Stimulating the Economy: The Great Debate

The debate on the fiscal stimulus plan is all the rage these days. Prominent economists are killing each other over this topic. The arguments from the pro-stimulus camp can be found from Krugman (1), Krugman (2), Stiglitz, Mankiw, Summers, Feldstein. The anti-stimulus camp include the usual Chicago-school suspects such as Fama (1), Fama (2), Barro, Cochrane, Murphy, and Chinn (Chinn is not Chicago). You can click on the names to view their arguments.

Where do the disagreements come from? The whole thing centers around three key issues:

Is government intervention worth the costs?

Keynesians believe that an economy can become stuck in a recession when its natural recovery forces operate far too slowly, creating prolonged periods of high unemployment. They further believe that the government is able to move the economy out of a recession through fiscal policy and it should.

Chicago-school economists believe that the government has no business interfering in the economy, and that government intervention, however well-intentioned, too often makes things worse, not better.

What extent of the role should government play?

People on the left of the political spectrum – liberals, socialists, and Democrats – believe that more control by the government over resource allocation in the economy is a good thing. Those on the right – conservatives and Republicans – believe the government is an inefficient allocator of resources, and that individuals, through spending financed by tax cuts, can cause the market to produce and distribute more desirable outputs in a more efficient fashion.

How should the government finance an increase in spending?

An increase in government spending can be financed in three ways:

1. Raising taxes

2. Selling bonds to the public

3. Printing money

Chicago-school economists, such as Fama, essentially ignore printing money as a method of financing. As a result, stimulus plans can never work because raising taxes or selling bonds to the public lead to a phenomenon called “crowding out”, that is, financing offset the impact a stimulus plan is supposed to have on aggregate demand.

In contrast, financing by selling bonds to the central bank increases the money supply. When buying a government bond, the central bank writes a check against itself and thereby creates money out of thin air (printing money). In this case, there are no crowding-out effects. This is where Krugman thinks Fama made his mistake.

Recently, China proposed to increase government spending by a massive 4 trillion Yuan, or about 16% of GDP. This dwarfs the proposed stimulus package in the United States, a mere 5% of GDP. However, the U.S. has expanded its monetary base by 100% from last year. Clearly China favors the use of fiscal policy while the U.S. favors monetary policy. Why is it so? I will blog about this interesting phenomenon in the near future.

The above materials are based on Peter Kennedy’s Macroeconomic Essentials, a wonderful book written by my favourite university professor.

Comments

[Danny Newton:]

I don't understand how anything can be considered stimulating without some formal scoring process that would rank missions that would be supported by the new spending. Obviously, the old spending was not stimulative or there would be no recession. California should be the most stimulated state in the country if the mere volume of dollar increases per year are added up over the last three governors is any gauge.
I hope this period of confusion will be a time of reflection also. There are a lot of assumptions in the system that are not exactly 100% true but we are acting as if they were. The importance of education may be over rated. When everyone gets a masters degree, somebody is still going to be working at the Wal-Mart and bagging groceries. Most Mexicans have about an eighth grade education in a foreign language. They seem to find jobs without a diploma by presenting other attributes like being reliable. If you gave a person a bill instead of a diploma upon graduation from high school, there would be a howl of protest over the long term burden. Old folks like to pretend that their kids are out of school so they have a lowered obligation to support schools. The system however needs their tax money for a lifetime to fund the system.
Picking winners and losers on the basis of jobs produced only makes the least efficient projects float to the top of the pile. We could make more jobs by just getting rid of ATMs. We could make more jobs by dropping bulldozers into the sea and start building with shovels. The best performers with respect to GDP and value added are those that use labor efficiently.
I think that Keynesian Economics is being over simplified when people believe that the government only needs to spend money to stimulate demand. I think that the government must spend money wisely to stimulate demand. The government is merely substituting its judgement to prioritize spending.

Jan 30 10:21 AM

[axelrod608:]

>> "Clearly China favors the use of fiscal policy while the U.S. favors monetary policy. Why is it so?" >>

Simple answer - monetary policy favors the financial institutions over the individual citizens. The US policy is welfare for megabanks, with the hope that it will result in a trickledown to the people. One might as well hope for a golden-egg-laying goose for every citizen.

Jan 30 02:35 PM

[perceptions...:]

If faced with a simple temporary loss of confidence, then the resulting economic slowdown could be usefully offset by a temporary government stimuls.

However, where an economy, either National or Global, is adjusting to lower levels of Supply & Demand, which are permanent, then any stimulus simply postpones the inevitable. .

Indeed, it could be argued that the use of taxpayer dollars, in the form of a temporary stimulus, purely to delay the onset of a permanent reduction in Supply & Demand, is a wasteful use of public taxes, at any time.

Given that the major reasons for this downturn, aside from Greed, are once in history events, such as Peak Oil (a permanent Supply reduction) and the Baby Boomer Reirement Bust (a permanent reduction in Demand) , there is zero chance of restoring the old status quo.

As we can not go back, it is time to clear the decks and for both the people & governments, to catch up with a new reality, before that reality catches us.

Jan 30 07:39 PM

[biomedlives:]

"They seem to find jobs without a diploma by presenting other attributes like being reliable." They're also willing to work at low wages, often under hazardous conditions.


On Jan 30 10:21 AM Danny L. Newton wrote:

> I don't understand how anything can be considered stimulating without
> some formal scoring process that would rank missions that would be
> supported by the new spending. Obviously, the old spending was not
> stimulative or there would be no recession. California should be
> the most stimulated state in the country if the mere volume of dollar
> increases per year are added up over the last three governors is
> any gauge.
> I hope this period of confusion will be a time of reflection also.
> There are a lot of assumptions in the system that are not exactly
> 100% true but we are acting as if they were. The importance of education
> may be over rated. When everyone gets a masters degree, somebody
> is still going to be working at the Wal-Mart and bagging groceries.
> Most Mexicans have about an eighth grade education in a foreign language.
> They seem to find jobs without a diploma by presenting other attributes
> like being reliable. If you gave a person a bill instead of a diploma
> upon graduation from high school, there would be a howl of protest
> over the long term burden. Old folks like to pretend that their kids
> are out of school so they have a lowered obligation to support schools.
> The system however needs their tax money for a lifetime to fund the
> system.
> Picking winners and losers on the basis of jobs produced only makes
> the least efficient projects float to the top of the pile. We could
> make more jobs by just getting rid of ATMs. We could make more jobs
> by dropping bulldozers into the sea and start building with shovels.
> The best performers with respect to GDP and value added are those
> that use labor efficiently.
> I think that Keynesian Economics is being over simplified when people
> believe that the government only needs to spend money to stimulate
> demand. I think that the government must spend money wisely to stimulate
> demand. The government is merely substituting its judgement to prioritize
> spending.

Jan 31 09:28 AM