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How Stimulating Is Stimulus?

Lee E. Ohanian, 06.17.09, 12:01 AM EDT

Not very. (Sorry, Paul Krugman.)

Last week's column elicited strong opinions from readers about government stimulus programs as a tool for promoting recovery, and led some to ask for another column on this topic. Strong opinions are held not only by Forbes readers, but seem to be the norm when it comes to stimulus.

There are a number of economists who strongly object to even the basic idea that government spending is a useful tool during this crisis. For example, 1995 Nobel Laureate Robert Lucas called multiplier estimates from Economy.com "schlock economics"; John Cochrane of the University of Chicago has called government spending stimulus "a fallacy"; Robert Barro of Harvard called one version of the American Recovery and Reinvestment Act (ARRA) "the worst bill that has been put forward since the 1930s."

Other economists say stimulus proponents are basing their arguments on the economics of yesteryear. Thomas Sargent of New York University and the Hoover Institution remarked that the support for the ARRA "ignore[s] what we have learned in the last 60 years of macroeconomic research," while 2004 Nobel Laureate Edward Prescott has said, "Stimulus is not part of the language of economics. There is an old, discarded theory that's been tried and failed spectacularly. The stimulus bill is likely to depress the economy."

On the other side of the debate, however, Nobel Laureate Paul Krugman has written that "first-rate economists keep making truly boneheaded arguments against [stimulus]." Others, like Robert H. Frank of Cornell, have also come out punching for stimulus.

So what are the sources of these strong differences of opinion? The arguments in favor of government spending stimulus, including the majority of those discussed in the media, come from the traditional Keynesian view that government spending increases aggregate demand--the sum of consumer, business, government and net foreign expenditure--and that increasing aggregate demand increases real output and income.

Now whether this actually works or not depends largely on the impact of higher public spending on private consumption and investment. In the Keynesian model, private spending rises in response to higher public spending, which leads to the controversial multiplier effect--one dollar of government spending increases real GDP by more than one dollar.

Spending skeptics regard the impact of government spending on private spending very differently, as the Keynesian model was replaced many years ago, at least among research economists; and many of the presumptions of the Keynesian model have changed as well. The central message from new research on fiscal policy is that the impact of government spending depends critically on what the spending is on, and how it is ultimately financed.

For these reasons, there is no simple answer to the question of how spending affects the economy, but what new research does tell us is not supportive of spending stimulus programs. Studies that include the important requirement that higher spending must be ultimately financed with higher tax rates find that government spending expansions do not expand the economy.

In some cases, higher spending can raise GDP for a short period of time if tax increases are delayed, but the greater the delay, the greater the long-run decline in employment and output that ultimately swamps the temporary gain. These findings are summarized in a new paper by Harald Uhlig of the University of Chicago, who writes that "the analysis here may lead one to conclude that the long-term consequences of massive expansions in government stimulus come at substantial costs."

And if public spending is a very close substitute for private spending, there may well not be even temporary gains from higher spending.

Edward Prescott's research presents evidence that an important reason hours worked in Northern and Western Europe are 30% lower today than in the 1960s is because of higher government spending that substitutes very closely for private spending in conjunction with large tax increases that were required to pay for this spending.

The key reason recent studies don't find a Keynesian-level multiplier is because the higher taxes on incomes or expenditures that ultimately accompany higher spending depress economic activity. And the depressing effect of these tax increases is the largest when government spending closely replaces private expenditures. Ironically, the largest temporary gains of higher spending occur when the spending is on items that have little direct value to consumers, such as military spending.

Recent military episodes are too small to cleanly detect this in the data, but my recent work with Ellen McGrattan of the Federal Reserve Bank of Minneapolis presents evidence that one reason the World War II economy boomed was because the level of war expenditures--which represent a pure drain of resources from households--was off the chart. Consequently, it is not surprising that economic activity was high during the war. If employment hadn't increased significantly in wartime, there would have been very few resources available with with households could consume.

The bottom-line thinking among many economists specializing in this area is that the current body of research doesn't warrant a $787 billion package with the goal of spurring the economy. But this doesn't imply government should never consider increasing spending during economic declines.

The standard approach for judging government spending is cost-benefit analysis, which judges a project to be worthwhile if the costs--including impact on future taxes--are less than the benefits it provides. It may be useful for government to consider accelerating spending on worthwhile programs during a downturn, since the cost of some initiatives, such as construction projects, may indeed be lower.

A more modest fiscal program founded along cost-benefit lines would have engendered support from at least some of the most vocal critics of the ARRA. And at least some of the programs within the ARRA would pass a cost-benefit test. But anecdotes from the ARRA indicate that not all would pass this test. For example, the Minneapolis City Council voted to spend $2 million in ARRA funds for developers to convert a vacant theater into a dance center. The city estimated the project would create about 48 permanent jobs, far fewer than a solar energy panel manufacturing plant that the city estimates would create 360 jobs. But that manufacturing plant was awarded just $300,000, which wasn't sufficient to warrant the plant being opened. Councilman Paul Ostrow, in a dissenting vote, said the theater wasn't creating enough jobs to justify stimulus investment, but the solar-energy plant "clearly fit the president's goals ... It was a home run."

As I noted last week, most of the ARRA funds have yet to be spent. The Minneapolis example raises questions about whether reasonable cost-benefit analysis is being used in calculating where to invest ARRA money. Let's hope cost-benefit analysis is used sensibly as the ARRA moves forward.

Lee E. Ohanian is a professor of Economics and director of the Ettinger Family Program in Macroeconomic Research at UCLA. (Forbes columnist Thomas F. Cooley returns next week.)

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