Friday, 26 August 2011

Government Stimulus and the Expenditure Multiplier

I am quite fed up with the way professional economists discuss the pros and cons of stimulus spending. I would like to remind them that textbooks teaching the income and expenditure multipliers also explain that the effects of increased spending are partially offset by two types of leakages – savings and imports. So, one would expect that economists would fight their corner by fencing with different estimates about these two effects. But that is not so.

Surprisingly, they keep discussing government spending in general terms rather than the various types of stimulus spending. These can be grouped into four main categories: a) useless spending; b) capital write-off spending; c) productivity enhancing spending; and d) unallocated spending.

The first group includes the so-called roads to nowhere, paying someone to dig a hole and after paying him to fill it again, creating new services that nobody is willing to pay for or wants, etc. The main purpose of these spending programs is to put money in the pocket of those delivering such services and hope that they will go on spending their earnings. So, basically this type of spending is similar to the fourth group of spending.

The fourth group of government spending includes various forms of tax breaks and rebates, showering notes with helicopters or through bank transfers and paying subsidies to various types of recipients. Under these proposals the government does not know where to spend the money and leaves it to the private sector to decide whether to hoard or to spend it. Its advantage in relation to the first group of spending is that taxpayers know best how to use this is “manna from heaven”; its main drawback is that it cannot be targeted to minimize the leakage through savings and imports.

A common problem with these two groups of spending is that they are seen as a waste of resources and taxpayers assume that they will have to pay for them later on. So, they undermine the credibility of governments, raising more the fear that causes inaction than lifting the hope needed to stimulate entrepreneurial animal spirits.

The second type of spending is based on the idea that destruction requires reconstruction and this galvanizes the spending needed to start-off the economy. It may be justified by anticipation or after the disaster. This is often the case with rearmament and war reconstruction or in dealing with natural and manmade catastrophes. Other types of policies within this group include subsidizing the anticipation of capital replacement (e.g. the recent program of cash-for-clunkers) and the acceleration of depreciation charges.

This type of spending is obviously inefficient because the wealth created by the extra people employed as a result of the stimulus is offset by the costs of destroying existing wealth. Moreover, you could use the same money to fix broken assets rather than breaking and then fixing them. But, unfortunately, this is occasionally seen as the most efficient way to stimulate aggregate demand because often politicians only act fast in the presence of calamities.

By contrast the better type of stimulus – the productivity enhancing spending – is often slow to impact on the animal spirits of entrepreneurs and consumers. This type of spending includes infrastructures, research and development, health, education and the arts. Indeed, the development of profitable programs in these fields takes a long time to implement which often is not consistent with the short run impact needed from stimulus programs. Attempts to rush in programs in this field risk turning such spending in useless spending of the type one. Another unfortunate nature of this type of expenditure is that productivity enhancing policies often require lay-offs to reduce the productivity drag caused by over manning and this offsets the intended goal of employment creation.

Apart from discussing the various types of spending stimulus, two other important issues on which economists should focus are the trade-off between speed and efficiency and the phasing out of stimulus programs to prevent perpetuating the consequent growth of the public sector at the expense of the market capitalism sector. Also the potential for collateral damages resulting from increased government spending – unsustainable debt levels, crowding-out and inflation risks – should be discussed in a dispassionate way.

In conclusion, instead of searching for abstract and absolute yes or no answers on the working of the expenditure multiplier and business cycle management policies, economists should focus on the when and how to make the stimulus programs work.

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