The Temptation of Protectionism

I think that the really scary thing is that even though we've been through this before (although the article makes the point that it was in a different form) we seem to be making the same mistakes, in this case most specifically the Buy America provisions in the stimulus. There doesn't really seem to be a point if we can't learn from our mistakes. It seems coordination is the real problem here, as it is difficult to consolidate the different political pressures of various countries, which is the problem that the EU is facing in finding a solution for this crisis.

The protectionist temptation: Lessons from the Great Depression for today, by Barry Eichengreen and Douglas Irwin, Vox EU

Banks opting out of bailout money

From the NYT:
Some Banks, Citing Strings, Want to Return Federal Aid

In depth analysis of Fiscal Stimulus

This is an interesting (a bit long) and thorough analysis by John H. Cochrane of the University of Chicago Booth School of Business discussing fiscal stimulus both in general but more specifically relating to the current situation and how the argument for a general fiscal stimulus (without much of a commentary on the specifics of the Obama team's plan) applies to the credit crisis. Although I would be interested to see a Keynesian's rebuttal to some of Cochrane's points, specifically on the points of the merit of the multiplier argument for fiscal stimulus, he provides some good insight and also a very interesting solution of his own. I specifically liked the points he made at the end of the paper where he points out, "Others say that we should have a fiscal stimulus to “give people confidence,” even if we have neither theory nor evidence that it will work. This impressively paternalistic argument was tried once with the TARP. Nobody could say how it would work in any way that made sense, but it was supposed to be important do to something grand to give people “confidence.” You see how that worked out. Public prayer would work better and cost a lot less." This rang true with something that bothered me with Obama's strategy of rushing a 1000 page long bill through congress. Basically, there may not be anything wrong with what he his proposing, but with so much money at stake, it is worth a closer look to make sure it will do what he says it will do.

Fiscal Stimulus, Fiscal Inflation, or Fiscal Fallacies?
By John H. Cochrane.

The 5 governors saying no to stimulus money

This, from the Wall Street Journal opinion section, seems to be a nice twist to the Keynesian argument in favor of stimulus/infrastructure/deficit spending in that running a deficit now in favor of future, sustained, long-term growth. I see the benefits in temporarily inflating the budget in favor of investing in infrastructure and investment in technologies such as alternative energies. These can provide jobs now and will also lay a strong foundation for future growth without need of the heavy hand of a continued and increased government presence. However other types of spending that only create a situation requiring continued government involvement, though may not all be bad, should be looked at separately and not lumped into a stimulus bill supposedly aimed at infrastructure. It seems incredibly misleading of President Obama to say on the one hand that the stimulus bill will be focused on infrastructure and technological development and on the other hand use the excuse that “No plan is. I can’t tell you for sure that everything in this plan will work exactly as we hope, but I can tell you with complete confidence that a failure to act will only deepen this crisis” in order to pass legislation that deviates from his originally stated goals. It seems that with such an argument, it wouldn't be too hard to sneak spending that deviates from the more traditional Keynesian spending programs into a bill that is 1073 pages long. Of course we could just pay the unemployed to dig ditches and fill them back in again until the recession passes as Keynes himself suggested...

From the Wall Street Journal:
Governors v. Congress

Debt-laden state governments were supposed to be the big winners from the $787 billion economic stimulus bill. But at least five Republican Governors are saying thanks but no thanks to some of the $150 billion of "free" money doled out to states, because it could make their budget headaches much worse down the line. And they're right.

These Governors -- Haley Barbour of Mississippi, Bobby Jindal of Louisiana, Butch Otter of Idaho, Rick Perry of Texas and Mark Sanford of South Carolina -- all have the same objection: The tens of billions of dollars of aid for health care, welfare and education will disappear in two years and leave states with no way to finance the expanded programs. Mr. Perry sent a letter to President Obama last week warning that Texas may refuse certain stimulus funds. "If this money expands entitlements, we will not accept it. This is exactly how addicts get hooked on drugs," he says.

Consider South Carolina. Its annual budget is roughly $7 billion and the stimulus will send about $2.8 billion to the state over two years. But to spend the hundreds of millions of dollars allocated to the likes of Head Start, child care subsidies and special education, the state will have to enroll thousands of new families into the programs. "There's no way politically we're going to be able to push people out of the program in two years when the federal money runs out," Mr. Sanford says.

The Medicaid money for states is also a fiscal time bomb. The stimulus bill temporarily increases the share of state Medicaid bills reimbursed by the federal government by two or three percentage points. High-income states now pay about half the Medicaid costs, and in low-income states the feds pay about 70%. Much of the stimulus money will cover health-care costs for unemployed workers and single workers without kids. But in 2011 almost all the $80 billion of extra federal Medicaid money vanishes. Does Congress really expect states to dump one million people or more from Medicaid at that stage?

The alternative, as we've warned, is that Congress will simply extend these transfer payments indefinitely. Pete Stark, David Obey and Nancy Pelosi no doubt intend exactly this, which could triple the stimulus price tag to as much as $3 trillion in additional spending and debt service over 10 years. But the states would still have to pick up their share of this tab for these new entitlements in perpetuity. Thanks, Washington.

Governors are protesting loudest over the $7 billion for unemployment insurance (UI) expansions. Under the law, states will increase UI benefits by $25 a week. The law also encourages states to cover part-time workers for the first time. The UI program is partly paid for by state payroll taxes imposed on employers of between 0.5% and 1% of each worker's pay. Mr. Barbour says that in Mississippi "we will absolutely have to raise our payroll tax on employers to keep benefits running after the federal dollars run out. This will cost our state jobs, so we'd rather not have these dollars in the first place."

The problem for these Governors is that they may be forced to spend the federal money whether they want it or not. Representative James Clyburn of South Carolina slipped a little-noticed provision into the stimulus bill giving state legislatures the power to overrule Governors and spend the money "by means of the adoption of a concurrent resolution." Most state legislatures are versions of Congress; they can't say no to new spending.

These five Governors deserve credit for blowing the whistle on the federal trap that Washington has set for their budgets. They stand in contrast to most of the other Governors, who are praising the stimulus as a way to paper over their fiscal holes through 2010. But money from Congress is never as free as it looks, as the banks can attest. Don't be surprised if two years from now states are still facing mountainous deficits. They will have their Uncle Sam to thank.

How a US Housing Slump spreads the pain to Canada

Today Canadian Transport Minister John Baird, whose responsibilities include federal infrastructure, announced a planned $7 billion in infrastructure spending over the next two years, with emphasis on job-rich public works projects that can be started this year.

The $7-billion in new infrastructure funding also includes a $2-billion fund to support repairs and maintenance and accelerated construction at colleges and universities across Canada, and a $1-billion Green Infrastructure Fund.

The past week has seen an unprecedented series of budget previews, beginning last week when Harper's office indicated the country will run deficits totalling $64-billion over two years. And yesterday the Human Resources Minister Diane Finley announced that the budget will include $1.5-billion in training funds for laid-off workers.

In the wake of a coalition threat to topple the minority Conservative party last November, efforts at openness have taken place within the federal government. Individual provinces have put forward hundreds of ideas over the past few months for how to spend the multibillions the government plans to make available for roads, bridges, water-treatment plants, broadband initiatives and the like. The premiers also met with the Prime Minister and made suggestions on how to reform Employment Insurance and spend money on retraining.

It was a far cry from last year when Mr. Flaherty advised international investors that Ontario was one of the worst places in the world to invest.

But whether the Prime Minister can rebuild trust quickly is still a question. The government reconvenes today and the budget is presented tomorrow. Liberal leader Michael Ignatieff has said he will meet with his advisors after learning the contents of the budget and make a decision whether to support it or not within 24 hours.

Excerpts from an article in the Globe and Mail:

Looking through the blizzard of economic statistics, one stands above all else as a reliable barometer of where the Canadian economy is headed.

And it isn't even Canadian - it's U.S. housing starts.

When a backhoe digs into the ground in Phoenix or Peoria, starting work on a new home, it sets off a chain reaction of purchases that ripples through the North American economy.
Each new home generates hundreds of thousands of dollars in purchases ranging from labour, cement and lumber all the way to chandeliers and big-screen TVs.

Unfortunately for Canada, this great economic engine is still gearing down. At the height of the housing boom in 2005 and 2006, Americans were breaking ground on new homes at a rate of more than two million a year. In December, housing starts fell to a new postwar annual low of 550,000, according to figures released yesterday.

Recessions have little regard for national boundaries - least of all the 49th parallel.
"Canada can't insulate itself," said Craig Alexander, deputy chief economist at Toronto-Dominion Bank. "It's going to go along for the ride."

It all starts with Canada's heavy reliance on exports to its southern neighbour. The percentage has slipped over the past decade, but nearly 80 per cent of Canadian goods exported still go to a single foreign customer: the United States. And those exports contributed roughly 22 per cent of economic activity. Add in services, and the U.S.-centric orbit of the Canadian economy is even more pronounced.

Americans aren't just buying fewer homes: it's cars, computer software, potash and a whole lot else.

U.S. businesses are retrenching at an alarming rate, buying less and demanding lower prices.

Exports aren't the only conduit for the radiating U.S. economic pain. As the world's largest consumer, the United States helps set the price of the major commodities that Canada depends on for much of its wealth: oil, forest products, minerals and agricultural products.

The price of oil has plummeted to roughly $40 (U.S.) a barrel from more than $147 as recently as six months ago. Other commodity prices have also fallen, though not as sharply.

With the eastern part of the country already in recession, the commodity price collapse brought down the West, according to TD's Mr. Alexander. This year, the economy is expected to shrink in every province, except Saskatchewan.

"We didn't feel the effect of what was going on in the U.S.," said Stéfane Marion, chief economist at National Bank Financial Inc. in Montreal.

The root problem is that U.S. banks and their consumer customers took on too much debt, Mr. Marion explained. That isn't the case in Canada, but it's still our problem.

"We are in the second phase of the recession," Mr. Marion said. "The second wave is coming from the auto industry and the drop in commodity prices."

The U.S. problems have also migrated northward through the credit markets, upon which companies on both sides of the border rely to finance their operations. Tighter credit in the U.S. quickly led to the same in Canada.

"To a large extent, the Canadian economy is integrated north-south, not east-west," Mr. Alexander said. "The Canadian economy gets hit from all of these channels."

If you look back over recent decades, the correlation between U.S. and Canadian economic cycles, it's a virtual perfect match, said BMO Nesbitt Burns economist Sal Guatieri.
"It's almost impossible to avoid the U.S. fate," he said.

Canada suffered more than the United States during the recessions of the early 1980s and 1990s, weighed down by higher interest rates and government deficits.

The good news now is that economists don't expect Canada's slump to be as bad.

"The Canadian recession will be half as bad and half as long as the U.S. recession," Mr. Guatieri predicted.

Another bonus for Canada is that it's about to get what amounts to a double dose of economic stimulus.

There's Mr. Harper's plan, and then there's Mr. Obama's $800-billion-plus (U.S.) package.
It hardly matters how all the money is spent because the same channels that spread this made-in-USA recession to Canada will eventually carry the next economic expansion northward.

The lag of Government spending

From Carpe Diem:

WASHINGTON POST -- Less than half the money dedicated to highways, school construction and other infrastructure projects in a massive economic stimulus package unveiled by House Democrats is likely to be spent within the next two years, according to congressional budget analysts, meaning most of the spending would come too late to lift the nation out of recession.

A report by the Congressional Budget Office found that only about $136 billion of the $355 billion that House leaders want to allocate to infrastructure and other so-called discretionary programs would be spent by Oct. 1, 2010. The rest would come in future years, long after the CBO and other economists predict the recession will have ended.

For example, of $30 billion in highway spending, less than $4 billion would occur over the next two years. Of $18.5 billion proposed for renewable energy, less than $3 billion would be spent by 2011. And of $14 billion for school construction, less than $7 billion would be spent in the first two years.

From Bruce Bartlett's Wall Street Journal article "If It Ain't Broke, Don't Fix It" (12/2/1992):

This follows the pattern of postwar countercyclical programs: All were enacted well after the end of the recession. They exacerbated inflation, raised interest rates and made the next recession worse.

Bartlett documents the fiscal stimulus plans that were passed in response to the recessions 1948-49, 1957-58, 1960-91, 1969-70, 1973-75, and 1981-82, and shows that: a) in each of the six recessions, the fiscal stimulus legislation wasn't even signed into law until the end of the recession at the earliest, and in some cases wasn't passed until a year after the recession ended, and b) in all cases the fiscal stimulus plans took effect well after the recessions had ended.

MP: There has been a lot of debate lately about the effectiveness of stimulus plans, and the size of the multipliers, etc., and most of that debate probably assumes that the timing of the stimulus is perfect. But what if the timing isn't perfect, due to the long legislative lags designing the policy and the long lags before the policies actually take effect? In that case, even if some of the multiplier effects work as intended, it's still possible the policy will fail, and will actually destabilize an economy that has already recovered from a recession.

In other words, unless fiscal stimulus is timed perfectly, it will fail to stimulate the economy. Given the reality of legislative and effectiveness lags, perfect timing is impossible. Given that reality, fiscal stimulus policy won't work due to the problem of lags, regardless of any multiplier effects.

See Greg Mankiw's related post about fiscal policy lags here.

Infrastructure Spending

Infrastructure in a Stimulus Package-Becker

Last week we blogged on how much stimulus to GDP and employment might be expected from a version of the Obama fiscal stimulus plan. I concluded that the amount of stimulus from the spending package would be far less than estimated in a study by the incoming Chairperson of the Council of Economic Advisers ("The Job Impact of the American Recovery and Reinvestment Plan", by Christina Romer and Jared Bernstein, January 9, 2009). The activities stimulated by the package to a large extent would draw labor and capital away from other productive activities. In addition, the government programs were unlikely to be as well planned as the displaced private uses of these resources.

The stimulus package's plans for spending on "infrastructure" clearly illustrate both concerns. I put this word in quotation marks because of the many definitions of what is included in the concept of infrastructure. Promoters of various stimulus packages- such as the just released House Committee on Appropriations $825 billion stimulus plan- include in infrastructure not only the traditional categories of roads, highways, harbors, and airports. They also include spending on broadband, school buildings, computers for school children, modern technologies, research and development, converter boxes for the transition to digital TV, phone service to rural areas, sewage treatment plants, computerized medical records and other health expenditures, and many other activities as well.

Some of this infrastructure spending may be very worthwhile-I return to this issue a bit later- but however merited, it is difficult to believe that they would provide much of a stimulus to the economy. Expansion of the health sector, for example, will add jobs to this sector, but it will do this mainly by drawing people into the health care sector who are presently employed in jobs outside this sector. This is because unemployment rates among health care workers are quite low, and most of the unemployed who had worked in construction, finance, or manufacturing are unlikely to qualify as health care workers without considerable additional training. This same conclusion applies to spending on expanding broadband, to make the energy used greener, to encourage new technologies and more research, and to improve teaching.

An analysis by Forbes publications of where most jobs will be created singles out engineering, accounting, nursing, and information technology, along with construction managers, computer-aided drafting specialists, and project managers. Unemployment rates among most of these specialists are not high. The rebuilding of "crumbling roads, bridges, and schools" highlighted by in various speeches by President Obama is likely to make greater use of unemployed workers in the construction sector. However, such spending will be a small fraction of the total stimulus package, and it is not easy for workers who helped build residential housing to shift to building highways.

A second crucial issue relates not to the amount of new output and employment created by the stimulus, but to the efficiency of the government spending. Efficiency is not likely to be high partly because of the fundamental conflict between the goal of stimulating employment and output in order to reduce the severity of the recession, and the goal of concentrating infrastructure spending on projects that add a lot of value to the economy. Stimulating the economy when employment is falling requires rapid spending of this huge stimulus package, but it is impossible for either the private or public sectors to spend effectively a large amount in a short time period since good spending takes a lot of planning time.

Putting new infrastructure spending in depressed areas like Detroit might have a big stimulating effect since infrastructure building projects in these areas can utilize some of the considerable unemployed resources there. However, many of these areas are also declining because they have been producing goods and services that are not in great demand, and will not be in demand in the future. Therefore, the overall value added by improving their roads and other infrastructure is likely to be a lot less than if the new infrastructure were located in growing areas that might have relatively little unemployment, but do have great demand for more roads, schools, and other types of long-term infrastructure.

Of course, at some point new taxes in some form have to be collected to pay for infrastructure and other stimulus spending. The sizable adverse effects on incentives of these taxes also have to be weighted against any value produced by the infrastructure (and other) stimulus spending.

The likelihood that such a rapid and large public spending program will be of low efficiency is compounded by political realities. Groups that have lots of political clout with Congress will get a disproportionate amount of the spending with only limited regard for the merits of the spending they advocate compared to alternative ways to spend the stimulus. The politically influential will also redefine various projects so that they can fall under the "infrastructure" rubric. A report called Ready to Go by the U.S. Conference of Mayors lists $73 billion worth of projects that they claim could be begun quickly. These projects include senior citizen centers, recreation facilities, and much other expenditure that are really private consumption items, many of dubious value, that the mayors call infrastructure spending.

Recessions would be a good time to increase infrastructure spending only if these projects can mainly utilize unemployed resources. This does not seem to be the case in most of the so-called infrastructure spending proposed under various stimulus plans.

The Keynes Debate

From Economist's View

Someone from the Cato Institute sent me this with the message "I’ve been reading your blog posts on the Obama stimulus plan, and I wanted to bring this to your attention, something I think you’ll find interesting." I interpret "interesting" to mean "you are mistaken to think fiscal policy can benefit the economy":

Making Work, Destroying Wealth, by David Boaz: Journalists are telling us that John Maynard Keynes, the intellectual inspiration of the New Deal and its tax-and-spend philosophy, is all the rage again. The Wall Street Journal offers an interesting vignette on Keynes’s view of how to create jobs:

Drama was a Keynes tool. During a 1934 dinner in the U.S., after one economist carefully removed a towel from a stack to dry his hands, Mr. Keynes swept the whole pile of towels on the floor and crumpled them up, explaining that his way of using towels did more to stimulate employment among restaurant workers.

Now I should say that various people report this story, including Ludwig von Mises, but no one cites an original source. Assuming it’s true, though, it just seems to underline the absurdity of the whole “make-work” theory that is back in vogue. Keynes’s vandalism is just a variant of the broken-window fallacy that was exposed by Frederic Bastiat, Henry Hazlitt, and many other economists: A boy breaks a shop window. Villagers gather around and deplore the boy’s vandalism. But then one of the more sophisticated townspeople, perhaps one who has been to college and read Keynes, says, “Maybe the boy isn’t so destructive after all. Now the shopkeeper will have to buy a new window. The glassmaker will then have money to buy a table. The furniture maker will be able to hire an assistant or buy a new suit. And so on. The boy has actually benefited our town!”

But as Bastiat noted, “Your theory stops at what is seen. It does not take account of what is not seen.” If the shopkeeper has to buy a new window, then he can’t hire a delivery boy or buy a new suit. Money is shuffled around, but it isn’t created. And indeed, wealth has been destroyed. The village now has one less window than it did, and it must spend resources to get back to the position it was in before the window broke. As Bastiat said, “Society loses the value of objects unnecessarily destroyed.”

And the story of Keynes at the sink is the story of an educated, professional man intentionally acting like the village vandal. By adding to the costs of running a restaurant, he may well create additional jobs for janitors. But the restaurant owner will then have less money with which to hire another waiter, expand his business, or invest in other businesses. Before Keynes showed up in town, let us say, the town had three restaurants among its businesses, each with neatly stacked towels for guests. After Keynes’s triumphant speaking tour to all the Rotary Clubs in town, the town is exactly as it was, except the three restaurants are left to clean up the disarray. The town is very slightly less wealthy, and some people in town must spend scarce resources to restore the previous conditions. ...

Now we are told that “Keynes is back,” and we need a new New Deal, and the Obama administration is going to create millions of jobs by shuffling money through the federal government. And the theoretical underpinning of this plan comes from a man who thought you could stimulate employment by breaking things. ...

President-elect Obama proposes that the federal government “create or save” jobs by spending upwards of $600 billion. Where would this money come from? If it comes from taxes, it will be taken out of the more efficient private sector to be spent in the less efficient government sector, and the higher tax rates will discourage work and investment. If it is borrowed, it will again simply be transferred from market allocation to political allocation, and our debt burden will grow even greater. And if the money is simply created out of thin air on the balance sheets of the Federal Reserve, then it will surely lead to inflation. ...

You ... can’t get economic growth back by breaking windows, throwing towels on the floor, or spending money you don’t have.

It's easy enough to dispense with this by simply mentioning public goods, i.e. goods with high social value that, because of market failure, will not be produced without government intervention. Producing these goods is just the opposite of "throwing towels on the floor," and the net benefits from these projects are particularly high now since input costs have fallen so much as the economy has weakened. There are other easy counterarguments as well, but rather than rehashing those, I want to play the window game.

Suppose there is an economy that is humming along at full employment. Then, all of a sudden, out of nowhere, a giant, extremely rare windstorm - it's like nothing anyone can remember - comes along and blows out many of the windows in town's homes and businesses. The windows are broken.

This is unfortunate. The town specializes in delicate goods that cannot be exposed to the weather, and when the windows were broken and the weather rushed in all of the inventory, or much of it anyway, was destroyed. In addition, since all of the town's wealth was invested in the inventory, and then some (i.e. they had borrowed to finance some of the inventory), the people of the town lost both their wealth and their ability to borrow from residents of other towns.

So they are wiped out. With all of their wealth gone and no way to borrow, there is no way to rebuild the town and go on as before. Most people are struggling just to get by each day, they don't have time to repair the windows, let alone the resources to finance the repairs and then restock the shelves.

Or maybe there is a way. Suppose the government steps in and hires people to replace the broken windows, and then makes loans as needed (or makes loan guarantees, with an appropriate allowance for risk, or even outright grants in some cases) to recapitalize the businesses and cover the cost of the repairs. That way, the business owners can purchase new inventory and go on as before (well, not exactly as before, one condition of the government loan is that windows of a certain strength are installed, by regulation if necessary, so that the government financed inventory is safe from another disaster).

Thus, instead of destroying wealth, the government is essential in creating it. After the economy-wide window disaster, the government ignores the advice to turn its back in a time of need, and instead steps in and provides the help that is needed to get the economy up and running again. Because of the government action, the economy is revived, and they all live happily ever after.


So in the end we have to hope for two things: One, that the government is able to efficiently distribute resources to those areas that suffer from market failure (the most popular example is roads and now Obama is looking at renewable energy) and second, that those companies that "get their windows replaced" by the government have actually learned their lesson rather than suffer from what is called moral hazard, meaning that the store owners in the town appreciate the help of the government but are not reliant on future government help (bailout) in the case of any future disaster. Otherwise, the government guaranteeing resources now in an unforeseen disaster to ensure short to medium run growth will only result in further, future waste of resources that could have been avoided through the allocation of resources in the private sector by the better run, more efficient businesses.

"Bailouts and Stimulus Plans"

By Eugene Fama from his blog:


There is an identity in macroeconomics. It says that in any given year private investment must equal the sum of private savings, corporate savings (retained earnings), and government savings (the government surplus, which is more likely negative, that is, a deficit),

PI = PS + CS + GS ⁽¹⁾

In a global economy the quantities in the equation are global. This means the equation need not hold in a particular country, but it must hold in the world as a whole. For example, in recent years private investment in the US has been greater than the sum of private, corporate, and government savings in the US. This means the US has been importing savings from the rest of the world (by selling US securities to the rest of the world). But the equation always holds for the world as whole.

The quantities in the equation are not predetermined from year to year, and government actions affect them. The goal of government policy is to expand current and future incomes. When I analyze the auto bailout and the stimulus plan below, I judge them on whether they are likely to achieve this goal.

Government bailouts and stimulus plans seem attractive when there are idle resources - unemployment. Unfortunately, bailouts and stimulus plans are not a cure. The problem is simple: bailouts and stimulus plans are funded by issuing more government debt. (The money must come from somewhere!) The added debt absorbs savings that would otherwise go to private investment. In the end, despite the existence of idle resources, bailouts and stimulus plans do not add to current resources in use. They just move resources from one use to another. And bailouts and stimulus plans only enhance future incomes when the activities they favor are more productive than the activities they displace. I come back to these fundamental points several times below.

A Bailout of the Auto Industry

The bailout of the auto industry is a good place to cut one's teeth on the effects of government action.

Most politicians favor the auto bailout. They fear that if the big three automakers fail, millions of jobs will be lost. Many people have pointed out that U.S. bankruptcy law makes this outcome unlikely. When a big company goes into (Chapter 11) bankruptcy, it is not liquidated. Instead, the company continues to operate, while reorganizing under court supervision.

There is, however, an important point, never mentioned by those in favor or those against a bailout. I phrase it in terms of the equation above. Bailouts of auto firms will be financed with government debt. The government deficit gets larger; that is, government savings, GS, become more negative. If private and other corporate savers do not save more in response to additional government debt, the auto bailout displaces productive investments elsewhere. If private and other corporate savers do save more in response to additional government debt, private consumption must go down by the same amount. This lost consumption and investment, and the incomes they would create, are the big costs of a bailout.

The real question posed by the auto bailout is then clear. Will the benefits, in terms of higher current and future incomes in the auto industry, fully offset the incomes lost as a result of the lost consumption and investment that the bailouts displace?

We are all moved by the visible prospect of lost jobs in the auto industry. We tend to forget the unnamed people who lose jobs or don't get jobs, the businesses that close or the new businesses that don't start, because the bailout displaces productive activities elsewhere.

The Sad Logic of a Fiscal Stimulus

In a "fiscal stimulus," the government borrows and spends the money on investment projects or gives it away as transfer payments to people or states. The hope is that government spending will put people to work, either directly on government investment projects or indirectly through the consumption and savings decisions of the recipients of government spending. The current stimulus plan adds up to about $750 billion. Will it work?

Unfortunately, there is a fly in the ointment. Like the auto bailout, government infrastructure investments must be financed -- more government debt. The new government debt absorbs private and corporate savings, which means private investment goes down by the same amount.

Government infrastructure investments benefit the economy if they are more productive than the private projects they displace. Some government investments are in principle productive. The government is the natural candidate to undertake investments that have widespread positive spillovers (what economists call externalities). For example, a good national road system increases the efficiency of almost all business and consumption activities. Because all the benefits of a good road system are difficult for a private entity to capture without creating inefficiencies (toll or EZ Pay booths on every corner), the government is the natural entity to make decisions about road building and other investments that have widespread spillovers.

Like all government actions, however, government investments are prone to inefficiency. To survive, private entities must invest in projects that generate more wealth than they cost. Public investments face no such survival threat. Even good government investment projects can become wealth burners because their implementation is captured by interest groups (for example, minority or gender set asides, or insisting on unionized labor). Moreover, a $750 billion stimulus package will draw a feeding frenzy by public (state and local) and private interest groups, to pressure for their favored projects, which might not otherwise meet the market test. If the interest groups win, the country will be poorer, and future incomes will be lower.

But we're talking about future benefits. "Stimulus" spending must be financed, which means it displaces other current uses of the same funds, and so does not help the economy today. If you want to build roads or do other investment projects, defend them by standard cost/benefit calculations. And don't use the misleading "s" word.

Suppose the stimulus plan takes the form of lower taxes, another proposal of the incoming administration. Alas, we can't get something for nothing this way either. If the government doesn't also spend less, lower tax receipts must be financed dollar for dollar by more government borrowing. The government gives with one hand but takes them back with the other, with no net effect on current incomes.

The details of the effects of lower taxes depend on how the public uses the proceeds. If taxpayers understand that lower taxes now are exactly offset by the current market value of the future tax liabilities implied by the current increase in government debt, they may simply save the proceeds from the tax windfall. Private savings then substitute for the fall in public savings due to the government debt issue, and there is no effect on private investment or economic activity more generally. (This is what Robert Barro dubbed Ricardian Equivalence.)

Suppose the recipients of the tax reduction from the stimulus don't know about Ricardian Equivalence, and they use the windfall to buy consumption goods. Does this increase economic activity? The answer is again no. The composition of economic activity changes, but the total is unchanged. Private consumption goes up by the amount of the new government debt issues, but private investment goes down by the same amount.

I must shade my arguments a bit (but just a bit). Remember that the (investment equals savings) equation above holds for the global economy but not necessarily for an individual country. If we can get foreigners to buy the additional debt to finance bailouts and a stimulus, we can have additional government spending without reducing private spending. This is how we have financed government deficits for at least the last eight years, so perhaps we can do it for another year or so, and on a grand scale. At the moment, however, most countries are deep into their own bailout-stimulus games. More important, this "cure," if available, is temporary. When foreigners transfer savings to us now in exchange for our government bonds, they take back the resources plus interest later. If the government expenditures generate less wealth than they cost, the wealth loss is borne by future taxpayers, when the government debt is repaid.

A common counter to my arguments about why stimulus plans don't work is to claim that the current situation is different. Specifically, the investment equal savings equation doesn't work because savers currently prefer to invest in low risk assets like government bonds rather than in potentially productive but more risky private investment projects. In other words, there is a "flight to quality." Sorry, but this is a fallacy. A flight to quality does raise the prices of less risky assets and lower the prices of more risky assets. But when new savings are used to buy government bonds, the people who sold the bonds must do something with the proceeds. In the end, the new savings have to work their way through to new private investment, and equation (1) always holds.

The Bottom Line

The general message bears repeating. Even when there are lots of idle workers, government bailouts and stimulus plans are not likely to add to employment. The reason is that bailouts and stimulus plans must be financed. The additional government debt means that existing current resources just move from one use to another, from private investment to government investment or from investment to consumption, with no effect on total current resources in the system or on total employment. And stimulus plans only enhance future incomes when they move current resources from less productive private uses to more productive government uses - a daunting challenge, to say the least. —EFF