The Trouble with Keynesian Stimulus Spending

By Tony Caporale. He is Professor and Chairman, University of Dayton Department of Economics & Finance.

"For  more  than  70  years,  a  strand  of  Keynesian  economic  thought—the  belief  that  economic  growth  can  be achieved through  increased,  short-term  government  spending—has  maintained  that  the  cure  for  economic depressions is a matter of simple arithmetic. Economist Paul Krugman argues that the government can use a multiplier  formula  to  calculate  the  amount  by  which  to  increase  spending.  Moreover,  Keynesians  assert  that  even wasteful government spending can be desirable, since any spending is better than nothing.

In “The Trouble with Keynesian Stimulus Spending,” Tony Caporale and Marc Poitras disagree with this assertion. This  simple  Keynesian  approach  fails  to  account  for  several  significant  sources  of  cost.  Besides  the  cost  of  waste inherent  in  government  spending,  financing  the  spending  requires  taxation,  which  entails  an  excess  burden,  the reduction in output resulting from workers’ reduced incentive to work. Furthermore, the employment of even previously idle resources involves lost opportunities to invest in alternative uses of these resources.

BACKGROUND

Economist Kevin Murphy made one of the first attempts to challenge this Keynesian way of thinking using a formal benefit-cost analysis. Murphy identified three main sources of costs:

•The inefficiency of government: the possibility that the public receives less than full value for each dollar spent by the government.
•The relative value of idle resources: the sacrifices associated with employing resources that could have been employed differently.
•The excess burden of taxation required to pay for the spending.

On  the  basis  of  his  analysis,  Murphy  concluded  that  stimulus  purchases  by  the  government  are  unlikely  to  add value to the economy.

A  similar  but  more  detailed  benefit-cost  analysis  subsequently  suggested  that  government  purchases,  at  least during  a  deep  recession,  could  create  positive  value.  The  problem  with  this  analysis  was  that  the  only  costs  the model considered were the negative effects of taxation.

STUDY DESIGN

Caporale  and  Poitras’s  study  subjects  the  Keynesian  stimulus  spending  method  to  a  benefit-cost  test  that expands  on  Murphy’s  model:  it  accounts  for  waste, the  value  of  workers’  time,  wear  and  tear  on  capital,  and the deadweight loss of taxation. It relaxes Murphy’s constraint that the multiplier can be no greater than one.

This  model  was  calibrated  by  surveying  the  published  estimates  of  key  parameters,  including  the  Keynesian fiscal multiplier.

RESULTS

The benefit-cost test yields two important insights into Keynesian spending programs:

•Waste and other costs can negate the benefits of stimulus spending, even in an ideal Keynesian situation (a deep recession with 0 percent interest rates). Even for an efficient spending package that is free of waste, the net wealth created amounts to only about one-quarter of the measured increase in GDP.
•Pressuring the government to perform while “the economy is reeling” will result in the government not spending wisely. To generate wealth from spending packages, the government must limit waste and provide services that the public values. This means the government would need to invest a lot of time coming up with an efficient plan, by which point the economy could already be on the rebound.

CONCLUSION FOR POLICYMAKERS

It  is  wrong  to  say  that  “spending  is  spending”  or  that  any  spending  is  better  than  nothing.  How  the  government spends stimulus money does matter. The government should spend taxpayer money carefully on projects that offer real value to the public. There is no justification for spending for spending’s sake, even during a deep recession."