2008-12-12

The ineffectiveness of economic stimulus

A number of venerable economists believe in the Keynesian governmental economic stimulus concept, in which big government spending is supposed to boost a flagging economy.

To summarize roughly: when everyone across the board starts saving too much, this causes a fall in consumption, which causes a fall in production, which causes a fall in investment, which causes a fall in economic growth, all of which generally harms human well-being.

Many economists believe that, when this happens, the cure is for the government to print money and spend it. This ought to have a multiplier effect on the economy: for every newly created dollar the government thus spends, the recipient might save 20 cents, but spend 80 cents. The next person down the line might do the same, saving 16 cents and spending 64 cents, and so on until, ultimately, each $1 thus created ought to result in $5 of trickle-down spending.

Venerable economists think that this ought to boost the economy and get the GDP right back on track.

Except, it doesn't. The multiplier as practically measured is not 5. It is more like 1 to 1.4; at best. Each dollar the government spends like this raises GDP by... one dollar. Maybe $1.40.

At first, this seems counterintuitive. Assuming that the $1 the government created didn't previously exist - assuming that it's new money that would not have been present in the economy - then it ought to circulate in the economy like any other money. If the savings rate in times like this is 20%, this money too should be saved at a savings rate of 20%, so there should be a multiplier effect. Why don't we see one?

Let's take a look at what actually happens. Suppose that 90% of people who want work have work, and 10% do not. If government spending goes to existing businesses, then it's going to people who already have work. Now they have a bit more work. But what do they do with the extra money from the government that they would not have received otherwise?

Given the empirical measurements, it would appear that people treat the extra money as just that - extra money. Even if their average savings rate is 20%, the extra money is not saved at the same rate; instead, since it is surplus and the times are bad, it is 80% saved and 20% spent. This leads to a meagre multiplier of no more than 1.4, as observed. The money doesn't trickle down to the economy.

This suggests that stimulus might be more effective if it was used to purchase work from people who are currently unemployed. People who lack sufficient income to live reasonably in the first place would spend more of this windfall on consumption, likely increasing the multiplier more than if the money is given to existing businesses where people, obviously, already have work. But still, the multiplier will not be much more than 2, because when the formerly unemployed spend their new money, they will spend it with businesses where people already have work, and those people and businesses will save most of the extra income. The trickling down stops fast in hard times.

Meanwhile, Christina Romer and David Romer find that the multiplier from tax cuts is about 3. It would appear that every $1 of tax cuts raises GDP by $3. Still - this too might be true in economic good times more so than hard times.

Ever done indoor skydiving? You enter a vertical tunnel where you stand on a mesh while a huge fan blows wind up at 100 mph or so. You wear an oversized suit and you need to adopt a certain position in order for the wind to lift you. If you are gripped with fear, you reach down to protect from falling. Your form now fails to capture the wind, and indeed you fall. As long as you adopt the form of fear, the wind can't lift you.

So it seems to be with the economy. As long as people are afraid, they're going to save most of their extra income. This is something that only very radical government policies might be powerful enough to change; and I mean policies far more radical than tax cuts or deficit spending.

We are better off without those policies. The economy is undergoing some reconfiguring; it is now apparent to everyone that some parts didn't work, and they need to be thrown away. Not knowing how we are connected to those parts makes things uncertain, and in times like that, it's normal that most people will save. But as long as governments do not meddle too much, a new order will arise, and the economy will soar again.

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