Stimulus Myths

Genius Jeff Carter writes a column http://tinyurl.com/3uzw4mw that eloquently illustrates some commonly held economic fallacies. I’m going to address these as they occur in his column. 

The first fallacy is that people adjust their behavior to prepare because they believe a future tax increase will result from government borrowing. Way back during the Reagan administration it was believed that people would increase their savings as a result of tax cuts because they believed that taxes would have to be increased in the future. People were surprised when savings didn’t increase. 

This is based on the economic assumption of rational behavior. It is believed that people act rationally. In reality, people don’t act rationally and expect other people to not act rationally either. Oftentimes people count on the fact that other participants in the economy will not act rationally. Back in the late 90s when P/E ratios were going through the roof far beyond what had ever been seen, people knew that the companies behind most of those stocks were not worth what the stock price suggested. But they bought and held such stocks. Why? That’s irrational. The reason they did so was because they expected another investor to act even more irrationally and pay even more for the same stock at a later date. Eventually the bubble burst. 

Another reason people aren’t as a result of government borrowing is because many don’t believe that a tax increase is coming. Talk radio hosts and hack economists like Jeff Carter have convinced many that an increase in taxes results in a decrease in revenue. They’re convinced that a reduction in tax rates will increase revenues. Carter’s suggestion that people are going to change their behavior based on an expectation of a future tax increased as a result of government borrowing is unrealistic. 

Another fallacy is that government borrowing during a recession prohibits businesses from investing. “Let’s say that Peter was going to do something else with the money. Maybe he owns a business and was going to spend $1 on more production. Now he can’t because the government borrowed it.”

This is ridiculous. First of all, the government is borrowing the money in this case, not stealing it. Peter has the option as to whether he wants to put his money into an investment in more production or buy a government bond. If he believes that his investment in more production will reap a healthy return, then he will invest in the production. 

But the fact is that right now businesses are not expanding because they don’t anticipate a return on the investment. Carter writes in his column,“Cash is piling up on corporate balance sheets. Businesses are not expanding. That shows businesses are not investing.” Exactly. Businesses are not investing anyway. Rather than having the cash sitting in a bank account, the government uses the funds hopefully for projects that will benefit society like improving and maintaining infrastructure. 

“Governments cannot invest, they can only spend” is another fallacy brought up by Carter. The fact is that governments do invest. A road is an investment. A road is a capital asset that facilitates production. Let’s face it: the economy wouldn’t be able to function very well without roads. Roads, bridges, ports, dykes and dams, not to mention education and research are all investments.

 Another fallacy that Carter brings up is that the Kennedy tax cuts generated an economic boom. “Two times in the last fifty years have we lowered marginal rates and eliminated deductions. JFK, a Democrat, did it in 1961.” JFK didn’t do it at all. Kennedy proposed tax cuts. The actual tax cuts were signed by President Johnson after Kennedy had been assassinated, and by that time the economy had already been booming for years. 

Carter brings up these fallacies in an attempt to discredit Keynesian stimulus spending. Keynes is dead, he believes.

To evaluate whether Keynesian spending is effective, one must apply it in a clinical setting. With so many inputs and variables that affect economic growth, it’s impossible to tell the exact effect each input has. The only way to do this would to go back in time, change one input and then evaluate the results. This is impossible. But that doesn’t stop us from pondering whether a stimulus can work. 

It is often argued that the benefits of government spending (if any) are more than offset by the reduction in private spending. Those that submit this argument believe that the money supply is fixed, that a dollar spent by government is one dollar less spent by the private sector regardless of whether it is taxed or borrowed. In the long term, that is a valid argument. However, in the short term, it doesn’t hold up.

Jeff Carter already admitted that corporations are not investing. Cash is piling up on corporate balance sheets, he wrote. In the short term, the government can borrow that cash and use it to pay unemployment benefits or teachers or construction workers to build a bridge or public transportation. This reduces unemployment and increases economic activity in the short term. 

Consider the data for economic growth and employment. After the financial crisis the economy shrank and unemployment increased rapidly. A stimulus was implemented in mid-2009, and spending began increasing later that year. As the stimulus was spent, the economy recovered albeit slightly, and the sharply increasing unemployment rate was stabilized. Then in late 2010 and early 2011 as the stimulus funds ran out, economic growth slowed. This is not proof that the stimulus was effective. However, the results do not support the argument that Keynesian stimulus doesn’t have any short term effect at all. 

One question is begging to be asked: Was it worth it? Was it worth accumulating a trillion dollars in extra debt to produce a stimulus that didn't address the causes of the recession, didn't improve our financial position and if anything only produced a temporary minor increase in economic growth? Was it worth it? I think the answer is obvious: HELL NO!!