Robert Barro on the Impotence of Stimulus

by Mario Rizzo

In an interesting opinion piece for the Wall Street Journal, Robert Barro and Charles Redlick give empirical evidence supporting the claim that stimulus spending doesn’t work. By “doesn’t work” they mean that the government spending multiplier is less than 1. This means that stimulus spending increases national income by less than the amount of new spending. Why? Barro and Redlick are vague on the reasons. They invoke “crowding out” and, presumably, the “permanent income hypothesis”:

Empirically, our research shows that most of the fall was in private investment, with personal consumer expenditure changing little.

It would be good to know more about why private investment fell. Is Robert Higgs’s “regime uncertainty” hypothesis about the Great Depression the explanation? Another possible explanation is the traditional Hayekian one: A substantial part of the problem is the prior misdirection of resources that aggregate government spending does not address or may even make worse.

Is there one explanation for all the periods for which Barro and Redlick had data? And then there is the result that stimulus begins to work when unemployment reaches 12%. Huh? Why?

The problem with this kind of neoclassical answer to the Keynesians is that it doesn’t include a plausible theory to rationalize the admittedly thin empirical results. The Keynesians have a plausible story to tell.

Empirical work is valuable but empirical work with scanty, implausible or incomplete theories will not convince other economists, policymakers or the general public.

One of the most important reasons that both Hayek and Keynes still have a hold on the thinking of many highly intelligent people is that they told good stories. Don’t underestimate the power of “the story.”

13 thoughts on “Robert Barro on the Impotence of Stimulus

  1. I guess the opinion piece isn’t aware of Bastiat’s broken window fallacy. Any thoughts on that?

  2. “… since the main changes in military spending are independent of economic developments, it is straightforward to isolate the direction of causation between government spending and GDP.”

    I’ve heard a lecture by Tom Woods in which he mentioned some work that Higgs has done regarding the correlation between WWII GDP growth and price issues. Mainly that the huge growth in GDP during war time is absurd even at an intuitive level (with so many prime workers being sent to die at the front and their jobs being replaced by teenagers and women etc). This led Higgs to the conclusion that, because production was so distorted, the prices used to assemble the GDP data were not of the market, but of the government’s whim in wartime contracts and the like.

    If this is true, is it conceivable that the multipliers used for the WSJ estimate could actually be much smaller, especially in terms of ‘private product’? Or perhaps I have missed something..?

  3. Consider this quote from Mish’s blog.

    Bank Credit Still Contracting

    The monetary base has surged at a 51% annual rate over the past thirteen weeks, and that has churned out less than 3.0% growth in M1 and -4.0% in M2 over that period. This is classic ‘pushing on a string’ monetary policy. The Fed hasn’t really fixed anything per se — the Fed, along with the FHA and other government agencies, have basically supplanted the banking system with taxpayer-funded credit. Bank lending to the private sector plunged some $40 billion in the week ending September 16 and to put this in a certain context, the decline over the past three months has exceeded 16% at an annual rate, which is unprecedented. And, the contraction in credit is very broad based — down 5.3% for consumer loans; -9.4% for real estate credit; and -20.4% for business (C+I) loans.

    The banks are still sitting on over $1 trillion in cash assets, and they are putting the proceeds to work in the government bond market, snapping up over $20 billion of Treasuries and Agencies so far this month — 22% at an annual rate over the past thirteen weeks. This may be one reason — from a flow-of-funds basis — as to why the yield curve is flattening right now. This and the nagging notion among some very important bond investors, such as Pimco, who see the U.S. economy as we do … deflationary.

    So the banks are buying government bonds rather than increasing lending. That is, they are buying the ‘stimulus’ rather than doing more of what the stimulus is supposed to cause. That’s completely backwards!

    That banks are involved in large scale bond puchasing, and bond proceeds are simply being used to finance current consumption, raises the specter of capital consumption – that we are in affect consuming more now, by investing less.

    Normally economists think of budget deficits as competing with private investment for loanable funds (crowding out), but i think it’s just as likely that what can occur is for consumption to replace some investment, which of course sends the econonmy backwards and pushes any multiplier affect towards zero (or less).

  4. Zach,

    Interesting point. But that assumes that the value of the defense spending was zero. This is a controversial point. It brings in a particular philosophy of government. Economists want to say a dollar is a dollar and we are not going to bring in our own value judgments. Nevetheless, I’d like to see the results if we look only at the effect on private product.

  5. As I recall Higgs work, he argues that defense spending should not be counted in GDP. (I believe that was also Kuznets view.) If Higgs is correct, the entire multiplier calculation is meaningless mathematics.

  6. I did not see Mario’s last comment while I was drafting my own. The Higgs argument was not, as I understood it, a value judgment, but a scientific assessment. Defense spending is not a final good or service. It is neither consumption, nor investment (the source of future consumption). To paraphrase Kirzner, if you are building a home and I am building a bomb to blow it, one can’t meaningfully add the two values and get a coherent total. One is production, and the other is anti-production.

  7. Thank Dr. Rizzo et al,

    I meant only that, if GDP is inflated because of the effects of the wartime command economy and the multiplier is derived from those numbers then, by implication, shouldn’t the multiplier be even lower than their already low estimates?! Even assuming the defense spending has value greater than 0, but that its market price would likely be lower than the artificial GDP indicator.

  8. Zach,

    Barro included multiplier estimates for 1950-2006 data, so even if Higgs’ theory was correct regarding GDP, they should not affect 1950 onwards data (unless his theory applies to other time periods).

  9. A fundamental problem with government spending, which is rarely if ever considered by Keynesian economists, is that it is not made in anticipation of meeting expected consumer demand for goods and services. Instead, it is directed toward projects planned by bureaucrats and politicians, often in cahoots with lobbyists and their business owning, rent seeking paymasters. Some of the projects (e.g., roads and bridges) would exist in a free market, but would be created by profit seeking entrepreneurs and investors. Other projects, such as erecting monuments to dead politicians, incarcerating drug entrepreneurs and consumers, organized mass murder (i.e., unjust wars) would not occur.

  10. Yes, Higgs gets into the philosophical issues of whether military expenditures should be classified as “final output.” But there are some other issues too, having to do with Fed printing and price controls, which I explain here.

  11. >>Empirically, our research shows that most of the fall was in private investment, with personal consumer expenditure changing little.<<

    With the incredible collapse of housing market, how could private investment not fall?

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