[2143] Of stimulus may bite back in 2010

Economics has been labeled as some sort of a discipline that predicts the future. The application of various models and efforts at testing its various hypotheses that sometimes result in the affirmative may have contributed to that reputation but it is not about predicting the future. Rather, it is about finding lessons from the past, learning from it and applying it for future endeavors. More humbly perhaps, it serves as a cautionary tale.

In this spirit, what one may expect in 2010 in terms of the national economy?

Many things obviously, and it is beyond me to list it in an exhaustive manner. Given my mischievous agenda against the state in general, I will focus on only a few. That, and based on standard economic theory, two parts of the economy may deserve some attention in light of what happened last year. Two components of Malaysia’s gross domestic product are investment — specifically private sector investment — and net exports or really, exports.

Why?

Economic theory suggests that increased government spending adversely affects net exports and ambiguously affects overall investment after some time. For those who keep tabs on the local economy, the fact that the government launched two massive measures to stimulate the economy should be common knowledge. In promoting it, the government touted it as unprecedented. It is exactly because the size is unprecedented that the concern is legitimate, possibly in a way that is unprecedented too.

The same theory highlights that government spending places upward pressure on interest rate and the exchange rate.

With additional government spending on top of normal spending, it is reasonable to hold the position that the current interest rate is higher than would under a situation without such spending. Higher interest rate means higher cost of borrowing and that itself is a disincentive to invest, especially for the private sector, even if the effect on overall investment is ambiguous. The fact that the government financed its additional spending by borrowing locally further strengthens the phenomenon of crowding out the private sector. With the government expounding on the idea of having the private sector as the driver of Malaysia’s economy, the divergence between the government’s past actions as well as its theoretical consequences and the government’s words creates a noticeable dissonance — but the sun always rises in the east and so, what is new, eh?

The same effect on interest rate is applicable to the exchange rate. In doing so, it makes Malaysian exports more expensive compared to a situation without the stimulus and foreign goods cheaper. It depresses exports, given all else the same. The likelihood of depressed exports is even more worrying given the economy of Malaysia’s trading partners.

For instance, in the United States, which is a major destination for Malaysian exports and really, the world, there is fear that once its stimulus spending runs out some time in the second half of 2010, its recovering economy would go to the other direction, possibly reflecting the artificial nature of economic recovery based on government spending. Should the US economy take a nosedive again, Malaysia’s exports will take a hit, as it had earlier. It would be a double whammy for the exports component.

The importance of the exports component to the Malaysian economy cannot be overemphasized. Despite rhetoric heard these days of the need to move away from the export-driven model, there is no realistic way to make contribution of domestic demand to Malaysian economy a close rival to foreign demand for domestic goods without devastating the local economy. The chasm between the two is just too great to close. This is not to say that improvement of domestic demand is unwanted but Malaysian consumers are simply unable to consume as much as the export markets, even if Malaysia would suddenly become a high-income country tomorrow. Anybody who harbors a dream to remove the centrality of exports and trade at large to the Malaysian economy vis-à-vis domestic demand must be fast asleep.

If the US economy contracts again this year, the political pressure on the Najib administration for yet another fiscal stimulus would be great as Malaysia’s own ongoing fiscal stimulus measures expire. Already there are calls for a third stimulus in Malaysia. Needless to say, further government spending will exacerbate issues associated with the investment and exports components.

This may further discourage investment by the private sector and there may be an urge for the government to take a more active role in the economy.

Granted, at the moment, there is an effort to liberalize the economy. Yet, the reduction and the expansion of government happen in different parts of the economy, bringing about unclear net government intervention in the market as a whole. Economic theory suggests that the government of the economy portion will expand. Further involvement through stimulus spending will tilt the arrow towards the appropriate side.

Critics of this line of reasoning tend to point out that there is excess capacity during an economic downturn and hence, the negative impact of increased government spending is only a theoretical worry to be shrugged off. They forget that, as with most economic policies, there is a lag between implementation and effect. In the very short term, the impact of crowding out caused by government spending is non-existence. Notwithstanding other arguments against fiscal stimulus such as the relative ineffectiveness of fiscal stimulus for a small open economy such as Malaysia, they can hold on to their criticism in the heat of the crisis. In 2010 and farther into the near future however, the lag will catch up to make the issue less theoretical and more real as each day passes.

How the Najib administration will address that lagged impact will be an interesting economic problem. If the global economy — really the US economy — continues to improve, it will give a boost to Malaysia’s exports component. In doing so, it may solve the problem associated with the lagged adverse impact of the economic stimulus measures. Out of prudence, however, that is a bet deserving of hedging.

First published in The Malaysian Insider on January 1 2010.