First, the background: President Bush, stating that the economy has slowed sharply, signed the "Economic Stimulus Act of 2008" into law on February 13th, calling it a "really good piece of legislation" which will help to avoid a recession. Passed quickly and with strong bipartisan support, the bill calls for $168 billion to be fueled into the economy, primarily via tax "rebates" (which include some outright transfers) of $300-$1200 to an estimated 128,000,000 Americans in lower and middle-income tax brackets. Intended to spur new equipment purchasing in 2008, $50 billion of the total are business tax breaks via accelerated depreciation, and related legislation offers relief to troubled home mortgagors, including assistance in refinancing. Finally, in the wake of the collapse of Bear Stearns and rising job loss claims, additional fiscal stimulus measures including lengthened unemployment benefits are being considered.
That politicians running for re-election in a slowing economy would applaud a temporary stimulus measure is unsurprising, but many economists were also supportive. For example, Edward Lazear, Chairman of the Council of Economic Advisors to President Bush, said that "permanent tax cuts are the best way to grow the economy in the long-run", but that stimulus legislation was smart policy because "if we create growth right now, we'll create a situation where the economy can grow further in the future." Harvard's Martin Feldstein echoed this sentiment, saying that the stimulus plan would help in "offsetting the risk of an economic downturn".
Spending-leads-to-wealth is a distinctly Keynesian idea. Keynes held that when aggregate demand was insufficient in a period of unemployment and idle resources, government-led spending could increase demand, and via a "multiplier effect" across rounds of subsequent spending, return an economy to full employment. But this is not uncontroversial. Russell Roberts of George Mason University, for example, says the idea of a stimulus package is "like taking a bucket of water from the deep end of a pool and dumping it into the shallow end. If you can make the economy grow, why wait for bad times?" In other words, Roberts argues, stimulus spending will be ineffectual at best.
Let's examine this at two levels. First, fundamentally, what causes economic growth? Secondly, to what degree are the drivers of GDP growth reflected in the February stimulus bill? This allows for honest appraisal of the bill's efficacy.
I. What drives economic growth? Adam Smith made this question the centerpiece of his famous book in 1776, entitled An Enquiry into the Nature and Causes of the Wealth of Nations. Smith's comprehensive answer, confirmed by David Hume and further elucidated by David Ricardo and John Stuart Mill, has been borne out in the centuries since. Modern economists would describe Smith's book, and indeed the classical vision more broadly, as one highlighting the institutions which drive growth, summarized as follows:
- Private property and limited government--Smith was a keen student of John Locke, who eloquently enunciated a natural right to liberty and property, rooted in the very nature of man. For Smith, in fact, property and limited government were the cornerstones of a system of natural liberty, and a necessary condition for the advancement of civilization itself. From the vantage point of the economist, property implies private ownership of the means of production (capital), and limited government implies a regime of low taxation and regulation. With this institutional backdrop, in fact, proper incentives are in place to guarantee maximal economic growth via development of other necessary institutions undergirding a society based on liberty.
- Division of labor and exchange--Man, said Smith, has a propensity to "truck and barter". Further, individuals develop specific skills and knowledge which are unique across society, and lead naturally to what became known, at a country-level, as Ricardo's law of comparative advantage. In brief, comparative advantage mandates that each country should produce goods and services where there are cost advantages, and trade for those in which there is comparative inefficiency in production. Thus, a division of labor--and concomitantly, a division of knowledge--develops naturally in a free economy, and implies that trade and exchange between individuals (and eventually nations) also therefore ensues. The division of labor and knowledge leads to specialization and economies of scale in production, further enhancing the productivity of labor in an economy, and thus the profits of enterprise. Empirically, this has been borne out in the almost perfect correlation between increasing international trade and economic growth.
- Indirect exchange and money--Primitive trade consisted of direct exchange of goods, or barter. Over time, though, some goods such as gold became commonly accepted media of exchange, or money. Money permits far more efficient indirect exchange, because it avoids the barter requirement of a mutual coincidence of wants. A stable monetary unit also facilitates efficient economic calculation in terms of an accurate accounting of profit and loss; standardized pricing across markets for all goods; and, prospective forecasting and comparative cost analyses. Economists from Adam Smith to Hayek have thus affirmed the crucial role of monetary institutions in economic growth: stable money permits a radical intensification of the division of labor, widening markets wherever common money is used, and increasing productivity and profits from production and trade. Indirect exchange and the division of knowledge also lead to specialists in financial intermediation such as banks, which facilitate the allocation of capital to its most efficient uses.
- Saving and capital accumulation--Absent the fear of expropriation or confiscatory taxation, the institutions of private property and limited government foster strong motivating incentives for production and, in turn, allow for long term saving. Saving provides the fuel for investment, which in turn promotes the accumulation of capital. Capital formation is the primordial driver of wealth in an economy, because it increases output per unit of input, and is thus the primary source of growth in real wages to workers, and thus their living standards.
- Entrepreneurship and price discovery in competitive markets--Trade and exchange, aided by money, lead to the development of sophisticated markets in all goods and services, in which competitive behavior by buyers and sellers leads to efficient pricing of goods. Importantly, this pricing mechanism is activated by entrepreneurs who are present in every market; these are individuals who peer into an unknown future, accept risk of loss if they misapprehend the course of prices, and place bets on the future course of consumer desires by directing resources toward production yielding the hypothesized highest value. This process constitutes what Adam Smith referred to as the invisible hand--it promotes the optimal allocation of resources to their highest-valued uses, punishes (and hence minimizes) error due to mis-pricing, and leads to fulfillment of consumer priorities (e.g., higher prices accrue to those goods most demanded by consumers, drawing resources to their production).
These are the necessary and sufficient institutional conditions which guarantee maximal growth in an economy (Keynes himself would agree, differing only regarding the relative stability of a market economy and government's role). Effective economic policy, both fiscal and monetary, thus consists in fully promoting this institutional mix.
II. Are these growth-promoting institutions reflected in the stimulus bill? Measured against the template described above, the stimulus bill appears irrelevant, if not harmful:
- Per above, stable money is crucial to facilitate trade, encourage entrepreneurial risk-taking, and engender accurate economic calculation. But some of the tax "rebate" funds will be borrowed in the current year, inflating credit levels (while at the same time crowding out private investment and expanding the fiscal deficit). At the margin, further pounding of the dollar distorts investment, discouraging both entrepreneurship and the capital formation so necessary to generate increases in output and real wages. In this respect the stimulus bill is unambiguously harmful.
- The tax "rebates" are not distributed pro rata to all tax-payers, but instead via a redistributive formula to lower and middle income recipients--some of whom will not have paid federal income taxes in 2007. By definition, this merely redistributes wealth from current and future taxpayers to current recipients. The GDP impact is thus neutral at best, and may be negative, when factoring in the transfer of real wealth away from job-creating producers. Similarly, businesses taking advantage of accelerated depreciation will spike up equipment-purchasing this year, but largely at the expense of next year--the kind of palliative measure which deepens recessions when they eventually arrive.
- Finally, the (Keynesian) proponents of the bill emphasize the need to increase spending, in order to increase consumption, and ultimately GDP. However, economic growth occurs because saving and capital accumulation increase, leading to intensified production and output, and thence to increasing real incomes. To say this differently, Mr. Lazear, the President's chief economist, says increased spending will effectively engender increased output, which will "create a situation where the economy can grow further in the future". This is sometimes known as "Keynes' Law", and is in fact the obverse of Say's Law of Markets. Say's Law states, correctly, that output, once created, affords buying power in other product markets to the "full extent of its own value." The source of wealth, therefore, lies in production. Rather than vitiating Jean-Baptiste Say, Keynes could have learned from him: increasing consumption is an effect, not a cause, of economic growth.
To the non-economist, this is a subtle distinction, but much error has been spawned from the spectacular fallacy of Keynesian spending which, as Keynes himself erroneously wrote in 1943, has the capacity for "turning stones into bread." In fact, policies which impel spending at the expense of saving are harmful to GDP growth just as surely as eating today's seed corn hurts next year's harvest.
On balance, then, those economists who endorse spending stimulus as marginally helpful or neutral have it wrong. Combined with the Federal Reserve's abrogation of its responsibility to stabilize the dollar's value, the lack of truly pro-growth fiscal policy only deepens the dislocations that will be corrected in the eventual recession. In a better world, Mr. Lazear would have followed his initial instinct, and advised the President to pursue permanent cuts in marginal income, capital gains, dividend, and corporate tax rates. Additionally, incipient protectionism needs to be thwarted, and the dollar stabilized. That this argument has not been made is but the latest example of the triumph of politics over economics.
John L. Chapman is a NRI fellow at AEI.