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Thursday, January 29, 2009

Stimulus Economics and Reality

The Obama honeymoon didn't last long, did it? Exactly one week. From January 20 to January 27, 2009. The only question is who had a larger role in ending it -- Congressional Republicans like Senator John McCain and Representative John Boehner who publicly encouraged Republicans to vote against the current draft of the stimulus plan or House Democrats who tacked on small ("small" being a relative term in an $819 billion bill) but inflammatory spending items not directly focused on "jobs" or "economic relief."

President Obama and supporters of the stimulus plan believe it's the best (or maybe least worst) approach for immediately increasing cash flowing through the economy to slow down job losses while trying to focus a significant portion of the spending on things we should be spending money on and WILL be spending money on eventually anyway. Opponents believe the bill already resembles routine "Christmas tree" spending bills of the past twenty years and has too high a portion of spending not directly tied to the core goal of the legislation. Many opponents believe the bill should spend less and reduce taxes more to encourage private industry to reinvest in businesses and retain jobs.

Who's right?

No one. Yet.


Most of the debate around the methods and structure adopted by any stimulus plan centers around the timing of the stimulus, who is likely to benefit from the stimulus spending and what the spending is intended to produce. It's more productive to cut through the political posturing and just do some simple math to confirm how pointless the arguments over spending versus tax-based stimulus are.

Let's start with a few numbers:

* size of the September 2008 Troubled Asset Relief Program = $700 billion
* current size of the proposed 2009 stimulus plan = $819 billion
* 2008 gross domestic product = $14,330,000,000,000
* total number of American citizens = 303,824,640
* total number of American households = 105,480,101
* total number of American tax filers = 146,442,000 (#1)
* total number of full-time workers = 154,648,000 (#2)
* current unemployment rate / unemployed = 7.2 percent / 11,134,656
* median household income = $50,233 (#3)
* total value of home mortgages = $10,570,000,000 (#4)
* total number of mortgage foreclosures for 2008 = 2,300,000 (#5)
* combined mortgage delinquency / foreclosure rate = 9.16% (#6)
* total 2008 existing home sales = 4.9 million (13 percent lower than 2007) (#7)
* number of unsold homes on the market = 3.9 million (#7)
* median home sale price in 2008 = $175,400 (down 15.3 percent from 2007) (#7)
* December 2008 new home sales dropped 15 percent from 12/2007
* December 2008 existing home sales rose 6.5 percent from 12/2007 to an annual rate of 4.74 million (395,000 units monthly) (#7)

To understand the limits of the mechanics of any stimulus plan, one first has to understand the current state of American households targeted by the plan. From a housing standpoint, the very nature of the sub-prime mortgage problem indicates borrowers caught in that trap

a) could not afford normal mortgage terms,
b) had little or no equity in the home at the time of loan origination
c) likely owe 20 to 30 percent more than the home is now worth, and
d) likely have ZERO savings after burning through them making payments up until defaulting

In short, households in this predicament have ZERO margin for error. Any job loss in the household virtually assures a mortgage default and another existing home added to a nine-month backlog of inventory, further depressing home prices and curtailing demand for new home construction. Since the current household savings rate is negative, other households not currently facing the loss of a home might if they suffer a job loss. In short, most households have NO cushion with which they can hang on while stimulus dollars are being primed in the pump if they are put on the bubble.

One question commonly asked by virtually everyone (either rhetorically or seriously) is "why doesn't the government just give the bailout money to individual Americans instead of giving it to banks (via TARP) or corporations (via tax cuts) or state / local governments (via stimulus spending)?" Anyone posing this question seriously doesn't grasp the mismatch between the size of the solutions being proposed and the size of the credit overextension now crippling the economy.

How much "relief" would the TARP program have provided if paid directly to individual Americans instead of banks? $700 billion divided among the entire population amounts to $2304. If paid to every full time worker, it amounts to $4526. That's barely more than one month of median household income or maybe three mortgage payments. If that $700 billion in TARP money was aimed only at the currently unemployed, it would amount to $62,866 or roughly 15 months of median household income. If unemployment hits 10 percent, the $700 billion would amount to $45,264 for each of the 15.46 million unemployed workers or 10.8 months of median level income.

The math behind the proposed stimulus plan is actually far less impressive. Though discussed as an $819 billion dollar plan, the "plan" for the stimulus actually involves roughly $400 billion in expenditures over two years -- an immediate halving of the impact. In addition, the current plan (as of January 29, 2009) calls for roughly $275 billion of the plan to provide tax relief which immediately turns any rational discussion of the plan into a religious debate.

The absolute quickest way to provide tax relief at the consumer level is in the form of a rebate check. Unfortunately, numerous studies indicate in desperate times, the larger the check, the larger the likelihood that tax payers save it rather than spend it, which does no good from a stimulus standpoint. The most effective approach for getting taxpayers to spend more is for credits to be spread out over a longer period of time so recipients subconsciously view it as part of their stable pay rather than a one-time windfall. Providing the credit by slightly reducing payroll withholding would be ideal but, unfortunately, that is very costly and time consuming for businesses and would take months to implement, delaying the impact of the stimulus.

Perhaps the most important point about tax stimulus aimed at individuals as job stimulus is that it diffuses the impact across all taxpayers instead of focusing it at the margin on those who lost their jobs or those on the cusp of losing a job. Assuming the $275 billion in tax relief is split 50/50 between individuals and businesses, the individual tax break might amount to $939 per tax filer but remember, this is a two year plan so that's really $469 per year per filer. Woooooooooowwww. That'll really stoke the fires of economic recovery.

What about tax relief at the business level? Since the number of full time workers is greater than the number of tax filers, the per-worker average benefit of the business portion of the tax stimulus is even less than $469 per year per worker. If the stimulus comes in the form of special capital investment tax breaks, the tax benefit can only be captured

1) if the business can find an eligible capital asset related to the business
2) if the eligible asset is needed at the current time in a market with depressed sales
3) if the business can find a bank to loan it money to buy the asset (if it's expensive enough)
4) if the business is still in business at the end of each tax year to file for the credit
5) if the business actually has taxable income (assuming the benefit is a deduction, not a credit)

That's a lot of ifs. It's possible to cut through the ifs by examining recent tax cut history. The tax cuts of 2001 provide a useful recent case study of the net impact of corporate tax cuts on job creation and overall tax payments. According to studies issues by the Economic Policy Institute, roughly 4.3 million jobs were expected to be created in the first year after the 2003 tax cuts but only 1.6 million were created. (#8) Another group, Citizens for Tax Justice, analyzed tax write-offs taken by 275 corporations between 2001 and 2003 and their associated capital investment over the same period. Curiously, the 25 firms with the largest write-offs reduced their investments by 27 percent when capital investment in the overall economy only dropped 7 percent over the same period. (#9)

Is the spending side of the $819 billion dollar plan any better? The spending is aimed in part at plugging a gaping hole in GDP produced by collapsing car sales, collapsing construction work, collapsing demand for durable goods to go in the homes that aren't being built, etc. How big is that hole? If you assume the economy might actually shrink between 0.5 and 1.0 percent, that's a gap of $71 to $143 billion in a $14.33 trillion dollar economy. (#10) Of course, we need the economy to GROW a more respectable 2 percent or so to produce jobs which means we actually need roughly 3 percent of current GDP to put us back on a +2.0% growth plane. That's $430 billion in stimulus per year. The spending portion of the $819 billion dollar plan only amounts to $544 billion -- over TWO years. That's $272 billion per year or only 63 percent of what's likely to be required.


The reality is that the spending of the stimulus plan does nothing to address the short term or long term issues posing the greatest risk to the economy and its eventual turnaround. In the short term, the timing of the spending does not allow enough dollars to magically materialize from nowhere and circulate through the economy to boost economic activity in key sectors most at risk for job loss. When the normal lag between ACTUAL economic activity and improvement and PERCEIVED economic confidence on the part of consumers is factored into the analysis, the sweet spot of benefit from the spending is obviously far beyond the desired window, which is NOW.

The reality is that the tax cut side of the stimulus plan will likely provide even LESS help in saving jobs or increasing economic activity over any period of consideration. For taxpayers who manage to hold onto their job, a lump sum tax credit is likely to go into the savings account and stay there while they worry about keeping their job. For taxpayers who lose their job, the lack of household savings is highly likely to produce mortgage defaults or a personal bankruptcy, at which point a $939 credit will probably not even cover legal fees.

In the long term, nothing in the $819 billion dollar stimulus plan or the payout of the second $350 billion dollars of the September 2008 TARP disaster does a single thing to correct the root causes of the financial meltdown. Perhaps the most disturbing trend in the debate over solutions to the crisis is that virtually none of the debate even mentions the root causes. When the causes are discussed, they are always "complex" and "multi-faceted" and obviously far too sophisticated in nature for us rubes to understand. The crisis is "unprecedented", just trust us, we're professionals.

This is rubbish.

Any college degree program in economics includes classes on Money and Banking which explain the mechanics of fiat money, fractional reserve banking and their relationship to spending, inflation and macroeconomic output. They also cover the evolution of America's banking systems (there have been several) and the crises that triggered adoption of major changes or complete re-inventions of the system. The curriculum of these courses hasn't changed much in 20 years. Here are two textbooks used in actual college courses, one from 1986 and one from 2006:

Financial Crises: Understanding the Postwar US Experience
by Martin Wolfson (#11)

The Economics of Money, Banking and Financial Markets
by Frederic Mishkin, (#12)

The current meltdown began with a curious case of "vapor lock" on August 9, 2007 when inter-bank lending ground to a halt over seemingly nothing, requiring an intervention by the Federal Reserve that exceeded the emergency efforts taken after the terrorist attacks of September 11, 2001. (#13) Since then, many experts and policy makers claimed the current meltdown is the equivalent of a 10,000-year flood and is primarily due to "unprecedented" leverage built upon mortgage backed securities via credit default swaps. Unprecedented, unless you page through virtually any economics textbook and spend ten minutes reading about the Panic of 1907. In that episode, a consortium of investment trusts which had conspired to corner the market on one stock on margin failed to achieve their goal, caused a massive drop in the stock market which triggered a cascade of margin calls on other investors which then triggered runs on banks and another set of losses for speculators who had taken out bets on stocks -- not actual positions IN the stocks, just bets on their performance -- and lost their shirts.

Those bets weren't LIKE credit default swaps. They WERE credit default swaps. The bank panics produced by the crash and the realization that relying on a single private banker -- J. P. Morgan -- as the lender of last resort for two consecutive national panics (1893 and 1907) led to the formation of the Federal Reserve Bank. Regulators and legislators at the time also had the wisdom to realize the rampant gambling on stock prices and other financial numbers not only magnified the speed and depth of the downturn but served no legitimate business purpose in the first place. As a result, virtually all states across the country passed laws outlawing any contracts or speculation on individual stocks or financial instruments.

Credit default swaps remained illegal in most states until the Federal government passed the Commodity Futures Modernization Act of 2000. That legislation not only eliminated a dispute between two regulatory agencies over authority regarding futures contracts (apparently both agencies agreed NEITHER agency would pay any attention…) but it explicitly nullified any state laws restricting futures contracts and credit default swaps. This will probably surprise no one in America at this point but the Commodity Futures Modernization Act was subjected to exactly ZERO debate in the House or Senate and only took seven days from introduction in the House and Senate to a Presidential signature. (#14) Think about that for a moment before we continue.

* Zero debate
* Seven days from first draft to law
* Economic free-fall within eight years of passage
* Over $50 trillion in unregulated credit default swaps outstanding


The Commodity Futures Modernization Act of 2000 is easily the worst parting gift ever bestowed upon the American public by a Lame Duck Congress and Lame Duck President.

What's Missing?

Despite the dire signs of increased economic trouble, there are some rather fatalistic Americans who believe absolutely nothing has a prayer of stopping the freefall so the government shouldn't try anything. Just get the collapse over with and pick up the rubble afterwards. The above critiques about limitations of the current plan are in no way intended as an argument for doing absolutely nothing on the spending or tax front. If the fatalistic argument turns out to be true, it won't really matter which failed approach we try before the big "Ctl-Alt-Del" of the economy and our society occurs.

On the other hand, no real turnaround in the economy is likely to begin until investors regain confidence in the stability and transparency of financial institutions to provide capital that can provide liquidity to boost lending for legitimate investment. What would instill confidence?

1) a de-emphasis on mega-banks and new limits to prevent any additional consolidation of mega-banks
2) tighter regulation on credit default swaps and similar speculative instruments and eventual elimination of them
3) increased funding for regulatory agency staffing and training
4) criminal investigations into and prosecutions of fraud in ratings agencies, banks and hedge funds

I'm not holding my breath.


#1) http://www.irs.gov/pub/irs-soi/07ifss24.xls

#2) http://www.bls.gov/news.release/empsit.nr0.htm

#3) http://www.census.gov/Press-Release/www/releases/archives/income_wealth/012528.html

#4) http://www.federalreserve.gov/releases/z1/Current/z1r-4.pdf (see table L.218 Home Mortgages)

#5) http://www.bloomberg.com/apps/news?pid=20601068

#6) http://www.mbaa.org/NewsandMedia/PressCenter/64769.htm

#7) http://www.nytimes.com/2009/01/27/business/economy/27econ.html

#8) http://www.cbpp.org/8-25-04tax.htm

#9) http://www.ctj.org/pdf/obamastimulus.pdf

#10) https://www.cia.gov/library/publications/the-world-factbook/geos/us.html

#11) http://www.amazon.com/Financial-Crisis-Understanding-Postwar-Experience/dp/0873327497

#12) http://www.amazon.com/Economics-Banking-Financial-Markets-MyEconLab/dp/0321200497

#13) http://watchingtheherd.blogspot.com/2007/08/financial-markets-running-on-empty.html

#14) http://en.wikipedia.org/wiki/Commodity_Futures_Modernization_Act_of_2000