COVID, and Stimuli, and Keynes, oh my!
By Veronique de Rugy
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.