The Skeptical Optimist

"Government Waste" brain teaser

I was watching a conga line of politicians taking turns in front of the cameras yesterday, to complain about pork and waste in the stimulus bill. As usual, nobody would define "pork," and it still goes without saying that government "waste" should be despised by all.

Although I'm convinced we need stimulus by government to prevent a downward deflationary spiral if it's still preventable, I have a problem with the bill as it was passed by the House. Calling it a "stimulus" bill seemed a bit disingenuous, because much of it consisted of programs that won't go away after the stimuli have stimulated. A more honest process would have been to separate out true "stimulus" programs from the ones that won't go away, so that we could have a subsequent open debate on the merits of the permanent programs. (I, for example, would support GI-Bill-like college tuition subsidies for all who could qualify, because that's a great investment in our future—but it's permanent, not a "stimulus" intended to break a downward economic spiral, so it should be debated separately.)

In any case, I was thinking about wasteful government spending... specifically, what happens to the wasted money, after government wastes it. The impression the politicians give is that when government spends a dollar "wastefully," it's no different from holding it over a butane lighter and setting it aflame. But politicians, I've learned, don't always convey accurate impressions when they're trying to sell an idea. That's why I decided to think about it a little harder.

So, now I need some help. Below is a two-part brain teaser, showing what happens to (1) wasted money, versus (2) well-spent money. Let's assume (1) the Bridge to Nowhere really does go nowhere, will be used by nobody, and will be good for nothing. Let's also assume (2) the Bridge to Somewhere will be useful to the private sector for generations, in many ways.

In short: (1) is a bad investment, (2) is a good investment. Now, aside from the difference between the two bridges we end up with, look closely at the subsequent effects, make a mental list of the undesirable effects of the "wasteful" spending, then leave a comment summarizing your findings. (My list wasn't very long, but I probably missed something.)

I think I'll send a link to this quiz to my three representatives in Washington DC, too. They should be able to provide some insights, don't you think?

Defibrillate the economy... then what?

UPDATE: Tuesday's Wall Street Journal (1/27/09) explains this a little better than I did. An excerpt and link are now at the bottom of this post, but I recommend reading the whole thing.
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The Fed and Treasury aren't being shy as they attempt to prevent the economy from descending into a fatal deflationary spiral. The Fed has been flooding the system with new base money (which in normal times would be highly inflationary), and the Treasury is preparing to fulfill its role of "spender of last resort." Two paddles of a defibrillator. They are doing the right thing — for now.

But saving us from our economic heart attack requires a two-step cure, as follows:

Step One - Defibrillate.
Step Two - Back Off.

The second step is just as important as the first. True, without the jolt in step one, the patient dies quickly; but without shutting the electricity down after delivering the jolt, the patient dies almost as quickly.

In Step Two, the Fed will need to drain a lot of base money from the system to prevent inflation. Also, the Treasury (as it carries out Capitol Hill mandates) will need to back off from stimulating when the stimulus has successfully stimulated; otherwise it's something a lot more than just a "stimulus" package we're being sold. My own preference would be for sunset provisions in stimulus programs, driven by predetermined economic benchmarks. Remember, our top goal is supposedly to revive the private economy, not replace it. 

I do understand that the Fed and Treasury have their hands full trying to succeed with Step One, but shouldn't we be hearing more from the pundits about what should happen after the economy revives? I'm not sure the Fed has the necessary information or the skill to withdraw all that base money in a short timeframe—and I'm also not sure they don't. And I'm almost certain that Capitol Hill lacks the skill (and possibly the desire?) to hand the baton back to private sector business after the stimulus succeeds; I'd like to hear that topic get more airtime, too; wouldn't you?

Listen to the following segment of ABC's Sunday talk show (This Week's Roundtable discussion). Paul Krugman explains a lot about Step One, but is curiously silent about Step Two, even after George Will asks the important question about how to "unwind" it all. Carly Fiorina has some excellent thoughts on business responsibility, and even Sam Donaldson makes a few good economic points.

Click here to view the Roundtable discussion on ABC's This Week.

[By the way, this has been an excellent segment of ABC's This Week show for the several months I've been watching it, not only because all sides of the issues get exposure, but also because decorum is a priority as the participants debate the issues—a pleasant contrast to several cable news talk shows I could name.]

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UPDATE: Here's the Jan. 27 article in the WSJ, plus an excerpt...

Economic Policy Will Have to Be Very Agile, by Marina Whitman

At the moment, the Fed's focus is rightly on avoiding price deflation. Deflation would push consumers to hold off on spending as they wait for lower prices down the road, prolonging the recession. Deflation would also increase the already heavy burden of debt carried by both the government and the private sector... But once the world's economies are growing again, the Fed will have to contain the inflationary pressures it is now helping to generate.

"You know, I sincerely hope Obama is successful."

I bet I've heard that fifty times since the election, and here's my educated guess: it was uttered with true sincerity one time out of every ten. Okay, maybe two. The other eight times (out of ten) it sounded about as sincere as a similar "sincere" hope that there's, let's say, irrefutable proof that Obama's not really a secret muslim.

In any case, I've now come dangerously close to my tolerance limit for politely keeping my mouth shut when someone says it with feigned sincerity. I've been observing human nature for six decades, and I've  decided that even if Obama's plans do turn out to be successful, I'll never, ever see anyone muster enough courage to stand up and say:

"You know, even though I opposed Obama with every ounce of energy I had, it turns out that many of his ideas actually did work. By golly, that means I've been wrong most of my life! What was I thinking? I sure made an ass of myself, don't you think? Gee, I sure wish I'd had a better clue, but at least I finally get it now, after all those years of ignorance."

[Want an example? Watch this video of Fred Thompson, then try to picture him taking it all back some day down the road. I bet you can't.]

As you might have guessed, my top priority is the economy — specifically, a high-growth, low-inflation, low-unemployment economy for our grandchildren when they take over. (Your top priority may differ, but that's mine.) Obama and his new administration have a big economic problem on their hands; fortunately for us, they also have some bold plans for fixing it. Yes, those plans involve "big spending" by "big government"—and below is a sequence of three graphics illustrating why those plans make a lot more sense than doing nothing.

First is the economy we tend to take for granted during more-typical times...

But our current situation is a little different. The financial crooks and idiots (including mortgage lenders, mortgage borrowers, boards of directors, lawmakers, and securities regulators) scared the daylights out of consumers — who consequently started stuffing a much higher portion of their money into mattresses. That created a recession economy. One way we could choose to "handle" that situation would be to let it run its course.

The graphic below shows what smaller consumer spending does to our wages and salaries even if nothing else changes.

Some people prefer that approach, because, my goodness, anything else would require intervention by "big government."

But that's not what Obama's team has in mind, thank goodness. Below is their plan to minimize the pain our wages and salaries will have to absorb. Yes, it means invoking an increase in "government spending," the dreaded monster that always haunts many conservatives (Republicans and Blue Dog Democrats), who tend to focus most of their attention on the word "Government" with little attention left over for "Our Wages and Salaries."

Coincidentally, the graphic above isn't just a depiction of what the Obama team is planning for 2009-10. It is also a depiction of what the Reagan administration pulled off in 1981-82. Remember? It was a deep recession in '81, and "big" spending by "big" government was a major factor in pulling us out of the problem. Another similarity: in both cases, much of the spending is (was) investment by government (as opposed to consumption). In Obama's plans, it is investment in roads, bridges, and broadband that will eventually pay off in private sector productivity; in Reagan's administration, it was investment in national security that eventually paid off in the elimination of the threat of a thermonuclear war between superpowers. In my book, those are excellent examples of good investments by ("big") government.

Will the new government spending programs eventually settle back to their previous share of the size of our economy? They will if our lawmakers do their job correctly — by sunsetting enough of the emergency spending programs, contingent on a return to private sector economic vibrance. But if our lawmakers get bogged down in a misguided debate about "big government," we might not be able to duplicate the Reagan administration's accomplishment: pulling the economy out of a deep recession, while simultaneously shoring up the longer-term future.

Obama and his team are on exactly the right track. The near-term future looks a lot brighter now than it did two months ago, and I am optimistic that he and his new team will prevail over any fatally-nearsighted lawmakers who try to stand in the way. Undoubtedly there will be a different set of big challenges when the economy starts pulling out of the recession. But first things first.

Oh, and one last thing: I bet Ronald Reagan is smiling.

The paradox of the paradox of thrift

I found a must-read article on the subject of my previous post. Although I think the article at the link just below is mostly correct, it misses a key point that can be a traumatic show-stopper. First read the article; then come back and read my assessment below.

The article: Consumers Don't Cause Recessions
(Don't miss the metaphor-of-the-month, about politicians who think it's their duty to do a "Control-Alt-Delete" on the economy.)

My views
As I said, the article is mostly correct. But even though increased saving (decreased consumption) by consumers might be neutralized by decreases saving by the businesses they patronized (the "paradox of thrift"), it is incorrect to assume that all saving is automatically invested in future production. That's the flaw I spotted.

A more-complete title would have been this one: "Consumers don't cause recessions -- but they hate high unemployment, and they vote in droves." If nobody wants to invest in the future, prolonged high unemployment is all we can expect; in turn, voters who dislike high unemployment can be expected to vote in governments that will "do something" about it -- even though government is the biggest, most sluggish monopoly of all.

The situation we have today is not just a sudden shift by consumers toward saving and away from consuming, but a sudden lack of ability or desire by banks and entrepreneurs to lend, borrow, and invest. The offsetting shift in the saving mix (from business saving to personal saving) isn't the main point; the curtailment of investing is the point. (See Jerry's comment under the previous article.)

We need to jump-start investment activity; unfortunately, the drop in consumption ("demand") is getting all the press. With the fall-off in investment, financial intermediaries (banks) aren't intermediating anything, they're just playing the role of glorified mattresses. We need such things as cuts in corporate tax rates, which are a key ingredient in growth and prosperity for any country, as this article notes.

Restoration of the investing component of total spending is key. If it doesn't happen, we're in for a long spell of global cooling. 

Stimulate what?

Most economics experts, including Reagan administration veteran Martin Feldstein, are telling us we need to stimulate the economy in a big way. I agree.

It's not unanimous, though. There's still a small minority who think the option of doing nothing will sort things out more effectively in the long run. Unfortunately, none of them can say for sure how long the "long run" will take to arrive; maybe nine months, maybe two years, maybe more. To me, that's like asking Uncle Sam to do a bungee jump from a 200-foot tower using bungee cords that "might be" as long as 220 feet.

So yes, I'm with the stimulus crowd. But that begs the question, Stimulate what? I was thumbing through my favorite textbook on basic economics (Brad Schiller's), which I always keep close at hand, and came across an appropriate cartoon from the 1991 recession (it's on page 324):

I've noticed that economists in the Keynesian camp imply (predictably) that consumer spending, not saving, is the thing we need to stimulate; to them, saving is merely stuffing money into a mattress where it doesn't do the sluggish economy any good. Saving is "leakage." The solution to hard times is to stimulate consumers with tax cuts and rebates, stimulate business payrolls with more government spending, and hope the stimulus money gets spent instead of saved. In my judgment, that view is oversimplified; but here it is:

[By the way, opponents of this view don't do themselves any favors when they attempt to fight tax rebates by pointing out that last summer's rebate "didn't stimulate anything, because the recipients just saved it."]

Anyway, can you spot what's missing, and what's oversimplified? Hints: What's missing is the economic activity that transforms banks from mere fancy mattresses into true financial intermediaries. What's oversimplified is the business side of the diagram. Here's a more-complete picture; for a really big hint, look for the additional red star:

"Spending" doesn't just happen when consumers consume; it also happens when entrepreneurs invest in new businesses, or expand existing businesses. But investing doesn't happen as readily when banks are reluctant to lend money, or when entrepreneurs are reluctant to borrow. So, to provide a complete stimulus package for the economy, Congress and the new administration should stimulate investing as readily as consuming. That's what was missing from the first diagram.

One way for government to shoot itself in the foot is to discourage investing by keeping obsolete business firms alive, under the false pretense of "protecting jobs." When government keeps obsolete businesses such as General Motors afloat, it discourages healthy businesses from investing in expansions, and discourages entrepreneurs from investing in new startups. Protecting obsolete jobs prevents newer, more productive jobs from appearing on the scene. That's why the first diagram was oversimplified: it failed to depict the dynamic nature of the business side of the economy.

What would stimulate investment? Well, to stimulate lending, banks need to start feeling better about their ability to take on the risk, and in this environment, the prerequisites are (1) a larger cushion of capital on their balance sheets, and (2) cleaner assets. That's why the Fed and Treasury are (in theory) working to shore up the viable banks, and why the TARP was (in theory) set up in the first place.

As for business firms, existing and future, the stimulus ideas include more government purchases of today's products and services (...the proposed infrastructure spending is why I bought a few shares of the Shaw Group by the way), but it shouldn't stop there. Other incentives include a lower corporate tax rate, lower capital gains tax, and elimination of the double taxation of dividends. Those measures would increase the potential reward for entrepreneurs to start new businesses — for example, the guy who has a better idea for a fleet of hot dog stands, and the guy who thinks he has the superbattery problem solved.

Government won't just be stimulating consumption; it will be doing a lot of its own investing in infrastructure projects intended to yield benefits not immediately, but in the future. So why not give as much attention to stimulating private sector investing, too?

I'd like to see the private sector's creative destruction process get back into full swing — for our grandkids sake. That will require revitalized lending, borrowing, and investing, but for some reason those aren't getting nearly as much attention on Capitol Hill as is the stimulus of "consumption" spending.

Deflation, Inflation, and Money from Thin Air

In case you haven't heard, the Federal Reserve has been flooding the banking system with additional reserves (i.e., "printing money") in recent months. Take a look at the 12-month change in the Fed's balance sheet (3rd column on this page): a $1.35 trillion increase in reserves—more than a doubling—in 2008. That's the amount of money the Fed created "out of thin air" to purchase assets from the private sector.

Here's a diagram showing how the Fed creates new money:

That "thin air" thing infuriates some people, such as Ron Paul and his supporters. To them, "fiat money" is the dirtiest word of all, and "printing money" is the economic equivalent of skewering our grandkids and roasting them over red-hot charcoal. I personally wish Ron Paul would stick to the real goods and services side of the economy and stay away from monetary economics, because printing truckloads of new money in this economic environment is exactly what we need to be doing. For several months, I have been shuddering at the mental image of our economy plummeting into oblivion under Ron Paul's preferred gold standard, the economic equivalent of the iron maiden torture device pictured at this link.

Why is there such a disconnect about what the Fed is doing? Why do most economists agree that pumping large quantities of new money into the economy is just what we need these days, while a small contingent of Ron Paul supporters protests loudly that it's absolutely the wrong thing to do? Well, a good place to start would be a diagram of what typically happens to new money when it's injected into our economy.

Money in motion
Under normal conditions, most of the new money enters the transaction stream, where it's used as a "medium of exchange" by the public for consuming and investing in real goods and services.

Money at rest
However, not all of the new money becomes transaction money; some of it is used as a "store of value"—and takes several forms, such as currency sitting in safe deposit boxes or stuffed in mattresses, money sitting dormant in bank deposit accounts, or currency circulating overseas (in areas where it's perceived as safer to hold than the local currency).

Inflation/Deflation
If there's just enough money-in-motion to satisfy the economy's production of real goods and services, there is no price or wage inflation. A corollary: If the production of real goods and services grows, the money supply must grow at the same rate (or slightly more) to achieve price/wage stability.

To illustrate, here are two diagrams. The first is a balancing scale showing the stable price/wage condition achieved when money-in-motion matches the production of real goods and services. The second shows the inflation condition driven by the imbalance of too much money for the real goods and services.

It's easy to assume that the typically-running economy is all we ever have to worry about; and once we make that comfortable, naive assumption, we can spend the rest of our lives arguing our own pet opinions on what causes and what prevents unanticipated inflation. But the typically-running economy is not the only one we ever have to worry about. The dysfunctional economy is one we have to face every now and then, and guess what: the head-in-sand approach is not the way to handle it.

Specifically, there are conditions that can throw the scale out of balance in the other direction, with consequences arguably more severe than inflation. An economy can become dysfunctional in several ways; ours became dysfunctional because of a sudden shift in the public's preference towards money as a "store of value" instead of a "medium of exchange." [By the way, I've never heard Ron Paul address this condition.] Here's a diagram depicting the dramatic shrinkage of money-in-motion, due to the public's sudden preference for liquidity (money at rest). It also depicts why the flood of new money is not causing inflation; the Fed's attempt to stimulate money-in-motion has been largely diverted into mattresses and balance sheet "cash" accounts. The public hasn't been spending, borrowing, lending, and investing; it would rather avoid those risks by sitting tight on its most liquid asset—and that is what the textbooks call a "liquidity trap."

What happens when money-in-motion shrinks rapidly? It throws the scale out of balance in the other direction, towards deflation. Insufficient money-in-motion fails to support the production of real goods and services, as depicted below.

The result is price/wage deflation pressure, and it causes the real economy to shrink in compensation. If the money-in-motion side keeps shrinking (for whatever reason), the real economy keeps shrinking, too. That's called a deflationary spiral, and it is NOT pretty. At best, it means high unemployment and misery; at worst, it leads to the overthrow of governments. In any case, it eventually bottoms out at a much smaller level of economic activity.

Oh, I suppose the Ron Paul crowd would be popping champagne corks at each other, celebrating the fact that "inflation" had been defeated. Nonetheless, when the deflationary spiral finally hit bottom, we'd all be a lot poorer. And, sadly, so would our grandkids' generation: we would bequeath to them a shrunken, stagnant economy—if we chose today to ignore the dangers of deflation. That's what the Fed is currently fighting against, and that's why all that "money from thin air" has not even come close to generating wage/price inflation.

Can the Fed pull it off?
Let's say the Fed succeeds in challenge number one, preventing a deflationary spiral. In that scenario, the public gains its confidence back, and the huge stock of "money at rest" starts to tranform into "money in motion." Well, at that point we'd better leave the champagne sitting on ice for a while, because we wouldn't be finished yet—not by a longshot. The Fed would be facing challenge number two: recapturing enough money (making it disappear into "thin air") at a pace sufficient to prevent subsequent high inflation. Why? Because there is no way the real economy could grow fast enough, all of a sudden, in order to balance the vast quantity of money-at-rest if most of it were to become money-in-motion. The Fed would have to throw its Open Market Operations into reverse, and sell back a substantial portion of the assets it bought, in order to keep the scale in balance.

As the diagram below depicts, that is the process of making fiat money disappear into "thin air"—a scenario that presumably sends the Ron Paul crowd into blissful ecstasy.

I'm not sure the Fed will get its timing just right, on either of the two challenges. It might not blunt the deflationary pressures as effectively as it could, and it might not blunt the subsequent inflationary pressures with perfect timing.

But one thing is for sure: I thank my lucky stars that the Fed is there for us, wielding its weapons as effectively as it knows how. The alternative of a gold standard Iron Maiden would be Great Depression II, if not a total collapse. I'm glad we are dependent on our own Federal Reserve, and not on Russian and South African gold mine owners, to manage our money supply ups and downs on short notice. Aren't you?

If you'll excuse me now, the night sky is clear. I think I'll go out and thank my lucky stars one more time.

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End note:

The total money supply is equal to base money created "out of thin air" by the Fed, plus bank money created "out of thin air" whenever any bank makes a loan. It sounds complex, and it is — but it boils down to this: the Fed and banks create fiat money. The supply of fiat money is able to expand and contract with more flexibility than the supply of gold coins would be able to (under a gold standard). The Fed's job is to expand and contract the base money supply to support its target interest rate, which in turn is set periodically to control inflation and deflation, i.e., to achieve the goal of a steady, predictable aggregate price level.