Recently in business cycles Category

This article comes out in the Deseret News tomorrow morning.

The U.S. economy has been through several rough years, beginning with a severe recession in 2008 and an anemic recovery since.  The economy has actually been growing since June of 2009, but it hasn't felt like it to many Americans.  Jobs have been slow to recover compared to most postwar recessions.  Despite the weakness of the recovery, things are not as bleak as they seem.  The longer the recovery remains weak, the greater the potential for future economic growth.

Did the 2009 Stimulus Package Work?

This article appeared in the Deseret News yesterday.

Congress passed the American Recovery and Reinvestment Act in February of 2009. If you will recall, at the time it was touted by its proponents as an economic treatment for the recession caused by the housing financial crisis that preceded it.
This article is from the Deseret News on Nov. 14th


In the last article in this series, I talked about how economic stimulus is supposed to work.  The basic premise is that when the government spends more money on goods & services, they more than replace the spending that households would've done without the stimulus.  That is the marginal propensity to consume (MPC) of the government is higher than that of households.

Economist Robert Barro has argued for the past thirty years or so, that this simple story ignores important aspects of household reasoning.  Imagine for example, that the government decides to run a budget deficit by lowering taxes.  This should be stimulative, since it leaves more money in the hands of consumers, who will presumably spend at least some portion of it (based on their MPC).  Barro argues, however, that rational households will realize that cutting taxes today and leaving spending unchanged does not mean taxes can stay permanently lower.  Such a policy is unsustainable over a long period of time.  Forward looking households will realize that lowering taxes today means raising them in the future (holding government spending constant over time in our example).  As a result they have a lower tax burden today and higher taxes in the future.  Since most consumers prefer consumption that is smoothed out over time, rather than high consumption now and low consumption later, the best behavior is to save.  Barro showed that under certain circumstances households increase their savings by exactly the same amount as the government reduced their taxes.  This leaves consumption unchanged and hence gives not stimulus at all.

 Barro has termed this effect "Ricardian equivalence" based on work by David Ricardo in the 1800's. As mentioned, Ricardian equivalence holds only in certain circumstances.  First, all consumers need to be rational and forward looking.  If some consumers do not care about the future, they will view a drop in taxes today as an increase in spendable income and increase their consumption.  If some consumers do not expect to be alive when the tax increase occurs they will also be likely to increase their consumption.  In these cases, there will be a stimulative effect of cutting taxes, even when it must necessarily be a temporary cut. 

Similarly, if the government increases spending and does so by borrowing money, rational households will realize that even though taxes don' t rise today, they must eventually rise at some future date.  The further off into the future that date is expected to be, the greater the number of households that will expect to be dead when the increase hits.  And, hence, the greater the stimulus will be.

A perfect example of this effect occurred in 1992 when Presidents Bush used an executive order to reduce federal withholding of taxes from people's paychecks.  The order did not change their overall tax burden; the same amount of taxes was due on April 15th.  However because withholding was lower the expected payment (refund) in April was larger (smaller) than before the change.  Since almost everyone in the economy expected to be around when the tax bill came due, this is an almost perfect implementation of a policy subject to Ricardian equivalence.  The response was exactly what Barro predicted, consumers saved most of their withholding and the policy had virtually no effect on the macroeconomy.

Very few economists believe that Barro's strict version of Ricardian equivalence where stimulus spending has zero effect is correct.  Nonetheless, his point is well taken.  That is, the effects of a stimulus are likely to be much smaller than those predicted by standard Keynesian models.  The effects are also likely to be larger when the future burden of paying for the stimulus is paid by future generations.  Stimulus spending that is paid back in the near future is likely to have very small effects.

As citizens and voters we need to ask ourselves if the short-run gain from a meaningful economic stimulus is worth the cost it imposes on future citizens and voters.
This article appeared on Tuesday, November 1st in the Deseret News.

In February of 2009 congress passed and President Obama signed the American Recovery and Reinvestment Act.  At the time it carried an estimated price tag of $787 billion.  Commonly referred to as "the stimulus bill," it was intended to reinvigorate an economy battered by the subprime mortgage financial crisis.  In September of this year, President proposed the American Jobs Act, which is also intended to invigorate the economy and spur jobs creation.  Under this act an additional $447 billion will be spent, leading some people to refer to it as "Stimulus Jr."

How exactly is increased government spending supposed to stimulate the economy.  The basis for this prescription lies in a particular school of macroeconomic thought known as Keynesianism.  The name comes from the famous British economist, John Maynard Keynes.  When he came up with his theories Keynes had in mind an economy mired in recession or depression, as was the case around the world during the 1930s.  In this environment Keynes claimed that workers and firms stood ready and willing to produce goods at the prevailing prices, if only someone would buy them.  This is the description of a market surplus, which occurs in individual markets occasionally for a variety of reasons.  Keynes argued there was an economy-wide surplus of goods, not just a surplus in a few scattered markets.

Normally with surpluses markets respond by lowering prices to clear the market, so that all goods offered for sale are purchased.  Think of sales on day-old bread or DVDs in the discount rack and you get the right idea.  However, Keynesian theory postulates that prices are slow to adjust, particularly downward.  This is referred to as price "stickiness" and it implies that markets will remain in surplus for long periods of time.  In the long run prices will eventually fall and markets will clear, but as Keynes famously quipped once, "In the long run we are all dead."  Hence, we may be quite concerned about what happens in the short run while prices are not adjusting.

In this scenario the problem with the economy is coming from consumers on the demand side.  They are not spending enough to purchase all the goods offered for sale.  A Keynesian prescription is to let the government purchase goods and services instead.  In theory this increases the demand for goods.  Firms sell goods that would otherwise remain unsold or not even produced in the first place.  And workers go back to work producing those goods.

There are complications, however.  The government needs to get the money to pay for these purchases somehow.  If it raises taxes, and uses the increased revenue to buy goods, it is also lowering the income of the households and businesses it taxes.  As a result, they spend less even as the government spends more.  Whether this leads to a net increase in the demand for goods depends on whether those taxes reduce their consumption of goods by more or less than the government increases its consumption.  Economists call this the marginal propensity to consume or MPC and argue that the MPC of the government is close to 100% (at least for stimulus spending) while the MPC of consumers in less than that.   Hence, a stimulus increases government spending more than it depresses private spending and yields a net increase in demand.

If, however, the government pays for spending by running a deficit, private spending need not fall, because households are not taxed and need not reduce spending.  This reasoning is why the traditional Keynesian policy prescription is to stimulate via deficit spending in a recession.

Since Keynes, macroeconomic theorists have run across flaws in this reasoning, however.  For example, when the government runs a deficit, it borrows more money from the general public.  When domestic households lend to the government, they voluntarily reduce spending and buy government bonds instead.  Hence, deficit-financed stimulus looks very similar to tax-financed stimulus in its overall effects.

Another reason why stimulus spending may be less effective than Keynesian theory suggests is that the effects depend crucially on how the money is spent.  For example, older and younger people may have different MPCs.  The old have less of a savings motive than the young.  Indeed most retired workers are dissavers, withdrawing funds on net from savings accounts and pensions.  If a stimulus package reroutes money from the old to the young it can actually reduce demand.

Recent studies suggest that much of the money from the 2009 stimulus was transferred to state and local governments for local spending projects.  However, many of these governments had quite low MPCs and used these stimulus funds directly or indirectly to pay off or avoid debt.  In other words they saved the money rather than spent it.  This may be one reason the stimulus was so much less effective that its proponents believed it would be.

Additional problems with stimulus spending include the effect it has in the long-run on burdens of taxation and expectations of future taxes.  More on those issues will be forthcoming in a later column.

Authors

  • Richard W. Evans is an Assistant Professor of Economics at Brigham Young University

  • Jason DeBacker is an Assistant Professor of Economics at Middle Tennessee State University

  • Kerk L. Phillips is an Associate Professor of Economics at Brigham Young University