TCS Daily

Why Obama's Economic Plan Will Fail

By John L. Chapman - February 25, 2009 12:00 AM

The recent passage of the $787 billion malapropism known as the "American Recovery and Reinvestment Act of 2009" on Friday the 13th was full of irony. Beyond the portentous date of passage, or its questionable moniker, was the ugly process leading to the confirming Senate vote. While promising "unprecedented responsibility, transparency, and accountability" in securing passage of the largest ad hoc spending bill in U.S. history, the Obama team instead permitted their Congressional allies to rush through a 1,000-page monstrosity with no effective deliberation, no promised prior posting, and no lawmaker coming close to fully reading the pork-laden bill.

But the reaction of President Obama was, itself, the ultimate incongruity. For even as Mr. Obama hailed its passage as a "major milestone on the road to recovery" which would lead to "3.5 million new or saved jobs in two years," the bill in fact guarantees the failure of his economic program, a prolonged downturn, and a golden opportunity for the revival of his political opponents.

The market's subsequent reaction to the bill is indicative of its likely efficacy, but let us think critically about the broader challenge of stoking recovery. To begin with, a fundamental axiom of economic growth is that private capital investment is the one true "stimulus" that works -- that is to say, that creates sustainable employment and the path to wealth accretion. For example, it was British capital that developed the United States in the 19th century after building a veritable empire, and along with generally free trade and laissez faire policies, it was a surge in private investment which drove U.S. recoveries after nasty downturns in the early 1920s and 1980s. In fact, the major reason the U.S. economy did not turn around in the 1930s was precisely because private investment failed to recover until the mid-1940s, as economist Robert Higgs has demonstrated.

Investment ensues from saving, which is the driver of the capital formation that generates employment, income, and wealth. Therefore any economy which exhibits sustainable growth will be the beneficiary of policies conducive to saving. Foremost among these are low tax rates on profits, capital gains, and marginal income; when combined with a disciplined restraint in government spending, these serve to promote the accumulation of capital and low real interest rates, in a "virtuous circle" of ever rising productivity and income growth. It should also be pointed out that while increased saving necessarily entails a reduction in the rate of growth of consumption in the current period, it need not necessitate a decline in consumer spending. In any case, happily, saving and capital accumulation yield higher levels of consumption and a wealthier economy tomorrow.

It was for this reason, in fact, that Milton Friedman said he'd prefer an economy with a budget deficit and government spending at 25% of GDP, to a balanced budget where spending was 50% of GDP; his point was that the larger footprint of government spending "crowded out" the true source of economic growth, productive private investment. And ultimately, higher government spending promotes higher tax rates.

None of the foregoing economic verities are embodied in Mr. Obama's stimulus bill. There are no growth-inducing tax cuts on corporate profits, capital gains, or on marginal income, and there is no effective plank which advocates saving. The President himself has repeatedly stated that "the whole point" of the stimulus bill is to promote immediate spending and current consumption. Thus there are the usual assortment of transfer payments to favored constituencies, from the unemployed to ACORN, the infamous left-wing umbrella group for community organizing.

This spending-leads-to-growth concept is a perennial failure that can actually harm an economy. Its advocates suffer from a crucial error in their understanding of economics: for in fact, consumption is an effect, and not a cause, of economic growth. Stated simply, more spending without the greater output of goods and services that results from increased saving and investment -- and concomitant higher real incomes -- can only lead to higher prices and inflation. Alternatively, if government spending programs engender uncertainty and loss of confidence, while at the same time excluding incentives to invest (such as through tax cuts on profits or capital gains), the demand for money holding can increase dramatically, choking off recovery. The former scenario played out in the U.S. stagflation of the 1970s, while the latter occurred in the U.S. in the 1930s and Japan in the 1990s.

Mr. Obama is an admirer of FDR's New Deal, but the explosion in public works spending still left unemployment at 17% in 1940, eight years into his administration; so much uncertainty was created by all the New Deal programs that private investment did not recover until after 1943. And Japan's "lost decade" of the 1990s is a particularly tragic example of spending waste, because at least eight separate stimulus measures pursued by Tokyo between 1992 and 1999 totaled over $100 trillion yen (more than $1 trillion at current exchange rates), yet unemployment grew throughout the decade (to almost 5% from 1%), and GDP growth averaged an anemic 1% for over 10 years (and close to zero between 1996-2002). Meanwhile Japan's debt-to-GDP ratio has tripled since 1990, burdening future growth.

Sound money is also a necessary condition for optimizing capital formation. It acts as an inducement to invest in the long run, and promotes the effective allocation of scarce resources via allowing for calculation of true profits and losses through the price system's signals. To say this differently, when a currency is unstable or weak, economic resources are misallocated, causing waste and real decline in wealth; profits contract, and private investment is curtailed. The explosion of housing construction due to easy money and artificially low interest rates is a canonical example of this, and the current era proves that the economic ills which accrue from an unstable currency are magnified when it is the U.S. dollar, the world's reserve currency. Yet here as well, Mr. Obama's Treasury Secretary, Timothy Geithner, has virtually promised a continuation of the Bernanke/Bush weak dollar.

What does all this mean? Higher interest rates and a collapse of U.S. Treasury bonds seem assured, and a run on the dollar cannot be ruled out. Absent inducements to sustainable growth, the fiscal stimulus program will only add to the U.S.'s debt burden. Most importantly, there will be no global recovery without a return to growth in the United States, which can only happen via recapitalization (including banks) and the profit growth which drives employment. By ignoring both economic logic and history, Mr. Obama has condemned the world to repeat an unpleasant past.

Mr. Chapman is a research economist affiliated with the American Enterprise Institute. He may be reached at

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