Deciding if the fiscal stimulus is productive, a wash or a drag on economic activity has inspired a furious debate in economic circles this year. Some of the analysis is wickedly complex. In the interest of brevity (and clarity), Professor Eugene Fama has boiled down the key issues as follows:
1. Bailouts and stimulus plans must be financed.
2. If the financing takes the form of additional government debt, the added debt displaces other uses of the same funds.
3. Thus, stimulus plans only enhance incomes when they move resources from less productive to more productive uses.
The debate necessarily focuses on #3. That is, will the government’s stimulus spending end up in more productive investments relative to what the private sector would do with the money? History suggests we should be skeptical in answering “yes” in anything close to absolute terms. Of course, some government spending is productive, particularly when it goes into projects that are unlikely to find financing otherwise. The development of highways, for instance, to cite the standard example.
It’s not obvious that there are enough productive opportunities to satisfy billions of stimulus dollars. Even under the most optimistic assumptions about stimulus spending, the biggest bang for the buck comes early on. Eventually, the odds decline for producing a net gain (i.e., a positive multiplier effect) associated with the stimulus.
In fact, the hangover effect of stimulus is lurking. No less a proponent of fiscal stimulus than Paul Krugman is warning that the post-stimulus economy may be in for a fresh round of headwinds. Arnold Kling writes that “that the concept of a multiplier has completely disappeared.” Duncan Davidson observes, without a multiplier effect “we would have to keep increasing stimulus to keep the economy alive until we cannot fathom funding it anymore.”
Kling spells out the problem succinctly:
The more you spend this quarter, the more people are employed this quarter, the more they spend next quarter, and so on. If you do not believe in a multiplier, then any time you slow the rate of government spending growth you slow the rate of overall GDP growth.
If there is no multiplier, and we follow the Krugman logic, then we have no choice but to keep increasing government spending until…what point? when it is 100 percent of GDP?
On the other hand, if there is no multiplier, then I think we should question the whole concept of stimulus. With no multiplier, its benefits are almost entirely transitory and artificial.
The year ahead, particularly the second half of 2010, may look quite a bit different than 2009. A double-dip recession isn’t inevitable, although the odds for a slowdown in GDP’s expansion, such as it is, look higher than 50/50. Given the precarious state of the “recovery,” combined with a labor market that’s still a long way from expansion, the possibility of even a mild downshift in economic activity in 2010’s second half will put a lid on what the bulls can accomplish next year in the capital markets.