Dangers of the Stimulus Bill

There are many reasons to oppose the so-called stimulus bill and none of them are partisan.   An obvious one is the haste with which Congress is acting on a bill that is in excess of 700 pages and spends hundreds of billions of dollars. It is being rushed through both the legislative process with little or no input from the minority party legislators, much less the general public. The so-called Senate compromise was not available to most Senators until past 11 pm on Saturday night and yet a vote is expected by Tuesday at the latest.  

Even if the Keynesian theory behind the bill — the recession is being fed by lack of consumer spending and this can be rectified by government spending — is correct, the lack of analysis of such a major piece of legislation is dangerous.  To put this in perspective the compromise Senate amendment, at $827 billion, is about the amount of U.S. currency in circulation.  The entire federal budget did not reach $827 billion until 1984.  We may remember that the last time Congress rushed through a massive spending bill, the TARP legislation, the result was not what Congress had intended.

While we have had record layoffs in recent weeks, and most of us have been touched with the travail of a relative, friend, or neighbor having lost their job, the unemployment rate is at 7.6%.  When Reagan was President in the last major recession, 1981-82, the unemployment rate was 10.8%.  Reagan spearheaded a major tax reduction, but not with the threat to Congress that if it didn’t pass the bill in two weeks every member would be held responsible for sending us into the next Great Depression. The tax cut was passed after due deliberation and it played a large part in moving the economy out of the recession.

The Congressional Budget Office estimates that only 20.8 percent of the spending in the Senate substitute will occur in this fiscal year and another 38% in the 2010 fiscal year.  If only about one dollar in five of the spending will occur before October one suspects that the reason for the rush is that once taxpayers are made aware of all the extraneous spending that is in the bill, they would never support it.

Is the Keynesian theory behind the bill likely to be correct?  We may quote from two Nobel Laureates in Economics regarding Keynes’s theory that government spending can stave off recessions.  Frederic Hayek, in his Nobel address stated that he regarded the Keynesian theory of the relationship between employment and aggregate demand “as fundamentally false.” Milton Friedman, who famously attacked the Keynesian theory in his long and distinguished career, said n one of his last interviews:  “Now Keynes, in the General Theory of Employment, Interest and Money, set forth a hypothesis which was a beautiful one, and it really altered the shape of economics.  But it turned out it was a wrong hypothesis.”  

Common sense tells us that our problem is not that consumers are not spending enough.  As John Taylor, Stanford University economics professor wrote in a recent NBER paper, we are in the recession because of government actions that artificially expanded credit resulting in people buying houses and consumer durables that they couldn’t afford.  As a consequence, the market is now correcting and resources, including labor, are moving out of the housing construction and consumer durable (such as auto) industries.  

Harvard economist Robert Barro pointed out in The Wall Street Journal that the solution to the recession lies in increased incentives for business to produce things and hire people in the process.  He calls for tax cuts that reduce marginal tax rates, encouraging people to work, and “eliminating the corporate income tax would be brilliant.”  

The stimulus package, focused on government spending and disguising income transfers as tax cuts, will make things worse rather than better.  It will delay and make more severe the market’s redirection of resources. In addition it will lead to a smaller capital stock and inflation. There are only three ways to fund the $827 billion — cut other spending, increase taxes, or borrow.  Clearly the government’s intent is to borrow the money, and this will cause a drag on the economy rather than improve it.

Federal debt at the end of January stood at $10.632 trillion, up by $5 trillion since 2000.  The public holds about $6.3 trillion of the debt and of this, more than $3 trillion is held by foreigners, with China being the largest holder with more than $680 billion.  

Even without the passage of the stimulus bill, Treasury has just announced a record debt sale in February. The market is already signaling concerns about the large increases in the US debt.  The yield on the 10 year Treasury note has risen by about 50 percent since the end of December, from just over 2% to almost 3%.  The stimulus bill will, according to CBO, increase deficits by more than $850 billion.  This increase in the supply of Federal Treasuries will drive up interest rates. This will cause the federal spending, as Friedman noted decades ago, to crowd out private investment.  While the private investment would have increased the productive capacity of the economy, the federal spending will be directed through the political process to those with the most influence.  This is one reason that in a letter to Senator Gregg, CBO estimated that the Senate amendment would lead to a decline in economic activity in the long term.

The rise in interest rates will be met by monetization of the debt by the Federal Reserve, which has already signaled that it will be buying at least some of the new debt issuance.  This will increase the supply of money which will increase prices and reduce the value of the dollar.  This will cause foreigners reduce their demand for US debt due to the falling value of the dollar, and interest rates will continue to rise while we are faced with rising inflation.  This is not the recipe for economic recovery.  

Government actions caused a misallocation of resources into housing and consumer durables.  The administration is rushing through a bill that would use a crisis caused by government to create a massive expansion of the federal government into major sectors of the economy such as health care and education and provide benefits for special interest groups.   This should be rejected in favor of tax cuts that provide incentives to invest and produce.  It is government action that got us here and our fear should be that government action will prolong the crisis rather than solve it.