Economics

Why the Stimulus Plan Won't Work

And several ideas that might

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President Barack Obama insists that the massive $800 billion stimulus package is necessary to avoid "catastrophe." Indeed, during his first primetime news conference, Obama said bigger was better, and pointed to Japan's failed stimulus packages as a reason to go really big.

"We saw this happen in Japan in the 1990s, where they did not act boldly and swiftly enough," Obama stated. "And, as a consequence, they suffered what was called the lost decade, where essentially, for the entire '90s, they did not see any significant economic growth."

Obama is right to cite the example of Japan. That nation's collapsed housing and stock markets in the 1990s are very relevant to today's recession. Between 1992 and 1999, Japan passed eight stimulus packages, totaling roughly $840 billion in today's dollars. During that time, the debt-to-Gross Domestic Product (GDP) ratio skyrocketed, the country was rocked by massive corruption scandals, and the economy never recovered. All Japan had to show for it was a mountain of debt and some public works projects that look suspiciously like bridges to nowhere.

Will the goods and services in the Democrats' stimulus plan—be they concrete for new highway projects or groceries for hungry families—pump up flagging demand and boost stalled economic activity?

If so, it will be the first time in recorded history.

Take the New Deal. According to the economists Christina Romer, chair of Mr. Obama's Council of Economic Advisers, and David Romer, New Deal spending did not pull the economy out of recession. In a 1992 Journal of Economic History paper, the Romers examined the role that aggregate demand stimulus played in ending the Great Depression. They concluded: "A simple calculation indicates that nearly all of the observed recovery of the U.S. economy prior to 1942 was due to monetary expansion. Huge gold inflows in the mid- and late-1930s swelled the U.S. money stock and appear to have stimulated the economy by lowering real interest rates and encouraging investment spending and purchases of durable goods."

Even the massive spending during World War II, long touted for pulling America out of the Depression, didn't necessarily help. In a 2006 paper for the National Bureau of Economic Research, economists Joseph Cullen and Price V. Fisher asked whether the local economies that were the biggest beneficiaries of federal spending on military mobilization during World War II experienced more rapid growth in consumer economic activity than others. Their finding: Military spending had virtually no effect on consumption.

Another economist, Robert Higgs, offered an even more thoroughgoing critique in an excellent 1992 Journal of Economic History paper. After challenging the conventional portrayal of economic performance during the 1940s, Higgs concluded that "the war itself did not get the economy out of the Depression. The economy produced neither a 'carnival of consumption' nor an investment boom, however successfully it overwhelmed the nation's enemies with bombs, shells, and bullets." Breaking windows in France and Germany didn't bring prosperity in America.

In his 2008 book Macroeconomics: A Modern Approach, Harvard economist Robert Barro shows that $1 of government spending in wartime produces less than $1 in GDP—80 cents, to be exact. Stanford economist Bob Hall and Sand Hill Econometrics chief Susan Woodward, neither particularly pro-market, argued recently that each dollar of government spending during World War II and the Korean War produced about $1 of GDP. In other words, the economy is not stimulated by war spending.

Most taxpayers are familiar with the two most recent failed stimulus experiments. The Bush administration passed the Tax Relief Act of 2001 and the Economic Stimulus Act of 2008, two similar tax rebate packages with similar effects on the economy. Which is to say, not much. In 2008, the major component was sending $100 billion in cash to Americans so they would have more to spend and thus jump-start the economy. It failed. People spent little, if anything, of the temporary rebate, and consumption did not recover.

The theory of economic stimuli suffers from several serious problems. First, it assumes people are stupid. Tax rebates, for example, presume that if people get money to increase their consumption, businesses will expand their production and hire more workers. Not true. Even if producers notice an upward blip in sales after the rebate checks go out, they will know it's only temporary. Companies won't hire more employees or build new factories in response to a temporary increase in sales. Those who do will go out of business.

Second, the thinking behind stimulus legislation assumes that the government is better at spending $800 billion than the private sector. When President Obama says, "We'll invest in what works," he means, "unlike you bozos." The president's faith in Washington is charming, but politics rather than sound economics guide government spending. Politicians rely on lobbyists from unions, corporations, pressure groups, and state and local governments when they decide how to spend other people's money. By contrast, entrepreneurs' decisions to spend their own cash are guided by monetary profit and loss. That's likely to work better and certain to produce more innovation.

But the biggest problem is that the government can't inject money into the economy without first taking money out of the economy. Where does the government get that money? It can either borrow it or collect it from taxes. There is no aggregate increase in demand. Government borrowing and spending doesn't boost national income or standard of living; it merely redistributes it. The pie is sliced differently, but it's not any bigger.

Stimulus packages—and present or future tax increases that fund government spending—end up burdening the economy. Such was the case in the 1930s, during World War II, and in 1990s Japan. Thankfully, the 2001 and 2008 tax rebates, while ineffective as stimuli, didn't make things worse.

If politicians actually want to do something cost-effective to solve our economic woes, here's some advice: Stay away from spending increases and tax rebates. Instead, focus on real incentives to stimulate work and investment, such as cutting everyone's marginal tax rates, slashing payroll taxes for employees and employers, and ending the corporate income tax.

Veronique de Rugy is a columnist at Reason magazine and an economist at the Mercatus Center at George Mason University.

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  1. I liked this article Veronique…Christine Polek says hi

  2. Great article – best one on the Stimulus i’ve seen yet at Reason.

  3. Ah, so this “multiplier” neo-Keynesians refer to is a fraction! Now I understand.

  4. This has been the mantra of Democratic politics for a while. The people are not to be trusted to spend their own money. They will only spend it on SUVs, iPods, porn, six-packs, and other items the left deems unacceptable. Contrastingly, they believe money is best spent by sending as much of it, as quickly as possible, to the closest available special interest.

  5. Corporate income taxes produce roughly $400 billion each year. That’s half the “stimulus bill.” A permanent federal corp. tax rate of zero would decimate the accounting ranks (keeping MACRs records, preparing ten hundred thousand page tax returns, etc.)and end lots of deadweight papershuffling and lawyering. Prices of goods would fall, corporations could afford to give out more wages to workers, offshored operations would return to the U.S., foreign business would flood in, etc. etc. But, given the anti-business animus generated on both the left and populist right, it aint likely to happen anytime soon.

  6. Best article yet on the Stimulus

    I posted this yesterday, but it bears repeating. No one has more experience with failed statist intervention in economics than the Russians.

    At Davos, in a not-to-veiled reference to the upcoming Stimulus package:

    “Russian Prime Minister Vladamir Putin has said the US should take a lesson from the pages of Russian history and not exercise “excessive intervention in economic activity and blind faith in the state’s omnipotence”.

    “In the 20th century, the Soviet Union made the state’s role absolute,” Putin said during a speech at the opening ceremony of the World Economic Forum in Davos, Switzerland. “In the long run, this made the Soviet economy totally uncompetitive. This lesson cost us dearly. I am sure nobody wants to see it repeated.”

    Sounding more like Barry Goldwater than the former head of the KGB, Putin said, “Nor should we turn a blind eye to the fact that the spirit of free enterprise, including the principle of personal responsibility of businesspeople, investors, and shareholders for their decisions, is being eroded in the last few months. There is no reason to believe that we can achieve better results by shifting responsibility onto the state.”

    Seems like he should know.

  7. This has been the mantra of Democratic politics for a while. The people are not to be trusted to spend their own money. They will only spend it on SUVs, iPods, porn, six-packs, and other items the left deems unacceptable. Contrastingly, they believe money is best spent by sending as much of it, as quickly as possible, to the closest available special interest.

    Agree with that, but let us not forget George ‘Bismark’ Bush who wanted in that domestic spending special interest action with his faith base initiative, no child left behind, prescription drug benefit, and steel tariff. I don’t care about this on the matter of hypocrisy (which it is for GWB supporters), but instead the pressing need to purify the ranks of the GOP of the likes of the ‘compassionate conservatives’ for whom we should never see hold the reign of power again. The media will spin this in 2010 and 2012 and ask if the GOP can find a moderate to lead them forward who accepts the realities of modern society and when they do we must not ever forget that GWB was THAT guy.

  8. Good to point that out Douglas. It is quite a change in circumstance in my life time that I now have much more to fear from the leaders of the United States than I do the leaders of Russia.

  9. The criticism of Bush driving up the debt was more of a political strategy to drive away the former President’s support among the fiscal conservatives. My previous statement needs a slight altering in light of Bush’s larger government: Money is best spent on liberal priorities by a government headed by a liberal.

    The idea that resources are better spent by the private sector, which has a vested interest in ensuring every dollar is spent wisely, is rejected on the left and lost on the right.

  10. But the biggest problem is that the government can’t inject money into the economy without first taking money out of the economy. Where does the government get that money? It can either borrow it or collect it from taxes. There is no aggregate increase in demand.

    Your assertion, which is overly formulaic and final, is “more” true during a time of either economic growth or in a time of recession. In a time of a debt-deflation, your assertion is “less” true as the capital the government attempts to borrow is generally being hoarded and is not currently deployed. It’s axiomatic, actually, that if we are in a debt-deflation ( a depression) then capital is being hoarded on not lent privately. Meanwhile, a ton of capital has been destroyed already.

    So in those conditions, the crowding out effect is less of a consideration. The formulaic certitude you offer is too simplistic. It’s really just a way of avoiding current conditions, which, everyone from the Chicago school and other anti-Keynesians continue to do, because to admit this is not a post-war recession would immediately render your analysis is marginal

  11. Your assertion, which is overly formulaic and final, is “more” true during a time of either economic growth or in a time of recession. In a time of a debt-deflation, your assertion is “less” true as the capital the government attempts to borrow is generally being hoarded and is not currently deployed. It’s axiomatic, actually, that if we are in a debt-deflation ( a depression) then capital is being hoarded on not lent privately. Meanwhile, a ton of capital has been destroyed already.

    So in those conditions, the crowding out effect is less of a consideration. The formulaic certitude you offer is too simplistic. It’s really just a way of avoiding current conditions, which, everyone from the Chicago school and other anti-Keynesians continue to do, because to admit this is not a post-war recession would immediately render your analysis is marginal

    If you were correct than the traditional Keynesian concept of the multiplier would also be correct. Empirical evidence suggest otherwise. Whether or not borrowing drops off, or we are not at ‘full employment’ the opportunity cost that the government shifts with its spending still exists, and in fact the burden on those who absorb those cost are even greater during a recession than during the good times thus government stimulus is counter productive.

  12. In a time of a debt-deflation, your assertion is “less” true as the capital the government attempts to borrow is generally being hoarded and is not currently deployed.

    Regardless of whether this is true or not (and I’m not sure that it is), it doesn’t affect the out-years, when the debt created by the government now has to be paid off by increased taxes or additional borrowing.

  13. It’s funny that in one spot you decrey the borrowing for the stimulus because it will increase the debt and crowd out future private investment, but at the end recomend lowering the marginal tax rate which would also be financed by debt, and would end up crowding out private investment in the future.

    I’m all for lower taxes, but they must be combined with a decrease in government services, or they are almost as bad.

    For example, Bush lowered the marginal tax rates singnficantly, but revenues did not rise enough to make up the difference, thus we doubled the deficit in the last 8 years or so. And in so doing really increased interest payments on the debt.

    Just like with personal finances we would have done much better paying higher taxes for a couple more years and eliminating the deficit, then lowerd taxes in conjunction with a balanced budget (and entilement reform).

    The mantra that tax cuts are always good is just as simple minded as the mantra that government spending is always good.

  14. Well, I wasn’t quite sure up to this point, but I’m forced to conclude that Obama is a blithering idiot.

    He cites Japan’s failure, and claims that they failed because they didn’t throw enough gasoline on their burning house.

    -jcr

  15. I’m all for lower taxes, but they must be combined with a decrease in government services, or they are almost as bad.

    Perfectly sensible. I would not go as far as to call what is government largess “Services”, but the statement is perfectly reasonable.

  16. Well, I wasn’t quite sure up to this point, but I’m forced to conclude that Obama is a blithering idiot.

    He cites Japan’s failure, and claims that they failed because they didn’t throw enough gasoline on their burning house.

    Not only that, but even if Obama was right, the bill they’re about to pass is worse than what Japan tried. It takes longer to go into effect, and it’s smaller than the total Japanese ‘stimulus’. So by the Obama administration’s own understanding of why the Japanese stimulus programs didn’t work, this one can’t work either.

    But they don’t care, because this isn’t about ‘stimulus’. The CBO is projecting that the economy will begin to recover in another 16 months anyway. What this is about is using the fig leaf of a crisis to ram through Democratic big-government projects that they’ve been wanting to pass for 20 years but couldn’t get public support for.

    I do believe the plan is to pass this thing, then when the economy recovers on its own, to attempt to take credit for it, and at the same time use that to ‘prove’ that big government is good for you. In the meantime, a lot of the funding in this bill will go directly towards shoring up electoral and financial support for the Democrats.

    It’s a blatant power grab and payoff to Democratic interests, under the guise of a ‘stimulus’. Therefore, arguments justifying don’t have to be sound, they just have to sound reasonable enough to buy time to get the bill rammed through.

  17. Through use of this crisis, Obama will soon bring us free market reforms despite the unrelenting clamor for socialism from the populace as aptly described in Naomi Klein’s “The Shock Doctrine”.

  18. In the meantime, a lot of the funding in this bill will go directly towards shoring up electoral and financial support for the Democrats.

    That’s right out of Roosevelt’s playbook.

    -jcr

  19. I think the telling point is that they do this all the while failing to recognize that the So-So Security baby bust is just around the corner. Even if they convince the PAL that this is a bandage for the nick suffered while shaving, it doesn’t change the fact that right around 2012 the blade of the guillotine that is retiring baby boomers begins to fall on the whole social security charade.

    The question I want to know is, with only about half of the SSNs remaining to be passed out, will they run out of numbers or money first?

  20. Readers might also be interested in my Nolan Chart column, “Wealth,
    Illth, Money, and the Financial Crisis”:
    http://www.nolanchart.com/article5480.html

  21. “They will only spend it on SUVs, iPods, porn, six-packs, and other items the left deems unacceptable.” Since when did the left become the conservative country folk group. The left usually consists of the the iPod, macbook, porsche/VW SUV, $5 coffee bunch.

  22. But the biggest problem is that the government can’t inject money into the economy without first taking money out of the economy. Where does the government get that money? It can either borrow it or collect it from taxes.

    This is not true. In fact, it’s completely backwards. A sovereign currency issuer can create money ex nihilo, and there is really no practical limit to the amounts a currency sovereign can “spend” or “borrow.” The household budget analogy does not apply to an issuer of fiat currency. Fiscal deficits can be as large as necessary and can scale almost infinitely. Inflation is the only risk. Taxes are an instrument of money destruction not a source of revenue for present or future spending. And “borrowing” really just changes the accounting of reserves.

    That said, the stimulus bill is the worst possible way to go about running a “reflation” deficit. It’s wasteful and unproductive trickle-down spending mediated through a single, limited channel. The best option: an open-ended payroll-tax holiday for all Americans. Open-ended is key if you want to increase aggregate demand in any meaningful way. The wisdom of a broad, grass-roots approach to stimulus is just painfully obvious.

    See Winterspeak and Warren Mosler for better explanations than I could ever provide.

  23. True… iPods are usually associated with leftist youth. But my complaint is more about the self-declared elitist who believe the masses lack the intelligence to determine an acceptable level of consumption for themselves and thus need the intervention of the well-intended state. In achieving that goal they are willing to betray any goods or brands.

  24. True… iPods are usually associated with leftist youth.

    By whom?

    I’ve had an iPod since 2002, and so have tens of millions of other people. If there are as many lefties as there are iPod owners, we’re in bigger trouble than I’ve feared.

    -jcr

  25. The CBO is projecting that the economy will begin to recover in another 16 months anyway

    On this matter, CBO’s guess is no better than that of any other halfway informed person. It is a shot in the dark. The WSJ had a nice chart a few days ago showing how predictions for the length of the recession just keep getting worse and worse as it drags on. Six months ago, it was supposed to be over by April. It reminds me of nuclear fusion, that wonderful technology that is always 50 years away.

  26. I would also think the writer of this article would feel under at least modest obligation to add something original to the current debate. There is nothing here that hasn’t already been stated ad infinitum at various economics blogs and Op-Eds over the past 120 days.

    Here is an example of the herding behaviour taking place in Economics right now. Frankly, I think the profession has been unmasked on all sides as just another exercise in political tribalism, rather than rigorous thought.

    Recently a group of economists affiliated with the Cato Institute ran an ad in the New York Times opposing the Obama’s stimulus plan. As chair of my department I tried to arrange a public debate between one of the signatories and a proponent of fiscal stimulus — thinking that would be a timely and lively session. But the signatory, a fully accredited university macroeconomist, declined the opportunity for public defense of his position on the grounds that “all I know on this issue I got from Greg Mankiw’s blog — I really am not equipped to debate this with anyone.”

    http://paul.kedrosky.com/archives/2009/02/16/be_it_resolved_13.html

  27. “But there are, writes Veronique de Rugy, several ideas that COULD stimulate the economy.”

    So the ‘several ideas’ are to cut taxes, and then cut taxes, and after that’s done, cut taxes? Brilliant!

    As for the people who have no job from which to take taxes…

  28. “As for the people who have no job from which to take taxes…”

    … cutting taxes creates jobs.

    I find it hard to believe that you’re too blind to see that. So you must be gainsaying the tax-cut position, which a lot of far-left people do because the far-left needs them some taxes.

    Cutting taxes helps everyone across the board.

  29. Thank you author for this article.. Carry on the good work….

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