This is the long-awaited (mostly by me) fourth post in my series about the stimulus bill. I would have got it posted earlier, but I've been kind of busy. (You might want to read the first three parts about GDP, Fear, and Spending.)

Recall that under the theory behind the stimulus, recessions happen when consumers decide to reduce their consumption to try to save cash for an uncertain future. Individually, this is often a wise decision, but collectively, the crash in consumer demand leads to a drop in production which leads to unemployment. A stimulus plan is designed to replace the lost consumer spending with government spending, with the goal of keeping production and employment from slumping so drastically.

The fundamental problem with this approach is a simple matter of microeconomics. Think about what happens when you buy something for yourself---a shirt, or a hot dog, or a music CD: You trade your money to get something you like. In particular, you trade your money for something you like more than the money you traded for it.

Say you go to the store to buy a shirt. You find one you like, and based on its fit, comfort, and appearance, you figure it will improve the quality of your life enough that you'd be willing to spend $30 on it. So, if it costs more than $30, you will leave it on the hanger, but if it costs less than $30, you'll take it.

Good news! It's priced at $25. You pay the clerk and take the shirt home. You've now got a shirt that's worth $30 to you, but you only spent $25 on it. You have made a net improvement in the quality of your life, to the tune of $5.

The difference between what you spent and what you got out if it is called consumer surplus, and it's very important: Nearly all the benefits of our modern economy eventually show up as consumer surplus, with the result that most Americans live better than medieval lords. (Sure, they had servants, but we have antibiotics, clean water, and the internet.)

Sure, consumers sometimes make mistakes---that new Bon Jovi album that wasn't as wonderful as you'd hoped---but nevertheless, when you spend money on yourself, you tend to spend it pretty well. There are two important reasons why this is so.

First of all, you are a world-class expert on yourself. When you bought that shirt, you knew the right size, the right color, the right fit, the right style of collar, the right material and so on. You might not know everything, but you know more than anyone else. And although you may have guessed wrong about that Bon Jovi CD, nobody else could have guessed better.

There are a few areas---professional services such as medicine and law, for example---where this may not be true, but for most purchases, from nail polish to televisions to homes, you are the expert on fulfilling your own needs and desires.

The second reason you spend so well on yourself is that nobody in the world is more motivated to make wise choices on your behalf than you are. If you let somebody else make these choices, you tend to run into agency problems---the people making the choices tend to serve themselves rather than you.

(For example, send someone shopping for your groceries, and instead of returning with products that closely match your grocery list, they may return with the products that were easiest to find.)

Consumers spending for themselves are having their purchasing decisions made by the best-motivated and most well-informed individuals available. The same cannot be said when politicians and government bureaucrats make purchases on your behalf. In a nutshell, this is the libertarian argument against stimulus spending.

For that matter, this is the libertarian economic argument against all government spending.

It helps to imagine the purest case of stimulus spending, which is usually described as hiring half the unemployed to dig holes and the other half to fill them. This will certainly have the effect of pumping money into the economy, as the diggers and fillers spend their hard-earned salaries, but the entire first-order effect of the stimulus is useless. All that hard labor produces nothing that improves anyone's quality of life.

This is the libertarian's fear of government spending: Government bureaucrats are likely to waste the money because they are neither motivated enough nor well-informed enough to spend efficiently. Since government spending pulls resources away from more efficient private industry, the result is a net loss of production. And that would be bad.

However, there's an escape clause: During a recession, production is below it's theoretical limit, which means that valuable people and resources are sitting idle, waiting for someone to put them to work. Clearly, giving them work, even stupid work, can't possibly pull them away from something more valuable.

That's why so many economists agree that one of the best ways to stimulate the economy is to extend the amount of money given out through unemployment insurance. It's a direct handout of money to the people hardest hit by the recession, it doesn't tempt them away from real jobs, they'll probably have to spend most of it on consumer goods which spreads the money around, and since they're spending for themselves, they'll spend it wisely.

The next best stimulus plan is probably a tax cut of some kind, perhaps aimed at people near the bottom of the income distribution who are most likely to put it to good use. One way to do this is by giving block grants to state and local governments so they won't have to balance their budgets by taxing their residents to death. These taxes are often much less progressive than federal income tax so they hit the poor kind of hard.

These two stimulus measures---unemployment payments and tax cuts---are likely to be successful because they leave the decision making to the smartest people in the economy, the consumers.

Unfortunately, that's not how the stimulus package works. I'll explain what goes wrong in my next post.