The foolishness of economic 'stimulus'

A consensus is building that America's economy is sliding – perhaps plummeting – into recession. In December the unemployment rate jumped to 5.0 percent, up 3/10ths of 1 percent from its November level. And of course investors are now growlingly bearish.

To no one's surprise, politicians are rushing in with various plans for helping the economy. Most of these plans involve "stimulus." The calls are loud to put more money into the hands of ordinary Americans in hopes that they will spend – not save – it, thereby boosting the overall economy.

Such stimulus, however, is futile. Government cannot create genuine spending power; the most it can do is to transfer it from Smith to Jones. If the Treasury sends a stimulus check to Jones, the money comes from taxes, from borrowing, or is newly created.

If it comes from taxes, the value of Jones's stimulus check is offset by the greater taxes paid by Smith, who will then have fewer dollars to spend or invest. If Uncle Sam borrows to pay for the stimulus checks, this borrowing takes money out of the private sector. Any dollars borrowed – whether from foreigners or fellow Americans – for purposes of stimulus would have been spent or invested in other ways were they not loaned to the government.

The only other means of paying for such stimulus is for the Federal Reserve to create new money. Unfortunately, this option leads inevitably to inflation.

All Americans wind up with more dollars in their wallets but also paying higher prices in the stores. Prosperity is not created by raining down upon the populace more monochrome pictures of dead statesmen.

Stimulus funded with newly created money is especially harmful. Most obviously, the inflation it causes prompts investors to flee the dollar. But because inflation can take time to show up, injecting new money into the economy can create a temporary sense that consumers and investors are wealthier than they really are. Such a false sense dangerously delays the necessary pruning of unfruitful investments. A bad economy is prolonged.

"It's only when the tide goes out that you learn who's been swimming naked." That saying, credited to Warren Buffett, points to the important – if painful – role that recessions play: moving money from bad investments to sound ones. Delaying this adjustment with the hallucinogen of easy money does no one any favors over the long-run.

Spending power is not so much the fuel for economic growth as it is its reward. And the key to economic growth is investment that raises worker productivity.

The best way for policymakers to foster such growth is to avoid panicking over any current economic downswing. Instead, they should focus on getting the economic fundamentals right. Such emphasis might not make things better – or even make things appear to be better – today, but it will make our tomorrows as bright as possible.

The good news: These fundamentals really are fundamental. President Bush can take action tomorrow. The bad news: All of these steps require a lame duck to swim against the political current.

First, Mr. Bush should call for a substantial and permanent cut in both capital-gains and personal-income tax rates.

Next, he should insist on a large reduction in federal spending, including elimination of all agricultural subsidies. While he's showing such courage, he might as well unconditionally endorse free trade.

Cutting taxes is, of course, a good thing, but it's important to know why. The goal would not be to increase consumer spending. Instead, it would be to raise the returns on investment and work.

By letting investors and workers keep more of the fruits of their risk-taking, creativity, and efforts, the economy will enjoy more risk-taking, creativity, and effort. Businesses that would otherwise not be started would be created. Likewise with machinery and training that increases worker productivity. Investors worldwide would flock to take advantage of these lower tax rates, further increasing productive investments.

Cutting government spending would result in more of the economy's resources being used by wealth-creating businesses rather than being siphoned away to special-interest groups and boondoggles such as bridges-to-nowhere and Woodstock museums.

Committing to free trade would assure global investors that Americans refuse to turn inward – that producers in America will not be stymied in their efforts to buy inputs from low-cost foreign suppliers and that investments and entrepreneurial ideas from abroad will continue to be welcomed.

Finally, Bush should assure the Board of Governors of the Federal Reserve that he neither expects nor wants them to use monetary policy politically. Reminding them of the wisdom of Milton Friedman, he should strongly urge them to keep a tight rein on the money supply.

Sound money, low taxes, and free trade might not "stimulate" the economy today, but this combination will surely increase its vigor over the long-run.

• Donald J. Boudreaux is chairman of the economics department at George Mason University.