The Futility of Stimulus

Fiscal stimulus, or government spending, dominates the discussion, despite its even more complex problems of timing, knowledge, coordination with monetary policy and risk of adding to the debt burden.

Markets went into a tailspin recently when Federal Reserve Chairman Ben S. Bernanke’s hinted that the central bank might end monetary stimulus. That alone should be evidence of the dangers of intervention by the Fed that continues for years. Monetary stimulus, or manipulation of the money supply, rarely comes alone. It tends to be the junior partner in the futile dance of “doing something” that policymakers undertake in the face of falling economic growth and rising unemployment.

Fiscal stimulus, or government spending, dominates the discussion, despite its even more complex problems of timing, knowledge, coordination with monetary policy and risk of adding to the debt burden.

The history of the United States since the end of World War II with respect to stimulus can be characterized, charitably, as a triumph of hope over experience, or, less kindly, as a doomed repetition of history owing to the failure to learn from it. The most recent and ambitious example was the American Reinvestment and Recovery Act, as the economy went into meltdown with the subprime crisis. It was a far cry from the modest attempt by President Eisenhower to cope with the slowdown in 1953, which largely relied on automatic stabilizers inherent in a progressive tax system and tax cuts. Spending increased, as stimulus-spending advocate John Maynard Keynes himself would have recommended.

The idea behind the stimulus is that the federal government borrows and spends, and the people who receive the money also spend it, triggering a multiplying effect of the original spending. The same effect can be accomplished by a tax cut, which leaves more income with consumers, who spend and trigger the multiplier — but without the public-debt aspect of government spending.

As early as 1957, as Antony Davies and Bruce Yandle detail in a Mercatus Center study, the tides were already shifting in favor increasing spending as a way to stimulate the economy out of the doldrums. By the Kennedy administration, the Economic Report of the President was expressing what has turned out to be misplaced optimism about the ability to fine-tune the economy. The report acknowledged the difficulty in recognizing economic trouble, and just as problematic, the danger of overheating the economy owing to the lag time between stimulus implementation and result. Given policymakers with imperfect knowledge and restrictions on their power to act, hitting on the right combination of policies at the right moment was largely a matter of luck. Nonetheless, recession coupled with inflation led President Nixon into a disastrous experiment with a combination of fiscal stimulus, and wage-and-price controls in 1971, a policy course maintained by President Ford, even while he acknowledged the impossibility of fine-tuning. The hodgepodge of activist policy continued under President Carter, with no better results.

Despite this history of failure, rather than letting the market correct itself when the subprime crisis hit, Washington again launched into a grandiose experiment with fiscal and monetary stimulus. The American Reinvestment and Recovery Act included a smorgasbord of Keynesian options: $357 billion for federal spending, $144 billion to states mostly for Medicaid and education, $288 billion for tax incentives with some modest tax credits directly to households. The act was accompanied by vast injections of liquidity into the system by the Fed in a series of “quantitative easing” programs. The goal was to prevent the unemployment rate from rising above 8 percent. Instead, unemployment hit 10 percent in October 2009, and stayed above 9 percent for more than two years. Economic growth has remained sluggish, barely reaching 1.8 percent in the first quarter of 2012.

The fiscal stimulus failed to stimulate the economy. According to Stanford University’s John Taylor, individuals and families generally saved the tax rebates they received; therefore, the stimulus did not give the expected bump in consumption. State governments similarly simply substituted federal funds for the monies they would have otherwise used and did not increase overall spending. The federal government found very few shovel-ready projects. Unsurprisingly, the economy showed little reaction to the hundreds of billions of dollars poured in from the stimulus.

It did, however, increase the public-debt level significantly. Valerie Ramey estimates that multipliers have generally been on the low end — a factor of 0.6 in the short run and 1.2 in the long run — not a great deal. Other studies find negative multipliers; that is, in the long run, the aggregate spending increase was less than the stimulus — a poor result.

The aggressive quantitative easing, which has kept interest rates low, has failed to spark investment but has punished savers. It has also increased uncertainty in the system as investors dither while waiting for the Fed’s next move rather than make decisions based on market fundamentals.

Stimulus, both fiscal and monetary, is an empty promise. It is past time to accept that reality.