Crawl Across the Ocean

Friday, January 23, 2009

Stimulus Stories

I’ve been doing lots of reading over the last few months, trying to get my head around the current financial meltdown.

In my current thinking, which is likely to change as I continue to try and organize my thoughts, I see three stories that relate to the question of 'should we try to undertake a government stimulus and if so, how big should it be?'

This post lays out those three stories to provide some context for our current economic situation and perhaps sort out some of the different threads of the argument.

Story #1: The Counterweight

In this story, we have an economy that goes through periodic ups and downs. Because we would prefer things to be stable rather than having ups and downs, the government times its discretionary spending to offset these ups and downs.

When times are good, government runs a surplus and dampens economic activity. When times are bad, government runs a deficit and increases economic activity.

It’s a pretty simple story. The main concerns are 1) Does government surplus/deficit have the effect on the economy we think it does? And 2) Will government actually run a surplus during the good times to offset the deficits from the bad years, or will they just accumulate more and more debt.

One positive is that by spending during downturns, government can generally get more bang for its buck since things tend to be cheaper during a downturn. Since these things (like infrastructure spending) need to be done anyway, it is good long term planning to undertake them during downturns as much as possible.

Certain government programs such as welfare and unemployment insurance are called 'automatic stabilizers' because they naturally go up during hard times and go down during good times, providing the sort of counter-cyclical government activity that is desired in the counterweight story.

Given that Canada is in a downturn, this story suggests that a government deficit that will boost the economy during this downturn is a good idea. However, these types of recessionary deficits are usually just the ones that occur naturally when tax revenue falls and government social spending goes up in a recession. We don't normally pile a large additional 'stimulus' on top of the recession caused deficits.

Story #2: The Global Imbalance

In this story, the world is comprised of a number of countries, some of whom, like China, Japan and Germany (the savers), produce a lot more than they consume, some of whom, like the U.S. and the U.K. (the consumers), consume a lot more than they produce, and some, like Canada, that are pretty much in balance.

In order to make the payments balance, the savers use their extra money to buy up the countries of the consumers, investing in their stocks and bonds to generate a return in dividends, capital gains and interest payments. This process, however, can only go so far before it starts to break down and the consumer countries no longer have enough money to keep paying the saver countries the interest and dividends on all the investments the savers have made in the consumers country. Or as more typically happens, you reach a point where the savers get nervous that the consumers can't pay them back so they yank out their money and crash the economy of the consumers.

Eventually, one way or another, the consumers will have to consume less and save more, and vice-versa. Typically, you would expect the currency of consumer nations to fall, making their exports cheaper, their imports more expensive and rebalancing the situation (we can see this happening currently with the fall in the value of the British Pound), but this does not always happen soon enough to prevent a crisis and there can be barriers to this process (for example, savers might peg their currency to the currency of the consumer nation as China does with the U.S.)

In this story, it would be unwise for the consumer nations to take on more debt in an effort to sustain their consumption. It is, instead, the saver nations that should be trying to stimulate their economies so that their own citizens can take up some of the slack when the consumer nations stop living beyond their means.

Given that Canada is relatively balanced between saving and spending, this story has little relevance for us.

Story #3: The Stag Hunt

The Stag Hunt is a 'game' (in the game theory sense), that has the following characteristics:

There are two equilibrium situations:

1) A 'good' equilibrium where hunters catch deer, the most valuable game animal in the forest. Because the deer is elusive, catching it requires cooperation between the hunters.

2) A 'bad' equilibrium where the hunters don't cooperate, and are not able to catch the deer so they catch rabbits instead, which can be caught without cooperation, but are not as tasty and meaty as deer. Mmm, venison.

In the 'bad' equilibrium, the hunters know they could do better by working together to catch a deer, but because nobody can act on his own (you can't catch the deer without help) and because they can't be sure that if they go to hunt deer that others will help, it is safer to just catch rabbits, rather than going off by yourself to catch the deer, having nobody help you and ending up with nothing.

During the Great Depression, Keynes theorized that the economy resembled the Stag Hunt game (although of course Game Theory had not been discovered yet, so he didn't describe the situation in those terms). The economy had a 'good' equilibrium where people were willing to make risky investments because these had a reasonable chance of making a good return, because everybody else was also making investments, allowing money to circulate and the economy to reach its full capacity.

The Great Depression, per Keynes, reflected a situation where the economy had fallen into a 'bad' equilibrium, where people were too scared to make risky investments, and that because nobody had enough resources to act alone, anyone who did make investments would just lose their money and scare off other would-be investors even more.

In this situation, Keynes reasoned, the only way out was for government, the only entity in society with the necessary resources, to commit itself to doing so much investment that it could carry the economy by itself for a while. This would then encourage others to make investments since they would know that the economy was going to be all right since it was being sustained by government spending.

Once the 'good' equilibrium had been restored, then government could withdraw and allow the economy to continue functioning on its own.

It is as if a mighty hunter appeared who could catch deer by themselves and set off, boldly announcing their intention to do so, knowing that if their claim was credible, and that if deer catching was now seen as assured (or reasonably likely) then the other hunters would all come along to share the bounty. Once all the hunters were happily deer hunting again, the mighty hunter could withdraw and leave them to it, resting his or her weary steed for the next hare-brained crisis.

Under this story, the stimulus needed is not the sort of counter-cyclical balancing described in the counterweight story, but rather a massive, 'shock and awe' style stimulus that is enough to carry the economy almost on its own for long enough to persuade the private sector to join in. The historical view of this story says that it was the massive government spending undertaken to fight World War II that shifted the economy from the 'bad' equilibrium of the Great Depression to the 'good' equilibrium of the post-War years.

So the question for Canada is if we are in danger of slipping into the 'bad' equilibrium (I don’t think anyone would say we were there already). If the answer is yes, then we have a second question – can we pre-emptively stimulate the economy to prevent the transition to the lower equilibrium, or do we need to wait until the 'bad' equilibrium is reached and then try to stimulate ourselves out of it.

One of the risks here is that if the government tries to shift the economy from one equilibrium to another and fails (the people don't believe the government can catch the deer), we will have that much more government debt and be no better off (aside from now having whatever it is the stimulus was spent on). For consumer nations like the U.K. and the U.S., there is the added risk that the government will spook its foreign creditors running up all the extra debt, moving forward a crisis as people scramble for the exits.

Another risk is that it is possible that there were certain weak points in the economy that triggered the transition from 'good' equilibrium to 'bad' equilibrium and that the 'good' equilibrium is not actually an equilibrium any more and can not be achieved, or at least sustained, until those weak spots have been fixed. Based on the run-up to both the Great Depression and our current troubles, likely candidates for such weak points include, at the least, overly high debt levels and income inequality.

Given our current situation, an inadequate supply of cheap energy may be another potential weak point that prevents the 'good' equilibrium from being sustained.

What type and size of stimulus you support for Canada depends to a great extent on which of these (or some other) stories you believe to be operative currently and how you weigh the benefits and risks of each approach.

A note on game theory, the 'stag hunt' problem is quite similar to the better known prisoner's dilemma. The main difference is that in the prisoner's dilemma, the best possible outcome for an individual is for the other person to cooperate and for you to betray them. In the stag hunt, the best possible outcome is the cooperative one.

The effective difference is that to reach the best overall outcome in the stag hunt game, you only need coordination and trust, whereas in the prisoners dilemma you need coordination, trust AND some additional quality (you might call it 'loyalty' or 'empathy' - or, in a repeated game, 'payback') that makes you feel the pain of the other person so that you choose the overall optimum (cooperation) rather than the personal optimum (betraying the other player).

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  • A thoughtful post, as usual.

    I've always been a little leery of the ease with which economists and economic pundits draw up causal relationships.

    Each of your stories has advocates. What I rarely seem to hear in the media is that elements of each may well be true and may contribute more or less than the others to the overall economic situation without necessarily invalidating the others.

    By Blogger KevinG, at 2:50 PM  

  • So the governments of the world are acting like Nimrods. I KNEW it!

    By Anonymous DR, at 5:22 PM  

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