Stimulus and the great recession

Stimulus and the great recession Sinclair Davidson

On the use of language Economics, Finance and Marketing

Adam Smith on Government • The statesman who should attempt to direct private people in what manner they ought to employ their capitals, would … assume an authority which could safely be trusted, not only to no single person, but to no council or senate whatever, and which would nowhere be so dangerous as in the hands of a many who had folly and presumption enough to fancy himself fit to exercise it. (Book IV, Chapter II) • It is the highest impertinence and presumption, therefore, in kings and ministers, to pretend to watch over the œconomy of private people…. They are themselves always, and without any exception, the greatest spendthrifts in the society. Let them look well after their own expence, and they may safely trust private people with theirs. If their own extravagance does not ruin the state, that of their subjects never will. (Book II, Chapter III) Economics, Finance and Marketing

Adam Smith on Economic Growth • Great nations are never impoverished by private, though they sometimes are by publick prodigality and misconduct. The whole, or almost the whole publick revenue, is in most countries employed in maintaining unproductive hands. Such are the people who compose a numerous and splendid court, a great ecclesiastical establishment, great fleets and armies, who in time of peace produce nothing, and in time of war acquire nothing which can compensate the expence of maintaining them, even while the war lasts. Such people, as they themselves produce nothing, are all maintained by the produce of other men's labour. … Those unproductive hands, who should be maintained by a part only of the spare revenue of the people, may consume so great a share of their whole revenue, and thereby oblige so great a number to encroach upon their capitals, upon the funds destined for the maintenance of productive labour, that all the frugality and good conduct of individuals may not be able to compensate the waste and degradation of produce occasioned by this violent and forced encroachment. … (Book II, Chapter III) Economics, Finance and Marketing

Adam Smith on Economic Growth • The annual produce of the land and labour of any nation can be increased in its value by no other means, but by increasing either the number of its productive labourers, or the productive powers of those labourers who had before been employed. The number of its productive labourers, it is evident, can never be much increased, but in consequence of an increase of capital, or of the funds destined for maintaining them. The productive powers of the same number of labourers cannot be increased, but in consequence either of some addition and improvement to those machines and instruments which facilitate and abridge labour; or of a more proper division and distribution of employment. In either case an additional capital is almost always required. (Book II, Chapter III) Economics, Finance and Marketing

The role of fiscal policy • Fiscal policy represents the spending and taxation (including borrowing) decisions taken by government. • Provision of public goods. • Provision of merit goods. • Redistribution. • Question: should fiscal policy be used as a tool to manage the economy? • Can fiscal policy be used for counter-cyclical policy? • Yes. • Keynesian theory suggests that government can successfully intervene in the economy. • No. • Ricardian equivalence suggests that government cannot successfully intervene in the economy. Economics, Finance and Marketing

A digression on the Great Depression • Popular Understanding of the Great Depression • Capitalism lead to excesses in the 1920s. • Economic growth was unsustainable. • Stock Market crash of 1929 started the depression. • Irresponsible application of orthodox policy worsened the depression. • FDR saved the world by spending. • A slightly more sophisticated view would have FDR and JM Keynes saving the world. • When FDR did try to balance the budget he made things worse. • WWII ended the Great Depression. Economics, Finance and Marketing

Popular Understanding of the Great Depression • This is a very American view of the Great Depression. • Probably exported to the world by popular culture and Hollywood. • But even as a history of the US it is misleading. • Amity Shlaes in The Forgotten Man: A New History of the Great Depression has a far more nuanced view of the Great Depression (pg. 392). • ‘But what really stands out when you step back from the 1930s picture is not how much the New Deal public works achieved. It is how little. … The story of the mid-1930s is the story of a heroic economy struggling to recuperate but failing to do so because of perverse federal policy. The worst factor was Roosevelt’s war on business. But one can also make the argument that lawmakers’ pre-occupation with public works got in the way of allowing productive business to expand and pull the rest forward.’ • In February 1931 Ludwig von Mises had written • ‘All attempts to emerge from the crisis by new interventionalist measures are completely misguided. There is only one way out of the crisis: Forgo every attempt to prevent the impact of market prices on production.’ Economics, Finance and Marketing

The Great Depression in America Source: Angus Maddison. 1990 International Geary-Khamis dollars Economics, Finance and Marketing

What Happened to Government Spending? • Source: Bureau of Economic Analysis Economics, Finance and Marketing

Source: FT August 11 2009 Randall Kroszner “In 1936-37, the Federal Reserve made a colossal mistake in its “exit strategy”. This time round it is crucial that central banks get their timing right. Seventy-three years ago, fearing the large accumulation of reserves held by the banks at the Fed could result in an “uncontrollable expansion of credit in the future” if the banks decided to lend out those reserves, the Fed raised reserve requirements to absorb them. This sharp tightening of monetary policy stopped the robust recovery that had been in train since 1933, precipitating a “double-dip” contraction in 1937-38, which according to Milton Friedman and Anna Schwartz in their 1963 book A Monetary History of the United States, 1867–1960 “was one of the sharpest on record”.” What happened in 1936-37? Economics, Finance and Marketing

Causes of the Great Depression • Stock standard recession. • Amplified by monetary policy mistakes. • Incorrect application of Gold Standard leading to US and UK inflation. • Animal spirits. • Excesses of capitalism. • Austrian Theory. • Both the Monetary theory and the Austrian Theory posit that policy errors lead to the Depression. • Increasing Tariffs etc. exacerbated a bad situation. Economics, Finance and Marketing

An Austrian Explanation of the Great Depression Economics, Finance and Marketing

An Austrian Explanation of the Great Depression • Putting the model through its paces Economics, Finance and Marketing

Australia in the Great Depression • Source: Angus Maddison. 1990 International Geary-Khamis dollars Economics, Finance and Marketing

Australia in the Great Depression • Australia and the US Compared Economics, Finance and Marketing

Australia in the Great Depression • Source: Steve Kates, ABS Economics, Finance and Marketing

Australia in the Great Depression • Unemployment Compared to US Economics, Finance and Marketing

Australia in the Great Depression • You’ll notice the Australian turning point is very marked. • What Happened in 1931? • Australia went off the Gold Standard. • Australia adopted the ‘Premiers’ Plan’. • Kevin Rudd on the Premiers’ Plan • ‘The alternatives [to the stimulus packages] were to do nothing or, worse, effectively replicate the Premiers' Plan of 1931 when governments cut expenditure, thereby compounding the problems created by a private sector already in retreat. The result, of course, was an economic rout, appalling unemployment and a decade of negligible growth through the 1930s.’ • This statement is completely at odds with Australian economic history but not political history – the ALP government was thrown out of office. Economics, Finance and Marketing

Australia in the Great Depression • The Premiers’ Plan • Reduction in government spending of 20 percent. • Increase in Commonwealth income tax and sales tax. • Reduction in interest Rates. • Spending cuts were deeper that tax rises. • Commonwealth ran a budget surplus from ‘ordinary transactions’ for the period 1931/2 onwards. Economics, Finance and Marketing

Australia in the Great Depression • Is the turning point (just) due to going off gold? Economics, Finance and Marketing

Lessons learned from the Great Depression • Lesson learned from the Great Depression: • Keynes’ contribution: Replace the decline in private aggregate demand with increased public spending (and debt). • Friedman’s contribution: Keep the stock of money in circulation from declining to ensure that monetary liquidity is maintained. • Are those good lessons to have learned? • What about these lessons? (Gwartney) • Avoid these policies: • Monetary contraction. • Trade restrictions. • Tax increases. • Constant changes in policy; this merely creates uncertainty and delays private sector recovery. Economics, Finance and Marketing

The Global Financial Crisis or Great Recession • The GFC began in mid to late 2007. • August 7, 2007 Banque Paribus freezes two hedge fund accounts. • September 6, 2007 Northern Rock bailout. • March 15, 2008 Bear Sterns Rescue. • September 7, 2008 US government seizes control of Fannie Mae and Freddie Mac. • September 15, 2008 Lehman Brothers files for bankruptcy. • September 16, 2008 AIG bailout. • September 21, 2008 TARP proposed. • September 23, 2008 TARP rejected. • September 24, 2008 Ben Bernanke appears before Congress; President Bush on national prime time television. • October 3, 2008 TARP Legislation passed. • February 17, 2009 American Recovery and Reinvestment Act passed. Economics, Finance and Marketing

Bernanke to Congress September 24, 2008 • “Despite the efforts of the Federal Reserve, the Treasury, and other agencies, global financial markets remain under extraordinary stress. Action by the Congress is urgently required to stabilize the situation and avert what otherwise could be very serious consequences for our financial markets and for our economy. In this regard, the Federal Reserve supports the Treasury's proposal to buy illiquid assets from financial institutions. Purchasing impaired assets will create liquidity and promote price discovery in the markets for these assets, while reducing investor uncertainty about the current value and prospects of financial institutions. More generally, removing these assets from institutions’ balance sheets will help to restore confidence in our financial markets and enable banks and other institutions to raise capital and to expand credit to support economic growth.” • No wonder markets panicked. Economics, Finance and Marketing

Was all this necessary? • Roger Congleton (2009) • Much of the data associated with the recession of 2008, however, suggests that the term “crisis” was overused in mid-2008, although that term did trigger rapid, although not necessarily well-considered, responses from government. The first year of the present recession was caused by routine responses of consumers to wealth reductions associated with the end of the real estate and stock bubbles, and by the usual adjustment of firms to reduced consumer demand. Two of the three major U.S. markets for credit performed more or less normally. Moreover, much of the policy response also has been fairly routine. The Federal Reserve reduced interest rates and expanded the monetary base. Congress extended benefits for the unemployed and increased government spending (and deficits). Many bank failures were addressed by the FDIC through mergers, some of which were subsidized with FDIC reserves. • There is some evidence that the “Great Depression” rhetoric used to secure passage of the bailout bill exacerbated the credit problem and the recession. Because individual investors and firms naturally assume that Treasury experts have the very best data, the risk of another Great Depression apparently was “new news” to many of them. Economics, Finance and Marketing

Shitstorm – the Australian experience • January 10, 2008 Wayne Swan becomes aware of crisis after call from Hank Paulson. • January 21, 2008 Kevin Rudd identifies financial crisis as problem, but less so than inflation. • February 6, 2008 RBA raises interest rates. • February 29, 2009 Rudd asks Ken Henry for some worst case scenario planning. • March 5, 2008 RBA raises interest rates. • August 5, 2008 Rudd organises meeting of gang of 4 to discuss fiscal stimulus. • September 3, 2008 RBA cuts interest rate. • September 21, 2008 Government bans short selling. • October 7, 2008 Gang of 4 meet in Brisbane to discuss stimulus • Gillard and Tanner learn of advanced plans Economics, Finance and Marketing

Shitstorm – the Australian experience • October 8, 2008 RBA drops interest rate by 100 basis points. • October 9, 2008 Tanner is told stimulus plan will go ahead by his department secretary. • October 11 – 12, 2008 Gang of 4 and bureaucrats discuss Stimulus I (Swan from US and Tanner from Melbourne). • October 12, 2008 Government guarantees bank deposits. • October 14, 2008 $10.4 billion stimulus package announced. • November 5, 2008 RBA drops interest rate by 75 basis points. • February 3, 2009 $42 billion stimulus package. • February 4, 2009 RBA drops interest rate by 100 basis points. • February 9, 2009 Senate Inquiry into Stimulus package – 3 economists appear for 10 minutes each. • April 8, 2009 RBA drops interest rate by 25 basis points • October 7, 2009 RBA raises interest rate by 25 basis points. Economics, Finance and Marketing

Doing the Time Warp • Richard M. Salsman • If there is anything more tragic than our current banking crisis, it is that the crisis is being blamed on the wrong group, on the bankers, instead of on the primary culprit, government intervention. The tragedy lies in failing to identify the fundamental cause of the problem, thereby ensuring its continuance. Bankers are not entirely innocent of wrongdoing in the present debacle, but to the extent that bankers have been irresponsible, it has been primarily government intervention that has encouraged them to be so. … Government has created these banking crises – by making it nearly impossible to practice prudent banking. Having done so, government has then pointed to bad banking practices as sufficient cause for still further interventions in the industry. Economics, Finance and Marketing

Doing the Time Warp • Richard M. Salsman • If there is anything more tragic than our current banking crisis, it is that the crisis is being blamed on the wrong group, on the bankers, instead of on the primary culprit, government intervention. The tragedy lies in failing to identify the fundamental cause of the problem, thereby ensuring its continuance. Bankers are not entirely innocent of wrongdoing in the present debacle, but to the extent that bankers have been irresponsible, it has been primarily government intervention that has encouraged them to be so. … Government has created these banking crises – by making it nearly impossible to practice prudent banking. Having done so, government has then pointed to bad banking practices as sufficient cause for still further interventions in the industry. • These words were written in 1991! • They could have been written to describe the current crisis. Economics, Finance and Marketing

The Global Financial Crisis • Causes of the Global Financial Crisis • Bubbles: Very unsatisfactory explanation. • The Krugman Hypothesis: ‘Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble.’ • Imbalances: It is true that there are various imbalances in the international economy, many of these are due to various government interventions to prevent prices from fully reflecting economic conditions. • Financial Deregulation: The idea that the financial system is very deregulated has taken hold. Financial deregulation is a mythical beast. • Minsky moment: • The Efficient Market Hypothesis: Very confused explanation. • Greed: Trivially true, yet what is lacking is an explanation for the sudden outbreak of greed. ‘Greed’ is a constant. • Government intervention: A perverse incentives argument is likely to be able to explain much of origins of the crisis. Economics, Finance and Marketing

The Global Financial Crisis • Inappropriate Monetary Policy • Inappropriate Housing Policy Economics, Finance and Marketing

The deterioration in lending standards • In the 1970s US social justice activists alleged that banks and other financial institutions were discriminating against minorities – usually African Americans and Hispanics – in a practice known as ‘redlining’. • The Home Mortgage Disclosure Act (HMDA) required banks and financial institutions to collect and report data on their mortgage applicants. • The Community Reinvestment Act (CRA) of 1977 required banks and financial institutions to conduct business over the entire geographic region where they operated. • In 1992, the Boston Federal Reserve produced a working paper, subsequently published in the prestigious peer-reviewed American Economic Review that provided empirical evidence showing that banks were discriminating against minorities. Economics, Finance and Marketing

The deterioration in lending standards • Banks were directed by government policy choice to make loans they otherwise would not make and were able to on-sell the loans. • This type of government action assumes that politicians and bureaucrats can better understand and manage financial institutions than the management of those organisations. • It also makes the assumption that lenders dislike minorities more than they like making profit. • Financial markets have historically been very competitive so this form of discrimination would be very unprofitable and would likely not survive long. • Those individuals making the redlining argument have never explained how and why it survives. Economics, Finance and Marketing

The deterioration in lending standards • It subsequently transpired that the data used in the 1992 Boston Fed paper was deeply and fundamentally flawed. • Unfortunately they never made their entire data set public. There was a series of academic papers that criticised the Fed report. • One 1994 study looked at a very small sub-sample of the data yet found that more than half the observations contained serious errors. • The definitive study the Boston Fed report was conducted by Theodore Day and Stan Liebowitz and was published in the 1998 Economic Inquiry – also a peer reviewed journal. • That study found that after correcting the most severe data errors that no evidence of racial discrimination could be found – banks and other financial institutions had not engaged in redlining. Economics, Finance and Marketing

The deterioration in lending standards • The Boston Fed had published a document in 1993 entitled ‘Closing the gap: A guide to equal opportunity lending’; it is still available on their website. • ‘Even the most determined lending institution will have difficulty cultivating business from minority customers if its underwriting standards contain arbitrary or unreasonable measures of creditworthiness.’ • ‘Policies regarding applicants with no credit history or problem credit history should be reviewed. Lack of credit history should not be seen as a negative factor.’ • Stan Liebowitz • Those “outdated” standards existed to limit defaults. But bank regulators required the loosened underwriting standards, with approval by politicians and the chattering class. … It also let community activists intervene at yearly bank reviews, shaking the banks down for large pots of money. Banks that got poor reviews were punished; some saw their merger plans frustrated; others faced direct legal challenges by the Justice Department. Economics, Finance and Marketing

Partial mea culpa • Lawrence Lindsey, former member of the Federal Board of Governors • The regulatory community was placed under intense political pressure to come up with ways of providing access to credit for those populations, and did so, most notably with new rules under the Community Reinvestment Act. I was involved in that process and am proud of what was accomplished. In fact, most of those individuals could be and did turn out to be responsible borrowers and homeowners. But there can also be little doubt that in hindsight the new regulations did contribute to some of the excessive expansion in credit that has occurred. I note this mainly to provide a cautionary tale. Even very well intentioned and largely successful regulations can have unintended consequences. Economics, Finance and Marketing

Round up the usual suspects • Government Senators’ Minority Report (October 2009) • From the middle of 2007, financial markets began showing signs of considerable turmoil as the realities of trade in exotic financial derivatives and the explosion in sub-prime lending that had characterised the finance market boom became clear. As subsequent events would reveal, inadequate regulation and greed on the part of financial market players would set in train a sequence of events in the United States, the United Kingdom and Europe that would culminate in the collapse, nationalisation or government bailout of major banks, insurers and credit providers. These included Citigroup, American International Group, Northern Rock, Fannie Mae, Freddie Mac, Bank of America, Goldman Sachs, Morgan Stanley, Royal Bank of Scotland, Lloyds TSB, HBOS and a number of major continental European financial institutions. The list of institutions involved reads like a veritable Who’s Who of those who only months earlier would have considered themselves “masters of the universe”. As we now know, these emperors had no clothes. Economics, Finance and Marketing

Round up the usual suspects • Peter Wallison in a dissenting report to the US Financial Crisis Inquiry Commission • Like Congress and the Administration, the Commission’s majority erred in assuming that it knew the causes of the financial crisis. Instead of pursuing a thorough study, the Commission’s majority used its extensive statutory investigative authority to seek only the facts that supported its initial assumptions—that the crisis was caused by “deregulation” or lax regulation, greed and recklessness on Wall Street, predatory lending in the mortgage market, unregulated derivatives and a financial system addicted to excessive risk-taking. The Commission did not seriously investigate any other cause, and did not effectively connect the factors it investigated to the financial crisis. The majority’s report covers in detail many elements of the economy before the financial crisis that the authors did not like, but generally failed to show how practices that had gone on for many years suddenly caused a world-wide financial crisis. In the end, the majority’s report turned out to be a just so story about the financial crisis, rather than a report on what caused the financial crisis. Economics, Finance and Marketing

Making excuses • A minority report in the US Financial Crisis Inquiry Commission did argue that contentious regulatory failures in the US could be justified. • Regulator behaviour • “The government should not have bailed out _____”. • For a policymaker, the calculus is simple: if you bail out AIG and you’re wrong, you will have wasted taxpayer money and provoked public outrage. If you don’t bail out AIG and you’re wrong, the global financial system collapses. • Regulators follow a mini-max rule – they minimize their maximum regret. Economics, Finance and Marketing

Making excuses • “Bernanke, Geithner, and Paulson should not have chosen to let Lehman fail”. • To make this case one must argue: • Bernanke, Geithner, and Paulson had a legal and viable option available to them other than Lehman filing bankruptcy. • They knew they had this option, considered it, and rejected it. • They were wrong to do so. • They had a reason for choosing to allow Lehman to fail. • These conditions were not met – unlike many of the other firms there was no credible buyer for Lehman. • It wasn’t just the failure of Lehman Brothers that intensified the crisis. • In quick succession in September 2008, the failure, near-failure, or restructuring of ten firms triggered a global financial panic. Economics, Finance and Marketing

Sensible Commentary I • Wall Street Journal Asia (November 2009) • The idea that bankers caused the financial crisis is only credible with politicians and unaccountable bureaucrats. It’s especially seductive in the U.S., where Wall Street firms leveraged up to their necks and then took taxpayer money when they were bailed out. But no such crisis happened in Hong Kong, where banks more prudently managed their balance sheets. The idea, too, that a public-sector bureaucrat can better align banker incentives than a competitive marketplace is laughable. In its draft proposal the HKMA didn't define what “excessive risk” is because it doesn’t know. Only a private-sector banker competing to hire talent away from a rival can make that judgment. Economics, Finance and Marketing

Sensible Commentary II • Wall Street Journal Europe (November 2009) • Whether banks benefit from the explicit guarantees of deposit insurance or the implicit protection of being too-big-to-fail, or both, governments have a right to demand that banks not ride free on the backs of taxpayers. But whether it's less leverage, more capital, or restrictions on banking activities, no one should be under any illusion that the same people who failed to detect the last bubble and crash will be able to design a system capable of catching the next one in time. The relative risks of being too lax or too restrictive may be hard to gauge, but either way the odds of getting it wrong are substantial if not overwhelming. This is why putting the risk of failure back into the system should be the sine qua non of any effort at reform. If regulators around the world get nothing else right, the final backstop has to be bankruptcy and/or dissolution for firms that have earned it. Economics, Finance and Marketing

What do Banks do? • The business of banking is well-described by Ludwig von Mises (1912, 1981) • Banks borrow money in order to lend it; the difference between the rate of interest that is paid to them and the rate that they pay, less their working expenses, constitutes their profit on this kind of transaction. • Imprudent granting of credit is bound to prove just as ruinous to a bank as to any other merchant. That follows from the legal structure of their business; there is no legal connection between their credit transactions and their debit transactions, and their obligation to pay back the money they have borrowed is not affected by the fate of their investments; the obligation continues even if the investments prove dead losses. Economics, Finance and Marketing

The Logic of Stimulus • David Gruen: Australian Business Economists Conference (December 2008). • The first, and most obvious, benefit is that involuntary unemployment is lower than it would otherwise be. … • But there are further benefits to avoiding a recession that would need to be taken into account in a realistic cost-benefit analysis of discretionary fiscal stimulus. Recessions break productive links between firms, and between firms and workers, when firms that would otherwise be viable over the long-term are driven into bankruptcy by a recession. In other words, plenty of the destruction that occurs in a recession is not creative destruction. Finally, recessions do long-lasting damage, particularly to that cohort of people entering the labour market at the time the recession hits. Thus, for example, university graduates entering the labour market in a recession suffer sizeable initial earnings losses, losses that persist for a period estimated at between eight and fifteen years – that is, long after the recession has ended (Oreopoulos et al., 2006, Kahn 2009). Economics, Finance and Marketing

The Logic of Stimulus • Robert Reich believes government spending is self-financing • "The huge debts we're wracking up will cause your taxes to rise!" Wrong again. When it comes to the national debt, as I've said before, the relevant statistic is the ratio of debt to the gross domestic product. The only sure way to bring that debt down and make it manageable in future years is to get the economy growing again -- which requires that, in the short term, the government spend a lot of money (because consumers and businesses won't). • Lateral Economics • So for every dollar the government spent, tax revenue to Australia’s governments rose by around 22.5 cents, leaving just 77.5 cents to be repaid. The total windfall to the budget – and to the community – of the additional tax revenue from the cash transfers is around $6.7 billion. This money and the production of all those people and all that capital kept in employment are the riches of good economic management – the only kind of free lunch we know of. Economics, Finance and Marketing

The logic of the stimulus Suppose I walk up to you and forcibly take from your wallet $3636. That is roughly about the amount of the Federal Government's combined stimulus programs per head of population. I immediately give you back $900 of this for you to spend on anything you want - cigarettes, clothing, computer games, fridges, handbags, mobile phones, tattoos, anything you care to buy. You could even deposit it straight back into your own bank account. I then spend $2227 of your money on things that take my fancy. Some lobbyist told me that throwing some of the money I've taken from you (let's call it what it is, a tax) towards housing insulation batts would somehow save the Earth. Someone else whispered in my ear that spending a fraction of the $2227 tax take on school gyms, at inflated rates, would help kids read, write, add and subtract. In fact, so many people are lobbying me to spend your money that I need more cash from elsewhere. I resolve this by borrowing even more currency, on top of your taxes. I forgot to mention at the outset that 14 cents out of every dollar I spend is on my own administration costs. Julie Novak - The Courier Mail 23rd September, 2009 Economics, Finance and Marketing

Stimulus Package I Economics, Finance and Marketing

Stimulus Package II Economics, Finance and Marketing

Other Spending • December 2008: Nation Building Package $4.7 billion • May 2009: Nation Building Infrastructure $22.5 billion • Total: $79.1 billion • Stimulus I: $10.4 billion • Stimulus II: $41.5 billion • Nation Building: $4.7 billion • Budget: $22.5 billion Economics, Finance and Marketing

Stimulus and the great recession