Milton Friedman on why Bush’s stimulus plan won’t work
After Federal Reserve Board Chairman Ben Bernanke basically said yesterday that making the Bush tax cuts permanent should be off the table for now, in exchange for a Keynesian temporary “stimulus” package of income-boosting “rebates,” the Dow Jones Industrial average fell by more than 300 points. (Hat tip to John Tamny of RealClearMarkets.com for making this connection in one of his e-mail alerts). Today Bush formally announced a temporary “stimulus” –again backing away from making permanent his 2001 and 2003 cuts in income, capital gains, and dividend tax rates — and the stock markets tumbled further.
It is far from clear we are facing a recession, but we are facing an uncertainty about the economy that is making the market nervous. And part of what is making the market nervous is, ironically, politicians’ urge to do “something,” anything, to save it.
The Dow had gone up over 100 points on Wednesday and was heading up on Thursday morning, until Bernanke gave his speech ruling out permanent tax cuts for now. There had been some surprisingly strong 4th quarter earnings reports from companies such as IBM. In an excellent article in the Washington Post yesterday that combed through industry data in the Federal Reserve’s “Beige Book,” financial reporter Neil Irwin noted that in some sectors such as hotels, health care, consulting and engineering, growth was actually “robust.”
Yet there are still things that concern the market, and many of those concerns stem from Washington. The market is concerned about inflation and unstable dollar, as Bernanke basically said last week he will lower interest rates at will. And it is concerned about the tax cuts expiring — in 2011 by law, and possibly sooner depending on things like election results.
This uncertainty constrains investment. And that’s why it would be so much better reduce this uncertainty by an action such as making the tax cut permanent than a Keynsian temporary stimulus that has been show again and again to be flawed. The late Milton Friedman’s “permanent income” hypothesis demonstrably shows that people do not spend money from a one-time stimuli from the government — in fact if they perceive bad times, they are likely to hoard any extra money they get — but with regard to expectations about their future income. (A good summary of his views can be found at this eulogy from the Wall Street Journal editorial page)
That’s why he argued that during a recession, the best thing the government could do was raise income expectations by changing incentives through policies such as permanent tax cuts. As he told Radio Australia in the late ’90s, “Cut taxes in order to increase incentives, but there is no need for the government to increase spending.”
Rebates aren’t the worst thing the government could do. At least it’s not distorting the market as other policies, like spending on farm subsidies, do. But it’s not going to do much to improve economic growth. Much of business investment is not temporary. You can’t build a factory in 2008, and close it in 2009. Both businesses and individuals consider their permanent income when making major investments.
Permanent tax and regulatory relief are the best cures for economic doldrums. If the federal government is not gong to do that, it should follow the medical oath, and first do no harm.