A fiscal stimulus? (originally written after the 2009 G20 meeting in London)

Various 2009 463In April 2009 the G20 countries, of which there are 19, agreed a fiscal stimulus package which was enthusiastically adopted by the U.K and arguably we and those other countries who agreed the package will continue to suffer low growth and high unemployment.  So where does this idea of a fiscal stimulus come from?  Is it a good idea, or, if you like your loaves uncut, is it the worst thing since sliced bread?

A fiscal stimulus is a legacy from the Keynesian economics of aggregate demand management.  Now, I have great respect for John Maynard Keynes as an economist but no respect for his self confessed followers who call themselves Keynesians and who manifestly misunderstand, misinterpret and misuse their devotion to Keynes by claiming the non-sequitur that, if Keynes was still alive, then he would have said this and because we say he would have said this, let’s assume it has equal value to the things he actually said.  In consequence, Keynesians have strayed an unrecognisable distance from the great economist.

Johns Maynard Keynes actually said that: “The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood.  Indeed, the world is ruled by little else”.

The importance of this quotation is the reference to “when they are wrong”, because using a fiscal stimulus to kick-start the economy is both wrong and damaging, as I will now explain.

Let us start by looking at what is meant by a fiscal stimulus.  Put simply, it is government spending more and taxing less and filling the gap with a borrowing requirement.  In the past, politicians have not been averse to this because it is has an immediate vote-catching effect, a bit like a shot of heroin to a drug addict, and if there is an election nearby, then hopefully the withdrawal symptoms will not set in until after the election if the government gets its timing right.

At this point, a slight digression as you are asking yourself why do government receive this advice from economists and the answer is that governments demand bad economic advice, particularly if it is good for elections, and therefore bad economists supply themselves to meet this demand and tell governments what they want to hear.

To understand why it is a mistake to use a fiscal stimulus, there is a fairly simple train of logic to follow.  It has already been said that a fiscal stimulus must, by definition, result in a borrowing requirement and there are two elements of this that are damaging: firstly related to who buys the debt and secondly who services the debt.

Firstly, if the debt is bought by real people, then demand is transferred from the private sector to the public sector and there is no real overall increase in aggregate demand and probably just an increase in overall inefficiency as it is a rough rule of thumb that governments spend money less efficiently than the private sector.

In order to sell debt, the government must make the yield attractive and this will mean raising interest rates and doing what is called crowding out the private borrower.  During these exceptional times, it was thought that the government will find it easy to sell debt as they are the only borrower who can tap the taxpayer to compulsorily finance this debt. However short-term debt is being sold with a very low coupon (1%), but the government is not finding it easy to persuade people to buy 40 year debt with the promise of only a 1% yield.

So what happens if they cannot sell their debt. This is where quantitative easing or printed money can be used to buy unsold debt.  Now, this does expand aggregate monetary demand and, yes you have guessed it, it is likely to cause inflation. Another interesting point is that inflation reduces the real value of the debt that government has to repay to the private sector – a win win for government and a lose lose for the private sector.

Secondly, the servicing of the debt causes a problem:  To service the debt in a non-inflationary way requires the taxpayer to pay larger and larger proportions of their tax to the holder of debt.  Further to this, as governments become weakened by their incompetence so the only other alternative is to print money and cause inflation, which can be described as an unconstitutional tax on the holders of money as the value of their holding is reduced in value by inflation.

Basically what is happening is that this generation of taxpayers is paying part of the fiscal stimulus while subsequent generations pay the rest.  Also another thing to reflect upon is that the inflation is not likely to occur immediately, but after a time lag of anything up to 2 years, by which time the Governor of The Bank of England can write to the Treasury blaming whatever current prices are rising for causing the inflation and this will distract attention away from the past profligacy which was the actual cause.  Keynesian economists even give a name to this inflation, referring to it as cost push inflation (something that cannot exist according to the monetarist school of thought).

So what happens if all the countries of the G20 pursue a fiscal stimulus policy?  Bearing in mind the analysis above, it is obvious that there are many variations that can exist within similar policies, and these variations will manifest themselves by adjustments to exchange rates.  The variations include different amounts of stimulus, different ways of financing the debt and different starting positions.  For example, if all countries started from the same position and financed their stimulus by printing money, then each country will inflate and exchange rates will remain the same. However, if one country inflates and another sells its debt to real people, then the exchange rate will fall for the inflating country and rise for the debt seller.

I know it is all very well rubbishing the idea of a fiscal stimulus but is there an alternative solution to our current problem?  Well, bearing in mind that the fiscal stimulus either creates an inefficient allocation of resources or an unnecessary inflation, then one could argue that doing nothing would be better, but in this case, there is a much better alternative:  It use to be called open market operations and it is a reversible (very important) monetary stimulus that provides an alternative way of managing aggregate monetary demand without imposing an unbearable strain on public borrowing.

John Hearn    May 2009

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