While it is expected to get more spending during emergencies, the assumption behind the increase is that the increase will not be sustained in the future. You wouldn’t know it based on the Biden administration’s recent budget request. While the recession is receding and the economy is quickly moving toward full employment, the document shows a $7.2 trillion budget for FY2021, and requests $6 trillion for FY2022. Just to give an idea of the scale of this request, in FY2020, spending reached $6.5 trillion up from $4.4 trillion in FY2019.
But I guess “enormous” is what describes best all spending bills these days, as evidenced by the scale of Uncle Sam’s COVID-19 relief bailouts—most of which are reflected in last year’s and this year budget’s numbers. As a reminder, there were 5 of them: $192 billion from the Families First Coronavirus Response Act; $2.2 trillion from the Coronavirus Aid, Relief, and Economic Security (CARES) Act; $733 billion for the Paycheck Protection Program and Health Care Enhancement Act; $915 billion for the Coronavirus Response and Relief Act; and, finally, $1.9 trillion for the America Rescue Plan Act of 2021.
Much of this response was, and is still, considered “stimulus”, designed to save jobs that would have been lost or to create jobs that would have gone uncreated otherwise, and ultimately create economic growth. Was it though?
To answer that question, Garett Jones and I decided to do a review of the most recent literature on the short-term effects of government spending. That paper is now out. This is our main conclusion:
“The evidence presented in this policy brief suggests that government purchases—for example, directly hiring federal employees, paying contractors for public projects, and so forth—probably reduce the size of the private sector at least a little, even while they increase the size of the government sector. On net, incomes grow, but privately produced incomes shrink. Therefore, government purchases tend to crowd out private consumer spending, private investment, and exports to foreign countries.
Many economists say that government purchases still stimulate growth in the private sector when the economy is at its lowest ebb, such as when interest rates near zero or when deep recessions occur. But the massive fiscal multiplier that economists rely on to reach that conclusion (whereby government spending jump-starts the private sector into vigorous action, usually by hiring workers whose incomes are spent on various goods and services in ever-expanding circles of consumption) is largely a myth. According to the best available evidence, there are no realistic scenarios where the short-term benefit of stimulus is so large that the government spending pays for itself. In fact, even when government spending crowds in some private-sector activity, the positive impact is small, and much smaller than economic textbooks suggest.”
That’s what our review of the literature finds. But it is worth adding to points as they relate to the current moment. For starters, the COVID 19 recession was more of a cost shock, or a bad supply shock, which makes it a poor fit for Keynesian stimulus in the first place. Then, as far as multipliers in a zero lower bound interest rate environment are concerned, I find Scott Sumner’s insight on this point compelling. As we write:
Economist Scott Sumner at the Mercatus Center at George Mason University argues that the finding [a zero lower bound interest rates can cause the fiscal multiplier to be larger than one] is conditional on having an incompetent or passive monetary policy in place; that is, having a monetary policy not designed to hit a growth target in aggregate demand. However, if the Federal Reserve is acting appropriately, it has already set its policy to achieve optimal growth of expected aggregate demand, a rate of growth that should not change along with fiscal policy. Therefore, the central bank will attempt to neutralize the impact of fiscal stimulus (perhaps with quantitative easing or by communicating to financial markets that future monetary policy will be different) and thus will push the fiscal multiplier toward zero, helping ensure that expected aggregate demand growth is unchanged by fiscal policy.”
If you think that the current monetary policy of the Federal Reserve is reasonably competent, then you shouldn’t expect the fiscal stimulus to have much of an impact because the Federal Reserve will offset the effect of any stimulus such that inflation will average about 2 percent during the 2020s. The closer to zero the multiplier, the bigger the crowding out of the private sector. This is, of course, before taking future taxes into account.
I am not expecting newspapers to stop calling government spending “stimulus”, but it would be nice if textbooks would adjust their Keynesian theory content to reflect what we know the value of the multiplier actually is rather than what Keynesians hope that value will be. At the very least, they should note that just because an idea is true in theory does not mean it is true in fact.
Veronique de Rugy is a Senior research fellow at the Mercatus Center and syndicated columnist at Creators.
READER COMMENTS
Phil H
Jun 8 2021 at 10:52am
Sorry to be dim, but I’m still not quite understanding the theory of offsetting.
“you shouldn’t expect the fiscal stimulus to have much of an impact [on growth] because the Federal Reserve will offset the effect of any stimulus such that inflation will average about 2 percent during the 2020s”
in the first half of that quote, we have growth; in the second half of the quote we have inflation. It looks like the writer is assuming that there’s something like a fixed relationship between growth and inflation.
(i) Am I right that that’s an assumption? (ii) Is that assumption motivated by theoretical or empirical evidence? (iii) Doesn’t the recent relatively strong growth and low inflation challenge the assumption?
Jon Murphy
Jun 8 2021 at 11:37am
That is the standard assumption in Keynsian style economics, which Veronique, Jones, and Sumner are responding to.
The assumption has been challenged many times. It’s not a particularly good assumption, and yet Keynesian economics still touts it.
Scott Sumner
Jun 8 2021 at 12:28pm
The Keynesian assumption is that both fiscal and monetary policy affect aggregate demand. (Specifically tax and transfer fiscal policy, which is what we did in this case.) If a competent Fed is setting monetary policy at a position expected to produce enough AD to generate 2% inflation, then it will offset the effects of fiscal shocks that threatened to move AD away from the Fed’s preferred target.
Phil H
Jun 9 2021 at 1:52am
Thanks, Scott. I think I understand that. But isn’t it your contention that in fact, aggregate demand is not the driver of growth or inflation? That in fact monetary policy affects both much more?
So… sorry, I’m still thinking this through… you’re saying that the idea of fiscally stimulus doesn’t work in the Keynesian framework that most policy makers still seem to think in, even within that framework’s own theory, because the two levers will end up canceling each other out?
But monetary policy can accurately target future NGDP, and then the primary role of fiscal policy is to get out of the way of the private sector so that the composition of the rise in NGDP will be mostly growth and not so much inflation… Is that right?
Thomas Lee Hutcheson
Jun 8 2021 at 10:09pm
I think “stimulus” is not the right way to think of fiscal policy. The Fed can (indeed is mandated to) keep employment high (roughly to avoid recessions and promote recovery if they happen). Fiscal policy could have a “stimulus” effect only if (as in 2008-19) the Fed was failing to buy enough whatever to keep/return the economy to full employment but would buy enough if the additional stuff to be bought were newly issued debt. What recessions do is change the calculations of which activities with current costs and future benefits, whether of the government directly or people to whom is may transfer money, pass NPV tests. When there is unemployment many more activities pass the test so spending looks superficially “Keynesian.”
Lizard Man
Jun 11 2021 at 12:51am
What about positive supply shocks? My impression is that there is a ton of labor saving technology that is commercially mature, but isn’t being employed because it has been cheaper in nominal terms to hire people to do things. So even if the Fed is doing its job well, they are still likely underrating the probability of productivity growth, especially if deployment of technology and hence productivity growth is impacted by nominal wage growth. Having businesses working on solving the problem of solving insufficient supply seems like it should lead to higher productivity growth than businesses trying to figure out how to cut costs in the face of low demand.
Anecdotally, I have seen this in action. I worked for a professional services firm, and when I joined in 2012, they insisted that everything ultimately have a paper copy, and that everything be vetted as a paper copy, and that the paper copies be retained for a number of years. Then, in 2016, a surge of work required everyone to work long hours for a six month period, and the firm had difficulty hiring new employees. Finally, management realized that it was, in fact, possible for the firm to go paperless, and that it would be lead to more efficient and speedy work flows, and save money in other ways as well (postage, all of the costs associated with the space of storing all that paper, paper, increased employee retention and productivity as offsite work became possible). Were it not for the surge in work and a tighter labor market, God only knows how many years it would have taken them to go paperless, given that they were already a decade behind the times.
Lizard Man
Jun 11 2021 at 1:02am
One example of a mature labor saving technology is the use of cell phones, QR codes, and digital menus for ordering food in restaurants. Another might be the use of electric passenger vehicles, as the useful life of the mechanical parts and body of the car could well be 4 decades or more. And given learning curves in manufacturing and continuing research into battery chemistry and engineering, batteries should continue to get cheaper as well, even if demand causes increases in the price of raw materials.
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