Stimulus, Austerity, and Economic Dogma

The more one learns of the discipline of economics, the more distrustful one becomes of any predictions or pronouncements that emerge. The field has been referred to as the "dismal science," but that appellation is only half correct. The label "science" is as yet unearned.

In the 1930s, during what was arguably the darkest hour for global economics, two contending views emerged. One, held by the British government’s financial officials (thus referred to as the "Treasury view," held that


"Any increase in government spending necessarily crowds out an equal amount of private spending or investment, and thus has no net impact on economic activity."

John Maynard Keynes produced counter arguments to support the efficacy of increased government spending in increasing the level of economic activity.

One might have thought that, given the severity of the consequences of not resolving this issue, there would inevitably have been some sort of confrontation where one side or the other was compelled to admit error. With all the wars, recessions, and policy fluctuations that have occurred in the many countries with modern economies, there must be sufficient evidence to support one side or the other.

This ultimate confrontation never occurred. Instead, the two sides retreated into enclaves and surrounded themselves with disciples trained (indoctrinated) in the appropriate dogma. These opposing schools of thought are even geographically separated. Those who adhere to variations on the Treasury view are often referred to as "freshwater schools" because they seem to be distributed in the center of the country, with the University of Chicago being ground zero. Those adhering to variations on the Keynesian approach have accumulated in schools on the east and west coasts and are appropriately referred to as "saltwater schools."

Since the big picture issues were determined by revelation (Keynes or Treasury approach), students could occupy themselves writing more and more papers about less and less. Big issues are difficult to address. And they are risky to address. If one is proved wrong, then a lifetime of effort and accumulated prestige are rendered worthless. That cannot be allowed to happen—so it didn’t happen.

Rather than some sort of accord being attempted, the economic polarization became conflated with political polarization. The big business oligarchs wish to control the economy of the nation themselves and fear any hint that the government might have a role in directing it. Consequently, they and their party, the Republicans, have an interest in supporting and propagating the activities of the freshwater economists. The notion of government spending being useful in fiscal policy—as well as related social policies—led those who contend with business oligarchs, supporters of the Democratic party, to grow quite comfortable with the saltwater economists.

Consequently, when the latest financial disaster struck, the Great Recession, the two flavors of economists were ready to provide totally conflicting advice. Arguments centered on the degree to which government spending could stimulate the economy and produce sufficient growth to bring us out of the recession. A decrease in government spending would have the same size effect, but in the opposite direction. A saltwater type would believe that government spending has a large positive effect on the economy, and decreases in spending have a large negative effect. Freshwater types believe spending has little effect; therefore cuts in spending also have little effect. Obviously, they both can’t be right, and pity the nation whose government makes the wrong selection.

At issue is what happens after the government spends funds. In particular, what is the multiplying factor on the spending as a contribution to economic activity—the effect on GDP. If the government pays a company to build a bridge, the money will buy equipment and supplies and pay wages. All those who receive income from the bridge builder will then spend some of that money on wages supplies and personal expenses. The initial government expenditure sends ripples out through the economy and, on the face of it, seems to increase economic activity beyond that of the initial input. If so, this would indicate a multiplier greater than one. The exact contrary view would say that this input of activity is, to some degree, cancelled by secondary effects and the multiplier would be less than one, and could be as low as zero.

Here are examples of what these opposing views arrive at. The first is data presented by Mark Zandi in a brief to a congressional committee in 2008. Zandi was described as chief economist of Moody’s economy.com.

These numbers indicate multipliers much greater than one for government spending.

Robert J. Barro provided an alternate view in an article in the Wall Street Journal.

　

"I estimate a spending multiplier of around 0.4 within the same year and about 0.6 over two years. Thus, if the government spends an extra $300 billion in each of 2009 and 2010, GDP would be higher than otherwise by $120 billion in 2009 and $180 billion in 2010. These results apply for given taxes and, therefore, when spending is deficit-financed, as in 2009 and 2010. Since the multipliers are less than one, the heightened government outlays reduce other parts of GDP such as personal consumer expenditure, private domestic investment and net exports."

"Thus, viewed over five years, the fiscal stimulus package is a way to get an extra $600 billion of public spending at the cost of $900 billion in private expenditure. This is a bad deal."

This is not the place for an extended argument about who might be correct in this battle. Paul Krugman provides an interesting discussion of these issues in his book End This Depression Now! Krugman is perhaps the most vocal members of the saltwater school. Interestingly, he admits that the issues are more complex than a simple analysis can resolve. Fiscal actions must be correlated with political policy decisions and the state of the economy at the time in order to even attempt to extract a cause and effect relationship. He suggests a broad analysis of the many instances of fiscal actions that have occurred is required and indicates that the International Monetary Fund (IMF) has recently performed an appropriate study.

This source provides us with information about the IMF’s conclusions.


"In October 2012 the International Monetary Fund released their Global Prospects and Policies document in which an admission was made that their assumptions about fiscal multipliers had been inaccurate."

‘IMF staff reports, suggest that fiscal multipliers used in the forecasting process are about 0.5. our results indicate that multipliers have actually been in the 0.9 to 1.7 range since the Great Recession. This finding is consistent with research suggesting that in today’s environment of substantial economic slack, monetary policy constrained by the zero lower bound, and synchronized fiscal adjustment across numerous economies, multipliers may be well above 1.’

"This admission has serious implications for economies such as the UK where the OBR used the IMF's assumptions in their economic forecasts about the consequences of the government's austerity policies."

The Eurozone countries have also been enamored with austerity policies and were similarly encouraged by the IMF. How has that worked out? An article in The Economist provides this chart with Australia thrown in as a bonus.

The US has maintained a slowly growing economy, whereas the European countries seem to have entered a death spiral.

Thankfully, the US had a Democratic president and Democratic economists in our time of need, and it will be at least four more years before the Republican economists can return and cause us grief again.