Will the Stimulus Work?

The Skeptical Optimist writes,

On Capitol Hill, it's those damn deck chairs again: nobody can agree how they should be arranged. Partisanship continues to trump statesmanship. Even though the $800 billion package is called "stimulus," everyone seems to be paralyzed by old, worn-out talking points. Click here for the article.

I wouldn't hold my breath waiting for politicians to say something other than talking points. What else could they say? They are not financial geniuses, and it's a rare politician that seems to understand even basic economic principles.

Steve, I love your blog, but I will have to disagree with you on this issue. Keynesians are not right. History and economic logic both tell us that additional spending is not the way out of a recession. Neither FDR's new deal spending, nor WWII spending per se ended the world-wide recession. We can't buy what hasn't yet been produced. Increased production ends recessions. What WWII did was show businesses, consumers, and investors a believable future–one that engaged millions in greater production.

Keynesians focus on spending when it's really production that ends recessions. Hayekians correctly observe that governments don't produce much in the way of real goods and valuable services; the private sector does.

What few people seem to be talking about is what causes insufficient spending from the private sector in the first place. Until the causes of insufficient private spending are removed, recession will not abate, quite regardless of how much deficit spending the federal government does.

If more real goods and services are not produced, increased government spending will result in inflation or crowding out.

I'm really quite amused by all the talk about "velocity." Velocity adjusts to become whatever it needs to be to allow spending people want to do, given however much money exists, however much real production we have, and the average price level.

In the equation of exchange, M*V=P*Y, V and P are the only two variables that can change over a period of just a few months.

Real output Y takes many months to change, even when there is excess capacity. M takes many months to change, even if the Fed does manipulate the monetary base. Lots of prices are sticky over periods of even several months because they are contractual. What's the big changer when expectations about the future change? Velocity, of course. If the Fed really believes they can do something in response to changes in velocity, then we really have to questions its thinking.

Without additional production, additional federal spending must be accomplished though more money or higher velocity, higher prices, or some combination of all three. So what? Additional federal spending, in and of itself, will not foster additional production, per se.

What's causing the recession is not mysterious. The recession is due to exceptionally bad monetary policy and fiscal policy over the past several years. Until those policies change, no amount of additional spending will end the recession, just as it did not end the recession for FDR and his new deal.

Businesses will quicken their rate of production when they have reason to think that consumers and other businesses will buy what they produce. Consumers will quicken their rate of spending when they have reason to believe their income streams are not going to be unexpectedly interrupted. On what do such beliefs depend?

(1) money that has predictable purchasing power over the long run; flooding the world with even more new high-powered money, as the Fed has done since 9-11 won't help.

(2) aggregate credit based on aggregate household saving and responsible underwriting of loans; banks and non-bank financial institutions took the risks they took because they believed they would be bailed out; it appears that they were correct; now people have no idea about what to believe for the future.

(3) governments must confine their spending to what they tax away from households; sustained government deficit spending beyond household saving would not be possible at all without sustained growth in the money supply.

Everyone who understands macro economics at all understands that sustained growth in the money supply at a rate above growth in real output is the same thing as sustained loss of purchasing power of every dollar in existence.

Forget velocity; reductions in velocity sufficient to stave off inflation cannot be sustained in the face of a money supply rising faster than real output.

Congress had better focus on why private spending is not growing and on what would stimulate production of goods and services. Deficit spending is not the answer now; it never has been, and logic tells us it never will be.