Sunday, January 27, 2008

Stimulus Stupidity

With economic troubles unfolding, politicians in Washington are scrambling to "do something". They sense a compelling need for economic "stimulus". Just like the last time the economy had a downturn eight years ago, Keynesian nonsense is being promoted.

Democrats want increased unemployment compensation. Whatever the merits of such a policy, it won't stimulate the economy. Paying people not to work will tend to cause them to not work.

Then there are targeted tax rebates, where government sends checks to folks to spend, spend, spend. That'll stimulate the economy for sure!

This myth was covered in an article on economic growth last year. It is excerpted below. The best thing that government can do to stimulate the economy is to cut spending, regulation, and taxes, in that order.


One of the myths of Keynesian economics is that spending is what improves the economy. One version of this argument promotes government spending. It states that government spending pumps more money into the economy. This creates jobs, and people have more money to spend and improve their lives. They spend their money and the cycle repeats, improving the whole economy.

This argument is a variation of the classic economic fallacy called the "broken window fallacy." In brief, the broken window fallacy states that breaking a window improves the economy because money must be spent to fix it and this benefits the window-maker and others. The problem with this argument is that it ignores the cost of fixing the window. That is, the money used to fix the window could have spent on something else that would have created the same overall benefit for the economy. Breaking the window does not make the economy better off than not breaking the window, and it destroys a window in the process.

The problem with the argument that government spending improves the economy is that it also has a cost. Government can only get money by taking it away from other people. Those people would have spent the money in other ways. Thus government spending provides no net economic benefit.

Another version of the argument that spending improves the economy is that private spending improves the economy. Sometimes this argument comes with appeals to spend more. Other times, this argument is used to support "targeted tax cuts" or "tax rebates," which are one-time cuts in tax rates, sometimes retroactively.

Private spending is certainly better for satisfying people's desires than government spending, since people know their own situations better. But it will not provide a net economic benefit since government is just as capable of spending money.

Increasing spending may improve the economy in the short run, but it must correspondingly depress the economy in the long run, since money that is spent now cannot be spent later.

The real alternative is between spending and saving. Money that is saved can be invested. People can buy stocks directly or through mutual funds. Money that is saved in a bank is invested by the bank, which is how they can afford to pay interest on savings. Individual retirement accounts and pension plans both invest money that has been saved. Insurance companies do the same with money that is paid by policyholders.

Investment is the only real way to increase production and grow the economy. Increasing spending must decrease saving, and hence damage economic growth in the long run.

What about government investments? Government investments do not perform well because government does not face the same incentives as private individuals and companies. Government can fund itself by taking money by force. It does not have the same incentive to use money wisely as do private investors, who will suffer losses from making bad choices. Government has a tendency to continue to pump money into obviously insolvent investments rather than admit that it made a mistake and suffer embarrassment. Investment decisions are often made for political reasons rather than to maximize profit.

These days, it has become fashionable for politicians to talk about "investment," when what they are advocating is simply spending.

Government policies damage economic growth. Taxation necessarily reduces the incentive to make money, which reduces efforts to produce more goods and services. Penalizing profit reduces the value of investments that increase production and improve people's lives. Capital gains taxes are particularly destructive since they specifically penalize investment. Government policies that threaten property rights increase the risk associated with investments and hence discourage them.

The best thing that government can do to improve the economy is to stop hurting it.

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