Stimulus Debates

Two models exist that purport to show the effects of a Congressional stimulus on GDP. Fitst notice the similarity, they both get an initial effect of 1.0, each dollar spent by Congress shows up in GDP. The first point is verified in my opinion by comparing empirical results of the spending in the first year of the recession. The empirical seems seems to follow the pink lines.

The models differ based on whether government spending competes for scarce resources. This effect is called Ricardian Equivalence and will show up as a rise in interest rates for the Treasury curve, and money set aside by firms to pay taxes. A short hand way to think about this is that one model assumes Congress makes a profit, the other assumes Congress will make a loss, when Congress is considered a firm.

Which model do we have? We will find out in two or three months.

Consider David Merkels rule on sector manias:

When a sector as a whole borrows far more than in the past, it is often a mania, and the management teams are expanding capacity all at once, because conditions are so favorable. I experienced this twice as a bond manager. When I came on the scene in 2001, I tossed out all of my investment grade telecom bonds (aside from some of the Baby Bells), and auto bonds. I could not see how they would make money over the long haul.

David applies this to Congress today:

Still, I would underweight Treasuries relative to high quality bonds in other sectors. Issuance is high as far as the eye can see — and beyond 2050, given all of the difficulties with entitlement programs. Many high quality corporates won’t have much issuance over that same period; they will be scarce versus the massive amount of government debt to pay. Beyond that, when the Fed tightens, debt costs for the government will rise dramatically. Perverse, huh? When you have so much to refinance, everything fights against you.

David, the investor, is applying Ricardian Equivalence.