In a few weeks, Congress will likely enact the largest fiscal stimulus legislation in history. Surprisingly, the whole idea of such a stimulus is much more controversial among A-list economists than I would have expected, given the depth and breadth of the economic malaise. Although the debate is rather technical, it's important to try to understand it because much is at stake.
Eighty years ago, the conventional view among economists was that government had nothing to do with business cycles--it neither caused them nor was there anything it could do about them. They were like the weather; you just coped the best you could. Eventually, economists came to understand that vast numbers of individuals and businesses throughout the economy don't make exactly the same mistakes simultaneously unless something has changed the rules of the game. Government isn't always responsible--bubbles can occur on their own, as they have over the centuries--but systemic errors usually result from government policy. The Federal Reserve, our nation's central bank, is the institution mainly responsible for altering the terms of trade. That is because it has the power to change the value of the currency, which is the intermediary in every single economic transaction, and also to alter the terms of every intertemporal transaction--those between the present and future, such as saving today to consume tomorrow--by raising or lowering the interest rate....
Keynes was right, but many of his followers weren't. They thought that budget deficits would stimulate growth under all circumstances, not just those of a deflationary depression. When this medicine was applied inappropriately, as it was in the 1960s and 1970s, the result was inflation. Economists then concluded that it was a mistake to pursue countercyclical fiscal policy, and the idea of "fine-tuning" became a derogatory term. Even those who continued to believe it was theoretically possible to counter recessions with public works or government jobs programs were eventually forced to concede that it was impossibly difficult to make them work in a timely manner.
In the 1980s and 1990s, economists came around to the view that only monetary policy could act quickly enough to reverse or moderate a recession. But they never really came to grips with the Fed's responsibility for causing recessions in the first place. It always tightened a little too much when inflation was the problem and eased too much when slow growth was the problem. For a time, a cult grew up around Fed Chairman Alan Greenspan. Many who should have known better convinced themselves that the "Maestro," as journalist Bob Woodward called him, would fix everything....
Somewhat surprisingly, there has been rather heated opposition to the very principle of fiscal stimulus--a return to pre-Keynesian economics. And among those expressing dissent are some of the leading lights of economic theory over the last 40 years....
We have now had several tests of the Keynesian idea--most recently with last year's $300 tax rebate, which was supposed to prevent a recession. According to a new paper by University of Michigan economists Matthew Shapiro and Joel Slemrod, only a third of the money was spent, thus providing very little "bang for the buck." The failure of rebates has shifted the focus to public works and other direct spending measures as a means of stimulating aggregate spending. A study by Obama administration economists Christina Romer and Jared Bernstein predicts that the stimulus plan being debated in Congress will raise the gross domestic product by $1.57 for every $1 spent.
Such a multiplier effect has been heavily criticized by a number of top economists, including John Taylor of Stanford, Gary Becker and Eugene Fama of the University of Chicago and Greg Mankiw and Robert Barro of Harvard. The gist of their argument is that the government cannot expand the economy through deficit spending because it has to borrow the funds in the first place, thus displacing other economic activities. In the end, the government has simply moved around economic activity without increasing it in the aggregate. Other reputable economists have criticized this position as being no different from the pre-Keynesian view that helped make the Great Depression so long and deep....
I think the critics of an activist fiscal policy are forgetting the essential role of monetary policy as it relates to fiscal policy. As Keynes was very clear about, the whole point of fiscal stimulus is to mobilize monetary policy and inject liquidity into the economy. This is necessary when nominal interest rates get very low, as they are now, because Fed policy becomes impotent. Keynes called this a liquidity trap, and I think there is strong evidence that we are in one right now. The problem is that fiscal stimulus needs to be injected right now to counter the liquidity trap. If that were the case, I think we might well get a very high multiplier effect this year. But if much of the stimulus doesn't come online until next year, when we are likely to be past the worst of the slowdown, then crowding out will greatly diminish the effectiveness of the stimulus.... Thus the argument really boils down to a question of timing. In the short run, the case for stimulus is overwhelming. But in the longer run, we can't enrich ourselves by borrowing and printing money. That just causes inflation...
Very interesting and helpful piece. Citation?
Posted by: Buce | January 27, 2009 at 02:12 PM