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Generational Dynamics Web Log for 12-Jan-2009
The effects of massive fiscal stimulus - Part II

Web Log - January, 2009

The effects of massive fiscal stimulus - Part II

President-elect Barack Obama is turning apocalyptic in his speeches.

He's no longer claiming to heal the economy and the world by January 21.

Related Articles

Fiscal stimulus
The current stock market bubble correlates with bailouts and stimulus: This is another refutation of Richard Koo's stimulus theories.... (14-Oct-2009)

Fiscal stimulus programs in 1930s and today: Did Hitler really do everything right?... (1-Apr-2009)

The effects of massive fiscal stimulus - Part II: President-elect Barack Obama is turning apocalyptic in his speeches.... (12-Jan-2009)
The economic outlook for 2009 : How we got to where we are today, who's to blame, and where we're going in 2009. (5-Jan-2009)

The effects of massive fiscal stimulus.: A study comparing Japan's deflationary spiral with ours shows the way.... (24-Dec-2008)

One, Two, Three ... Infinity: Watching the world spin out of control.... (25-Nov-2008)

Here's an excerpt from the speech he gave on Thursday:

"We start 2009 in the midst of a crisis unlike any we have seen in our lifetime, a crisis that has only deepened over the last few weeks. Nearly 2 million jobs have been now lost, and on Friday we're likely to learn that we lost more jobs last year than at any time since World War II. Just in the past year, another 2.8 million Americans who want and need full-time work have had to settle for part-time jobs. Manufacturing has hit a 28-year low. Many businesses cannot borrow or make payroll. Many families cannot pay their bills or their mortgage. Many workers are watching their life savings disappear. And many, many Americans are both anxious and uncertain of what the future will hold.

Now, I don't believe it's too late to change course, but it will be if we don't take dramatic action as soon as possible. If nothing is done, this recession could linger for years. The unemployment rate could reach double digits."

Interestingly enough, he also blames the crisis on the United States:

"For years, too many Wall Street executives made imprudent and dangerous decisions, seeking profits with too little regard for risk, too little regulatory scrutiny, and too little accountability. Banks made loans without concern for whether borrowers could repay them, and some borrowers took advantage of cheap credit to take on debt they couldn't afford. Politicians spent taxpayer money without wisdom or discipline and too often focused on scoring political points instead of problems they were sent here to solve. The result has been a devastating loss of trust and confidence in our economy, our financial markets and our government.

Now, the very fact that this crisis is largely of our own making means that it's not beyond our ability to solve. Our problems are rooted in past mistakes, not our capacity for future greatness. It will take time, perhaps many years, but we can rebuild that lost trust and confidence. We can restore opportunity and prosperity."

One thing that really bothers me is that I cringe whenever he uses the word "partisan" or "ideological," as he does all the time. When he uses those words, what he means is that everything that the Bush administration did was based on ideology and partisanship, while every decision he makes is based on pure, golden facts.

This is at the heart of Generation-X nihilism, destructiveness and self-destructivenes that I've discussed so many times. It represents such complete contempt for other views, that those views can't even be grasped, and have to be explained as being bizarre and ideological. From this contempt is a willingness to destroy everything that came before, and this inevitably leads to self-destruction. No wonder Strauss and Howe found that, of the four generational archetypes, people in the "Nomad" archetype (like our Generation-Xers) are by far the angriest and bitterest in old age.

As I discussed a couple of days ago in "The outlook for 2009," I am very concerned that we're headed for a catastrophic financial crisis.

The macroeconomic view

The above remarks are based on intuition. I've seen what's happened in the past few years, and what I hear from Obama and his supporters today. But is my intuition correct?

Now I have to return to an article that I wrote a few weeks ago, called "The effects of massive fiscal stimulus." In that article, I discussed a presentation by Richard C. Koo, Chief Economist at Nomura Research Institute, comparing Japan's 1990s deflationary spiral with America's in the 1930s and today. (It's still worth watching the entire video of that presentation, as you can do by following the link in the above referenced article.)

I said at that time that Koo's presentation is one of the few things I've seen in years that have forced me to reevaluate my thoughts on the coming financial crisis, and indeed some of Koo's conclusions seem to contradict what my intuition tells me about the potential destructiveness of Obama's completely undisciplined economic policy.

Let's recap with a summary of some of the major concepts of Koo's presentation.

In "normal" times, money is created by private saving and private lending, with the banks as the intermediary. Thus:

Individuals and businesses save money by depositing it into banks, expecting a return in the form of interest.

Banks are interested in lending out that money to borrowers, since the way they make money is by charging interest on loans.

Individuals borrow money from banks to purchase consumer goods and services. The money flows to businesses that provide the goods and services, and some of it is saved in the bank, completing the loop.

Businesses borrow money from banks to invest in company growth, creating new products and jobs. Some of the income from product sales pays the salaries of the employees, and some goes into savings, completing the loop back to the bank.

The government can stimulate this process through either monetary or fiscal policy. In monetary policy, the Fed lowers interest rates, the banks borrow from the Fed, and loan money out of individuals and businesses, who then spend it or invest it. In fiscal policy, the government borrows money and uses it to reduce taxes, make direct payments, or fund public works projects and the military.

Money is actually created by the above process. Suppose that I have $1000 in my pocket, and you have nothing. Then between us we have a total of $1000.

Suppose I deposit $1000 in the bank, and you borrow $1000. Then how much money do we have between us? The answer is that we now have $2000; I still have my $1000 as a bank deposit, and you have $1000 in your pocket.

During a deflationary spiral, that process is reversed. You pay down your $1000 debt, and I hoard my money. The result is that we now once again have only $1000 between us. There is actually less money in the world than there was before. (As the saying goes these days, the extra money has gone to "money heaven.")

A deflationary spiral occurs because of a massive change in attitudes and behaviors by the general public. In "normal" times, people are interested in consumption and growth, causing a growth in the money supply. In a deflationary spiral, people are interesed in minimizing debt, causing a reduction in the money supply.

During a deflationary spiral, nobody wants to borrow money, since they're paying down debt. This is a problem for banks, since they need to lend to make money. Hence, monetary policy (lowering interest rates) fails to stimulate the economy, since nobody wants to borrow at the low interest rates.

However, fiscal policy still works: The government borrows money and uses it to reduce taxes, make direct payments, or fund public works projects and the military.

How do we pay for fiscal stimulus?

This is the most mind-blowing part of Koo's presentation. According to Koo, the fiscal stimulus pays for itself in the form of savings. Since money is being used to pay down debt, it returns to the banks in the form of savings or debt repayment.

The banks have to make money, and they only way they can do that is to lend the money out and collect interest. The problem is that there are no private borrowers who wish to borrow money. So the bank might be stuck with the money. Instead, the banks use the money to buy Treasury bills and bonds. This returns the fiscal stimulus money to the government.

Here's an excerpt from Koo's presentation (at time 1:03:55):

"Last point: Who's going to buy these Treasury bonds with this large fiscal stimulus? That question has been raised many times during my visit. The US has no savings to finance this fiscal stimulus that I'm talking about.

My answer to that is: No worries. There should be no problem with the funding issue. And the reason is the following: The amount of fiscal stimulus needed to stabilize the GDP in this instance is exactly the same amount as the excess savings created in the US economy through increasing household savings and the increase in debt repayment.

This is the funding that the government should pull out of the banking system and put back into the income stream, which means that the entire amount of savings needed is generated in the economy. And the US government will be just taking that extra savings generated and putting that back into the income stream. So there's no reason for interest rates to increase.

Quite the contrary, the fund managers of the banks, who have to manage these funds, should be more than happy to lend to the government, because there are no other borrowers who would borrow the money, so that the banks can earn interest.

And we saw this happen in Japan as well. At the beginning, when we saw our budget deficit growing very rapidly, a lot of people were out there saying, "The whole thing will collapse, and high interest rates will result, and we're all dead."

But interest rates actually came down over this period. Our budget deficit in Japan is 180% of GDP, the highest of any industrialized nation at the moment.

Our interest rate, long 10-year Japanese government bonds, is only 1.5%. That's lower than the lowest that the US government reached during the Great Depression, which happened to be 1.85%.

And why is the rate so low? Because there are no private sector borrowers, and people are still saving money. The government is borrowing that money, and the fund managers are more than happy to give that money to the government because it's the only borrower left. The same thing will happen in this country as well.

And so, I don't think people should be too worried about interest rate implications of this large fiscal stimulus. Of course, if you don't put in the fiscal stimulus, then the economy will collapse, and then interest rates will go even lower. But I think you'd rather have a slightly higher interest rate and a working economy than a Great Depression type situation."

Recent events have strongly supported this prediction by Koo. Banks have been pouring money into Treasuries in the past few months, pushing yields (interest rates) to historic lows. This money from banks is now available to the government for fiscal stimulus and, if all goes well, the money will once again return to the Treasury in the same way.

Generational trends in fiscal stimulus

Well OK, if money spent on the fiscal stimulus just loops back into the Treasury, what happens a couple of years down the road, when people have paid off most of their debt, and they start spending and investing again?

This is where generational theory enters the picture. As we've described many times on this web site, the 1990s dot-com bubble occurred at precisely the time that the risk-averse survivors of the Great Depression all disappeared (retired or died), all at once, and were replaced in senior management positions by risk-seeking Boomers.

Koo confirms this generational interpretation in the following excerpt (at 1:06:35):

"And it will be a long while before interest rates go back up to anything we remember seeing in normal times. After the Great Depression, those people who experienced the Great Depression, they never came back to borrow money in their entire lives, their remaining lives.

[Exhibit 23.] And as a result it took the United States 30 years to bring interest rates back to the level of the 1920s. Thirty years. In 1929 the NY stock market crashed; it was 1959 that interest rates finally reached the level of average interest rates in the 1920s, because private sector sorts just pulled themselves out of borrowing altogether.

You might know some parents or grandparents who lived through the Great Depression. They never borrowed money the rest of their lives because the pain, the experience of paying down debt during the Great Depressioin was just so overwhelming.

We still have this problem in Japan right now. That's why interest rates are so low - 1.5%. The US will have that problem, [and so will] Europe, China. They all will have this problem of too much savings, too little borrowing in the private sector, and the government trying to put that money back into the income stream.

And so, I don't think interest rates is going to be a big problem, I don't think inflation is going to be a big problem, but maintaining aggregate demand - that is going to be the challenge."

And so, according to Koo, paying for the fiscal stimulus won't be a problem in the near term, and it won't be a problem in the long term -- not for 30 years, anyway.

This leaves me personally with a bit of cognitive dissonance. On the one hand, my intuition tells me that the policies of Obama and his advisors are reckless, and will lead to disaster.

But Koo tells me not to worry. Any amount of fiscal stimulus is OK, because the money just comes back to the Treasury anyway. It sounds like a dream come true -- a credit card with an unlimited credit line that never has to be paid back.

Problems with fiscal stimulus theory

So let's try to resolve this cognitive dissonance by looking at some of the problems with Koo's theory. And there are three serious ones.

Problem #1: The coming crash.

As I've written many times (and won't discuss further here), neither Obama nor Koo has repealed the Law of Mean Reversion, nor have they repealed generational theory, and a major stock market crash is still in the wings, since stocks have been overpriced since 1995.

What effect would a stock market crash have on the fiscal stimulus program? That's really a political question, but history tells us that the likely result would be greater unity behind President Obama.

In generational terms, the crash would seal the "debt minimization" behavior in the current generations. Today, there's still a lot of irrational hope that Obama will save the world on January 21. A crash would remove that irrational hope.

Problem #2: Leakage.

A glaring omission in Koo's presentation is what I call "leakage."

The whole point is to stimulate demand within the country. This requires a somewhat closed system, where any consumer purchases are of products and services supplied domestically. If a consumer consumes imported goods, then money leaves the country to pay for those goods, instead of returning to the Treasury. It's this money leaving the country that I call "leakage," and the only solution is to export products and services equal to the level of imports.

Koo developed his theory from Japan's experience in the 1990s and early 2000s, where it apparently worked satisfactorily. But during this period, America, China and other Asian and European countries were in an economic bubble, able to import as many goods as Japan could export.

In the coming crisis, almost every country on earth, including America and China, will be unable to purchase goods manufactured in other countries. In fact, we've already seen this happening, in last month's article, "World wide transportation and trade sink farther into deep freeze." Thus, the environment in which Koo's theories worked for Japan will be totally and dramatically different from the environment that we'll be facing soon.

Just take one example: Oil. America imports millions of barrels of oil every day, paying for it with dollars borrowed from China by selling them Treasuries. When China's financial crisis becomes so bad that they will be unable to purchase any more Treasuries, then America will no longer be able to purchase oil. In fact, that's probably the point at which the American government will go into default, and outstanding Treasuries will be marked down to a fraction of their previous values.

Meanwhile, on main street, there'll be little heating oil available to heat homes, and there'll be little gasoline available to run cars.

I suppose the ironic result will be that Obama will then agree to use some of fiscal stimulus money to drill for oil offshore, and in Alaska.

Problem #3: Timing.

The other glaring omission from Koo's presentation is timing.

Koo's examples are of the Great Depression, starting in 1934, five years after the crash, and of Japan, starting in 1997, seven years after their crash.

In both of those cases, the crash triggered the bursting of the credit bubble and the beginning of the deflationary spiral. People immediately started paying down debt, and after 5-7 years had past, most of the debt had been retired, either through paying it down or through bankruptcy and foreclosure.

Personal consumption - quarterly changes <font face=Arial size=-2>(Source: WSJ)</font>

Personal consumption - quarterly changes (Source: WSJ)

According to a recent article in the Wall Street Journal:

"U.S. household debt, which has been growing steadily since the Federal Reserve began tracking it in 1952, declined for the first time in the third quarter of 2008. In the same quarter, U.S. consumer spending growth declined for the first time in 17 years.

That has resulted in a rise in the personal saving rate, which the government calculates as the difference between earnings and expenditures. In recent years, as Americans spent more than they earned, the personal saving rate dipped below zero. Economists now expect the rate to rebound to 3% to 5%, or even higher, in 2009, among the sharpest reversals since World War II. Goldman Sachs last week predicted the 2009 saving rate could be as high as 6% to 10%.

As savings increase, economists say, spending is likely to contract further. They expect gross domestic product to decline at an annualized rate of at least 5% in the fourth quarter, the biggest drop in a quarter-century."

Thus we see that the sharp reversal in population behavior, from being net borrowers to being net savers, began in the third quarter of last year, very recently. This means that the deflationary spiral didn't really begin to take hold until at most six months ago.

Furthermore, as I pointed out above, the major stock market crash hasn't even occurred yet, and that's when the real debt minimization behavior will begin.

So the timing problem is that Koo's theories may work well 5-7 years after the deflationary spiral begins, so that it's had some time to work itself out, but they may not work well at the beginning of the deflationary spiral.

These two factors -- leakage and timing -- indicate that the deflationary spiral will be far deeper and far more devastating than indicated by Koo's figures.

Military spending

So what's the solution to my little puzzle, my cognitive dissonance? Is my intuition right, that Obama and his advisors are making reckless, catastrophic plans that will destroy the economy? Or is Koo right, that fiscal stimulus is an infinite credit card line, where loans never have to be repaid?

It's quite possible that the answer is "all of the above" and "none of the above."

Koo himself went out of his way to characterize military spending as the most effective form of fiscal stimulus, though he said he hated that conclusion. But military spending produces "useless products," while forms of fiscal stimulus that produce useful products end up putting the government in competition with private industry to produce those products.

Koo also made the following rather ominous observations: What Germany discovered in the mid-1930s, and America discovered after 1941, is that the most effective way to end a deflationary spiral is to have a major war. (I suppose that Koo might have made the same observation about mid-1930s Japan.)

This fact will not be lost on China. China has been implementing a massive military expansion for several years now, and has been preparing specifically for war with America. China's "fiscal stimulus" package is certain to boost military spending even farther. Add to that the increasing civil unrest in China, and Beijing will be sure to redirect that anger towards Japan and the United States.

China is going to do this irrespective of what America does. It thus seems likely that Obama will have to include additional military spending in his own fiscal stimulus package, and if he doesn't do it now, events will force him to do it later.

Thus, the solution to the worldwide financial crisis may well be the Clash of Civilizations World War.

During a discussion of all the confusion about the details of the planned fiscal stimulus on the Sunday morning news talk shows, one pundit, Peggy Noonan, made the following observation:

"I think they're sending a big cloud out there, a huge rolling plan, that they mean to go forward almost of its own dynamism, and pushed in part by a sense of emergency and crisis. My sense of watching the President-elect today is that he just may get a lot of the things he wants, so he'd better be wantin' the right things, because it's going to be on him in a very big way."

Right now we need President-elect Barack Obama to lead us. As his speeches becom increasingly apocalyptic, let's all hope that he'll be wantin' the right things, because the survival of America depends on it.

(Comments: For reader comments, questions and discussion, as well as more frequent updates on this subject, see the Financial Topics thread of the Generational Dynamics forum. Read the entire thread for discussions on how to protect your money.

For those interested in learning more about the theoretical side of Generational Dynamics, Matt1989 has just started a new thread and new discussion called Generational Crises and Methods for Evaluation in the Generational Dynamics forum. Matt has done an enormous amount of extremely valuable work developing generational timelines for numerous countries.) (12-Jan-2009) Permanent Link
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