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.

London bridge is falling down

Look at GBP collapse against the dollar and the UK banks implode. It's been a long time coming. The UK government did an admirable job fighting the tide, but gravitation wins.

That's what happens when you're not a global reserve currency and you borrow short, lend long internationally, purchase foreign non-liquid assets, and have huge FDI inflows from commodity based currencies (Gulf). This isn't to say the US isn't in deep doo-doo, we're knee-deep in it, but the UK is neck-deep. It'll take too long to re-type my thinking, so here it is, in the raw:

11/19/08 4:30:41 PM	eugene:	i think GBP going to be rocked
11/19/08 4:30:49 PM	leo:	yeah, i can't wait
11/19/08 4:30:55 PM	eugene:	does the UK even produce anything these days?
11/19/08 4:31:02 PM	eugene:	lol at least we have crappy car companies
11/19/08 4:31:07 PM	leo:	nothing that's why they're screwed
11/19/08 4:31:11 PM	eugene:	they're a big hedge fund
11/19/08 4:31:16 PM	eugene:	actually
11/19/08 4:31:18 PM	eugene:	they really are
11/19/08 4:31:18 PM	leo:	yeah, only financial services
11/19/08 4:31:30 PM	eugene:	IIRC they also did a huge amount of FDI
11/19/08 4:31:37 PM	eugene:	let me find the piece
11/19/08 4:31:48 PM	eugene:	well not huge
11/19/08 4:31:50 PM	eugene:	but substantial
11/19/08 4:32:59 PM	eugene:	received a huge amount of FDI
11/19/08 4:33:07 PM	eugene:	i think i touched on it
11/19/08 4:33:15 PM	eugene:	that is not GBP supportive
11/19/08 4:33:17 PM	eugene:	haha long day
11/19/08 4:33:54 PM	eugene:	i think a huge amount of gulf money
11/19/08 4:33:57 PM	eugene:	was laundered in UK assets
11/19/08 4:33:59 PM	eugene:	into
11/19/08 4:34:07 PM	eugene:	real estate
11/19/08 4:34:11 PM	eugene:	businesses
11/19/08 4:34:30 PM	eugene:	as that money is pulled out
11/19/08 4:34:36 PM	eugene:	it is being converted to dollars
11/19/08 4:34:43 PM	eugene:	because gulf currencies are pegged to dollars
11/19/08 4:35:19 PM	eugene:	gulf states were in such a rush to convert oil into other long term assets
11/19/08 4:35:27 PM	eugene:	sort of like money laundering
11/19/08 4:35:35 PM	eugene:	a mobster is willing to run an unprofitable business
11/19/08 4:35:49 PM	eugene:	to convert useless dollars into ones he can spend freely

11/25/08 11:56:22 AM	eugene:	pound is doing a little bit of a retracement
11/25/08 11:56:52 AM	eugene:	risk aversion decreasing a bit too and US gdp not so good... but oh boy just wait until the GB info comes out
11/25/08 11:57:07 AM	eugene:	im going to short a bit at these levels methinks
11/25/08 12:00:26 PM	eugene:	1) sov funds propped up assets and now fleeing to dollars and euros 2) financial services is a 25% portion of GB exports, kiss that goodbye 3) GB bailout of banks is in sterling for foreign denominated liabilities
11/25/08 12:01:12 PM	eugene:	a train wreck is a-comin
11/25/08 12:02:00 PM	eugene:	gbp isnt much of a reserve currency either
11/25/08 12:07:50 PM	eugene:	the US has its share of problems but the UK problems seem far worse. e.g. price to income ratios for housing, much worse in the UK, export versus import breakdown is not good for balance of payments in a recession, and the currency isn't really in demand globally... no one is fleeing to british gov't bonds
11/25/08 12:07:50 PM		Conversation ended.

More on the fourth horseman

Another blogger did a great job quantifying part of the fourth horseman this week, thanks for saving me the work:

Fiscal Situation of 50 States: Combined Budget Gaps Estimated at $350 Billion for 2010 and 2011

Unfortunately, this summary only covers state budget shortfalls, which amounts to a whopping $414 Billion over the next three years (2009-2011), at $89B, $145B, and $180B, but does not include municipal budget shortfalls.

Taxation at the state level is responsible for your sales tax and income tax.
Taxation at the municipal level is responsible for your property tax and municipal income tax (e.g. NYC).

Does anyone have municipal budget shortfall figures? Conference of mayors perhaps?

New York City alone has had its Independent Budget Office projecting a budget shortfall of $4 Billion for 2010, and $7 Billion for each of 2011 and 2012, or a gap of approximately 7% and 12% respectively.

With municipal bond markets still in the crapper, how oh how will municipalities and states meet their budget shortfalls? They can't borrow against future income without paying much higher interest rates than usual and risking their credit ratings given their reduced ability to service existing debt, much less new debt. Surely they will try to do some of that. But with so many bonds chasing so little capital, can we say higher income, property, and sales taxes, anyone?

Let's perform a quick thought exercise. State and local tax burdens amount to approximately 10% of GDP, or approximately 1.4 trillion.

Roughly speaking, state budgets total ~$800B for FY 2009, and for purposes of this exercise and guesstimation, let's assume inflows roughly equal outflows, leaving approximately $600B of municipal budgets. With best, intermediate, worst case budget gaps of 5%, 10%, 15%, the total municipal 3 year budget gap run $90B, $180B, $270B. So taking the intermediate case, we're looking at a budget shortfall of around $200B in municipal budgets over the next three years.

With state and municipal budget shortfalls running over $500B in the next three years, it seems like that is where the stimulus should be placed, the programs are already established, and it would be a much simpler exercise than 'infrastructure' spending. Also, I would expect it would reduce the impact of government spending crowding out new private spending as the funds would simply support programs and projects already in place at the state and municipal level. Last, but not least, state and municipal taxation tends to be extremely regressive, with little, if any, income banding/marginality and sales taxes are naturally regressive. By placing stimulus funds into infrastructure projects or other projects rather than providing funds to states and municipalities for existing projects or locked-in expenditures, the states and municipalities will have to respond by raising their tax rates, with the regressive nature of their taxes resulting in the middle class Americans that Obama says he is trying to protect, being the hardest hit.

Thus, given the nature of the currently proposed stimulus package, I expect any stimulus received by taxpayers on the Federal level to be negated by increased taxation at the state and municipal level, with middle income Americans hit the worst.

Recovery in 2009? I think not

The talking heads are now calling for a recovery in H2 2009. It's always 8-12 months off, isn't it?

I find this to be a very amusing prognostication. Nearly every economic indicator in the last few weeks has been worse than expected, where expected was quite bad already. The real unemployment rate jumped another percent in December to 13.5%.

The economy is like a massive pendulum, it does not stop on a dime. The boost to income (or as Larry Kudlow likes to say, massive tax cut) created by the precipitous decline in crude and gasoline prices has worked its way into the economy, possibly preventing a disastrous shopping season from being the apocalypse, but there isn't much meat left in gas prices, so further boosts to disposable income from gas are not happening.

The first horseman was a decline in home prices. The second horseman was a decline in the stock market based on expectations of declining earnings. The third horseman was the implosion of the credit market and a crisis of confidence.

The fourth horseman will be counter-cyclical tax policies at the municipal and state level being implemented for 2009. Obama can write a $500 stimulus check, but it will simply be gobbled up by states and municipalities, in the form of business tax increases, property tax increases (actual, or phantom increases by eliminating rebate programs), income tax increases, and sales tax increases to fill giant state and municipal budget gaps. Worse, those state and municipality tax increases will be most severe in the states that have been hardest hit, California, Florida, Nevada, Michigan, New York.

Based on historical declines in the housing market and the size of the stimulus package being proposed my expectation is for the housing market to bottom out in H2 2010 and start appreciating in H2 2011. Peak to trough in prior housing busts in California and New York in the 1980's ran for around 40 months (nominal price decreases), with generally flat prices out to 60 months (real price decreases). Another good indicator is when the P/E ratio for housing declines to historical levels, where the P/E ratio for housing is the price:yearly rent ratio. Each housing market has its own historical price:yearly rent ratio, but one can use generalized Case Shiller number for the national level as a proxy