With recession concerns mounting, politicians and pundits have started proposing programs to “stimulate” the economy. All of these plans involve some combination of additional short-term government spending and one-time transfer payments to people who would be expected to spend the additional money. But there is one small problem with these proposals: They are based on economic superstition.
Recessions are periods of falling gross domestic product. They are presumed to be caused by falling demand, and it is assumed that the stimulus measures being proposed will increase demand. In fact, they will do no such thing. Similar programs were tried in the U.S. in the 1930s, Japan in the 1990s, and again in the U.S. in 2001. They all failed. The belief that government spending and deficits stimulate demand is a superstition.
#ad#Superstitions have power because they form an unquestioned part of the way we look at the world. They’re drilled into our heads from early on and are influential because they seem so obviously true. The superstition at hand is cultivated in Economics 101, where students are taught that: demand = consumer spending + business investment + government spending + net exports.
From this equation, it seems obvious that if the government spends more, demand will rise. It is equally obvious that if the government transfers money from people who are inclined to save it to people who are eager to spend it, consumer spending will rise and demand will rise with it.
The problem, and it is a subtle one, is that the above equation describes what demand is numerically equal to, not what demand actually is.
At the concrete level, demand is someone saying, “You want $20 for that widget? I’ll take it.” When the transaction is completed, government statisticians add $20 to their running total for demand. Accordingly, what demand actually is is the transfer of money in transactions. As soon as a dollar is used to complete one transaction, it is available for another. The seller in one transaction becomes the buyer in another, part of an endless chain.
Government stimulus programs involve taking in money by selling bonds and then sending that money back out, either in the form of direct government spending or as transfer payments to individuals. All such programs can ever do is take money circulating in the economy and send it on a detour through Washington, D.C. There is no way that this can increase demand.
Of course, the mere absence of an expected result does not cause people to question their model of reality. That’s part of the nature of superstition. Medieval doctors believed that bleeding patients cured sickness. When a patient recovered, this was proof that the bleeding worked. If they died, it was assumed that their condition had been beyond help all along. The discussion among the doctors of the time was not the efficacy of bleeding, but rather the amount of bleeding necessary for a given patient and what kind of leech to use.
When economic stimulus programs fail to stimulate, the explanation is always some variation on “Well, the economy would have been even worse without our stimulus program.” This is usually followed by calls for new, larger stimulus programs. Then, as if guided by a conclave of medieval doctors, the discussion turns to which government-spending programs to enlarge and who should get the increased transfer payments.
Once demand is properly understood, the solution to the problem of insufficient demand becomes obvious. If more demand is needed, the answer is for the Federal Reserve to create more money. Creating more money involves expanding the size of the monetary base. Lowering the Fed’s target for the interest rate on federal funds will only work if it results in an increase in the size of the monetary base. In the 1990s, the Bank of Japan managed to lower its interest-rate target to zero without producing an increase in the yen monetary base sufficient to avoid a grinding deflation.
The “stimulus” superstition is buttressed by another economic myth, that of the “liquidity trap.” It is believed that certain economic conditions can render “monetary policy” impotent, leaving the Fed powerless to increase demand. Under these conditions, expanding the monetary base is said to be “like pushing on a string.” The explanation offered is that the Fed can only expand bank reserves, and if banks don’t lend out the newly created money, it has no effect on demand. Once the economy is in this “liquidity trap,” the only solution is for the government to borrow the money and spend it on stimulus programs.
This superstition is also exploded by looking at the process in concrete terms. The Fed creates money by buying government bonds. It is true that the newly created money appears in the form of bank reserves. However, it also is true that the Fed buys each bond from someone. That someone formerly owned a bond, and now they have money. Having just been the seller in the transaction involving the bond, that person will be the buyer in some other transaction.
Thus, when the Fed creates a dollar, it sets off an endless chain of transactions involving, and powered by, that dollar. If the transaction rate in the economy is insufficient to provide adequate demand, the Fed just needs to buy more bonds and create more dollars. Obviously, if the banks use the newly created reserves to expand lending, the process will be accelerated. The whole point of fractional-reserve banking is to increase the transaction rate that can be supported by a given amount of monetary base. But even if the banks make no use of the new reserves, the Fed always can get the level of demand it wants by brute force.
Recessions don’t just happen. They are caused by government mistakes. When recession looms, the answer isn’t superstition-based stimulus programs, but to correct the mistake. Economies need three things from government: incentives, money, and certainty. Right now, the main problem seems to be certainty. The solution is to make the 2003 tax cuts permanent and to stabilize the value of the dollar. If we do that, we can stop talking about stimulus programs.