Has a Stimulus Ever Been Necessary?

One cannot watch the news these days without being reminded of two things: The economy is in recession and Barack Obama will soon be President. One cannot listen to the latter without hearing that he will do everything he can to save us from the former.

Can he, however, actually do this?

Commentators and various politicians believe he can. At least they believe the government, which he will soon lead, has the power to do so. The Federal Reserve has preempted the president-elect with an expansionary monetary policy via artificially low interest rates and the purchasing of private assets. Obama and his supporters contend that they can do more to spur economic growth. They claim that spending as much money as possible will return the economy to prosperity.

Not surprisingly, Congressional leaders, the media, and even a large swath of the American public are encouraging this course of action. Congressional Democrats hope to have a “stimulus package” prepared for Obama to sign as soon as he is inaugurated. Supporters of this fiscal stimulus contend that it will create jobs and encourage consumers to start spending money.

At first blush, it seems that both the government's fiscal and monetary remedies are counterproductive. Pumping more money into the economy will just reduce the value of money and lead to price inflation. Spending money on government projects is just shifting money from one type of spending to another. Government economists and most media commentators, however, would respond that these objections are naïve.

Prior to the Great Depression and the publication of John Maynard Keynes' General Theory, most economically knowledgeable people would have agreed that government intervention is unhelpful if not detrimental. Today, we ostensibly know better: Government intervention is imperative to prevent economic downturns from turning into economic calamities. Therefore, the Federal Reserve must inject liquidity into the economy, and the government must actively combat unemployment and prop up spending.

The theory that underlies this policy approach holds that economic downturns are the result of too little spending where overall (or aggregate) demand for goods and services sharply declines. The government can restore aggregate demand by running budget deficits (via increased spending and/or lower taxes) and printing more money. This understanding of economic downturns is too simplistic for and not universally accepted by most (if not all) economists, but it has generally been adopted by mainline politicians and the media.

Aside from noting their general understanding of this already oversimplified theory, the proponents of economic stimulus have failed to justify exactly why it is so dire for the government to intervene in this particular crisis. Even if the above theory is correct, why won't the economy correct itself? The commentators, et al. are apparently proposing that a stimulus package is a proven method for curing a recession. History proves them wrong.

America, like any capitalist nation, has gone through a number of boom and bust periods. The number of economic downturns the nation has actually experienced is not entirely clear. Different economists (and approaches to economics) have different criteria for evaluating the business cycle. (The National Bureau of Economic Research [NBER] keeps “official” count.) Regardless of the number of actual recessions, there is little evidence that any have been brought to an end by an economic stimulus package.

As mentioned, prior to the Great Depression, there was little support for the government to pursue counter-cyclical economic policy. The laissez-faire approach allowed the economy to return to prosperity by liquidating mal-investments, shifting employment to more productive sectors, and allowing the price level to drop. In the early 1920's, the nation experienced a severe contraction after the end of World War I. There is evidence that some in the government wanted to adopt a more interventionist approach to the downturn, but the economy recovered (as it had in the past) without any form of economic stimulus.

At the close of the decade, the economy faced another economic contraction, but this time, the government did intervene. Both Presidents Hoover and Roosevelt pursued greater government control of the economy. Most notably, President Roosevelt ran deficits to fund a number of public works projects as part of his “New Deal.” Neither FDR's domestic spending nor the later war brought America out of economic stagnation.

Proponents of the New Deal disagree. They point to the economic expansion that took place from 1933 to 1937, but this “expansion” was illusory. While unemployment declined and government statistics indicate that an expansion did take place, they hardly demonstrate that a genuine recovery took place. For one thing, unemployment remained in the double digits throughout the “expansion.” Moreover true economic recovery and growth is associated with an increase in private business activity – people return back to (mostly) private sector jobs, businesses start growing again, consumers return to their usual spending habits, etc. This was not the case in the 1930's.

The “expansion” was illusory because it was not a return to normal business activity. It merely reflected a growth in government spending. GDP takes into account government spending, and the increase in employment was primarily the result of government-created jobs. The New Deal did not stimulate actual economic growth.

Even this pseudo-recovery did not last for long as the economy fell back into a depression in 1937. New Deal advocates insist that this was the fault of reduced government spending. In part, they are correct because so much of the “expansion” was merely a reflection of government expenditures. The decline in government spending, however, did not retard private commercial growth which, had never really recovered in the first place. Even if this was a true recovery, Keynesian theory calls for budget reductions during a period of expansion. Moreover, if five years of government spending truly resulted in economic recovery (as the New Dealers claim), it seems far-fetched to believe that a slight retreat in the growth of the government would plunge the economy back into a severe depression.

On the eve of the Second World War, the economic situation was as gloomy as it had been when FDR took office. Many historians and academics, who may doubt the effectiveness of the New Deal, hold that it was actually the War that lifted the nation out of the Depression. This is also incorrect.

Like the New Deal, US wartime production also created the illusion of prosperity. Movie reels from the period depict shipyards and munitions factories teeming with workers eager to produce weapons of war for the Cause while young men donned uniforms and headed overseas to fight the Axis threat. These images may appear to illustrate an economy on the mend, but what they fail to display are the rationing, shortages, and general dearth of consumer products during this period. The increased employment was merely being directed towards serving the needs of the state. Once again, this was not the true economic recovery of the private sector that follows most recessions.

As the war came to an end, the need for government spending declined. As economist Robert Higgs observed, government spending fell from $98.4 billion in 1945 to $33 billion in 1948. The government also abandoned a number of New Deal policies in the post-War years. Despite this “anti-stimulus,” the economy did not fall back into a severe depression and instead finally returned to genuine prosperity.

The middle part of the century also provides little evidence that economic stimulus is necessary to pull the nation out of a recession. Despite two recessions in the 1950's, the government did not propose the active fiscal policy that had been pursued in the 1930's or that is being proposed today. The government, in fact, even reduced expenditures during the 1957 recession. In both cases, the economy recovered.

The 1960's was a period of fairly consistent growth. Keynesians may attribute this to the significant tax cuts and increased spending during the decade. Tax rate reductions, however, not only have the effect of encouraging spending, they also remove disincentives to production and investment. Regardless, the policies of the 1960's were not employed as countercyclical measure to lift the economy out of recession.

By the 1970's, the nation was again facing serious economic challenges. Inflation had become a serious concern. Despite the loose monetary policy and significant government spending throughout the decade, the economy faced a recession in the middle of the 70's and general economic weakness throughout the rest of the decade – particularly with high interest rates and inflation.

In the early 1980's, the Federal Reserve sought to combat inflation with a more restrictive monetary policy. This plunged the economy into the most severe recession since the Great Depression. The economy, however, recovered without a stimulus package.

Advocates of economic stimulus may argue that despite its professed pro-market orientation, the Reagan administration actually did pursue an active countercyclical economic policy. The administration did, in fact, push through significant tax cuts while doing little to restrain spending, which led to larger budget deficits.

This analysis, however, ignores a number of points. For one thing, the Reagan administration's fiscal policy coincided with a restrictive monetary policy. Keynesian economists at the time likened this to stepping on the gas and the breaks at the same time. Furthermore, Keynesians were also fairly critical of the tax cuts because upper income people (who benefit the most from income tax reductions) are less likely to spend their tax savings than lower income individuals. Moreover, many politicians and others (much like today) urged President Reagan to pursue a stimulus package of public works and public “investment” to combat the recession. The President rejected these pleas.

If Reagan was an accidental Keynesian, his successors were incidental anti-Keynesians. In the early 1990's, the economy fell into a minor recession. It is true that the recession coincided with a tighter monetary policy, a tax hike, and even a slight retreat in military spending as the Cold War came to an end.

The Clinton administration, however, did not respond with an expansionary economic policy. The new administration raised taxes, further curtailed military spending, and sought to remedy the large deficits it had inherited. It is true that President Clinton pursued an economic stimulus package and a proposal for government-managed health care, but both initiatives were defeated by the Congress. Clearly, this tightfisted (at least by today's pessimistic standards) approach to fiscal policy did not impede recovery.

Soon after the (now outgoing) Bush administration took office, the nation faced yet another recession. The current administration did take a more active role during the downturn than some of its predecessors. It cut tax rates, issued rebate checks, and extended unemployment benefits. Nonetheless, none of these measures resembled the type of spending advocated by the incoming administration for dealing with the current recession.

Today, of course, we hear little but cries for economic stimulus in order to prevent the next Great Depression. Not only is the President-Elect ignoring the economic history of the United States, he's also ignoring the reigning policy of the past few years. The government has essentially run consistent deficits ever since President Bush took office. The current administration has executed two wars, created a homeland security cartel, and has been responsible for a slew of new domestic spending initiatives. It has done all this while the central bank has continued to ease its monetary policy. It is difficult to contend that the government has not done enough to prop up artificial demand.

The fallacy behind the call for economic stimulus is that declining aggregate demand is the mother and not the daughter of economic contraction. When left to its own devices, the market will return back to prosperity (consumer demand and all). Government intervention oftentimes has the effect of actually prolonging the crisis. The new administration would be wise to let the market adjust on its own and spare us the additional debt and debased currency that an active fiscal and monetary policy will yield.

January 15, 2009