Why stimulus fails

Posted on June 10, 2009 in Debates

NationalPost.com – fpcomment – Why stimulus fails: Deficit-financed stimulus spending won’t bring recovery, but our children will still have to pay for it
Posted: June 09, 2009.   By Niels Veldhuis

Trust us, stimulus spending works. That is the conclusion you might come to by reading an op-ed by James Dean and Richard Lipsey, two Simon Fraser University professors, in last week’s Globe and Mail (“Why stimulus won’t stifle recovery”). According to Professors Dean and Lipsey, “conservative economists” and “think-tanks like the Fraser Institute” have it “unambiguously wrong” on two central criticisms of stimulus spending. Do we really? A realistic analysis and real-world evidence would suggest not.

The first point of contention is whether or not stimulus spending is wasteful and can be done in a timely manner to influence an economy in recession. Dean and Lipsey clearly believe that spending won’t be “hurried and wasteful.” Their reason: Canada is in dire need of new infrastructure and therefore such stimulus spending is by definition not wasteful.

While Canada’s infrastructure certainly needs improvement, worthwhile infrastructure initiatives takes months or years to design and build and will not necessarily provide jobs in time to help counter the recession. In addition, when money is shovelled out the door as quickly as possible, projects that do receive funding are not typically ones that provide the greatest economic return.

In total, only 27% of the federal stimulus package is actually intended to be spent on physical infrastructure. The federal stimulus package also plans for billions in non-infrastructure initiatives including bailouts for troubled regions and industries. Examples include $4-billion for the auto industry (which has since increased by billions), $500-million for agriculture and $1-billion for a new southern Ontario development agency.

Given the dismal results of the $182-billion in corporate welfare delivered to businesses over the past 12 years and other massive regional development agencies (Atlantic Canada Opportunities Agency, Western Economic Diversification and Canada Economic Development for Quebec Regions), it’s hard to see how more of the same will not be wasteful.

Dean and Lipsey brush this aside by claiming that “even unproductive projects are better than none at all if the alternative is to leave labour and capital unemployed.” One of course has to wonder how literally to take their claim. Filling the Rogers Centre with sand for a massive beach volleyball tournament would certainly be unproductive, but would it actually be better than handing out cheques to individual Canadians as an alternative?

Unproductive or not, proponents of stimulus spending place faith in the government’s ability to get the timing right and actually implement stimulus spending during the recession. All of the evidence thus far points to the fact that “stimulus” spending will actually occur when the economy begins to recover. For example, first quarter GDP results in the United States show that government spending at all levels of government (federal, state, and local) actually decreased, not increased during the first three months of 2009.

In Canada, government spending on goods and services in the first quarter increased at an annualized rate of 1.0% (compared to 6.4% in both 2007 and 2008). Government capital investments increased at an annualized rate of 0.1% in the first quarter compared to 9.8% in 2007 and 19.7% in 2008. Governments have slowed the increase in spending considerably during the beginning stages of the recession — hardly what one would call stimulus spending.

If governments fail to implement stimulus spending during the recession, the spending will occur during recovery when labour and inputs are in greater demand. This will affect the relative price of inputs for Canadian businesses and negatively impact economic efficiency through a reallocation of resources. However, this does not lead to inflation (general increase in the price level) as Dean and Lipsey claim. When it comes to inflation it does not matter who (government or families) is doing the spending, what matters is how much money is being created by the Bank of Canada. As Milton Friedman taught us, “Inflation is always and everywhere a monetary phenomenon.”

Even more important however is Dean and Lipsey’s second point of contention, with “conservative economists’ ” criticisms of stimulus spending — the debate about where all of the money comes from. Thankfully, unlike most stimulus-crazed economists, politicians and media pundits, Dean and Lipsey do at least attempt to address the unseen side of the stimulus equation.

Unfortunately, they assume that deficit-financed stimulus spending does not “crowd-out” (econ-speak for replace) other private-sector spending and investment, and offer many sophisticated theories about the relationship between government borrowing and bond markets, bank lending and the money supply. But they ignore the consequences that government borrowing will have on Canadians’ expectations for the future.

Running a deficit (borrowing) today implies higher taxes or lower spending sometime in the future. As a result, people and families tend to increase savings or pay down outstanding debts in order to brace themselves for higher taxes or lower government spending in the future.

The use of Japan as an example supporting the arguments by Dean and Lipsey is particularly interesting. Japan is the poster country for why deficit-financed stimulus spending does not work. As detailed in a 2003 Fraser Institute study, Japan attempted to stimulate its economy throughout the 1990s. A total of 11 separate fiscal stimulus packages, amounting to $949-billion Canadian, were implemented during the 1990s. In addition, more than 40% of the funds were allocated to public infrastructure.

All told, government spending in Japan increased from 31% of GDP in 1990 to 39% in 2000 while net debt increased at a staggering rate from 14.4% to 60.4% of GDP over the period (debt now stands at over 90% of GDP in Japan).

For all this stimulus spending, Japan’s economy languished throughout the 1990s, consistently performing well below the average of the industrialized countries. Notably, its rate of fixed capital formation was stagnant and its unemployment rate increased, not decreased, throughout the 1990s.

Ultimately, Dean and Lipsey forgot the old saying, there is no free lunch. Increased government spending financed through deficit will ultimately be offset by a reduction in private-sector activity, be it consumption, investment and/or exports. The money has to come from somewhere. Real-world evidence shows that stimulus spending does not work.

Financial Post
Niels Veldhuis is director of fiscal studies at the Fraser Institute and co-author of The Sun is Setting, & the Shamrock is Skyrocketing: Fiscal Policy in Japan and Ireland available at fraserinstitute.org


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