Fiscal Stimulus, Fiscal Inflation, or Fiscal Fallacies?

1. Fiscal Stimulus, Fiscal Inflation, or Fiscal Fallacies? John H. Cochrane Myron S. Scholes Professor of Finance University of Chicago Booth School of Business By Alex Macri 11/30/11

2. Cochrane sets out to examine the fallacies of fiscal stimulus and its poor track record of efficacy across countries/continents in which it has been applied. • The familiar argument for this policy is that “animal spirits” cause aggregate demand to tumble to a prolonged and undesirably low level which only government orchestrated stimulus can resurrect to the status quo ante. • If a trillion $ were to be dropped from helicopters people would trigger inflation by spending it on goods and services. That this or any combination of transfer payments is a last resort for preventing deflation is a virtually unanimous conclusion amongst economists. • The caveat to this reflation mechanism is that people expect the government debt to be monetized rather than retired via taxation.

3. If higher future taxes are expected in order to pay for the stimulus then at least some of the transfer payments will be saved to cover the future higher tax liability instead of consumed. • The trillion dollar demand stimulating channel is not to be interpreted as good Rx for the current predicament as the economic dislocations this inflow would unleash are “too frightful to contemplate” • Cochran then returns the discussion back to a hypothetical stimulus paid with future taxes. • The discussion debuts with 3 fallacies often overlooked or ignored by stimulus proponents: • 1st Crowding out. If money is not being printed, every $ spent by government is a $ drained out of the private sector which can’t create additional jobs, demand etc.

4. 2nd Private investment and consumption are identical from an overall macroeconomic accounting. Whether you choose to invest in a stock which capitalizes a car factory or buy the car of the lot is irrelevant. Both events qualify as consumption and both stimulate demand. • 3rd, if future taxes are raised in order to pay for the stimulus then people’s aggregate demand will be blunted in anticipation of higher tax rates. • The real question in not if the multiplier exceeds one but if it exceeds 0. • A dislocated credit market rather than depressed aggregate demand is a far more accurate diagnosis of our current economic malaise. • There is a pervasive capital flight to the perceived safety of government backed securities.

5. The currently glacial rate of privately securitized debt is making credit is very expensive. • A simultaneous destruction of strategic refineries in the gasoline supply chain is a good analogy: • While oil (capital) would be sitting in the harbor and the cost of capital would be the same as before, gas (credit) prices would be high because oil cannot be refined into gasoline. To complete the analogy, the refineries are the credit markets. • Cochran posits that in the appropriate response is for temporary government credit market management until the private market can reclaim its rightful role. • The Fed can meet the tremendous demand for government

6. debt by issuing treasuries against high quality commercial paper, corporate bonds and other private debt instruments. • This mechanism would temporarily substitute for the currently missing private intermediation channels (credit market). Furthermore, once the economy recovers, an eventual threat of inflation caused by this infusion of government monetary instruments can be averted with the Fed simply taking back government issued debt in exchange for the private debt and make a nice profit in the bargain. • The current policy of buying troubled assets to the tune of $700 billion will not make the remaining $10 trillion more valuable.

7. All the aforementioned amounts to subsidies to banks to be ultimately paid for by future taxpayers or inflation. • If government debt is wisely invested in good, tax stream revenue generating assets then soaking up the massive increase in government debt will not create the massive economic dislocations it would if it were spent unwisely or given away. • If the massive debt incurred is paid off by correspondingly higher future taxes we run the risk of a decade of anemic economic growth. • If taxes are insufficient to pay for the debt and government outlays are not reduced, then the magnitude of ensuing inflation will not be tamed by monetary/interest rate policy.

8. The argument that the current recession does not allow the luxury of worrying about future inflation does not hold water. • Inflation is a real possibility which combined with high unemployment can unleash tremendous stagflation. • The various Obama tax rebates are ineffectual because they have short horizons, are means tested and do not change incentives. • In order for incentives to change ,tax rates must be predictably lowered for an extended period of time thus broadening the tax base and lowering government overhead. • By the 1970’s classical Keynesians gave up on the view that

9. Fiscal stimulus will inject sufficient demand in a timely enough manner to matter. • The equilibrium school of thought which began to replace Keynesianism by the mid 1970’s is skeptical of stimulus measures. • Nobody argues that expectations do not matter; if people realize that stimulus will be paid for via higher tax rates or inflation then the rationale for present stimulus vanishes. • New Keynesians do not contest equilibrium theory; they merely argue that some frictions can prevent immediate re-equilibration and unlike their classical counterparts, stress the importance of monetary policy. • The classic Keynesians could no longer defend their views

10. In view of the evident failure of their policies; Britain 30 years of anemic growth, the US economic misery of the 1970’s foretold by Friedman in 1968. • Keynes emphasized consumption, minimized the importance of investment, ignored the incentive changing nature of tax rates and in general believed in centralized government planning. • Hayek demonstrated why prices must be allowed to adjust via the free market and why central planning is a fool’s errand. • Ignoring this caution will lead us to one of many undesirable roads: British style anemic growth, bureaucratic India, spend –inflate-spend-borrow South America etc.

11. In short fiscal stimuli have a very poor track record across countries and continents where it has been applied. • The administration’s touted fiscal stimulus multipliers do not have any theoretical or evidentiary underpinnings and embody all 3 of the aforementioned fallacies. • Some economists insist that the efficacy of fiscal stimulus must be believed in despite 40 years of contradictory evidence. • Restoring the public’s confidence is another argument posited by fiscal stimulus proponents, which again goes against concrete evidence. • Economists must acknowledge that they do not have any specific or knowledge or expertise in divining what

12. “intrinsically meaningless” gestures will or will not restore confidence • The government must remove itself from the business of deciding whom will subsidize whom for imprudent lending and focus on stopgap credit market intermediation until the private sector credit market can channel new savings to new borrowing. • This will prove difficult because of the political dimensions imbedded in fiscal stimulus policy. (i.e. buying influential votes).. FDR understood this