Stimulus plan vs. the bailout


There is a lot of financial and economic jargon and buzzwords floating around these days. From Washington to New York, numbers and terms are being thrown about with abandon. It has become clear many people do not fully understand the subtle and not-so-subtle differences in economic policy.

Many Americans' first experience with staggering numbers and economic bailouts was the Troubled Asset Relief Program. This piece of legislation was crafted to aid the financial sector and was put into effect on Oct. 3, 2008. The problem with the financial sector was that it found its balance sheets filled with assets of little value. The net worth of a firm is equal to the difference between its assets and its liabilities. If the liabilities are worth more than the assets, then the firm is considered insolvent; in other words it owes more than it owns. The vast majority of the "toxic" assets were mortgage-backed securities, which had been repackaged and sold by commercial banks to other financial institutions. When the housing bubble collapsed, borrowers defaulted on loans worth more than their homes. This made all the mortgage-backed securities nearly worthless. Had financial institutions marked down their assets, as is custom, they would have been forced into bankruptcy. It was feared that the fall of Wall Street would have disastrous repercussions on Main Street.

TARP was designed to bail out the financial institutions by offering them a lifeline in the form of funds. The federal government pledged $700 billion in two stages to Wall Street to help them cope with the drastic markdown of their assets. This money would be spent in two ways: purchasing preferred stock, and either purchasing toxic assets or offering government guarantees on those assets. The acquisition of preferred stock may be the only thing that the American citizen sees out of the $350 billion spent so far. In theory, when stock prices rise or the companies make a profit, the government will be able to recoup some of the initial expenditure by receiving dividends or selling the stock. Contrary to what many argue, this is not nationalization of banks, as preferred stock does not confer voting privileges on the owner. The purchases and guarantees of toxic assets are much more troubling. First, there is no way to price these assets. The market has clearly stated that private investors are not willing to pay much for these assets. It is probable that we, as taxpayers, paid too dearly for these assets that may never appreciate in value. This has amounted to a massive subsidy for an industry that failed to see the writing on the wall. Even more disturbing is the fact that Congress seems to have no idea where any of this money is going. The firms that received taxpayer money have not been forced to make any real concessions — the $500,000 salary cap is merely symbolic. To wipe out upper management at any firm that accepted taxpayer money would have been appropriate. If they were so incompetent as to require a bailout, why should we as taxpayers allow them to stay on to gamble away our money?

The effects of TARP failed to stabilize the larger economy as weekly layoffs, quarterly losses and declining industrial production have shown. This forced the government's hand a second time. Typically the government acts through the Federal Reserve System by manipulating interest rates through open market sales or purchases of treasury securities. Most recently the Fed has lowered the federal funds target rate to a historically low 0.25 percent! The effective federal funds rate is actually a little bit below this but the difference is academic. The point is the Fed cannot jolt the economy into action by lowering interest rates — we've hit the lower bound. This is precisely what makes this current economic downturn — I am still waiting to see whether to call it a recession or a depression — so difficult to combat.

The only remaining response the government has in its economic arsenal is creating demand through expenditures. When the government purchases something, it creates demand and jobs. The initial purchases stimulate industry and all of the feeder industries that work together. When contemplating whether the automobile industry needed a bailout, it was important to recognize that the rubber and steel industries were also on the line as well. In order to fill in the output gap, the difference between potential and real gross domestic product, the government must be spending on the order of the difference. In reality, we need not spend exactly as much due to a multiplier effect on demand. When the government builds a school, the construction worker gets paid and will then spend his or her paycheck on food, rent and clothing which will then generate demand in those industries and so on. Empirical estimates of the multiplier effect from spending generally range between one and two, with many clustered around one and a half. The Congressional Budget Office estimates that the output gap over the next three years will be approximately $2.9 trillion. This number is derived from Okun's Law, which states the relationship between unemployment and the output gap. Even if we assume a large multiplier of, say, two, we would still need to spend on the order of $1.5 trillion! And this is a very optimistic view of the situation.

Unfortunately for all of us, the current stimulus bill, as being considered in the Senate, is too small and contains insufficient spending. The stimulus bill is being viewed as a one-time thing and should therefore be on the order of the $1.5 trillion discussed above. This number also assumes that all of the money is being spent directly. Approximately 35 percent of the Senate version of the stimulus bill is dedicated toward tax cuts which have been widely shown to be less effective than direct spending in creating jobs and demand. When a tax cut is given, people will spend some of it but they will also save some of it. This means that $1 of tax cuts is less effective in creating demand than $1 of direct spending.

The problem with both the House of Representatives and Senate versions of the bill is that the Democratic leadership acquiesced to Republican demands for tax cuts. Ironically, even after all the concessions in the House, not a single Republican representative voted for the bill. What is troubling is that even after this display of partisanship by the Republicans, the Senate then expanded the fraction of the bill dedicated to tax cuts, and at the same time cut some of the most vital expenditures — direct aid to states. All across the nation, states are finding themselves in dire fiscal straits. States are being forced to cut basic services and lay off employees. Both of these reactions only make the situation worse. One of the most effective ways to spend stimulus money is to offer it to the states so that services such as health care, food stamps and education can be continued. This money would be spent immediately and would have the effect of improving or maintaining standards of living and creating or preserving jobs. Given the current economic condition, a job saved is a job earned.

The TARP program and the stimulus bill in the Senate are very different. The TARP program was not designed to create jobs, demand or even get any bang for the taxpayer buck. A lack of Congressional oversight has made the TARP program a give-away to financial institutions whose lack of foresight helped to land us in this mess. The failure to include strings in the bailout was another failure of Congress to ensure that firms were forced to give something up in order to get something.

The stimulus package is designed for the rest of us. It will generate demand for goods and services across the board. When an industry does well, it tends to spill over to other industries and the same holds true for when it does poorly. Further, the stimulus bill will actually give the American public something for its money. This is an opportunity to fix schools, bridges, highways, railroads, hospitals, police and fire departments, and so much more. The stimulus package is an investment in both the present and the future. Despite all the accolades the stimulus package deserves, it also deserves criticism. It is too small and is more than one-third tax cuts. Only two-thirds of this bill can even be described as fiscal stimulus. The other third is ineffective and wasteful. Congressional Democrats offered their hand across the aisle and were slapped away. Senate Democrats have shown even less spine in pandering to the opposition and in the process have watered down a vital bill. I urge all senators to vote for the bill as any fiscal stimulus is better than no fiscal stimulus, but would also caution them that now is not the time to low-ball and cut corners. Bold and decisive action is needed to escape the downward spiral that leads to a depression and the time for that action is quickly slipping away.

   

Alexander Draine is a Rutgers College senior majoring in economics. His column, "Draine on Society," runs on alternate Tuesdays.


Alexander Draine

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