Fiscal stimulus: a warning and an alternative idea

More power to the UK Government for acting quickly and apparently forcefully in coming up with measures to counter an oncoming recession ! But the type of fiscal stimulus proposed (tax cuts as opposed to direct spending) runs at least one significant risk in that it will not, in fact, stimulate the economy as directly as is necessary.(1)


The origin of the current recession lies, unlike some other recessions that we have been through, with the balance sheets of corporations and households: These balance sheets look less good now than two years ago because we are in a spiral of declining asset prices. Both households and corporations are holding off on consumption because they are using funds available to 'repair' their balance sheets. When cutting taxes, the Government runs the risk that households' and corporations' tax savings will simply be channelled to a further repair of those balance sheets. This is a good thing, but only in the very long run, with asset prices taking many years to react. More immediate measures are needed if we are to avoid a recession, and raising direct government spending would be a more appropriate way to boost demand.


Justified as any criticism may be, I've always preferred not simply criticising but coming up with a good alternative as well. The below is only one idea of how the UK Government could provide more direct fiscal stimulus to the economy - certainly not a full fiscal program but at least one idea that could be an important contributor to economic growth. I'm very enthusiastic about this idea, although some may find it outrageous, and I strongly invite comments.


My proposal is for the UK Government to engage in a program of house demolition and re-building. The UK housing stock is notoriously old and suffers from relatively low energy (and water) efficiency when compared to our closest neighbours, while the rate of housebuilding has been slow compared to the needs of the UK population. As of late-2007, empty homes accounted for 3.2 per cent of the housing stock, or 672,924 units (2), of which I estimate approximately 50% to be in the state sector.


A Government program of demolishing empty homes in its ownership and tendering work for their rebuilding, could provide for a dramatic injection into the economy at minimal cost or even a profit. The current value of an empty home to the state sector is zero or negative, since most of these homes are, at best, unfit for habitation and, at worst, an environmental liability. I presume that the cost of demolition that gets us to a blank canvas for re-building is also low and would, in any case, be money well-spent that stimulates the local economy.

The above means that there is a real opportunity for the Government to inject money into the economy while, in the long run, easily recovering its investment: Population data clearly show that housing demand continues to go from strength to strength, at prices, although declining, still well above building costs. The Government could easily re-sell or rent out the additional housing it creates - indeed, doing so has been an aim of the current Government since it came to power.

But it gets better still. Rather than tackling the re-building work itself, the Government should tender out each stage of the work in the re-building process in a way that stimulates innovation and maximum spend by the private sector (3): It should set very high standards in terms of living and environmental quality. Then, it should have architectural and surveying firms bid for the design work to be done, have construction firms bid for the construction work (and make certain that both small and large firms get their chances), have firms that develop innovative and efficient fixtures and fittings bid for work - and many other such instances that provide both a fiscal stimulus and help drive innovations.

Outside of the housing stock explicitly owned by the state, the Government could provide incentives for the owners to private, empty homes so the exact same dynamic develops in the private sector. It could either force these owners to sell up at knock-down prices while at the same time providing them with an incentive to demolish and re-build. Programs can be envisaged such as stage-by-stage grants paid to owners as they demolish and re-build to a certain standard or direct and more important Government aid in exchange for which the Government takes a share of future rents or sales prices.

The key advantages of the program described are that it is efficient in solving a large number of problems that have been long-term goals of this government in a cost-effective way:
(a) Current book values of empty housing stock plus re-building cost is well below current market value, with housing demand high enough to absorb additional supply of housing stock to the market without an undue effect on prices (4);
(c) Government funds spent have a maximum multiplier effect as the private sector makes significant outlays to try to take advantage of this Government program;
(d) This program could provide a major stimulus in providing the necessary updating of a significant part of the housing stock that urgently requires it;
(e) This initiative would stimulate a domestic 'green' industry with international allure that is at the vanguard of environmentally friendly construction worldwide;
(f) Budget deficits created by this program now are recovered quasi-automatically in coming years as tax revenues increase and the Government sells or leases the renewed housing stock now in its hands .

A program in which the UK Government applies the above principles to the housing stock it owns would represent, at conservative estimates, a £30billion+ direct stimulus to the UK economy, with the total effect a multiple of this number. It is not suggested that this type of measure be anywhere near the most important measure taken, but the numbers involved suggest that it can be at least one, significant measure. Importantly, it is one of few significant measures that is both fiscally conservative while providing a very large boost to the UK economy.

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Notes:

(1) The additional risk exists that the economic program currently proposed is too short-term in scope. My intuition (and I'm largely relying on my reading of the Japanese crisis in the 1990s) seems to suggest that a longer-term program is needed to get households and corporations to start spending with confidence. A short-term fiscal relaxation on behalf of the Government runs the risk of being ineffective, especially if counter-balancing measures for the years ahead are already announced - and it raises the fear of having to implement a stricter fiscal policy when the economy is still experiencing, at best, fragile growth (2010-2011 ?). Trying to reduce the UK budget deficit while the economy is still not back on track raises the perverse possibility that stricter fiscal policy will widen the deficit even further.

(2) http://www.communities.gov.uk/housing/housingmanagementcare/emptyhomes/


(3) The risk that adding formerly empty properties to the existing housing stock will further depress already declining house prices is largely countered by the fact that empty homes are, generally, in areas that have been unattractive to buyers. Adding quality homes to the available housing stock in those areas may have a positive rather than a negative effect on house prices in the areas involved - especially if the Government would also pay attention to improving local conditions by, e.g., incentivising local councils to improve local streetscapes, green areas etc., all of which are measures that, in turn, help stimulate local demand and employment.

(4) The Government should ensure that the type of program that I propose has maximum multiplier effect, i.e. stimulates maximum amounts of private investment based on the funds that it injects itself. It can do so by packaging work regionally or in other manners, such that every contract represents a huge amount of work that is attractive to many firms (For those interested in micro-economics, this kind of recommendation relies on what I call positive skew, the reason why more people buy lottery tickets when the jackpot is large, even in cases where their chance of winning is lower than in other instances when the jackpot is lower). This approach runs the risk of excluding smaller firms. Another way is to have firms bid on a house-by-house basis. Maybe the best way is a mixture of both plans, where large-scale packages are combined with a series of individual house-by-house projects. Key is to multiply the effect on the private sector as efficiently as possible.

For those who think that this is the end ...

I am writing this three two days after the parent company of Lehman Brothers has filed for Chapter 11 protection, one day after the US Government has agreed to inject capital into AIG and hours after CDS rates on a strong firm such as Morgan Stanley have widened significantly. To many, it seems like the end of the financial system as we know it is near. The question is: How deep will this crisis go ? What shoe will drop next ? How much of our financial infrastructure lies open to destruction ?

The end-game, I believe, lies not with the financial economy in the narrow sense, but with the economy as a whole. How much more money can nations source to prop up what remains of our financial system ? In this, we have to remember that all of the (generally central bank-originated) measures that we have come to know have never existed to change the overall pattern of growth, but simply to smooth out the inevitable ups and downs that take us away from the long-term growth rate of the economy, what some call the 'business cycle'. Interest rates have never been a weapon to radically change the direction of our economy, they have simply served to prop us up when we are, temporarily, down, and to hold us back when we are getting ahead of ourselves. The long-term path of our economy depends on much larger variables, which no central bank or central government has ever been able to control.

When we think of the end-game in this whole sorry saga, we should therefore think of the big picture. The end-game consists of the collective power that any nation has to create, or destroy, economic growth that finances, or lacks the ability to finance, the overall growth that we enjoy, or lack. And in that sense, I believe the balance is largely positive. More financial institutions may go bust, or not go bust for the mere intervention of incredibly powerful government intervention. But that government intervention can only be financed by our collective ability to create long-term growth, our collective ability, as an economy, to profitably solve problems that we would all like to see solved - and that ability is unaffected.

Large government deficits will be created in getting through the current crisis. But I believe that those deficits will, in the long run, be financed by our joint ability to create value. Much remains to be done in this world that is far from trivial. Billions of us are looking for food, clean water and a life expectancy that has escaped them for too long. Legions of hard-working people in our developed, and less-developed, economies can create value by providing those solutions and can therefore finance the necessary sacrifices that we need to make right now. The present seems bleak, and we will no doubt go through a difficult couple of days. But the long-term picture is one in which much opportunity exists - and we have all the resources at our disposal to grab that opportunity and to put our economies, including our financial sectors, on a sound footing. It certainly is crunch time. But we can get through the crunch by realising the immense opportunity we have to create wealth and to pay off the deficits that, necessarily, we are incurring to get through these hard times.

Does this crisis mean we need more, not less, market ? Am I going to get flamed for even suggesting this ?

More and more commentators are starting to point to the weaknesses of the market system and how they contributed to, even caused, the current credit crunch and accompanying crises [quotes needed]. However, two key factors contributing to this crisis (the two key factors, some would say) are not so much market-based but to do with government and planning.

Firstly, central banks' interest rates. Some point to interest rates being too low for too long as a key factor in the inflation of asset prices (which is a problem when economic subjects start loading up on leverage under the assumption that no deflation will ever take place). Central banks, however, are government institutions (they may be independent or a-political but are still integral parts of the political organisation of most nations). Very capable central bankers may have kept interest rates low with the best of intentions, but would it be an idea to replace this system, usually consisting of a number of wise men periodically getting together in a room and setting one or more interest rates central to our economy, by a market-based system ? Why not let institutions that demand money bid for it, thereby setting a much more natural rate of interest ? When demand is high, interest rates would go up, when demand is low, interest rates would go down. Much more details need to be worked out (e.g. how much money would be on offer at each session) but I think a market-based system should at least be considered as a much more efficient way of setting interest rates central to the economy.

Secondly, rating agencies. I am quite surprised that, in the current crisis, rating agencies seem to be getting of scot-free, while they are the ones that 'laundered' many of the financial products that now turn out to be toxic to its buyers. Is it not the fault of credit analysts at rating agencies that subprime mortgages were, incorrectly as it now turns out, converted into some tranches of AAA paper ? Rather than just the programmatic analysis of the kind usually performed by the small number of analysts that compose these companies, would it make sense to also create a market-based system that continuously evaluates these securities ? A sort of 'twitter for CDOs' that shows how positively or negatively a large number of market participants feel about a certain financial instrument. In the current crisis, some people blindly believee in the"AAA" rubberstamping of some instruments by some analysts, and used these ratings as an excuse for not having to understand the instruments themselves. A market-based system could at least provide a second opinion or create more of a discussion where now there is neither.

Of course, no market-based system is perfect. We know markets are subject to over- and under-shooting and we are gradually finding out that even some of the most sophisticated markets are liable to manipulation from time to time (there seems to be a worrying trend for short-sellers to do well off the back of spreading specious rumours these days), but I believe that markets can help in the current crisis where institutions and some regulation failed. And if those markets can be made ever more transparent, for example by clearly attributing opinions and information to the parties that distribute them, this could be a valuable contribution to avoiding similar crises in future.