October 23, 2008
Brief questions and answers on the fiscal stimulus
No time to post much today, so I'll just pass along an interesting question and brief answer from the Econbrowser mail room.
A reader writes:
My wife and I were thinking of getting some work done on the house. I thought to myself that this would also be our civic duty since it would keep economic activity going elsewhere. Then I thought to myself that Paul Krugman plans to spend my money anyway-- via government stimulus spending that would come out of higher taxes (at some stage). I can't afford both new walls on the basement and landscaping for Princeton's new Krugman Park.
a) Am I right that such Keynesian spending is essentially to force the hand of oversaving consumers sitting on their cash? (No doubt in our collective interest.)
b) If enough people think this through would they increase savings still further and cancel out the anticipated stimulus package? (If I understand correctly this is analogous to the rational expectations critique of the 60s unemployment-inflation tradeoff.) Or at least force much higher levels of government spending?
c) Would it therefore be better to ban all economics blogs, except for Econbrowser, so as not to confuse the semi-literate (such as myself)?
Here's a quick stab at answering:
If you buy materials to redo your basement you'll help my economy at least, since we just bought some Home Depot stock last week.
The premise of the Keynesian stimulus is that we're at an inefficiently low level of total spending. According to traditional Keynesian doctrine, that could be changed either by increasing government spending (hire people to care for that park) or by lowering taxes (supposedly encouraging you to buy stuff from, say, Home Depot). And if the level of output is indeed inefficiently low, it's conceivable we could have both better basements and a nicer park if the government acts wisely.
My own view is that there are more fundamental problems beyond the low level of total spending, namely, the financial system is broken and needs to be fixed, and until it is both our basements and parks may go wanting, despite the willingness of Congress to increase the deficit.
You're all invited to elaborate below.
Posted by James Hamilton at October 23, 2008 09:32 AMdigg this | reddit
"the financial system is broken and needs to be fixed"
Are we close to a fixing things (not there yet but things are heading in the right direction and Governments are stepping up to the plate)?
If you bought Home Depot last week then it would appear that you are thinking like Warren Buffet - be greedy when others are fearful?
Do you feel the market has likely bottomed or is, at least, not that far off bottom?
Posted by: Anon at October 23, 2008 11:33 AM
Anon, yes, I'm thinking exactly along the lines of Buffet, though like him I don't claim to be able to call a market bottom. No, I'm not convinced that we've done what's needed. Hopefully I'll have a chance to elaborate on one or both of these topics this weekend.
Posted by: JDH at October 23, 2008 11:42 AM
Your reader is asking: does Ricardian equivalence hold. Ricardian equivalence does not hold. Ergo stimulus works.
Posted by: no at October 23, 2008 11:46 AM
I acted more broadly. I upped my contributions to my retirement account from 5% (amount to get full matching) to 25%. Investment will be spread out over time.
Posted by: aaron at October 23, 2008 12:39 PM
My view is the government has broken our financial system but they can't admit it so they are keeping the average person out, but he is the only one who can fix it.
I think Keynes would be all for throwing as much money at it as possible. The money he would throw to the people in the park would be called lowering unemployment, the money he would throw to Home Depot would be called an investment, and the money thrown to everyone else would be called a tax cut whether the person receiving it paid taxes or not. Then he would propose raising taxes to pay for it all but that would be called a spending offset not a tax increase.
Posted by: DickF at October 23, 2008 01:30 PM
In honor of Milton Friedman, can I observe that by leaving the Fed Funds rate at 2% from April 30th until October 8th the Fed did not provide enough monetary liquidity to a banking system that was steadily freezing up? Not to mention but that in one of the most ill-considered central banking moves of my professional career, right in the middle of the 5/30 to 10/8 monetary drought, the ECB RAISED rates by 25 bp in early July!
Please note, this doesn't argue that the system would be fine and unbroken if the Fed had only pushed more liquidity out the door sooner. But as JDH and others have pointed out, with all those fancy new "liquidity" programs (TAF, TSLF, etc) the Fed was cranking out in 2008, they were diligently stepping forward afterward to sterilize away the money-creating aspects of the facilities (as they HAD to, else FF would have cratered below 2%).
I was and am in the camp that the S&P 500 intraday low of 839.80 on Friday October 10th will hold, and that it's NOT A COINCIDENCE that the Fed eased policy two days before . . . .
Posted by: Anarchus at October 23, 2008 02:26 PM
In addition to a broken financial system with too much insolvency, and a biting recession, we have a third force to contend with, which is the large amount (absolute and percentage measures) of US debt held by foreigners. Keynes would spend his way out of the first two problems, but our foreign creditors, China in particular, will be very resistant to us inflating our way out and further reducing the value of their dollar reserves.
Though I'm not expert in this area, I think the current situation is outside of Keynes experience, since I perceive that he drew the system boundary at the country level. It is not clear that his analysis and problem solution applies when there are multiple countries inside the system boundary interacting with large, lagged economic forces on each other.
Posted by: Mike Laird at October 23, 2008 02:49 PM
I think that its inevitable that the government will increase its deficit to stimulate the economy during a recession (depression). If it goes conservative, it runs the risk of the "social order" coming unglued, riots in the streets, and a jingoistic populistic government taking power. Contracycle stimulous, oh well, continuous stimulous is how the ruling elite control the reigns of power.
Anon & JDH - S&P 500 2009 earnings forcasts have been revised downward every month since March 20th @ $81.52/share to October 14th @ 48.52/share... At the bottom of the trough, the P/E should be in the 7 to 11 range, meaning that the S&P 500 should be down to about 450 at its trough, assuming that projected earnings do not continue to erode... Currently the S&P 500 is trading at about 900,,, We have a long way to go!
Keep your powder dry.. don't shooot until you see the whites of their eyes....
Posted by: MarkS at October 23, 2008 03:30 PM
At the bottom of the trough, the P/E should be in the 7 to 11 range
Posted by: Bob Dobalina at October 23, 2008 03:45 PM
Bob Dobalina - A P/E of about 9 is equivalent to a ROI of 8%... This is reasonable during a severe recession after equity prices and earnings have eroded by more than 50%... Equities are risky, so they have to deliver a higher yield.
Besides, if the FED & Treasury do it legally, and securitize their more than $1 Trillion of liquidity injection via auctions, the over-supply of bonds will force higher interest rates in order to clear the auctions. In the event that they simply print money without the bond sales, the resulting inflation will cause the same thing: HIGH INTEREST RATES on Treasury debt. Equities have to trade at a low P/E (high P/E) in order to compete.
SEE this article by Chris Puplava condensing historical work by Campbell and Shiller. It contains several links to Robert Shiller's data and publications:
Posted by: MarkS at October 23, 2008 08:58 PM
Stock price is less than 1/2 of highs from 2+ years ago. Annualized P/E ratio of 6.7 using Q2 earnings. Hmmm. JDH If I may ask: What's the exit strategy?
A comment on Warren Buffett. He is a true American patriot. So I reckon he is personally willing to buy ahead of where he sees the bottom forming.
A comment on home renovations. They create streams of non-pecuniary benefits that are orthogonal to broader market gyrations.
A comment on Ricardian Equivalence. The refutation of the RE hypothesis does not in itself justify Keynesian fiscal stimulation. The US is currently enduring a crisis in political leadership. Willy nilly increases in expenditures risks further hurting confidence in leadership. That, my friends, is a Keynesian argument in favour of moderation.
Posted by: GNP at October 23, 2008 10:27 PM
This is just wrong:
"At the bottom of the trough, the P/E should be in the 7 to 11 range . . . "
Earnings go through cycles for the S&P 500 and larger cycles for the cyclical companies in the S&P 500. In a moderately efficient market, AT the peak of the cycle, P/Es should be lower than average, and at the trough (because earnings are cyclically depressed) the P/E ratio should be higher than average.
For all the PANIC! in the marketplace this morning, the intraday low of 839.80 on the S&P 500 on Friday October 10th held easily. The Barbarians are still At the Gates for now, and haven't made it over the ramparts. And I'm betting it stays that way.
Posted by: Anarchus at October 24, 2008 08:49 AM
P/E does not bottom at the same time that earnings bottom. The S&P500 will never hit 450.
The two deepest bottoms of the last 70 years were 1974 and 1982 (both had single-digit P/E ratios). Both are equivalent to an S&P500 of about 700-750 in today's terms. Also, after each of those bottoms, the market promptly rallied 60% in the next 9 months.
So quite a likely scenario is that we get to 700-750, followed by a rally back up to 1150-1200.
Note that psychology is the only thing trumping all. The fundamental elements of a recovery are in place :
1) Low oil prices
2) Low interest rates for 7+ months now.
3) Unemployment at 6.1% and rising, and Productivity growth also rising. High productivity gains always lead to job growth 6-9 months hence.
So while fear trumps all, how long can fear last? It is the only thing holding back a recovery.
Posted by: GK at October 24, 2008 04:56 PM
Are we faced with a runaway inflation? Not unless the credit of the U.S. Government is put in jeopardy. We can, however, expect more of the same -- only worse. Periods of excessive money expansion and excessive monetary flows (MVt) relative to the output of real-GDP inducing intolerably high levels of inflation and interest rates followed by collapsing production and high rates of unemployment in the private sector.
Up until now we have ameliorated these un-nescessary sel-imposed economic hardships largely through massive transfer payments to non-productive recipients. Deficit financing by the Federal Government provided the principal source of funds.
As we all should know, there is a finite limit to this "remedy".
Posted by: flow5 at October 25, 2008 08:02 AM
" So while fear trumps all, how long can fear last? It is the only thing holding back a recovery.
There are fundamental differences between previous post-war recessions and our current predicament..
- The huge growth of hedge funds and their leveraged securities is now unraveling. They have been the victim of the counterparty CDS failure of Lehman, Yen and dollar appreciation forcing unraveling of their Forex positions, and the drying-up of their credit lines from investment banks. They are forced to sell equities into a deteriorating market, increasing volatility and market decline. We will likely see large numbers of these funds fold when their "lock-up" periods expire... dumping more securities into the market. SEE:
- The banking system is undercapitalized. The hundreds of billions of dollars contributed by the FED and the Treasury have gone to topping off reserve requirements not to supporting new lending.
- The Credit Derivative industry remains essentially opaque and under severe stress. Counter party support is now heavily subsidized by Government supports to insurance companies and (former) investment banks. Because OTC derivatives are essentially unregulated, their unwinding will be slow and litigious.
- The Government is now subsidizing investment banking, mortgage securitization, the commercial money market, the credit derivative market, the auto industry, the insurance industry, and soon the ethanol industry.
- Total debt (private and public) in the USA is now more than 350% of GDP. The last time that this happened was in 1933 when this ratio was 287%... This can only be corrected by gargantuan debt write-offs, or by massive devaluation of the dollar. SEE:
Posted by: MarkS at October 25, 2008 09:12 AM
We'll see. This is still just a recession, nothing more. The plunge in oil prices more than offsets many of the problems you mention.
Plus, your point on 'devaluation of the dollar' does not seem to be happening, as the dollar has strengthened.
Posted by: GK at October 26, 2008 01:28 PM