Will governments be forced to exit from ‘stimulus?’

August 25th, 2009

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Currently, there’s a belief in the financial markets that the worst of the Global Financial Crisis (GFC) is over and that it’ll be blue sky from now on. Indeed, it is possible that the the US economy may see a positive GDP growth in the next few quarters to come.

But here, as contrarians, we see a different picture. As we quoted the Bank for International Settlements (BIS) in Bank for International Settlements (BIS) warning on stimulus spendings, the ‘green shoots’ of growth is largely contributed to government bailouts, ‘stimulus’ spendings, money printing and cheaper money (e.g. zero interest rates in US).

Make no mistake about this: Government interventions cannot be sustained forever without increasing negative consequences in the longer term. Governments cannot ‘stimulate’ the economy. In fact, the word ‘stimulus’ is the most misleading word in economics lexicon because it conveys the idea of a surgeon ‘stimulating’ a heart into self-sustained beating. In reality, what government interventions did was to put the economy on a crutch. The longer the economy leans on the government crutch, the more dependent it will be on the government. Eventually, the government will become the economy. For those who haven’t already, we encourage you to read Preserving jobs at all costs leads to economic stagnation and Are governments mad with ?stimulating??.

Letting the economy lean on crutches indefinitely will result in decreasing economic health as time goes by. Furthermore, there’s always the risk that the side-effects will pressure governments to remove the crutches. As we quoted the BIS in Bank for International Settlements (BIS) warning on stimulus spendings,

Perhaps the largest short-term risk associated with the expansionary policies is the possibility of a forced exit. Monetary and fiscal authorities of the major economies have so far been relatively unconstrained in their ability to follow expansionary policies. This need not last. An extended period of stagnating economic activity could undermine the credibility of the policies in place. Governments may find it hard to place debt if market participants expect the underlying balance to remain negative for years to come. Under such circumstances, funding costs could rise suddenly, forcing them to cut spending or raise taxes significantly.

How will a pressure for a “forced exit” from crutches (bailouts, stimulus, money printing and cheaper money) happen? We can look no further than China as an example where ‘stimulus’ is most effective. As we wrote in Will August 2009 be the top for the year in China?,

Forcing credit growth in this case does not result in economic ?stimulation.? Instead, the result was a dangerous asset price bubble. Apparently, the Chinese government flipped its position and decided to rein in the bubble before it’s too late.

China is right now in a dilemma. Turning the credit tap off will result in many projects failing, which in turn will result in bad debts. Not turning the credit tap off will result in price inflation and asset price bubbles.

The problem with economic crutches is that there will be negative side-effects. It is only a matter of time before excess liquidity leaked into asset and commodity prices. Initially, this may not be a problem. But as we saw last year (see Who is to blame for surging food and oil prices?), this will eventually result in acute problems of price inflation (unless the next deflation pressure comes, for which it will be déjà vu again). If governments decide to withdraw the economic crutches, they risk letting the already weakening economy fall into deflation. If they decide not to withdraw them, they risk letting acute price inflation run amok.

What is likely to happen is that governments will attempt to walk on the middle ground by pretending to ‘fight’ inflation (e.g. raising interest rates too slowly and talk tough on inflation) and support the economy at the same time, hoping that the economy will turn out fine. It may work initially, but it’s a matter of time before the public will see through it.

Tougher times is ahead for everyone.

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  • David

    Hi CIJ
    You concluded with “What is likely to happen is that governments will attempt to walk on the middle ground by pretending to ?fight? inflation (e.g. raising interest rates too slowly and talk tough on inflation) and support the economy at the same time, hoping that the economy will turn out fine. It may work initially, but it?s a matter of time before the public will see through it.”

    I think they have been trying to walk a middle ground (from their point of view) from the beginning. It is why they didn’t do the right thing from the start (let failed institutions fail) and why they didn’t do the right thing from before the start (low interest rates that created a boom, and no enforcement of basic laws against bank fraud) and why they continue to do the wrong thing (keep rates low, while monetizing debt, and getting more and more involved in failed corporations in the real economy, and creating more debt). Lets suppose they want to keep doing the same thing because (from their point of view) it has been working. IE No (Obvious to most) Economic Collapse.

    My question is, what will they do to keep things rolling along (if BRIC doesn’t stop them) to keep the US dollar the reserve currency, to keep Washington in Cash, to keep their friends in power and in money, etc (ie keep things like they have always been (for 25 years anyway))? I think the answer is more of the same, because they are not that creative a bunch. If the Fed doesn’t go along, then Bernanke will be replaced by someone who will keep the monetization going. I think the lure of low rates and the illusion of T-Bills being bought has too great an allure for them to do something else. Does anyone really thing this is a bunch of people who are going to give up power and benefits to do the right thing? I haven’t seen evidence of that yet. Is any branch of the Federal US Government going to decide they should make the hard choices today, instead of putting it off for as long as possible? I don’t see any evidence of that yet. Is the US public ready to say lets take our medicine and have a lower standard of living and use less energy and not use our military to maintain our global empire that helps keeps tyrants in oil rich countries in charge, etc? I don’t see much evidence. What are your thoughts?

  • David

    Hi CIJ
    You concluded with “What is likely to happen is that governments will attempt to walk on the middle ground by pretending to ?fight? inflation (e.g. raising interest rates too slowly and talk tough on inflation) and support the economy at the same time, hoping that the economy will turn out fine. It may work initially, but it?s a matter of time before the public will see through it.”

    I think they have been trying to walk a middle ground (from their point of view) from the beginning. It is why they didn’t do the right thing from the start (let failed institutions fail) and why they didn’t do the right thing from before the start (low interest rates that created a boom, and no enforcement of basic laws against bank fraud) and why they continue to do the wrong thing (keep rates low, while monetizing debt, and getting more and more involved in failed corporations in the real economy, and creating more debt). Lets suppose they want to keep doing the same thing because (from their point of view) it has been working. IE No (Obvious to most) Economic Collapse.

    My question is, what will they do to keep things rolling along (if BRIC doesn’t stop them) to keep the US dollar the reserve currency, to keep Washington in Cash, to keep their friends in power and in money, etc (ie keep things like they have always been (for 25 years anyway))? I think the answer is more of the same, because they are not that creative a bunch. If the Fed doesn’t go along, then Bernanke will be replaced by someone who will keep the monetization going. I think the lure of low rates and the illusion of T-Bills being bought has too great an allure for them to do something else. Does anyone really thing this is a bunch of people who are going to give up power and benefits to do the right thing? I haven’t seen evidence of that yet. Is any branch of the Federal US Government going to decide they should make the hard choices today, instead of putting it off for as long as possible? I don’t see any evidence of that yet. Is the US public ready to say lets take our medicine and have a lower standard of living and use less energy and not use our military to maintain our global empire that helps keeps tyrants in oil rich countries in charge, etc? I don’t see much evidence. What are your thoughts?

  • pb

    David, i agree, if change happens it wont be by choice.

    CIJ, you talked about the ‘next deflation pressure coming, for which it will be déjà vu again.’ could you elaborate on that a bit more?

  • pb

    David, i agree, if change happens it wont be by choice.

    CIJ, you talked about the ‘next deflation pressure coming, for which it will be déjà vu again.’ could you elaborate on that a bit more?

  • Hi pb & David!

    Yes, change wouldn’t happen by choice unless forced upon by hyperinflation.

    CIJ, you talked about the ‘next deflation pressure coming, for which it will be déjà vu again.’ could you elaborate on that a bit more?

    Ralph Norris, head of CBA mentioned said that the International Monetary Fund estimated in April there was $US4 trillion ($4.9 trillion) of toxic assets in the global financial system, with only $US1.5 trillion so far brought to account. “So where is (the rest of it)?” he asked (see Banks warn of second wave of toxic assets). A possibility of where toxic assets are is as what we wrote in Looming Black Swan that can bring the market back into panic.

    So, the government’s formula is this:
    1. If there’s problem (e.g. deflation, panic, etc), print money- e.g. Panic of 2008
    2. More problem, print more money. Coming in 2010???
    3. If problem persisit, yet print even more money. Coming later still??

  • Hi pb & David!

    Yes, change wouldn’t happen by choice unless forced upon by hyperinflation.

    CIJ, you talked about the ‘next deflation pressure coming, for which it will be déjà vu again.’ could you elaborate on that a bit more?

    Ralph Norris, head of CBA mentioned said that the International Monetary Fund estimated in April there was $US4 trillion ($4.9 trillion) of toxic assets in the global financial system, with only $US1.5 trillion so far brought to account. “So where is (the rest of it)?” he asked (see Banks warn of second wave of toxic assets). A possibility of where toxic assets are is as what we wrote in Looming Black Swan that can bring the market back into panic.

    So, the government’s formula is this:
    1. If there’s problem (e.g. deflation, panic, etc), print money- e.g. Panic of 2008
    2. More problem, print more money. Coming in 2010???
    3. If problem persisit, yet print even more money. Coming later still??

  • All this stimulus reminds me of what happened to poor Michael Jackson.

  • All this stimulus reminds me of what happened to poor Michael Jackson.

  • anon

    I think hyperinflation is pretty impossible in the short-medium term.

    Given that you pointed out that there are still plenty of toxic assets and debt, and the sort of liquidity panic it would entail – wouldn’t that lend greater credence to the deflationary scenario over the short-term?

  • anon

    I think hyperinflation is pretty impossible in the short-medium term.

    Given that you pointed out that there are still plenty of toxic assets and debt, and the sort of liquidity panic it would entail – wouldn’t that lend greater credence to the deflationary scenario over the short-term?

  • Anon

    Hey anon, my twin lol?

    anon, CIJ has some articles on money printing and government intervention that talks about what you mentioned.

  • Anon

    Hey anon, my twin lol?

    anon, CIJ has some articles on money printing and government intervention that talks about what you mentioned.

  • We didn’t know there’s 2 anon… 🙂

    Anyway, we recommend Marc Faber vs Steve Keen in inflation/deflation debate- Part 2: Marc Faber?s view to answer this question.

  • We didn’t know there’s 2 anon… 🙂

    Anyway, we recommend Marc Faber vs Steve Keen in inflation/deflation debate- Part 2: Marc Faber?s view to answer this question.