Keynesian orthodoxy is flawed
06 July 2011
Fiscal stimulus packages are doomed to failure – as the current situation in America proves, insists Richard Wellings
Faced with one of the worst recessions since the 1930s, many governments launched huge fiscal stimulus programmes. In the United States, for example, President Obama introduced an $800bon package of expanded unemployment benefits, increased welfare provision, tax incentives and various health, education and infrastructure projects.
Keynesian orthodoxy dominated the economic agenda and it was assumed that these stimulus policies would kick-start the recovery by replacing lower private spending with higher public spending and marshalling idle resources. A positive multiplier effect would operate, whereby the increased spending would circulate around the economy - increasing employment and boosting demand still further.
But the plans have failed in their heartland, America. Unemployment has continued to rise and economic recovery, if evident at all, has been anaemic. The disappointing outcomes of fiscal stimulus programmes come as no surprise to those economists, who argue they were flawed from the outset. Perhaps, the most prominent critic is Robert J. Barro, Paul M. Warburg Professor of Economics at Harvard University, who delivered the Institute of Economic Affairs Annual Hayek Memorial Lecture in London, this week.
Professor Barro argues that fiscal stimulus programmes are mostly a waste of money. They may boost growth figures in the short term, but the medium and long-term effects are negative. Government debt is increased to pay for the packages, which in turn leads to larger interest payments. Higher government borrowing levels also mean that taxes will eventually have to rise. Economic actors realise this and adjust their behaviour accordingly. Indeed, they typically respond to the prospect of higher taxes in the future by decreasing spending and investment – thereby counteracting the desired effect of the stimulus measures.
A further problem is that stimulus measures are often wasteful in themselves. A prime example Barro used in his lecture was Obama's "cash for clunkers" programme, designed to boost the automobile industry and improve fuel efficiency by paying consumers thousands of dollars to scrap their old cars if they bought a new car. Economic resources were needlessly destroyed as more than 600,000 cars were scrapped, many of which would have been usable for years to come. In addition, the timing of car purchases was brought forward – another example of a short-term boost with no clear long-term benefits, despite the additional burden placed on taxpayers.
At least, "cash for clunkers" was a temporary measure. Many economic distortions created by stimulus programmes are far more longlasting. Barro is particularly critical of the decision by the US government to lengthen the duration of unemployment-insurance benefits to 99 weeks – compared with the previous maximum, during recessions, of 50 to 60 weeks. This misguided measure has raised long-term unemployment by reducing work incentives. If the benefit expansion had not taken place, the official unemployment rate in the US could be around 8 per cent rather than over 9 per cent, as it is today. But, the large number of people now dependent on such benefits makes it politically risky to reverse this decision – illustrating the danger that once increased by stimulus packages, government spending may be difficult to roll back.
So, if fiscal stimulus programmes are largely ineffective, which policies should governments adopt during an economic slowdown? There are no easy solutions when public deficits are large, but Barro suggests that tax cuts are generally more effective than equivalent spending increases. In particular, cuts in marginal rates of income tax stimulate economic growth by improving incentives to work and invest.
Dr Richard Wellings is deputy editorial director at the Institute of Economic Affairs think-tank, in the UK
Faced with one of the worst recessions since the 1930s, many governments launched huge fiscal stimulus programmes. In the United States, for example, President Obama introduced an $800bon package of expanded unemployment benefits, increased welfare provision, tax incentives and various health, education and infrastructure projects.
Keynesian orthodoxy dominated the economic agenda and it was assumed that these stimulus policies would kick-start the recovery by replacing lower private spending with higher public spending and marshalling idle resources. A positive multiplier effect would operate, whereby the increased spending would circulate around the economy - increasing employment and boosting demand still further.
But the plans have failed in their heartland, America. Unemployment has continued to rise and economic recovery, if evident at all, has been anaemic. The disappointing outcomes of fiscal stimulus programmes come as no surprise to those economists, who argue they were flawed from the outset. Perhaps, the most prominent critic is Robert J. Barro, Paul M. Warburg Professor of Economics at Harvard University, who delivered the Institute of Economic Affairs Annual Hayek Memorial Lecture in London, this week.
Professor Barro argues that fiscal stimulus programmes are mostly a waste of money. They may boost growth figures in the short term, but the medium and long-term effects are negative. Government debt is increased to pay for the packages, which in turn leads to larger interest payments. Higher government borrowing levels also mean that taxes will eventually have to rise. Economic actors realise this and adjust their behaviour accordingly. Indeed, they typically respond to the prospect of higher taxes in the future by decreasing spending and investment – thereby counteracting the desired effect of the stimulus measures.
A further problem is that stimulus measures are often wasteful in themselves. A prime example Barro used in his lecture was Obama's "cash for clunkers" programme, designed to boost the automobile industry and improve fuel efficiency by paying consumers thousands of dollars to scrap their old cars if they bought a new car. Economic resources were needlessly destroyed as more than 600,000 cars were scrapped, many of which would have been usable for years to come. In addition, the timing of car purchases was brought forward – another example of a short-term boost with no clear long-term benefits, despite the additional burden placed on taxpayers.
At least, "cash for clunkers" was a temporary measure. Many economic distortions created by stimulus programmes are far more longlasting. Barro is particularly critical of the decision by the US government to lengthen the duration of unemployment-insurance benefits to 99 weeks – compared with the previous maximum, during recessions, of 50 to 60 weeks. This misguided measure has raised long-term unemployment by reducing work incentives. If the benefit expansion had not taken place, the official unemployment rate in the US could be around 8 per cent rather than over 9 per cent, as it is today. But, the large number of people now dependent on such benefits makes it politically risky to reverse this decision – illustrating the danger that once increased by stimulus packages, government spending may be difficult to roll back.
So, if fiscal stimulus programmes are largely ineffective, which policies should governments adopt during an economic slowdown? There are no easy solutions when public deficits are large, but Barro suggests that tax cuts are generally more effective than equivalent spending increases. In particular, cuts in marginal rates of income tax stimulate economic growth by improving incentives to work and invest.
Dr Richard Wellings is deputy editorial director at the Institute of Economic Affairs think-tank, in the UK
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