Hot! Harpernomics

NationalPost.com – FP Comment – The federal government’s attack on our study showing that the stimulus failed is pure politics and ignores sound research
Posted: March 29, 2010.   By Niels Veldhuis and Charles Lammam

Last week on these pages we detailed the findings of our study, “Did Government Stimulus Fuel Economic Growth in Canada?” Based on the latest economic data from Statistics Canada and using the same methodology for analysing the data as the Bank of Canada, we found the federal government’s deficit-financed $47.2-billion Economic Action Plan had virtually no impact on last year’s economic turnaround.

Prime Minister Stephen Harper and Finance Minister Jim Flaherty responded to our report with harsh words. Both criticized the report as being “ideologically” motivated. Minister Flaherty was “disappointed” and remarked that our report was “poorly done” and “shabby.”

Prime Minister Harper went further and according to the CBC, said: “Economic theory and history is clear, governments must … make sure [funds] are put to productive use in the economy to create jobs … that is what we have been doing, that has been successful [and] every reputable international study says so.”

With all due respect, Mr. Prime Minister, that is simply not true.

A vast body of academic research casts serious doubt on the ability of government stimulus spending to boost economic activity. Worse still, our government’s estimates of the impact of the Economic Action Plan on employment and economic growth are based on discredited assumptions that have no empirical basis.

Let’s first review some recent and important independent academic studies on the effects of government stimulus.

Last October, internationally renowned fiscal policy expert and Harvard University professor Alberto Alesina and his colleague Silvia Ardagna conducted a comprehensive analysis of stimulus initiatives in Canada and 20 other industrialized countries from 1970 to 2007. Their study “Large Changes in Fiscal Policy: Taxes Versus Spending” identified 91 instances where governments tried to stimulate the economy and found that unsuccessful stimulus initiatives relied on government spending. Alesina noted that “a one percentage point higher increase in the current [government] spending to GDP ratio is associated with a 0.75 percentage point lower growth.” In plain English, increased government spending reduces, not increases, economic growth.

Professor Alesina’s study also found that successful stimulus initiatives — those that increase economic growth — focus on tax cuts. However, only 13% of the federal government’s $47.2-billion Economic Action Plan was dedicated to tax relief.

In another 2009 study published in the prestigious American Economic Review, Stanford University professor John Taylor reviewed the evidence over the past decade on fiscal stimulus and concluded “there is little reliable empirical evidence that government spending is a way to end a recession or accelerate a recovery.”

A 2008 study, “What are the Effects of Fiscal Policy Shocks?” by University of London professor Andrew Mountford and University of Chicago professor Harald Uhlig, assessed and compared the economic impact of various cases of deficit-financed spending, deficit-financed tax cuts and tax-financed spending from 1955 to 2000. They found that spending related measures are the weakest ways to stimulate the economy and that both deficit-financed and tax-financed spending have the effect of discouraging private investment.

The International Monetary Fund (IMF), which Prime Minister Harper has cited as an authority, recently surveyed fiscal stimulus initiatives in advanced and emerging economies and concluded that the average effect of discretionary fiscal policy “does not provide strong evidence of countercyclical effects.” Simply put, the IMF concluded that fiscal stimulus is generally not an effective way to combat recessions.

Unfortunately, the Prime Minister’s Office and Department of Finance are not aware, or worse still, chose to ignore these and dozens of other reputable studies that contradict their rhetoric.

Instead, the Conservative government continues to highlight its internally generated estimates of the impact of its Economic Action Plan. These “estimates” assume that an extra dollar of government spending increases economic output (GDP) by $1.50. In econ-speak, the government uses a “multiplier” of 1.5.

Put differently, the folks that called our study “ideologically” motivated assume that if the government takes a dollar out of your pocket or borrows it and then spends it on somebody else, it generates an extra $1.50 in economic activity (GDP).

How did Minister Flaherty and the Department of Finance derive its 1.5 spending multiplier estimate?

Well, it certainly does not come from “reputable” studies, as the Prime Minister has suggested. The estimate is actually from a political document co-authored by Christina Romer, chair of U.S. President Barack Obama’s Council of Economic Advisers. That political document dubiously assumes a government spending multiplier of 1.57.

Many internationally renowned economists have directly criticized Romer’s spending multiplier, including Stanford University professor John Cogan and his colleagues, who in a 2010 study, accused Romer of making “highly questionable” assumptions to arrive at a multiplier of 1.57.

Under more realistic assumptions, professor Cogan and his co-authors found that the spending multiplier is substantially smaller and that it likely lies between 0.5 and 0.6. In other words, if government spending increases by one dollar, GDP increases by only 50 to 60 cents.

It is important to note that the multiplier results apply for a given level of taxes. If the spending is deficit-financed, like the federal government’s Economic Action Plan, or tax-financed (increased taxes), the increased spending reduces other parts of GDP such as consumer spending, private sector investment and net exports.

Romer’s multiplier for government spending is also inconsistent with research by Harvard University professor Robert Barro, who has spent most of his academic career estimating fiscal stimulus multipliers. While Barro’s seminal 1981 study calculated a spending multiplier of 0.8, his more recent work suggests that it is even lower.

Earlier this year, Barro noted that the spending multiplier is actually negative after accounting for the fact that the government has to balance its budget over time with future tax hikes to finance current day deficit spending. Barro has also criticized Romer and noted that there is no “serious scientific research by Ms. Romer on spending multipliers” and that he “cannot understand her rationale for assuming values well above one.”

Professor Cogan and Barro’s work is supported by another 2009 study by Professor Eric Leeper of Indiana University. The Leeper study found that stimulus spending multipliers for government investment are negative due to the long delays associated with infrastructure projects and the expectations taxpayers form when the government finances these projects through debt.

This should be a concern to Canadians, given that more than 40% of the federal government’s stimulus package was earmarked for infrastructure initiatives and the stimulus is financed through large deficits.

Finally, even the IMF’s survey found much of the same and indicated that, despite some rare outliers, a typical range for spending multipliers is below one.

Rather than rely on economic models in which the answer is “built-in” and assumes government spending increases economic growth, our study examined Statistics Canada data on stimulus spending. We found that before the recession, during the recession and well into economic recovery in 2009, the government’s contribution to GDP growth has been markedly constant. In other words, whether the economy was shrinking, stagnant or growing, the contributions of government spending and government infrastructure investment to economic growth had little effect on changes in GDP growth.

The unfortunate reality for Canadians is that the federal government’s stimulus package was politically motivated rather than economically motivated. And now, again due to politics, the Conservative government that reluctantly implemented the stimulus package is aggressively defending it and attacking sound, rigorous, independent economic research.

Our study, supported by a large body of academic evidence, confirms that the stimulus package didn’t work. It’s time for the government to admit its stimulus mistake and return to prudent fiscal policies.

Financial Post
Niels Veldhuis and Charles Lammam are economists at The Fraser Institute and co-authors of “Did Government Stimulus Fuel Economic Growth in Canada? An Analysis of Statistics Canada Data”, available at
fraserinstitute.org.

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