The Failed Stimulus

by Pejman Yousefzadeh on September 18, 2009

Those who want to relegate Keynesianism to the ash heap of history–like me–believe that Keynesian stimulus does nothing to get the economic engines roaring. As John Cogan, John Taylor, and Volker Wieland point out, fears that Keynesian stimulus will do nothing to help the American economy recover from the recession we suffered appear to have been validated:

Consider first the part of the package that consists of government transfers and rebates. These include one-time payments of $250 to eligible individuals receiving Social Security, Supplemental Security Income, veterans benefits or railroad retirement benefits–and temporary reductions in income-tax withholding for a refundable tax credit of up to $400 for individuals and $800 for families with incomes below certain thresholds. These payments, which began in March of this year, were intended to increase consumption that would help jump-start the economy. Now that a good fraction of these actions have taken place, we can assess their impact.

The nearby chart reviews income and consumption through July, the latest month this data is available for the U.S. economy as a whole.

Consider first the part of the chart pertaining to the spring of this year and observe that disposable personal income (DPI)–the total amount of income people have left to spend after they pay taxes and receive transfers from the government–jumped. The increase is due to the transfer and rebate payments in the 2009 stimulus package. However, as the chart also shows, there was no noticeable impact on personal consumption expenditures. Because the boost to income is temporary, at best only a very small fraction was consumed.

This is exactly what one would expect from “permanent income” or “life-cycle” theories of consumption, which argue that temporary changes in income have little effect on consumption. These theories were developed by Milton Friedman and Franco Modigliani 50 years ago, and have been empirically tested many times. They are much more accurate than simple Keynesian theories of consumption, so the lack of an impact should not be surprising.

Indeed, one need not have looked any further than the Bush administration’s Economic Stimulus Act of 2008 to find plenty of evidence that temporary payments of this kind would not jump-start consumption. That package made one-time payments and rebates to people in the spring of 2008, but, as the chart shows, failed to stimulate consumption as had been hoped. Some argued that other factors such as high oil and gasoline prices caused consumption to fall during this period and that consumption would have been even lower without the stimulus, but no significant impact of these rebates is found even after controlling for oil prices.

Here is the chart Cogan, Taylor, and Wieland reference:


That is just part of the analysis, of course. There is a whole lot more, which discusses the government spending portion of the stimulus package, and its utter lack of impact on economic performance. Read/watch it, and weep. There went nearly $800 billion down the drain. I am sure we could have found an alternative use for it.

(Via Veronique de Rugy.)

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