Does Stimulus Grow the Private Economy?

The Atlantic

Garett Jones--Economist at George Mason University

Many thanks to Megan for inviting me toguest blog. 

Most of my research is on how intelligence--IQ--matters morefor nations that it does for individuals. I've also done work on how monetary policy does or doesn't influence theeconomy, and on how we really didn't need to give unlimited bailouts to the bigbanks. 

I'll talk about a few of these topics in coming days, but let'sstart off by rehashing the battle over whether the 2009 stimulus bill--ARRA, the AmericanReinvestment and Recovery Act--really worked. I'm not talking about the tax cuts--I'm talking about the spending: greenjobs, new government buildings, health clinic staffers. With my coauthor Dan Rothschild (now atAEI) I wrote two paperslast year on the stimulus for the MercatusCenter at George Mason that got me thinking quite a lot about this. 

The Keynesian theory of stimulus is elegant: When arecession needlessly throws people out of work, the government can hire them,and then those people take their paychecks and buy stuff made in the privatesector. So it's a win-win: Thegovernment and the private economyboth expand. No cruel tradeoff: the pieis bigger than before, there's a "multiplier effect." I imagine Keynes genuinely loved the thoughtof saving his beloved market economy. 

So, how often does it work out that way? Well, ValerieRamey of UC San Diego (FD: one of my dissertation advisers) has looked at themajor studies and written some of her own, and in a new articleshe concludes that in the U.S., "on balancegovernment spending does not appear to stimulate private activity." Yes, it boosts government hiring--and lowersthe unemployment rate--so on average you're getting a free lunch there. But Faberge shampoo-style storiesyou read about in freshman economics texts where "he spends money at her store,and she spends money at another store, and so on, and so on" just doesn't seemto show up in the real world. 

You might think, "Textbooks don't really claim that government spending sets off waves ofprivate-sector spending---that's just a caricature." But I've got a textbook right in front of me--Schiller/Hill/Wall,in its 13th edition so it must have moved some product--and theytalk about a multiplier of 4: One dollar of government spending sets off three dollars of private spending. If that's how the real world works, let's doublethe Department of Defense. 

Case/Fair/Oster,a popular text coauthored by deservedly famous economists, is more careful--but evenonce they throw in all of their caveats, they conclude "in realitythe size of the multiplier is about 2." Everydollar of government spending sets off an extra dollar of private-sectorspending.

The Congressional Budget Office is a bit more conservativethan both of those textbooks: Theyoffer high-low ranges for the multiplier, so I'll cavalierly report amidpoint: 1.5. They also note that after post-ARRA "discussions on this topic with its panel of economic advisers" (tobe a fly on the wall at that meeting) they dropped their lower-bound multiplierestimate down to only 0.5: So they think there's a reasonable chance that adollar of government spending shrinks the private sector by fifty cents.

How could that possibly be? How could extra government spending shrink the private sector?  Well, in the simplest Keynesian model, it can't.You have to add some bells and whistles--let's call that "reality"--to get amultiplier less than one. 

Here's one path to a tiny multiplier: Let's suppose thegovernment is trying to find the right person for the job.  Now, what if that person already has one....

I'll talk about that, and about much else, later thisweek.  Glad to be aboard. 



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