Sunday, December 14, 2008

$1,000,000,000,000 of stimulus?

Obama's econ recovery experts are supposedly setting their sights higher with each passing day. Two weeks ago it was going to be a half-trillion of infrastructure projects over two years, now it could be as much as a full trillion or even more over two years.

Is this the best way for the government to help the economy? To put $1 trillion in context, consider that in FY 2008 the federal government received $1.146 trillion from personal income taxes, $304 billion from corporate income taxes, $900 billion from social security taxes, and $171 billion in excise taxes, customs duties, estate and misc. taxes.

I've argued here that tax cuts are a much more effective way to stimulate the economy. Just consider the difficulties involved in choosing, designing, approving, acquiring raw materials, and building and constructing infrastructure projects, and you have delays that could be measured in many months to years. In contrast, reducing income taxes has immediate effect, changing people's incentives to work, save and invest almost as soon as it appears that a change in the tax code is likely to happen. Instead of spending $1 trillion or more on infrastructure projects over several years, we could cut corporate income taxes by half for the next 7-10 years. Is it too hard to imagine that corporations might put all that extra money to better use than the federal government?

Not only do tax cuts take immediate effect, they also lead to a sorts of virtuous things because they change people's behavior. Cutting taxes increases the after-tax rewards to work, savings, and investment, so we would quickly see more of all the things that make the economy grow. Cutting corporate taxes would likely attract plenty of new foreign investment, by putting the U.S. economy in the lead when it comes to competing for the world's capital.

Greg Mankiw has a nice summary of Obama's economic team, in which he highlights their credentials and policy preferences. Christina Romer, soon-to-be chair of Obama's Council of Economic Advisors, has done impressive research showing that tax cuts are much more effective than government spending at stimulating the economy. Is she being consulted on these stimulus plans?

What if we consulted the American people: would they prefer a trillion dollars of infrastructure projects over the next several years, or would they prefer to eliminate the personal income tax entirely for a year? Or cut income taxes by half for the next two years? Unfortunately, since the majority of workers pay a minority of all taxes, the vote might come down in favor of infrastructure spending, but then again it might not. Was Obama elected with a mandate to make these sorts of decisions? I suspect not. We shall see what happens as details of these plans emerge.

On another front, Obama seems increasingly likely, given his recent appointments, to favor an aggressive plan to transform the way our economy uses energy. One proposal could be a big carbon tax. My hunch is that such a plan, which would significantly increase the cost of anything that uses hydrocarbon fuels, would face a wave of opposition across the board that would be reminiscent of the furor that erupted over HillaryCare when the details became know. Significantly higher energy costs up front, plus many hundreds of billions of new investment in developing alternative sources of energy which would likely cost more than fossil fuels, and for what purpose? To make a tiny dent in the world's carbon emissions, which might or might not make a measurable difference in the world's climate, which we wouldn't have any way of measuring for decades. That's a very tough sell, if you ask me.

I see the press trying to link Obama's stimulus plans to a some vague sense among the public that the future looks brighter. But meanwhile I see the markets still struggling in the depths of despair, and everyone I know is cutting back on nonessential spending. Corporate bonds are priced to the expectation that a significant fraction of the corporations existing today will be out of business in the next 5 years; equities are priced to the expectation that the next 5 years will be worse than the worst of the Great Depression; and Treasury bonds are priced to the expectation that deflation will ravage the economy for at least the next 5 years. I don't know anyone, outside of crazed Obamafans and environmental fanatics, who thinks that massive government spending and massive government intervention in our economy will make things significantly better in short order.

Memo to Obama: think twice about how you would like to spend a trillion dollars.


jj said...

Great post as always, I'm wondering if you saw the NY Times article this weekend on the carnage in the bond fund industry, they mentioned WAMCO and a few others.. Wonder what your take is and if you think the Times is giving us the straight skinny on this? Thx.

Scott Grannis said...

The NYT is correct in saying that this has been a godawful time for active bond market managers--indeed, it's hard to imagine anything worse than what we've seen in the past year or so. It's hard for the layman to understand exactly why it's been so bad, so let me try to explain.

In order for a bond manager to have performed well in the past year or so, he would have had to have had great certainty that the end of the world as we know it was approaching. Knowing this, he would have invested everything in Treasury bonds. That would have been a heroic endeavor, to say the least. Anything that is not a Treasury bond has fallen in price. Anything that is below investment grade has literally collapsed.

The bond market over the past year has behaved as if the end of the world were a foregone conclusion--as if a huge percentage of the bonds outstanding will default with very little recovery value. How many managers could have expected that? Does that forecast even make sense today with all we know? I still find it hard to believe how pessimistic the valuations have become.

As I have said several times before, if you think the future will be anything less than catastrophic, then you are bullish. You could only want to hold Treasury bonds today if you are absolutely convinced that there is a gigantic depression waiting around the corner, and a deflation to boot. If you have even a shred of optimism, then you cannot hold Treasury bonds in your portfolio because they will be crushed if the economy experiences anything better than an outright depression.

If bond managers are guilty of anything, it's that they believe the economy is going to pull through this crisis without literally collapsing.

If you think the economy will collapse, then even Treasury bonds won't save you. I would advise you buy guns, plenty of ammunition, plenty of food, and the title to an obscure South Pacific island to which you should retreat posthaste.

jj said...

Thanks for the reply. Assuming that risk premiums gradually will be returning to normal, are there any areas of the fixed income market that one should especially focus on now? I know you've been suggesting TIPS, but I'm thinking hi-grade intermediate corporates, any thoughts on a particular vehicle would be most helpful, looking for high quality holdings, tight bid/offer spread, low management costs,etc. , just the stuff everyone else is looking for!

Again, really appreciate the blog, I feel a little like I have my own in house economist. Thanks.

pcpb participant said...

The Ireland example bears repeating, ...'til "He" gets it, perhaps.

Scott Grannis said...

The fixed-income market is chock-full of opportunities. Credit spreads are extremely wide in general, reflecting fears of massive bankruptcies. Investment grade corporate bonds have an average spread of 610 bps over Treasuries, for a yield of 8.2%. That yield has been declining recently, with the result that IG bonds have returned over 2% so far this month.

High yield bonds are incredibly attractive if you think we can avoid a serious depression/deflation. Yields are about 22% on the average junk bond, and yields in junk land appear to be stabilizing and even declining some of late.

If yields on corporate bonds just stop going up, they will produce very handsome returns. Actual defaults are still very low compared to the extra yield these bonds carry.

Small investors would be well advised to use funds that are indexed and carry low expense ratios. Some closed end funds are trading at huge discounts to NAV, but you run the risk that the discount may reflect additional risks such as leverage.

Buying individual bonds can incur significant transactions costs for small investors, so funds are preferable unless you have strong feelings about the company you are buying.