But … the model says so!

Administration’s belief in stimulus spending defies reality

By Geoffrey Lawrence
  • Wednesday, August 11, 2010

Eighteen months ago, the signature piece of legislation of the incoming Obama administration, the American Recovery and Reinvestment Act of 2009 (ARRA), was signed into law. 

At the time, the Obama administration promised Americans that the bill's passage would ensure that unemployment would not exceed 8 percent nationwide. Today the nationwide unemployment rate sits at 9.5 percent — its floor over the past year — while in Nevada, joblessness tops 14 percent. 

Given the dramatic failure of the "stimulus" package to achieve its stated goals, and the ongoing calls among some opinion makers for a "second stimulus," it is imperative that policymakers and the public understand why the initial stimulus failed.

The intellectual justification for the stimulus package was provided in a paper by Christina Romer, the incoming chair of President Obama's Council of Economic Advisors. That paper adopted a thoroughly Keynesian view of the potential for new government spending to spur economic growth through so-called "multiplier" effects. 

This theory holds that injecting new money into an economy through government purchases will yield secondary and tertiary transactions as the recipients of new government funds spend that money elsewhere. Hence, government spending is said to "prime the pump," allegedly creating new private-sector jobs as stimulus spending cascades throughout the economy. According to Romer's analysis, "more than 90 percent of the jobs created [from ARRA] are likely to be in the private sector."

Keynesian economists such as Romer acknowledge there are two primary methods for injecting government "stimulus" into an economy: tax cuts or new government spending. Romer's intellectual rationale for ARRA relied on her calculation that each dollar of new spending through ARRA would yield $1.57 in total economic activity once the multiplier effects were taken into consideration. Injecting money through tax cuts, by contrast, would — according to Romer's analysis — yield only $0.99 in new activity for every dollar in tax cuts.

Significantly, in 2007, before her job was to provide rationalizations for political action, Romer concluded that one dollar in tax cuts yields roughly three dollars in additional economic activity — far more than for government spending. Also before that, in 1992, she concluded that, during the 1930s, both fiscal and monetary stimuli were ineffective at alleviating the Great Depression.

However, even if one looks beyond these discrepancies, the Administration failed to account for many important factors — the same that are routinely overlooked by standard Keynesian macro-models. First, when governments borrow money to finance deficit spending, they deplete credit markets and drive interest rates up, crowding out private-sector investment and job creation. This means that there is a negative "multiplier" offsetting any positive multiplier effect — as government borrowing eliminates the secondary and tertiary transactions that would have otherwise resulted from private sector investment.

Second, Keynesian models that prescribe new government spending as stimulus fail to consider how large-scale government involvement in the economy can change individuals' expectations. A structure of production that is predicated upon government policy — which can change arbitrarily and at any time — introduces additional political risk into the marketplace. This can drive away private sector investment and discourage consumption as investors and others save more to hedge against uncertainty. The spike in reserve holdings since ARRA's passage strongly suggests that the Administration should have given greater consideration to this concept.

Third, and perhaps most importantly, any model that solely analyzes the impact of government action on macroeconomic indicators fails to consider how that action impacts the huge, particularized and diverse universe of transactions that Keynesians erroneously conflate together as aggregate economic activity. 

When government spending diverts productive factors — e.g. labor, capital equipment, raw materials — into uses that are politically-determined instead of market-driven, it might artificially boost a measure like GDP. However, that doesn't imply that actual wealth is being created, since government spending, while providing obvious utility to the politicians controlling it, does not necessarily provide utility to consumers. 

There is no meaningful economic benefit from a "bridge to nowhere," for example, meaning the resources diverted for its construction would be put to better use under a price system. When left free to determine their own consumption, individuals expend resources on purchases they determine to provide the highest value.

In its intellectual rationale for ARRA's passage, the Obama Administration ignored these considerations and, sure enough, ARRA failed to achieve its purported goals. Nevertheless, some pundits and congressional leaders today obstinately insist that the flawed assumptions behind the president's models are correct — despite their obvious, real-world failure.

In science, when an experiment proves the hypothesis wrong, one rejects the hypothesis.

If congressional leaders, including Nevada's own Harry Reid, are sincere about fixing the economy, they must acknowledge that more government spending is simply not the answer.

Geoffrey Lawrence is a fiscal policy analyst at the Nevada Policy Research Institute. For more information visit http://npri.org/.

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