Important article in the FT last Friday about how fiscal stimulus plans can unfortunately prop up inefficient enterprises. The article addresses the steel industry as an example:

Tangshan steelmakers acknowledge that their unexpected revival is built on flimsy foundations. Local steelmen say Beijing’s Rmb4,000bn ($584bn) November economic stimulus package – much of it smoke and mirrors and previously dedicated spending – has had a big role in restoring confidence to depressed Tangshan steelmakers.

Deng Shuwen of Tangshan Iron and Steel, the local industry giant, says his company and its affiliates will be back to normal production by the end of the year, after cutting back by up to 40 per cent in September and October.

The reason, he says, is that high-priced inventories of steel have been digested, prices of raw materials like iron ore have fallen – but even more crucially, the government has demonstrated the macro-economic will to support Chinese economic growth, by announcing a range of measures from the economic stimulus programme to interest rate cuts and tax rebates.

The upside of this is apparent. The short-term goal is to keep the doors open and keep people working. To the extent that the stimulus package announcement has restored some faith in the system, perhaps some job cuts have been forestalled. Unfortunately, large-scale stimulus programs, and across-the-board tax breaks and rebates, are broad measures that can not be used for discrete policy-making purposes, at least not without a great deal of time and effort legislating and supervising.

The steel industry has been bloated and inefficient for years, and the government has been trying to push for consolidation and modernization for a while now. A sudden flow of money, or even a short-term boost to the confidence of plant owners, may send the wrong message and complicate the government’s goals for this sector.

The Chinese government is painfully aware that towns such as Tangshan – with many high-polluting and low-value mills – are its biggest problem. But in the short term, unfortunately, boosting production of such towns is the easiest kind of spending that can be wielded to boost the Chinese economy.

No one can force the Chinese to buy cars or washing machines, but the government can force them to build railroads and buildings, and that will – unfortunately – boost demand for exactly the kind of low-value steel products in which Tangshan excels .

“Normally a downturn is a great time for larger players to squeeze margin players out of business,” says Graeme Train of Steel Business Briefing, the steel consultancy. But the government’s economic stimulus package could, ironically, favour just those mills that Beijing would otherwise have hoped would fail.

Looking at this another way, this is the same discussion I had with Rich the other day about incentives for home appliance purchases. We both agreed that this was not a very good approach, but while Rich thought the government should look for other policies to help shore up demand, I suggested that perhaps in the face of scary econ forecasts, the immediate goal was to keep people working, even if you have to use a sub-par policy to do it. There is no perfect answer or solution, of course.

No one wants inefficient steel makers out there dumping product on the market, polluting the environment and holding down the sector. But everyone wants jobs. The question, then, is whether a stimulus package can be fine-tuned to cut back on some of these effects or whether we have to take the good along with the bad in the short term.