Obama’s economic team is planning a major economic stimulus that will rely heavily on government spending on infrastructure. What we’re all trying to figure out is, will it work? Greg Mankiw links to two economic analyses that say no:

One approach to answering this question is to examine the data using the techniques of time-series econometrics without imposing much a priori theory. For monetary policy, there is a large literature that does this; for fiscal policy, the literature is smaller but growing. The results from this exercise, however, do not always confirm the predictions from textbook Keynesian models.

The first study is from Andrew Mountford and Harald Uhlig called “What are the effects of fiscal policy shocks?” Their conclusions are: 

  • A surprise deficit financed tax cut is the best fiscal policy to stimulate the economy.
  • A deficit spending shock weakly stimulates the economy.
  • Government spending shocks crowd out both residential and non residential investment without causing interest rates to rise. 

Furthermore, they state:

As with Blanchard and Perotti (2002) we find that investment falls in response to both tax increases and government spending increases and that the multipliers associated with a change in taxes to be much higher than those associated with changes in spending. With regard to private consumption we find, in common with Blanchard and Perotti (2002) and Gal¶³, L¶opez-Salido, and Vall¶es (2004), that consumption does not fall in response to an unexpected increase in government spending. However, in contrast to these studies we do not find that consumption rises strongly. Our results show that the response of consumption is small and only significantly different from zero on impact and are thus more in line with those of Burnside, Eichenbaum and Fisher (2003) who find that private consumption does not change significantly in response to a positive spending shock.

The second paper is from Olivier Blanchard and Roberto Perotti called “An Empirical Characterization Of The Dynamic Effects Of Changes In Government Spending And Taxes On Output“. Their conclusions:

We find that both increases in taxes and increases in government spending have a strong negative effect on private investment spending. This effect is consistent with a neoclassical model with distortionary taxes, but more difficult to reconcile with Keynesian theory: while agnostic about the sign, Keynesian theory predicts opposite effects of tax and spending increases on private investment. This does not appear to be the case.

Mankiw goes on to say that he is not sure how convinced he is by these findings. I’m not sure why he finds them unconvincing except to say that he was trained as a Keynesian economist (which he concedes at the beginning of the post) and it doesn’t fit his world view. For those of us who see economics through a neo classical or Austrian view however, the findings are perfectly consistent with theory and practice.

The 1970s should have ended the debate about Keynesian economics forever. The economy of the Carter years was the result of trying to apply Keynes theories in the real world. It didn’t work then and it won’t work now.

There are those who will say that Obama is not applying a pure Keynesian response since his plan includes “tax cuts” for everyone except the rich, but that is not really true. The “tax cuts” in the Obama plan are tax rebates and marginal rates are left unchanged. As such they will not change incentives and will be viewed by taxpayers as temporary. We’ve already seen the effectiveness of those types of rebates.

The spending plans of the new Obama administration will probably mitigate some of the effects of the recession, but at what cost? My expectation is that we will end up spending at least 10% of GDP trying to counter the effects of the recession. In the process we will not be addressing the root causes of the recession, namely excessive debt and spending. We may be able to make the recession less painful but the cost is that we will exit the recession with the same problems as when we entered. Consumers will spend less and save more but the government borrowing and spending will just offset that positive.

It also means that whatever recovery we get will be weaker than it should be. As debt has risen in the US our recoveries from recessions have been weaker and weaker:

This can also be seen in the change in non farm payrolls. Each recovery has produced fewer jobs:

If we are to ever achieve a growth rate near our potential, we will have to reduce our debt load. We are devoting too much of our income to servicing debt rather than creating jobs. Deficit spending to get out of this recession will just mean kicking the can down the road a little further.