Are Useful Projects Really Better than Useless Ones?

In my last post I argued

...the general purpose of stimulus packages is to mobilize the economy's unused resources, and, in this particular case, to...prevent prices from plummeting. Does the presence of pork in a package...in any way hinder the pursuit of such purposes? As far as the deflation issue is concerned, useless projects are precisely the place we should be putting our power. Useful projects will augment aggregate supply and thus push against the attempt to arrest falling prices. Instead of one bridge to Nowhere, let's have two! Just so the builders of those bridges can use up labor and make it harder for others to hire, thus halting the hemorrhage of wages and helping stabilize the price level.

An anonymous commenter replies:

I think we need useful projects. Can you explain how this works with the aggregate supply thing you mention? I don't understand why we would favor useless projects over useful ones.

All things considered, I will also tend to prefer useful projects over useless ones, but there really is a respectable case to be made for deliberately wasting the government’s money (recognizing, of course, that under the current circumstances, the government can create the money out of thin air, so the only real cost is opportunity cost).

The underlying premise is that deflation is very bad and reasonably possible, or, more precisely, that it is bad enough and possible enough to be a greater concern than productivity and, to some extent, a greater concern than employment. (I could be even more precise by talking about integrating across multidimensional probability distributions the convolution of the social welfare function with the aggregate supply function, or something like that. I’m too lazy to figure out how to say it right, and I doubt anyone cares anyhow.)

First, to justify the underlying premise: why is deflation very bad? Deflation means that money increases its purchasing power over time, which is to say, it becomes more valuable over time. Under those circumstances, people will prefer to hold their wealth in the form of money rather than investing their wealth in real capital such as computers, buildings, and research. The decreased demand for real capital goods will cause prices to fall further. Even prices for other types of goods and services will fall: workers who make capital goods (computers, buildings, &c) will be laid off, and employers in other industries will be able to hire them for lower wages, or use them to increase bargaining power over current employees, thus lowering their costs, whereupon competition from other cost-reducing firms will force them to lower prices. When prices fall, there is (by definition) more deflation, and we get a vicious circle between declining real investment and declining prices. Also, with deflation and widespread layoffs, people will choose to save as much as possible to prepare for the possibility of job loss, and consumption will decline, and with lower demand, prices will fall, and thus there is another vicious circle. Really, deflation is very bad. (As to whether deflation is reasonably possible, I think TIPS yields tell the story.)

So let’s suppose the government has a choice between two projects, a Bridge to Nowhere, which is completely useless, and a Bridge to Somewhere, which is useful. What happens if they choose to build the Bridge to Somewhere? It becomes cheaper to ship goods to Somewhere, so the people of Somewhere can get those goods for lower prices, and goods in the stores of Somewhere have lower price tags. We can quibble about the definition of deflation, but certainly we should expect the Bridge to Somewhere to result in falling prices, at least in Somewhere. If the government undertakes similarly useful projects of various types in various places, the result will be broadly declining prices. That is deflation. And deflation is very bad. Spend money on useless projects such as the Bridge to Nowhere, and we avoid that deflationary impact.

One way to think about this is in terms of the monetarist quantity equation, which I learned as

MV = PQ

where

M=quantity of money
V=velocity of money
P=general price level
Q=quantity of goods and services produced

If the product of M and V is constant, then if Q goes up, P must go down. So if the government expects that product to be constant, and it wants to avoid declines in P, it should choose projects that don’t increase Q, which is to say, useless projects.

You might ask why anyone would expect the product of M and V to be constant. If Q is going up too quickly, wouldn’t the government just increase M and thus avoid declines in P? That is usually the right answer, since V doesn’t usually depend heavily on M. The late 1990s are an example. Q was rising quickly, and V was reasonably stable, so the Fed wisely chose to increase M quickly to avoid declines in P.

But things are different today, because we are in a liquidity trap. People (and, more to the point, institutions) are so eager to keep their assets safe and available that they will save any money the government can create. If all the new money is saved, it goes nowhere: it has zero velocity, so the average velocity of money goes down. Thus, with increases in the money supply, the (average) velocity of money declines in such a way as to exactly offset those increases, and the product MV remains constant. The only way to get P up is to decrease Q.

Well, OK, you could also try to increase V, which is the point of a stimulus program: the newly created money goes to the government, which spends it, so it has some positive velocity, and the increase in M is no longer entirely offset by the decrease in V. But while increasing M is easy, increasing V can be difficult, since in this case it requires an act of Congress, which may be hesitant due to concerns about government debt and the like. So it would help to try decreasing Q, or at least limiting its increase, at the same time as trying to increase V.

As I said, all things considered, I would still favor useful projects, but I don’t think this argument for useless ones is just academic sophistry. After Franklin Roosevelt was elected during the Depression, he didn’t deliberately spend government money on useless projects, but he did something with a similar effect: he spent money on useful projects, but he offset the overall macroeconomic effect of their usefulness by creating government-sponsored cartels to keep prices up. The majority of economists have now decided that cartel-sponsorship programs such as the National Recovery Act were counterproductive, but there is still a significant minority who disagree (and I should say, I’m rather sympathetic to their point of view). I have to ask that minority (and I’m serious; this is not an attempt at reductio ad absurdum): rather than going to the trouble of setting up the cartel-sponsorship apparatus, wouldn’t it be easier, and just as effective, to spend the government’s money on useless projects instead of useful ones?