Fiscal Stimulus Leakage

We have had huge fiscal stimulus by the US govt and the US govt has also bailed out many of the big banks. We should have seen huge increase in economic activity given the size of the stimulus but the unemployment is still high. I was discussing this with a friend a week back. One of the thing that came up was the high leakage of the fiscal stimulus overseas due to the heavy automation of the infrastructure work in the US - the stimulus was supposed to be aimed at shovel ready infrastructure projects. One thing is that there were not many shovel ready projects to immediately fund and so the fiscal stimulus is only slowly seeping into the economy. The other interesting thing relates to the heavy automation of infrastructure work. Say 20 years back, they needed 10 people for a road laying job. Now that same job may require only 3 people with machines being able to replace the other 7 people. If $100 was spent earlier on 10 people, now $30 may be spent on 3 people and $70 to buy the machines. So a big chunk of the money is being spent to buy the machinery. If the machinery was made in the US, then that money would eventually end up as wages to the US workers. But that machinery is made in China, Japan or Korea and end up supporting employment overseas. The govts of these foreign countries end up getting the $70 and then they lend it to the US govt by buying US Treasuries. In effect, the US govt tried to spend $100 in the US economy but only $30 got into the US economy and the other $70 came back to fund the US deficit. So the the US govt spending is currently not as effective as it would have been previously when many of the manufacturing jobs were in this country. The US govt now has to do repeated stimulus to get the same effect of a past stimulus. and the US stimulus ends up stimulating the rest of the world (supplying the manufactured products to the US economy) more than the US for every $1 spent by the US govt.

Buffett and Squanderville

I had a discussion with a friend of mine on the US trade deficit and on an article published by Buffett in 2004 on Thriftville vs Squanderville. I am posting this on my blog to keep track of these kind of discussions.

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Meanwhile, the citizens of Thriftville begin to get nervous. Just how good, they ask, are the IOUs of a shiftless island? So the Thrifts change strategy: Though they continue to hold some bonds, they sell most of them to Squanderville residents for Squanderbucks and use the proceeds to buy Squanderville land. And eventually the Thrifts own all of Squanderville.
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If thriftville citizens don't believe in the squanderbonds, the squanderville residents know more about their bonds and so will not give squanderbucks for the squanderbonds. They already know those squanderbonds are not worth much. ok, you may say that the squanderville govt will give thriftville squanderbucks in redemption of the squanderbonds. Those squanderbucks won't buy much property of squanderville either - as they try to buy property, thriftville citizens will find that the property costs in thriftville shoots sky high.

Coming back to reality, china can't do much with the $2 trillion of US bonds - if they try to buy land assets in the US, the huge liquidity will shoot up property prices here that they would only be able to buy say 10% of what they thought they could buy. A foreign country never gets to own another country by stealth - they own it by attacking it militarily (or meddling around using military powers). If china doesn't believe in the US bonds, nobody is preventing them from buying up private businesses here (if they can get thru all the regulatory loopholes). It will be actually good that they did that instead of buying the US bonds. but buying private businesses also carries with the responsibility of managing it - it won't be a passive investment any more. are they up for it? and the chinese assets could be seized by a class action lawsuit by chinese US citizens who have suffered human rights abuse back home.

and you have a hangup with default. defaults and bankruptcies happen all the time in the US - that is a good way of eliminating the weaklings and having more efficient firms survive. Whenever a bank gives a loan to you, your credit score is used to set the interest rate. The higher interest rates for higher risk customers is done on the assumption that a certain percentage of customers are going to default. It is accepted part of the system. Venture capitalists do fund people who have failed more than a few times starting businesses. You give credit to entities after looking at their business case and if the entity fails, it doesn't mean all the employees of the firm will become slaves to the creditor. The creditor is looking for yield and there is always risk in losing it all. The different creditors have different priorities in collecting the liquidated assets, based on how the debt was secured.

Trade deficits are created not by the action of just one trading party but by both. If china had allowed free floating of its currency, its currency would have kept rising to eliminate the trade deficit. They created their dollar reserve by deciding to keep the yuan pegged to the dollar at a low level. They released more yuans into their economy thru that process and high inflation is an effect of that. The chinese govt. is seeing the high inflation and not able to decide what to do. Without foreign exchange manipulation, you don't get huge trade deficits. There is no trade deficit between Massachussets and Missouri - Mass residents won't sell to Missouri residents without getting properly compensated for it.

Every country in this world wants to be a net exporter and that is a mathematical impossibility. All the asian economies want to save 30% of their salaries and that is not sustainable - you can only do that if you remain a perpetual exporter. Their savings will get spent by the consuming nations like the US. and there is no point in saving money beyond a certain emergency need. At an individual level, you are exposed to job losses but at the system level, the job losses won't be more than say 20% (which was at the height of the depression in the 30s). That is why countries create safety nets which are like insurance systems to increase economic acitivity. If you are a self-contained nation (net zero export-import), any savings will get wiped by slowing down of the economy to a level where the average savings comes down to zero. Money is just a medium to trade and it has no value by itself other than what is set in the market in terms of its tradability.

I do consider the govt deficit to be a serious problem compared to the trade deficit. China is abetting the US govt to run these deficits by buying the govt. bonds. The govt deficit can not run at this current pace for long. increase in taxes, decrease in govt spending - something has to happen and usually this country does take some steps or the market forces it to. I am quoting Buffet again below:
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I will close by reminding you again that I cried wolf once before. In general, the batting average of doomsayers in the U.S. is terrible. Our country has consistently made fools of those who were skeptical about either our economic potential or our resiliency. Many pessimistic seers simply underestimated the dynamism that has allowed us to overcome problems that once seemed ominous. We still have a truly remarkable country and economy.
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The US is still an amazing country compared to the rest of the world. In fact, Buffet lost money on his currency bets as the US currency actually appreciated after Jan 2004. During last year's crisis, the whole world flocked to the US dollar. and Buffet said that he is making a bet on the US economy when he bought CSX a few months back.

Economic Model - 4

In the simple model I described earlier, the economic model is limited by the fact that once a farmer gets a massage, the farmer has to wait for the masseuse to buy a bushel of wheat before he can pay for another massage. I also arbitrarily said that one massage is equivalent to 1 bushel of wheat = 10 cents. The market may set different rates. How does a market set different rates? based on supply and demand. In this model, say a farmer decides that one massage for 1 bushel is too little and so demands more massages. The farmer may demand 2 massages for 1 bushel - the masseuse has to eat food to survive but the farmer could survive without a massage though he would like to have a massage. So the farmer only pays 5 cents for a massage now and the masseuse has to give 2 massages before he can get his bushel of wheat. What if the farmer demands 5 massages for 1 bushel of wheat - the masseuse may have to overwork so much that he would decide to leave this line of work and become a farmer himself. Either that or he must keep improving the massage experience every year to keep the farmers craving for the massages. This always happens in the service industry - people want some better experience to keep buying next year. Today's ipod becomes boring next year and apple has to keep offering some other addition to the ipod to keep luring the existing customers (and also lure new customers who weren't impressed with last year's ipod). In this example, the price of wheat or massage would be set up based on supply/demand. To keep his well being, the farmers may need to get some minimum massages every year and so there will be some masseuses around after some of them get out of the business. The minimum massage could be 5 massages per year. So there must be enough masseuses to provide 10*5 massages every year to the farmers. I will explore next a 3 entity model - that gets more interesting than the two entity model and will bring about a lot of revelations about the workings of our modern economy. I would also need to introduce some credit infusion function into the economy by the banks.

Economic Model - 3

Back to my example of 10 farmers and 10 masseurs, each farmer produces 20 bushels of wheat. Normal consumption of food for each person is 10 bushel of wheat per year. Each person gets 10 massages during a year normally. I am going to seed this system with $0.1 of money for each person - total of $2 in the system. At the beginning of the year, each person has $0.1. The current rate is $0.1 per massage and $0.1 per bushel of wheat. The farmer will spend his $0.1 to get a massage and then the masseuse will buy 1 bushel of wheat for $0.1 from the farmer. There is no savings in this system. Everybody spends their entire money. In reality there is savings and I will expand the model later for it. Over the course of a year, each farmer would have spent $1 on 10 massages and earned $1 selling 1o bushels of wheat. At the end of the year, each farmer and masseuse will be left with $0.1 to start spending next year. The GDP would be $20 as $20 of economic transactions took place in this economy. We had $2 in the system and produced $20 worth of economic transactions - this is the money multiplier effect. The multiplier effect will be more evident when we have three entities rather than two and how an increase in savings will reduce this money multiplier effect. Now what if the farmer finds a way to produce more 30 bushels of wheat. The farmer could decide to eat 5 more bushels and doesn't have a need for another 5 bushels. He can sell it to the masseuse but the masseuse would have to give more massages for it. With the increased production of wheat, the economic transaction between a farmer and a masseuse could be 15 bushels of wheat and 15 massages. The farmer and masseuse could still trade at $0.1 for both the massage and bushels but there will be 15 transactions now instead of 10. The GDP would now become $30. Without any increase in the amount of money in the economy, we were able to increase the total economic value of transactions as we had more transactions in this case.