Friday, 27 August 2010

Fantasyland and the imaginary world of spending multipliers.

"The president still seems to believe in the imaginary world of spending multipliers — whereby each dollar of additional spending results in something in the order of $1.40 in additional output."

"Bury Keynesian Voodoo Before It Can Bury Us All"
by Kevin Hassett

"Aug. 23 (Bloomberg) -- Initial claims for unemployment benefits surged to 500,000 in mid-August, a level more typical of a recession than a recovery. The bad news confirmed what conservative economists have been saying for some time: The biggest Keynesian stimulus in U.S. history was a bust."

"A 2002 study by economists Richard Hemming, Selma Mahfouz and Axel Schimmelpfennig of recessions in 27 developed economies from 1971 to 1998 found that increased spending by government had, in almost all cases, a barely noticeable impact, and sometimes a negative one. Heavily indebted countries that spent more in recessions grew about 0.5 percent less, relative to trend, than countries that didn’t, the study found."

It is impossible to calculate the effect of deficit-financed government spending on demand without specifying how people expect the deficit to be paid off in the future, this is the very reason why the Keynesian inspired stimulus did not work. The theory of rational expectations can be used to support this:

"If the Federal Reserve attempts to lower unemployment through expansionary monetary policy economic agents will anticipate the effects of the change of policy and raise their expectations of future inflation accordingly. This in turn will counteract the expansionary effect of the increased money supply. All that the government can do is raise the inflation rate, not employment. This is a distinctly New Classical outcome."

The Policy Ineffectiveness Proposition (PIP) is a new classical theory proposed in 1976 by Thomas J. Sargent and Neil Wallace based upon the theory of rational expectations:

"If the government employed monetary expansion in order to increase output, agents would foresee the effects, and wage and price expectations would be revised upwards accordingly. Real wages and prices remain constant and therefore so does output, no money illusion occurs."

Marc Faber the author of the famous Gloom Boom & Doom Report also thinks QE will be interpreted as inflationay. Marc Faber sits in the Austrian camp and his latest comment is based on the theory of rational expectation. A self-fullfilling prophecy?

We have witnessed the impacts of a herd mentality and the effects on numerous occasions, such as bank runs. Also, people believing another recession is coming, and will be hoarding cash, which will trigger a deeper slump in consumption and another downturn.

The Macro picture is still very bleak and inflating air in a pierced balloon just doesn't work.

David Goldman on his excellent blog, accurately describe the terrible state of the US economy:

"Pension funds will have umpty-zillion-dollar deficits once they recalculate their liabilities at a 3% rate of return rather than the fictional 8.5% return assumed by most of the defined-benefit plans during the 2000s. The equity risk premium will remain depressed for a generation. The banks can’t make money after the short-lived boom in distressed assets because demand for yield has flattened the curve to the point that their old trades are less economical. Hedge funds can’t make money because they are behind the banks in the queue for assets."

It is going extremely difficult going forward for pension funds to cover their liabilities. In conjunction with very severe headwinds with high unemployment and damaged balance sheets, you also have demographic issues in the coming years which will be painful to address.

Although Wall Street has been bailed out, Main Street is still ongoing the pain of unemployment and deleveraging. It is still very tough out there and balance sheets haven't been repaired.

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