Today’s post on economic stimulus
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Today’s post on economic stimulus

I’m not an economist, I’m not even kind of an economist. But there are a lot of other people out there who are not economists who have a lot to say about the economic stimulus, and some of what they’re saying leads me to some questions. Oh how I wish I could demand that a real economist answer them.

People are saying that Obama’s stimulus plan is too small. For example, here’s John Judis:

There’s much to like in Obama’s plan. But there are two important ways he may have to go further. Most economists agree that what finally pulled the U.S. out of the Great Depression was military spending for World War II. Some liberals argue that if the Roosevelt administration had not abandoned a Keynesian stimulus strategy in 1937-38, the U.S. might have gotten out of the depression without a war. But in 1936, unemployment was still at 16.9 percent; by 1942, after two years of war spending, it was 4.7 percent, strongly indicating that it was war spending that did it. I am not suggesting that the United States start a world war in order to solve the world’s economic problem. But I am suggesting a strategy that could be called the fiscal equivalent of war.

So let’s talk about fiscal stimulus a little bit. For at least the past decade, the US (and world) economy has grown due to one factor — the rise in housing prices. As housing prices went up, people borrowed against the value of their homes and spent the proceeds. That took the place of real income growth. As we now know, the rise in housing prices was not sustainable. Prices stopped rising, people lost the ability to borrow, and now the economy has essentially shrunk down to its pre-bubble size.

I don’t know how to mathematically model any of this, so let me use an analogy. Before the housing bubble burst, the economy was a size XL shirt. Now it’s size L shirt. The economy is rapidly losing weight so that it can fit into the size L shirt. What this means is closed down factories, canceled construction projects, and massive job loss.

The purpose of fiscal stimulus is to stretch the shirt back out to size XL. This works by replacing consumer borrowing (by way of home equity loans, cash-out refinances, and credit cards) with government borrowing. The idea is that the government will stretch the shirt until the economy grows enough for the shirt to remain size XL without fiscal stimulus.

So that leaves me with two questions about the stimulus plan in particular. One, is the government able to stretch the shirt as much as it needs to, and two, for how long will it be required to stretch the shirt? There’s some level of government borrowing that is not sustainable. And there’s some level of borrowing that can be managed for a year or two but not longer.

And my bigger question is this: what if the size L economy is the new normal, and the only thing that will save us in the end is population growth? What then is the proper course of action for the government? If the current crisis is a product of structural change, what’s the best recourse? Replacing consumer borrowing with government borrowing isn’t going to save us if there’s no path back to the size XL economy anytime soon.

Update: I am very glad this guy is our next President.

7 thoughts on “Today’s post on economic stimulus

  1. There’s a difference between government borrowing and consumer borrowing. What consumers did (in the general case) was borrow a whole lot of $ and spend it on crap. Ideally, government borrowing would not be spent on crap, but rather on needed investments that will create jobs, new opportunities, wealth, etc. I’m thinking of infrastructure, green tech, and so on. In the best case (or even a good case), it’s not accurate to equate government borrowing/investment and consumer borrowing/spending, although there are certain vested interests that have motive to do so.

  2. Good analogy. My take would be:

    L is the ‘right’ size for the economy.

    We suddenly went from XL to M. All we should reasonably expect is to go from M back to L. XL wasn’t sustainable before, and we shouldn’t strive to go back to that size, because any method we employ will also be unsustainable.

    (Side note: we might again get back to XL some day via conventional means: productivity increases, sensible monetary policy, sound regulation of investments, population growth, etc.)

    For instance, people keep screaming, “We’ve got to get banks lending again!” Well, they’re not going to lend like they did before, and we shouldn’t hope that they do. We hope to get them lending more than they are now, but only a reasonable, sustainable level.

    But, that (assuming I’m right) is an ugly truth that nobody wants to really state. Though, when Obama suggested yesterday that the recession could last several years, that was a much more frank statement than I’ve come to expect from all sides–federal government, economists, Wall Street, and, unfortunately, the media.

  3. “The idea is that the government will stretch the shirt until the economy grows enough for the shirt to remain size XL without fiscal stimulus.”

    My take is: The government needs to stretch the shirt just enough so that we don’t have to lose weight too quickly as we resize to the L size – which is probably where we should be.

    The problem isn’t just that the economy is contracting. It’s that it’s contracting in so many areas so quickly that it’s having a snowball effect. If we are not careful the response will cause an overshoot and the shirt will become an M and things will get really painful.

    Many people now need to limit spending so that they can pay off the over spending that they engaged in in the past. Once those debts are paid off, it will free up some available cash for more spending at a more sustainable pace (L).

  4. Re: Medley

    I definitely wasn’t comparing the merits of government spending versus irresponsible consumer spending, but more looking at the goal, which is to manage the changing size of the economy to prevent shock.

    If we have a stimulus that makes it far less painful to move from XL to L then I’m for that, I just don’t think that we can expect the stimulus to keep us at size XL, which is what some people seem to be advocating.

  5. Wages were pretty much stagnant to down over the past decade, only the top end was seeing growth (very top end, < 10%) in wages. Wealth was generated from the Mystery Box of real estate where you put in $0 and get out $X.

    Government spending programs might increase wealth by increasing wages, and investing in things that generate job growth, not equity growth. GDP in the mid 30′s was clipping along in the 8% range according to NPR’s Planet Money.

    So it may be that getting the economy to size XL is possible with government stimulus, but it really needs to be on the backs of wages, not equity bubbles, which would be sustainable and work for more people.

    The NPR piece quoted the theory that if the initial push in 34 had been sustained longer, it would have recovered the economy faster and cheaper than having to come around with the second round of stimulus in 37.

    I guess it remains to be seen what happens, there is a lot of talk of free money, low fed rates, etc., which supposedly devalues the dollar, but with wage stagnation and unemployment, most people are experiencing deflation. The stimulus package has to not be aimed at equity bubble control (like fed funds), but at wage earners to get the economy running smoothly and sustainably. We’ll see what happens.

  6. The function EconomySize(population) is not as simple as productionPerCapita * population. In pre-industrialized economies when the economy outgrows the regenerative resources of the environment, additional population lowers the standard of living and can shrink the economy (see the excellent A Farewell To Alms). Extending this model to include the past few hundred years and the post-industrial economy are left as an exercise.

    Economies grow for other reasons, too: Manufacturing efficiency gains, removal of other transport and trade frictions, increasted trust lowers the cost of protecting the transactions (ie: why prostitutes in low income areas need pimps) etc.

    The proper course of action for the government would have been to tighten the money supply when the economy was growing without underlying fundamentals, but politics didn’t allow that. It seems to me that what we want is people feeling okay to spend money again, and it seems like the right way to do that is to make a strong public commitment to social security. Take those two or three (or more) trillion bucks of debt we were going to give to cronies and campaign contributors and the Wall Street power structure and say to the common man “go forth and consume, you will have a retirement!” My fear with infrastructure spending and similar things is that they’ll both turn into amazing boondoggles (much like the Paulson plan already has), and that they’ll put us in a situation like Japan: Lots of capital expenditures on projects that now need upkeep, and are mostly unused.

    I also think we need to see a return to an economy with 401k and similar retirement plans that aren’t so blatantly a “give favors to Wall Street”, where investment can be made to startups and smaller enterprises so that ordinary citizens feel vested in the power of the economy once again. Because right now making money feels like random chance rather than the result of hard work, goals, and savings, and as long as that continues there’ll be more incentive to buy lottery tickets than to do something productive.

  7. …and while there was a housing bubble in the UK and Spain that, subsequently to the US bubble, also collapsed, both countries’ citizens are not in the habit of borrowing against the appreciating value of real estate.

    So really only the U.S. economy’s growth was fueled by your own local housing bubble and a gross injection of cheap capital from U.S. pension funds.

    Germany’s economy, for example, while under pressure from the global lending crisis and at risk by the CDS-disaster waiting to happen, will most likely maintain most of the growth that happened over the last 3 years and only shrink by a minuscule amount this year (<1%). I.e. Provided that we don’t see a huge collapse in the US consumer credit market… but then all bets are off anyway.

    I just wanted to add this to the discussion to reiterate that we have to take a differentiated look at the worlds’ economies.

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