From the WSJ Opinion Archives
THINKING THINGS OVER
Does Spending Stimulate? Do Deficits?
No. But tax cuts do.
Happily the economy seems to be recovering without any help from fiscal policy, because the ongoing debate over a "stimulus bill" reflects utter confusion about what in fact boosts the economy. Some worthies assume deficits stimulate, as they learned in Econ 101, vintage 1950. Other serious-looking people tell us the opposite, that stimulus comes from surpluses to pay down the national debt.
One of these answers has to be wrong. Hint: It could also be all the above. Indeed, it's worth reviewing the bidding. For one thing, the vigor of the incipient upturn remains in doubt, and stimulus would still be appropriate. For a second, if the Fed has to manage the economy with the single instrument of monetary policy (which has theoretical and practical problems of its own), it's more likely to overdo tightening and easing, setting off a boom-and-bust cycle like the one we've seen these past three years. For a third, faster growth is always better, if we could figure out how to achieve it.
By the 1960s, the monetarist school of economics had revived, and asked, where does the government get this money it "injects." If it's created by the Fed, you're talking about monetary policy, not fiscal policy. If it isn't, you have to siphon whatever you "inject" out of the private sector by taxing or borrowing. How does it stimulate to take with one hand and give with the other?
Even sophisticated economic commentators seem to have forgotten this question. Castigating our tax-cut editorials as "dumbed-down economics," a Fortune writer says: "After all, if the government gives $50 billion to poor people in a year when the GDP is $10 trillion, that will increase GDP by 0.5%, which might seem reasonable if there's a chance that GDP growth would otherwise be, say, zero."
Well, no. Transfer payments are not included in gross domestic product--for the excellent reason that GDP is the retail value of goods and services the economy produces, and the handouts to the poor do not directly produce anything. They do create a cash flow that the poor would presumably use to buy something someone produces, but this cash flow is precisely offset by other transfers. If the government gives $50 billion to the poor when it's running a surplus, it would pay $50 billion less to retire debt. So the poor would receive $50 billion more and bondholders $50 billion less; this is stimulus?
You probably can still find Keynesians who would argue that the poor have a higher "marginal propensity to consume" than bondholders, and would spend their money faster, boosting "aggregate demand" and GDP. At best this looks like a small effect, not a big stimulus. And there is quite a bit of evidence for Milton Friedman's "permanent income hypothesis," that both the poor and the bondholders would use temporary windfalls for savings or debt reduction. There are empirical studies to show that this is what happened to last year's rebates.
In any event, if you receive some money, how do you avoid spending it? No one, at least in the U.S., any longer stashes dollar bills in a mattress. If you put the money in a savings account, you have just spent it to buy a financial claim. The bank will proceed to lend it to someone who will use it to buy goods and services, building a house or office building for example. The effect of this money on GDP or economic growth can be only trivially different because you put it in the hands of a financial intermediary instead of spending it directly.
In defense of John Maynard Keynes, his "General Theory" was published in the midst of the Great Depression. The world economy had broken down, challenging the belief of classical economists that a self-regulating economy would generate full employment. Financial intermediation was crippled, and it was plausible to conceive of a pool of unused savings that might be tapped to boost aggregate demand. Even F. A. Hayek, Keynes's historical antagonist, avowed that during the Depression his insights were badly needed.
Hayek observed at the time that Keynes was cavalier about the inflationary impact of his theories; when he wrote the price of gold was where Sir Isaac Newton had fixed it a century and a half earlier. As disciples elaborated the Keynesian religion, they arrived at the Phillips Curve, which held that the solution to unemployment was a little more inflation and the solution to inflation a little more unemployment. On these grounds, the intellectual challenge to the Keynesian consensus was soon followed by the practical challenge of the 1970s.
As classical economics was unable to explain the Depression of the 1930s, Keynesian economics was unable to explain "stagflation" of the 1970s. It had neither explanation nor answer for the simultaneous appearance of both inflation and faltering growth. Pump-priming deficits to stimulate real growth would only aggravate inflation.
The stage was set for a new view of "stimulus," which arrived with Ronald Reagan. He countered stagflation with tax cuts to boost incentives for growth, combined with tight money to constrain inflation. To the surprise of most economists, this policy mix stimulated an economic boom that started in 1983 and lasted, except for a nine-month credit-crunch recession in 1990, until the expansion peak in March 2001.
Yet the political culture seems to have forgotten what it learned. Today we have rote invocations of a single-entry Keynesianism long since intellectually and practically obsolete. Or we have the bizarre notion, to be addressed in a future column, that Keynes had it exactly backwards, that deficits don't stimulate, surpluses do.
Mr. Bartley is editor of The Wall Street Journal. His column appears Mondays in the Journal and on OpinionJournal.com.
