Stimulating Ourselves to Death

They might sound great, but do stimulus packages work?


Barack Obama says his "unprecedented" economic stimulus package will not merely be "a short-term program to boost employment." No, it "will invest in our most important priorities like energy and education; health care; and a new infrastructure that are necessary to keep us strong and competitive in the 21st century."

The massive cost of the stimulus doubled even before any legislation was written, much less approved. Originally tagged at $400 billion, the proposal quickly jumped to $825 billion, and latest estimates at press time have it costing north of $1 trillion (comprised of 60 percent spending and 40 percent tax cuts).

Given the size, will the stimulus work as advertised? Will the goods and services—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 modern recorded history.

Take the New Deal. According to the economists Christina Romer—chair of 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 as pulling America out of the Depression, didn't necessarily help. In a 2006 paper for the National Bureau of Economic Research, the 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.

The example of 1990s Japan, with its collapsed housing and stock markets, is also relevant. Between 1992 and 1999, Japan passed eight stimulus packages totaling roughly $840 billion in today's dollars. During that time, the debt-to-GDP ratio skyrocketed, the country was rocked by massive corruption scandals, and the economy never did recover. All Japan had to show for it was some public works projects and a mountain of debt.

Finally, the Bush administration passed the Tax Relief Act of 2001 and the Economic Stimulus Act of 2008, two similar 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 jumpstart the economy. It failed. People spent little if anything of the temporary rebate, and consumption did not recover.

The chart shows how personal disposable income jumped at the time of the rebate while personal consumption did not increase noticeably. Formal statistical work by Joel Slemrod, a professor of tax policy at the University of Michigan, has shown that rebates generally produce no statistically significant increase in consumption.

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 some 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 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 $825 billion than the private sector. When Obama says, "We'll invest in what works," he means, "unlike you bozos." The president's faith in Washington is sweet, 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.

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 a) borrow it or b) 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.

In fact, the data suggest that stimuli often end up shrinking the pie. In a 2008 paper, budget analyst Brian Riedl of the conservative Heritage Foundation summarized several studies that found past increases in government spending reduced the economic growth rate by between 0.14 and 0.36 percentage point. This means that every dollar's worth of production used to satisfy the government's demand is offset by more than a dollar's worth of production that is no longer available to consumers and businesses.

Present or future tax increases that fund government spending often 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 and tax rebates. Instead, focus on real incentives to work and invest, such as cutting marginal tax rates for everyone.

Contributing Editor Veronique de Rugy is an economist at the Mercatus Center at George Mason University.