Politics & Policy

Mechanical Failure

From the July 19, 2010, issue of NR.

The Democrats are pushing for yet another stimulus package to revive our moribund economy. As of this writing, they have been unable to round up the requisite 60 votes to push the package through the Senate. President Obama has urged deficit-wary moderates to get on board, calling the bill “essential” to addressing the ongoing economic “emergency.” A handful of senators stand in his way, unopposed to the spending in principle but unwilling to vote for another bill that adds to this year’s $1.3 trillion deficit.

If the Democrats prevail, it will be the third time that Congress has extended provisions of the 2009 stimulus bill since its passage in February of last year. Counting the stimulus bill that President Bush signed into law in 2008, it will be the nation’s fifth round of fiscal stimulus since the first flickers of the subprime-mortgage conflagration began to appear at the edges of the economy. It will bring the total amount we have spent on such measures to $1.085 trillion — more than we have spent on the wars in Iraq and Afghanistan combined.

From 2008 to now, the composition of the stimulus bills has changed, from mostly tax rebates intended to boost consumer demand to mostly income transfers from the employed to the unemployed and from the federal government to the states. Though the stimulus machine’s architects would be loath to admit it, this transformation represents the failure of its stated purpose, which is to create jobs and to jump-start sustainable economic growth. The unemployment rate is stalled out at around 10 percent, and no growth model that relies on continued infusions of borrowed money is sustainable. The stimulus machine is designed to provide the illusion of growth in the absence of a solution to the jobs problem, and since no one in Washington seems to know how to solve that problem, it is going to be very difficult, as a matter of politics, to turn the machine off.

The mechanics of the machine are simple. Politicians feel an irresistible compulsion to “do something” about persistently high unemployment, yet they lack the will or the ability to do things that might actually work: so they give away money. Republicans are not exempt from the laws that govern this system: The Economic Stimulus Act of 2008 passed with the support of 169 House and 32 Senate Republicans and was signed by a Republican president. Granted, this was the least objectionable of the five stimulus bills. It consisted mostly of individual tax rebates and temporary enhancements to business-tax deductions, and was intended to provide a “booster shot” to the economy by encouraging spending and hiring.

But consumers and businesses tend to make spending and hiring decisions based on long-term income expectations, not short-term windfalls, as the late economist Milton Friedman explained. And as Friedman would have predicted, the 2008 stimulus had little effect on economic growth, and it certainly failed to prevent the economy from spiraling into a recession as large problems in the banking sector came to light. The best that can be said for the 2008 measure is that policymakers minimized the inefficient allocation of resources by giving the money to the private sector instead of spending it themselves. For the most part, that was not the case with the stimulus bills that followed.

Democrats in Congress started talking about a “second stimulus” as early as the summer of 2008, just a few months after the rebate checks from Stimulus I started rolling out the door. This time, however, they wanted the stimulus to be weighted toward government spending instead of tax rebates. In September, the House passed a $61 billion package consisting of infrastructure spending, expanded unemployment benefits, and aid to cash-strapped state governments, but opposition from Senate Repub­licans and the Bush White House doomed the bill’s chances. No matter, said Democratic congressman Barney Frank: “We’ll just wait until January.”

Frank’s assessment of the political landscape turned out to be correct, and the House-passed bill turned out to be a gaunt shadow of the gargantuan $787 billion American Recovery and Reinvestment Act of 2009. Dem­ocrats took the first bill, multiplied the spending by ten, and then added a number of extraneous provisions that rewarded Democratic constituencies and funded longstanding liberal priorities. Still, at its core, Stimulus II — which came to be known as just “the stimulus” — was premised on the same Keynesian ideology as Stimulus I: Deficit spending, whatever form it takes, increases “aggregate demand,” boosting economic activity.

Keynesian macroeconomics is not without its applications, but in the context of the ongoing financial crisis and employment slump, it is a harmful distraction from the real source of the problem, which is our weak and overleveraged housing sector. During the inflation of the housing bubble, millions of Americans took out mortgages that they could pay back only if housing prices continued to rise. Financial institutions bought a lot of these mortgages in the form of securities. The bursting of the housing bubble deflated the value of the securities, which weakened, sometimes fatally, the banks that provide credit in our economy.

The government could have dealt with the crisis by letting the weakest of these banks fail. UCLA economist Bradford Cornell explained how this would work in a paper published last year. Mortgage-backed securities would be marked down to their market values, bank debt and equity holders would take their losses, depositors would be protected by the FDIC, and the banks would be restructured and recapitalized by raising new debt and equity.

Alternatively, the government could have forced the banks to restructure their debts and recapitalize their balance sheets as a condition of taking bailout money. But it did neither. It bailed out the banks without requiring the recognition of losses or the necessary recapitalization. The resulting weakness in the banking sector is the primary contributor to the prolonged unemployment that has necessitated Stimulus III, Stimulus IV, and, if Senate Democrats can find the votes, Stimulus V.

The president’s economic team had predicted that Stimulus II would hold the unemployment rate at 8 percent. By October, with stimulus spending nearing its peak, the unemployment rate stood at 10.2 percent. The answer, according to Obama, was more stimulus. Stimulus III, a.k.a. the Worker, Homeownership, and Business Assistance Act of 2009, extended unemployment benefits for the nearly 5.6 million Americans who had been unemployed for at least 27 weeks. (According to Keynesian economists, extending unemployment benefits is an especially good form of stimulus, because the unemployed will almost certainly spend the money.)

Stimulus III also extended the Homebuyers Tax Credit, a program intended to prop up home prices and slow the deflation of mortgage-backed securities by providing new homebuyers with a tax credit in the neighborhood of $8,000. Like Cash for Clunkers, a stimulus program intended to boost car sales by providing a tax credit to people who swapped their old cars for new ones, the Homebuyers Tax Credit served nicely to illustrate the futility of stimulus spending. Both programs tended to encourage sales that would have happened eventually anyway. The expiration of the Homebuyers Tax Credit last May coincided with a severe drop-off in new and existing home sales, indicating that the credit had concentrated demand in earlier months at the expense of later ones.

This is how all deficit-financed government spending works: By definition, when we borrow, we spend tomorrow’s income today. Keynesian economists assume that, eventually, growth will return, and we will be able to pay the money back when times are good. But this raises a two-part question: One, how long can we afford such a strategy? The economist Paul Krugman argues that the U.S. government made a grave mistake by scaling back fiscal stimulus in 1937, eight years after the onset of the Great Depression. Adopting his time frame would push our current stimulus efforts out to 2013, perhaps beyond. And two, what happens if our creditors — the bond markets — refuse to keep lending us money, just as they are now cutting off the heavily indebted countries of the northern Mediterranean?

As of this moment, the U.S. government can still borrow money relatively cheaply. But when creditors lose confidence in a debtor, further borrowing can become prohibitively expensive in a matter of days — just ask former Lehman Brothers CEO Dick Fuld. The consequences of such an event for the U.S. economy would be many times worse than anything we are currently experiencing, yet Keynesian economists wave off the risk. They point out that, unlike Greece and other heavily indebted members of the eurozone, the U.S. can avoid default by printing its own currency. But any investor dumb enough to accept repayment in Monopoly money for long is also the kind of investor who is basing his decisions purely on what the rest of the market is doing (which is most investors). Such an investor is likely to panic and abandon his positions in U.S. government securities at the first sign that others are doing so.

Keynesian economists also argue that scaling back stimulus spending might actually hasten a debt crisis. Cutting spending during a period of economic weakness, they say, would depress growth, which would depress tax revenues, which would make debt service even more difficult. The reason they are enchanted with this argument is that it never occurs to them to cut spending and tax rates simultaneously. To be clear, I am not claiming that tax-rate cuts would foster enough economic growth to pay for themselves, but there is strong evidence that they would foster more growth than deficit-financed government spending would — evidence that economist N. Greg­ory Mankiw recently summarized in the journal National Affairs. The incentive effects of tax-rate cuts would more than offset whatever harm (my guess is: very little) might accompany spending cuts of an equivalent size. Meanwhile, the spending cuts would offset the revenue lost to the tax cuts.

It is important to emphasize the difference between tax-rate cuts and Keynesian-style temporary tax rebates, exemptions, and credits. “Attractive as such ideas may seem at first, targeted tax cuts and incentives are in fact very difficult to implement properly,” Mankiw writes. “If tax cuts indeed make for better fiscal stimulus than direct government spending, they should be broad-based cuts or incentives, rather than narrowly tailored interventions.” Stimulus IV, a.k.a. the Hiring Incentives to Restore Employment (HIRE) Act of 2010, provided us with more evidence that Keynesian “tax cuts” rarely work as economic stimulus.

The HIRE Act’s centerpiece was a temporary tax exemption provided to employers for each new worker hired. Data on how many employers have taken advantage of the credit is not yet available, but this provision has manifestly failed to have the desired effect on employment. Private-sector job creation fell from 218,000 jobs in April, the first month after the law took effect, to only 41,000 in May. Also, it’s likely that many of those who did take advantage of the credit simply hired workers they would have hired eventually anyway — something akin to what happened with Cash for Clunkers and the Homebuyers Tax Credit.

There is another reason many Keynesians favor the application of yet more fiscal stimulus and fear the consequences of retrenchment: They have learned the wrong lessons from Japan’s “lost decade” of economic stagnation. In 1992, Japan suffered the collapse of a real-estate bubble similar to ours, to which the Japanese government responded with similar palliatives: several rounds of fiscal stimulus, coupled with an expansive monetary policy. After years of weak growth, Japan scaled back its stimulus spending in 1997, a move that coincided with the Asian financial crisis and preceded another Japanese recession. Finally, in the early 2000s, a new economic team forced Japan’s big banks to recognize losses on their bad loans and recapitalize their balance sheets. As a result, Japan experienced strong GDP growth from 2002 to 2008. Japanese leaders, however, fearing a repeat of 1997, were reluctant to throttle back on the fiscal and monetary stimulus and thus kept providing it.

Japan’s decision not to cut back on fiscal and monetary stimulus, even though the restructuring of its banks had prompted a recovery, had consequences. Chief among these is Japan’s truly massive debt burden relative to GDP, which, at 190 percent, is the highest in the developed world. So far, Japan’s debt has not set off any major alarm bells, because most of it is owed to Japanese savers. (By contrast, the U.S. is highly dependent on foreign creditors such as the Chinese.) But Japan is in demographic trouble. Its savers are getting older, and they are going to be less able to finance Japan’s debt as they start needing that money to live in retirement. A number of the same hedge-fund managers who bet heavily on the collapse of the housing bubble are now betting that Japan won’t make it through the decade without a debt crisis.

At this point, the Democrats in power in the U.S. have committed to the strategy that gave Japan a decade of weak growth, serial recessions, and exploding debt, while failing to adopt the strategy that actually dealt with the underlying problems in Japan’s banking sector and kicked off six years of real economic growth. To make matters worse, their legislative overreach, as seen in the avalanche of 2,000-page bills, has created a climate of uncertainty in which it is hard for businesses to thrive. The resulting low-growth, high-unemployment economy has made continuing rounds of stimulus almost a matter of political necessity. The latest round, Stimulus V, is mostly another extension of unemployment benefits and a disbursement of aid to broke state governments. We’re past the pretense that these “jobs bills” are actually creating jobs. Now we’re just doing repeated end-runs around the limits of our welfare apparatus.

For its part, the Republican party appears dangerously close to accepting this state of affairs. Most Republicans laudably opposed Stimulus II, a.k.a. the Big One, but Stimuli I, III, and IV all passed with large bipartisan majorities, and the only objection Republicans have raised against Stimulus V is that it should be paid for by canceling some of the unspent funds from Stimulus II. Most Democrats are unwilling to agree to this, and instead have tried to bring down the bill’s price tag by shortening the duration of the unemployment-benefit extensions. Our recent history demonstrates that this is a limitation without meaning: It will only reduce the time that passes between Stimulus V and Stimulus VI.

Not all Republicans are equally complicit, and at times over the past two and a half years various GOP members of Congress have put forward alternative solutions that make sense, such as House minority whip Eric Cantor’s 2008 proposal to enact a broad-based corporate-income-tax cut instead of the hodgepodge of temporary rebates and carry-backs that eventually passed. Republicans have been forced to work within the confines of what is politically feasible given their limited numbers. But it is not enough to say that “the stimulus failed.” It is necessary also to connect the dots from Stimulus I to Stimulus V — to argue that “temporary stimulus” is an oxymoron, one contributor among many to the destabilizing uncertainty that has made it impossible for businesses to make long-term plans. The stimulus machine will not run forever, because our creditors will eventually get tired of shoveling dollars into its furnace. But a vastly better outcome would be for the party ostensibly committed to limited government to find the political will to turn it off.

Stephen Spruiell is an NRO staff reporter. This article originally appeared in the July 19, 2010, issue of National Review.


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