At a recent Cato Institute forum, Douglas Holtz-Eakin of the Council of Economic Advisers argued that the principal reason for an economic stimulus package right now is to improve business and consumer confidence. There is no question that a lack of confidence is the economy's most critical problem today. But whether there is anything the government can do about it is another matter. Consequently, there is a danger that the stimulus plan being taken up by the House this week may be oversold as a "quick fix" for a problem for which there may be no legislative cure.
Economists generally view consumers as the driving force in the economy. When consumers buy, this leads producers to produce and investors to invest. And with consumption representing about two-thirds of the gross domestic product, even small changes in consumption can have a major impact on GDP growth. Thus, Friday's report that retail sales were down 2.4 percent in September -- four times worse than expected -- pretty much guarantees that third quarter GDP growth will also be negative.
Historically, economists have viewed consumers as passive. They simply spend whatever income they have. Therefore, consumption is entirely a function of income. Raise disposable income, therefore, and consumption will rise automatically. That is why tax rebates have been viewed as an effective stimulus. It puts money in peoples' pockets. They spend it, and this raises growth.
The only problem with the rebate idea is that there is no empirical evidence supporting it. Congress enacted a rebate earlier this year that sent checks for $300 ($600 for couples) to every person who paid income taxes last year. These checks started going out in late July and all through August and September. Yet, even before Sept. 11, the data showed no increase in consumption. On Aug. 31, the Wall Street Journal ran this headline: "Rebates Boost Incomes, but Not Spending."
It was quite clear that this was going to be the case based on experience with past rebates at the state and federal level, which show that most rebates are saved and not spent. Moreover, poll data have consistently shown that it would be the case this time as well. A July 24 Gallup poll found that only 17 percent of people expected to spend their rebates. Bloomberg News polls in August and September found that only 14 to 15 percent would spend their rebates. A University of Michigan poll released on October 9 got exactly the same result.
Nevertheless, despite the total failure of rebates to boost consumption, Congress is poised to enact yet another rebate. This one would give $300 to everyone who didn't get a rebate earlier this year -- that is, those who had no income tax liability in 2000, and probably none this year either. Thus, it is not a rebate at all, but a transfer from those who pay taxes to those who don't.
The central problem with all of this is that the assumption that consumers are passive, reacting only to changes in income, is wrong. Since the 1940s, consumer sentiment or confidence has been surveyed on a regular basis by the University of Michigan and the Conference Board in New York. These surveys show that psychology plays a critical role in consumers' decisions to buy today or not. While over time, consumption is clearly driven primarily by income, over short periods, it can be overwhelmed by other factors.
An October 3 poll confirms the fact that right now consumers are being influenced more by fears about the terrorist threat and future economic conditions than by their current financial circumstances. Gallup found that 43 percent of Americans say they are in "a good position to spend money." This is up from 35 percent in April. And data from the Investment Company Institute show that consumers have money to spend if they want to. As of October 10, there was $2.3 trillion in cash just sitting in money market funds and immediately available to spend or invest.
The Bush administration's theory is that consumers are holding back primarily due to fears about future layoffs. According to Gallup, 13 percent of Americans now believe that they are likely or fairly likely to lose their jobs in the near future. This is why they are putting off buying, avoiding investments with higher risk, such as the stock market, increasing precautionary saving and investing only in ultra-conservative assets such as Treasury bills.
To turn the economy around will require changing attitudes, and that won't happen until people's outlook for the future improves. Once they see meaningful signs of renewed economic growth, their fears about layoffs will recede, and they will begin to spend and buy stocks again. A rising stock market will further improve consumer balance sheets and reduce the need for precautionary saving.