Monday, November 29, 2010

Which Is Better - Stimulus or Austerity?

Here's an interesting article comparing the ongoing responses to the fiscal crisis that started in 2008 - both the European response and the American response.  The American response has primarily been one of stimulus - the government is taking on additional debt to provide a stimulus to the public sector.  Conversely, the European response has primarily been one of austerity - cutting government workers and programs and raising taxes.  Let's take a look at the likely outcomes of these policies - and how these may impact your investments in the future.

As an initial matter, let's define what we want.  We want a country that experiences economic growth on a consistent basis - of at least 2%/year GDP growth.  One reason that we want this is so that the economy will continue to create jobs for those entering the work force.  Another thing that we want is inflation at a rate of 2-3%/year - and we certainly don't want deflation.  With inflation at 2-3%, we are basically forcing people to invest money in order to maintain the value of that money over time - which in turn drives our economic development - your dollar will be worth a lesser amount next year, so you better invest so that you have $1.03 by next year.  In contrast, with deflation dollars are worth more the longer you wait - which makes people put off expenditures - which in turn means that companies can't sell anything because people are not buying - which means that the companies begin laying people off.  Generally, deflation creates a negative spiral that is hard to recover from and should be avoided with all reasonable effort.

First, the American response of stimulus is based on Keynesian economics which postulates that we can use government stimulus to raise the level of economic activity to soften an economic slowdown - thus avoiding a potential deflation of the currency.  Frankly, this appears to be working in general.  It is certainly the case that the stimulus could have been more directly injected into the US economy if the purchasing power of the stimulus was constrained to purchase goods from American manufacturers - or American services.  For example, if stimulus money goes to purchase a Chinese-made TV, then the stimulus is not helping the American economy - it's helping the Chinese economy.  Frankly, the way we did the stimulus was kind of sloppy, but it seems to have worked to an extent.

However, the cost of the stimulus is a massive increase in national debt - which typically drives down the value of a currency - and has done so for the US dollar.  This in turn helps make the prices of our goods more attractive in foreign countries.  Unfortunately, the national debt will need to be paid off.  Keynes' idea is that the government should have the discipline to pay down the debt once economic growth has recovered.  By paying down the debt, our currency rises and our goods become more expensive, thus slowing down economic growth to prevent another bubble. 

So in one real sense, the US is in the "good part" of this boom/bust cycle.  Our economic growth is being artificially inflated now, but will need to be artificially deflated later by debt repayment.  Failure to repay the debt will put the US in a much more vulnerable economic position during the next cycle.  Further, even if our stimulus/repayment model works, we can see by the amount of debt that we have accumulated that American economic growth is going to be greatly restrained by debt payback (and the additional taxes and increase in currency valuation associated with it) until at least 2017 - and maybe until 2020.  It's probably not going to get much worse, but the upside potential is going to be constrained for most of the next decade.

On the other hand, let's consider the European response of austerity.  I agree with the author of the article that the European response is pretty old school - it does not take into account the realities of cross-border trade, the impact of increased taxes and reduced government spending on economic growth, and the problems with the Euro as a multi-national currency.  That is, consider what happens to an economy when the largest employer goes away - many people lose their jobs - which in turn causes a decline in economic activity because those people can't buy anything - which in turn causes the companies to lay off more people.  Additionally, you will see an increase in the foreclosure rate due to job loss - which will make it more difficult to get lenders to put up money to build additional houses, further decreasing the economic condition.

However, once the economy reaches a stable point, they will not be saddled with the long-term drag on economic growth that the US will have for several years thereafter as it works to repay the debt due to the stimulus.  Consequently, once Europe reaches the bottom, Europe is going to be a good place to invest (compared to the US) and will likely outperform the US for several years thereafter.

However, Europe still has the problem of the multi-national Euro - which is actually kind of a big problem.  Normally, when a country's economic growth declines, their currency will also decline - which will then make their exports relatively less expensive, which in turn helps their economic growth recover.  However, weaker European countries that use the Euro (like Greece) won't be able to take advantage of this effect because the currency that they employ will not be able to decrease to a level reflecting their new economic reality because the Euro's value is held up by stronger countries like Germany. 

In reality, one of the best things for Greece right now would be to get dumped from the Euro.  An individual Greek currency that is not coupled to the Euro would allow Greece to recover much faster - same for Ireland.  Frankly, without the stimulative effect of a reduction in currency value, I seriously question whether Greece can recover in a decade.  Further, the failure of Greece to recover will be a drag on the Euro's value - which would serve to act in apposite to the likely project growth of Europe as a whole.

So which is better, stimulus or austerity?  For the US, the answer is pretty clear - a period of stimulus (preferably more targeted to US economic activity) followed by a pay-back period with regard to the debt looks like it will smooth the economic turmoil and produce the fewest negative impacts.  Conversely, implementing austerity by greatly cutting government spending and increasing taxes appears that it might create the dreaded deflationary spiral.  Small cuts and small tax raises are probably OK, especially governmental cuts to purchases of materials from non-US manufacturers or service providers. 

On the other hand, instead of spreading out the pain over a decade, austerity seeks to take all the pain right up front so that the economy can get to it's new level as soon as possible.  That can be traumatic, but once the economy is at the new level, it's going to go up faster in general.  The catch here is the drag on growth produced by underperforming Euro countries like Greece.

In general, for the citizens of a country - stimulus appears better than austerity in the short and medium term.  For investors, the US is likely to be a better country to invest in for at least the next year to 18 months.  In Europe, I would expect further turmoil and a bitter spiral wherein austerity produces economic decline - which in turn produce more austerity in Europe.  I would not be surprised to see other countries like Portugal get impacted.  However, I would recommend re-evaluating the European situation every 6 months or so to look for a stabilization at the bottom.  Once it happens, Europe is likely to outperform the US for years afterwards - especially if Greece gets dumped from the Euro. 

What's your take?


  1. The trouble with using a stimulus to get out of a recession is that it creates artificial demand for things we don't really need or want. We might lower unemployment, but we're not building an economy.

    This is like taking a kid who's underweight, and feeding him ramen and cheese puffs. Sure, he might get up to a "healthier" weight, but the kid's going to have all sorts of health problems in the future.

  2. Hi BL1Y - good comment! We certainly don't want to create artificial, long-term unsustainable economies. I certainly agree that in some conditions a stimulus may be inappropriate. However, to narrow our conversation down to a specific example, let's take the housing stimulus that offered $8K to new home buyers. This has the net effect of increasing demand for new houses and helping the new home construction industry retain workers. Let's postulate that before the crash 100% of home builder workers were employed. After the crash without stimulus, maybe only 20% of them would be employed - with stimulus maybe 50% would be employed. What's the long-term impact? Most likely slower housing appreciation because there is an increased supply - not a complete unsustainable, artificial market supply, but an increased supply. Let's also postulate that the steady state (the number of workers that need to be building houses to make up for the constantly increasing population) is 75%. If we let it drop to 20% instead of keeping it at 50%, we actually may create a bubble in housing prices because once people start returning to the market, supply will not keep up with demand.

    What I am driving at is that there is kind of a fundamental rate of new housing creation that tracks population growth - but that demand may fluctuate based on fear - and that the 1-2 year lead time for making the product may cause asset bubbles. If instead we use stimulus dollars to keep producing the asset at the steady-state rate, even if demand is temporarily depressed, it seems like we are not creating an overextended market in the long term.

    Obviously, I agree with you that we should be on the lookout for unsustainable overproduction - which should be avoided.

    Another aspect of using stimulus dollars that seems good to me is for products providing a long-term benefit. For example, building high-speed rail or other long-term improvements. However, this is one area that I have not been happy with how the stimulus has been administrated. It seems like many of these projects have been coopted by political interests and may not be providing much benefit. Good idea, not so great implementation.

  3. You're missing the most important point which is the state/federal system in the U.S. States have been cutting and the Feds are treading water. That's not stimulus. At the aggregate level, the European core looks alot like the U.S. and the periphery (where there's been real austerity) is a complete disaster.

  4. Both are false choices. The corporations need to be broken up and corporate governance needs change. They're become fat lumbering beasts that stifle and strangle innovation.

  5. 5:27 - Thanks for your comment. I have heard from many sources similar comments to the extent that the US is treading water or is not making headway, etc. However, my thinking is that the stimulus is more to moderate decline in the face of downward pressure as opposed to put everything back where it was before. Unfortunately, it's hard to quantify success at that point and it may not feel as satisfying.

    I have to agree with you that the US is more like the European core economically than like Greece - where austerity is going to have a big impact.

  6. 6:38 - Interesting comment. I take it your innovation tie-in is due to innovation being a great way to increase economic activity. Certainly corporate governance seems like it has lost a great deal of accountability to the shareholders. Your comments with regard to lumbering beasts that stifle innovation seem interesting, but I am not sure what you are alluding to there.

  7. 5:27 is making the point that the "increase" in federal spending in the U.S. Has been offset by decreases at the state level. Thus, our overall "stimulus" looks similar to the spending profile of the Euro-core. In the places where there has been real austerity (Baltics, Ireland), the economic problems are not getting better - and there's no reason to expect that they will anytime soon.

    Just FYI.

  8. You understood my previous post, except I would go further.
    Large business combinations stifle inovation as a result of thier consolidation of markets, beauracracy and internal coroprate politics: essentially, its a path of least resistance to continue making the same obsolete product with the same aging employees and use finance to acquire smaller competators than to make change. Government spending (stimulus) or cutting (austerity) does nothing to create wealth or value -- it simply rearranges teh deckchairs on the Titanic. The key IMHO, is to use government policies to re-position value into leaner hungry innovative interests, so that when one part of the economy or business collapses the government can allow that part to fail while remaining parts support the economy, in other words: diversify.
    Austerity/ stimulus is a false dichotomy.

  9. 3:03 - Interesting! You are certainly right that if the states are cutting while the federal government is stimulating and there is zero net stimulus, then there is unlikely to be a positive impact. I will also agree that states seem to have been raising their taxes/fees somewhat - some states more than others. However, the federal stimulus is really, really, big - and some of it is provided directly to people, like the extended unemployment benefits. I would agree that state tax increases and cuts act against the federal stimulus, but it is hard for me to find evidence that the state actions represent a significant counter - say 30% or more - of the federal stimulus. I stand ready to be corrected if you have better data than I do.

  10. 8:03 - Good point - if we can use government policies to promote start-ups and more innovative businesses (those being where the majority of job creation and economic growth really take place), the better policies can provide us with an economic stimulus - possibly even better than cash could. That's very appealing to me. A caution is that it seems like it is a long-term solution and it may be difficult to implement. That's not a reason why we should not be working on it, but we may need something in addition in the short term. I am also curious as to the policies that you might recommend. Beefed-up SBA? Low-cost capital loans to small businesses if they will agree to hire a certain number of people? Tax freedom for businesses of certain size? Note that all of these ideas could promote small business, but all require some money - and thus could be called a stimulus. I mention this because I have a little confusion between your anti-stimulus statements as opposed to pro-small business policies. Are there some effective zero cost policies that you would recommend?

  11. Why 2 to 3 percent inflation? It seems to me this is the single greatest cause (highest positive correlation in OLS regression) of asset bubbles. Additionally, with inflation the playing field for liquidity is uneven, some even say stacked ( their was a 60 minute piece on this) which allows for large financial companies to profit without a justified add to liquidity.

    To answer your question Asked, I believe austerity is better. Stimulus does not work as their are not sufficient controls to reign in the spending when times are "good". Our federal government as a practical matter has not spent less in 50+ years and the elected politicians would be unelected if they did. The conflict of interest is to great to meaningfully overcome. It is similiar to communism, great in theory but when adding the human element to it it becomes unworkable.

    I have really enjoyed your posts. I wanted to add some information regarding your social security piece. The reason that the benefits are not equal after 35+K is that in the 80's there was a reform (I believe Volcker or Greenspan chaired it) which when adopted effectively kicked the can down the road, by taking more in and paying out less for what was taken in.

  12. Are you planning on doing a post on IRA and ROTH-IRA conversions? Many of us don't get any immediate tax deduction when contributing to an IRA (though the growth is untaxed). So, I am sure it would be interesting for many to know what you recommend for the ROTH/ROTH-IRA decision. If you do write about it, can you please outline your conversion strategy?

  13. MP, I like your analysis, and as liberal as I am, I share BL1Y's concerns of stimulus mal-investment. But, I don't want to fall prey to the belief that government is utterly inept at spending, so I favor infrastructure investment. One other thought I had was to pay work gangs to demolish all the empty, excess houses built during the bubble.

    A thought on Keynesianism: the problem I see is that we're fairly consistent about deficit-spending to maintain demand, but we don't pay any down during times of surplus. Then again, US policy on the national debt since 1787 has been to drown it out with growth, so it might not be that big a problem.

    Ultimately, I don't think austerity is a good idea. Sure, if countries like Greece mess up (it wasn't seriously collecting taxes and didn't even have a land registry), it goes to the IMF. Austerity is great for individuals, but governments shouldn't force their own people to live under the bridge. De-Euro-fication would cause enormous financial damage, but it's probably the only real solution for the PIIGS.

  14. 4:04 - Thanks for the comment! I also have a concern that the government will not have the fiscal restraint to reign in the stimulus. You are certainly right about human nature. Further, the current, unsustainable status of our social programs like Social Security, etc. also adds credence to your view. I still remain very concerned about entering a deflationary spiral, though.

    Thanks also for the Social Security comment - isn't that so like the substantially misleading promises that we keep getting from our government. With the new program, they can still say that our earnings up to the top amount are "counted toward the social security benefit", but in reality, they are 90% not counted toward the benefit. That solution seems to have worked so well, I would not be surprised to have them try something similar again - maybe "all earnings" count toward Social Security" with earnings about $100K discounted 99%.

  15. 7:28 - Thanks for the topic! I will address it soon. If you have any other topics of interest, please let me know in the comments or at

  16. LSTB - Yep. I like the idea of the stimulus going to provide something that would give the country a long-term advantage. Infrastructure seems good. With regard to the houses, I am hesitant to demolish well-constructed homes, but certain areas of cities where there is a high rate of abandoned, trashed homes seems like it might be useful. For example, Detroit has a problem where there are only 2-5 occupied houses in a whole block in some areas. That's a terrible drain on city resources because for indiviudal houses the city must pave roads, maintain pipes, provide copes, etc. Their long-term plan is to demolish the houses and rip up the expensive infrastructure that they can't maintain. In the near term - stimulus due to the jobs created to demolish. In the long term, austerity due to fewer city resources needed to maintain? We should be able to come up with other projects that are human-intensive, but provide a long-term gain.

    You also echo the comments of 4:04 above and some of my personal concerns that the government is not able to exercise sufficient fiscal restraint.
    I agree that it is a real concern. You also mention the option of growing our of debt - and I agree that it seems to have been conscious US policy for decades (don't know if I can go for "since 1787", but certainly decades.) In that sense, even if some of the stimulus remains, as long as most of it is shut off when the economic condition turns around and we can have solid US growth, then we should be OK.

    Your comment about austerity being good for individuals also keys on something that I have been thinking about. For example, if everyone becomes austere, then economic growth crashes because few are buying anything (I think that this is one of the main issues behind Japan's lingering malaise). For individuals as a whole, on an economic growth level, I think we want them to spend - but within their means. Austerity (which I am estimating as spending 80% or less of what the individual makes) would seem to lower economic growth while spending beyond their means seems to create bubbles. For individuals on an individual level, it's probably best for them to be the sole austere person in a land of big spenders!

  17. MP – You mention Japan and its endless problems. I’ve spent a good chunk of my adulthood there, so it’s always on my mind.

    One blogger I’ve found insightfully pointed out that while Japan’s private sector reduced its debt (not by much), the public sector increased its share. At the same time, the private sector resisted restructuring, leading to zombie firms.

    The one question I have is precisely what the government spent the stimulus money on. My impression was that the stimulus went to “roads to nowhere”—highways connecting rural cities that didn’t need connecting. But that’s all I know. Meanwhile, household debt remains fairly low, despite that this was caused by a real estate bubble twenty years ago. All this is why I’m concerned about needless infrastructure investment—I don’t want a depression, nor do I want lost decades. I do want high-speed rail, though. When I took a vacation to southern Japan, my former co-workers thought I was crazy for wasting five hours on the shinkansen when I could’ve taken a two-hour plane ride. What a treat!

    As for Japanese consumption: I’m surprised they consume as much as they do. Living spaces are so small and prosperity so widespread that people throw out tons of stuff. They also move frequently, so I’m not so surprised that there’s deflation.

  18. LSTB - Great insight - and a great factor in favor of directing any stimulus toward the establishment of things that provide a continuing gain. I don't have the extent of your insight, but one aspect that has seemed like it might have an impact to me is the greater emphasis and societal acceptability of entrepreneurship in the US. Seems like it is easier to incorporate and people take you much more seriously as a small concern. Because so much of our employment in the US comes from small business, I wonder how Japan matches up?