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Debunking 'Government Stimulus'

This article is more than 7 years old.

Last month, I wrote in this space that so-called government stimulus plans are "economic quackery." Some of my readers disagreed, so this column is dedicated to explaining why government stimulus is bad economics and harmful policy. To do that, I'll examine both the historical record of government stimulus programs and the theoretical underpinnings of the doctrine.

The basic premise of the stimulus idea is that when the overall economy is performing sluggishly, whether growth is feeble or in a state of outright contraction, government should act to boost growth by stimulating the economy through increasing government expenditures, even if it means incurring budget deficits. The original theory also calls for tax cuts, which I'll discuss below, but in practice, US presidents have favored more government spending as the stimulant of choice.

The original "stimulus" programs were those of Presidents Hoover and Franklin Roosevelt in the 1930s. They did so even before John Maynard Keynes' stimulus theory was published in 1936, but they were the first two presidents to try to restore growth and prosperity by massively increasing government spending and budget deficits. Did those interventions succeed in fixing what ailed the economy? Obviously not -- the Great Depression was a 12-year economic disaster. Even FDR's own Treasury Secretary, Henry Morgenthau testified to Congress in May, 1939, "We are spending more than we have ever spent before and it does not work...I say after eight years of this administration we have just as much unemployment as when we started...And an enormous debt to boot!" (Note that Morgenthau said "eight years," even though Roosevelt had been president for only six at that time. He was acknowledging that the deficit spending tactic had started under Hoover.)

The other time frame in which "stimulus" was employed on a vast scale was under the presidencies of George W. Bush and Barack Obama. Some economists might say that there were earlier stimulus programs, but as I see it, episodes of huge government spending increases between FDR and G.W. Bush were primarily for reasons other than stimulating a sluggish economy. To wit: Deficit spending in the 1940s was for the purpose of financing World War II. In the 1960s, it was to finance "guns and butter" -- Lyndon Johnson's simultaneous wars in Vietnam and against poverty. 1970s deficits were incurred to finance the expanding welfare and regulatory state. In the 1980s, deficits were to pay for Ronald Reagan's military buildup to challenge the Soviet Union and the increased domestic spending demanded by Tip O'Neill and the Democratic House in exchange for the increased military spending.

After the turn of the century, though, deficit spending for the purpose of counteracting weak economic activity returned with a vengeance.

During his second term, President George W. Bush secured passage of The Economic Stimulus Act of 2008, but the economy continued to sputter which, combined with the financial panic of 2008, paved the way for the election of Barack Obama. Whether Bush was consciously pursuing a stimulus strategy throughout his presidency or not is hard to say, but if nothing else, Bush's eight years showed that deficit spending resulting from huge spending increases don't produce a thriving economy. Federal spending soared by 50% (from $2 trillion to $3 trillion per year) in Bush's eight years (the first six of those years with a Republican Congress, it should be mentioned). The result was the largest pre-Obama deficits in history, but all that putative "stimulus" failed to stimulate.

The biggest test of the effectiveness of deficit-spending-as-economic-stimulus in modern times came from Barack Obama. In his first economic speech, given just a few days before he took the oath of office in 2009, President-elect Obama averred, "Only government can provide the short-term boost necessary to lift us from a recession..." Obviously, Obama was (and remains) a true believer in government, instead of free market prices, as the driver of the economy, and so he jacked up Uncle Sam's annual spending by approximately three-fourths of a trillion dollars while doggedly pursuing additional tax revenues. The results of Obama's stimulus plan are well known and undeniable: the weakest economic recovery from a recession in history.

The dismal results of stimulus plans adopted by a bipartisan quartet of American presidents (the deficit spending of Republicans Hoover and Bush was continued and expanded by their Democratic successors, FDR and Obama) should have been sadly predictable to anyone who understood basic economics, and that brings us to the theoretical aspects of the stimulus doctrine.

The Keynesian theory of government stimulus was based on several flawed premises:

1) The notion that "aggregate demand" was more important than the specific demand for each good and service traded in the economy is pernicious. The ineluctable problem with government boosting demand in an attempt to strengthen the overall economy is that government officials only boost demand in areas of their choice. Because government officials don't know as well as the people do what their economic preferences are, they produce less of what people want, and so "the economy" (that is, the people) ends up poorer than otherwise would be the case. If government planners knew better than the people themselves what they want, then socialist central planners would be able to engineer prosperity for the masses and we would have opted for socialism by now, but, of course, planners lack that knowledge and therefore cannot possibly engineer widespread prosperity.

2) When governments spend more in some areas, they achieve increased activity there, but only by diverting scarce resources from producing what consumers value more highly, thereby making the general population poorer. Truly, there is no free lunch in economics.

3) The constellation of market prices signals to producers what consumers want most, coordinating production in the present and showing their time preferences for how much consumption they wish to defer to the future. When government intervenes by jacking up spending on certain goods, it jumbles up those price signals, distorts present production, and robs the future in unknowable but very definite ways.

In short, then, government attempts to stimulate economic growth by increasing government spending end up discombobulating and misdirecting production thereby impeding rational economic growth and making the population poorer. Some "stimulus"!

There is another side to Keynes' stimulus theory, however, that makes more sense. Keynes understood that one way to increase consumer demand would be to lower taxes on consumers and let them keep more of their income. It has been detrimental to Americans and somewhat unfair to Keynes's reputation that FDR and Obama were so obsessed with redistributing wealth that they ignored the tax-cut part of Keynes' stimulus theory. Undoubtedly tax cuts would have mitigated the damage done by government's klutzy, politicized stimulus spending.

In fact, one of my readers wrote to say that President Reagan's policy mix was highly stimulative. His facts are correct: Reagan's policies led to strong, sustained economic growth. However, the word "stimulus" is misleading. As already discussed, increases of government spending are inherently uneconomical. Reagan managed to boost production and economic activity by cutting marginal tax rates, thereby reducing the disincentives to labor, investment, and production. Tax cuts were economically beneficial, but I still object the phraseology that tax cuts "stimulate" the economy.

The "stimulus" verbiage makes it sound like government itself provides the fuel that propels economic growth. Entrepreneurs, businesses, and workers produce a society's wealth. Taxes impede that process by imposing economic burdens on entrepreneurs, businesses, and workers. Tax cuts reduce the impediments to wealth creation, which is economically beneficial. However, tax cuts don't mean that government has become a positive producer of wealth; rather the positive effect of the tax cuts is that the government is now retarding economic production less. Government isn't stepping on the economic gas pedal, so to speak; it is merely lightening its pressure on the economy's brakes. Tax cuts don't "stimulate" the economy; rather, they liberate it. It is accurate to say that Reagan implemented an "economic liberation plan" rather than an "economic stimulus plan."

Whether you buy my dissection of Keynes' stimulus theory or not, I don't see how you can refuse to admit that the two biggest stimulus programs in history -- Hoover/FDR tandem in the 1930s and Bush/Obama pair over the last ten years -- have resulted in the

Great Depression and Great Recession. What more do you need to convince you that the last thing the USA needs is another government stimulus plan?