The federal government is spending more than it planned to—more even than the high spending Bush administration spent.  Some states are spending less than they planned to.  Will the second cancel out the first?

              This makes sense only if one believes in Keynesianism—the idea that the government taking a dollar away from you through taxes or debt and  spending that dollar creates more jobs and wealth and national income than you spending the dollar you earned.  Somehow, if this theory worked in the real world the nice people of Zimbabwe would be rich and folks would flee from South to North Korea.  But it doesn’t.

            A second stimulus would be another batch of earmarks rewarding the politically connected over the hard working.

The underlying premise here is that government spending “injects” money into the economy, therefore raising demand and GDP – and that state government spending cuts would thus remove demand and GDP. But if there was truth to the commonly-circulated estimates that $1 in deficit spending brings $1 (or more, with the multiplier) of new GDP, then this year’s massive $1.6 trillion budget deficit would have already overheated the economy – even before any stimulus was enacted.  Instead, the economy continued contracting. Standard Keynesian theory cannot explain this.

The simple reason government spending fails to end recessions is because Congress does not have a vault of money waiting to be distributed. Therefore, every dollar Congress “injects” into the economy must first be taxed or borrowed out ofthe economy. No new income and therefore no new demand is created. It is merely redistributed from one group of people to another.

This is intuitively clear in the case of funding new spending with new taxes. Yet funding new spending with new borrowing is also pure redistribution, since the investors who lend Washington the money will have that much less to invest in the economy. The fact that borrowed funds (unlike taxes) must later be repaid by the government makes them no less of a zero-sum transfer today.

Even foreign borrowing is no free lunch. Before China can lend us dollars, it must acquire them from us. This requires either attracting American investment dollars or raising the Chinese trade surplus (and the American trade deficit). The balance of payments between America and other nations must eventually net out to zero, which means government spending funded from foreign borrowing is zero-sum.

Keynesian economists counter that redistribution can increase demand if the money is transferred from savers to spenders. Yet this “idle savings” theory assumes that savings fall out of the economy, which clearly is not the case. Nearly all individuals and businesses invest their savings or put it in banks (which in turn invest it or lend it out)—so the money is still being spent somewhere in the economy. Even in this recession, with tightened lending standards, banks are performing their traditional role of intermediating between those who have savings and those who need to borrow. They are not building extensive basement vaults to hoard cash.

Since the financial system transfers savings into investment spending, the only savings that drop out of the economy are those dollars literally hoarded in mattresses and safes—and there is no evidence of this occurring en masse. And even if individuals, businesses, and banks did distrust the financial system enough to hoard their dollars, why would they suddenly lend them to the government to finance a stimulus bill?  

Consequently, government spending changes will not automatically impact the GDP. Economic growth is based on labor supply and productivity. State tax increases risk reducing productivity by reducing incentives to work, save, and invest. And even if they spend that money on productivity investments, most would take too long to be provide short term stimulus (roads can take a decade to build before they can increase productivity, education spending will not affect productivity until the students enter the workforce). Overall, mountains of academic studies show that government spending typically reduces productivity – it turns out that politicians cannot outsmart the marketplace.

Thus, I would worried more about state tax increases that could quickly reduce productivity than about state spending cuts.

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The first stimulus could have focused more on helping bolster the states' finances, but the President was intent on micromanaging the states' spending programs by encouraging them to tailor spending to his preferences. That resulted in spending assistance that will be too late and too large (a "lose-lose" outcome that will do little to help states during the recession and worsen the mounting government debt problems over the medium and long runs). It would have been better to give broader assistance more quickly and on a smaller scale. But it does not follow that now we should add to spending with a second additional stimulus.

The $9 trillion estimate of the Administration for accumulated deficits over the next few years would result in an estimated rise of government debt from its current 56% of GDP to 76% of GDP by 2019. This borrowing binge is unsustainable and, unfortunately, is also a gross underestimate of our mounting debt problems, as it reflects unrealistically high forecasts of economic growth (persistently in excess of 3%). It is also important to recognize that this is not a temporary blip in expenses or the debt ratio, but rather reflects a secular acceleration in expenses, including not only the Obama Administration's spending binge, but the growing preexisting commitments for Medicare and Social Security. Given the scant (nonexistent) evidence that government spending adds to growth, and given the strong empirical evidence that higher taxes and inflation will retard growth, there is no credible argument for a second stimulus package.

But there is something the government can do, namely pursue financial sector policies that entail little spending but which could have dramatic consequences for bringing an end to the credit crunch. The FAS 166/167 proposals currently under consideration, which would effectively apply on-balance sheet capital requirements to off-balance sheet securitization conduits, would have disastrous adverse consequences for securitization flows, and there is no reason to allow the wrong-headed reasoning of the accounting standards board (FASB) to dictate regulatory capital standards (economic theory suggests that capital in support of off-balance sheet exposures should be much lower than capital in support of on-balance sheet credit, as shown in my 2004 Journal of Financial Services Research article with Joseph Mason). Furthermore, although it is crucial that we phase out Fannie Mae and Freddie Mac over the next several years, to prevent a recurrence of the mortgage bubble that they helped create, the government (which now effectively owns and controls these institutions) is enforcing too stringent a standard on Fannie's and Freddie's mortgage lending at this time. It would be desirable to phase in reduced leveraging in the mortgage market, and a 20% minimum equity contribution is a reasonable long-run target. But the leap to a minimum 20% downpayment requirement in the middle of a housing bust in which one in six mortgages is delinquent is a bad idea. Fannie and Freddie should support the refinancing of high-cost subprime mortgages into standard mortgages with downpayments lower than 20%, as my colleagues Glenn Hubbard and Chris Mayer have proposed.

Government policy should focus on these obvious areas of improvement in the credit markets. A more gradual approach to strengthening capital standards and reducing mortgage leverage will make much more difference for economic growth than another counterproductive stimulus package. 

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