The Treasury View: Swimming pool version

A reader sent me, for comment, one of those letters that circulate through the Intertubes. This one is sent as “an explanation of the stimulus bill”. I wouldn’t call it that, but it is quite a good exposition of what’s known as the “Treasury View”[1]. If you believe that the economy is like a swimming pool, and that no matter how big a splash some shock (such as the collapse of the financial system) might make, the water in it will rapidly find its own level, then you will agree that there is no need for, or possible benefit from, the stimulus package. And conversely, if you think the economy is not like this, you are entitled to wonder about the kind of economist (regrettably not imaginary) who would employ such an argument.

fn1. The reference is to the British Treasury, circa 1931

Stimulus Bill Explanation

Shortly after class, an economics student approaches his economics professor and says, “I don’t understand this stimulus bill. Can you explain it to me?”

The professor replied, “I don’t have any time to explain it at my office, but if you come over to my house on Saturday and help me with my weekend project, I’ll be glad to explain it to you.”

The student agreed.

At the agreed-upon time, the student showed up at the professor’s house. The professor stated that the weekend project involved his backyard pool.

They both went out back to the pool, and the professor handed the student a bucket. Demonstrating with his own bucket, the professor said, “First, go over to the deep end, and fill your bucket with as much water as you can.”

The student did as he was instructed.

The professor then continued, “Follow me over to the shallow end, and then dump all the water from your bucket into it.”The student was naturally confused, but did as he was told.

The professor then explained they were going to do this many more times, and began walking back to the deep end of the pool.

The confused student asked, “Excuse me, but why are we doing this? The professor matter-of-factly stated that he was trying to make the shallow end much deeper.

The student didn’t think the economics professor was serious, but figured that he would find out the real story soon enough. However, after the 6th trip between the shallow end and the deep end, the student began to become worried that his economics professor had gone mad.

The student finally replied, “All we’re doing is wasting valuable time and effort on unproductive pursuits. Even worse, when this process is all over, everything will be at the same level it was before, so all you’ll really have accomplished is the destruction of what could have been truly productive action!”

The professor put down his bucket and replied with a smile, “Congratulations. You now understand the stimulus bill.”From Hell

58 thoughts on “The Treasury View: Swimming pool version

  1. #47 et al

    I am writing a paper about the contemporary relevance of Keynes.
    The answer depends on the extent to which the problem is caused by, or reflected in, a deficiency of total spending relative to our potential to supply. Clearly, overindebtedmess was causing some overspending (and over-production). We cannot strive to pump AD up to quite the level it was before.

    We may reasonably regard the banking crisis as a negative technology shock that has resulted, or is likely to result, in a necessary contraction or slowdown. But markets (financial and real) overshoot. There is the likelihood of an overcontraction of total spending and production. Pre-emptive fiscal stimulus may be a good idea: a hasty stitch in time may save an elegant nine later. The form, size and timing of this stimulus are separate issues.

    In the 1930s, the Fed allowed banks to fail and even initially tightened monetary policy to deal with the asset bubble. (I wonder if those who recently advocated high interest to break the asset bubble “before it got too big” realise how tricky this is to do.) Many thousands of US banks failed and millions lost their life savings. The effects on confidence and on spending were catastrophic. At least this blunder has not been repeated.

    The central bankers with Treasury support (resulting in a fiscal deficit) are the greater part of the current answer, and this has nothing much to do with the traditional methods of raising G or cutting taxes.

    Although there also was a financial crisis in the 1930s, I doubt that standard Keynesian remedies are as fully applicable today. In the 1930s, one could replace the private demand for steel with government demand (Hoover dam, battleships). And one could rely on liquidity-constrained people spending extra income on necessities. If people were hungry, you know that producing more soup can’t be far wrong.
    Now much consumption is discretionary and devoted to deferrable durables. In Australia, the government cannot simply enter the market to buy iron ore and coal to replace overseas buyers.

    But the idea of governments being employer of last resort is not dead. What these people do with their income (save or consume) is their business, I feel. I think exhortations to spend (and to buy locally) are tacky and ineffective.

    But I have no problem with significant fiscal stimulus. And there is no risk whatever in Australia that the deficits involved would constitute sovereign risk of defaulting on government bonds, even over accumulated deficits in a period of a few years. The US and UK may be in greater danger of a lack of public (actually, I probably just mean “market”!) trust and lack of credibility, it is worth remembering that these countries ended WW2 with national debts of about double their GDPs. And prosperity reigned. Furthermore I think there are degrees of trust and credibility, So there may be a corresponding degree of fiscal success even in those countries.

    Aggregate demand shocks are seldom spread remotely evenly across the affected sectors. There is always a structural impact. Some of these are “temporary’ (the investment sector is hit), but some may be more permanent. Markets do a better job of sorting resource out long-term structural change on a microeconomic scale. Macrostructural shocks may require fiscal stimulus so that the resources rendered idle will more smoothly find a new use elsewhere. But I am not a fan of propping up industries that merely have srong political lobbying power.

  2. Bruce

    I regard the current financial crisis as overwhelmingly the result of an extended period of loose monetary policy. While reigning in asset bubbles does present some problems for policymakers, the longer the bubble is allowed to run the greater the cost of reigning them in.

    The parallels with the 1930s are there for all to see, then as now the Fed conducted what was loose policy before tightening in the hope of putting a break on what had become a runaway train.

    Once the bubble popped, the Fed initially cut rates hard pushing the discount rate to a low of 1.5% by mid-1931. Unfortunately when your banking system is broken monetary policy doesn’t work.

    Sure the Fed later raised rates in an effort to stem gold outflows, and though this was a policy disaster, by this time, excessive debt, deflation and the banking collapse were major drags on the economy.

    In short the problems in my opinion were overwhelmingly caused by loose money which fed a excessive debt accumulation and the Fed’s failure to render assistance to the banking system once it had become apparent the system was in collapse. Not in my opinion tight monetary policy in the traditional sense.

    Back in the present, the Fed is no orphan among central banks in keeping monetary policy too loose for too long.

    Fom a domestic point of view, the RBA itself also kept rates too low for too long. While the RBA could be excused for underestimating the extent of the terms of trade boom early in the piece, by
    mid-2006 it had become apparent the commodities boom was a huge shock to the Australian economy yet they sat on their hands, raising the cash rate at a snails pace while household debt continued to build to astronomical levels.

    And now we get to 2009 and the turn in the terms of trade is set to hit us like a freight train.

    While I and others may quibble about the exact composition, in my opinion the government is doing what it should be doing in getting in early with a stimulus package to try and limit the damage.

  3. srfc
    In so far as monetary policy is directed primarily towards fighting goods-and-services inflation, asset prices are only of indirect relevance to central bankers. Given their blinkered view, interest rates were pretty much right.
    Old-fashioned Keynesian and Austrian critics of Orthodoxy could see there was a problem of easy money in the financial sector. Everybody saw it except orthodox New Keynesian adherents of so-called Taylor rules. (But Taylor has recently complained that his rule was not followed properly.)
    Mainstreamers rejected bubbles as old-fashioned Keynesian nonsense. Austrians and old-style Keynesians disagree about whether crises can be market failures or are essentially monetary-policy failures, but that’s a separate bunfight.

  4. Explaining the Stimulus Bill Part 2

    Upon closer observation, the student spots a leak in the swimming pool and sees the President trying to refill the pool and plug the leak at the same time. Unfortunately, there are many cracks that started 30 years ago, and it has become even worse over the last 8 years. We could let rainwater refill the pool over time (free market), but the pool is leaking and evaporating too fast (deflationary spiral.) The remaining water will freeze next winter because the pool pump is broken (liquidity trap, banks not making loans) and the pool cracks will further breach causing the even more water to leak out in the spring. A real economist knows there is never a constant volume of water in the pool. After all, the government just added half a trillion gallons. It should have been lots more, except someone was standing on the water hose screaming MORE TAX CUTS! Last year, the Fed added 2 trillion gallons in the deep end where all the wealthy bankers hang out and where the largest cracks are leaking the most water. The President wants to help the professor RENOVATE his pool by making the shallow end deeper and the deep end deeper. That way he lifts ALL boats. But the professor only believes in the free market, not government, thus clouding his judgment. He would call his insurance company and file a homeowners’ policy claim, except they are backed by AIG who are now owned by the government. Too bad, I guess the pool will drain leaving the shallow end high and dry while the deep end has just enough water for the privileged few. The student realizes the professor is a hack and drops his class. The student was last seen reading a book on Keynesian economics.

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