How to Stimulate the Economy

When you are in the middle of a recession and people are losing their jobs left and right, what do you do?

In the nineteenth century, the answer was simple. Nothing. The government was not expected to manipulate the business cycle. It was expected to maintain the value of the currency. However, the history of the 19th century shows that much of the economic turmoil was due to politicians mucking around with the credit system. Think Andrew Jackson and the Second United States Bank. Think the deflation after the Civil War when the government deliberately worked to increase the value of the dollar back up to its prewar level. Think free silver.

In the first great crash of the 20th century, the Crash of 1907, J.P. Morgan brought the wealthiest men in America together to organize a bailout. They conducted a triage operation on ailing companies. They refused to bail out companies that they judged would survive the crash anyway. They refused to bail out the companies that they judged would fail anyway. They decided to bail out the companies that they judged would survive if loaned some money.

The 1907 crash occurred before the creation of the Federal Reserve Board. So it's not surprising that when the first big financial crisis hit in 1929 the Fed botched the job. You'd expect that with a new government program. The Federal Reserve, set up as a lender of last resort, let thousands of banks fail. The money supply contracted sharply and the credit system ground to a halt. Millions were thrown out of work, and unemployment went over 20 percent.

In the 1930s, British economist john Maynard Keynes wrote The General Theory of Employment, Interest, and Money. It actually wasn't much of a general theory, but it did propose a policy for getting out of the Great Depression. The policy was to ramp up government spending on useful projects, like infrastructure--roads and bridges. This would create a "multiplier" effect that would stimulate other economic activity and so get the economy out of the slump.

In the event, the US economy finally recovered with the war spending of World War II.

The problem with the Keynesian stimulus policy is that the projects the government chooses to fund may not in fact be economically beneficial projects that stimulate other economic activity. They might be bridges to nowhere. Or they might be bailing out companies, like General Motors, that probably cannot be saved anyway. In other words, government chooses based on political considerations, while bankers like J.P. Morgan choose based on economic considerations.

That's the situation we are in the present time. The Democrats, inspired by Keynes, have enacted a huge stimulus program to stimulate the economy. But it has turned out that the stimulus program is not full of economically beneficial projects but political payoffs. It is designed to help Democrats and Democratic constituencies weather the recession. It is not designed to encourage economically beneficial activities.

Of course, if you want to turn the economy around, then you need to encourage people to do things that will start a a new economic expansion. You want to direct credit towards those activities that will deliver the most profit, understanding profit as a surplus of benefit over cost. If you think that then you will be inclined to reduce tax rates on employment, such as the FICA tax. Or you might want to reduce tax rates on small businessmen, who are the primary generators of new ideas and new employment.

But politicians don't think that way. They do not get elected by helping unknown business startups in unknown garages. They get elected by helping established special interests that have the money to support their campaigns and the influence to bend their ears and threaten bad things if they don't get what they want.

In the United States, marginal rates on business taxes are already high. The corporate income tax rate hits 34 percent for income over $75,000 and then bobbles around, hitting 39 percent before settling down at 35 percent for corporate income over $18,333,333.

Guess what. In Europe corporate income taxes are in the 25 percent range. In Japan there is not capital gains tax at all. So US businesses are at a disadvantage.

Next year, 2010, the Bush tax cuts will expire and individual income tax rates will go up.

The issue really is this. Do you think that politicians and their staffs are best at figuring out what projects are best for the economy? Or do you think that individual businessmen are best?

The answer is important. About 10 million people have lost their jobs in the last two years. They want to get back to work.