The risks of more stimulus

My favorite line from “Jaws” comes from police chief Martin Brody who, upon seeing the enormous great white shark, declares: “You are going to need a bigger boat.” We are now seeing the shape of this economic downturn—and it seems we are going to need a bigger stimulus. Of course, we might get lucky. Maybe the next four months will be a time of unreserved good fortune, and we will then conclude that what we have done to stabilize the North American and world economies is appropriate.

But more likely not. Even mixed news would mean that four months from now we are going to want another round of government spending boosts and tax cuts to try to keep a lid on unemployment. And if the next four months present a string of bad news—well, let’s not go there right now.

As we prepare to buy a bigger stimulus boat to grapple with this Jaws recession—whose bite just pushed the unemployment rate up to 8.1 percent in February—it’s important to know why it may be necessary. In my last column, I wrote about how a government fiscal boost—just like any private boost to spending from the business world—would spur the economy. The strange, right-wing talking point that posits that a government fiscal boost would not spur the economy because . . . because . . . well, it's not clear why—is badly mistaken at best, disingenuous at worst.

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But there are legitimate reasons to fear that a fiscal boost would work—but not well. And there are legitimate reasons to fear that undertaking a fiscal boost now will have significant costs later. These fears fall into four categories.

The first is the risk of bottleneck inflation. In this scenario, the fiscal boost increases spending as intended. But businesses, responding to increased demand for their products, hire more workers to boost production. They succeed in this only by offering higher wages— so high that they have to increase their prices—and by snatching scarce commodities out of the supply chain by paying more for them —requiring still more price rises. If such inflation produces general expectations that prices will continue to rise, then we find ourselves back where we were in the 1970s, with businesses focused on changes in the overall price level rather than on executing their business plans for goods and services.

The second legitimate fear is that capital flight and exchange-depreciation-driven inflation will take root. If the stimulus package causes foreign holders of domestic bonds to believe there will be inflation, they will sell their U.S. Treasuries, pushing down the value of the dollar. As the dollar falls, the dollar prices of imported goods and services will rise—and we are off to the inflation races again.

The third risk is that government borrowing may—not will, not must, but may—push up interest rates. This makes it expensive for businesses to expand, thereby discouraging private investment and leaving us with a low productivity-growth recovery, one that is dragged down by too little private investment and too much government spending.

The fourth risk is that the long-term costs of the stimulus will be too large because those from whom we borrow the money to finance the government’s spending will only continue to lend to us at high interest rates.

All of these are legitimate fears when a government undertakes a deficit-spending plan. We had bottleneck and wage inflation in the late 1960s and the oil-shocked 1970s. In France, capital flight and exchange-depreciation-driven inflation resulted from President Francois Mitterand’s 1981 attempt to produce Keynesian full employment. I carried spears for Lloyd Bentsen and his Treasury Department subordinates Roger Altman and Lawrence Summers in 1993 when they argued that federal deficits were threatening to crowd out private investment by generating rising interest rates. And the fear that deficit spending will produce an unsustainable debt burden precedes Adam Smith’s warnings to George III about the costs of debt-financed wars.

In each of these scenarios, however, we can see the storm clouds approach in the form of rising prices. If the stimulus is going to be ineffective because it generates bottleneck inflation, we can see the price of high-demand goods and services spike. If the stimulus is going to fail because of capital-flight-driven inflation, we can see the value of the dollar collapse as foreign-exchange speculators incite capital flight (then we can observe import prices spike, putting upward pressure on prices elsewhere in the economy). If the stimulus is going to fail by crowding out private investment, we first see medium-term corporate interest rates—those most relevant to financing plant expansion—spike. And if stimulus is going to impose a crushing debt repayment burden, we see long-term Treasury bond interest rates spike.

Right now, we see none of those things. If any soon materialize, however, even non-economists will be able to spot the telltale sign. Just look for stimulus advocates—me included—backpedaling as fast as we can.