The case against fiscal stimulus

Everybody else seemed to hear Bernanke say he was in favor of fiscal stimulus as one approach to our economic problems. But I instead heard him articulate very intelligently the potential pitfalls of the strategy.

Menzie laid out very nicely on Monday the traditional concerns many economists have about trying to use new fiscal legislation to combat an economic downturn. In brief, once you take into account how much time it will take to get new proposals signed into law, and the time it will require after that before the legislation actually has its effect on the economy, you are looking at a delay of at least a year and perhaps considerably longer. If, as some fear, we are already in a recession, and if this recession lasts about 9 months (which is the average duration of the last 4 U.S. recessions), that means the recession would be over by the time the new fiscal stimulus starts to have its initial effect.

Paul Krugman argues today that although the 2001 recession technically ended November 2001, sluggish growth in employment continued for some time, so fiscal stimulus might still be welcome one or two years from now. But it was just such thinking that led the Federal Reserve to keep the fed funds rate at 1% through 2004, a policy that I think most of us recognize today to have been a serious mistake. Overstimulus at the wrong time lays the seeds for resurgence of inflation. And the process of trying to bring that inflation back down later could be the cause of the next recession after this one is long over.

If we take as a particular example the case of tax cuts, this is something many politicians were advocating before the latest indications that a downturn may have begun, and something many of them would still be advocating even if a recession was long past. Whatever the nature of the stimulus package Congress may approve and the President sign, I cannot imagine that there would fail to be a strong constituency seeking to ensure that it is anything but a temporary change. Thus when I read Bernanke’s warnings

To be useful, a fiscal stimulus package should be implemented quickly and structured so that its effects on aggregate spending are felt as much as possible within the next twelve months or so. Stimulus that comes too late will not help support economic activity in the near term, and it could be actively destabilizing if it comes at a time when growth is already improving. Thus, fiscal measures that involve long lead times or result in additional economic activity only over a protracted period, whatever their intrinsic merits might be, will not provide stimulus when it is most needed. Any fiscal package should also be efficient, in the sense of maximizing the amount of near-term stimulus per dollar of increased federal expenditure or lost revenue. Finally, any program should be explicitly temporary…

–I thought to myself, of course Bernanke’s exactly right, and of course this is exactly what Congress and the President are inherently incapable of doing.

I have another concern as well, and this arises from the observation that previous fiscal deficits have greatly tied our hands in the current situation. I worry (perhaps excessively) that the U.S. may be in danger of surrendering our status as the preferred safe haven for international capital, and can envision a situation in which there is a rapid flight from U.S. assets that could cause some very difficult dislocations. That’s the kind of thing that really should never happen to the United States. Due to our sheer size and long traditions, the U.S. is uniquely positioned to reap enormous benefits from an unquestioned commitment to price stability and honoring existing financial commitments. In my opinion, the reckless U.S. budget deficits of recent years have been one of the most important threats to that special and very valuable status. And again I heard that theme raised by Bernanke today, albeit with milder language than I might have used:

the nation faces daunting long-run budget challenges associated with an aging population, rising health-care costs, and other factors. A fiscal program that increased the structural budget deficit would only make confronting those challenges more difficult.

So I guess if you thought, of course Congress and the President are up to the task of meeting these long-run fiscal challenges responsibly, and of course they’ll make sure the changes adopted now are timely and strictly temporary, then I suppose you’d read Bernanke as giving the green light for fiscal stimulus. But the light I see him shining seems to have a pretty hefty dose of red in it.



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28 thoughts on “The case against fiscal stimulus

  1. calmo

    Well, I too was listening intelligently to Ben Bernanke and in addition, James Hamilton for the real message…whether it was intended or not (my kind of intelligence includes intuition and even Buzzcut voodoo).
    I read this as a call for immediate action as opposed to permanent tax cuts for the rich…as a call for economic measures to ward off significant social dislocations (of which the California measure of freeing 20,000 criminals is only a drop in the bucket) that are coming. Bernanke seems to be saying that dropping the interest rates is not going to fix this problem.
    But I don’t hear any Bernanke squeaks about a pending shift in the Financial Center of the Universe…that note Paulson sounded about the impact of US regulations on HFs, should they be implemented.
    Me (and Buzzy) will worry about those bums and their holdings in the Carib when I am convinced that ordinary people –who thought they had something, absorb the reality that they have to start over with a lot less.

  2. odograph

    I have no idea if stimulus is called for, but I want to comment on the idea of a short or average recession. I don’t see that happening. Too many entities (government, business, individual) have debt problems. Falling equity values create a feedback … can that really be over in 9 months? I mean, housing downturns are supposed to be long, and housing is a big part of this. Just askin’

  3. bsetser

    “that is the kind of thing that really should never happen to the United States”
    nice turn of phrase. it pretty much describes how i feel about the prospect of the United states turning to less-than-democratic governments in the emerging world (tho some such countries are very rich with oil at $90) to provide emergency capital to backstop the US financial system.
    that said, there is very little evidence that emerging market economies are turning away from the dollar, though they perhaps are holding it more because they have to so long as they manage their currencies against the dollar than because they want to. dollar reserve growth will set a record in 2007.

  4. Movie Guy

    Brad Setser,
    Money has no friends. In a time of crisis, the inflow of monies from other nations, democratic or not, is essential. And, for practical purposes, the sources among U.S. allies (key phrase, Brad) is irrelevant.

  5. Michael

    Tax cuts for the rich, and ordinary people starting over with a “lot less”? Do we have an operative for a Democratic candidate for president posting in the thread?

  6. Bruce Hall

    The idea of stimulating or drugging the economy certainly seems to be the great tradition of the Federal Reserve.
    Anna Schwartz had her say about this: http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/01/13/ccschwartz113.xml
    Tax cuts or increases may affect individual’s spending patterns and overall economic activity. The relative cost of money from one time period to another does, too [e.g., an increase from 1% to 5.25% which is somehow the same change as going from 5.25% to 9.5%].
    The problem, as I see it, is that neither are aimed at the risky behavior of Wall Street and Big Banking that brought us hedge fund scams and the sub-prime fiasco… and subsequent economic problems.
    It seems to me that the there is a disconnect between government thinking/actions and private manipulation of the economy over the past couple of decades.
    For whom or at what are these stimulus actions really aimed… consumers, manufacturers, manipulators? Who is really being bailed out?
    The average consumer will see a few extra bucks… maybe. Not enough to trigger a spending spree. U.S. manufacturers continue to be at a distinct disadvantage with foreign counterparts for a variety of reasons that a stimulus package is not going to address. Does the government stimulus fix the problems at Citibank or Merrill Lynch?
    It seems this is more a confluence of many negative issues and, while a small “stimulus package” may be aimed at improving the “economic psychology”, there are some real underlying issues that it won’t address.

  7. markg

    The real economy is measuerd by the goods and services consumed. Is a recession caused by producers not being able to increase the supply of goods and services or by consumers not being able to consume more goods and services? Does the future challenges of the nation have more to do with providing the goods and services of an aging population with a smaller workforce, or paying for the goods and services? And does a bigger govt deficit today as a result of fiscal stimulus have anything to do with providing more goods and services in the future?

  8. shelby

    Prof. Hamilton is right on point…..The burden of continuous (year after year) budget deficits could prove painful on the U.S. economy down the road. Not just in terms of a weak dollar but also a fall in the material standard of living. (real gdp/capita)
    Remember, the deficit is not the real problem here. It’s that every recorded deficit adds to an already massive level of outstanding public debt. (around 9 trillion I believe)
    The federal gov’t, just like the household, has a budget constraint that must be adhered to over the long run..(i.e. no ponzi schemes and long-run solvency is a fact of life)
    ..Amazing how so many “economists” seem to forget this fundamental piece of theory.

  9. Footwedge

    It is hard to be long term (5-10 yrs)optimistic with the amount of dillusion that exists in our country. We are fast becoming a cold Guatamala (no offense meant to Gautamala) with mushrooming debt service and declining productive capabilities. I’m not sure if this will be a long or short recession – although I think we should hope for a long one – but I suspect it will be short (or appear to be)so we can get back to doing what we do best which is living a so called asset-based (read debt based) economy. If so, I think it reasonable to plan on the next president to be one term and an extremely tough next decade. Hope I’m wrong but planning on being right.

  10. kharris

    Even if we don’t credit (?) Bernanke with being the sly political operator that Greenspan was (regretted that tax cut thing immediately, just forgot to say so till now), he very likely knew what he was getting himself into. There was no “fiscal stimulus bad” or “fiscal stimulus good” message. There was only “here’s how a good fiscal stimulus is done.” And that approach makes good sense. This is an election year. We are going to get what politicians think they need to give us to get themselves elected. This year, that’s a stimulus package. My guess is, Bernanke knows that. So his job yesterday was to constrain elected officials to do things that will help more than they hurt. Over and over, Bernanke directed the discussion away from long-term measures and toward short-term, temporary measures.
    No green light. No red light. Just a manual of safe driving practices.

  11. psummers

    JDH (and others),
    I think you raise some very important points. However, Krugman also points out in today’s NYT that:
    “Some critics say that the Fed helped inflate the housing bubble with low interest rates. But those rates were low for a good reason: although the last recession officially ended in November 2001, it was another two years before the U.S. economy began delivering convincing job growth, and the Fed was rightly concerned about the possibility of Japanese-style prolonged economic stagnation.”
    Though I personally think that the Fed started raising the funds rate too late and too slowly, that certainly wasn’t obvious at the time. For me, I think this strengthens the case that labor-market elements (extended UE benefits, food stamps, EITC, etc) should be the main features of a stimulus package. It seems like those could be easily extended or curtailed depending on the strength of the recovery.
    PS
    PS

  12. Buzzcut

    I find all this talk of “fiscal stimulus” deeply depressing. It’s like we have the same arguments over and over and never learn from experience.
    The 2001 tax package was chock full of “short term stimulus”. How’d that work for ya?
    Here’s the Buzzcut “stimulus” package. Suspend IRS audits for tax year ’07. If I could just make up a bunch of bogus charitable contributions and such, I could “save” thousands of dollars in taxes. I promise to spend every cent of it on home improvements, and then some!

  13. Joseph

    I shouldn’t take a year for certain stimulus mechanisms to take effect.
    I would think that a payroll tax holiday could be implemented in less than 60 days. The IRS mails new tax tables to employers and the bonus money automatically ends up in their paychecks. Unfortunately this method would deprive Bush of mailing out actual rebate checks with a blatant campaign letter saying how grateful everyone should be like he did in 2001.
    Likewise, extending unemployment benefits would have almost instant results for those who have already lost their jobs.

  14. Joseph Somsel

    Since when has any capitalist, free market economy been free from the business cycle?
    While government can certainly make a down cycle worst (see Hoover, FDR, and the Great Depression,) and government can amelorate the pain from a down cycle, corrective retreats from growth trends are helpful to the long term health of an economy.
    Frankly, there are any number of really stupid ideas that need to fail in harder times. That clears the field for the better ideas and reminds us that risk has its downside and wisdom is more important than enthusiasm.
    That said, my first thoughts were “Where’s my government check, dude?”

  15. pgl

    Buzzcut – no sure why you think the 2001 tax cut was loaded up with short-term stimulus. I always viewed that tax legislation as having mostly back loaded tax cuts. Of course, that was the wrong prescription then and making those tax cuts permanment today is also silly stimulus policy. Alas, that’s what the GOP leadership may be insisting upon.

  16. John Thacker

    no sure why you think the 2001 tax cut was loaded up with short-term stimulus. I always viewed that tax legislation as having mostly back loaded tax cuts.
    Well, the creation of the 10% tax bracket out of the lower part of the 15% bracket was a short-term stimulus of exactly the sort that many Keynesians propose now. It also took place retroactively, unlike the various phased-in cuts. The “$300 rebate” that it created was a pretty significant part of the tax bill– for that reason, the overall effect was to make the tax code slightly more progressive, not that anyone noticed in a time where pre-tax inequality was becoming greater. Of course the 10% tax bracket became permanent due to getting the 60 votes necessary.
    In my opinion, the reckless U.S. budget deficits of recent years have been one of the most important threats to that special and very valuable status.
    It is interesting that the deficits were larger and more reckless in the years leading up to 1992, debt as a percentage of GDP was much higher, and the proposed stimulus package went to defeat then, and yet the recovery was relatively fast and robust. I remain very skeptical of the case of economic stimulus packages.

  17. Matt

    BEN BERNANKE IS A GENIUS!
    For those who have been listening to Bernanke’s comments over the last several months, he has been paranoid about inflation. So much so, that (according to most on Wall St.) he has been very slow at cutting interest rates and should cut them by at least 50 basis points (and maybe 75) at the next Fed meeting on January 30th. With core inflation already over the Fed’s target rate of 2%, and top line inflation (which includes food & energy) considerably higher than that, Bernanke was likely (and probably more so, now) to disappoint Wall St. by only cutting interest rates by 1/4%.
    Fiscal stimulus (government provided), such as rebate checks, will in fact, promote growth as a side effect, not from direct spending by consumers.
    The main cause of the current state of the economy is the amount (hundreds of billions of dollars) of bad debt. Whether it is the fault of uninformed consumers or overzealous, greedy banks is irrelevant. Ultimately, the availability of credit consumers has shrunk. It has become harder for consumers to get credit from banks, credit card interest rates have been rising (counter to the actions of the Fed).
    So far the Fed has cut interest rates by 1 full percentage point, and loaned banks $60 billion dollars in order to promote banks to lend that money to consumers. Both of these actions are inflationary in nature. By adding money to the economy, the value of the dollar drops and inflation rises.
    Fiscal stimulus (tax cuts and rebates as proposed by the President & Congress) are not inflationary, in that they are simply taking money that is already in circulation (albeit in the government’s bank account) and moving the money somewhere else.
    So far from what, I’ve heard, rebate checks to taxpayers will be in the neighborhood of $800 per individual and $1600 per family. One of two things will happen to this money. Either consumers will spend it (which is stimulative to the economy, but will have little effect on the overriding problem) or they will save it. Saving (in economic terms) comes in two forms, either depositing the money into a bank account (any interest bearing account) or (and more importantly) paying down credit in one form or another.
    It is most likely that the most distressed credit will be the first to receive payments. (Put simply, given the choice between buying an HDTV or paying your mortgage, most would pay their mortgage). This will help in raising the value of this debt on the open market, and will help banks in have more liquidity, which will allow banks to extend more credit on easier terms which will pull the economy out of it’s current slow down.
    All this without having to cut interest rates much further and risking a period of 70’s style stagflation.
    This is bad news for Wall St. because they have spent the better part of the month banking in a large drop in interest rates which may nio longer be necessary.
    Bernanke has thought up a way to ensure that the economy does not slip too far into a recession without overstimulating the economy as it had been done in the past (witness the 1% Fed Funds rate of 2001-2002) which started the housing bubble to begin with.
    BEN BERNANKE IS A GENIUS!

  18. knzn

    “But it was just such thinking that led the Federal Reserve to keep the fed funds rate at 1% through 2004, a policy that I think most of us recognize today to have been a serious mistake. Overstimulus at the wrong time lays the seeds for resurgence of inflation….”
    This seems like a bit of a non sequitir. It’s true that the inflation rate is higher today than most people would prefer, but I don’t think most economists blame the 1% funds rate for that inflation. (Competing foreign demand for energy and raw materials is probably a more important cause.) The US has hardly experienced anything that looks like an overall inflationary economic boom. The concern is not that the Fed overstimulated the economy in a way that has produced inflation but that the easy money policy produced a housing boom that then could not be stopped in a smooth manner. And the problem is not that the economic stimulus from the housing boom was excessive overall, but that the boom itself was an inefficient use of resources and that the process of stopping the boom was so jarring. Seems to me that is an argument FOR using fiscal policy (even if it is slow to implement) rather than relying on monetary policy to stimulate the economy.
    Not that another housing boom is likely, but again one may worry about the mechanism by which monetary policy would stimulate the economy. It looks like a weak dollar will be a large part of the mechanism this time around, and, since we ARE worried about inflation, there is all the more reason not to rely on a mechanism that has a direct impact on the price level.

  19. JDH

    knzn, perhaps the inflation has not been a big problem, but I would have thought you’d be at the head of the list of those who believed that the Fed’s measures to prevent inflation (namely, bringing the funds rate up to 5.25%) made a contribution to our present difficulties. And I further maintain that the Fed helped contribute to an excessive housing boom with that 1% rate.

  20. knzn

    JDH, I’m not sure you read my entire comment. Of course I do agree that “the Fed’s measures to prevent inflation…made a contribution to our present difficulties.” I would even concede (though I don’t think it necessarily follows) that the Fed overshot its mark a bit with the low interest rates, but I would classify that as a relatively minor mistake. I’m not sure we have enough information now to say that *ex ante* it was much of a mistake at all. We have a few more data points, but if the Fed again faces what appears to be a significant risk of deflation, I’m not sure one should advise it to behave any differently.
    The problem, as I see it, is not mostly that the Fed went too far with the monetary stimulus, but that a monetary stimulus has inherent problems, which would not be present in the case of a fiscal stimulus. (This is a lesson I claim to have learned from the current business cycle. Before 2002, I opposed using fiscal policy to stimulate the US economy, except under quite extreme circumstances — though 2003 seemed at the time like it might be such a circumstance.) The “long and variable lags” associated with monetary policy have become a huge problem, which is to say, yes, easy money did contribute to an excessive housing boom, but the 2-year lag involved makes the implementation lag for fiscal policy look like not much of a problem by comparison.

  21. DickF

    Menzie laid out very nicely on Monday the traditional concerns many economists have about trying to use new fiscal legislation to combat an economic downturn. In brief, once you take into account how much time it will take to get new proposals signed into law, and the time it will require after that before the legislation actually has its effect on the economy, you are looking at a delay of at least a year and perhaps considerably longer. If, as some fear, we are already in a recession, and if this recession lasts about 9 months (which is the average duration of the last 4 U.S. recessions), that means the recession would be over by the time the new fiscal stimulus starts to have its initial effect.
    This is the typical response to those who have never run a business. Businesses must be forward thinking, they do not operate on a present basis. If congress creates fiscal problems through legislation business reacts instantaneously; likewise, if congress makes a change that removes a fiscal wedge, business will react instantaneously to the change, planning will be engaged and orders will be cut to take advantage of the change. The change will be immediate.
    Monetary policy does not stimulate.
    Bad monetary policy can destroy, but good monetary policy simply creates a stable economic environment where business can more efficiently satisfy wants and needs. Monetary injections to stimulate demand can increase consumption but this only leads to shortages and capital dislocations, not to innovation or increases in productivity.
    Overstimulus at the wrong time lays the seeds for resurgence of inflation. And the process of trying to bring that inflation back down later could be the cause of the next recession after this one is long over.
    There is no right time for overstimulus. Monetary injections lay the seeds of inflation and without fiscal policies that allow real economic demand to increase through productivity to absorb additional money, inflation is always the result.
    If we take as a particular example the case of tax cuts, this is something many politicians were advocating before the latest indications that a downturn may have begun, and something many of them would still be advocating even if a recession was long past.
    This is a mistake that is made by those with just enough understanding of Supply Side Economics to be dangerous. Simply mailing a check out to certain citizens, the tax cuts being floated by Nancy Pelosi and Bush supporters, is not a supply side tax cut and is likely to create more problems than to have any kind of supply side impact. Such action would do absolutely nothing to the economy other than allow a few people to take a weeks vacation, but then on Monday come back to the same old economy.
    Whatever the nature of the stimulus package Congress may approve and the President sign, I cannot imagine that there would fail to be a strong constituency seeking to ensure that it is anything but a temporary change.
    To be useful, a fiscal stimulus package should be implemented quickly and structured so that its effects on aggregate spending are felt as much as possible within the next twelve months or so. Stimulus that comes too late will not help support economic activity in the near term, and it could be actively destabilizing if it comes at a time when growth is already improving. Thus, fiscal measures that involve long lead times or result in additional economic activity only over a protracted period, whatever their intrinsic merits might be, will not provide stimulus when it is most needed. Any fiscal package should also be efficient, in the sense of maximizing the amount of near-term stimulus per dollar of increased federal expenditure or lost revenue.
    Finally, any program should be explicitly temporary…
    It is foolish to believe that there is a difference between the destructiveness of a short term versus a long term stimulus. If congress makes the correct fiscal changes they will have a positive impact on the economy in both the short term and the long term. If there is an attempt to head off a recession through an injection of money it will always have a negative effect unless that injection is demanded by a growing economy. A declining economy does not need more money it needs fewer impediments to the creative process of producing goods and services.
    Due to our sheer size and long traditions, the U.S. is uniquely positioned to reap enormous benefits from an unquestioned commitment to price stability and honoring existing financial commitments.
    This is the correct recommendation and is almost a direct quote of Alexander Hamilton, but how to have price stability and honor commitments? Hamiltons solution was a return to a gold standard for the currency full honor of government commitments. That means Social Security and Medicare commitments. Congressional proposals to renege on promises do much to undermine the reputation of the federal government.
    the nation faces daunting long-run budget challenges associated with an aging population, rising health-care costs, and other factors. A fiscal program that increased the structural budget deficit would only make confronting those challenges more difficult.
    But a fiscal solution that would stabilize the currency and remove wedges to production would grow the nation to the point where social promises were honored. The problem is not past promises. The problem is that each congress increases the commitments of the federal government to more and more special interests. If the government eliminated programs that should be done by the private sector, such as education and the entire Department of Commerce, federal spending could be reduced and the economy would actually improve.
    So I guess if you thought, of course Congress and the President are up to the task of meeting these long-run fiscal challenges responsibly, and of course they’ll make sure the changes adopted now are timely and strictly temporary, then I suppose you’d read Bernanke as giving the green light for fiscal stimulus. But the light I see him shining seems to have a pretty hefty dose of red in it.
    So finally on the last line we agree. Yes, Bernanke is presenting us with a hefty dose of red but the primary fault does not lie with monetary policy. It lies with congress, the only agent with enough power to thwart the institutions that can pull us from our quagmire.

  22. Footwedge

    Bravo, Dick F, I’m with you. But not it’s not clear if you’re an optimist or a pessimist. Do you think that there’s a chance that your approach would be embraced by politicians (let alone the many economists who obviously disagree)? Or do you state your ideas knowing that they won’t? I have to agree with that great American soldier Col. Jessup (Jack Nicholson, A Few Good Men). To paraphrase, we can’t handle the truth. I think we should plan on everything BUT the right response (by right, I mean what’s good for the country in the long term versus immediate pain remediation.) We have just lived with untruths for too long.

  23. nobody

    DickF wrote:
    Bad monetary policy can destroy, but good monetary policy simply creates a stable economic environment where business can more efficiently satisfy wants and needs. Monetary injections to stimulate demand can increase consumption but this only leads to shortages and capital dislocations, not to innovation or increases in productivity.
    I think you misunderstand. Nobody here is arguing that fiscal or monetary stimulus will lead to an increase in the economy’s long-term growth trajectory.
    They are arguing that such policies can smooth the fluctuations around that trajectory — effectively reallocating some “GDP”/”consumption”/whatever from the good times to the bad times.

  24. DickF

    nobody,
    Even if that is the case it is still bad policy. It either does nothing at all and so is a waste of time or it creates problems. Money is not magic. It is a tool. Try using a hammer that keeps changing shape and size right before your eyes.
    Thanks Footwedge. With our current leadership, and sadly I include Bush in that, I am a pessimist, but long term I am an optimist. If we can maintain our democratic republic the people will ultimately find another leader to make the right changes. Reagan did a lot, but so much more needs to be done, and much of what Reagan did has undone.
    Bernanke is worse than I thought he would be. He is driving us headlong into serious inflation. My fear is that when the inflation that is already going on becomes manifest in BB’s statistics there will be a panic and we will see a recession worse than the one engineered by Volker in 1981-2 because there may not be a tax cut to ease the bite.

  25. Raj

    Maybe this is a naive question but can someone explain to me where does the money come from in case of a fiscal stimulus?
    Is some existing government program cut?
    Does the government raise more debt? Is so, from whom (more specifically what’s the mechanism for that)? Does raising that debt have any impact on short term rates?
    Appreciate the answers.

  26. nobody

    Even if that is the case it is still bad policy. It either does nothing at all and so is a waste of time or it creates problems. Money is not magic. It is a tool. Try using a hammer that keeps changing shape and size right before your eyes.
    It could be good or bad policy.
    Imagine a person whose income decreases temporarily. This person has two options — one is to move his consumption one-to-one with the change in income. (In the extreme case, where he loses his job, this would mean starving himself.) The other is to move some future consumption to the present by borrowing against future income — i.e., to smooth the path of consumption. Most individuals prefer to engage in such behavior.
    This is the logic behind the ideal fiscal stimulus. It could be bad policy in the execution, but is not in principle.

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