Thursday, June 16, 2011

Did Cash for Clunkers Work?

A microcosm of the Keynesian idea of stimulating aggregate demand would have to be Cash for Clunkers. Here was an industry which experienced a tremendous crash because of the recession. The Keynesian cure would be to give people money to buy new cars. With this new demand, the auto industry would start making new cars, providing jobs, and those jobs would create demand in other industries, and so on and so on. It is the multiplier effect. Spending money prompts production prompts more spending. It is a net negative.

Of course, as with most Keynesian economic theories, it is seriously flawed. Keynesians do not understand capital markets. When a business experiences new demand, there is pressure to expand. That expansion, however, does not come from profit alone. Businesses must borrow money to meet the new demand. It would take too long to wait for profit to fund the expansion. This is where investment enters in. However, recall today that much of our capital is being used up by government. So even though interest rates are low, commodity prices are spiking. We cannot ignore scarcity; there is only so much capital to go around. Government is using all of that capital on its stimulus programs.

So in our current economic situation, what would happen when you try to stimulate demand? If it is too expensive for businesses to expand, the only result can be higher prices. This is where the example of cash for clunkers comes in. Look at what happened to the price of used cars as a result of the programs. But there was some growth in the auto industry as a result, but that has crawled to just 0.4% in the 2nd quarter.

But people might say that the benefits in this case outweigh the negatives. But alas, I did not discuss all of the negatives. The Broken Window Fallacy states that when money is spent on one thing, it is necessarily not spent on something else. Opportunity cost is a very real issue. So because consumption was driven in the auto industry, growth in other industries was necessarily stifled. These other industries, where consumers were actually demanding growth, must now comparatively shrink as compared to the situation we would have been in. We are worse off as a result since the products we demand are not produced as they can and should be. Is government intervention saving our economy? Not likely.

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  1. "However, recall today that much of our capital is being used up by government."

    I'm not the economic scholar that you are, Tony. I do agree totally with what you are saying about the Broken Window Fallacy. But is the quote above correct? Supposedly the banks are sitting on over a trillion dollars in excess reserves and business is supposedly sitting on another trillion plus dollars. The government has been borrowing mostly from the Fed, thanks to Quantitative Easing. So, in this case, I don't see how the government is using up capital. What am I missing?

  2. You're missing actual capital goods, not cash. The cost of commodities are soaring. Banks are not ignorant to that fact. They know that by loaning that money they'll probably end up losing because costs are still rising and so projects will not be profitable. Actual capital markets are a wreck. Yes, there is a ton of liquidity, but cash is not wealth. I hope this makes sense.

  3. Excellent analysis. Isn't the cost of commodities soaring precisely because of Quantitative Easing, i.e. increasing the money supply & devaluing the dollar?

  4. Yes, though supporters of the loose monetary policy will say that the Fed has been following the Taylor Rule and that this is not possible. They conveniently ignore the Fed's activities and instead blame increased demand from developing economies, which, while true, cannot possibly explain the precipitous rise in commodity prices. They fail to ignore that monetary manipulation drives investment in commodities which causes those prices to rise, not to mention the direct effect of increased investment which requires those commodities and hence drives up prices. Of course, they would also like to ignore the problem of malinvestment and say that this new investment is a good thing. Well, investment isn't a good thing if it is not based on consumer demand, now is it?

  5. Tony, things were a lot simpler when I was a kid and the only QE anybody had ever heard of was a British luxury liner.

  6. You're good at explaining things, Tony.

    Obama and his minions point to "jobs saved," while totally ignoring Bastiat's "unseen."

    They just do not understand markets. It's all connected and nothing happens in isolation.