The Stimulus Will Fail

Recently, I have been receiving a great deal of email that has resulted in responses in which I find myself either defending the stimulus package or defending the proponents of the stimulus package. These defenses, however, have much more to do with the flawed reasoning of fellow stimulus skeptics than with any sort of favorable outlook toward the stimulus package itself. With this in mind, it is perhaps time to clarify my position.

As I have previously noted, there are two questions that seem to be at the center of the debate:

1. Can a stimulus package be designed to give a boost to the economy in the short-run?

2. Can the stimulus package get us out of the recession?

Under the current circumstances, with unemployment approaching 8%, the answer to (1) is undoubtedly “yes.” HOWEVER, this does not imply that (2) can similarly be answered in the affirmative as many stimulus advocates would have you believe. Unfortunately, the debate regarding stimulus has diverged to the point in which those on each side are answering different questions and ultimately giving the impression that there is widespread disagreement as to the effectiveness of fiscal stimulus. Thus, this post is my attempt to explain why the answer to (1) is “yes” and the answer to (2) is “no.”

The traditional Keynesian multiplier analysis suggests that if the government spends money on a particular project it not only increases output by the amount of the increase in government spending, but also by the increase in consumption of those employed to work on the project. Given the idea of the multiplier, government spending can clearly be seen as providing an affirmative answer to both (1) and (2) since $1 of government spending producers more than $1 of additional output.

Unfortunately, this analysis is entirely too simplistic. If fails to take into account the fact that the government must compete for resources (and credit) with private enterprise. The traditional Keynesian response to the criticism is that during times of less than full employment, there are idle resources (e.g. unemployed workers) that can be put to use without competing with private firms. The failure, however, is that to rule out any sort of crowding out effect, all resources utilized by the government must be idle. This is not to say that government spending cannot promote a temporary boost to the economy. Even if there is crowding out, so long as the multiplier is greater than zero, output will increase in response to an increase in government spending. The question as to the value of the multiplier is thus an empirical question.

John Taylor recently presented a paper (non-gated link here) at the AEA meetings on the revival of fiscal policy. In his introduction, Taylor writes:

A decade ago in a paper, “Reassessing Discretionary Fiscal Policy,” published in the Journal of Economic Perspectives, I concluded that “in the current context of the U.S. economy, it seems best to let fiscal policy have its main countercyclical impact through the automatic stabilizers….It would be appropriate in the current circumstances for discretionary fiscal policy to be saved explicitly for longer term issues, requiring less frequent changes.” This was not an unusual conclusion at the time. As Martin Eichenbaum (1997) put it, “there is now widespread agreement that countercyclical discretionary fiscal policy is neither desirable nor politically feasible,” or, according to Martin Feldstein (2002), “There is now widespread agreement in the economics profession that deliberate ‘countercyclical’ discretionary policy has not contributed to economic stability and may have actually been destabilizing in the past.”

Taylor also discusses some of his own empirical work from his 1992 book Macroeconomic Policy in a World Economy on the actual value of the multiplier:

. . . simulations of my (1992) empirically estimated multi-country dynamic model with rational expectations indicates that multiyear changes in government spending phased in at realistic rates have a maximum government spending multiplier less than one because of offsetting reductions in the other components of GDP.

Further, he provides empirical evidence of the utter failure of the tax rebate checks issued in 2008.

Taylor also echoes the point made by Casey Mulligan that there are some types of government spending that can be justified by their intrinsic value, but are unlikely to cause economic stimulus:

To be sure, it may be appropriate to increase government purchases in some areas including for infrastructure as in the 1950s when the interstate highway system was built. But such multiyear programs did not help end, mitigate, or prevent the recessions of the 1950s. In sum, there is little reliable empirical evidence that government spending is a way to end a recession or accelerate a recovery that rationalizes a revival of discretionary countercyclical fiscal policy.

Another issue at hand here is the idea of Ricardian equivalence, which essentially posits the claim that there is no fundamental difference between spending financed by deficits or taxation. Suppose that the government increases spending. It follows that they must either tax current economic agents or issue government bonds to pay for the increased spending. The intuition behind Ricardian equivalence is that when the government increases spending individuals recognize that, even if the spending is financed through government borrowing, the spending creates an increase in their future tax liability.

Consider the incredibly over-simplified example. Suppose the government decides to issue a check for $500 for each taxpayer. They pay for these checks by issuing bonds that will be paid off next period. Under Ricardian equivalence, the individuals recognize that while they will receive $500 this period, but will have their taxes increased to pay for the bonds next period. Thus individuals would simply buy the bonds (save the $500) in order to meet their increased tax liability in the next period.

Critics of Ricardian equivalence have long argued that this is incorrect to the point of being trivial. For example, if individuals have finite lives and the government lives forever, this would seem to refute the idea of Ricardian equivalence — unless, of course, the finite-lived agents view their offspring as mere extensions of their lifetime. This exception, of course, leads to criticism based on the idea of myopic economic agents or the failure of operative bequests to future generations. The list of criticisms far exceed the very small sample above, but they do seem to suggest that Ricardian equivalence fails in simple theoretical applications. Again, however, we must turn to the empirical investigations.

In regards to the validity of Ricardian equivalence, John Seater at N.C. State wrote an excellent survey that appeared in the Journal of Economic Perspectives in 1993 (non-gated link here). Regarding the theoretical issues above, Seater explains:

Finite horizons, nonaltruistic or inoperative bequest motives, childless couples, liquidity constraints, and uncertainty all can lead to failure of Ricardian equivalence, and it seems virtually certain that some of these sources of nonequivalence are operative. It appears likely that the world is not Ricardian. (p. 155 – 156)

Upon examination of the empirical evidence, however, Seater concludes:

Nevertheless, equivalence appears to be a good approximation. Although some of the early empirical literature sent conflicting signals, recent work generally supports Ricardian equivalence. It is true that existing data cannot distinguish the Ricardian model based on altruism, from one of approximate equivalence, based on pure selfishness, but there seems little practical significance to that fact.


Empirical success and analytical simplicity make Ricardian equivalence an attractive model of government debt’s effects on the economic activity. (p. 184)

Thus, while Ricardian equivalence is seems literally untrue, the idea “holds as a close approximation” (Seater, p. 143) based on empirical evidence.

In short, the fact that Ricardian equivalence serves as a close approximation to actual results and the widespread failure of discretionary fiscal stimulus described by Taylor above, suggest that the stimulus package will be a failure. Further, given the pork-laden nature of the stimulus package, it is unlikely that the spending can even be justified on its intrinsic value, let alone on stimulation.

The stimulus will fail.

13 responses to “The Stimulus Will Fail

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  3. I think it goes even further than this. The stimulus isn’t just full of pork (which isn’t inherently non-stimulative, but it is certainly socially undesirable to the benefit of the few who receive it), but it is also full of extensive transfer payments, which stand to keep idle capacity idle!

    But, as my own blog says, Keynes is right. Keynes is king. Keynes can do no wrong. That is, unless you just look at the evidence, where all of a sudden, his fraud is revealed.

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  6. The stimulus will fail because it is based upon the philosophy of a command economy. Only the free market knows how to spend money, not the government. It didn’t work for the Soviet Union, it won’t work now nor ever. The money is best spent toward a $5,000.00 tax credit toward every enterprise for each full time wage earner on the books. That will solve the unemployment problem overnight.

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  11. Great post; three points: 1. Government spending can boost output even if the multiplier is less than one (as long as their are idle resources). 2. The underlying issue behind that of Ricardian equivalence etc. is expectations. If people believe problems are due to a temporary shock — if they believe there’s nothing to fear but fear itself — then fiscal stimulus might work. But after such a protracted slump, nobody believes this. People think times are bad, and that they’re guilty — they believe problems are structural. For fiscal stimulus to be effective, it would have to be long and sustained enough for the public to well and truly forget that ‘times are bad’. Programs of finite duration announced in advance (even monetary programs like QE2) won’t do it. That’s assuming a fiscal stimulus could be practically implemented (Taylor shows ARRA wasn’t).

    Ricardian equivalence has a better chance of failing if the government isn’t already leveraged to the hilt. Keynesian stimulus is assumed to be countercyclical, but I can’t remember Keynesians loudly calling for savings when times were good. And it seems to me that a democratic government is so closely tied to the zeitgeist that there is little prospect for countercyclical savings.

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