WV Executive

IN RECENT MONTHS the nation has suffered from an acute economic slump. As events began to unfold, the Bush Administration pushed through massive bailouts in an attempt to bolster the collapsing financial sector. However, markets did not react positively. As the crisis continues to spread under President Obama’s direction, the federal government seems poised to increase its efforts to prevent further woes to an ailing economy. The “American Recovery and Reinvestment Act,” a roughly $800 billion behemoth, has become the answer hoped to address the dire situation facing the nation. Unfortunately, based on simple economic and historical evidence, this bailout will in all likelihood fail to stimulate a recovery.

In 1936, the late economist John Maynard Keynes published “The General Theory of Employment, Interest and Money,” which revolutionized economic thought for years. Keynes introduced the notion that governments should play a much more proactive role during recessions. He argued that the best way for an economy to recover would be for a central government to increase spending, reduce taxation or create some combination of the two. Essentially, the government should “prime the pump” in order to return economic activity to normal by issuing debt.

Although this appears to be what Washington is currently undertaking, there are serious flaws associated with such logic. Examples can be found in both the American Great Depression, when prior to World War II average unemployment rates never dipped below 15 percent, and the more recent Japanese experience when that country faced negative or stagnant growth for nearly a decade. Though the causes were different in each case, the prescribed solution was increased government spending, which in the end did not help alleviate the situation in either historical case.

More recently, economists have seriously challenged the validity of the Keynesian idea, particularly because his models were unable to explain the period of stagflation (simultaneous inflation and unemployment) during the 1970s. Modern economic theory, to the extent that there is an emerging consensus, suggests that Keynesian fiscal policy is relatively impotent. The key to our modern understanding comes from the simple recognition, which Keynes ignored, that the money the government spends actually comes from somewhere, and thus the benefit of fiscal spending is completely offset by the lost private spending elsewhere in the economy when money is transferred to the government.

Unfortunately, it appears that politicians today neither pay attention to history nor follow sound economic logic. Modern economic theory suggests that this “stimulus” package will do little more than transfer and redirect spending with no change in overall economic activity, further distorting an already reeling economy and bringing little actual recovery.

Most glaring about the bill is its overall size. In order to raise the revenue necessary to fund such massive expenditures there are essentially two options: increasing taxes or the federal debt. Currently it appears the government will simply increase the national debt. However, in order to eventually pay this debt off the government must either increase future taxes or print money. So as to avoid the former, the Federal Reserve has recently indicated that it will likely begin buying long-term government debt. This is known as debt monetization, whereby the central bank prints money to buy debt and then injects the new funds into the economy. From an accounting standpoint this device is rather nice, as it wipes liabilities from balance sheets; however, it has the perverse effect of increasing overall prices on goods and services. Left unchecked, such action can spiral into rampant inflation, thereby suffocating economic activity.

Furthermore, by entering the loanable funds market in order to borrow, the government will effectively crowd out private investment. Given the current depressed state of the financial system, driving away those few entrepreneurs, individuals and firms who still wish to undertake productive projects by borrowing will more than likely further reduce growth. In other words, crowding out productive activity in order to finance a skyrocketing debt will mean that capital investment and employment in the private sector will be even harder to come by.

While most people could easily see that if the bailout was financed through taxes there would be no change in total spending in the economy (e.g., taking $5 from Mary in taxes, then having the government spend it, means she spends $5 less, so no net impact), this isn’t as easy to see for debt financing, but it’s equally true. In essence, the government will issue more savings and treasury bonds to finance the new debt, meaning that this Christmas more kids will get savings bonds from Grandma rather than sweaters. The money private individuals use to buy these bonds, just like the money used to pay taxes, also results in less current private spending.

The stimulus package will also lead to lobbying by groups who have vested interests in the associated projects and bailouts and those looking for a free handout. However, lobbying leads to a complete net loss to society. Such activity does nothing to create value. Rather, it places money which could have been used for job creation in the hands of politicians. To highlight this point, many of the financial firms which received Troubled Assets Relief Program money are now expending portions of that bailout toward lobbying for further federal aid.

Another key component to the bill is the tax refund to individuals and families. As it currently stands, the majority of individual taxpayers will receive a $500 refund and families will receive $1,000. These refunds are similar to those issued under the Bush Administration, which evidence shows clearly had no impact on the overall economy. Given this, best would be a reduction in overall marginal tax rates, which would then create long-term incentives for individuals to undertake productive behavior and at the same time free up much needed capital for firms to invest in production and employment. Such examples are found in both the Kennedy and Reagan tax cuts, which helped to substantially increase economic activity after years of stagnation.

Obviously the nation is facing an economic crisis the likes of which have not been seen in years. At this point many seem to believe that Washington should do something, even anything. Although it would appear that the federal government is responding, it is doing so in a fashion that has been tested and tried before. Economic downturns are not corrected through government intervention and fiscal injections. This does little, if anything, to combat the actual problem. Therefore, the government should avoid direct involvement, reduce marginal individual and corporate tax rates, stem spending and allow the market process to correct itself. If done, this crisis, like all others, will dissipate and economic activity and growth will return.