Berkshire Ruminations

Thursday, August 06, 2009

100% Insanity

To me, this is proof the mainstream media has absolutely no clue about economic reality.

CNN proudly boasts today that Cash For Clunkers program is “Real Stimulus,” claiming that “The boost to auto sales caused by the government trade-in program should lead to increased production from Detroit. That could have a big ripple effect.”

This whole Clunkers idea is rooted in the Keynesian logic that spending in and of itself stimulates economic growth. The logic goes that, because we built up our economy during good times and when times get rough various elements of the economy are suddenly underutilized, someone needs to fill the gap. Keynesians believe this gap should be filled by the government. What is ridiculous about this idea is that the government cannot produce any wealth, it can merely reallocate it. In order to fill this gap it must either tax its citizens or borrow. No new wealth is created through either process.

While Keynesian stimulus is clearly ridiculous, a lot of people believe it. So let’s say, just for the moment, that government spending is economically stimulative. All Cash For Clunkers will do is to pull demand forward a period or so. All those people who were driving vehicles that would need to be replaced in one or two years will replace them now. What happens in one or two years? Lower auto sales because fewer people are replacing their clunkers! This results in the same overcapacity a few years down the road that the stimulus was designed to fill today. The moral of this story is simple: the government can treat the symptoms, but it cannot cure the disease.

People can easily define their wealth on an individual level. I own a house, a car, furniture etc and all these things have value because they are useful. Therefore my wealth is defined as the cumulative value of all these useful things I own less the claims others have on them (read: debt). But when we expand this to the national level people seem to have trouble understanding.

American wealth is all the stuff we own, collectively, that has value. So when the government destroys things that have value, like cars worth less than $4500, this destroys wealth. The guy who sold his $2000 car to the government for $4500 may indeed by $2500 wealthier, but this wealth had to come from somewhere. (While the government can create money out of thin air, it cannot create wealth out of thin air.) In this case, because $2000 in wealth was actually destroyed, the full $4500 will come from everybody that doesn't sell their car to the government. The rest of the population doesn’t notice this personal wealth loss because it is either too small when spread throughout the economy or it hasn’t even happened yet and will eventually be borne by future generations.

This wealth destruction is particularly pronounced when the government doesn’t have the $4500 in its pocket that it needs to purchase the vehicle that it plans to destroy, because this means the purchase will have to be financed with borrowing. Because the national debt is already unmanageable, eventually this $4500 debt will be monetized by printing new money to repay it (a process that, incidentally, has already begun). This causes inflation, which lowers the wealth of everyone that owns dollars.

So I guess the only conclusion I can draw from this nonsense is that our elected leaders and the majority of our population continue to behave like children. Listen carefully: Americans already have too much debt. The last thing the government should be doing is encouraging them to take on even more, while simultaneously taking on more itself!

But alas, humans aren’t long-run thinking for the most part, so it shouldn’t be a surprise that the reaction to economic crisis is to lessen the pain in the short term at the expense of long term prosperity. And that, clearly, is why the Clunkers program has been praised by just about everyone that hasn’t really thought it through. Just as someone apparently has defined “stimulus” as government spending concentrated over a short period of time, they have defined “success” of the Clunkers program by the program’s ability to concentrate car sales in a short period of time. Congrats guys. You did it. I hope your grandchildren can forgive you.

5 Comments:

  • Hi Andy,

    Long time no speak. Hope all is well with you.

    I have to take the opposite view on this one. There is no doubt that government spending like “Cash for Clunkers” stimulates the economy. Not only does it add to GDP (by definition) but much more importantly, the ripple effect is pretty significant. To see this we simply need to track how the act of someone trading in an old car for a new, more fuel efficient one affects the entire economy. Not only that, the government is actually going to get tax revenue in return from their spending.

    The obvious direct beneficiaries of “Cash for Clunkers” are the automobile dealers and the automobile makers. Higher sales and profits for the dealers and the car makers themselves directly result in higher tax revenue for the government.

    Since auto sales are accelerating, inventories are declining more rapidly and more and more idle plants will see their manufacturing capacity increase to meet demand. This means more workers are building cars, more paychecks are being handed out, and therefore more money is in the system to create economic growth.

    Then you have the consumers themselves. The average consumer using the rebate is upgrading to a car with 61% more gas mileage. That means, of course, that it will cost them less to fill their tanks, which means more disposable income to spend on other things (stimulus). Owning a new car will also reduce maintenance costs for the car owner (more disposable income, more stimulus). Higher consumer spending will not only boost the economy, but also government tax revenue again (via increased profits earned by the corporations selling them goods and services).

    This is the multiplier effect at work. One dollar of spending results in a large ripple effect throughout the economy. The government also gets a return on its investment in the form of higher tax revenue. Then of course we have the environmental and health benefits of less pollution in the air from transportation vehicles… harder to quantify in dollar terms, but another benefit nonetheless.

    I know all of this is being spun in many circles as pure politics, but the reality and economics behind it (fortunately) is pretty non-partisan.

    By Blogger Chinch, at 06 August, 2009 12:20  

  • Chinch,

    If the government multiplier on spending is really as high as you assume and you take the bold assumption that the deadweight loss from the increase in taxes in the future as being nill, there may be some logic to your arguments. However, the empirical research on govt spending multipliers and the estimated deadweight losses from increases in taxes don't bear out your arguments. If you can point to some serious empirical evidence on this subject I would be surprised.
    One thing this stuff may help is in dealing with 'animal spirits' and 'tricking' everyone into having more confidence...

    Perhaps we should just dig post holes and have people fill them, or maybe burn crops to increase prices on goods...or pay people cash payments so the government can destroy our current capital stock and increase it artificially so some auto maker unions keep voting democrat...come on...are you serious? You can show me the most complicated theory on the planet that keeps the Keynesian ball rolling, but not much of this stuff passes the 'common sense' test.

    the only real idea from all of this is perhaps infrastructure spending that needed to be done anyway. Right now with slack in labor markets you could theoretically pick up 'underutilized' labor and allocate them to projects we needed to do anyway, but when the opportunity cost of the labor is low...

    who knows, I tend to agree that we are leading down a path of fiscal insanity and any dogmatic economic views can lead to potential issues.

    By Blogger Wesley R. Gray, at 06 August, 2009 22:14  

  • Chinch,

    Here is another thing you should read on the 'broken window fallacy.'

    http://bastiat.org/en/twisatwins.html

    anyway, interesting stuff and i don't think anyone has it all figured out

    By Blogger Wesley R. Gray, at 06 August, 2009 22:22  

  • The thing is, all of that ripple effect that I went through isn't complex economic theory, it is simply common sense. My economics classes are too far back in the past for me to use theories for this argument, or to exactly try to quantify the multiplier effect. There is nothing theoretical about the effects of C4C on the general economy, though, so I am simply arguing that it is certainly stimulative. By how much exactly is out of my skill set.

    From the future tax perspective, I find it odd that we assume taxes will go up to fill the debt gap. Consider that the U.S. National Debt as a percentage of GDP peaked at the end of WWII at 120% of GDP. It then collapsed to under 30% by the early 1980's and has risen steadily since Reagan to now sit at around 80%.

    Higher tax rates were not needed to go from 120% to 25% debt/gdp over a 3 decade period. In fact, if you look at the top marginal tax rate, it has been in free fall for decades and now stands at nearly the lowest level ever. If we repaid all of the debt from WWII back without raising taxes, why do we assume we will have to this time, especially when our debt today is one-third lower than it was back in 1945?

    By Blogger Chad Brand, at 07 August, 2009 06:49  

  • Wesley

    When the economy is in recession unemployment benefits are known to have a positive effect on the economy. The reason is not that a lot many lazy people are doing us good and so we are compensating them, the reason is the money on other people's hands create demand and hence goes on to increase productivity. We have to understand that a government's primary aim should be to drive employment which will lead to increased production of real goods and boost the economy. While digging pits and filling them may not have any conspicuous economic benefits for many, still it will serve the same purpose as giving unemployment benefits. And this program has some other social benefits like decreasing pollution. While you may argue that spending public money could have had better uses (say the stimulus program could have been designed better by giving cash benefits etc), you cannot deny the utility of this program.

    By Blogger moy, at 08 August, 2009 14:57  

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