Will the Economic Stimulus and TARP Banking System Rescue Work?

By: Hans_Wagner

So far, the government has spent $350 billion of the TARP funds to shore up a number of financial institution's equity position. They also loaned money to GM and Chrysler. All this money to help stave off a worse condition. Now the U.S. Congress is about to pass legislation to help stimulate the economy amounting to more than $800 billion. The U.S. is encountering one of the worse recessions ever and the employment picture is getting worse by the week. Moreover, the Federal Reserve has lowered rates to zero to 0.25% range and they are buying securities of many types expanding their balance sheet dramatically.

All the spending by the government and the expanded monetary policy by the Fed, raises the question whether all the spending will work to reverse the course of the economy?

Recent History

The $163 billion stimulus package passed in early 2008 was intended to help the United States avoid a recession. The stimulus came as a tax rebate to most taxpayers. Economists expected that the Gross Domestic Product (GDP) of the United States to rise by 0.5 to 1.5% over the next two quarters. According to various economists, 85% of the money was saved rather than spent, as consumers cut back on their spending and restocked their depleted savings. As a result, the impact on the GDP was minimal.

There are two messages from the 2008 stimulus effort. First, the net impact of a stimulus from the government is likely to be less that originally estimated. Consumers take action to fit their needs and do not follow what economists and governments expect.

Second, consumers are de-leveraging their balance sheets along with the banks. Having borrowed to pay for much of their life style, now they face the reality that they must live within their means. As a result, consumers are reducing their spending, trying to pay off their credit cards and other borrowings, and increasing their savings. We should expect them to do much the same with the next stimulus money they receive.

If you see another $20 per paycheck in your take home pay later this summer, ask yourself what will I do with the money. Pay more on my debt, put it into savings, or spend it. I would encourage you to put it into your 401K or other savings plan, rather than spend it. It will pay off later when you near retirement. You will not remember what you bought with the money you spent. However, you will appreciate that you saved a little more each pay period in the years to come. And it will actually to the right thing for the economy in the long run.

Will the Stimulus Shock Work?

Economists have counseled President Obama and the Congress that the economy needs to be shocked out of its current demise. Soon we will know the final details of the stimulus package that will be passed by Congress and signed into law by President Obama. I suspect the changes that will be made to the one passed by the House of Representatives will relatively minor. This means that there will be some tax cuts, investment in roads and bridges, updates to government buildings and schools, renewable energy investments, payouts for various social programs and bailouts to states that over spent. This money will be spread out over several years, with about half by the end of calendar year 2010.

Will the high expectations that the stimulus package will save the economy and generate more than 3 million jobs? I suspect that it will not achieve all that has been promised, but it will help.

The chart below is from the Levy Economics Institute of Bard College. It is borrowed from their December 2008 Strategic Analysis Report titled “Prospects for the United states and the World: A Crisis that Conventional Remedies Cannot Resolve” by Wynne Godley, Dimitri B. Papadimitriou and Gennaro Zezza. The chart shows the affects of different stimulus (they call them shocks) on unemployment and the output gap. The output gap is the difference between the actual output or GDP and potential output or GDP. Shock 1, in red, is fiscal stimulus applied immediately that is equal to an increase in government outlays of about $380 billion of 2.6 percent of GDP. Shock 2 assumes stimulus of $760 billion or 5.3 percent of GDP. Note they assume the stimulus is applied immediately, not over several years as the one before Congress. It is interesting to note that when the authors wrote this study, they assumed that $760 billion was “almost inconceivably large fiscal stimuli”.

In each case, the stimulus reduces the base-case max unemployment rate, but it does not keep it from climbing through 2010. The GDP reflects a quick upturn but then resumed falling, just not at as fast a pace as the baseline. Moreover, GDP does not rebound but remains flat for years to come as the economy works through all the excess spending and debt from the past few years.

As the chart indicates, even with a large stimulus, GDP will not increase enough to keep unemployment from rising through the next two years. This is with the entire stimulus being applied immediately, not over several years as forecast by the Congressional Budget Office (CBO). While the authors did not indicate the make up of the stimulus package they assumed, I suspect it would not include some of the expenditures that are social programs rather than economic stimulus.

Looking at this one study, one can conclude that the stimulus will help the economy to some extent. However, it will not reverse the current trend, but rather mitigate the downtrend in employment and GDP somewhat.

One of the factors that we need to keep in mind is the affect a large and growing U.S. deficit has on the rest of the world. A large deficit can help offset the drop in private expenditures and reduce unemployment. The problem is it will cause a large and growing external imbalance, which will keep world growth on an unstable path. The large deficit created by stimulus spending and the lower collection of taxes must be funded by some one. The U.S. financial institutions have been one of the larger buyers of U.S. debt. As we know, many of them are in financial difficulty and will not be able to buy more debt for some time to come. Foreign countries that have large surplus of cash, especially U.S. dollars may buy up this debt. This movement off shore exacerbates the imbalance in funds flows, causing the U.S. to become even more of a debtor nation. The cost to service, let along pay off this debt, will negatively affect the U.S. economy for years to come. The U.S economy is more likely to experience a slow recovery once it begins and a lower growth rate that has been in the past.

What Should Investors Do

Investors are faced with a new environment that will require them to be focused and more nimble than in earlier years. There are three points investors should take away from this review.

First, do not assume that the economy will rebound quickly, but rather continue to deteriorate for the next year at least. After that expect the economy to slowly recover at less than the long-term growth rate. The market will follow along, with the bear market continuing through 2010. We might see an end to the bear market in the early part of 2011.

Second, seek to take advantage of the interim rallies and the pullbacks that are likely to be the nature of the market for years to come. Even after the bear market is over, the indexes will tend to trade sideways, experiencing rallies that can last for several months and then pull backs back to the former low levels.

Third, this does not mean that investors should abandon the market. Rather it means they should look be more nimble, looking for opportunities that will always arise. Look for sectors and companies that can take advantage of the current situation and avoid those that cannot. These opportunities will change over time as sub-sectors recover and then flourish. Other sectors will continue to struggle and should be avoided.

This means there will be excellent opportunities to generate wonderful profits in the market. We just need to stay focused on our investing discipline and we will benefit.

If you wish to learn more on economic growth, I suggest reading: Economic Growth by David Weil. An easy to read book that presents the key factors to understand global economies. It is expensive and is used as a text book for college students, but it is worth the money.

By Hans Wagner
tradingonlinemarkets.com

My Name is Hans Wagner and as a long time investor, I was fortunate to retire at 55. I believe you can employ simple investment principles to find and evaluate companies before committing one's hard earned money. Recently, after my children and their friends graduated from college, I found my self helping them to learn about the stock market and investing in stocks. As a result I created a website that provides a growing set of information on many investing topics along with sample portfolios that consistently beat the market at http://www.tradingonlinemarkets.com/

Copyright © 2009 Hans Wagner

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