Wednesday, January 13, 2010

Things I learned in 2009 Part II

It's approaching the one year anniversary since the 800 billion dollar stimulus plan went into effect in the US. In that time, I transitioned from a Keynesian to an Austrian in terms of my understanding of economics. This new viewpoint involved unlearning everything I was taught in economics in university. To clarify my new understanding, I'd like to examine the stated goals and mechanism of the stimulus plan compared to it's results
Here are some predictions last year from Christina Romer and Jered Bernstein, Chairs of Economic Advisers for President Obama. The relevant part is the prediction that the stimulus will create 3 million jobs with a total 138 million jobs. Their claim is that without the stimulus, there will be 8.8 percent unemployment and only 134 million jobs. All these benefits for only 800 billion dollars.

So, what happened?
It's true that these are predictions for later this year, but so far unemployment is worse with the stimulus than was predicted without! It was claimed without stimulus unemployment would be 8.8% (it's now 10% after stimulus or 17% depending on how you measure it.) Either the economic advisers are incompetent and have no business spending hundreds of billions of borrowed dollars, or the economic theories they employ are completely wrong.

The Keynesian theory behind all this stimulus is that a dollar spent by the government is multiplied through the economy depending on what it gets spent on. A dollar that gets spent building a road goes into a contractors pocket who then spends that money on groceries etc. This is said to stimulate demand causing employment to rise. The increased demand provides work that more than makes up for the costs of the stimulus by reducing the length of economic downturns and those returning workers are paying taxes sooner than they would have otherwise. So says the dominant economic thinking with plenty of fancy math to back it up.

What has become clear to me this year is this just makes no sense.

How the Economy Got This Way
Over the last ten years, the value of the dollar was diluted through unsustainable low interest rates. It was intended to stimulate the economy after the bursting of the tech bubble and the consumer demand crash after 9/11, remember Bush telling people to go out and spend? The Federal Reserve flooded the market with easy credit and money flowed into real estate and the markets. Bidding wars for property and assets continued for almost ten years but the value of these assets were not due to increasing wealth but money supply. The artificially rising assets were being leveraged by banks loaning out the appreciation on assets that were not payed for. Demand was a function of credit.

Peter Schiff tells a great story about renting a beautiful condo during the housing bubble. He goes next door to look at a dingy townhouse for sale. After fees, taxes and mortgage, he would be paying the same as renting his current place. He asked the real estate agent who would buy it since you could rent next door and get way more for less money? The agent said that the townhouse will be worth more next year while Schiff won't have gained any equity in his rental. Schiff questioned in disbelieve why anyone would pay even more next year for a place that isn't nicer than one you could rent next door! The real eastate agent should have said that Ponzi schemes are only bad if you get in at the end!
This story illustrates the disconnect between real estate demand (prices) and the wealth needed to trade for it (it was credit driving prices-not wealth.) When we moved to Calgary a few years ago, I could barely believe that 150,000 dollar houses were being sold for 400, 000 dollars. During the hot economy in Calgary it was easy to imagine that price was a function of demand. Hidden from view was the expansion of credit fueling the larger economy, driving up commodities and the demand for goods being bought not with savings but with credit against rising asset prices. A vicious circle sponsored by the Federal Reserve.

As it turns out, what I witnessed was the Austrian School explanation of the business cycle. The Austrian School explains that inflation occurs due to deflating money by printing it or creating more of it through fractional reserve banking. This increase in money creates the business cycles and bubbles that eventually burst.
Investments are like fruit, the lowest ones get picked first (the ones that have the best return.) The more money that becomes available to invest, the more difficult fruit gets picked (the poorer those returns become.) Artificially low interest rates and surplus money and credit cause malinvestment (the fruit that no one is picking because you need a ladder.) In the end, if you give people money to buy fruit, fruit prices rise and a valuable ladder was not used somewhere else.
The Austrian school is better explained by more lucid and elegant thinkers than I. The vonMises Institute offers many elegant and simple primers.

Multipliers are not Immune from Opportunity Cost or Inflation
I've come to realize economies are like any other natural system, you can't cheat them. You can try to stay up for a while drinking coffee but eventually, you fall asleep. You can't artificially create wealth out of thin air by taxing and borrowing money, then spending it. Any multiplier effects are offset by the opportunity costs of taxpayers keeping more money themselves. In a downturn, people are more likely to save money which is where future capital comes from. Multiplier effects are also condemned because they create artificial demand which diverts resources away from profitable, wealth-generating projects. This diversion has real costs that greatly offset any multiplier effects. If stimulus projects were economically feasible, the market would be investing in it. They are by definition malinvestments! Meanwhile, the creation of this stimulus money devalues savings through inflation (America's next financial meltdown that nobody saw coming.) This massive devaluation effects people who worked hard and didn't invest in speculative housing or derivatives, whose only crime was to save money! This inflation is not seen yet because prices are falling relative to the Fed attempt fight falling asset prices though the creation of money. Also, the Fed is currently paying banks to hold even greater of their reserves in the Fed Reserve system. The only way they can pay banks not to lend money is to issue more money which forces the Fed to force the banks to deposit even more money with the Fed in a never ending borrow from Peter to pay Paul situation!

Apart from witnessing the Austrian explanation first hand, so much of macro economics makes more sense through the Austrian lens. In the stimulus bill mentioned earlier, Keynesians are left to make ad hoc explanations of why injecting billions of dollars into an inflated economy isn't making things better. They say that things would be worse without it or it will take more time or that there wasn't enough stimulus! Now I understand that the last ten years prosperity was based on an economy inflated by the creation of money not just the addition of capital to labour and resources. The solution is not to add more inflation. The solution is to let the malinvestments fail, let real estate devalue to a new equilibrium price, let people pay down debt rather than consume. Adding more money just delays the necessary price adjustments, creates inflation, and diverts resources. The rising unemployment demonstrate the error of trying to re-inflate the economy.

At best, the results have been incompetence, mis-allocation, savings devaluation, inflation, and the squandering of scarce resources. At worst is opportunism, graft, theft, collusion, fraud, dishonesty, and lies.


and then the_doctor said...

With many thanks to Vin who planted the Austrian School in my head last year with much early resistance on my part.

Vincent said...


You are a more patient man than I, to go to the trouble of authoring this post for the benefit of those who won't read the primers.


and then the_doctor said...

It was an exercise more for my own benefit to clarify and focus my own thoughts. More work to do still in that regard.