Why the Democrat’s Economic Stimulus Will Not Work

I find it both foolish and amazing that almost the entire Democrats’ “economic stimulus” package and the accompanying rhetoric are focused on trying to get Americans to spend more money. Consider what got us into this current economic crisis:

1. Government support (through Fed policy) of very low interest rates made it very cheap to borrow money (easy credit). Credit of all kinds proliferated based on an underlying sense that the U.S. would always grow and house prices would always go up.

2. “Easy credit” led to people borrowing more money. They often borrowed money without collateral (e.g., credit cards); they were encouraged to borrow money against depreciable property (e.g., $40,000 for an SUV that will depreciate by 1/3 as soon as you drive it off the lot); and they were encouraged by government programs and quasi-governmental agencies (e.g., Fannie Mae and Freddy Mac) to borrow money against real property of questionable value or without the “real” ability to repay the loans. Additionally, many other financial institutions over extended themselves — sometimes holding a reserve of only 1/30 of their liabilities.

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   Thus, “easy credit” led to over-consumption. People bought more and more cars, houses, consumables, entertainment, and so forth. The net effect of over-consumption is to drive either prices or production up – and sometimes both. House prices continued to climb, for example.

4. Over-consumption led to over-production. There were too many sources for products, entertainment, restaurants, and so forth, all being sustained by a false economy being stimulated artificially by Fed policy based on unsound assumptions.

This is a classic “economic bubble” – over-consumption driving over-production driving upward-spiraling prices, production and profits. At some point, someone must realize that that the “bubble” is supported by nothing but hot air, that the “bubble” is not economically sound. When that realization grips the market, that’s when the collapse occurs.

The “collapse,” in this case, took several trillions of dollars of “capital” out of the market. Of course, much of the “capital” – as stated in dollars – that existed during the market “bubble” was an illusion to begin with. However, it was still carried on the “books” of the various companies as “dollars” in capital. Essentially, the collapse was a “destruction” of paper-based capital.

Now, to rebuild, we (the U.S.) must begin replacing the capital value lost with genuine capital. It is a law of economics that all capital comes from “savings and sacrifice” and not from spending. That’s one of the reasons that the money thrown at the problem already by the TARP fund has had so little effect. The financial institutions have “absorbed” that money in an attempt to rebuild their own capital base. Until they have rebuilt that base, they cannot liberate dollars for lending.

What the U.S. absolutely must go through right now is not a period of renewed spending, but a significant period of renewed saving to stimulate the economy. That is why tax cuts will work while throwing money at the problem will not.

Tax cuts will allow individuals and businesses to save money (from the tax cuts) and pay down their current over-extended credit lines or build a larger capital base from which to innovate, grow, expand and hire new employees.