On the Efficacy of Stimulating Your Way Out of a Recession

In an earlier essay I suggested that the bailout of the banks was necessary and that if it hadn't been done, the economy would have died for lack of liquidity. We need banks to make loans to individuals and businesses. If the banks have no money, no one gets a loan and the economy crumbles.

In this essay, I propose that the stimulus plan to jump start the economy via a large expansion of federal programs to be paid for by a combination of massive borrowing and increased taxes on high-income individuals and businesses is exactly wrong.

Despite the programs' popularity at the time, the New Deal stimulus packages are now recognized by most economists as a huge mistake. In a 2004 study, two UCLA economists attempted to quantify how much longer the recovery took than it should have and concluded that FDR's programs extended the depression by 7 years. "Why the Great Depression lasted so long has always been a great mystery, and because we never really knew the reason, we have always worried whether we would have another 10- to 15-year economic slump," said Ohanian, vice chair of UCLA's Department of Economics. "We found that a relapse isn't likely unless lawmakers gum up a recovery with ill-conceived stimulus policies."

While the currently proposed stimulus proposals differ from FDR's, they share some striking similarities. Both take money out of the private sector and convert it to public use. Unfortunately, the huge deficits demand that the government borrow massive sums of money and this results in the government "crowding out" private sector borrowing. Who would loan to a private company if they could get nearly the same return loaning to the government? As discussed in my previous essay, the problem in recessions/depressions is that the economy suffers from a lack of liquidity. Policies that have the government vacuum up available capital resources are counter-productive in situations such as we find ourselves in today.

The second method the government is going to use to pay for the stimulus package is to increase taxes, primarily on the wealthy. Where on earth do the politicians think jobs come from? It takes money to create jobs so the poor cannot create jobs, as they don't have the necessary capital. Many of the businesses that at one time could have provided jobs, such as the auto industry, are now in disarray and are hemorrhaging jobs. And so, current policy is to suck more capital out of the hands of the few profitable businesses who actually could create new jobs to help pay for the "stimulus package" via higher taxes.

The government's hope is that the stimulus will boost demand for goods and services and this will keep businesses from laying off current workers. It's a strategy to preserve jobs, not to create them. Unfortunately, the problems in the economy do not fall equally on all sectors. It is impossible to stimulate the economy to such an extent that there would be no, or nearly no job losses in the auto, steel, concrete, lumber and a whole host of other construction and heavy manufacturing industries. Does anyone seriously expect that any amount of stimulation to the economy is going to cause a significant number of people to build new houses with record numbers of vacant houses in foreclosure? Trying to preserve jobs across the board is a horribly losing proposition. Ideally, while some industries contract, others would expand. But expansion requires capital which government policies are deliberately constricting.

People are fond of pointing to Carnegie Libraries and other landmarks of the New Deal as beautiful additions to our cities. And they are. But when 25% of the people in the US were unemployed, wouldn't it have been better to build a factory or other workplace to employ people? Sure, people were employed while the building was being built. But very few actually worked there afterwards and none of them produced anything that the economy could use. It was a one-time shot in the arm that left behind a beautiful building. What was needed was an ugly factory that produced jobs that would employ people for the duration of the depression. Too bad economic policy made it so difficult for businesses to expand. Money that is spent to create jobs has a far greater multiplier effect than does simple government expenditure. At a time when money is tight and credit hard to come by, it is far more important than usual for government policy to maximize each dollar spent -- and this means we need to see to it that the money goes where the multiplier effect is greatest.

When one looks at the contents of the stimulus packages one is struck by how inappropriate they are for the situation we are in. Unemployment is shooting up, jobs are needed. But the the main stimulus is to build transportation infrastructure, improve education and increase medical coverage. All of these things are nice, but think about it. There is less traffic on the roads with so many out of work, there is less rail traffic, airlines are in trouble due to a lack of customers. Is this really the time when we need transportation infrastructure? Improvements to education are way, way overdue. Most of our education system is a disaster. But improvements in education today won't manifest themselves in the economy for a generation. Do we really want to wait that long for the "stimulus" to kick in? Improvements to medical coverage may or may not be the purview of government, but is this the time when we want to undertake a major shift in policy? As with the New Deal these are one-time stimulations. The teachers, transportation builders and medical providers certainly receive the benefit of the stimulus and they will spend money in the economy. But that's just a multiplier of one. Spend the same amount of money on a job in the private sector and not only does the employee have the one-time stimulation to the economy, but the products the worker produces can be sold in the economy, which provides jobs to distribution, transportation and retail people as the product is eventually sold. The company the worker is employed by makes a profit on the labor of the worker, which can be used to create even more jobs. The multiplier effect from this kind of employment is much greater than one. At a time when we are simultaneously short of jobs and money, a large multiplier effect is what is needed.

In the current rounds of G-20 meetings in London, Germany and much of Europe have a far better handle on the way out of this quagmire than does the US or UK. Germany has bailed out her banks, but is resisting any large-scale rescue package. It is a shame that Europe, whose economic growth has lagged the US for the past 50 years precisely because their governments controlled larger portions of the economy than did US governments (federal, state and local), has finally learned from us, just as we forget why our economy has grown so successfully for so long.

April 2, 2009