Why the Stimulus Plan Won't Work

And several ideas that might

President Barack Obama insists that the massive $800 billion stimulus package is necessary to avoid "catastrophe." Indeed, during his first primetime news conference, Obama said bigger was better, and pointed to Japan's failed stimulus packages as a reason to go really big.

"We saw this happen in Japan in the 1990s, where they did not act boldly and swiftly enough," Obama stated. "And, as a consequence, they suffered what was called the lost decade, where essentially, for the entire '90s, they did not see any significant economic growth."

Obama is right to cite the example of Japan. That nation's collapsed housing and stock markets in the 1990s are very relevant to today's recession. Between 1992 and 1999, Japan passed eight stimulus packages, totaling roughly $840 billion in today's dollars. During that time, the debt-to-Gross Domestic Product (GDP) ratio skyrocketed, the country was rocked by massive corruption scandals, and the economy never recovered. All Japan had to show for it was a mountain of debt and some public works projects that look suspiciously like bridges to nowhere.

Will the goods and services in the Democrats' stimulus plan—be they concrete for new highway projects or groceries for hungry families—pump up flagging demand and boost stalled economic activity?

If so, it will be the first time in recorded history.

Take the New Deal. According to the economists Christina Romer, chair of Mr. Obama's Council of Economic Advisers, and David Romer, New Deal spending did not pull the economy out of recession. In a 1992 Journal of Economic History paper, the Romers examined the role that aggregate demand stimulus played in ending the Great Depression. They concluded: "A simple calculation indicates that nearly all of the observed recovery of the U.S. economy prior to 1942 was due to monetary expansion. Huge gold inflows in the mid- and late-1930s swelled the U.S. money stock and appear to have stimulated the economy by lowering real interest rates and encouraging investment spending and purchases of durable goods."

Even the massive spending during World War II, long touted for pulling America out of the Depression, didn't necessarily help. In a 2006 paper for the National Bureau of Economic Research, economists Joseph Cullen and Price V. Fisher asked whether the local economies that were the biggest beneficiaries of federal spending on military mobilization during World War II experienced more rapid growth in consumer economic activity than others. Their finding: Military spending had virtually no effect on consumption.

Another economist, Robert Higgs, offered an even more thoroughgoing critique in an excellent 1992 Journal of Economic History paper. After challenging the conventional portrayal of economic performance during the 1940s, Higgs concluded that "the war itself did not get the economy out of the Depression. The economy produced neither a 'carnival of consumption' nor an investment boom, however successfully it overwhelmed the nation's enemies with bombs, shells, and bullets." Breaking windows in France and Germany didn't bring prosperity in America.

In his 2008 book Macroeconomics: A Modern Approach, Harvard economist Robert Barro shows that $1 of government spending in wartime produces less than $1 in GDP—80 cents, to be exact. Stanford economist Bob Hall and Sand Hill Econometrics chief Susan Woodward, neither particularly pro-market, argued recently that each dollar of government spending during World War II and the Korean War produced about $1 of GDP. In other words, the economy is not stimulated by war spending.

Most taxpayers are familiar with the two most recent failed stimulus experiments. The Bush administration passed the Tax Relief Act of 2001 and the Economic Stimulus Act of 2008, two similar tax rebate packages with similar effects on the economy. Which is to say, not much. In 2008, the major component was sending $100 billion in cash to Americans so they would have more to spend and thus jump-start the economy. It failed. People spent little, if anything, of the temporary rebate, and consumption did not recover.

The theory of economic stimuli suffers from several serious problems. First, it assumes people are stupid. Tax rebates, for example, presume that if people get money to increase their consumption, businesses will expand their production and hire more workers. Not true. Even if producers notice an upward blip in sales after the rebate checks go out, they will know it's only temporary. Companies won't hire more employees or build new factories in response to a temporary increase in sales. Those who do will go out of business.

Second, the thinking behind stimulus legislation assumes that the government is better at spending $800 billion than the private sector. When President Obama says, "We'll invest in what works," he means, "unlike you bozos." The president's faith in Washington is charming, but politics rather than sound economics guide government spending. Politicians rely on lobbyists from unions, corporations, pressure groups, and state and local governments when they decide how to spend other people's money. By contrast, entrepreneurs' decisions to spend their own cash are guided by monetary profit and loss. That's likely to work better and certain to produce more innovation.

But the biggest problem is that the government can't inject money into the economy without first taking money out of the economy. Where does the government get that money? It can either borrow it or collect it from taxes. There is no aggregate increase in demand. Government borrowing and spending doesn't boost national income or standard of living; it merely redistributes it. The pie is sliced differently, but it's not any bigger.

Stimulus packages—and present or future tax increases that fund government spending—end up burdening the economy. Such was the case in the 1930s, during World War II, and in 1990s Japan. Thankfully, the 2001 and 2008 tax rebates, while ineffective as stimuli, didn't make things worse.

If politicians actually want to do something cost-effective to solve our economic woes, here's some advice: Stay away from spending increases and tax rebates. Instead, focus on real incentives to stimulate work and investment, such as cutting everyone's marginal tax rates, slashing payroll taxes for employees and employers, and ending the corporate income tax.

Veronique de Rugy is a columnist at Reason magazine and an economist at the Mercatus Center at George Mason University. This column first appeared at Reason.com.

Veronique de Rugy is Senior Research Fellow





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