Time to prime the pump? Democrats sure think so. "There was an overwhelming consensus that the time has come to stimulate the economy" is what Barney Frank, chair of the House Financial Services Committee, told Bloomberg News yesterday. This stimulus would presumably be done through targeted tax cuts, tax rebates, or increased government spending. All temporary measures to give the economy a quick boost. All quaint throwbacks to old-fashioned, Keynesian, demand-side, "put money in people's pockets" thinking. And all unlikely to give the politicians the "bang for the buck" they might hope for. Here's the deal:
1) Back in 1957, Milton Friedman proposed something called the "permanent-income hypothesis," which said that people spend money based on what they consider their normal level of income and what they expect to earn over the long term. Short-term fluctuations in income, whether for better or worse, are smoothed out by more debt or less spending if consumers perceive the fluctuation as temporary. People adjust slowly to changes in income—just as the economy adjusts slowly to changes in Federal Reserve interest rate policy—which makes it tough for the government to fine-tune the economy. Short-term moves simply don't have the oomph policymakers expect, especially when the slow movement of legislation puts them out of step with the actual business cycle.
2) Look at recent history. Whatever the long-term benefits of the 2001 Bush tax cuts—particularly the cuts in marginal tax rates—they didn't do too well as short-term fiscal stimulus. The economy only slowly perked up as job growth remained weak. There was too little in the package that encouraged work, savings, and investment—stuff critical to long-term economic growth. As Brian Riedl of the Heritage Foundation notes, Washington borrowed billions of dollars and then mailed that money to families in the form of $600 rebate checks. That transfer of existing income had a predictable effect: Consumer spending increased a bit, and investment spending decreased by a corresponding amount. "No new wealth was created," he concludes. The 2003 tax cuts, on the other hand, lowered rates on investing income, and the economy responded vigorously with higher growth, more jobs, and rising incomes.
3) For more examples of the failure of fiscal stimulus to be fiscally stimulative, check out Japan, which during its two-decade economic funk trotted one multibillion stimulus spending package after another to little effect. A less recent example is the United States in the 1970s. All Uncle Sam's pump priming got us was stagflation caused by government spending and tax fiddling that did nothing to increase productivity—and plenty to increase inflation.
Rather than temporary gimmicky, a better path might be to revamp the tax system so that it would be full of incentives to spur business investment and create more productive workers. That is the sort of thing that increases a nation's growth potential.