FOO Law and Economics

Friday, February 6, 2009

Tax cut as the best stimulus

Robert P. Murphy at the von Mises blog offers food for sober thought.

The Keynesian view is that unemployment stems from inadequacy of aggregate demand, along with "sticky" wages and prices. Accordingly, the remedy is expansionary fiscal and monetary policies to make up for the "lost" aggregate demand. The Austrian school, on the other hand, believes that it is better to do nothing because the problem is a maladjustment of the economy that led to the previous bubble.

Neither view is complete. If the Austrian view is correct, then the Keynesian stimulus will work only when the unemployed resources are absorbed in a healthy economy (one without the excesses of the housing market, the "toxic" assets in the financial system, etc.). In other words, expansionary policies need to be accompanied by structural changes that take some time.

The Austrian prescription of "doing nothing" is also incomplete. After all, there are pockets of the economy without "malinvestments" but suffer along with the rest. Policies to allow the price mechanism to work would seem to be the more proper Austrian prescription.

The Austrian school can at least explain why and how the crisis might take a while. That is no mean achievement, compared with Keynesian economics. Experts who have studied the history of past crises note the need for a painful phase of financial restructuring in the U.S. economy (see Reinhart and Rogoff at the Wall Street Journal, for example). That view is consistent with the Austrian school.

There is common ground between Keynesians and the Austrian school. Both would favor cutting taxes. As Murphy put it in another post, "if the government wants the economy to recover as quickly as possible, [it should] cut taxes, stop inflating the money supply, and stop changing the rules every three days."

In my view, the same prescription could apply equally to other countries, including the Philippines, because crises tend to propagate across borders, not only through trade linkages but also through confidence factors (known as “animal spirits” in Keynesian economics). But, unfortunately, as Murphy put it, the Austrian solution is not likely because "it doesn't allow the politicians to pose as generous saviors."

The IMF staff have a "diversification" view on the components of the stimulus package. They claim that we do not know enough about the multipliers of tax cuts and expenditures, and they therefore advise countries to "pick and choose." In the Philippine case, it seems clear that the burdened citizenry would prefer tax cuts, and would spend them. Government expenditures on public works and on "green" projects will take time to bid out and implement, and of course, there is the possibility of "leakages" through corruption. Incidentally, the IMF staff do not like the idea of using the stimulus to subsidize local industries, raise public sector salaries, or create new entitlement programs. They view these types of expenditures as politically difficult to undo later on.

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