Friday, July 30, 2010

Small and ineffective stimulus in 2007-2009

Paul Krugman has an blog post titled How Did We Know The Stimulus Was Too Small? He discusses three points. First shortfall was about $2 Trillion. Second, the stimulus was designed at $780 billion. Third, the multiplier that was expected to magnify the impact was not properly enabled. 

There are few points and other reasons that I have highlighted over the days:

First part of stimulus went to mending the financial system. This part is basically used in wetting the system rather than actual priming.

Second, the type of activities under stimulus determines the effectiveness of the stimulus. Some activities are better at stimulating than others. Income supporting activities are often better at stimulating than consumption driving activities. Thus the proverbial dig-a-hole-fill-that-hole Keynes stimulus had better bang for the buck than the Obama-Bush please-spend-the-tax-cut stimulus.
Third, individuals save because there is uncertainty about incomes. The only way to counter uncertainty is by creating certainty. It is OK if the level of "certain income" is lower than actual. Once there is certainty that bottom is in place, the direction of wage declines stems and even reverses.
Fourth, the choice of monetary or fiscal stimulus was available in 2007. It is still available provided you write-off the stimuli till date.

Fifth, Scott Sumner proposed that monetary and fiscal policies were acting against each other. There is an element of truth to this argument. However, predominantly the fiscal stimulus failed because it was ill-designed.

Sixth, since banking system was under threat,
    • I would have created a parallel national banking system using post office infrastructure. 
    • This national bank would have bought assets from the consumer (mortgage transfers) at a marked-down prices so that the balance sheet of this bank stayed healthy.
    • Since we did not do this, we have a huge bailout liability and we are still not sure if banks are sound or not.
Seven, if we had designed the stimulus better and gone with a simple job-creating fiscal stimulus, we would have needed far lesser money that we needed to bailout the banks.

In Sum, there were a lot of things wrong with the stimulus. Size was just one of them.