Saturday, November 22, 2008

The Road to Financial Ruin: We Have to Spend Money Now

Axel Merk, November 19, 2008

When just about all economists agree, should we rejoice or be scared? During the Weimar Republic, economists at the Reichsbank argued that printing money to finance a war was “exogenous” to the economy and thus not inflationary. Hyperinflation in the ensuing years proved them wrong. We tend to think we are so much smarter today. Economists know how to run regression models; in the absence of a historic precedent, some economists know how to draw shifting supply and demand curves. But common sense seems to be missing in the toolbox of all but a few.

This past Sunday, President-elect Obama was asked by 60 Minutes where the money would come from for the ambitious projects and stimulus plans:

Question: Where is all the money going to come from to do all of these things; and is there a point where just going to the Treasury Department and printing more of it ceases to be an option?

Obama: Look. I think what's interesting about the time that we are in right now is that you actually have a consensus among conservative, Republican leaning economists and liberal, left leaning economists. And the consensus is this: that we have to do whatever it takes to get this economy moving again that we have to, we're going to have to spend money now to stimulate the economy and that we shouldn't worry about the deficit next year or even the year after. That short-term, the most important thing is that we avoid a deepening recession.

Just about every living soul has advice for our president-elect on where to spend money. Had McCain won the election, things would have been no different; indeed, McCain seemed to enjoy the race to bailouts even more than Obama. Economists are worried about deflation, about imploding asset prices, about demand destruction. They argue that the government must step in where the private sector is falling short. The goal is to prop up demand and preserve jobs. Political considerations on how to spend the money will come into play; it will be interesting to see whether healthcare and education will receive injections as spending in these areas doesn't translate to immediate boosts to employment, spending or investments.

Many economists (Keynesians) believe that government spending ought to be countercyclical to dampen the impact of boom-bust cycles. In practice, everyone wants to be a Keynesian during bad times, boosting government spending, but there is no mechanism in place to force restraint, say through increased taxes, during boom times. This ‘restraint' existed when the gold standard was in place as money was backed by a limited supply of gold. But such restraints were inconvenient and central bankers are now in charge.

There are cushions built into the system already; take unemployment benefits as an example: unemployment benefits reduce the impact of lost wages and stimulate demand during tough times. Note that European countries tend to have more generous unemployment benefits than the U.S.; further in the U.S., most states need to balance their budgets. As a result, when state revenues decline, the downturn in the U.S. economy is particularly exacerbated as government services are cut. There are some that argue that such spending cuts are healthy because the faster we weed out the excesses of the boom, the faster one finds a bottom upon which to have sustainable growth. Further, risk takers might be more cautious if they know that the government won't bail them out, reducing the risks of systemic failures in the first place. Some may even recall that there used to be a breed called fiscal conservatives in Congress, an almost extinct species. Democrats and Republicans alike are all Keynesians these days.

There are two major reasons why we may be setting ourselves up for financial ruin: first, spending is unlikely to lead to a sustainable recovery; second, we cannot afford it.

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