Stimulus Spending and why it Fails to Stimulate

Posted by PITHOCRATES - January 23rd, 2011

Stimulus Checks are often used to Pay down Debt, not Buy Stuff

We have had a lot of stimulus spending between George W. Bush and Barack Obama.  And yet we still have the greatest recession since the Great Depression.  So why hasn’t this stimulus spending worked?  Because Keynesian Economics doesn’t work (see Where Did the Stimulus Go? By John F. Cogan and John B. Taylor published January 2011 in Commentary Magazine).

Keynesian stimulus packages come in three basic types. In the first type, the federal government puts money directly into the hands of consumers. The hope is that consumers will use the money to increase their purchases of goods and services. In the second type, the federal government directly purchases goods and services, including infrastructure projects, equipment, software, law enforcement, and education. In the third type, the federal government sends grants to state and local governments in the hope that those governments will use the funds to purchase goods and services.

And how has it worked giving the money directly to consumers?

In the 2008 stimulus, the U.S. Treasury began issuing one-time payments to households in the spring. This temporary boost in income was designed to jump-start personal consumption of goods and services and thereby increase production and jobs at the firms that produce those goods and services. It didn’t work.

Why?

It went to pay down some debt or was simply saved rather than spent on consumption.

This should not have surprised anyone. Long ago, the Nobel Prize–winning economists Milton Friedman and Franco Modigliani explained that individuals do not increase consumption much when their income increases temporarily. Instead, they save most of the funds or use the money to pay back some of their outstanding debts. Friedman and Modigliani demonstrated that most people, when deciding how much to consume, consider more long-lasting, or permanent, changes in income. Because one-time increases in transfer payments and temporary tax rebates are, by their very nature, temporary, people should not have been expected to alter their consumption patterns. The Friedman-Modigliani theory, called “the permanent income” or “the life-cycle” hypothesis, profoundly influenced macroeconomic thinking for decades. It was, oddly, ignored in the development and enactment of the stimulus of 2008.

So one-time stimulus payments to individuals don’t stimulate.  We often just use them as an opportunity to pay down high interest debt.  If you get a check for $600, what’s better in the long run?  Spending the money one time and leaving a high-interest large balance on your credit card?  Or paying down your credit card balance, leaving a smaller monthly payment?  A smaller monthly payment will let you buy more stuff each month.  Or help you pay down your balance faster.  In the long run, you’re better paying down your balance.  Which is what most people did.  Which is why the stimulus did not stimulate.

Ditto for state and local governments.

So where did the stimulus funds sent to state and local governments go…most of it went to reduce borrowing by state and local governments.

In fact,

In 1979, the late Ned Gramlich, who served on the Federal Reserve Board and earlier as a professor at the University of Michigan, studied the impact of similar grants in stimulus packages in the 1970s. He found that the federal stimulus grants to state and local governments had little effect on their purchases of goods and services. He concluded that the grant recipients used the grants “to pad the surpluses of state and local governments.”

And what they didn’t use to pay down the debt they used on transfer payments (mostly health and welfare).  Not on buying goods or services that would stimulate the economy.

Medicaid grants were unlikely to provide much if any stimulus to aggregate economic activity, and they haven’t. Moreover, these grants appear to have caused state governments to shift funds away from purchases of goods and services and into their Medicaid programs.

What about those Shovel Ready Projects?

Apparently, there’s no such thing.

The slow pace of infrastructure spending is not unique to the 2009 stimulus. The slow-spending phenomenon has been a common element in public-infrastructure appropriations in stimulus programs dating back to at least the 1970s. The administrative process that federal agencies use to allocate appropriated funds, to incur binding obligations, and to eventually liquidate those obligations is cumbersome and slow. The idea of a “shovel ready” job is useful in concept but not in allocating federal funds. A San Antonio official put the reality succinctly: “FEMA stated to me that ‘shovel ready’ was not a term in their lexicon.”

Anyone laid off from a construction company because the federal funding for that big project had been delayed can relate to this.  When federal money is involved things don’t move fast.  Because of that process.  That cumbersome and slow process.  So direct federal spending on infrastructure may stimulate.  But when it does, it’s usually a couple of years after they appropriate the money.  Often when we no longer need the stimulus.

Borrowing from Peter to pay Paul

Stimulus doesn’t create spending.  It just moves money.

To sum up: the federal government borrowed funds that it mainly sent to households and to state and local governments. Only an immaterial amount was used for federal purchases of goods and services. The borrowed funds were mainly used by households and state and local governments to reduce their own borrowing. In effect, the increased net borrowing at the federal level was matched by reduced net borrowing by households and state and local governments.

In effect, borrowing from Peter to pay Paul.  Let’s say the amount in question going between Peter and Paul is $250.  And what do we have after this transaction?  Peter has $250 less to spend.  While Paul has $250 more to spend.  The total economic stimulus is:  -$250 +$250 = 0.  There is no net economic gain.  Which is why stimulus spending fails to stimulate.  It’s the same money we’re spending.  Just different people are spending it.

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