Stimulated? No, me neither

Economics and entrepreneurship go hand-in-hand. While I’d wager that most people starting companies spend little time thinking about economic theory, their daily reality is an exercise in unleashing what Joseph Schumpeter called the gales of “creative destruction.” Entrepreneurs usher in change and innovation, which are the driving forces of economic growth and job creation. Given this, it seems appropriate to visit the topic of economics on this blog, especially given the nature of the policy changes being discussed in Washington DC.

PiggyBankRepairI was pleased to see that my undergrad thesis advisor, Hoover fellow John Cogan, co-authored an op-ed in Thursday’s WSJ entitled “The Stimulus Didn’t Work.” Along with John Taylor (the Stanford professor who wrote Getting Off Track, which makes the convincing case that monetary policy errors led to the housing bubble) and Volker Wieland, Cogan breaks down the Q2 rebound in GDP and shows that consumption didn’t rise as the forecasts of the Obama Administration predicted.

Liberals tend to invoked the fiscal policies of John Maynard Keynes as the remedy for economic downturns. Keynes advocated government spending as a means of priming the pump to generate consumer demand. Obama’s near-$800 billion stimulus plan is the largest recent example of this kind of demand-side policy. Keynesian theory goes that in a downturn, the government can stabilize the economy through all sorts of public works and transfer payments, which in turn improves cashflow and serves as a jump start for economic growth. To put it in business terms, Keynesians seem to view the economy as operating on a cash basis, so transfer payments from the government should prompt consumers to spend again and break the vicious downward spiral caused by an economic shock.

It’s an elegant theory, but it’s also wrong. As Cogan, et al, demonstrate in their editorial, Obama’s stimulus has not stimulated consumer spending — nor did the stimulus plan signed by George W. Bush in 2008. A major reason why demand-side stimulus doesn’t work is the permanent income hypothesis, which was articulated by Milton Friedman. This hypothesis says that people don’t change their behavior due to one-off occurrences, but rather base their economic decisions on what they perceive to be their long term prospects. Hence it’s no surprise that American consumers, who are in the process of de-leveraging and increasing their savings rate, did not respond to the roll-out of the stimulus by spending more. The current rebound in the economy can be traced to a rebound in business activity, which is generally the case following a recession, since companies that slashed inventories during the downturn have to build them back up as the business cycle improves.

Keynes may have given the dismal science some valuable insights, but his modern disciples need to rethink his policy prescriptions.

I suspect that many politicians who advocate Keynesian fiscal policy during recessions have an unstated ulterior motive, namely increasing government control over the economy. Massive stimulus does this in two ways: 1) it expands the government’s reach into the private sector, giving it greater influence over more entities than were previously beholden to it, and 2) it promotes the misleading narrative that government rode to the rescue to clean up the excesses of the free market.

This is why entrepreneurs should be concerned with economic policy. Expansive governmental involvement in the economy hinders growth and innovation. A study released earlier this year suggests that the optimum size of government is less than 25% of GDP, whereas the U.S. is at 36% and rising. Big government chokes out entrepreneurship and tilts the playing field in favor of big business (e.g. Europe). And the projected massive budget deficits being run up in Washington will make it harder for entrepreneurs to obtain capital in the years to come. It’s not a pretty picture, especially since we now know that the economy bottomed out and stabilized with no help from the stimulus package.

3 thoughts on “Stimulated? No, me neither

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