Why Deficit Stimulus Spending Doesn’t Fix Recessions, Part 2 of 2

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7 MIN READ - You might want to save the Cautious Optimism Economics Correspondent’s new column for the next recession. Here he finally explains the “why” in “why government stimulus spending doesn’t work" and why he thinks stimulus package after stimulus package will only prolong China's current economic malaise.

In Part 1 we looked at historical examples of massive government stimulus not only failing to end recessions and depressions quickly, but stretching them out into record numbers of years or even decades: 

-The Great Depression
-Japan’s post-1990 “three lost decades”
-The “secular stagnation” snail’s pace recovery from the 2008 financial crisis
-Europe’s even worse post-2008 recovery that produced Great Depression level unemployment in several Mediterranean countries

We also mentioned how Keynesian economists like Paul Krugman, when faced with record-long slumps after large stimulus packages are spent, always about-face from initial promises of “stimulus will end the recession now,” to excuses like “well, the stimulus just wasn’t big enough” or “well, it would have been even worse without the stimulus” later.

Today we’ll lay out the theoretical explanation why deficit stimulus spending has made things worse in all these cases, and why Beijing will stretch China’s economic problems out for years or even decades if it resorts to stimulus package after stimulus package like Japan has for thirty years.

But first we’ll briefly explain the theory behind the stimulus rationale to begin with.

KEYNESIANISM

The Keynesians, proponents of British economist John Maynard Keynes (1883-1946), argue when the economy turns south there is a “lack of aggregate demand" or not enough spending from consumers and businesses.

In their eyes, rapid recovery requires more spending. Consumers are hesitant to spend, therefore businesses invest less and create fewer jobs which leads to consumers spending even less, and so on.

So the solution, according to the Keynesian theory, is for government to borrow and spend in ways that get cash into lower and middle-income households’ pockets. Once consumers start spending government cash, business confidence will return and companies will spend more on investment and jobs. From there the economy will run strongly on its own—the so-called “virtuous cycle of spending," or what Paul Krugman has called “liftoff.”

Keynes himself thought spending was so important that he argued it was OK to borrow and spend on socially useless projects, writing that the government should pay people to “fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and… dig the notes up again.” (1936)

Incidentally the “spending on anything is helpful” mantra has provided politicians with decades of intellectual justification for stimulus spending on the most absurd and wasteful programs, such as during the 2009 Obama stimulus.

In fact the theory that “all we need is more spending” is symptomatic of the direction modern macroeconomics has shifted towards for nearly a century. 

The old classical economists like Adam Smith, J.B Say, and David Ricardo tended to look at everything—consumer preferences, capital accumulation, physical capital investment, business projects in the real world, and yes, also money, trade, and spending.

But modern macroeconomics has devolved into mostly theories about money and exchange, neglecting factors such as physical economic resources, consumer preferences, and right/wrong capital investment structures.

FREE MARKET CAPITAL THEORY

The free market Austrian School economists and supply-siders argue the economy doesn’t need more spending: it needs a big adjustment in the real, physical world that goes far beyond simple flow of dollars. To best illustrate this dissenting theory the Correspondent will borrow from his own column on the same subject of five years ago:

Austrian economists argue that blindly stimulating spending just prolongs what was an original physical error that caused the recession to begin with. We’ll use a good analogy the Correspondent credits to Austrian economic historian Thomas E. Woods using a restaurant.

Take a restaurant owner in a small town doing a steady business.

Then one day the circus comes to town. The circus is an unsustainable boom or even bubble, usually produced by the central bank’s cheap money policy, just as cheap central bank money spurred irrational asset bubbles in 1927-1929 (USA), the late 1980’s (Japan and the USA), the late 1990’s (USA), and the 2000’s (at least 32 different countries).

The restaurant owner, not being a free market economist and unaware of the danger, is overjoyed to see his store full of new customers: clowns, trapeze artists, and acrobats. Not having enough tables, food, supplies and employees to serve them all, he borrows from a bank, builds a new, larger restaurant right next door, and operates both. The construction, restaurant supply, and restaurant food distribution industries also ramp up borrowing and investment to meet the second restaurant’s new demand.

This is the pre-recessionary boom which we know is unsustainable, but in the euphoria of the bubble many people (including Keynesian economists) claim “We’ve entered a new era in economics and solved the business cycle forever.”

But then suddenly, as is always the case, the circus suddenly leaves town when the bubble bursts, demand returns to its pre-bubble levels, and the owner discovers his error: he's stuck with a new, expensive second restaurant sitting empty and losing money—what Keynesians call “idle capacity.” The restaurant’s suppliers suddenly find demand is insufficient for their new employees and warehouses too.

The Keynesian/Democratic line of thinking is for the federal government to borrow and spend trillions of dollars on stimulus—which often takes the form of payoffs and handouts to political allies and constituents—in hopes of getting something like the circus to come back. If the circus returns the owner can keep paying his workers and go back to ordering food, utilities, and equipment for his second restaurant. This, we’re told, will help his suppliers too.

But the Austrians/supply-siders ask “Is putting the second restaurant on life support really good for recovery?" 

We already know that Circus 2.0 isn't going to last long. The moment the stimulus runs out the second restaurant, which was never sustainable to begin with, will just sit empty again.

So we’re right back to square one, except now we have trillions of dollars in new debt.

This is why so often after a stimulus package, we read headlines that GDP got a bump, only to slump right back a quarter or two later… sometimes into a “double dip” recession.

The Austrians explain that as much as we hate to see the second restaurant idle, there’s no way we can go back to the conditions that prompted its erroneous construction. Because it was all built on a mirage created by the central bank.

So as painful as it is resources, including workers, must be shifted away from the erroneous investments and back to rational ones that consumers don’t need bubbles to support. In other words: liquidation. And the sooner it’s over and done with, the sooner the economy can get back to rational, sustainable growth.

Another common analogy is a binge drinking hangover. 

Like a bubble, drinking too much can be fun for a while. Later, the inevitable hangover doesn’t feel good but it’s necessary: a sign the body is returning back to health, so it’s best to get it over with. The Keynesian prescription, drinking more alcohol (chasing the hair of the dog) might make the body feel better for a little while but we know the hangover will just come back, sometimes even worse.

Yes, it’s a tragedy that the central bank erroneously pushed concrete, parking lot asphalt, and workers to an irrational project, and that the central bank spurred restaurant supply companies to increase hiring and expand as well. Now some resources like restaurant supply, furniture, and dishware will have to be sold off at firehouse prices (ie. devalued capital), although if we’re lucky some ingenious entrepreneur might think of a cheap way to transform the building into a more usable business venue. 

But there’s no reason to spend borrowed money to employ extra workers, food, restaurant equipment, and utilities that consumers won’t patronize without the government borrowing and spending trillions of dollars in perpetuity.

Let’s go reductio ad absurdum to really drive the point home: 

If a speculative bubble spurred a businessman to build the world’s largest shopping mall in Antarctica, would it make sense to borrow trillions of dollars for deficit stimulus every year in the hope of generating enough customers to keep the mall going? 

Of course not. Better to admit it was a mistake and stop pouring even more money and scarce resources into it.

This theory explains why every recession prior to 1929—when countercyclical deficit stimulus spending theories hadn’t been invented yet—ended years faster than the Great Depression, the 2008-2015 Obama “recovery,” Japan’s three lost decades, etc… 

Most of what were called “depressions” in the 19th century, plus the Depression of 1920-21, were ended in one or two years, the recoveries were violently strong and rapid, and full employment was achieved in at most four years after a financial crisis (it took seven years after the 2008 financial crisis to reach full employment). Because before 1929 the economy was allowed to rationally reallocate resources, and do it quickly. The government didn’t delay or prevent the adjustment process with endless “stimulus.”

This also explains why stimulus isn’t going to solve China’s problems. The central bank and government central planning mistakes that plowed so much debt and so many resources into ghost cities and giant construction projects have to be corrected, not propped up. Production lines that were wrongly diverted to those sectors must be allowed to reallocate to other industries that consumers both prefer and are able to support without a bubble.

That will take some time and there will be some pain, but the adjustment is necessary.

Instead, by borrowing and blowing trillions of yuan to keep the real estate and government-sponsored construction projects “stimulated,” the Chinese government—just like Herbert Hoover and FDR, Japan, Obama, and the PIIGS countries—will prevent the adjustment from occurring or at minimum slow it down dramatically.

And when the stymied realignment is finally allowed to finish many years later the government will have needlessly accumulated trillions of dollars in debt that hangs around the country’s neck like an albatross.

If you feel you understand this explanation, the Correspondent will close out by presenting this same theory in nerdy economics language:

“The unsustainable investment errors made by businessmen during the boom must be liquidated, and physical resources and other factors of production that were misallocated must be redirected to rational business lines that consumers will support under normal economic conditions, not temporarily ‘stimulated’ back to boom levels only to slump right back into idleness once stimulus is removed."

and...

"The market process of reallocation results in some temporary job displacement, but the sooner it’s completed the sooner the economy can resume rational growth based on the consumption and saving decisions of the public rather than distortive central bank policy.”