The Costanza-Hoover Principle

The idea of the stimulus plan is that we get some money directly into our pockets ($200 – $300 billion of tax breaks without matching government spending reductions) plus about another $550 – $600 billion worth of new bridges, unemployment benefits, electronic patient records and so on (plus all the jobs required to make all this stuff). Even better, the people who do these jobs have to buy food, shelter and digital camcorders, so that creates yet more wealth. This sounds pretty sweet. The catch, of course, is that we would add over $800 billion – or more like $1.2 trillion if you include interest payments – to the national debt.

And, of course, it’s likely to be much, much more than this. Most of the spending is in the form of increased transfer payments, additions to school budgets, spending on health care and so on. Does anybody really think that when these programs expire the recipients are just going to say “Hey, a deal’s a deal”? This will likely increase the baseline of future expenditures. Further, we will be setting a precedent that states that run huge deficits will be bailed out by taxpayers in the 49 other states, and thereby create a Prisoner’s Dilemma – we should expect lots more state deficits that become federal responsibilities. And it’s not like we don’t have various other “rescue” packages lined up behind this one. And it’s not like we shouldn’t expect a large decrease in government tax collections over the next coupe of years as incomes, profits and capital gains decline. If the experience of other countries after bubbles like the one we’ve just had is any guide, we should expect an increase in national debt of trillions of dollars.

But what does this really mean, in practical terms? When I hear politicians say that “we’re borrowing this money from our kids” or whatever, this can seem abstract. It turns out that it’s not a metaphor.

If we enact the stimulus legislation, there will people from Beijing to Dubuque who will hold pieces of paper saying, roughly, that on a specified date they can show up at the door of the United States government and demand trillions of dollars. On that day, it seems to me that some combination of only four things must happen:

1. Rollover the Debt: Convince either these specific debt holders to take another piece of paper that says they can come back at a later date for the money, or convince some other party to take such an IOU and use the money that party provides to pay off the original debt. This is kind of like paying off one credit card with another one. It comes with further interest charges. In theory, if your debts are modest enough you can do this forever, just like with your credit card. Of course, you will pay interest forever this way, and this will just spread out the trillions of dollars (in present value terms) over many future generations. Taxes will be somewhat higher forever than they otherwise would be.

But if you don’t want to do this – or more likely can’t, because you’re so indebted – you are left with some combination of the next three options. Each has its own special charms

2. Higher Taxes: Our children’s taxes are trillions of dollars higher than they would otherwise be, but they get no roads, bridges or health care from these taxes, because they are all used to pay down the historical debt for stuff we consumed. This is the most responsible option and would require a large reduction in consumption all at once. It’s like going on a strict budget at home in order to pay down the balance on your card that’s been sitting there for two years from that great vacation you charged. For your parents.

3. Default: The U.S. government refuses to pay it, and as we have the world’s most powerful armed forces and reasonably good civilian control of the military, it’s hard to see how anybody could collect. Of course, this would almost certainly result in a dollar collapse and a loss of economic value of many, many trillions dollars for our children. Think this is inconceivable? Think again. In January, the bond market estimated the probability that the U.S. government will default on at lest some of its debt within the next ten years to be about 6 percent.

4. Devalue the Currency: The government simply prints several trillion dollars and gives them to the debt holders. Inflation gets a lot higher than it would be otherwise, with all the loss of consumption that implies. If inflation gets up to Weimar Germany levels of hyper-inflation, this becomes a default by another name.

As of now, the likeliest result is that we would avoid the true disaster scenarios, and that future generations would “only” have to give up a few trillion dollars of wealth through a combination of much higher taxes and inflation. How could we justify doing this if we claim to care about our kids?

The theory of the case that is the stimulus would not only transfer wealth, but also create wealth by moving the current and future economy to a much higher level of output than it would without achieve without the spending. Future taxpayers could pay more absolute dollars, but still have more after-tax income because of this higher growth. It’s not blowing a bunch of money on ourselves – it’s an investment in the future. Everybody wins!

In effect, we are asking our children for a loan, and promising that we are good for the money because we will pay them back with interest. Only we get to be both the person asking for the loan and the loan officer at the same time. My guess is the loan officer has a lot of faith in us.

Should he?

Many leading economists believe that the stimulus will create value by driving higher output, and is therefore a good idea. Paul Krugman and Joseph Stiglitz, both Nobel laureates in economics sure think so. In fact, they think the stimulus should be bigger. On the other hand, Nobel laureates in economics James Buchanan, Edward Prescott, Vernon Smith and Gary Becker all think it’s a bad idea. The only thing we can say with high confidence about this is that at least several Nobel laureates in economics are wrong.

The truth is that nobody knows if it will work or not. It would be as if, on the night before the Apollo launch, half of the world’s Nobel laureates in physics were asserting that rockets can’t get as far as the moon, and the other half were saying they can get there in theory, but we need much more fuel. This is a question about which expert opinion isn’t worth much. We are making decisions in a sea of ignorance, and shouldn’t kid ourselves about this.

The strongest argument for the stimulus (and the one that I think, in their heart-of-hearts, most supporters actually hold) is what could be called the Costanza-Hoover Principle: do the opposite of whatever Herbert Hoover did. In a world of limited knowledge, this isn’t as crazy as it might seem, at least as a starting point. It sure seems like Hoover screwed up; and hopefully we can avoid his mistakes. This pretty much boils down to: avoid a tariff war; don’t try to balance the budget right now; don’t restrict the money supply (that gold standard thing is right out); and, most importantly, prevent a collapse of the banking system.

This principle would lead to deficits (and as a practical matter, we are going to have large deficits for some time), but would also lead to us trying to feel our way into it, rather than making a huge commitment all at once. So-called boldness in the face of ignorance is simply lack of judgment. What would it mean to “feel our way into it”? That’s the subject of an upcoming post.