Obama’s $1 Trillion Gamble

President-elect Obama is considering an economic stimulus package that will include increases in government spending and tax cuts of approximately one trillion dollars. Many fear a prolonged depression resulting from a sharp reduction in consumer spending.

After saving very little for many years, Americans have begun to save more in response to the economic crisis. When people spend less on consumer goods and services, producers sell less and cannot afford to employ as many workers. Thus, it seems self-evident that if unemployment is to be reduced and the economy is to recover from the recession, there must be an increase in spending. If consumers insist on saving more and reducing their spending, it is widely believed that the government should offset this decline by spending more on public works projects.

The above analysis reflects several fallacies that are common in popular discussions about economics. First is the erroneous assumption that if people save more money, total spending will decline. While this would be true if they saved money in cash and stuffed it under their mattresses; in today’s economy, almost all savings is deposited in financial institutions or used to buy stocks, bonds, or mutual funds. Financial institutions and corporations that issue stocks and bonds use that money to fund investment projects. If people save more, more can be invested, which means employment will increase in those firms producing capital goods like machines, computers, and factories. No economic stimulus package is needed because the increase in investment spending will offset the decline in consumer spending, creating new jobs producing investment goods to replace the jobs lost producing consumer goods.

If jobs producing investment goods replace jobs lost producing consumer goods, why is the unemployment rate rising? Because it takes time for people who lose one job to find another. In addition, because of the financial crisis, financial institutions are more hesitant to lend. Many have increased the amount of money they hold in reserve. This means that less of what people have saved is being lent for investment. Although the bank bailout and other actions by the Federal Reserve increased bank reserves, meaning that banks will be able to lend more, the continued reluctance of banks to increase their lending may keep investment from increasing as much as needed for a quick economic recovery.

Even if banks continue to hold so much in reserve that investment spending does not increase to offset the reduction in consumer spending, a free-market economy has another self-correcting mechanism that, if allowed to operate, will lead to an economic recovery. Falling demand will lead to declining prices, which will result in a corresponding increase in the quantity of goods and services demanded. If wages fall along with prices, firms will want to hire more workers and unemployment will fall. This is the dreaded “deflation” that many people, including Federal Reserve Chairman Bernanke, fear. Deflation is hard on debtors, because it would mean that the dollars they must pay back are worth more than the dollars they borrowed. Homeowners and stock-market investors have already experienced severe deflation in the value of their assets, so why shouldn’t debtors also share some of that pain through price deflation?

We do not need an economic stimulus package for the economy to recover from the current recession. One argument in favor of a stimulus package is that it may result in the economy recovering more quickly. A more important reason why Congress may pass the stimulus package is that it will reduce the losses experienced by debtors and other politically powerful groups. Those who receive the additional government spending, which most likely will include state governments, will not have to tighten their belts as much as many of the rest of us who have been affected by the economic crisis.

Although it is possible that the economic stimulus package could hasten the economic recovery, its likely long-run consequences are far worse than any short-term benefits which might result. One trillion dollars of additional government debt is going to be a drag on the economy for many years. For the reasons noted above, the private market demand for goods and services will recover in the next year or two. When it does, the additional government borrowing in competition with private borrowing will lead to rising interest rates. These high interest rates will discourage private investment, which is the key to rising productivity and higher standards of living in the future.

The Federal Reserve might be able to keep interest rates from rising (as much) while the economy recovers by rapidly increasing the money supply. This, however, will result in accelerating inflation, leading to price inflation of 10 to 20 percent per year or more. If this continues for a few years, it will do more to wipe out retirement savings than last year’s market crash.

The choice is clear: If Congress passes the proposed economic stimulus package and the new president signs it, debtors will suffer less pain, state and local governments may be able continue to spend freely, and a variety of government projects will be funded that might produce benefits for some Americans. This will come at a very high cost in terms of reduced private-sector investment and long-term economic stagnation or rapid price inflation that creates massive losses for those who have carefully saved for their retirement. The alternative is to allow the economy to recover in response to voluntary decisions by consumers and entrepreneurs in the marketplace without a further expansion of the government’s role. This will preserve economic freedom without burdening future generations with one trillion dollars of new government debt.