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Can Keynesian-style short term stimulus engender economic growth and forestall recession? Or is such a package of no effect or even harmful to the economy? This essay examines this question differently from recent commentary, via a return to classical fundamentals. In turn, we reach a different conclusion than economists who have forecast a benefit from either the recently-passed or further 2008 legislation.
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:
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:
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.
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