Much Ado About Stimulus: If it sounds too good to be true...

This article is from the RIIB blog of May 11, 2009.

We are continually assured by politicians and pundits that a massive economic stimulus package is needed to get the economy out of the current recession. The road to recovery, we are told, is built with government spending on bridges, highways, public transit and other large public infrastructure projects; this recovery road is paved with tens of billions of dollars (or in the case of the US hundreds of billions of dollars) of government debt. With the recent, less optimistic projections by the Bank of Canada, opposition MP’s are calling for a second round of “stimulus spending” to save the faltering economy.

The power of government spending to fix our current economic problems seems almost magical. Like Rumpelstiltskin of fairy tale fame, who could spin straw into gold, the government seems able to borrow our otherwise worthless money and spin it into economic recovery. How does this magic work and is stimulus spending the appropriate remedy for our economic ills? In an insightful analysis of the current economic problems in the United States, John Cochrane, Myron S. Scholes Professor of Finance at the University of Chicago Booth School of Business, argues that debt-financed spending packages are no magic bullet and are not the cure for the United States’ current economic problems. (For the full text of Cochrane’s analysis, see his paper at the web site http://faculty.chicagobooth.edu/john.cochrane/research/Papers/fiscal2.htm).

While Cochrane’s analysis is specifically aimed at the US, it has valuable insights for Canada. The basic message comes in two parts. The first part can be summarised as follows. Imagine that the government borrows a dollar from you to spend on infrastructure projects. If that borrowed dollar would otherwise have gone to personal consumption, then the spending has no net impact on the economy – all that has happened is that the government has substituted a dollar of its spending for a dollar of your spending. Suppose, though, that the dollar you lend the government comes from your personal savings. If those savings were invested in private sector investment projects, either because you invested directly yourself or because your bank invested your savings for you, then again you are just substituting government investment for private investment and there is no net impact.

For the borrowing to have a net impact, one, or both, of two things must be happening. One is that you chose to keep your dollar out of both the bank and private sector investments. Some of this is surely going on in the US as households pull out of risky investments and move toward safer assets such as government bonds. This is not so obviously a problem in Canada. The other is that the bank chooses to hold on to your savings rather than invest them in private sector projects. Again, there is evidence in the US that this is also at play. The evidence for Canada is less clear. In any event, the message is simple: It is only to the extent that the borrowed money would otherwise “sit idle” that the stimulus package has an effect.

The second part of Cochrane’s message is that, if the economy is weak because consumers and banks are holding on to money, then we need to ask what the appropriate remedy is for this problem and if this remedy is debt-financed government spending. If consumers are keeping money outside of banks for fear of bank failure, then the solution is to ensure the stability of the financial system, not a stimulus package. If consumers and banks are investing in “safe assets” and not risky private investment projects – the presumed problem for the US in the current situation – then, again, Cochrane argues that debt-financed public infrastructure projects are not the answer. The reason is that, while a government stimulus package “puts the money to work”, we leave it to bureaucrats and politicians to decide what are and are not valuable investment projects. In addition, we must live with the effects of massive future tax liabilities caused by the stimulus package.

Instead, Cochrane argues, the appropriate policy for the US is one that puts the “idle cash” to work in the private sector. His plan calls for the Fed and Treasury Department to use borrowed money to purchase high quality corporate and securitized debt in normal credit markets. In essence, the government fills the credit market role that would normally be played by banks and private lenders in the US until these parties are prepared to assume risk again. By substituting for private lenders, the government uses competition for its investment dollars to drive investment in the most valuable projects. Moreover, the government can avoid the overhang of future tax liabilities since it can sell these assets in the future to pay for its borrowing.

What does all of this say for the Canadian context? We need to ask ourselves how much of Canada’s economic problems are caused by “idle money” -- consumers and banks holding on to cash/ government debt rather than making private-sector investments. If this is not the real problem, then a stimulus package will have little positive impact and will saddle us with large future tax liabilities. If the real causes of Canada’s economic ills are a $100 a barrel drop in oil prices and a faltering US economy, as seems likely given Alberta, Ontario and British Columbia have suffered the most significant job losses, then stimulus packages are largely irrelevant for improving the economy. Government spending isn’t a magic bullet that solves all economic problems.