Without a doubt, the effectiveness of government stimulus packages in fighting the global recession is the hottest topic in economics.
On the one hand you have the “freshwater” economists who tend to argue that government spending and debt crowds out private investment, negating any possible stimulus.
On the other you have the “saltwater” economists, who think that under certain circumstances government spending can stimulate the economy to be healthier than it would be otherwise.
Over in the opinion pages of the Wall Street Journal today, economists Robert Barro and Charles Redlick attempt to take the debate beyond theory and test the effectiveness of past stimulus plans. What they find is that in the past, stimulus spending is far less effective than tax cuts when it comes to growing the economy.
The bottom line is this: The available empirical evidence does not support the idea that spending multipliers typically exceed one, and thus spending stimulus programs will likely raise GDP by less than the increase in government spending. defence-spending multipliers exceeding one likely apply only at very high unemployment rates, and nondefense multipliers are probably smaller. However, there is empirical support for the proposition that tax rate reductions will increase real GDP.
This is a strong case against stimulus spending under any normal circumstances. But it doesn’t really address the point made by the house economist of the New York Times, Paul Krugman, that this time it is different. We know that’s a phrase only used ironically these days but it is worth paying attention to the argument that under our present circumstances, government spending may be uniquely fitted to growing the economy.
According to Krugman’s view, our economic growth is stagnating because the global demand for savings has increased too rapidly. The supply of savings–the preference for holding money and its equivalents over investing and spending it–has grown to a level that the economy is under-performing, unable to operate near its existing capacity.
Krugman’s term for this is “a liquidity trap.” Under these circumstances, Krugman argues, even somewhat ineffecient government spending can increase the real GDP because it is actually bringing about new spending and investment rather than just crowding out private sector investment. So you get a benefit–even if there is no multiplier effect.
We’re instinctively sceptical about government spending problems, largely for a host of issues that have little to do with macroeconomics and more to do with political science. Government spending tends to b ewasteful because governmental authorities are captured by special interests and irredeemably ignorant about the unintended consequences of their programs. It almost certainly involves malinvestment in economically unsuitable projects, and can drive further malinvestment by “crowding in” private investment chasing government subsidies.
But Barro and Redlick’s analysis falls short of addressing one of the core arguments for fiscal stimulus, which means the title of their essay–“Fiscal Spending Doesn’t Work”–should at least be amended to read “except maybe in special circumstances such as the ones we face right now.”