A Primer on Whether Stimuli Stimulate

Does Stimulus Stimulate? By Bruce Bartlett
Forbes, Jan 23, 2009, 12:01 AM ET

In a few weeks, Congress will likely enact the largest fiscal stimulus legislation in history. Surprisingly, the whole idea of such a stimulus is much more controversial among A-list economists than I would have expected, given the depth and breadth of the economic malaise. Although the debate is rather technical, it's important to try to understand it because much is at stake.

Eighty years ago, the conventional view among economists was that government had nothing to do with business cycles--it neither caused them nor was there anything it could do about them. They were like the weather; you just coped the best you could.

Eventually, economists came to understand that vast numbers of individuals and businesses throughout the economy don't make exactly the same mistakes simultaneously unless something has changed the rules of the game. Government isn't always responsible--bubbles can occur on their own, as they have over the centuries--but systemic errors usually result from government policy.

The Federal Reserve, our nation's central bank, is the institution mainly responsible for altering the terms of trade. That is because it has the power to change the value of the currency, which is the intermediary in every single economic transaction, and also to alter the terms of every intertemporal transaction--those between the present and future, such as saving today to consume tomorrow--by raising or lowering the interest rate.

No one today believes that the Great Depression just happened or dragged on as long as it did because the private sector kept making mistake after mistake after mistake. It only made them and continued to do so because government interfered with the normal operations of the market and prevented readjustment from taking place.

The Great Depression resulted from a confluence of governmental errors--the Fed was too easy for too long in the 1920s, tightened too much in 1928-29 and then failed to fix its mistake, thus bringing on a general deflation that was very difficult to arrest once downward momentum had set in. Herbert Hoover compounded the problem by signing into law the Smoot-Hawley Tariff and sharply raising taxes in 1932.

Unfortunately, Franklin D. Roosevelt misunderstood the nature of the economy's problem and tried to fix prices to keep them from falling--thus preventing the very readjustment that would have brought about recovery. (See this paper by UCLA economists Harold Cole and Lee Ohanian.) He doesn't seem to have ever understood the critical role of Fed policy and mistakenly thought that arbitrarily raising the price of gold would make money easier.

Then, in 1937, just as the economy was starting to build some upward momentum, Roosevelt decided to raise taxes and cut spending, and the Fed suddenly concluded that inflation, rather than deflation, was the main problem and tightened monetary policy. (Note: According to the National Bureau of Economic Research, the Great Depression was basically two severe recessions--one from August 1929 to March 1933, and another from May 1937 to June 1938--not a continuous downturn.)

The result was an economic setback that didn't really end until both monetary and fiscal policy became expansive with the onset of World War II. At that point, no one worried any more about budget deficits, and the Fed pegged interest rates to ensure that they stayed low, increasing the money supply as necessary to achieve this goal.

It was then and only then that the Great Depression truly ended. As a consequence, economists concluded that an expansive monetary and fiscal policy, which had been advocated by economist John Maynard Keynes throughout the 1930s, was the key to getting out of a depression.

Keynes was right, but many of his followers weren't. They thought that budget deficits would stimulate growth under all circumstances, not just those of a deflationary depression. When this medicine was applied inappropriately, as it was in the 1960s and 1970s, the result was inflation.

Economists then concluded that it was a mistake to pursue countercyclical fiscal policy, and the idea of "fine-tuning" became a derogatory term. Even those who continued to believe it was theoretically possible to counter recessions with public works or government jobs programs were eventually forced to concede that it was impossibly difficult to make them work in a timely manner.

In the 1980s and 1990s, economists came around to the view that only monetary policy could act quickly enough to reverse or moderate a recession. But they never really came to grips with the Fed's responsibility for causing recessions in the first place. It always tightened a little too much when inflation was the problem and eased too much when slow growth was the problem.

For a time, a cult grew up around Fed Chairman Alan Greenspan. Many who should have known better convinced themselves that the "Maestro," as journalist Bob Woodward called him, would fix everything. Investors began seriously talking about a "Greenspan put"--the idea that the Fed would always protect them from a severe decline in the market. Nitwits wrote and bought books predicting astronomical levels for the stock market because Greenspan had permanently reduced the level of risk.

As we have seen, the Fed could not prevent the greatest financial downturn the world has seen since 1929. This has revived the idea that fiscal policy must be the engine that pulls us out.
Somewhat surprisingly, there has been rather heated opposition to the very principle of fiscal stimulus--a return to pre-Keynesian economics. And among those expressing dissent are some of the leading lights of economic theory over the last 40 years.

To be sure, the idea that fiscal policy was impotent never entirely disappeared. In 1969, economist Milton Friedman argued strenuously that only monetary policy really matters and that fiscal policy has no meaningful effect. Said Friedman, "In my opinion, the state of the budget by itself has no significant effect on the course of nominal income, on inflation, on deflation or on cyclical fluctuations."

Yet at the same time, monetarists argued that monetary policy had no lasting effect on the same economic variables. In the long run, they said, monetary policy could only affect nominal incomes, not real incomes. Real incomes were a function of things like growth of the labor force and productivity per work hour.

This led to a renewed emphasis on fiscal policy, but on the tax side rather than the spending side, as Keynesians tend to focus. Supply-siders argued that certain changes in tax policy--lowering marginal tax rates, reducing taxes on entrepreneurial income--were especially powerful, economically. Keynesians think that just putting dollars in peoples' pockets in order to stimulate consumption is the key to growth.

We have now had several tests of the Keynesian idea--most recently with last year's $300 tax rebate, which was supposed to prevent a recession. According to a new paper by University of Michigan economists Matthew Shapiro and Joel Slemrod, only a third of the money was spent, thus providing very little "bang for the buck."

The failure of rebates has shifted the focus to public works and other direct spending measures as a means of stimulating aggregate spending. A study by Obama administration economists Christina Romer and Jared Bernstein predicts that the stimulus plan being debated in Congress will raise the gross domestic product by $1.57 for every $1 spent.

Such a multiplier effect has been heavily criticized by a number of top economists, including John Taylor of Stanford, Gary Becker and Eugene Fama of the University of Chicago and Greg Mankiw and Robert Barro of Harvard. The gist of their argument is that the government cannot expand the economy through deficit spending because it has to borrow the funds in the first place, thus displacing other economic activities. In the end, the government has simply moved around economic activity without increasing it in the aggregate.

Other reputable economists have criticized this position as being no different from the pre-Keynesian view that helped make the Great Depression so long and deep. Paul Krugman of Princeton, Brad DeLong of the University of California at Berkeley and Mark Thoma of the University of Oregon have been outspoken in their belief that theory and experience show that government spending can expand the economy under conditions such as we are experiencing today.

I think the critics of an activist fiscal policy are forgetting the essential role of monetary policy as it relates to fiscal policy. As Keynes was very clear about, the whole point of fiscal stimulus is to mobilize monetary policy and inject liquidity into the economy. This is necessary when nominal interest rates get very low, as they are now, because Fed policy becomes impotent. Keynes called this a liquidity trap, and I think there is strong evidence that we are in one right now.

The problem is that fiscal stimulus needs to be injected right now to counter the liquidity trap. If that were the case, I think we might well get a very high multiplier effect this year. But if much of the stimulus doesn't come online until next year, when we are likely to be past the worst of the slowdown, then crowding out will greatly diminish the effectiveness of the stimulus, just as the critics argue. According to the Congressional Budget Office, only a fraction of proposed infrastructure spending can be spent before October of next year; the bulk would come long after.

Thus the argument really boils down to a question of timing. In the short run, the case for stimulus is overwhelming. But in the longer run, we can't enrich ourselves by borrowing and printing money. That just causes inflation.

The trick is to front-load the stimulus as much as possible while putting in place policies that will tighten both fiscal and monetary policy next year. As terrible as our economic crisis is right now, we don't want to repeat the errors of the past and set off a new round of stagflation.

For this reason, I think there is a better case for stimulating the economy through tax policy than has been made. Congress can change incentives instantly by, for example, saying that new investments in machinery and equipment made after today would qualify for a 10% Investment Tax Credit, and this measure would be in effect only for investments largely completed this year. Businesses will start placing orders tomorrow. By contrast, it will take many months before spending on public works begins to flow through the economy, and it is very hard to stop it when the economy turns around.

Stimulus based on private investment also has the added virtue of establishing a foundation for future growth, whereas consumption spending does not. As economist Hal Varian of the University of California at Berkeley recently put it, "Private investment is what makes possible future increases in production and consumption. Investment tax credits or other subsidies for private sector investment are not as politically appealing as tax cuts for consumers or increases in government expenditure. But if private investment doesn't increase, where will the extra consumption come from in the future?"