Wednesday, January 28, 2009

The $800 Billion Stimulus Package and the Critical Importance of Efficient Allocation

Stimulus spending can create (1) new real growth if it more efficiently allocates resources than would have been done otherwise.

If that is not the case, then stimulus spending will, at best, only (2) create real current growth at the expense of future growth.

The Federal Reserve traditionally manages (1) and (2) through monetary policy. In terms of (1) it attempts to create new real growth by preventing price shocks, in which damaging resource allocation can occur because of price level uncertainties. In terms of (2), additional short-run real economic growth can be boosted through monetary policy, at the expense of of future growth, given a functioning financial system, through interest rate mechanisms.

However, in the current crisis, we have variables that fall outside the Federal Reserves control that are negating or reducing the influence of interest rate policy: (3) a major divergence from Federal Reserve direct-to-bank interest rates versus interbank lending which signifies bank unwillingess to lend to ANYONE (though this has returned more or less to pre-September levels, as measured by the TED spread)

(4) an even larger divergence in secondary markets (e.g. bond markets) from Fed rates signifying investors unwillingness to lend to companies and municipalities for fear of default.

Hence, the thinking is to bring additional weapons to bear on the current economic recession, namely an $800 billion stimulus package. However, it seems very clear to me that this package will allocate the funds in a very wasteful and economically harmful way given the alternatives.

First, the budget gap in state and municipal budgets over the next three years will run from $400-$700 billion as I've outlined in earlier posts.

It makes absolutely no sense to me to leave this gaping hole in the budget from the perspective of marginal dollar/marginal utility.

What we are doing is spending an extra $700B on infrastructure and other magical elements of stimulus, for which we don't know the effect (who knows, maybe a multiplier of 0.8 due to graft, waste, purchase of foreign goods and services?) and for which the marginal utility of each dollar spent rapidly decreases (I can assure you that the last dollar spent will have very little to show for it), while leaving this gaping hole in state and municipal budgets, which is going to be closed, in part, by firing teachers, garbagemen, police, firefighters, EMT's, mental health workers, home aides, and various other civil servants, i.e. losing goods and services which have definite utility.

Think about it, the federal, state, muni, and personal balance sheets were at some equilibrium value from a spending perspective. Now we are adding $700 B to the federal market, rather than allocating the funds on an even basis, or even better, a true marginal utility basis.

The gaping hole is also going to be filled by raising state and municipal taxes, which means higher state income taxes (which have no or very limited progressive banding), higher sales taxes (which tends to burden the poor and middle class the most since their spending is a higher percentage of income and worse it discourages spending), and higher property taxes (which burden the elderly and older Americans the most, since they tend to have appreciated home values but limited incomes). In other words EXTREMELY REGRESSIVE TAXES.

So while your average American family will get a $400-$800 stimulus check, they will also pay thousands more in sales, income, and property taxes this year, due to the idiotic structure of this stimulus package.

I drew a simple diagram at lunch yesterday to explain the stimulus problem, since a picture really is worth a thousand words:

What's worse is the pork and special interest spending that will occur with the current stimulus package. That infrastructure cloud is filled with lobbyists and politicians jockeying for the $700B, so I can guarantee you the allocation will be extraordinarily wasteful.

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