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Why the U.S. Spending Stimulus Has Failed

Sunday December 5th, 2010   •   Posted by David Theroux at 1:54pm PST   •  

In a new article in the Wall Street Journal, “Why the Spending Stimulus Failed: New economic research shows why lower tax rates do far more to spur growth,” Stanford University economist Michael Boskin examines how and why the U.S.’s $814 billion economic stimulus has failed.

For many years now, Independent Institute Senior Fellow Robert Higgs has been showing that such Keynesian economic measures have and will only prolong and deepen economic malaise, which is exactly what has happened. For further details, see Dr. Higgs’s seminal book, Depression, War, and Cold War: Challenging the Myths of Conflict and Prosperity, as well as his many articles on the subject (e.g., here, here, here, here, here, here, here, here, and here).

As Professor Boskin notes in his new article:

President Obama and congressional leaders meeting yesterday confronted calls for four key fiscal decisions: short-run fiscal stimulus, medium-term fiscal consolidation, and long-run tax and entitlement reform. Mr. Obama wants more spending, especially on infrastructure, and higher tax rates on income, capital gains and dividends (by allowing the lower Bush rates to expire). The intellectual and political left argues that the failed $814 billion stimulus in 2009 wasn’t big enough, and that spending control any time soon will derail the economy.

But economic theory, history and statistical studies reveal that more taxes and spending are more likely to harm than help the economy. Those who demand spending control and oppose tax hikes hold the intellectual high ground.

Writing during the Great Depression, John Maynard Keynes argued that “sticky” wages and prices would not fall to clear the market when demand declines, so high unemployment would persist. Government spending produced a “multiplier” to output and income; as each dollar is spent, the recipient spends most of it, and so on. Ditto tax cuts and transfers, but the multiplier is assumed smaller.

Macroeconomics since Keynes has incorporated the effects of longer time horizons, expectations about future incomes and policies, and incentives (including marginal tax rates) on economic decisions.

Temporary small tax rebates, as in 2008 and 2009, result in only a few cents per dollar in spending. The bulk (according to economists such as Franco Modigliani and Milton Friedman) or all (according to Robert Barro of Harvard) is saved, as people spread any increased consumption over many years or anticipate future taxes necessary to finance the debt. Empirical studies (such as those by my colleague Robert Hall and Rick Mishkin of Columbia) conclude that most consumption is based on longer-term considerations.

In a dynamic economy, many parts are moving simultaneously and it is difficult to disentangle cause and effect. Taxes may be cut and spending increased at the same time and those may coincide with natural business cycle dynamics and monetary policy shifts.

Using powerful statistical methods to separate these effects in U.S. data, Andrew Mountford of the University of London and Harald Uhlig of the University of Chicago conclude that the small initial spending multiplier turns negative by the start of the second year. In a new cross-national time series study, Ethan Ilzetzki of the London School of Economics and Enrique Mendoza and Carlos Vegh of the University of Maryland conclude that in open economies with flexible exchange rates, “a fiscal expansion leads to no significant output gains.”

My colleagues John Cogan and John Taylor, with Volker Wieland and Tobias Cwik, demonstrate that government purchases have a GDP impact far smaller in New Keynesian than Old Keynesian models and quickly crowd out the private sector. They estimate the effect of the February 2009 stimulus at a puny 0.2% of GDP by now.

Click here to read the full article…

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December 2010