Bleeding the Economy Back to Health
When someone got sick during the Dark Ages, doctors would use leeches to bleed the patient. If the patient got well, then the bleeding worked. If they died, then they were beyond help in the first place. If they remained sick, the doctors attached more leeches. No matter what the outcome, the efficacy of bleeding was never questioned.
In early 2008, Dr. George W. Bush prescribed $168 billion of "stimulus" (government spending) to treat an economic patient suffering from recession. In late 2008, the patient got sicker. In early 2009, a new doctor was called in. Dr. Barack Obama prescribed $787 billion of "stimulus". He warned that without this treatment, the patient could get very sick indeed, with unemployment going as high as 8.5%. In June, unemployment hit 9.5%. In response, Dr. Paul Krugman and others have called for more "stimulus".
"Stimulus" does exactly the same thing for an economy that a leech does for a patient-it sucks the blood out. The more "stimulus" we employ, the worse the economy (especially unemployment) will get. Here's why.
"Stimulus" is usually thought of as government spending, but it really consists of government borrowing and spending. Before the Federal government can spend "stimulus" money, it must first sell bonds to get that money. Money is the lifeblood of the economy and selling bonds literally sucks out that blood. The subsequent Federal spending puts the blood (money) back in, but in a degraded form, leaving the economic patient weaker than before.
Here is the mechanism. When the government sells bonds, the proceeds are deposited into the "U.S. Treasury, general account" at the Federal Reserve. The money in this account is not part of bank reserves. It disappears from the monetary base. As far as the economy is concerned, the money has fallen into a black hole.
Because the velocity of the monetary base is currently about 8.5, it is reasonable to expect that for every dollar taken in by selling bonds, GDP will go down by $8.50. Because GDP is the sum of personal consumption spending, private investment, government spending, and net exports, each of these categories will take some of the hit.
When the Federal government spends one of the dollars it took in by selling bonds, GDP goes up by $8.50, restoring the level of total GDP to what it was before the bonds were sold. However, the additional GDP shoes up primarily in the "government spending" category and secondarily in the "personal consumption" area (because of government transfer payments). This leaves private investment and net exports lower than they would have been without the "stimulus".
It is the "stimulus"-induced reduction in private investment that does the most economic damage. Private investment fell from 15.1% of GDP in the first quarter of 2008 to only 11.9% in the first quarter of 2009. Meanwhile, government consumption spending grew from 17.5% of GDP to 18.3%. Personal consumption spending, a growing portion of which is being funded by government transfer payments, grew from 71.4% to 72.2%.
GDP grows linearly with the nation's total fixed assets, which are driven by private investment. Since 1948, the ratio between GDP and "fixed assets" has been remarkably stable at around 36%. The suppression of private investment caused by "stimulus" will cost the nation dearly in terms of economic output for years to come.
Even worse for the average American is the fact that employment is a direct function of private investment. Private investment has been falling for four straight quarters now and the rate of decline has been accelerating. If this trend is not reversed, unemployment could easily reach 14% in a year or so. Unfortunately, the Obama administration is counting on "stimulus" to turn things around, and "stimulus" hurts, rather than helps, private investment.
Right now, Dr. Obama is telling the family (the American people) to be patient. He points out that most of his "stimulus" money has not yet been spent. In other words, the economic bleeding has hardly begun. This is supposed to be reassuring.
Medieval doctors bled patients because their minds were in the grip of a superstition. Economists recommend "stimulus" for the same reason. Dying patients did not cause doctors to question bleeding. Rising unemployment does not seem to cause economists to question "stimulus".
What would a sane economic recovery program look like? It would focus on two things: "supply" and "demand".
The quickest and most effective way to boost supply is to repeal the corporate income tax (CIT). The CIT is on track to bring in only about $100 billion in FY2009, which is less than 13% of what Obama's "stimulus" will cost. Repealing the CIT would cause private investment to skyrocket, taking GDP and employment with it.
The economy also needs adequate demand. The sharp economic contraction that hit in late 2008 was caused by a fall in monetary velocity-the speed at which dollars change hands.
The standard way to counteract a fall in velocity is to increase the size of the monetary base. This the Fed did. From August 1, 2008 to January 1, 2009, the Fed more than doubled the size of the monetary base. Under normal circumstances, this would have been more than enough to solve the velocity problem. Unfortunately, on October 6, 2008, the Fed began paying interest on bank reserves.
Right now, the Fed is paying 0.25% interest on bank reserves. This isn't much, but it is "above market" for what amounts to a one-day T-bill. (90-day T-bills are trading at an annual interest rate of 0.18%, and the yield curve slopes upward from there.) In essence, the Fed has created a "roach motel" for the monetary base-the money goes in and it doesn't come out. If the Fed stops paying interest on bank reserves, monetary velocity will rise and demand will rise with it.
Let's hope that someone in power figures all of out before millions more Americans lose their jobs.
