FED and fin crisis: Part II

Indeed, the linkages of the local mortgage market with international markets in the period, has reduced impact of the fed funds rates on home finance. As the Chairman of the Fed, Benjamin Bernanke pointed out in 2007, mortgage credit is now less dependent on conditions in short term money markets, after regulation Q (which had several restrictions on mortgages including ceilings on rates) was repealed.
Loose or tight monetary policy should affect all classes of investments roughly equally. But total investment to GDP in 2001-05 has no trend. On the other hand, residential investment displays a sharp uptrend as was already shown. The rise in only one type of long term investment is difficult to rationalize. It is clear that circumstances peculiar to the housing market was responsible for the same. The argument that this happened because all other asset classes were depressed is frequently made. However, while stocks certainly took a beating after the tech bubble had burst, this does not reflect the fact that overall investment also did not rise. Even though stocks may have been depressed, the time period is too long to justify this argument. If loose monetary policy should stimulate one class of investments, other classes should also be at least partly stimulated.
Finally, the imbalances in the market (to be discussed briefly following this argument) led to a sharp fall in the spreads of many securities. Banks seemed to somehow assess risk to be much lower than in the past. This happened independent of the loose monetary policy of Fed and offers a reason for housing ownership to rise even though long run fundamentals did not change. Thus, the relevant interest rate would have fallen irrespective of Fed monetary policy and is a better explanation for the crisis.

Real house prices rose 86% between 1996 and 2006. Was this necessarily a bubble? If so, how is the fundamental value of a house determined? It should be noted that high prices alone do not necessarily imply a bubble. The current price of house typically equals the expected stream of real rents and the discount rates (long run interest rates) for the period of the house. The period of 1996-2000 seems fairly valued based on this metric. (The prior period was a period of depressed prices versus historical averages and good GDP growth justified the rise).
However, 2001-05 clearly showed a divergent trend from fundamentals. Real home prices were 70% higher than real home rent as shown in figure 2. This clearly represents a bubble. The only way this rise is acceptable is if there is an expectation that real rent would increase a lot over time or long term rates are going to fall a lot. However, neither was the case. Average GDP growth in 2001-05 was much lower than those during 1996-2000 (2.3% versus 4.6%) while unemployment was higher (5.4% versus 4.6%). So clearly rents are not a factor. Also, as was already argued, for a long term investment like homes you cannot expect a rational agent to believe that a counter cyclical monetary policy would result in low rates for ever (on the other hand it is rational to assume that although prices are inflated, we can still make a quick buck by selling before the bubble bursts).
Is there any other reason for long term interest rates to be low? Clearly fed rates affected the long term interest rates. But long term rates are affected only if future short term rates are also expected to fall. So what is the reason for this connection?
Clearly Robert Shiller’s psychological theory (that people keep assuming rising prices once it passes a threshold) is applicable to home or stock price bubbles. But to extend the same argument to interest rates is a stretch of imagination. One reason often cited is that core inflation in 2001-04 saw a sharply negative trend. Thus there was a general feeling that the Fed was getting really good at controlling inflation and cheap goods from china, and improved productivity in consort with inflation hawks in most central banks around the world contributed their bit. Taylor (2007) argues that federal funds rate responsiveness to inflation dropped in 2003-05. Hence investors could have thought that a change in long term policy was possible and hence long term rates would remain low. Be that as it may, this explanation risks overemphasizing the Fed’s role.

Is the FED the sole culprit for the financial crisis?

Figure 1: Real Fed Funds Rate and residential investment in the US over the years



Figure 2: Relation between real rents and real home prices

The immediate motivation for this post is Greenspan's comment that the FED is not solely responsible and cant be held wholly accountable for the financial crisis. I hate to agree with Greenspan but I sort of agree with him on this.

First, let us look at the following fact: This is the first time in the last 50 years that the relationship between lower rates and higher residential investment is even seen. In figure 1, we can see that in the 2000-2006 time period, the fed funds rate and residential investment move in opposite directions. This has naturally led to the conclusion, obviously appealing, that lower rates would stimulate housing and prolonged low rates caused the bubble. However, there have been eleven recessions in this time period in the US, nine of which were linked to declining housing markets, and none of them have even remotely shown this trend. In fact, one can claim that, based on figure 1, the Fed cuts rates whenever investment falls, rather than the claim that raising rates caused a decline in home ownership (note the almost identical routes followed by the fed funds rate and investment in housing). This is obviously misleading and hence using the theory which has been universally propagated is questionable at best.

Of course, one can argue that history is not a good guide and this time was different (as it undoubtedly was), which brings us to the next question. The period from Nov 1998 to January 2001, the fed funds rate was raised from 4.75-6%. However, from Quarter 1, 2001 to Quarter 4, 2005, there was a sharp rise in ownership coincides with sharp falls in fed funds rate. If the rate hikes that followed in 2004 really caused the bubble to burst and home prices to fall (with a lag of 2 years), then how is it that the same lagged decline is not visible after the 1998-2001 rate hikes? Clearly, the contention that monetary policy is countercyclical to investment in housing seems tenuous at best.
An even more important question is this: Economic logic dictates that the lag (assuming that there is some relation between fed funds rate and investment) should be MORE IMPORTANT for rate cuts than rate hikes. This is because rate hikes would immediately be used as a reason to deny loans and postpone new construction decisions (these can be implemented immediately). On the other hand, starting a new construction or bringing in more mortgage-financed investments is more time consuming, as would be required in the event of a fall in rates. On the other hand, we have observed the reverse: the fall in rates has no lag while the rise in rates does have a lag. In short, factors other than mere interest rate cuts where playing a far bigger role in the boom.
Housing is a long term investment: typically a house is expected as an investment over a 50 yr period or more. It is considered a durable investment. Hence, a rational economic agent will focus on long term fundamentals rather than counter cyclical monetary policy as a reason to invest in a house. . The fed funds rate is an overnight rate. It would seem that an investment would be made more on psychological factors than short term interest rates.
In the period of the bubble, there was a growing divergence between real home prices and real rent as shown in figure 2. This fact seems to have been ignored by both home buyers and lenders. This is certainly not directly related to monetary policy.

Budget 2009 (?), more stimulus and state of the economy

Budget 2009 (or vote on account?) was a singular non event.....it read like the UPA govt's election manifestos and even there it was not properly articulated. The only noteworthy issue was the increase of the defence budget which I think was better spent elsewhere.....at this time of crisis social programs deserve more funding especially given the slowness in defence spending and little stimulus from it.

A few days after the budget we get a slightly better stimulus package reducing service tax and other duties. This will help in the next 6 months to limit the damage to exports and unemployment.

Finally, the 3Q Nos suggest a massive slowdown as expected in this column......I frankly dont see any pickup in the rest of the year as consumers cut back in urban areas contrary to expectations or even current wisdom.....with salary growth all but stalled and unemployment rising, consumer confidence is ebbing fast and while it may stabilize we should not expect a bounce any time soon...all in all a depressing post to match a gloomy world economy

Slumdog Millionaire

Not sure this is exactly how a news channel should be describing happy children....I am a liberal yes.....so it may seem that I am baiting foxnews unnecessarily....but this is appalling as a headline and a photo...

Inflation in India

The Finance Minister cautioned against letting up on inflation. And claimed credit for containing it. What a joke!!! Inflation should not even be on anyone's mind. Defaltion is the risk. In India price declines are unlikely. But a prolonged period of low inflation is possible. As for the govt. doing anything....thats downright right stupid. Sure, they did take some supply side actions. But the major impact on lower inflation is the global crash, aggregate demand falling and commodities and manufacturing prices crashing. Finally, supply side shortages where contained by good monsoons rather than any govt. efforts.

More on nationalisation

A couple of weeks back I put up a bank on nationalisation as the best solution. See Nouriel Roubini and Mark Richardson endorsing my view in this article in the Washington Post:

No one said its clean or easy, but it is the best solution. As John McCain would say "We are all socialists now" :P

On the Geithner Plan

Due to a lot of work I will be posting smaller and less frequently.

My first take on Geithner's plan: he doesn't have one!!! On closer reflection, i realise there are two possible reasons for the approach: One would be that he is afraid of hurting creditors and private shareholders of the bank....and is hoping for the best. The other is that he actually believes nationalization is the way but this is a creeping version (with this as a first step)to make it the most palatable form for US citizens to digest.

Will private investors really come in? Hardly a chance. Will this remove uncertainty? No. Can he value assets? No. Are guarantees protective of tax payers? No. However, this is better than two other options: "bad bank" buying at par, and "bad bank" buying at market price. Maybe the hope is that the economy recovers. In that case the guarantees are sufficient and more loans wont go delinquent. Eventually private investors enter. If not, as is currently the case, the system will be insolvent and we nationalize at that stage (end of the year?). Either way he can make it seem that he has no choice at that stage.

It is not often that I agree with a Wall Street Journal article but I think a quick nationalization, stripping bad assets and injecting fresh equity and handing it back to private investors is the best way. This way govt. fear mongering is removed and free marketeers are happy.

More on this later.

The Party of Herbert Hoover returns

If the senate version of the stimulus passes, and it fails to stimulate, blame Herbert Hoover's disciples. I refer to those ideologically blinded, anti-people senators from mainly Southern states. Very specifically, Bob Corker, Lamar Alexander, Jim DeMint and Tom Coburn are so insanely blinded by their philosophy that they will burn their country for ideology.

The heart of the matter is the fear of one entity: the government. And the fear that help will foster a new democratic majority for years and more importantly (as far they are concerned), the social safety net expanding. Mr Coburn, the government which you demonise all the time employs 20% of your state's people (Oklahoma). Mr DeMint, the education spending which you deride, would help repair the crumbling schools which doubtless havent seen in South Carolina. But no, government is always bad, to be feared and to be dismissed. Balanced budgets are a holy cow. Debt will kill future generations......................

All I can say is the stimulus is poor, because it does too little, has too many tax cuts and in general poorly written. It may fail in its efforts. But the democrats shouldnt worry. A republican mayor in red Indiana loves your money. The poor would love healthcare. The middle class favors infra spending. The rich like the economy stabilised. Big business likes your plans as does big labour. Even faith based groups like some money routed through them. The democrats may suffer in 2010, but the price is small as they are likely to retain a majority in both House and Senate, and likely build formidable coalition come 2012. If they dont go for more centrist, bipartisan crap like this and shy away from their goals.

As for the party of Herbert Hoover, their path back resembles hoping for the stimulus to fail, highlighting small Pork, keep promoting tax cuts, and hope for a terrorist attack. I hope no of that happens, but history shows that thunderbolts do happen once in a while. Lets hope I am wrong, and the GOP becomes a permanent minority.

Act Now and Act Big on the stimulus

As I write this, the numbers for Jan unemployment is just coming in and seems worse than most estimates. President Obama must call the GOP's bluff on this issue. No more bipartisanship nonsense. Let them filibuster if they want. To hell with Bill Nelson as well. I think that if Reid pushes a final vote a couple of Republicans will vote for it (the maine senators unlike GOP house members represent a moderate electorate). And make it big.

The tradeoff: it doesnt work, but heck it will not be noticed, when people dont see job cuts. And GOP credibility will be eroded either way. Inflation is a worry for a later time. So is pork, transparency, bigger govt. and bipartisanship. Uncertainty is there, and this bill may fail in its efforts. But all alternatives are worse. A recovery in late 2010 should save the dems from big losses in the house. Go for it. Whats the reason for a delay?

Gopalaswami vs Chawla, who's right?

Finally, some Indian story I am going to comment on.

Issue: The Chief Election Commissioner (CEC) Gopalswami recommends dismissal of a fellow election commissioner (chawla) for bias

Govt's response: He doesn't have that right. Govt. shall decide

Fali Nariman's point: CEC overreached and timing was bad

My verdict: Article 324 (5) of the Indian constitution clearly suggests that the CEC shall adjudicate. That the govt. can decide is even morally unacceptable, given the non-partisan nature of the EC. The SC should decide on the case. I believe the CEC has the law on his side. On a moral plane, it seems his dossier is complete in its case against Chawla. The reason why the above article MAY not be read as I do it, is because in the last few years, election commissioners have been appointed on a permanent basis, rather than temporary as was envisaged and followed till early 2000. Hence, it was clear that as the sole permanent commissioner, the CEC had the authority. But the amended law doesnt address the new issue of whether a permanent commissioner can be removed. My sense is in the absence of the clarification, the CEC has the right. But, the law should be amended for a non partisan panel to adjudicate and appoint commissioners.

Mr President, Is this "Change We can Believe in?"

For a year, I have been accused of being a hypocrite for criticizing everyone else but having a soft spot for Barack. My critiques on his policies apparently are not enough evidence of my independence. But the President has now handed me a perfect stick to whip him. I am, if you haven't realized yet, talking about his "tax paying" cabinet nominees.

Let me lay the full opprobrium out first. The President, dint just "screw it up", as he kept suggesting. He has shown himself in such poor light that I now doubt his capability to bring about "change we can believe in". At least 3 nominees with just tax problems!!!!!! One more with issues on her Husband's activities. A former lobbyist in the Defense Dept. An attorney General who is everything you dont want in one: no independence from his bosses (refer Mark Rich). And a new Commerce Secretary who voted to wind up his own office. Lets not even start on his old choice for Commerce.

My suggested solution to the President: if you are serious about ethics reform, start by cleaning your own stables. First, Geithner HAS TO GO. Hell, the entire financial system can collapse if necessary, but the head of the IRS cannot NOT KNOW how to pay his taxes properly. Can every tax payer get away with this? Will only those who are offered roles and vetted be discovered for evasions?

Second, the Defence Nominee (Lynn) has to go. John McCain is right. National security cannot justify an exception. You cant make an exception to your new ethics policy for any person. Third, get rid of people who dont think their new dept. deserves to stay. Trust is more important than bipartisanship. Four, if possible, get rid of your attorney general. And finally, the secretary of state has to go if you truly believe in conflicts of interest.

In this whole episode, everyone has been bloodied. Democrats who supported Daschle, Republicans who supported Hillary and Geithner, all people in the GOP who will support Gregg and first and foremost, the President for incompetent vetting.

I regret to have to public express my views, Mr President. This is not CHANGE WE CAN BELIEVE IN. This is MORE OF THE SAME.
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Further Thoughts: Let me unload further cynicism into this debate. The cabinet was supposed to be diverse: racially and gender wise. So it seems when it comes to those who have had problems. You got black (holder), white (daschle, killefer...) and hispanic (richardson) (even propotionate to their population); Men and Women; Democrat and Republican (note the allegory to his campaign speeches). If I didn't know before that America is a place where all things are possible, I know now.

Finally some prediction time!!!

US Q1 GDP (annusalised QoQ)...... -4.5% (risk: optimistic ?)
Year S&P lows: 700-720 ...... (currently at 825, that signals a drop of around 15%.

Reasons: P/E's during deep recessions can go to 11-12 range. Estimated earnings this year for S&P would be $ 60 (optimistic again). Hence a very optimistic low during the later part of the year for S& P is 720.

As for GDP, I think the pain will likely be spread out even with the previous quarter inventory. So my estimate is probably consensus right now and many people expect worse.

Yet to work out detailed year projections on GDP and unemployment.....and will do so soon for India as well.

Wall street bonuses: some know no shame

The motivation for this piece: 18 billion dollars in bonuses for the same thugs who have caused this meltdown.

In the past, I have argued that the reason for financial failures is the asymmetric compensation of bankers: big payoffs for profits, and no haircuts for losses; In the process the tax payer should step in and save the system from collapse. However, this set of bonuses beats even that: almost antisymmetric rather asymmetric in a sense. When was the last time you were rewarded for bankruptcy? Well, it seems Merryl Lynch gave $ 4 billion dollars in bonuses. I can only say "No use hanging your head in shame, since clearly they have none of it".

To be sure, some people do deserve the bonuses and the entire amount is not unjustified. Even the concept of bonuses is ok,(maybe they should change the name). But this type of extravagance is uncalled for. When you grovel in front of the govt. for a bailout, dont increase lending, dont even disclose how capital infusions are being used, pad up your balance sheets and then pay obscene salaries and bonuses you must be bonkers. In the nationalisation piece, this was precisely the reason I wanted top management to be fired and bonuses frozen. Some people had legitimate concerns that operations would be affected. But it can be done quick and have business minded people running the show. As for high salaries govt. need not mandate it and only impose caps. If people still feel they are insufficiently compensated, then they can quit. On a different argument, I believe that compensation independently is unjustified anyway, but that is an argument for another day.

Just an example of the pernicious disregard for money in these organisations: I saved 10000 USD during my 2 month internship. Assuming I spent nothing (close enough), this was my stipend. Add 80 usd/day as approximate housing cost in a fairly upscale hotel in Hong Kong. Hence a total of 15000 USD which would be around 90K USD per annum. This for doing no brilliant work.

Finally, the worst bit of this episode is that these hot shots crib that bonuses have been cut or not paid. And they crib about limits on pay, and being dragged to Congress. I think they should be subjected to water-boarding. Ok, maybe that was overboard. I oppose torture personally. An exception could be made I guess.

UPDATE: Since this post, new evidence of "no shame" profligacy: BoA spends millions on Super Bowl promotions, and MS has a private retreat for people in Florida

UPDATE 2: Add JP Morgan, American Express and Wells Fargo to the list...amazing...

Judd Gregg as Commerce Sec.

Judd Gregg, if nominated by Barack as Commerce Secretary in the US, would be a wise choice given his background. It helps also in the aura of bipartisan that Barack wants to build. For Gregg, perfect time to retire rather than face defeat in 2010. For the Democrats a non-incumbent is best in 2010. For the GOP, Governer Lynch should appoint a Republican anyway (a rockefeller republican to be sure). Seems like everyone will be happy.

Nationalisation as a solution to the banking crisis

Nationalization seems to suggest that we are abandoning the principles of markets. However, if done in an orderly fashion, we can bring the banking system back to reasonable health and restore confidence.

These are the steps that should be followed in nationalization. First, a quick review of every major and mid level bank must be made to determine the extent of their exposure to these assets. Second, the ones that are otherwise healthy must be saved, while the ones which are irredeemable must be allowed to fail. Third, the fundamentally healthy but impaired banks (those which don’t need capital can exist as it is) should be placed under a conservatorship (like Freddie and Fannie). Fourth, their entire equity must be wiped out, managements fired, and no golden parachutes must be given. This takes care of one form of moral hazard. Fifth, debt holders, other than senior most debt holders, must be forced to take a haircut, as there is no rationale for the tax payer to fund bond holders. Sixth, managers may be incentivized to lend according to long term profitability. Seventh, the bad assets are now moved to an RTC like bank where debt is paid down and the assets are gradually sold to private investors. Finally, when the books are sufficiently cleaned up and markets stabilize the banks can once more be available for public ownership.

What are the advantages of nationalization? The most obvious advantage is that uncertainty in the markets is removed once and for all. Rather than lurching from one bailout to another, and markets worrying about creeping nationalization, a bold solution like this would signal a bottom. Another advantage is that banks can begin to lend again. The problem with equity stakes without control was that managers and shareholders, worried about their future would rather use the money to pay their salaries and repair their balance sheet, resulting in a hobbling bank which does not take risk. At the same time moral hazard is vastly reduced when exiting managers are punished for reckless lending and hence future excessive risk taking is minimized. The greatest advantage though is that the problem of valuing assets is no more a necessity. Since both the “good” bank and “bad” bank are under government control, the asset valuation does not matter, as it merely involves transfer of assets from one part to another part of the same owner. This could be done at historical cost or zero value or any other value as there is essentially no difference. The “bad” bank collects all the cash flows associated with the assets and if no market develops, then it holds the assets to maturity. The “good” bank can be privatized when conditions improve. The cost of nationalization has been shown to have a lesser final fiscal cost than this stage wise bleeding. As an example of its actual implementation, we need not look further than Sweden which in 1993 did the same thing. The overall cost to the government was minimal. Finally, the reason debt holders have to pay a price is because there is no reason for risky debt investors to be rewarded while stock holders suffer. The tax payer should not subsidize them (senior debt holders may need to be accommodated for fear of greater contagion while junior debt holders’ rationale for investing itself is that they sought more risk and hence where paid a higher rate).

The arguments against nationalization exist. The major reason is the mistrust that government cannot run efficient operations and would be prone to political pressures. By appointing commercially oriented managers, this problem can be reduced. Further, it can be argued that state control may become permanent. Finally, a very credible argument exists to make a distinction between the Nordic experience in the 1990’s and the US. The US banking system is much larger than the Swedish system and both the costs and time required are higher and chances of a successful withdrawal at a later stage by the government are likely to be lower. The linkages in global finance may also cause issues on valuation of assets unlike in the 1990’s when most of the assets in Sweden where regionally owned. However, none of these reasons are sufficient to continue with status quo. The costs are too high, and a bold initiative is a must. Nationalization and nimble restructuring is the quickest and cleanest end to the mess we are in right now.

GDP-US and China

My excuses for no posts for nearly a month: too much work, poor internet speeds and really sheer indolence!!! So, fourth quarter GDP figures for the US was “better” than expected: -3.8% vs -5% consensus. So started cheering yet? Maybe AK and other Dr Doom’s are wrong and the doomsayers must be dismissed right? Unfortunately, the devil is in the details. Consumer spending fell 3.5%, non-residential investment 19.1%, residential fell 23.6%. All this means that real final sales, the barometer I really watch, fell 4.9%. If that doesn’t shock you, it should. I certainly was, and it was worse than most expected. Final retail sales are important because they are the final measures of domestic demand. Such nos. portend a lot more pain ahead. Indeed, back when Q1 GDP nos. for 2008 came in, people were celebrating. When I told my professor that it was poor since retail sales fell for the first time, I was pooh-poohed (unfortunately didn’t blog at the time). People at the company I interned in where sure that a soft landing was the base case. I insisted a severe recession would follow and we were already in it then. The first tax rebates skewed Q2, and Q3 showed people the real damage. Then, Lehman (which also I consistently predicted) collapsed and the rest is history.
So, predictions for Q1 2009? Before this no. I thought 3.5%. Now maybe 4-4.5%. Why? Because, all this abnormality was due to build up of inventory which added 1.6% to GDP. To cleanse this inventory we will see Q1 see a sharp drop and hence the further decline.
A note is in order here. These are QoQ figures annualized. Hence a small error in QoQ can translated into a factor of 4 in error. Thus, if the nos. turn out to be 3.8 vs 4.2% an error of 0.1% is the real error in prediction which really is not bad. The one no. truly puzzling is the trade data which added 0.1%.
Finally, GDP in china at 6.8% is YoY figure. There are two issues in interpretation here. First, one doesn’t know the true data given China’s propensity to massage the nos. It could be to portray a rebound, or on the contrary it may be a way to prepare for future shocking nos. I believe it’s the latter. Which brings me to the second issue: YoY is misleading. QoQ figures based on the above nos. would indicate negative quarter growth!!!! If that didn’t shock you, it should. I believe that QoQ in Q1 2009 will indicate a second contraction, and viewed in this light, we can call China to be in a recession.

Stimulus-Part II

In the last post, I had berated that tax cuts are ineffective. However, tax cuts are also a virtue in some cases as I shall shortly put forward. Reagan's supply side economics had its time but tax cut seekers should realize the limits when demand slumps.
When are tax cuts most effective? Any conservative would argue that it creates incentive to work and hence improves long run productivity. They also argue that tax dollars are best spent by society individually rather than government deciding how to use it. Both these have their merits. But neither is a reasonable stimulus. Also government has to step in to make good for the collapse in private demand, to prevent a deflationary spiral.
Even for a stimulus however, there is a need for tax cuts to boost consumption. First, there may not be enough "shovel-ready" projects for government to spend on. Second, if tax cuts are properly directed properly then people may actually spend it. In that way, targeting lower income people is a good start for stimulus tax cuts. That is one place that Obama has actually correctly identified.
On the politics now- why is PEBO doing this? Does he really think that Senators like Shelby, DeMint, Coburn and other southern GOP senators are really going support this stimulus? Well, they would want the whole package to be only tax cuts rather than the present 40%. Next they will argue that we need cuts in business, capital gains and wealthy people's taxes. Then they will call cuts for non income tax payers as socialism. So, the whole thing seems such a waste. Of course, none of these tax cuts would be sufficient stimulus in the short term. And the poor would suffer inordinately.
However, the tactic may be that by agreeing to look at GOP proposals and proposing tax cuts he can call the GOP's bluff and make this into a wall street vs main street fight. That is a sure fire winning argument for Barack. But this approach carries too many risks. Most importantly, politics could threaten the entire economy. In my opinion, and in the next post I intend to quantify this, the size of stimulus, and its composition is not enough. We MUST err on the side of more rather than less stimulus.

Stimulus- Part I

The president elect is just revealing his plans for his first important legislation: the stimulus. And I am afraid it is poorly designed, at least at first glance.
Lets start with the tax cuts: 40% of the package to draw "considerable" GOP support. For starters, despite all the ramblings of conservative intellectuals on the vices of government spending and the virtues of tax cuts, it is indisputable that the multiplier effect on the economy by spending is greater. A conservative (no pun intended!!) value of the multiplier would be 1.2. This is assuming that most spending is pork, useless etc.
For tax cuts, the best case is a multiplier of 1. Why? For one, when people get tax cuts, they dont spend in times of crisis. They use it to draw down debt (pay it off), and spend on essential commodities. Not blaming the consumer, for whom it makes perfect sense, but a poor stimulus. If you wanted further proof, just look at the stimulus passed in 2008. The economy recovered for one quarter and then anemically shut down. Now, this was at a time when people where still optimistic. Anyone bets that times are better now???
Business tax breaks, as suggested add little as incentive. By allowing losses offset with past taxes, you are merely transferring wealth. What stimulus is that?
This is not to suggest that all tax breaks are bad, or that the stimulus should avoid them. Indeed this much better than Bush's tax cuts for those who dint need them and were not even asking for one. I will address this issue and the politics behind it in detail in the next post.