Where Did the Stimulus Go?

Where Did the Stimulus Go? by John F. Cogan and John B. Taylor (Commentary)

During the recent recession, the U.S. Congress passed two large economic stimulus programs. President Bush’s February 2008 program totaled $152 billion. President Obama’s bill, enacted a year later, was considerably larger at $862 billion. Neither worked. After more than three years since the crisis flared up, unemployment is still very high and economic growth is weak. Why have such large sums of money failed to stimulate the economy? To answer this question, we must look at where the billions of stimulus dollars went and how they were used.

Keynesian stimulus packages come in three basic types. In the first type, the federal government puts money directly into the hands of consumers. The hope is that consumers will use the money to increase their purchases of goods and services. In the second type, the federal government directly purchases goods and services, including infrastructure projects, equipment, software, law enforcement, and education. In the third type, the federal government sends grants to state and local governments in the hope that those governments will use the funds to purchase goods and services.

In each case, according to Keynesian theories, the increase in purchases will stimulate additional economic activity over and above the initial increase in purchases. The 2008 stimulus was mainly of the first type, while the 2009 stimulus was a mix of all three types.

Let’s start with the effort to put money temporarily into the hands of consumers. In the 2008 stimulus, the U.S. Treasury began issuing one-time payments to households in the spring. This temporary boost in income was designed to jump-start personal consumption of goods and services and thereby increase production and jobs at the firms that produce those goods and services. It didn’t work.

Take a look at Graph 1, which shows both income and consumption in the economy as a whole from the start of 2007 to the present. You can see the big blip in disposable personal income in the spring of 2008 as checks were sent out. But consumption did not increase at all around the time of the stimulus payments. What happened to the money? It went to pay down some debt or was simply saved rather than spent on consumption.1

This should not have surprised anyone. Long ago, the Nobel Prize–winning economists Milton Friedman and Franco Modigliani explained that individuals do not increase consumption much when their income increases temporarily. Instead, they save most of the funds or use the money to pay back some of their outstanding debts. Friedman and Modigliani demonstrated that most people, when deciding how much to consume, consider more long-lasting, or permanent, changes in income. Because one-time increases in transfer payments and temporary tax rebates are, by their very nature, temporary, people should not have been expected to alter their consumption patterns. The Friedman-Modigliani theory, called “the permanent income” or “the life-cycle” hypothesis, profoundly influenced macroeconomic thinking for decades. It was, oddly, ignored in the development and enactment of the stimulus of 2008.

The American Recovery and Reinvestment Act of 2009 (ARRA) repeated this mistake. The amount paid out to households was smaller and delivered over a longer period of time than the 2008 stimulus, but the largest portion of increased payments was made in the spring of 2009. You can see the resulting blip in income in Graph 1.

Again, there was no noticeable effect on consumption. Instead, individuals used the money to shore up depleted bank accounts or pay off overextended credit card bills. As had been true a year earlier, the temporary cash payments failed to create consumption and, as a consequence, failed to increase production and employment.

Graph 1 also illustrates the failure of another recent stimulus attempt: the 2009 “cash for clunkers” program. For a temporary period, this program provided a one-time subsidy if individuals purchased a qualifying new car and simultaneously traded in their old car. The program’s objective was to increase the demand for new cars to spur production and employment.

By definition, a one-time subsidy cannot cause a permanent increase in consumer demand. So what happened? Consumers merely shifted forward in time the purchase of a new car by a few months. This behavior is evident in the lower-right-hand part of Graph 1. Consumption rose sharply as consumers responded to the temporary subsidies, then came right back down. There was no net increase in consumption to bolster the recovery.2

(Read the rest to understand exactly, incontrovertibly, how it is that the stimulus spending has failed to improve the economy or joblessness): http://www.commentarymagazine.com/viewarticle.cfm/where-did-the-stimulus-go--15610