Why Obama's Stimulus Blockbuster Could Flop

There is little evidence such a spending spree will actually work.

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Hollywood has nothing on Washington when it comes to shamelessly recycling stories and plot devices. Remember that big-budget turkey of the fall, "The Amazing Trillion-Dollar Bailout"? It was the story of how Uncle Sam persuaded American taxpayers (or at least Congress) that if they didn't fork over nearly a trillion dollars to rescue Wall Street, the U.S. economy would tumble into a job-destroying, wealth-eviscerating free fall. (Director Hank Paulson has produced several sequels to that one already.)

But the inside-the-beltway crowd is already cooking up an obvious knockoff of that one. Coming soon in January 2009: "The Wondrous Trillion-Dollar Stimulus." It's the thrilling tale of how the new American president and Congress persuade American taxpayers that if Uncle Sam doesn't borrow hundreds of billions of dollars for a massive spending spree, the U.S. economy will tumble into a job-destroying, wealth-eviscerating free fall. (I can already imagine the teaser trailer. Deep-Voice Narrator Guy: "In a world gone mad, where banks are imploding and automakers disintegrating, only One Man and his Wondrous Stimulus Plan can save America ...")

Maybe it will be an economic blockbuster. Certainly a lot of pretty smart guys think so. Among the proponents of borrowing and spending at least $500 billion to boost the struggling economy next year (with perhaps yet another round of stimulus in 2010): the economic team at Goldman Sachs, bond guru Bill Gross, economist Martin Feldstein, Nobel Prize economist Paul Krugman, and Lawrence Summers, Barack Obama's nominee to head the National Economic Council. As Gross has put it: "To provide a stable recovery path, government spending needs to fill the gap—not consumption. Public-works programs, badly needed infrastructure repairs, as well as spending on research and development projects should form the heart of our path to recovery. Assistance for homeowners? That too." So a little something for everyone.

The only question remaining, at least among many economists, politicians, and the media, is how exactly to divvy up that staggering pile of dough. But there's at least one other question that someone might want to toss out there: Will the pricey stimulus plan work? Oh, and here's another: Is there a better option we should be considering to boost the economy?

As to the first question, former Bush economist Greg Mankiw points to a couple of studies that raise serious doubts about the efficacy of stimulus packages. A 2005 study, "What Are the Effects of Fiscal Policy Shocks?," which looks at U.S. economy policy since 1955, concludes that a "deficit-financed tax cut is the best fiscal policy to stimulate the economy" and that "a deficit-spending shock weakly stimulates the economy. Government spending shocks crowd out both residential and nonresidential investment without causing interest rates to rise."

The results, the authors say, do not support "the textbook Keynesian model which predicts that consumption should rise following a government spending shock." And then there is a study coauthored by Olivier Blanchard, the current chief economist of the International Monetary Fund, that finds "both increases in taxes and increases in government spending have a strong negative effect on private investment spending."

As to the second question, I think the answer is, "Yes, there is better route back to prosperity." In fact, Obama's nominee to head the Council of Economic Advisers, Christine Romer, conducted research that found "tax increases appear to have a very large, sustained, and highly significant negative impact on output...[and] that tax cuts have very large and persistent positive output effects."

Indeed, there are all sorts of tax-cut ideas floating around Washington, though none seems to be on Obama's radar screen. John Makin at the American Enterprise Institute suggests "a sharp reduction in the payroll tax, which would boost household disposable income while giving firms an incentive to retain more workers on their payrolls." And Larry Kudlow reports that economist Robert Mundell favors "a complete corporate tax holiday for one year. He then favors corporate tax reform that would drop the current top rate from 35 percent to 15 or 20 percent."

Perhaps the key guidelines should be, as free-market economist John Taylor recommends, that any tax cut be permanent, broad, and easy to understand. For the moment, such ideas, to borrow another movie-industry phrase, seem "stuck in development." But if Obama wants to steal any of them, I don't think their authors will mind. They do that sort of thing in Hollywood all the time.