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Stimulus: To Spend or Not to Spend?

As the House of Representatives prepares for a Jan. 28 vote on the $825 billion Obama fiscal stimulus bill, politicians want to know: How much does boosting government spending or cutting taxes help the private sector? Can massive fiscal stimulus, as Obama is calling for, create jobs and increase economic output?

You might think these simple questions would have clear answers. Remember, macroeconomists have been studying the U.S. economy for decades. After all this time, we should have some general agreement on the size of the "multiplier"—that is, whether an extra dollar of government spending leads to gross domestic product, or GDP, going up by more than one dollar, or less than one dollar. To put it another way, it's essential to know whether the Obama economic package will stimulate the private sector or actually drain resources away from the rest of the economy.

An Intellectual War

In their analysis, the top Obama Administration economists, Christina Romer and Jared Bernstein, used a multiplier of roughly 1.6 for government purchases and about 1 for tax cuts. These figures suggest, for example, that a $100 billion increase in government purchases would lead to GDP going up by $160 billion. Out of that $160 billion, $100 billion would be the direct result of the original stimulus and $60 billion would be the increase in private-sector economic activity. A tax cut of $100 billion, by these numbers, would generate a $100 billion increase in GDP.

But among top economists, there is hardly consensus about the size of these multipliers, or even agreement about the right range. Instead, we are getting the equivalent of a full-scale intellectual war, with Nobel prize winners and leading economists actively attacking each other in public.

On one side are a very long list of pro-stimulus economists, such as Nobel winner Paul Krugman of Princeton University, who believe government spending can have a positive impact in today's extremely weak economy. On the other side is a shorter but eminent list of economists who are skeptical about the benefits of stimulus, including Nobel winner Gary Becker of the University of Chicago and top macroeconomist Robert Barro of Harvard.

"What's been disturbing," Krugman recently wrote in his blog, "is the parade of first-rate economists making totally nonserious arguments against fiscal expansion." In turn, Tyler Cowen, a conservative economist at George Mason University, wrote on his widely read blog Marginal Revolution that "pro-stimulus proponents… are not putting up comparable empirical evidence of their own for the efficacy of fiscal policy and there is a reason for that, namely that the evidence isn't really there."

Keynes, Revisited

It's important to understand that the vehemence of this debate reflects the resumption of an intellectual conflict that dates to the Great Depression and the famous economist John Maynard Keynes. The question then was whether the New Deal helped shorten or soften the Depression, as Keynes argued, or whether government intervention actually hurt the economy.

Surprisingly, the evidence is ambiguous. The New Deal was passed in 1933, and the size of the fiscal stimulus peaked in 1934. However, the economy did not conclusively recover until 1939, when military spending started to ramp up before World War II.

This ambiguity has haunted macroeconomics ever since, because it became impossible to settle the question of whether fiscal stimulus was the right thing to do or not. Anti-stimulus economists could point to the 1930s and argue that government action really didn't work, because the Depression lasted for years after the New Deal was passed. But economists who believed in fiscal stimulus as appropriate medicine for deep recessions—many of whom identified themselves as Keynesians—argued that the New Deal simply wasn't big enough.

Milton Friedman effectively brokered a truce between the warring sides in the 1960s. He argued that the Great Depression was created by mistakes in monetary policy by the Federal Reserve. He was sufficiently persuasive that most economists adopted this perspective. Over time, most economic textbooks stressed monetary policy as the main line of defense against economic downturns, while fiscal policy was downplayed. Who cares about fighting over fiscal stimulus when good monetary policy could prevent any recurrence of the Depression?

Compelling Arguments

But the truce is over. Over the past year the economy has continued to deteriorate even as the Fed has cut interest rates to near zero. With monetary policy having failed, fiscal stimulus is one of the few economic tools left. That has raised the stakes of the debate.

Both sides have plenty of theoretical firepower. The pro-stimulus camp has three main reasons why the multiplier might be large—i.e., significantly greater than 1:

• First, they say the credit crunch makes it difficult for households and businesses to borrow, leaving a hole that must be filled by the government.

• Second, rigidities in the economy make it hard for businesses and workers to shift quickly from contracting sectors such as home construction to expanding areas such as health care, making it necessary for government to provide support for demand.

• Finally, government intervention can boost business and consumer confidence, improve their expectations about the future, and stop a recession from turning into a death spiral.

On the other hand, the anti-stimulus economists also have reasons why fiscal stimulus might not be effective—i.e., why it may have a multiplier of less than 1:

• First, they point to "crowding out"—the idea that government spending may actually draw resources away from the private sector, even when unemployment is high.

• Second, taking on a lot of debt now may weigh down the economy in the future.

• Third, anti-stimulus economists are worried about wasteful spending.

In the end, this near-depression is likely to be a transformative event for macroeconomics. We are going to have a mammoth fiscal stimulus package this year—and in all likelihood, more in the near future. And when we see what happens, we may finally settle some of the disputes that have bedeviled economics for 80 years. And who knows—we may get the next Keynes as well.

Mandel is chief economist at BusinessWeek. His new textbook, Economics: The Basics, was recently published by McGraw-Hill.

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