Watch Out for Stimulus 'Leaks'

The architect of Kennedy's tax cuts would have been skeptical of the Obama plan.

GEORGE MELLOAN

In economics textbooks the "leaky bucket" principle holds that when government transfers income or wealth from rich to poor a lot leaks out and is wasted. Some estimates put the leakage at most of what is meant for the poor, especially if you measure the damage to economic efficiency from the reduced work incentives of both the donor and the recipient.

The leaky bucket metaphor was coined years ago by Arthur Okun, a Yale economist who advised John F. Kennedy and later became chief economic adviser to Lyndon B. Johnson. Okun was a leading architect of the Kennedy tax cuts, passed shortly after the president's death with salutary economic effects. Because those cuts sharply reduced the top marginal rates on income, Okun has been called the first supply-sider -- one who worked for Democratic presidents no less. In his day, he would have been called a classical economist.

Although Okun's rule focused specifically on "antipoverty" programs, it can be argued that nearly all government outlays are transfers. Money from taxpayers and the credit markets goes to uses chosen by Congress. Thus, the leaky bucket has special application now as Democrats grope for ways to use wealth transfers to revive the economy.

Even before Barack Obama's inauguration, the Democrat-controlled House crafted a record-breaking $825 billion program to "stimulate" the U.S. economy. One measure -- withholding less income tax from paychecks over the next two years -- is a Keynesian effort to restore consumer demand for goods and services by sweetening take-home pay. Its authors assume that this $140 billion tax break will work better than last spring's $152 billion tax rebate, which seems not to have worked at all, judging by the economic debacle in late 2008.

The central question, however, is not whether "stimulus" programs are ineffective. It is whether they are counterproductive. A case can be made that the bucket not only leaks but that the leaks tend to drown out chances for economic recovery.

Circumstantial evidence that "stimulus" packages actually delay recovery can be derived from the Keynes-guided New Deal of the 1930s, which put large faith in federal deficits as a Depression cure. Federal debt climbed to 43.86% of GDP in 1939 from 16.34% in 1929 with very little relief from hard times. Huge Keynesian deficits in the 1970s did not arrest stagflation. The misery index, combining inflation and unemployment, soared above 20%.

Of the $825 billion package not slated for tax credits, the lion's share will go to states and cities, ostensibly for such things as infrastructure repairs. But in reality it is a partial federalization of state and city budgets -- of particular benefit to New York, New Jersey and California -- that are in large pools of red ink with no prospect of climbing out without federal help. The "stimulus" is partly a matter of the political class in Washington looking after its own in the nation's state houses. One danger of federalization is that it will reduce competition among states to attract investment, thereby weakening another driver of economic efficiency.

The Troubled Asset Relief Program (TARP) was at least a government attempt to make amends for the damage Washington did to the financial sector through monetary mismanagement and the pollution of the mortgage market by Fannie Mae and Freddie Mac. The second tranche of the $700 billion TARP authorization has now been approved by the Senate. It, like the $825 billion stimulus plan, is attracting lobbyists like flies to honey.

The central defect of government bailouts and stimulus packages is that the money is allocated through a political process. It goes to recipients who have the most political influence. Private entrepreneurs and even big business, by contrast, employ investment to earn a profit. The record shows that the latter yields greater economic efficiency, and hence creates real jobs.

The new stimulus package pays lip service to aiding the private sector with various tax incentives for hiring and investing capital. It acknowledges, just barely, that the private sector will be the engine for recovery if recovery is to be had. But the record for such measures is about as dismal as the one for short-term supplements to consumer income. They do very little to change the decisions or behavior of the recipient. If the recipient is wary and uncertain about the future, he or she will probably remain so.

Socialist economies, where governments decide how to allocate resources, are notoriously less efficient than market-capitalist economies. As in Washington, every politician demands his share. The late Abram Bergson of Harvard, after prodigious research, concluded that the old Soviet Union -- the ultimate in socialism -- employed capital only about half as efficiently as the U.S. That is one reason the Soviets collapsed from economic exhaustion.

Democrats are putting a lot of faith, to the tune of over $1.5 trillion, in economic policies with dodgy track records. At this time of a new president and great expectations, one hopes the political class will succeed better with massive spending than it has in the past. But don't bet the farm.