Following the global financial crisis (GFC) governments all around the world, including Australia’s, engaged in knee-jerk stimulus spending, aimed at ‘kick starting’ the economy. Advocates argue that such spending stimulates demand, which subsequently triggers increased circulation of money and credit. I’d like to dispel some misconceptions about such policy.
The entire stimulus argument is based on demand side (or Keynesian) economic principles. However, demand side stimulus is only one approach to stimulating an economy. The other is supply side stimulus, involving tax cuts and removing regulation barriers, which inhibit production. Supply side stimulus has the advantage that, like demand side stimulus, it stimulates circulation of money, but has the added benefit that it stimulates people to earn more, invest more and save more. In this sense, supply side stimulus is superior to demand side stimulus.
The argument that Keynesian economics, i.e. the government borrowing large sums of money and spending it, is beneficial is based on false assumptions. When the government borrows money, it doesn’t come out of thin air. Rather, it is borrowed from someone. That someone is generally the private sector. Thus, to establish whether Keynesian stimulus is beneficial one must ask the question “does the government or the private sector allocate capital more efficiently?”. If the government allocates capital more efficiently then it makes macro-economic sense for the government to borrow money. However, if the private sector allocates it more efficiently then it is counter-productive to do so. If the former is always the case then it would make sense to abolish the private sector altogether and transition to a centrally planned economy. Clearly this isn’t the case. While in some instances government spending is more valuable than private sector spending (e.g. vital infrastructure that the entire economy critically depends upon), this isn’t always valid. Thus, before engaging in Keynesian stimulus one must analyse the details of how the government plans to spend the money, and evaluate whether this spending represents more efficient allocation of capital than what the private sector would otherwise do. The answer to this question varies, depending on the government’s and the private sector’s spending intentions. The problem I have with the stimulus packages of various world government is that they haven’t performed a full macro-economic cost-benefit analysis to determine whether their allocation of capital is optimal. Rather, they present simplistic arguments for the benefits of stimulus spending, and then spend the money willy-nilly without much consideration as to whether its allocation is superior to the commensurate private sector spending.
To compound the problem, governments retrospectively justify their stimulus spending by arguing that the economy has improved since the policy was implemented. This is a highly unscientific claim, as the governments have no idea how the economic dynamics would have evolved had they not engaged in stimulus spending. The reality is that economies naturally periodically go through boom-bust cycles. Therefore to wait for a bust cycle, implement a particular policy, then wait for the recovery and claim that it was a direct consequence of policy is folly.
I won’t argue that government spending is always bad, nor will I argue that governments borrowing money is always bad. What I do argue is that world governments have presented a simplistic and shallow case for their actions and have failed to perform any in-depth analysis of its overall benefits. Therefore I remain highly skeptical about the merits of their actions. Their actions have put major world economies into almost inescapable levels of debt, which in the long term will result in higher taxation and lower provisions of services and infrastructure. In the long term this could be catastrophic.
interesting. the GFC posed an immediate threat to many economies, this is why i assume many governments did engage in this ‘knee jerk’, as you say, reaction. supply side stimulus would have taken much longer to implement. Tax cuts, deregulation (hmmm, in the context of the GFC…)not only take longer than direct stimulus measures but dont have nearly the same impact.they are suited to entirely different economic situations. when we were facing the GFC governments weren’t thinking about medium to long term economic reform but immediate fully fledged direct investment. there’s not much doubt who allocates capital more efficiently/effectively between government and private industry, especially the rudd governemnt – im just happy it wasn’t ALL in the form of handouts.
The justification for stimulus spending isn’t that government spending is more efficient than private spending. The argument is that the price of money relative to goods is out of equilibrium and needs to be manipulated towards the correct level.
@joe. has government policy achieved that?
That assumes that the recession was caused by regulatory barriers, or other impediments to production. If that were true, then we would have seen a rise in prices, to match the drop in supply.
We didn’t.
Instead, we have seen unprecedentedly low rates of inflation (despite huge efforts by central banks to pump more money into the system), and deflation is a serious worry.
The problem we are facing is not on the supply side.
Again, that’s not really the question. The private sector isn’t spending. Corporations are sitting on (again, unprecedentedly) large cash reserves. And individuals are deleveraging, and stuffing the proceeds under the mattress.
This may be, individually, prudent. After all, both corporations and individuals are facing lean times ahead (with falling sales, and people being laid-off left and right). But collectively, it is not by any stretch of the imagination an “efficient” allocation of capital.
We’ve already established that the private sector isn’t allocating capital in a (globally) efficient manner. That’s the problem we’re trying to solve.
You’re right that it would be better for Governments to spend money on useful things (like infrastructure improvements), that we would want, even without the economic downturn. But the primary point of fiscal stimulus is to spend and, thereby, prop up aggregate demand, when private-sector demand has collapsed.
I think that their economists have done quite a bit more macro-economic analysis than you have.
Do you really think that there are no econometric models which can be applied to address this question? Or do you not believe the results those models produce?
N.B.: not only every government, but every large corporation employs a team of economists, to run such models, not just retrospectively (to analyze “what if?” questions like the above), but also prospectively (to forecast economic conditions down the road).
Are all those Fortune-500 companies wasting their money?
So the business cycle is sorta like the weather? Nothing we can really do about it, so governments shouldn’t be in the business of counter-cyclical interventions?
This is flat-out wrong. Deficits have spiked, not because Goverment spending has risen sharply, but because revenues have fallen sharply. See this graph.
I could go on, at greater length, but probably this comment is long enough, as it is.
In relation to modelling. I have no doubt that many have carried out elaborate models, both by government and in the private sector. My complaint is politisization of the topic whereby politicians argue for spending without presenting any details on why their spending is good. As I wrote, I’m not against governments spending money, or even borrowing money for spending (I explicitly say this). What I advocate is presenting a coherent case for the particular spending that is being engaged in and why that is good for the economy. To me, just announcing spending per se is not a strong argument.
I will grant you that the Administration (at least in the US) has done a monumentally crappy job of explaining to the public why they have been doing what they have been doing.
One consequence is that “stimulus” has become a dirty word and (badly needed) further intervention is politically off-the-table. Instead, we have the Federal Reserve (which isn’t similarly constrained) engaging in unconventional improvisations in monetary policy called QE2.
I don’t believe that Bernanke would be doing this, were it not for the inaction of the political branches.
The other consequence is that I have to listen to Republicans running around explaining that the causes of the recession are excessive government regulation and uncertainty over the expiration of the Bush tax cuts.
Layered on top of the nation’s economic distress, such concentrated stupidity is too much to bear.
@jacques. In your earlier comment you highlighted the concern of deflation, or at least low inflation. I’m curious why you think government intervention is the solution to this problem, when it is monetary policy that largely dictates the inflation rate. I’m no expert on this, but I’d be interested in your thoughts on this.
Generally, you are correct. Monetary policy is the appropriate remedy.
The problem is that short term interest rates are already at zero. So there is no further scope for (conventional) monetary policy.
The Fed is now engaging in “unconventional” monetary policy, with the intention of reaching a target inflation rate of 2% (instead of the current sub-1%).
They taught us, in school, that it’s really hard (even for the Fed) to move long-term interest rates. Which is why what the Fed is doing with QE2 is, politely, referred-to as “unconventional.”
Let’s hope that what they taught us in school was wrong …
Some prominent American economists have analyzed economic developments since the bubble burst and concluded that (if I remember correctly)about 8 million jobs were saved by the US stimulus package. – The problem I have with the American approach is that, instead of pumping more money directly into job creation, most (or much of it) was spent on “polishing up” the banking sector.