Why the ‘Do Something’ Stimulus Bill Won’t Work

A free market answer to Obama’s Keynesian stimulus bill 

Free market economists raise serious questions about the stimulus package (American Recovery and Reinvestment Act of 2009) and Keynesian theory in general. Over the years Austrian School economists have generally been right about the economy as compared to other economists. For example, economist Von Mises and his protégé von Hayek correctly foresaw the 1929 crash and the aftermath of government intervention. They now turn their thoughts to the stimulus bill’s very serious implications for the future of our economy and the country.

Here’s my summary of these concerns. They should make you pause and think about where we are going.

1. The economic damage was done on the way up, not on the way down. The way down is just a necessary correction of bad investments.    

The housing boom was basically caused by the Fed flooding the economy with cheap money. Huge amounts of capital were steered into bad investments  (what is called in economic terms “malinvestment”).  In this case it flowed into the current hot thing: housing. This was not warranted by basic economics, since, when the money ran out (the Fed stopped inflating), the market crashed.  Evidence of this is that 20+% of buyers were speculators (non-owner occupied) and they are responsible for most of the foreclosures right now. If the investment was viable, real wealth would have been created and sustained. All the damage was done when the money was  steered into bad investments. The bust is the only way to correct this. Attempts to “fix” the bust will only lead to worse outcomes.

2. This crisis is typical of all boom-bust cycles.

There are several interesting papers (some by non-free market economists) that show that most booms and busts (going back eight centuries) are the result of expansion of government debt and/or inflation. The key point is that these cycles have all behaved similarly. So don’t believe that our modern crisis is somehow different than previous ones. Free market economists have shown time and again how money inflation causes business cycles, and have predicted many crashes, including 1929. Keynes never grasped the role of money in the cycle; a failing economy was because of the mystery of our “animal spirits.”

3. When bad investments are made on a colossal scale nothing can cause them to recover except when supply = demand.

This crisis is too big for any government to cure. Fueled by rising home prices, household debt expanded from $6 trillion in 2000 to about $14 trillion in 2007, a 233% increase. It is now collapsing because homes aren’t worth what people paid for them or the cost to build them. What do you do? Prop up the value of these homes by cash payments? Subsidize mortgage payments of people who got over their heads by buying with almost no equity at the top of the market? Government direct loans to refinance mortgages? The cost to any of these solutions is huge and beyond the capability of the government. The market readjustment can’t be stopped, only papered over. If you paper it over, capital will remain tied up in bad investments and you will end up with economic stagnation.

4. Keynesian fiscal stimulus to create consumer spending is like flogging a dead horse: there is no great untapped source of consumer money to spend.

Consumers did go on a spending spree because of the housing bubble. They pulled huge amounts of capital out of their homes to fund the binge. That has dried up. For the first time since 1945 home equity is less than 50% of home value. This is because of the bust in home prices. As a result many Americans are over-leveraged and in default. Don’t expect this to revive because home prices, the source  of spending, are going to continue to decline or stay  flat for a long time.

5. Government stimulus spending has never worked to revive any economy wherever and whenever it was tried.

Advocates of Keynesian fiscal stimulation through massive government deficit spending cannot point to any time it ever kick-started an economy. It doesn’t work. Even Keynesian Paul Krugman is now preparing for failure by saying the stimulus bill isn’t big enough. Keynesians often say it didn’t work in specific cases because not enough money was spent, it wasn’t done soon enough, there were intervening circumstances, or other excuses that proponents of any failed theory offer. It’s basically a radical social experiment economists are doing to us.

6. Government stimulus spending doesn’t create wealth.

People say we’ve got to spend to get out of this. Since you and I aren’t spending, they say, the government should spend because they’ve got the money. People focus on the spending without thinking about where the money comes from. It comes from taxes or from debt (which ultimately must be repaid through taxes). What people don’t see is that if the government takes my money; or drives up my cost of capital because of its borrowing, my business plans must go on hold. Instead, programs which the government deems politically worthwhile will get the money. Once the money runs out, the spending stops because the things the government supports aren’t economically viable. They aren’t going to give me my tax money back, so it reduces my opportunity to expand. Repairing a bridge or putting government workers to work doesn’t create a lasting stream of wealth as does private business. It will lead to huge government debt that must eventually be paid back.

7. Government stimulus spending doesn’t create jobs; it destroys jobs.

A job is not just a payment to someone to do something. A job is where someone gets paid to do something because some other person is willing to pay for the product of his labor. If the government pays someone to dig holes and pays someone else to fill them, as Keynes famously remarked, those aren’t real jobs. It is a transfer of your or my tax money to do something that is not economically viable. No government jobs are economically viable by definition: if the government stops paying, the “job” will go away. By taking your and my money and giving it to some people to do things the government wants done, it deprives us of capital and thus our ability to create real jobs. Thus, it actually suppresses real employment and increases welfare payments.

8. Government stimulus spending can cause serious damage to the economy.

Japan had a real estate bubble very similar to ours. Their government tried loose credit (a zero “Fed Funds” rate), supporting failing banks and corporations, and massive government spending on infrastructure. The result: almost 14 years of economic stagnation and huge government debt. FDR doubled the federal budget and that didn’t work. The Japanese are still paying on their huge national debt. Further, they are doing it again right now. Some reports say that they are slipping into depression. “’I thought America had studied Japan’s failures,’ said Hirofumi Gomi, a top official at Japan’s Financial Services Agency … ‘Why is it making the same mistakes?’”

9. The quickest road to economic recovery is to allow institutions holding “toxic” assets to fail.

Estimates of capital losses on the balance sheets of private institutions range from $2.1 trillion (Goldman Sachs) to $3.6 trillion (Roubini). About one-half of this ($1.8 trillion) is on the books of US banks. FDIC insured banks have equity of only $1.3 trillion. That means many of our leading banks are insolvent (source: RGE Monitor). Many of these so called too-big-to-fail banks need to fail. Not bailing them out will not cause a collapse of our financial system; there is plenty of money and there are enough banks available to borrowers. A recent Fed study said that while banks have tightened lending standards to more traditional levels, they have capital to lend but businesses and consumers aren’t borrowing. That is because they are uncertain as to the future. 

10. Repairing the economy is not a pretty sight.

The road to recovery will be the one that deals with bad investments the quickest. Spread the safety net and be patient. The alternative seems to be stagnation, if not depression, similar to what the Japanese suffered and are suffering now. Add on to that huge government debt that will have to be paid by our descendants. It is difficult to predict what will happen and how long it will happen. But history has shown that depressions are caused by governments and their central banks.

By propping up bad banks and bad companies, and by prohibiting capital from being redirected to viable economic activities, this stimulus bill will drag out the economic pain and lead us into serious stagnation. The actual cost to us will be tremendous in terms of wasted capital, lost opportunities, human misery, and a large slice of time.


12 comments to Why the ‘Do Something’ Stimulus Bill Won’t Work

  • Lloyd G

    Logical and sentient argument, but the dumbed-down public finds the promise of free candy and pony rides to be irresistible. The flim-flam artists win.

  • Kaydie

    This is fabulous. I think the #1 important thing to keep in mind with economics is the retrospective, which this bill clearly avoids.

    Nicely written, I’m a teenager and you wrote it in such a simple yet powerful way that I can understand it :)

  • Jeff Harding

    Thanks, Kaydie.

  • Concerned citizen

    Absolutely brilliant. Common sense free market. Don’t have central banks try to regulate things and make money out of thin air and everyone will be better off. People need to be educated that massive government debt (by stimulus nonsense and wars)and inflation is the problem. They also need to realize that public works projects are counterproductive and that getting the government to dspend more money on things like public healthcare is a baaaad idea.
    We need to get politicians elected that will get rid of the Federal Reserve and let the amount of money in cirulation stay the same. It really should be a law that you can’t print off more money, especially to spend on 1 trillion a year on military.

  • Blueridge

    I am trying to understand how money is created if there is no fractional reserve banking.

  • [...] doesn’t start off too promising: I look at these issues quite differently from Keynesian and Neo-classical economists. As we have seen the Fed has been unable to stimulate money growth [...]

  • Kevin

    Is there a reason for that linear growth trend line? I added a (very) quick overlay of an exponential growth function and it fits… embarrassingly well. Look at the green line:


    It seems almost a willful misrepresentation of the trend to call it linear. The truth is that exponential growth is unsustainable, whether or not that goes against dailycapitalist.com ideals somehow. For now I’ll just apply Occam’s Razor and assume that it was negligent or ignorant behavior to call this somehow sustainable linear growth.

    Ok, I just had a thought, maybe this is supposed to suggest that the dotted growth line trend is going to be the center point for future booms and busts? Seems shaky, it still doesn’t remotely fit the data, somebody help me out here!

  • mitch

    well jeff, ive read this post about every 4 months since you wrote it. im yet to see anything to refute the predicted outcome. but of course the next round of stimulus will fix it.

  • Jeff housing has been a problem for 30 years and in the 90′s when wall street brokers gave investors bad advice on these and thought that they had the good money, that all crashed. Both wall street and main stret together like a bad marriage. If the government hadn’t bailed out the banks, GM and Chrysler, we would have been in another great depression.

    I surely hope Obama taxes the 250,000 to 500,000 people. They have enough tax shelters to hide behind not only in spite of but because of their income.

    Of course the economy has to be stimulated! If everything fails, the country will come to it’s knees and surely you must see, given the current world situation, that that would be the very worst thing that can happen.

    Exports are up in the souble digits for the first time since 2000 because China and other countries like them need our innovation. America has always been the great innovator and we can sell products and do, overseas that others don’t have.

    I hope the democrats are able to continue to pass progressive legislation to stimulate the economy. It is so working. Your graphs are only used to prove your point. Not showing how the glass is half full.

    I can;t believe you only had 11 comments on this.