That 70's Economic Policy

In Washington we are unfortunately seeing the return of a demand-side economic philosophy. Democrats (and some Republicans) are calling for an "economic stimulus package" to soften the blow from a possible recession this year. Such a package would include new spending projects and temporary tax breaks to "get the economy moving again" by putting money into consumers' hands.

Recall from Coach Yeckley's class that demand-side (also known as "Keynesian") economics is a philosophy that basically says if the economy isn't doing well, it must be because the government isn't doing enough to put money in people's pockets. Thus, Washington must spend more to "prime the pump" in order to keep things afloat. More and more dollars must be "injected" and allowed to circulate to ensure growth. This philosophy dominated American economic policy following the Great Depression all the way up until the Carter Administration, and remains one of the most fallacious concepts ever developed.

The first fallacy is the assumption that the source of economic growth is consumer spending. This is false because without investment, you won't get any goods or services produced to buy in the first place. The second is the notion that money can just "come out of nowhere" and be placed into consumer hands through federal spending. Clearly this is false because there's no such thing as a free lunch: the money that would otherwise be spent in the private sector is being "crowded out" as it is sucked out and redistributed by politicians.

All of this may sound a little complex to some of you (Ryan), so to simplify things, let's illustrate these fallacies by using an easy real life example. Let's say you own a bar in downtown Athens. One night, Felton the frat guy is at your bar. After 7 jager shots, he is loaded and feeling no pain. He sees a Florida fan approaching the bar from a distance, and throws his Miller Chill bottle toward him at break-neck speed. Unfortunately, it misses the UF fan and smashes through the window directly behind him, breaking it. You and all the surrounding bar patrons are of course angry at Felton for doing this.

But the Keynesians would argue that Felton should be praised because he's actually done everyone a favor by "stimulating demand" for a service that previously did not exist. Think about it: you must now hire a window glazier to come fix the broken window, thus providing him employment. And the glazier will in turn spend this new money he wouldn't otherwise have on other things, where it will circulate throughout the entire economy. Had the window not been broken, the glazier would be out of work with less money to spend, but thanks to Felton, unemployment is reduced and dollars are circulating. Heck, maybe Felton should walk down Broad Street and break all the windows in every building he passes. Then we'd really have an economic boom, right?

The problem with this way of thinking is that it completely ignores the concept of opportunity cost: had the window not been broken, you the bar owner could and would have spent the money on something more productive: Maybe help to save up for a new plasma screen for bar patrons to watch Georgia games in high-def. Maybe to provide cleaner bathrooms. Maybe to hire an additional worker. Who knows. The point is, that money can't be spent on these additional luxuries now because the window must first be repaired. What originally looked like a $500 gain for the economy was actually a $500 loss.

Despite its flaws, Keynesian views were dominant for so long because they were hugely popular with politicians. It allowed them to see the economy much like a car engine that could be accelerated or slowed by providing the correct amount of inputs. The idea that the economy was a machine that could be fine tuned by the State's technocrats was very attractive to presidents like FDR, JFK, LBJ, and even Richard Nixon.

But the truth is the economy is not at all like a car engine; it is instead far more complex and organic: think of it like a large ecosystem where millions of organisms interact on a day-to-day basis. In this view the environment for growth, not the amount of "oil you put in the engine," is what matters. Low taxes, light regulation, sound rule of law, and open trade are all you need to have an environment where the economy is productive and prosperous.

Instead of pandering to economic ignorance, policymakers should reduce spending, keep taxes low, and focus on reforming what caused the recession in the first place: the Federal Reserve's ability to artificially cheapen credit.