Click to enlargeDo fiscal stimulus programs work? Do they actually stimulate the economy, or does routing resources through a central government and reallocating it according to political criteria wind up hurting the economy? Converted into economist-speak, the question is this: Do stimulus programs have a positive “fiscal multiplier” -- does $1 in government spending create more than $1 in economic activity -- or a negative one?
Conservative commentators tend to minimize the multiplier, suggesting that government spending tends to be a drag on the economy. Such views just happen to coincide with their philosophical preferences for small government. (I, for one, fall into this category.) Liberal pundits tend to maximize the multiplier. Again, such views reinforce their predilection for bigger, activist government.
Now come three economists — Ethan Ilzetzki, Enrique G. Mendoza and Carlos A. Vegh — with a paper, “How Big (Small?) Are Fiscal Multipliers?," published by the National Bureau of Economic Research. Their view: It depends.
The authors argue that previous studies were of limited value because they relied upon annual data, which tends to fudge the time-lag effects of stimulus programs. They have assembled a quarterly dataset for 44 countries (20 high-income and 24 developing) that, they assert, gives a clearer picture.
They find that the impact varies between developed countries and developing countries; between countries whose currencies have exchange-rate flexibility as opposed to fixed rates; between countries that conduct a significant amount of foreign trade compared to those that are more closed; and between countries with high outstanding central government debt and those with low debt.
Among their conclusions:
- Fiscal policy (particularly on the expenditure side) tends to be slow in impacting economic activity, “which raises questions as to the usefulness of discretionary fiscal policy for short-run stabilization purposes.” Medium- to long-run effects of increases in government consumption vary considerably.
- In economies closed to trade or operating under fixed exchange rates, increases in government spending lead to more economic activity. Conversely, countries with open economies and flexible exchange rates show fewer benefits.
- Fiscal stimulus tends to be counterproductive in highly-indebted countries (in which public debt exceeds 60% of GDP).
Write the authors:
With the increasing importance of international trade in economic activity, and with many economies moving towards greater exchange rate flexibility (typically in the context of inflation targeting regimes), our results suggest that seeking the Holy Grail of fiscal stimulus could be counterproductive, with little benefit in terms of output and potential long-run costs due to larger stocks of public debt. Moreover, fiscal stimuli are likely to become even weaker, and potentially yield even negative multipliers, in the near future, because of the high debt ratios observed in countries, particularly in the industrialized world.
Where does that leave the United States? The authors do not apply their conclusions to specific countries. However, we can easily do so ourselves.
The U.S. economy is one of the most open economies in the world. Although foreign trade does not constitute as large a percentage of the economy as it does in some other countries, the U.S. has very low barriers to entry. It should have come as no surprise, then, when funds under the American Recovery and Reinvestment Act (better known as the “stimulus” bill) designed to pump up investment in green energy were used to import solar and wind-equipment from China.
Likewise, the U.S. is one of the most highly indebted countries in the world, with a debt-to-GDP ratio well over 60 percent. While the ARRA stimulus did create new or support existing economic activity in certain areas, the mounting federal debt contributed to fear and uncertainty in the private sector, thus reducing private investment and expansion that would have occurred in the absence of the stimulus. It is impossible, of course, to document investment that “would have happened,” but the effect is no less real.
In sum, the logic of Ilzetski, Mendoza and Vegh suggests that fiscal stimulus could well have a negative multiplier in the U.S., thus doing more harm than good.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.