Less bang for the buck: the flimsy case for stimulus spending.

• Author: Young, Andrew T.
• Position: Economics

An economist asks, "Why in the world are we all Keynesians again?"

THE FEDERAL GOVERNMENT responded to the financial crisis and recession that began in 2007-08 with an unprecedented fiscal stimulus. Passed in February 2009, the American Recovery and Reinvestment Act (ARRA) came with a price tag of $831,000,000,000. Yet, the economy has not returned to a path of robust growth and unemployment stubbornly has remained high; only in September 2012 did it dip (barely) below eight percent. This has not stopped the Obama Administration from pushing for further fiscal stimulus.

Whether fiscal spending stimulus is effective hinges critically on the size of the spending multiplier, which is dependent on several factors. In particular, if individuals anticipate the future tax liabilities associated with deficit spending or are "crowded out" by the deficit spending, then the multiplier is likely to be less than one; that is, each dollar of stimulus increases total spending in the economy by less than one dollar. Ultimately, whether the government spending multiplier is less than or greater than one is an empirical question.

While no one seriously debates the long-run costs associated with exploding public debt, the evidence suggesting significant short-run benefits of stimulus spending is weak. Studies indicating that stimulus spending is effective assume that current economic activity does not affect fiscal policy. This assumption is questionable and, most important, the studies' results are very sensitive to it.

Alternatively, studies using a narrative approach based on historical and contemporary accounts of U.S. military buildups to identify government spending shocks find that the short-run effects of stimulus spending are small. These latter studies are grounded in historical reality and thus are more compelling.

In 1965, Nobel economist Milton Friedman was famously (or infamously, depending on your point of view) quoted as saying "We are all Keynesians now." Though he later remarked that he had been taken out of context, Friedman--who unquestionably was the antithesis of a Keynesian; he openly condemned the English economist's policies by providing evidence that Pres. Franklin Roosevelt's employment of them not only deepened, but lengthened, the Great Depression--accurately expressed a consensus among economists and policymakers at the time: countercyclical fiscal policy is an appropriate and effective means toward combating the business cycle. Specifically, in response to a recession, the Federal government should increase its expenditures and/or provide tax relief to make up for the shortfall in the private sector's aggregate demand for goods and services. Nearly three decades after his publication of The General Theory of Employment, Interest, and Money, the policy prescriptions of John Maynard Keynes were dogma.

However, by the beginning of the new millennium, all that had changed. Countercyclical fiscal policy had fallen into disrepute. A new consensus held that fiscal stimulus in the wake of a recession was politically infeasible and, even if it could be enacted in a timely fashion, stabilization policy was likely to be ineffective. Alan Blinder, former vice chairman of the Federal Reserve's Board of Governors, went so far as to say that "virtually every content discussion of stabilization policy by economists--whether it is abstract or concrete, theoretical of practical--is about monetary policy, not fiscal policy."

Yet, it would seem that the fashionableness of countercyclical fiscal policy is, well, countercyclical. Beginning in late 2007, recession and financial crisis led to a rehabilitation of Keynesian fiscal policy. Under the George W. Bush Administration, $152,000,000,000 of tax rebates and other relief was passed in February 2008. Almost exactly a year to the day later, Pres. Barack Obama signed the ARRA stimulus package into law.

Christina Romer...