Why ‘Stimulus’ Doesn’t Stimulate

President Obama has asked Congress for an additional $50 billion in “stimulus” money to finance infrastructure projects. The theory is that the additional spending will cause businesses to boost production to meet this demand. Producers will add jobs, triggering increases in consumer spending that will ripple through the economy and fuel a stronger overall recovery.

Unfortunately, however, such government pump-priming hasn’t worked in the past, and there’s no reason to believe it will work now.

Sure, consumer spending accounts for approximately 70 percent of America’s gross domestic product, and increases in consumer spending would provide the economy with an immediate boost. But a drop in consumer spending is not what ails the economy. In fact, as a percentage of GDP, consumer spending actually increased during the downturn, the Commerce Department’s Bureau of Economic Analysis reports—from approximately 69.2 percent of GDP in the fourth quarter (October-December) of 2007 to approximately 71 percent of GDP in the April-June quarter of 2009.

So the conventional wisdom—that a sharp decline in consumer spending caused the economy’s downturn—is wrong.

What did cause the downturn? The answer is: a sharp decline in private investment.

In fact, the ups and downs of the business cycle are always driven by investment spending, not by consumption spending.

When private domestic investment last peaked, in the first quarter (January-March) of 2006, it was nearly $2.3 trillion (in dollars of 2005 purchasing power), or 17.5 percent of GDP. When it hit bottom in the second quarter of 2009, it had fallen by 36 percent to $1.45 trillion, or 11.3 percent of GDP. It is still far below the 2006 peak.

By contrast, in the second quarter of this year, personal consumption was actually at an all-time high, at nearly $9.3 trillion (in 2005 inflation-adjusted dollars). If stimulating consumption were the key to an economic recovery, we would have achieved one already.

The media’s focus on consumption unfortunately tempts politicians to approve “stimulus” measures aimed at pumping up this part of total spending—measures such as long extensions of unemployment insurance, aid to state and local governments to help them avoid personnel reductions, and increases in federal employee salaries.

Some economists in fact single out such measures for special praise on the grounds that such payments, because they are most likely to stimulate near-term consumption spending, have the greatest “multiplier effect.”

Such arguments fail to grasp the true nature of boom-bust cycles, however, especially the central role of investment spending in driving them—and, more important, in driving long-term economic growth.

If politicians truly wish to promote genuine, sustainable recovery and long-term economic growth, they should focus on actions that will contribute to a revival of private investment, not on pumping up consumption. In the most recent quarter, gross private domestic investment was still running at an annual rate more than 20 percent below its previous peak. Net private investment was fully two-thirds below the previous peak.

To bring about this essential revival of investment, the government needs to put an end to actions that threaten investors’ returns or create uncertainty that paralyzes the undertaking of new long-term projects.

Gigantic government measures such as the recently enacted health-care legislation and the financial-reform law, which entail hundreds of new regulations whose specific content, enforcement and costs are impossible to forecast with confidence, contribute to such uncertainty and encourage investors to sit on the sidelines with large cash balances, or to park their funds in safe, short-term, low-yield securities. Such tepid investments cannot support genuine recovery and sustained long-run growth.

What entrepreneurs, investors and executives await is policy stability and predictability, not more government spending, borrowing, sweeping new regulations, and heightened uncertainty.

Our crying need at present is for a robust revival of private long-term investment. Consumption-oriented government “stimulus” programs, threats of tax increases for entrepreneurs and business owners, and costly regulatory onslaughts breed fear and uncertainty and thus ensure a protracted period of economic stagnation.