Did the Stimulus Fail?

Despite the $3/4 trillion fiscal stimulus package, the economic recovery is still halting and slow.  While most observers seem to treat this as evidence of just how bad the recession really was, I think it may in part be due to the stimulus package itself, and I think the stimulus package may have long-term negative effects for the U.S. economy.

The conventional wisdom is that the stimulus was necessary, and if anything, wasn’t sufficiently large.  The logic (if indeed there is any real logic to the argument) is that it was necessary to stave off a true depression, just to keep us from slumping further, and that even more might be necessary to stimulate real growth.  According to this Keynesian view, most notably supported these days by Paul Krugman, the problem is a surplus of savings, which government can make up for by spending the money that the private sector won’t spend.

But there are some real problems with this argument.  First, the claim that a second Great Depression was averted is, at best, unprovable.  How do you prove that something that didn’t happen would have happened if not for X, unless you can re-run the experiment?  You can’t.  It’s really little more than a faith-based claim, akin to Lisa Simpson’s tiger repelling rock.

My primary argument against the claim that the stimulus prevented a second Great Depression is that the argument is based on the belief that a Great Depression sized economic slump–by which I mean not just a dramatic decline in output, but long-term failure to recover–can occur in the absence of government action, that it can be a natural market phenomenon.  I think the infinitely more plausible argument is that a Great Depression size slump is caused by poorly conceived government action, even if the initial economic shock is purely natural. While an extensive argument is too much to go into right here, in general the arguments that free market economies can go into a decade long depression lack a coherent mechanism in their explanation.  Bubbles, certainly, can cause economic shocks, but what mechanism connects those to long-term failure to recover?  Government action, on the other hand, has at least two clear mechanisms that can delay recovery: crowding out of private investment and creation of an uncertain climate for investment.  More on that in a bit.

Looking at the economy right now, it’s clear that while we’re technically out of the recession–officially defined as at least two consecutive quarters of negative growth in GDP–recovery is slow.*  Is this because the stimulus was insufficient, or was it because the stimulus was the wrong government policy?

I know, I know, anyone suggesting the stimulus was the wrong policy is a brainless right-winger who is just responding ideologically and doesn’t really care about families who are struggling with unemployment.  Of course it’s equally plausible to claim that those who continue to wholeheartedly continue to support stimulus despite any proof of its success are responding ideologically, and putting their ideology above the interests of struggling families.  So let’s set the claims of blind ideology aside, which serve only to shut down, rather than encourage, debate, and hear me out for a moment.

Here are the general arguments against Keynesian fiscal stimulus, as advocated by Krugman and enacted by President Obama.

• First, that it crowds out private investment, as any money government borrows is money that the private sector is unable to borrow, and by leaving less to borrow, it increases the cost of that borrowing (interest rates), further limiting private investment.  Keynes and Krugman argue that this crowding out doesn’t occur because the private sector is not doing any investing.  This is the surplus savings argument.  Government is simply stepping in to do what the private sector won’t.  There are reasons, as Milton Friedman (drawing on Sayes) showed, to doubt this,** but for the sake of argument, let’s accept the Keynes/Krugman claim, because even if they’re right, it’s insufficient to demonstrate the effectiveness of government policy.  That is, the mere fact that the private sector isn’t doing what it ought does not, in and of itself, provide any evidence that a government response will improve matters.

• Second, because economies do tend to recover on their own eventually, fiscal stimulus can be poorly timed.  This is another point made by Friedman.  For fiscal stimulus to do any good, it must take effect when needed, not later than needed.  Not only does this require government to act in a timely fashion, but it also requires the spending to be effective in a timely manner.  I think we can reasonably posit that government acted in a timely manner this time around, and it tried to make the spending effective in a timely manner by focusing on “shovel ready” projects.  But as is well-known by now, the rate of actual spending was much slower than the Obama administration had hoped for.  Even if the stimulus is ultimately effective, the lag in effectiveness has prolonged the slump.  As Arnold Kling pointed out a year and a half ago,
  

  …the short-run effect of the fiscal stimulus is negative…

  …most of the stimulus spending does not take place until next year and beyond, so the short-run gains are puny. On the other hand, the big increase in the projected deficit creates the expectation of higher interest rates, which raises interest rates now. These higher interest rates serve to weaken the economy.

  According to this standard analysis, the stimulus is going to hurt GDP now, when we could use the most help. Much of the spending will kick in a year or more from now, with multiplier effects following afterward, when the economy will need little, if any, stimulus.

  This is the flaw with using spending rather than tax cuts as a stimulus. The lags are longer when you use spending.

  In a normal Friedmanesque/monetarist claim, the concern is that the stimulus begins to take effect just as the economy is already heading into recovery, and it can cause it to overheat, growing too quickly. I don’t think many people are worried about that with this particular recession (which even monetarist economists tend to think is abnormal), so perhaps at worst the fiscal stimulus is delaying recovery, but that’s still not good. And that all assumes that the targets of the spending are well-chosen. Merely being “shovel-ready” is not evidence that their multiplier effect is very substantial. And this is something I’ve never seen Krugman or his supporters discuss seriously–the general problem with ensuring that government policies are well-designed (given the assumption that some well-designed policy would solve the problem). They tend to treat government as a candy-machine, wherein you simply insert your dollar, hit C12 for a Snickers bar, and actually get a snickers bar. In their mind, the only thing that can go wrong is that you have the wrong people in charge, who push the wrong buttons, out of either stupidity or maliciousness. They don’t recognize that government is not a candy machine, that the labels on the buttons don’t necessarily correspond to what you will get, and that the price is rarely as advertised.**

• Third–and this is the crucial point–the government action may deter private investment by creating uncertainty. Investors like nothing better than a relative certain investment climate.  I think the primary cause of the length of the Great Depression was Roosevelt’s ever-mutating economic policy.  Who wants to invest today when the rules are likely to change tomorrow?  Some point to the continuing Depression despite all the different efforts of FDR as proof of just how bad the economy was.  But as I noted above, their explanation lacks a mechanism, an explanation for precisely what caused the economy to remain so poor, so they resort to lots of hand-waving about the inherent instability of free markets or capitalism’s tendency to implode, substituting further hypotheses for an actual mechanism that would explain things.  They assume that each of FDR’s policies was wise, well-designed, and would have worked if just the economy hadn’t been so bad.  It never seems to occur to them that the unique combination of Rooseveltian policies and the worst economic period in U.S. history might suggest a causal role for those policies.  Maybe it was the most extended economic slump not in spite of those policies, but (at least in part) because of them.  Even if Keyne’s theory of recessions is correct, and even if government can actually take up the slack in private spending, and even if the government spending is well-targeted, if it creates investor uncertainty, it will exacerbate the economic problems rather than resolve them.

So even if we give Krugman the first two points (even though I think the timeliness and targeting of the fiscal stimulus is hard to defend), he fails to address the investment climate that is created by the government’s policy. And it seems to me that by going beyond our prior unsustainable debt load (for which President Bush bears responsibility) and ratcheting it up even further, so that the foreseeable future holds long-term unprecedented (except for WWII) deficits, the investment climate is harmed, in two ways. First, by ratcheting up long-term interest rates and inflation. Second, by creating concern that this debt load will hamper the U.S. economy for the long term.

Krugman may indeed be right that there’s a surplus of savings, but by just asking the government to spend the money the private sector won’t spend, he’s not addressing the root problem of the failure to spend and invest–uncertainty. In fact he may be encouraging a path that worsens that fundamental stumbling block. In short, Obama’s fiscal policies may, like FDR’s probably did, extend the period of poor economic performance, rather than shorten it. I’m not alone in thinking this way. Harvard economist Alberto Alesina makes the same point:

American firms today are profitable and have large unspent resources. But their uncertainty over regulation and taxes discourages them from risk-taking, investment and consumption. In Europe, governments would strengthen the banking sector if they cut spending and reduced their default risk. This, in turn, would ease the flow of credit into the private sector.

The composition of fiscal adjustments is therefore critical. Based on what we know, the U.S. and Europe are currently at greater risk from increased stimulus spending than from gradual but credible spending cuts.

Many people agree that we need to make some fundamental policy changes, and shift away from an economy so reliant on debt, but most think we need to fix the current economy now and solve the problem when we can afford to. I think that’s misguided for three reasons. First, we may not be able really fix the economy unless we can resolve that problem. Second, the debt load incurred by the federal government may mean that we can’t afford to fix it for a long time (or at least will create the perception that we can’t afford it). Third, if we do, at least temporarily, have an economic recovery, we will respond as though the pressure is off. The crisis will appear to be over and politically we will not have the will to make any fundamental changes. Governments tend to be responsive in perceived crisis-situations (whether or not the response is wise, there is a response), and much less so in perceived non-crisis situations.

____________________________________________________

*It’s worth noting that during much of the Great Depression we were also technically not in a recession by today’s standard definition

**In what may be Krugman’s most offensive attack on his critics ever, here he compares those who reject Keyne’s critique of Sayes as being like biologists who’ve never heard of evolutionary theory.  Krugman’s an outstanding economist, but given to a ferocious ideological defense of Keynes.  It is simply absurd to claim that the stature of Keynes’ theories among modern economists is even a faint shadow of the stature of evolutionary theory among modern biologists.

***For all Krugman’s well-developed capacity to analyze markets, he perpetually fails to apply his analytical tools to government. I can think of no reason for this other than blind ideology, which is a shame, given Krugman’s intelligence.