Wednesday, June 17, 2009

Stimulus Analogy

A collegue sent me the following story:
Stimulus Analogy

It is the month of August, on the shores of the Black Sea. It is raining, and the little town looks totally deserted. It is tough times, everybody is in debt, and everybody lives on credit.

Suddenly, a rich tourist comes to town. He enters the only hotel, lays a 100 Euro note on the reception counter, and goes to inspect the rooms upstairs in order to pick one.

The hotel proprietor takes the 100 Euro note and runs to pay his debt to the butcher.

The Butcher takes the 100 Euro note, and runs to pay his debt to the pig grower.

The pig grower takes the 100 Euro note, and runs to pay his debt to the supplier of his feed and fuel.

The supplier of feed and fuel takes the 100 Euro note and runs to pay his debt to the town's prostitute that in these hard times, gave her "services" on credit.

The hooker runs to the hotel, and pays off her debt with the 100 Euro note to the hotel proprietor to pay for the rooms that she rented when she brought her clients there.

The hotel proprietor then lays the 100 Euro note back on the counter so that the rich tourist will not suspect anything.

At that moment, the rich tourist comes down after inspecting the rooms, and takes his 100 Euro note, after saying that he did not like any of the rooms, and leaves town.

No one earned anything. However, the whole town is now without debt, and looks to the future with a lot of optimism. And that, ladies and gentlemen, is how the United States Government is doing business today.

This story is being passed around as a critique of government spending to stimulate the economy. A closer examination shows why it actually supports stimulus spending.

Let’s review the story. At the beginning of the tale, the following loans exist:
The hotel proprietor owes 100 euros to the butcher.
The butcher owes 100 euros to the pig farmer.
The pig farmer owes 100 euros to the supplier of feed and fuel.
The supplier of feed and fuel owes 100 euros to prostitute.
The prostitute owes 100 euros to the hotel proprietor.

Apparently, there is a liquidity problem in this town. No one seems to have any money. If any one of these people had 100 euros, in the form of currency or bank deposits, then all the debts could be repaid. And the credit markets appear to be frozen. No one is willing to lend money to anyone anymore (or else they could borrow to pay back their other loans). The lack of money and credit in the economy is preventing the repayment of debts.

The debt problem is resolved with the arrival of the tourist who has money in the form of a 100 euro note. The hotel proprietor borrows 100 euros from the tourist. The tourist is unaware of the loan, but it is a loan nonetheless. The 100 euro note must be returned to the tourist before he leaves or this will become a 100 euro theft. It is this interjection of liquidity that allows the economy to function more effectively. Everyone pays the debts they have incurred and at the end of the story everyone is debt free.

If any of the characters in this story had 100 euros (or the ability to borrow them – from a bank or elsewhere), then everyone would be paid the money due them and the tourist would be irrelevant to the story. The tourist helps this small town economy by providing money (i.e., liquidity) that was otherwise unavailable.

So how does this story apply to the real world U.S. economic crisis?

Part 1: One of the roles of government is to maintain liquidity in the economy.

The bailout of banks and insurance companies was deemed essential to prevent a liquidity crisis in U.S. financial markets. Insufficient oversight and regulation allowed financial institutions to make excessively large and risky loans. The collapse of the real estate bubble made it impossible for some people to repay their loans. Financial institutions, who had loaned vast amounts of money to each other, became concerned they would not be repaid and thus they became unwilling to lend money to almost anyone

In the real world, the government played the role of the rich tourist by providing liquidity to the financial markets and maintaining it by preventing the collapse of some institutions with bailouts. Many analysts have said the U.S. narrowly avoided a severe liquidity crisis and the bailouts, although admittedly not perfect, were critical in preventing a widespread meltdown.

So the story actually supports the notion that government should be a lender of last resort and should step in with bailouts or whatever deemed necessary to maintain liquidity in financial markets.

Part 2: Another role of government is to mitigate the detrimental effects of the business cycle by interjecting demand into the economy during economic downturns.

The story begins by saying everyone is living on credit. The implication is that they are not earning enough income to pay their expenses. So suppose the rich tourist actually stays in the hotel, rather than just looking. The hotel proprietor earns 100 euros that he or she otherwise would not have. The hotel proprietor then has the means to buy meat, pigs, fuel, feed, sex, or whatever else any enterprising individual in town might have for sale. Those sellers earn additional income, which they then spend, and the cycle continues.

In tough times, if the people in the private sector are not spending sufficient amounts of money on newly produced goods and services, there is a real benefit if the government steps in and increases the demand for these products. So the story supports the principle of the government stimulating the economy by buying newly produced goods and services.

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