Numb to the Stimulus?

The most common and predictable argument levied against the stimulus (against any stimulus really) is that increased government spending is immediately offset by a proportional decrease in private spending and investment. Here's how the hypothetical "crowding-out" scenario goes:

Step 1: the enlightened representatives of the public interest recognize that the economy is dire need of some of well-honed and intelligently crafted fiscal stimulus and sign the corresponding bill in good faith

Step 2: the Treasury Department (or some such ministry depending on the country) raises the funds prescribed by bill by either a) drawing on current tax revenue or b) borrowing money

Step 3: Since we're talking about the U.S. government, which is already in a serious amount of debt, obvious choice "b" is selected; the mechanism for borrowing the selling of bonds, pieces of paper that investors "buy" for a certain price in exchange for a corresponding rate of return. Note that while the Treasury department is "selling" these treasury bonds--the terminology of "buying" and "selling" maybe implies the exchange of an ordinary good, the bonds are simply i.o.u.s; when the Treasury Department "sells" new bonds, it is only selling future, higher payments for current payments (another word for borrowing money at interest)

Step 4: the increase in the supply of tradeable treasury bonds pushes down the market price for these bonds. If a bond is said to pay $1000 in 6 months, a fall in the price of the bond from $900 to $800 is effectively an increase in the rate of return on that bond from 11% to 25% (this is hypotethical; these yields are insanely high). Therefore you can think of the price of a bond being inversely related to the yield on that bond; when bond prices go up, yields go down, and when bond prices go down, yields go up. Therefore, if a flood of treasury bonds causes the price of various treasury bonds to drop, the yield rises. Likewise, this trend might be amplied by the concern of investors. If the U.S. government is spending more money there may be a) fears of inflation in the future which would mean that future bond yields will be worth less or b) fears of default. In both cases, this makes investors in the treasury bond market less willing to purchase bonds at the going price. Therefore, this decline in quantity demanded for treasury bonds pushes prices lower and thus yields higher.

Step 5: Higher treasury bond yields reverberate throughout the economy. Since lending money to the U.S. government is seen as about the most riskless investment activity there is, a higher yield in the treasury bond market pushes up interest rates throughout the economy. Think about it with the following example: Sol Bank can lend out $100,000 at a rate of 6% to Dave the home buyer for 15 years, or he can invest in Treasury Bonds at a rate of 4% over the same period. Depending on whether Sol wants to take the risk with Dave for the higher return or not, he will make his choice accordingly. But if interest rates on Treasury Bonds rise from 4% to 6%, the choice for Sol Bank is pretty obvious; don't lend to Dave, lend to Uncle Sam. If thousands of bankers (and equity investors and bond investors) are making similar calculations about the tradeoffs between higher rates or less risk, higher rates for treasury bonds will drive money away from mortgage and other commercial loans (and the stock market and the private bond market), and towards the treasury bond market. This decline in available funds for the private lending sector will cause interest rates throughout to increase (if there is less money available to lend to Dave and Sol can just invest in U.S. bonds, Sol Bank is only going to lend to Dave at a higher interest rate.

Step 6: Higher interest rates throughout the economy mean, among other things, less consumption of homes and other high value durable goods, less lending to private companies, less stock market activity, and less investment. Also, the increased interest rates will cause foreign investors to hold less foreign bonds and more U.S. assets; being denominated in U.S. currency, this will cause the U.S. dollar to appreciate, making our exports less attractive. The over all effect then is negative and, according the "crowding out" argument, sufficient to completely negate the effect of the stimulus. Except that now the government is in more debt.

Summarized somewhat more concisely:

Unprecedented deficits to fund stimulus and bailouts means flooding the market with Treasuries to raise funds. Flood the market with Treasuries and you get higher interest rates.* Higher interest rates means asset prices get hammered more than they already have been. Knock asset prices down any more and already tattered household and corporate balance sheets will simply get obliterated.

In other words, massive “stimulus”—or more precisely massive government borrowing—could be the very thing that turns this deep recession into a nasty depression. (Source: Option ARMageddon)

Some economists, even left-of-center ones, find the above argument fairly presuasive (particularly given the current U.S. public deficit, the size of which, it is assumed, will make private investors that much more reluctant and risk-averse when it comes to lending the government more). Of course, we can all take refuge in the fact that this, like all else that currently ails America, can be blamed on Bush:

Everything would be different if we had spent the last 8 years preserving the budget surpluses that Bill Clinton bequeathed to George Bush. Then we would have paid down a big share of the national debt by now, instead of doubling it. We would be in a strong enough fiscal position to undertake the expansion today that we really need. (Source: Jeff Frankel)

But then, there are also those (and based on the support which the stimulus recieved, I'd say a less hysterical majority) who aren't really buying the standard talking point:

Crowding-out is real. Is it likely to happen? Well, if it were going to happen we would have seen the interest rates on U.S. long-term government bonds spiking upwards to scarily-high levels as the stimulus bill moves through the congress and its chances of final passage grow. Did we? No. (Source: Brad DeLong)

I'm not sure how convinced I am by this. Just because the bond market doesn't react based on future expectations of higher inflation, increased default possibility or a future decline in stock prices, does not mean that the expectations expressed by the market are correct. Financial markets are notorioiusly "inefficient" in this respect (see the Dot Com bubble); afraid of lending to the private sector, of investing in the stock market, of doing just about anything else with their money, high levels of panicked demand for (safe) treasury bonds may be keeping prices artificially high. That demand might very well subside in the future.

But then again, numbers are numbers:

But even if central banks bought about $700 billion of US treasuries in 2008, private investors also increased their holdings of Treasuries by over $1 trillion. In a year. That too is a record.

Some of those Treasuries were used to fund the Fed’s crisis lending, some funded the TARP and some funded the fiscal deficit. But in some sense it doesn’t matter. The market absorbed that huge increase in stock – and Treasuries even rallied in the process.

Facts are facts. The US has already proved it can raise over $1.5 trillion in a single year … without pushing yields up.

Therefore, despite a huge and sudden increase in the U.S. projected deficit, Treasury bond prices proved relatively resiliant. And in respond to my speculation that the financial crisis may soon subside, leading flighty investors to venture away from the warm and bountiful bosum of the American government, don't worry, say's Brad Setser: fear is here to stay.

The financial crisis should subside this year. The US government isn’t going to let a big bank fail. But the financial crisis has turned into a severe economic crisis. Consumption is falling in the US and globally; investment is tumbling. That frees up funds for the Treasury market. (Source: Brad Setser)

Update: A more substantial criticism:

Richard Kahn had argued in his famous 1931 article that an increase in the fiscal
deficit, far from "crowding out" private investment (we ignore net capital exports), generated through a
"multiplier" process, at any given interest rate, a larger output and employment
in the economy, such that private savings at this larger output exceeds private
investment by an amount exactly equal to the fiscal deficit. Indeed, private
investment is likely to increase within this period itself, or in subsequent
periods, on account of the larger output, in which case we have "crowding in"
rather than "crowding out". (Source: Amit Bhaduri)

To summarize: even if fiscal spending does increase interest rates, that same spending will also (hopefully) increase aggregate demand, employment and overall income. If we then assume that the amount of money saved through an economy is partially, perhaps heavily dependent upon total income, then the fiscal boost will increase the amount of savings and therefore loanable funds which may help to bring interest rates back down and to stimulate the private investment that so many predicted was about to be crowded out.