Bailout Good - Stimulus Bad

In October I argued that the bailout would be a decent investment for the government.  So far so good.  The government has nationalized significant pieces of large financial companies (which is bad), but in exchange our financial system has not collapsed.  Though it will take time, nothing so far suggests that the government won’t get most or all of our money back on the first $350 billion (the auto industry’s $25 billion may be an exception).

Running through the logic  of a bailout:

1. A company that is viable in the long run is about to run out of cash
2. If the company goes bust, systemic problems will ensue
3. No private entity will loan it cash because of a system-wide liquidity crisis
4. The government steps in as a “lender of last resort” and provides the cash at a painfully high price
5. The company recovers and the government liquidates its position

Print and Invest

Essentially, in a bailout the government prints money, then uses it to buy assets (like AIG, which is now 80% owned by you and me).  The assets are in a real company, which then strives to make money.  The value of the company is tracked on a public stock exchange, and we can get an unambiguous read on the value of the bailout investment.

Print and Spend

A stimulus is a whole different animal.   In a stimulus, the government prints money and then spends it on tax reductions ($275 billion in the current proposal) and infrastructure ($550 billion).  The theory is that these tax cuts and investments in infrastructure will be a smart, productive use of cash, and that the US economy will grow as a result.  In practice, governments are terrible at spending money productively, and the increase in government debt will reduce private investment, making this a zero sum game.

A Zero-Sum Game…at best

The global total of private investment every year is equal to the total of private savings, corporate savings, and government savings.  Think about this for a minute, and you’ll see that it makes sense.  Investment is simply the flip-side of savings, and if you total up all of the savings in a given year, you get the net change in investment.

When governments operate in a deficit, their savings are negative.  Every dollar of increased deficit means one dollar less of investment by the private sector.  Put another way, when the US government increases its debt by $825 billion, that’s $825 billion that must be borrowed.  In borrowing that money, the US government is competing against other uses of people’s savings.  If the US government gets the money, then the money won’t be used elsewhere for private investment.

Public vs Private

The purpose of any investment, public or private, is to increase future income.  So if the government takes money from private investment, then it had better use the funds more wisely than the private sector would have, otherwise future income will go down.  Given the general success of Capitalism as a way to allocate resources, this is a tough hurdle.  Hmmm….the stimulus isn’t sounding quite as rosy.

Here’s the logic:

1. The US Stimulus plan will be financed with borrowed money, increasing the US debt.
2. The added debt displaces other uses of the funds, specifically private investment.
3. Therefore, stimulus plans only increase income when they move resources from less productive to more productive uses than the private sector would have identified.

There are a few caveats to this whole argument.  First, if the US can borrow money from the rest of the world, it will take away from private investment in other countries, and not in the US.  This will be true as long as the world has an endless appetite for US Treasury securities.  The fly in this ointment is interest rates.  The more debt the US has, the more a tiny movement in interest rates can cost US taxpayers.  The government is always purhcasing more debt as notes come due.  If there is less demand for some reason, the interest rate paid will be higher than before.  This can get expensive very quickly.

There are a few other technical macro-economic arguments to be made, including the effect of the net change in inventory levels – call me if you’re curious, and I’ll steer you towards further learnings.

So, what’s an investor to do? 

For starters, get out of intermediate and long term US treasuries.  Long term treasury funds like Vanguard’s VUSTX were up over 22% last year.  That’s both unheard of and unsustainable.  Even short term treasuries are iffy but probably OK.  The next safest best in fixed income right now is TIPS, or treasury inflation protected securities.  These US gov’t securities are indexed to inflation and go up when inflation rises.  These funds took a beating last year, dropping almost 3% as inflation fell to nothing, and they are poised to rise with any increase in inflation off the current zero base.

My clients are also in municipal bonds, which continue to offer great returns, and both investment grade and high yield corporates, both of which took tremendous hits from the fixed income “flight to quality”, and are now still cheap but bouncing back.  Both munis and corporate were hurt by the liquidity crisis, but don’t have major underlying problems at their current valuations.

On the equities side, the US Dollar continues to be very strong, pointing the way for good returns to international investments.  This is trickier terrain and must be done very carefully to avoid getting burned.

Posted on January 26th, 2009