Thursday, February 12, 2009

Stimulate This!

Unless we are talking about cutting marginal tax rates, economic stimulus is woefully ineffective. It doesn't matter if we are talking about Keynesian style deficit spending or, as we are seeing around the world, moves to permanently increase the size of government.

What is Keynesian style spending? Basically, the idea here (owing to JM Keynes, coming from his book "The General Theory of Employment, Interest, and Money") is that the government should adjust its spending patterns depending on what the economy is doing. If the economy is tanking, the government should spend more money and run a deficit. If the economy is doing well, the government should run a surplus and pay off the debt it ran up during the downturns. First of all, we should note that this is most certainly NOT what is going on with these stimulus packages, despite what the politicians and talking heads are saying. The Keynesian prescription is for easily reversible increases in spending, while most of what is being put into these bills are new government programs, and are thus not easily reversible. The general economic idea here is what is called the "flypaper effect," which basically says that money sticks where it lands. Once the government creates new programs and new bureaucracies, bureaucrats become entrenched and will do anything they can to keep the money flowing. As nice as the Keynesian idea sounds, the politics of spending means that temporary spending is chimeric, as Robert Higgs work on the ratchet effect has pointed out.

Why won't this sort of spending work? The basic answer lies in the economic concepts of crowding out, Ricardian equivalence, and the permanent-income hypothesis and consumption smoothing. The basic logic of crowding out says that, if the government wants to temporarily spend money, that money has to come from somewhere and will lead to increases in inflation or interest rates or reductions in private spending (or some combination of all three) and will thus have no real effect on the economy. Let's say the government decides to start spending more money. They have to get the money somehow. One method is through an increase in taxation. It is obvious to see that this will result in those being taxed spending less money than before. So government spending will crowd out private spending. Another method is through the selling of bonds. As they flood the market with enough bonds to do their spending, this will push interest rates up. Firms who are thinking of borrowing money to finance projects (new factories, construction, etc., all of which increase employment!) now face a higher cost of so doing and, as a result, will cut their investment. Thus, government spending through debt finance will crowd out private investment. Moreover, taxpayers are not stupid. They see the government raising money with bonds and realize that the government will be forced to pay off those liabilities sometime down the road. As a result, taxpayers will start saving so that when those government liabilities come due, the tax bill they are hit with doesn't force them to cut their spending in a huge way (this is the gist of the permanent-income hypothesis). Thus, raising money for spending via bonds will have the roughly the same effect of cutting spending now as would raising the money through taxes--this principle is called Ricardian equivalence. Finally, the government could simply generate the money by printing it, which would of course lead to inflation.

Even at face value, however, these bills look less like temporary spending bills and more like permanent increases in government. I have been watching the spectacle of the US bill fairly closely, and it certainly looks like a move toward European style socialism, which is being lauded on the left as a good thing. A couple observations should be made. First of all, European countries are not doing any better than the more market based economies--nearly all European economies have experienced a sharp increase in unemployment in the past few months. Second, European unemployment numbers are consistently higher than more market-based economies. We are calling 7-8% unemployment bad--imagine if it was like that all the time, as it is in the best of time in Europe. And before people start calling me on that (Sweden has had official unemployment rates that rivalled those of the US for quite a long time), unemployment numbers are very difficult to compare across countries. You can't simply look at the official figures in a handful of countries to determine where market conditions are the best, because the way that unemployment is measured varies from country to country. A few years ago, the very left Swedish Secretary of Labour Hans Karlsson is reported to have had announced that Swedish unemployment was really in the 20-25% range but most of the unemployed were "stashed away" in various categories that statistically removed them from the calculation, but in effect they were unemployed. Finally, there is a ton of evidence that points out the simple fact that governments are not as effective as private markets in generating economic progress, for a whole host of reasons. According to most statistically based evidence (i.e. the Rahn Curve), the ideal size of government in terms of generating economic progress is for government spending to be something like 15-20% of total GDP. The US, which is considered by most to be a "small" government as far as developed countries go, has a government size over 35% of GDP. Most major European countries (aside from the UK) are in the 50-60% range.

What will work? Simply giving people stimulus checks or issuing "refund checks" will do nothing. I know they are politically attractive, but the crowding out mentioned above will still happen. The only real route is through cutting marginal tax rates. Now I know that people like to complain that tax cuts favor the rich--at face value it is unmistakeable that the rich gain a lot more in absolute terms than the poor from tax cuts. That can't be helped, simply because the rich are paying a lot more in taxes to begin with. But in percentage terms, the poor generally make out much better than the rich. Cutting marginal tax rates work because people make their working decision on the margin. They ask themselves how many hours they want to work, taking into account the costs and benefits of doing so. The benefit of working is obviously money, whereas the cost of work is reduced time with the family, less leisure, and so forth. If you reduce taxes, the marginal benefit of working an extra hour goes up, because you get to keep more of the money from that hour, so people work more. The basic logic of taxation is simple...the higher the marginal tax rate, the less people do of the activity that attracts the tax. The higher the tax on income, the less people work. The higher the tax on profits, the less energy firms spend on profitable activity, which can manifest itself in a number of ways, like gold-plating (the Averch-Johnson effect) or racial/sexual discrimination.


Valentina said...

How does racial/sexual discrimination stem tie in with the gold-plating effect?

Valentina said...

How does racial/sexual discrimination tie in with the gold-plating effect?

MD said...

Valentina: both are possible ways in which a firm may substitute profits, which are taxed, for on-the-job consumption. This on the job consumption raises costs, however these increased costs are simply written off against revenues so any enjoyment received from these activities are essentially untaxed. For example, assume profits taxes are 0%. The CEO of a firm has a choice between running his firm as efficiently as possible, earing profits of $10m, or indulging his private interests--he may be a racist and not want to hire black/asian/white/male/female/old/whatever employees, or he may like flying first class and having gorgeous marble statues in his lobby. Either of these will reduce firm profits (racist/sexist/ageist hiring practices reduce profitability because there are certainly members of the discriminated against group who are being overlooked that are better workers than those in the preferred group who are ultimately hired), say by 50% to $5m. If the CEO values the additional profit of $5m more than being surrounded by his preferred ethnic group or the marble statues, he will not gold plate or have racist hiring practices--in other words, so long as he values this on-the-job consumption less than $5m, he won't engage in these behaviours. Let's say he values this on-the-job consumption at $3m--he's a HUGE racist. Now, let's raise the profits tax to 50%. If he runs his firm efficiently, he gets 50% of $10m, or $5m. If he increases costs and takes on-the-job consumption, he gets 50% of $5m, or $2.5m. Now, he finds it in his self interest to engage in on-the-job consumption, and gold plates or engages in racist hiring practices.

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