Friday, December 30, 2011

Stimulus Debate: Round five

Round one (From John)
Round two (From Pablo)
Round three (From John)
Round four (From Pablo)

First, this whole stimulus debate got me thinking of a video published earlier this year by Econstories. If you haven't yet seen it, this is a great time:

Now, on to Pablo's post:

Pablo makes an important point about transportation and how there are more "shovel-ready" projects when it comes to highways. These projects take less time to plan, in particular if they only involve reparations, and they can indeed be highly economically efficient. I agree it's hard (although not impossible) for the private sector to build roads and highways, although I believe the private sector to be fully able to build and maintain railroads and airports (since it's easy to restrict access to those, which is not the case with regular roads).

So far we agree. Here's where I differ with Pablo: I believe we can make efficient public investments while cutting the deficit. Instead of passing another 800 billion dollar stimulus package, of which again probably around 50 billion will be spent on transportation (and the other 750 be wasted), I believe we should cut some wasteful spending, let's say 400 billion the first year, and then increase spending on transportation by let's say 100 billion. The positive short-term effect from the transportation spending will help outweigh some of the possible negative short-term effects that come from cutting the other spending.

The department of defense in particular should have its budget reduced significantly as the US is no longer in Iraq, but even if that wasn't the case, Pentagon is probably the biggest wasters in the entire federal government. I believe they got more paperpushers than they got soldiers.

Of course, the US will have to cut some spending that isn't technically waste yet not affordable given the circumstances. This is going to be a frankly heartbreaking task as it will mean firing federal employees who don't deserve it and who may have a hard time finding another job. Yet, it has to be done or we'll have do go through with even more heartbreaking measures in the future.

I also think you Pablo misrepresented my position a little bit when you said that "John has made the assertion that the United States government should not borrow any more money". I believe it's impossible to balance the budget in one year (even Ron Paul acknowledges that), but i believe the US needs to cut spending starting NOW. Not in 2014, but now. I believe the budget could be balanced in 5-7 years or so if we start now. In the meantime, of course the US will have to borrow some more.

The biggest problem with postponing spending cuts can be summarized in a single word: Expectations. If no-one believes the spending cuts will come, then everyone will act as if they won't. This will exasperate the problems with more and more investors starting to expect the US to go bankrupt. Also no-one trusts the stimulus programs anymore. There has been a lot of them and they've had no measurable positive effect. By chosing more stimulus over budget cuts, the US shows itself to be absolutely tone-deaf to the market signals sent by the falling stock markets and the high unemployment. Do we really want investors to think we're ignoring their concerns?

I'm happy you agree with my assessment regarding why bond yields are so low. However, you also appear to dismiss the importance of this subject when you state that the only thing that matters is that they are low, and not why. Any sales manager can tell you that the source of demand is highly important: Is demand increasing because customers are appreciating our product more than they did before? Because customers are getting richer? Because our competitors are getting worse? Every "source" demands a different course of action. Most of all, understanding the source of the additional demand will help answer the question: Will it last?

In the case of the US, we agree (I think) that the answer is no. Now the difference is that I think it will be much easier to keep the low interest rates if the US starts cutting spending now. Let me explain: Whatever we do, if we choose your path or my path, we'll have to borrow money for a couple of more years. Let's say the US will have to borrow at least another 5 trillion dollars before the budget is balanced - not unrealistic at all I think, might even be an underestimation. Now how do we ensure that we get as low as possible interest on these 5 trillion? A 1 % difference in yield will be huge because of the amount that will have to be borrowed.

Let's do the math: 2 % interest for 10 years on 5 trillion: 1.02^10 x 5 000 000 000 000 = 6.09 trillion dollars.
To be contrasted with 3 % interest for 10 years on 5 trillion: 1.03^10 x 5000 000 000 000 = 6.7 trillion dollars.

The difference is just above 600 billion dollars. And once interest rates start to spike, there's really no ceiling they can't break. Just ask Ireland. They were borrowing at 2-3 % as late as 2007, and this year interest peaked at 14.3 % (just FYI, borrowing 5 trillion at 14.3 % means having to pay back 19 trillion). Bond yields can be very volatile and are driven to a large extent by gut feelings, because the risk of default cannot be calculated very precisely mathematically. Right now, investors feel the US will be able to handle this debt crisis. I suggest we don't give them a single reason to re-evaluate that feeling. Once it's gone, it may very well be too late to cut and you may have to make very severe cuts very fast to again convince the markets that you won't go bankrupt. Even then it might not be enough.

There are two bond market equilibria: A good equilibria and a bad equilibria. The good equilibria is when bond yields are low because markets expect the US to be able to pay back its debt, and the low yields then help making sure the US can pay back its debt. The bad equilibria, as you may suspect, is the exact opposite: High yields because markets don't expect the US to be able to pay back its debt, and the high yields just like the low yields becomes a self-fulfilling prophecy.

In short: The US can't wait with cutting the deficit because even once you start cutting, it will take a long time to balance the budget and you'll have to borrow money to stay solvent during the time it takes to balance the budget. And if you've lost the trust of the market, believe me that will be expensive. Ireland began to cut spending in 2009 and yet bond yields kept going up, peaking this summer. Only recently have they began to fall back as Ireland finally managed to convince the world that they were serious about the deficit. Yet, yields remain stubbornly above 8 %.

Regarding taxation, we agree (and we're probably alone on this site) that all options must be on the table. Yet, a VAT on top of all the other taxes would not be my first choice. It would have a positive effect in boosting consumption temporarily (if you announce that "on january 1st 2013 everything will become 5 % more expensive" people will be sure to buy that TV, lawnmower and fridge they've been thinking about buying before then). I think we should go the other way and instead of making taxation even more complicated by adding a tax on top of all the others, we should just scrap the tax code and introduce the FairTax. The FairTax can then if necessary be raised, creating more revenue for the government AND a temporary (sometimes well-needed) boost in consumption resulting from people consuming as much as possible before the raise. It would save about 500 billion all in all in administration costs that this tax code causes. and that's 500 billion the US economy could really use right now. I would however accept a VAT if the Democrats agreed to a major entitlement reform or similar in return.

It is also important that americans understand that a lot of the problems in the US economy actually comes from the Eurozone crisis, which I've written about extensively. The US fiscal crisis is not only caused by weak domestic demand - this crisis is global. It's hard to see how the US can stimulate itself away from this crisis when such a large chunk of it is caused by events on the other side of the Atlantic. The Eurozone is not like Las Vegas: What happens there doesn't stay there. It spreads all over the globe.

Finally Pablo repeats what he said in his first answer: That this is a recession like no other, like the Great Depression in the 1930's. This is conveniently ignoring that, like I said in my first post, this recession ended back in june 2009 - before virtually any stimulus money was spent. So no stimulus money was needed to end the recession, and even trillions of it haven't been able to create a boom. Yet you suggest more stimulus will cure us from this 1930's nightmare we're supposedly in. I respect your opinion but I seriously can't understand how that makes sense to you.

We do need a good leader, and just like you, I believe Romney would make a good president - in particular in economic issues. He's a turnaround artist, after all. I think he should start turning around America's deficit starting the 20th of january 2013.

We just can't afford to wait.

John Gustavsson

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Pablo said...

Once again, nice job. It make take a couple of days for me to respond. Maybe we can go one or two more rounds and then pick another topic.

John said...

I'm thinking the next post should be your "final statement" and my answer my final statement if you don't mind. I think we've made ourselves clear :) And I'd love to continue with another topic, I really love these more intellectual debates.

Pablo said...

Sounds good, I will prepare something soon. Maybe a day or two.