that's way too late to be considered an efficient stimulus in a recession.

The same goes with railroads (where to put them, how to deal with houses that might be in the way etc), roads (where, what kind of roads etc) and basically every other infrastructure investment. They're too slow.

There is another problem too: Political corruption and waste. Even if there is a great need for more railroads in America - and I don't doubt that - that's no guarantee that politicians will have the good sense to build railroads in the right place. A perfect example of this is the John Murtha airport, with only three commercial flights but plenty of tax money. I doubt it has a stimulating effect on the economy.

Even if the government were building railroads, who's to say they won't just end up building a connection between hippietown and liberalville (population: 224)?

Some people claim that the market isn't good at infrastructure, and that it constitutes a "market failure". What they forget is that a market failure does not equal a government success. Many times, the market fail, and the government steps in and makes everything worst. Generally, the pains of a market failure are far more endurable than the pains of a government failure. If there is a demand for railroads, they will be built. The biggest problem really is environmental regulation and similar that scares away entrepreneurs who don't want to get sued by PETA. But that's an issue for another day.

Next, Pablo claims that demand for government debt is the highest since 1995. That might be, I don't know, but as one of the commenters pointed out, this is not because of trust in the US government but because of mistrust in the market. If you don't believe in the stock market and don't feel that you know enough about commodities to invest in that market, then your options are limited. Buying american bonds until the stock market improves makes perfect sense, because even though american bonds carry with them a nowadays not insignificant default risk, that's nothing compared with the stock market. It's still the safest investment around, investors figure, and so they all buy bonds - pushing the yields down. I actually explained in my first post why the US can borrow at 2 %, Pablo unfortunately couldn't be bothered to comment on my explanations. Another thing we should notice is that the 10-year yield is only based on expectations about the coming 10 years. I would agree that the risk that the US will default within ten years is rather small, but then it increases exponentially as social security and medicare payments start to really get out of control between 2020-2030. 10-year yields don't reflect this yet, but give it a few years and I promise you they will. Again, like I wrote in my original post, you cannot deal with government debt the way you deal with private, corporate debt. For a company, lending just for the sake of it when interest rates are low can make perfect sense, but that does not translate to governments.

In addition, since the uncertainty in the stock market is one of the things that are pushing investors towards bonds, this means that once the economy and hence the stock market recovers, bond yields are likely to rise, possibly sharply as investors go back to the stock market. But even if the economy recovers, the US will still be running a huge deficit - revenues aren't set to increase to 3.8 trillion any time soon. So a recovery, ironically, can be very costly for the US government. At the same time, without a recovery, the deficit will remain even bigger (though with a lower interest rate). It's really hard to see how this can get a happy ending.

Unfortunately Pablo, to borrow at 2 % with the intention of only borrowing as long as rates are low is not going to work. The US and its population is currently "getting used" to a 1.6 trillion deficit, and federal spending at 3.8 trillion all in all. Do you think if, in a couple of years, 10-year yields are at 6 % that voters will suddenly accept a 1.6 trillion spending cut? Do you think anyone in congress would be brave enough to suggest it? Right now, the average voter is horrified that the government is spending 3.8 trillion dollars per year. Just like the average voter once was horrified that the government decided to introduce an income tax. But give it a few years, and they get used to it. The average voter doesn't even know what a bond yield is, what they mean and how they work. We must cut spending before spending nearly 4 trillion dollars a year becomes "normal", at which point it will be too late and the US will have doomed itself to bankruptcy and poverty.

I have a paper published by the European Central Bank that I really think you should take a look at Pablo. It's called “The impact of high and growing government debt on economic growth”, and it basically concludes that once debt reaches 90-100 % of GDP, adding debt will have a negative effect on economic growth. And that's exactly where the US is right now. I originally read it because I'm writing an undergrad thesis on the topic of government debt. This is economic research, proving me right and you wrong, Pablo.

Developing a plan to cut spending after 2014 is not going to cut it, for several reasons. The main one being that we've heard that before. We'll cut spending tomorrow, we promise. And we'll also go on a diet... next week. And quit smoking... starting january 1st. And look over our retirement savings... yeah, you get it. It's not credible because it's been said so many times before, but it's never done. No investor will trust it, and no employer either. The fiscal crisis is burdening the US economy, and unemployment in particular, and promising to begin to solve it in a few years is just not going to cut it. Promising a VAT-or-something in a few years is not enough. The market has lost confidence in that the US government can stimulate the economy, having seen it try and fail for years. Restoring confidence ought to be priority number one for a Republican president, and repeating what Obama has said for years: "We'll solve it tomorrow" isn't going to do that.

There is another issue that Pablo is ignoring when he argues for more stimulus: Government dependency. When you increase spending, you create a dependency on government and an expectation that government will solve all problems. This is insane as the market already has a natural cleansing mechanism which makes sure that unprofitable businesses go out of business and resources are freed up to be used by the efficient, profitable businesses. As conservatives, we ought to be against government dependency and want as many people as possible to not have to rely on the government for their income - whether that income is in the form of a welfare cheque or in the form of a salary paid by stimulus money. You can count on a lot of "temporary" stimulus jobs to soon become permanent positions, if history is any guide. Can we really tolerate that government grows permanently every recession? I don't think so and I really hope everyone agrees. But that is a consequence of stimulus spending, and that's a big reason why we have to oppose it.

On a final note, in the beginning of his post Pablo draws a distinction between borrowing to build a welfare state and borrowing to stimulate the economy. I'd argue that borrowing to build a welfare state is significantly more productive than borrowing for the purpose of stimulus. Plenty of welfare states have really low levels of government debt (Denmark, Sweden, Norway, Finland...), and in welfare states, people are used to tax hikes and so if there is any trouble paying back debt, politicians can simply raise taxes and they won't risk getting voted out of office for it. The welfare state has certain benefits after all, that the stimulus does not. While in a welfare state, at least you get free health care and education, stimulus programs do nothing to help the economy but lead to a permanent increase in bureaucracy. I'm not a fan of the welfare state, but borrowing to subsidize education makes a lot more sense to me than borrowing to build another John Murtha airport.

This will do for now. Mr Pablo, the ball is in your court.


Pablo said...

Bravo, John. Yes, the ball is in my court now. It make take a few days, but eventually I will serve it back to you. Good essay. You are a formidable debater!

John said...

Thank you Pablo! You're a fantastic debater yourself.