The Money Managers | In the News

The stimulus package has been passed and Australia will be stimulating our economy as much as other economies around the world. Will it work? There is an assumption about the need for this type of prolific action to either prevent or dampen a recession or worse, a depression in the global economy. The cure may be worse than the disease. We have been led to believe that stimulation packages and free Government handouts are the only solution to the problems we find ourselves faced with. Investors need to be aware of the potential consequences of this type of action.

There is a formula in economics that states that in any given year private investment must equal the sum of private savings, corporate savings (by way of retained earnings) and government savings (or deficits). In our globalised economy this formula applies to the world as a whole but imbalances can build up and countries can become dangerously out of kilter.

For example, over the last few years, private investment in the US has been far greater than the sum of private, corporate and government savings, so the US has had to import savings from the rest of the world by selling US Treasuries primarily to China, Japan and the Middle East. The US deficit is equal and opposite to the surpluses elsewhere.

Government bailouts and stimulus packages are being promoted as a cure for heavily indebted countries. They are funded by issuing more government debt but the problem is the money must come from somewhere. It seems to be very popular, particularly with the recipients of the bailouts and cash giveaways. The problem is that the added debt absorbs savings that would otherwise go to private investment. In the end bailouts and stimulus plans do not add to current resources in use. They simply move resources from one use to another.

The reason we find ourselves in the problem we are today is because we have been spending money we haven’t yet earnt. In order to fund current lifestyle we have been borrowing money that must be repaid at some point in the future. The solution being offered in Australia, the US and elsewhere is to have the government give us still more money we haven’t earnt by borrowing it from the rest of the world (going into government deficit).

If the economic situation worsens in a year or two we will be in a far less flexible position to weather the storm if we are burdened by billions of dollars of debt. Bailouts and stimulus packages only enhance future incomes when the activities they favor are more productive than the activities they displace.

Most politicians will favor bailouts as they fear the voter backlash if thousands lose their jobs. Bailouts will be financed with government debt. The government deficit gets larger; government savings become more negative. If private and other corporate savers do not save more in response to additional government debt, the bailout displaces productive investments elsewhere. If private and other corporate savers do save more in response to additional government debt, private consumption must go down by the same amount. This lost consumption and investment, and the incomes they would create, are the real unseen costs of a bailout.

We are all caught up by the very visible prospect of lost jobs in the industries that cry out for a government bailout like the auto industry. We tend to forget the unnamed people who lose jobs or don't get jobs, the businesses that close or the new businesses that don't start, because the bailout displaces productive activities elsewhere.

Even when there are lots of idle workers, government bailouts and stimulus plans are not likely to add to employment. The reason is that bailouts and stimulus plans must be financed. The additional government debt means that existing current resources just move from one use to another, from private investment to government investment or from investment to consumption, with no effect on total current resources in the system or on total employment.

Stimulus packages only enhance future incomes when they move current resources from less productive private uses to more productive government uses. Government has not had a good track record for efficiency when compared to the private sector.

If Government was more efficient at allocating capital than private investors, North Korea would be booming and South Korea would be a basket case. The Soviet Union would have been the richest country in the world by the late 1980’s! This is patently not the case. Small business has always been the real driver of employment growth. Policy must be directed towards the support and encouragement of enterprise.

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