When you heard that the government was spending $787 billion in an attempt to stimulate the economy, did you brace for future tax hikes to pay for it by saving more and spending less? Some economists think you did. Consequently, they believe that government spending just serves to replace the contraction in consumer spending, and falls flat. This makes up one of several arguments made by economists analyzing the stimulus summarized by an article in the Wall Street Journal today. Does this theory make sense in the real world?
Here's the argument:
Carmen Reinhart, a University of Maryland economist who has studied the fiscal aftermath of financial crises, says more stimulus could be counterproductive because it could lead the public to expect even higher taxes in the future.
And consequently, people will spend less, rendering the stimulus mostly useless. Any demand the government creates would just replace demand lost by more consumers saving in response. While this makes logical sense in the theoretical world of academic economics, does the hyper-rational consumer that this theory relies on really exist?
Think about the magnitude of rationality the average person would need to possess for this claim to be true. Let's call him Joe American. Joe would first have to very carefully budget his spending and saving. In addition to having such a budget in place, but he must also constantly tweak it when there's a change in the economy. Next, he must pay very close attention to the government's spending, taxing, and deficits. When the deficit increases, he must determine how much that gap will cost him in the future, and adjust his budget accordingly.
Do you know anyone like Joe? I sure don't. There are some people out there who are pretty good at budgeting, but they're in the minority. There are also some people out there who pay a lot of attention to fiscal policy, but they're also in the minority. If you drew a Venn diagram of these two populations, it's hard to believe that the overlap could be a very large portion of the population. It's just not plausible that the Joe American above really represents the average U.S. consumer.
Moreover, many people who would argue that additional government spending during a recession is a bad idea argue that tax cuts would be a better alternative. But why would it be any different if deficit spending consisted of tax cuts instead of spending? Sure, some might argue that tax cuts will ultimately be better for long-term growth than government spending. But in terms of consumer demand, if people really are hyper-rational as explained above, then they would treat a $1 billion tax cut the same way they would $1 billion in additional spending. Demand would decline just the same.
When I heard that the government was spending $787 billion to try to revive the economy, I was cynical about how much positive effect it would have. But it didn't cause me to save more to pay for the future tax increases that would be necessary to pay for the new deficit. I shook my head and went on with my life. My demand as a consumer was the same as it would have been without the stimulus.
Maybe I'm less rational than the average American, but I doubt it. Bear in mind, I have a background in finance and economics, and now work as a journalist in Washington, DC. So I'm probably more interested in budgeting, numbers, and fiscal policy than the average American, yet even I didn't change my behavior based on the stimulus. If you have a different interpretation or experience, then please do share. Does hearing about big budget deficits cause you to save more?