Pocket money won't stimulate economy

Australia has so far followed the US fiscal expansionist response to the global financial crisis. However, unlike in the US, this radical fiscal turnaround has encountered minimal resistance from academic economists here.

In an open letter to President Barack Obama published in leading US newspapers earlier this year, hundreds of eminent US academic economists specialising in this field, including Nobel laureates James Buchanan and Edward Prescott, endorsed a statement that more government spending was not the way to improve US economic performance. Believing otherwise, they said, was "a triumph of hope over experience".

On both sides of the Pacific we have witnessed Keynesian fiscal responses motivated by fears of a repeat of the Depression of the 1930s. Yet as the US economists assert: "More government spending by Hoover and Roosevelt did not pull the US economy out of the Great Depression."

In other words, what could be called crank-handle Keynesianism, focused on government spending, did not even work when Model T Fords were around. So with suggestions that even more fiscal stimulus could be in the offing in the May budget, it is important to stress the drawbacks of misdirected policy, especially the cheque's-in-the-mail approach aimed at boosting aggregate household consumption.

Executing fiscal policy according to the motto "if at first you don't succeed, try again" is not advisable when that policy costs so much, is not evidence-based, diverts funds from more productive uses, adds to future interest rate pressures and risks the nation's international credit rating.

The economic consequences of giving money away to stimulate consumption can be illustrated by an exaggerated example. Instead of paying once-only bonuses to favoured groups who might spend their newly gotten gains, why not simply pay every schoolchild in the country a tuckshop bonus to be spent every day at their soon-to-be-refurbished schools. Every schoolchild could receive $5 - no, make that $10 - a day, paid directly from the federal budget. As the number of school students who attend class for 40 or so weeks a year is about 2.8 million, this would amount to about $5.6 billion a year, more than half the first welfare-based stimulus package.

You may think such a bonus would surely boost spending in the economy, the key rationale for previously announced bonuses. To use old fashioned Keynesian terminology, school students should have a propensity to consume tuckshop items of about one. That is, every dollar given away would be spent at the tuckshop.

Much of this money would buy food and beverages made locally, but some would also be spent on imported tuckshop items, which would increase the trade deficit.

To the extent that the tuckshop money is spent on local produce it could also push up grocery prices for everyone. This would worsen inflation and competitiveness, indirectly contributing further to the trade deficit, which has to be funded from abroad.

When the temporary tuckshop bonus stops, the extra consumption spending in the economy would also stop. And if consumption spending and imports fell back to where they were before the bonus, we would be back to where we started. You may well ask: what was the point of it all? Were any extra people employed, and if so were they simply attracted away from other parts of the economy?

But that is not the end of the story because the tuckshop bonus has increased the federal budget deficit and the level of public debt. The budget deficit must be funded by borrowing money that could have been used for alternative, more productive purposes, such as infrastructure. At some point, this public debt also would have to be repaid. Assume then that the students receiving bonuses were told that an amount equivalent to the bonuses received, plus interest on that amount, would have to be repaid by someone in the future. They could therefore choose one of two courses of action.

The first choice would be to spend all the money as it came in and let someone else worry about paying higher taxes later. The problem with this option is that it would actually be them, the students, once they left school, or their parents and others who would pay the extra tax.