What Went Wrong? Expectations Matter

Five years ago we found out who was not too big to fail. Lehman Brothers went down on September 15, 2008, with over $600 billion in assets setting off a remarkable chain of events. A few days later John McCain suspended his presidential campaign and flew to Washington, D.C. where he generally made a fool of himself thus removing any doubt about the outcome of the election in November.

Then on September 29, 2008, with the vote on TARP pending, Nancy Pelosi made her famous speech on the floor of the house blaming Republicans for the crisis. In reaction Republican members voted overwhelmingly against the bill along with 95 Democrats. The world looked into the abyss of a U.S. financial sector facing utter ruin. Market participants were dumbstruck by the economic ignorance on display and the DJIA marked the day with the single largest point decline in history.

Around the U.S. corporations acted swiftly, changing plans in reaction not only to the credit crunch but, more importantly, factoring in the expectation of a new administration that was unschooled in the private sector and potentially hostile. The ensuing months confirmed their worries as the appointees to the new administration were nominated. Pundits noted the lack of significant private sector experience. Faced with policy uncertainty of extreme proportions, the downsizing accelerated. Non-farm payrolls contracted on average more than 500,000 per month for the 12 months beginning with the election in November.

Now, for the first time we have a succinct measure of policy uncertainty that can be connected to changes in economic growth. In the chart nearby is the U.S. Policy Uncertainty Index* established by researchers at Stanford and the University of Chicago. As you can see, in the fall of 2008, policy uncertainty jumped and has stayed a high level ever since.Policy Uncertainty Chart

All of this falls naturally in line with the rational expectations theory of economics detailed by Noble Laureate Robert Lucas, Jr. The theory explains that people will adjust their behavior today in reaction to what they think will happen in the future. A reasonable assertion, yet the political class has inconsistent views on this idea. They raise taxes on cigarettes hoping that smokers will change their behavior (which they do) but when they raise taxes on income or capital they expect taxpayer behavior to remain the same.

In March this year, the Senate barely passed a bill to allow the Congressional Budget Office to use and disseminate alternative dynamic scoring for tax legislation. Incredibly, 48 Senators, (let’s call them the economic luddites) voted against the bill. The law simply requests that the CBO analyze how taxpayers would react to changes in the tax code so that Congress might benefit from the same type of analysis the rest of us have been using for 50 years.

With this prelude it is easier to understand the reasons for the failed recovery.

In 2009, a massive $800 billion fiscal stimulus was launched on top of the Bush administration’s 2008 $498 billion deficit. (Remember that in economic terms any federal spending in excess of tax revenue is considered a stimulus.) Whether the stimulus is created by reducing taxes or increasing spending defines much of the economic policy debate today. At the close of fiscal year 2013, total stimulus spending since 2008 will reach almost $6 trillion.

So why was this gigantic deployment of Keynesian economics such a failure?

To support the stimulus measure, White House economists carefully calculated the multiplier effect of three choices: cut taxes, give money to the states and spend the money at the federal level. They concluded that is was best to leave the money in their own hands. Federal spending they figured would create over one million jobs per $100 million of deficit while the same amount from tax relief would produce less than 700,000 jobs. After $6 trillion in stimulus, we now know how badly wrong they were.

Missing from their analysis was the reaction of households and businesses to the spending binge and the increased policy uncertainty that inevitably comes from such a large increase in government intervention.

As Nobel Laurent economist and N.Y. Times polemicist, Paul Krugman, is fond of saying, “The economy is an interactive system. Money flows in a circle. My spending (the government) is your income, your spending is my income (taxes).” Well, not quite. As consumers came to understand, Paul’s government spending is actually their future tax burden. As deficits ballooned beyond imagination, U.S. households hunkered down. They focused on reducing their debt and increasing savings to prepare for the day when the bill for those deficits would come due.

Households have also struggled with the policy uncertainty.  It ranges from, employer reactions to Obamacare, (will my company cancel my healthcare insurance, reduce my work hours or leave me alone?), to what are my payroll taxes going to be? Analysts were surprised at a sudden 2 percent drop in the savings rate in January until someone remembered that the feds had just increased payroll taxes by 2 percent.

Small businesses had a similar reaction. The Wells Fargo/Gallup Small Business Index (a measure of confidence) dropped from 114 to -28 by 2010. It has never truly recovered coming in at only 25 last month. The reason is clear. Federal regulations have squelched the Keynesian “animal spirits” in the private sector.  Today they total 174,545 pages in 238 scintillating volumes.

In economic terms we have experienced a coordination failure that continues to this day. The fiscal stimulus and multi-trillion dollar monetary policy stimulus have been almost completely offset by the uncertainty driven by the new and unpredictable policy actions of assorted federal agencies.

Despite the end of the recession more than four years ago, households and businesses continue to struggle under a cloud of uncertainty. Given the news of the past few weeks, it does not seem that these skies will clear anytime soon.

End Note:

Although nearly all politicians and the minions in the blogosphere revile it, the Troubled Asset Relief Program has to stand as one of the most successful government interventions in history. Setting aside our worries about moral hazard (which are significant), the near final accounting of the $700 billion program shows a peak of $245 billion dispersed to banks and total cash returned of $273 billion. Combined with the earnings from the AIG bailout the total profits for taxpayers from the financial sector are close to $30 billion. The only losing deal for TARP was the support provided to the UAW pension plans in the Chrysler and GM restructurings.  GM stills owes the treasury about $15 billion. For comparison, consider that taxpayer losses in the Savings & Loan bailout in the 1980s were a whopping 3.2 percent of GDP.

Jim Anderson


*Source: Scott Baker, Nicholas Bloom and Steven J. Davis at www.PolicyUncertainty.com