Monday, September 20, 2010

Deficit hawks would make terrible businessmen: a simple explanation of how the stimulus package works to boost the economy

For anyone running a business, living within your means is overrated. Sometimes you have to spend money to make money—even when the money’s not there. The metaphor of a family balancing its budget around the kitchen table simply doesn’t apply to a business, because businesses (1) can borrow money at low cost, and (2) can use that borrowed money to make more money.

Think about it this way. If a family borrows money to buy a flat screen TV or granite countertops, it will eventually have to curtail consumption elsewhere to pay back the loan (as long as its income remains constant). After all, the money has to come from somewhere. There are a few exceptions—for example, borrowing money to pay for education, or borrowing money to insulate your house and cut your utility bills, both will provide a future cash flow with which to pay back the loan. But those are investments, not costs. And unless you’re using borrowed money to make more money, you’ll eventually have to cut back. (This is why home equity loans are a scam, as mortgage industry veterans I’ve spoken with readily admit—unless you sell your house, you won’t actually have the cash to pay back the loan.)

Unlike a family at the kitchen table, businesses—especially large ones—do not operate under these constraints, because businesses have access to credit. When a business wants to expand, it can borrow money from a bank or issue debt on the capital markets (e.g. sell bonds). Unlike granite countertops, business debt generates future cash flows (either by increasing revenues or reducing costs) out of which to pay off the debt—and hopefully leave some leftover for the business. For example, a business might issue bonds to finance new plant equipment that will produce more products, or to buy automation software that will reduce its operating costs. Even though the business's debt increases, both investments generate cash that can be used to pay back the debt. A CEO who looked out at his market and said, “well, there are a ton of customers out there waiting to buy our product, but I can’t hire salespeople to reach them because I don’t have the money” would be justly fired for failing to take advantage of his credit access (assuming he did indeed have access to credit).

In other words, if everyone lived within their means, the economy would never grow.

The federal government is more like a business than a family around the kitchen table, because the federal government can borrow money at exceptionally low interest rates, and use it to make investments that grow the economy—or at least prevent it from shrinking—and pay back the loans out of the increased tax revenue.

That’s the logic behind stimulus. In the days following Lehman, the economy was in danger of entering a self-fulfilling death spiral. Banks stopped lending, meaning that businesses couldn’t borrow cash to pay their workers or keep the lights on. Laid off workers—or workers in fear of future layoffs—stopped spending money, reducing businesses’ revenues and forcing them to lay off more workers, further reducing business’ revenues: a positive feedback loop. As incomes fell, the federal government would have taken in less in tax revenue, increasing the deficit. And if the recession turned into a multi-year depression, trillions of dollars in expected government revenues would have simply vanished—meaning that as high as the deficit is now, it would have been even bigger without stimulus.

So like any good businessman, Presidents Bush and Obama borrowed money to stop the economy from collapsing. They injected capital into banks to ensure lending could continue and companies could meet payroll. They bought products from companies who would have otherwise had to lay off workers. They sent unemployment checks to workers so they could continue buying food and basic necessities. And in doing so, they preserved government revenues which otherwise would not have been available to pay off debt. In other words, stimulus is not government spending—it is government investment.

Don’t believe me? Ask the market: 10-year Treasury bond yields are down below 2.75%, which means that the market believes there is a very low risk that the federal government will not pay them back. So free marketers are left in a very tight double bind: either government stimulus works, or the Market is wrong. Either way, the orthodoxy dies.


Yes, government creates jobs


  1. I agree with the big picture of the article. Well-written, well-argued. Only minor thing is that the feedback loop you describe is actually "positive feedback", not negative. I agree the outcome is bad, but the effect of each thing is more of itself, so that's positive.

  2. You are right on the feedback loop - I didn't realize that downward spirals were examples of positive feedback. I'm reading a book "The Origins of Wealth" right now which pointed that out. I should have changed it. Changed now.

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  11. If everybody in the world had enough money, would there be any people who'd like to do menial jobs? if everyone lived within their means, the economy would never grow. True facts. You can read more information about economics.