11.24.08

A Warning from Reagan's Economist

Why the proposed $700 billion stimulus plan could drive the country to economic ruin.

As you read this, our government is committing enormous sums of money above and beyond normal spending, solely to stimulate the economy and prop up failing companies and markets. These additional sums are huge by any reasonable measure, with estimates as high as $3 trillion in an economy with a GDP of about $15 trillion.

Here’s the bottom line: Instead of making things better, increased spending will only drive our economy further into the ground.

And there is still a lot more spending to come. First it was a $170 billion stimulus package in February of 2008, then material add-ons to both the housing and agricultural bills, followed by Federal Reserve asset swaps with Bear Stearns and a bailout of AIG (which, by the way, isn’t over yet) and then came the debt guarantees of Fannie Mae and Freddie Mac.

There is no tooth fairy. Every dollar given to someone comes from someone else.

Shortly after that, the administration anted up $700 billion in a bailout package, and now Obama, Reid, Pelosi and Bernanke want another stimulus package of $300 billion. Just this week the powers that be are debating bailouts for Michigan’s auto industry. With the slowdown in the economy, tax receipts are now projected to fall sharply. The logic here is totally upside down, and each new measure, far from helping the economy, does enormous damage.

It is true, as the proponents of these stimulus packages argue, that recipients of government checks will spend more than they otherwise would have spent. And, that increased spending will have a multiplier effect increasing spending even further. But this is only part of the story.

The government can only transfer resources; it can’t create resources. There is no tooth fairy. Every dollar given to someone comes from someone else. The government can’t bail some people out of trouble without putting other people into trouble, plus a hefty “toll for the troll.”

In the case of last February’s stimulus package, the government literally borrowed an extra $170 billion and at the same time sent out checks to the transfer recipients totaling $170 billion. The result was a $170 billion increase in the amount of bonds held by the public, accompanied by a $170 billion increase in the current value of future taxes to pay interest and principle on the additional debt.

From the standpoint of accounting, the government is $170 billion further in the red, and taxpayers are liable for an additional $170 billion worth of taxes. Therefore, for every dollar of transfer payment there’s at least an equivalent dollar of future tax liabilities. Those people with the increased tax liabilities will spend less, thereby dis-employing people who had been supplying them with goods they’ll no longer buy. And the reduction in spending of those with higher tax liabilities will lead to a multiplied reduction in total spending equal to and fully offsetting the increase in total spending from the recipients of government checks. There is no stimulus from the stimulus programs!

To see this point more intuitively, imagine what the “stimulus effect” would be if they borrowed the $700 billion from the same people to whom they gave the $700 billion and then promised to raise their taxes by enough in the future to pay off their bonds. Where’s the stimulus in that?

This point is hugely important. For the proponents of increased government spending to argue that their policies will increase output, it is absolutely essential that the increased spending by transfer recipients more than offset any decline in spending by others. If the income effects of fiscal policy net to zero, there is no rationale for these spending policies. And, the income effects of fiscal policy do indeed net to zero.

The diffuse and imprecise nature of just who bares the increased tax liabilities makes the point difficult to understand. We all know who benefits from government programs: mortgage holders, undercapitalized banks, auto companies, low-income earners and the like. But who bears the increased tax burden? That’s a far trickier question, the answer to which I don’t have. But in the aggregate I do know that for every beneficiary of government spending there is someone who has to pay for it. As Milton Friedman so wisely noted, “There ain’t no such thing as a free lunch.”

What I don’t really know is just how far this process can go and just what it will take to stop this vicious cycle. Combine the unintended consequences of a flawed model with a crashing economy in ever more desperate need of beneficial policies, and the results are lethal. The old adage “if you don’t like government problems just wait till you see government solutions” has never been truer.

Dr. Laffer is chairman of Laffer Associates and co-author of " The End of Prosperity: How Higher Taxes Will Doom the Economy—If We Let it Happen," recently published by Threshold. He’s best known in economics for the Laffer curve, showing the relation between tax rates and revenue take.