12/13/2009

Why the Economic Stimulus Plan Doesn’t Work

When President Obama was elected, the economy was already sick and getting sicker.

If nothing was done, his economic team said, the unemployment rate would keep rising, reaching 9 percent in early 2010. But if the nation embarked on a fiscal stimulus of $775 billion, mainly in the form of increased government spending, the unemployment rate was predicted to stay under 8 percent. Obama bought into a classic Keynesian solution – and so did Congress.

Congress passed a huge fiscal stimulus that focused almost entirely on government spending. Yet things turned out worse than the White House expected. The unemployment rate is now in the 10 percent range — a full percentage point above what the administration economists said would occur without any stimulus!

So what should they  do now? The administration seems  determined to stay the course, although recently, the president showed interest in “increasing the dosage” – a bad prescription indeed. A better approach might be to rethink the entire strategy from the git-go.

When concocting its fiscal package, the Obama Administration relied on conventional economic models based largely on ideas of John Maynard Keynes. Keynesian theory says that government spending is more potent than tax policy for jump-starting a stalled economy.

The fallacies of Keynesian economics were exposed decades ago by Friedrich Hayek and Milton Friedman. Ronald Reagan's decision to dump Keynesianism in favor of supply-side policies—which emphasize incentives for investment—produced a 25-year economic boom.

According to  Christina  Romer, now chairwoman of the president’s Council of Economic Advisers, each dollar of tax cuts has historically raised G.D.P. by about $3 — three times the figure used in the administration’s recent report. That is also far greater than most estimates of the effects of government spending.

In an October study, Alberto Alesina and Silvia Ardagna  of Harvard looked at large changes in fiscal policy in 21 nations in the Organization for Economic Cooperation and Development. They identified 91 episodes since 1970 in which policy moved to stimulate the economy. They compared the policy interventions that succeeded —  those that were followed by robust growth — with those that failed.

What did they find? Successful stimulus relies almost entirely on cuts in business and income taxes. Failed stimulus relies mostly on increases in government spending.

These studies and others point toward tax policy as the best fiscal tool to combat recession, particularly tax changes that influence incentives to invest, like an investment tax credit.  This really should come as no surprise, since small and medium size businesses are the engine that creates 80 percent of American jobs. Throughout modern history, it is small business that fuels jobs and growth – not government.  Yet, the Administration and Congress’ knee-jerk spending reactions so far indicate that they “still don’t get it”. If Congress and the President really wanted to get the economy moving and create jobs, they could repeal the capital gains tax. But, they won’t.

There is a growing body of evidence to support that Keynesianism is not an effective way to “spend your way” out of a bad recession. It’s time for our legislators and the executive branch to stop the spending foolishness. Ronald Reagan got it. All we have now is simply a recipe to repeat the Japanese “Lost Decade” of the 1990’s.