Why Stimulus Doesn't Work
Over the past decade, America has engaged in a long experiment in economics. We have spent beyond our means in the hope of stimulating economic growth. Now, America is $15 trillion in debt, and economic recovery still appears almost as distant as in 2008. The bleeding may have stopped for the time being, but the patient shows no sign of recovery. How could this be?
The reason, very simply, is that, in reality, stimulus does not stimulate the economy. In the Keynesian view, however, stimulus spending accomplishes two tasks. By itself, the stimulus package constitutes demand, which boosts GDP, acting as a counter-cyclical force on the economy. As demand drops during recession, stimulus boosts demand which helps to stabilize the economy. The second function is that it stimulates additional demand by creating inflationary pressure. As consumers see the value of their savings drop, they decide to spend now rather than see the purchasing power of those same dollars disappear before their very eyes.
The idea is tempting. We spend, yet we become richer as the animal spirits are awakened and the economy grows. Unfortunately, Keynesianism has been a failure. After $4 trillion of additional debt since the 2008 crisis, unemployment (8.6% in November 2011) remains much worse than the depths of the last recession (6.3% in June 2003) and workers are leaving the market in droves. The stock market is back up, but the price of gold, silver and other commodities have also risen. We have more dollars in circulation, but our dollars don't go as far as they used to. The stock market is roughly where it was pre-recession in nominal dollars, but in real terms the Dow Jones is much lower.
The flaw in Keynesian thinking is not understanding how and why economies grow. Economies don't grow because demand grows. Economies grow because the supply of goods and services grows. In order to grow the supply of goods and services, producers must save and invest. Keynesian stimulus policies purposely punish saving, which makes the accumulation of capital and, ultimately, long term planning and investment more difficult.
The housing bubble is a good example of this. When Washington inflated the housing bubble (I never get tired of linking to that article), people were responding rationally to artificially low interest rates. They borrowed beyond their means, putting themselves in excessive debt. They bid up the price of hard goods, because real investment in productive ventures was less profitable. The accumulation of savings in order to purchase productive capital became a losing proposition as the value of the dollar was intentionally eroded. This left us, unsurprisingly, with even fewer jobs than before the 2002 recovery. In other words, net productive investment in the United States was effectively zero during the last bubble. All of the growth was demand side growth which dissipated once the bubble popped.
Imagine if, instead of houses, Americans had invested that money in small businesses. Imagine if we had instead invested in our manufacturing sector, or in training and employing a new generation of scientists to pioneer new technologies in bioengineering. Instead, valuable dollars were put into housing, gold and other unproductive assets. That is not to say that housing and gold are completely undesirable, but they constitute consumer spending. Americans don't need bigger houses right now, but we do need more businesses and jobs.
Another way to look at this is that inflation is a tax. It is a tax on savings. It is a tax on earnings. It is a tax on everything you buy at the grocery store. This tax is not applied evenly, though. Inflation is felt most in supposed "safe haven assets." As inflation hit our economy, the price of housing soared until Americans could no longer afford it, at which point the bubble burst. Subsequent efforts to reinflate the bubble have failed.
If inflation is a tax, what do we know about taxes? Taxes destroy wealth. Austrians eschew supply and demand charts, but such charts are useful in illustrating this. When you introduce a tax into a supply and demand chart, the result is a tax wedge. That is, the consumers get the goods. The producers get the money. The government takes its share, and a portion of wealth that would have existed otherwise simply evaporates. Taxes may be necessary, but they are not stimulative. Neither is inflation, which is why priming the pump never works. Demand-side economics encourages consumption at the cost of saving and investment, which diminishes the economy rather than expanding it.
On the other hand, supply side economics are truly pro-growth. Eisenhower's careful managing of the national debt helped to foster the postwar boom. The Reagan tax cuts and his strong dollar policy were effective, just as the Kennedy tax cuts and strong dollar policy lead to robust economic growth.The Bush tax cuts marked the inflection point after the Dot Com crash.
Not all tax cuts are created equal, however. The Obama tax cuts were not stimulative any more than the Bush stimulus checks were because the Obama tax cuts (the Making Work Pay tax credits) were given out in equal amounts to everyone. That is to say, your tax bill was $400 less for individuals and $800 less for famiilies regardless of whether you earned $50,000 or $100,000. This made the tax credits stealth stimulus checks, which, as we know, are merely a destructive tax on savings and investment.
If this were America's first flirtation with Keynesian, the shock of our leaders would be more comprehensible. However, this is our third major experiment with pump priming. The Great Depression lasted as long as it did because of Herbert Hoover's and FDR's desperate attempts to prop up collapsing markets, save failing banks, and keep all of the economic dead wood in place. LBJ's inflationary monetary policy led to more than a decade of stagflation. George W. Bush's and Barack Obama's economic policies should have been laughed out of polite society, yet their failed ideas represent the consensus of the Washington smart set.