A stimulus package has two objectives it must meet in order to qualify as successful: First, it must generate quick economic recovery. Second, that recovery must lead to sustained economic growth.
Contrary to popular belief, the government spending programs implemented during the Hoover, Roosevelt, Ford, and George W. Bush administrations that intended to generate this kind of economic stimulus did not create sustained economic growth or reduce unemployment long-term. Neither did Japan's years of stimulus spending in the 1990s bring Japan's economy out of recession. Stimulus packages are never fully successful.
The myth that stimulus works, achieving these ends, stems from the thought that increased demand for products will encourage increased production and thus spur economic growth. President-elect Barack Obama and Congress are beginning to debate a proposed two-year, $775 billion stimulus package that includes up to 40 percent in tax cuts. However, there are very practical reasons why this and other stimulus packages—either cash distribution or spending projects—don't work the way they are projected.
1. Stimulus packages frequently misdirect national resources
Stimulus spending draws economic activity to short-term projects (such as expanding a road or fixing a school roof) but as a result pulls resources away from investment in sustainable economic projects (based on what the market demands). The federal government, with its limited knowledge and lack of price signals represented in a market economy, can't always know how best to spend money.
2. Stimulus packages don't increase aggregate consumption
In order to inject money into the economy, the government has to take money out of the economy. Whether by increasing taxes, national debt, or printing the money (growing inflation), the government has to damage long-term wealth in order to provide short-term economic activity.
3. Stimulus packages don't create sustainable jobs
Infrastructure projects create jobs because they require workers. You need construction workers to build a road, but once the project is complete, the jobs go away. The contracting firm that used stimulus money to hire workers no longer can afford to keep them on staff. Employment is not sustained. As a result, the worker, while employed for a short-term period of time, is not able to seek long-term employment. The worker, while likely grateful for the short-term job, is still not sure if, or when, the next job will come. As a result, they will still likely limit their spending, thus reducing consumption and overall economic growth.
4. Stimulus packages increase national debt or cause rapid inflation
In order to pay for any stimulus—whether building roads or building schools—the government has to pass the cost on to future generations. The national debt more than doubled under New Deal spending during the Great Depression. While there may be some short-term economic activity, the weight of the national debt will limit economic growth in the future. Alternatively, if the government printed money to avoid debt, inflation would grow, also hindering sustained economic growth.
5. Stimulus packages are pork-laden and caught up in federal bureaucracy
Large government spending programs fall victim to pork spending. The U.S. Conference of Mayors recently submitted over 11,000 projects that are "ready to go" on their national infrastructure wish list. Duck ponds, dog parks, sports parks, tennis centers, and swimming pools were all part of the infrastructure stimulus that the mayors say is "needed" for economic recovery. Private firms and industries nationwide will line up to try and get their piece of the federal money, regardless of whether this will result in the most efficient use of tax dollars. The rent seeking behavior will deter politicians, under pressure from donors and constituents, from putting the money to the most effective use.
Tax cuts are a much better way to stimulate economic growth. Allowing companies to keep more of their revenue is an incentive to create more wealth and thus promote economic growth. Allowing individuals to spend more of their own money as they see fit helps the market more accurately understand demand signals than when the government just spends trying to create demand out of nothing.
Some of the tax cuts Mr. Obama has proposed will be helpful. Letting firms write down their losses to reduce tax bills will allow firms to keep much needed capital in the economic downturn. And any tax incentive to help employers keep or add jobs will be beneficial.