Monday, February 2, 2009

Primer on why government stimulus plans don't work

Eugene Fama, an eminent economist at the University of Chicago, does a great job of boiling down the whole debate about government bailout and stimulus plans to three simple points:
1) Bailouts and stimulus plans must be financed.

2) If the financing takes the form of additional government debt, the added debt displaces other uses of the same funds.

3) Thus, stimulus plans only enhance incomes when they move resources from less productive to more productive uses.
Since very little of the spending contained in the stimulus plan currently under consideration in the Senate is likely to result in projects that make more productive use of the money spent than if that money were put to use by the private sector, it makes sense to say that the stimulus plan won't be very stimulative, if at all. While there may be projects contemplated by the plan that turn out to increase the economy's efficiency and productivity (e.g., new and cheaper sources of energy, new infrastructure), those gains are likely to be negated many times over by waste, fraud, and the inefficiencies that are notoriously present in every government undertaking. Not to mention the fact that the plan involves hundreds of billions of transfer payments that simply take money from one segment of the economy (generally from those producing the cash flows necessary to fund the transfer) and give it to another segment of the economy (generally to those deemed by politicians to be lacking the cash flows they should otherwise be enjoying).

John Cochrane, another eminent economist, has written an excellent (but rather long) explanation of the logical fallacies behind all stimulus plans.

The argument against the stimulus bill is founded on a bedrock of logic. As it stands today, the stimulus bill is nothing but a gigantic waste of the economy's resources, and thus is likely to do more harm than good. More and more distinguished economists are making this point, and public support for the plan can only decline from here.


Jon S. said...

Good links, Scott, and of course great points in your post. The Republican leadership on the Hill has to do more than simply oppose or vote against this monstrosity. The House voted nay, but Boehner as is his way did it rather quietly. If there's one thing I hope we've all learned from the Bush years, you can't just do something, you've got to explain, persuade, cajole and ridicule the other side's arguments if necessary -- daily!

So, McConnell now has an opportunity. Senate rules (I worked there for 10 years) are much looser than House rules, which has always been run in modern times like the Central Committee of an old Communist Party -- no matter who's in charge, by the way.

There are numerous ways to stop or delay this bill, using the wonderful arcana of Senate rules. If McConnell and Co. take their time, delay endlessly, and use the pulpit that the media will surely give them (believing in their inimitable wisdom that Repubs are digging their own graves by not letting out-of-work investment bankers dig ditches), this plan can be stopped or at least seriously overhauled. McConnell needs to loudly and in simple terms proclaim the massive problems in this stimulus plan and really all stimulus plans -- and then he would earn his pay. And he will have established from the get-go that the minority party will not be pushed around.

And for those who think it can't be done, Jesse Helms often stopped all manner of legislation, appointments, etc, through Senate rules, and not just the filibuster. Show some will and act, Mitch!

Scott Grannis said...

Jon, those are very encouraging words!

Mark A. Sadowski said...

Both Eugene Fama and John Cochrane are asserting that savings are automatically equal to investment spending, and that any government borrowing must come at the expense of investment. This is one of the most basic fallacies in economics, interpreting an accounting identity as a behavioral relationship. Of course, savings have to equal investment, but it’s because any difference between savings and investment causes something to happen to the economy that causes them to be equal. If, for example, interest rates are fixed then GDP changes to make savings and investment equal. An increase in government spending doesn’t reduce investment one for one, it increases GDP, which leads to higher savings and taxes.In short it's a fallacy to argue that the savings-investment identity proves anything about the effectiveness of fiscal policy. This actually is one aspect of what I pointed out on another of your posts about "freshwater" economists. The knowledge that savings equals investment doesn’t imply the "Treasury View" seems to have been forgotten by some otherwise intelligent economists.

Scott Grannis said...

Mark: You apparently assume that "an increase in government spending ... increases GDP, which leads to higher savings and taxes." That is equivalent to saying that the spending multiplier is always positive. I'm not so sure. If it were, we could have the government spend us to prosperity. I think there is a strong logical case for the spending multiplier to be zero or less.

Mark A. Sadowski said...

A dollar spent is a dollar spent. Why would it be less? On the other hand one could easily make the case that, due to the multiplier effect, it would be more.

Scott Grannis said...

A dollar spent on "stimulus" by the government is one dollar less that the private sector has to spend. Spending doesn't create money out of thin air, the funds have to be borrowed from someone.

Mark A. Sadowski said...

I noticed you mentioned the CBO report on the macroeconomic effects of the Senate stimulus bill on a subsequent post. As I pointed out there, they say there will be absolutely no crowding out effect in the short term, contradicting the pre-Depression Treasury View. They further say that although there is a crowding out effect in the long term, they imply that it can be mitigated by more spending on infrastructure and education and more tax incentives for investment.