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December 11, 2001
Federal spending will not stimulate the economy
By James W. Coons
Passing an economic stimulus bill would be like giving a marathon runner a shot of adrenaline at the end of the race. The economy is down, but it can get up on its own, and it will. What is needed is patience while people adjust to changes in the economic environment. There is no way around this painful process.
Economic stimulus has never worked. Attempts at reviving a sagging economy have always come too late. Democracy just can’t seem to move fast enough. First, the seriousness of the problem has to be recognized. This is no small feat. The official arbiters of the business cycle at the National Bureau of Economic Research usually don’t recognize recessions until they are almost over. Forecasters forecast more recessions that don’t happen than do. Stimulating when it is not necessary would create its own problems.
Second, it takes too long to get measures enacted. The Bush Administration and Congress put tax cuts on the fast track at the beginning of the year, and passage still took six months. Following the attacks in September, President Bush called for an economic stimulus plan, which a dozen weeks later Congress is still debating.
Finally, once relief becomes law, it can take months to kick in. The recent tax cuts are not fully phased-in for many more years. Even the relatively speedy measures currently under consideration would take months to have an effect. If the recession is average in length, recovery will be here before springtime and well before stimulus could start to work.
Unless the government establishes a reliable early detection system and assembles an inventory of pre-approved tax measures and spending programs, effective counter-cyclical fiscal policy will remain beyond reach. Neither feature exists today.
But the economy is still deteriorating. Isn’t too late better than never? Probably not. The idea of economic stimulus is a compelling idea that loses its allure upon close examination.
Using fiscal policy – government spending and taxes – to stimulate the economy sounds like a good idea. There is no reason, however, to believe that it works, according to economist Milton Friedman in his book Capitalism and Freedom.
Suppose the government spends an extra $100 billion. That spending is income to the recipients, who save some and spend the rest. That spending is also someone else’s income, which fuels additional saving and spending, and so on. If people save one-third of any incremental income, then the extra government spending will result in a total of $300 billion in spending.
The flaw, as Friedman explained, is that there is no way of knowing whether extra government spending will actually multiply through the economy. The extra government spending could be offset by an equal reduction in private spending, spurring no additional economic activity.
If that seems far-fetched, consider Japan, where a decade of unabashed and unrestrained fiscal stimulus has produced the largest government debt among industrialized countries without preventing deflationary recession.
Counter-cyclical fiscal policy has two additional drawbacks. One is that it requires identifying worthy projects. If they couldn’t attract enough support before, why does a weak economy make them worthwhile? Economist John Maynard Keynes suggested that it didn’t matter, that the government could stimulate the economy by paying men to dig ditches and then fill them in. I think I am safe in speaking for the modern economics profession when I say that borrowing money and wasting it is probably not an effective way to spur the economy.
The other drawback is that there never is talk of fiscal restraint in the form of lower government spending when the economy is booming. This produces an upward bias in the size of government over time. And this bias results not from improvement in the government’s ability to satisfy our wants, but from an accumulation over time of dubious stimulus programs.
The economy is in a recession because things turned out differently than expected. Energy prices and interest rates were higher. Profits were harder to come by and equity values were lower. Businesses have adjusted by cutting production and capital spending and shedding inventories and employees. Consumers have trimmed borrowing and spending.
The economy will return to a healthy growth path as soon as this process is complete. Government can’t shorten the recession by spending extra money, but it could add to the economy’s ability to grow long-term by reforming the tax code. It’s never too late for that.