The Stimulus Placebo Effect

Will the almost $1 trillion stimulus plan being rushed through Congress help revive the economy? Right now that's all my institutional clients want to know. So when I meet with them, I have a page in my presentation book headed “What do we think of the stimulus plan?” Other than that heading, the page is blank. That's what I think about stimulus. Nothing.

How can anyone seriously think that government rushing to commit all that money for a hodge-podge of projects, programs and that other thing that begins with “P”—pork—could possibly be of any particular help to the economy? Yet apparently people do, even elite economists. In fact, it's standard textbook macroeconomics that government spending can get a country out of a recession. And doesn't everyone believe that it was government spending that got this country out of the Great Depression?

About the best thing I can say about it is that, if everyone believes it, it just might help for no other reason than that. It would be a placebo effect—something that works just because you expect it to. Why not? If everyone believed that rubbing blue mud in their navels would help the economy, then let's do it. After all, a great part of our problem in the economy right now is that people lack confidence to spend and invest. So whatever it takes to lift their spirits, we might as well try.

But a trillion dollars is a pretty expensive little pot of blue mud. And other than the placebo effect, there's not a lot of reason to think that it will really work, no matter what the economics textbooks say.

You shouldn't have to be an economist to see why it won't work. If government borrows money to pay for spending programs, that money has to come from somewhere. Someone has to not spend that money so that government can spend it. Economists reading other chapters of the same standard textbooks call that “crowding out.”

Those who advocate stimulus claim that the money wasn't going to be spent anyway, so there is no crowding out. There's something to be said for that point of view at the moment. After all, it seems there is a mad dash to buy Treasury bonds, because they are the safest investment around. That's why yields are so low. So as long as people are going to lend to the government anyway, why not take their money by selling them the bonds they want, and then spend it? Can't hurt, and it might help.

But it can hurt. If government didn't sell the extra Treasury bonds to accommodate the temporary desire for them by investors, then the great demand for bonds would drive interest rates even lower. That would reduce government's cost of financing itself, and the difference could be used for spending, though not as much as if new bonds were issued. And having lower interest rates on riskless bonds would make it more attractive for investors to consider making slightly riskier investments, like corporate bonds or even stocks. That wouldn't be such a bad thing in this credit crisis, would it?

And remember. The day will come when any bond the government issues will have to be paid back. Just where is the money going to come from if we spend it all now? Higher taxes? Lower spending? Either way, it would seem that spending our way out of a recession now just sets the stage for taxing our way into a different recession in the future.

And then there's the issue of exactly what the government spends the money on. Economists who rabidly support this kind of stimulus think that doesn't even matter. In a famous thought experiment, such economists argue that you could pay people to dig holes in the dirt and fill them up again, and that would be perfectly adequate to bring the country out of recession. But I don't see how that's different than paying people to stand still and do nothing—the same thing is accomplished either way. And paying people to stand still and do nothing is simply charity. Welfare. The dole. Is that supposed to get us out of recession?

I suppose an extreme case could be made that if the private economy is completely frozen, if people are so freaked out for one reason or another that they simply will not spend or invest at all, then government must step in and get things started again. Most economists would tell you that's what happened in the Depression of the 1930s, when a raft of New Deal spending programs were necessary to get the economy out of complete collapse.

But it's just not really clear at all that any of the New Deal spending programs really did any good. World War II came along and transformed the Depression economy into a vibrant wartime economy—until that happened, a decade of government spending had done very little to improve employment, production, or income.

There are some modern economists who even argue that the New Deal spending programs prolonged and deepened the Depression. They make the case that private investment was stymied because businessmen were afraid of what New Deal program or regulation or control would come along and ruin their plans.

That's another form of crowding out, and it's a very real issue. Say today's stimulus plan puts government in the business of promoting so-called “green energy.” If you're a private company that wants to do anything at all in energy, that makes Job One for you latching onto the government's money if you can. Or if not, at least being sure that the government doesn't end up supporting your competitors, wiping you out even if your competitors' products aren't as good as yours. Facing that prospect, why bother to go into business at all? I mean, why bother to go into any business but the lobbying business?

I applaud the efforts by Republicans in the U.S. House of Representatives and Senate to slow down the stimulus freight train now madly dashing through Congress. Committing that kind of money takes time and thought. And there are other approaches that should be considered, such as cutting taxes to stimulate spending by people and companies, rather than by government. Or for that matter, to stimulate investment rather than spending at all.

I'm not persuaded that we face some kind of dire and imminent emergency that virtually necessitates rushing into a trillion dollar pork-barrel fiasco. Besides, the worse the emergency, all the more reason to take a deep breath, count to ten, and think for a moment before we act.

So if the stimulus bill gets derailed, don't let that scare you if you've been trying to get into stocks near the bottom. Doing nothing, doing less, or at least waiting, could end up being the best thing for the economy and for stocks.