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October 05th 2009 print

Peter Smith

Stimulus hampers growth

If you give everyone a cheque in the mail before Christmas you have to expect that some people will spend it in retail stores.

Steve Kates, Testing the stimulus, rightly points out the flaw in testing the effectiveness of stimulus spending with a model whose parameters will always point to it being effective and rightly points out that no actual outcome, however contrary to predictions, is ever accepted as having disproved the effectiveness of stimulus spending. 

At question in the debate about the effectiveness of stimulus spending is whether the battle is fought on the right field. If the government, in any economic circumstances, spends an additional, say, $10 billion it will produce a rise in demand and production. It can do no other unless there is a total leakage of the spending on imports which is extremely unlikely and/or unless there is an immediate and corresponding fall in private sector expenditure, which is also extremely unlikely. The national accounts will reflect a rise of some order in the immediate aftermath of government spending, and even if production were to fall overall it would be still true to say that the fall would have been mitigated to some extent or other by the government spending. If this is the measure of whether stimulus spending is effective then game set and match to the Keynesians. But of course it shouldn’t be the measure. The measure should be whether stimulus spending hampers growth beyond the immediate term and there is good reason to believe that it does. It tends to push resources into unproductive areas – building thousands of new classrooms and school halls, putting free batts in thousands of ceilings, artificially and temporarily boosting retail sales by giving people money – and therefore interferes with the economy resuming a sustainable growth path. Separately and additionally it constrains growth because it leads to higher taxes and/or higher interest rates. 

The apparent boost in Christmas and January retail sales were adduced as evidence that the stimulus was working. Really? If you give everyone a cheque in the mail before Christmas you have to expect that some people will spend it in retail stores. If this is our measure of whether stimulus spending works and it seems to be the measure used by most economic commentators, it says something about the sad state of the way economics is taught and understood and persuades me that Keynes, however clearly he saw how the macro-economy fits together, has spawned generations of economists who do not understand how economies work and who in some cases, to our cost, bring that lack of understanding to policymaking. 

Let us just apply common sense; we don’t need economics to understand that an economy recovers when enough small and large businesses have sufficient confidence to invest, produce and hire labour and that one-off, willy-nilly, expenditures by government, coming with a price tag of future increases in taxes and/or higher interest rates, will not inspire that confidence.

Peter Smith, a frequent Quadrant Online contributor, is the author of Bad Economics