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Stimulus is Not the Answer Print E-mail

Mar 21, 2010 Jonathan Tonge

Krugman writes in the New York Times, The Soft Bigotry Of Low Expectations, IMF Edition

John Lipsky, the #2 man at the IMF, is quoted today as calling for early fiscal retrenchment:

"While it makes sense for the world’s largest economies to continue stimulus spending through the end of this year, “fiscal consolidation should begin in 2011, if the recovery occurs at the projected pace,” Mr. Lipsky said.

The projected pace presumably means the blue line above, which is taken from the IMF’s World Economic Outlook Database. The red line shows what would have happened if growth were to continue at its average pace from 2000 to 2007.

As you can see, what Mr. Lipsky apparently considers an acceptable result, good enough to pull back stimulus, is basically to accept the losses in output during the crisis as permanent, leaving us on a drastically lower trend as far as the eye can see.

Krugman fails to recognize the massive credit bubble that fueled the unsustainable growth from 2001-2007. That growth isn't coming back. He ultimately believes that the only way out of a debt bubble is to spend more money that you don't have. Well he's actually right about the short term results - it does feel good. But the assumption that it's a way out is completely wrong. Credit inflation larger than economic growth is not sustainable and it is not a 'way out'. It is simply delaying the inevitable.

In the absence of stimulus, the economy will revert back to what it was going to do if the stimulus had never been there. There is no logical argument that more debt helps economies in the long run, unless that debt is backed by strong investments in technology or much needed infrastructure. 'Ready-to-shovel' stimulus projects are neither and that's pretty much what we have seen.

In fact stimulus seriously damages the economy. First it is extremely costly. The debt hangs around for decades, driving up interest rates, taxes and government cutbacks. These forces are incredibly deflationary. Deflation in a healthy free market economy is a good thing, as it increases purchasing power and wealth. But deflation caused from falling disposable incomes is not.

Second, 'stimulus' is the elected few trying to determine what is important and what is not important in the economy and then forcing the allocation of resources into these areas. Stimulus creates opportunities that the market attempts to capitalize on. Labour, management, capital and other investments are hired or purchased, operations are set up, clients are acquired and value chains are assembled. Worldwide, trillions of dollars are being spent right now either directly or indirectly chasing stimulus dollars.

That stimulus won't necessarily be there in a few years. When those dollars dry up, the misallocation of resources will be obvious. The returns that investors thought would be there, won't. The economy will then need to restructure. By that time it is likely interest rates will be higher and the inclination for investors to take on more debt will be greatly reduced. This is incredibly costly to economic growth. It damages the wealth of nations and investor confidence.

Third, lower interest rates don't spur real investment. They spur speculation and are used to inflate asset prices. Higher asset prices are not good for the economy. The paper returns in RRSP portfolios may feel good, and through the wealth effect, may induce you to take on more credit and consumption, but eventually those returns end. If asset prices remain high, the economy will restructure itself to use less of those costly inputs. Economic transitions are incredibly expensive and do not necessarily provide real economic benefits to society. Furthermore, when the economy decides to restructure itself away from those assets and as a result, demand falls, the asset price will crash if its price was supported primarily with cheap money.

Speculation may be profitable in the short run, but it is gambling. It doesn't provide any real economic benefit to the overall economy. My advice to politicians is that if you want to grow your economy, you have to get back to what it really is. Economic environments should be measured by how well they foster innovation, how quickly they adapt and by how efficiently they produce utilitarian goods and services that people actually want to buy. Levels of credit and savings reflect the ability to spend more or less in the future. A combination of great investments in productivity and innovation, along with low levels of debt and increased savings makes for the strongest of economies. Stimulus encourages the exact opposite.

Unfortunately Krugman and most other economists just don't understand this. Furthermore, politicians, government agencies and crown corporations may not like my answer that the best way to achieve this growth is if they simply get out of the way. You are the problem, not the solution.

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