The U.S. suffered a net loss of 2.6 million jobs in 2008, the most since 1945. Now, 7.2 per cent of the work force is unemployed. New factory orders, housing construction and retail sales have shrivelled. The Obama administration claims the stimulus bill will "create or save three or four million jobs over the next two years . . . with over 90 per cent of those jobs in the private sector." According to the "stimulus bill", House Democrats propose to spend $550 billion of their two-year, $825 billion "stimulus bill" (and the rest of it being tax cuts). Because of the "multiplier effect", Keynesians argue that massive deficit spending by the federal government is the right policy for deepening recession. Why do Keynesian economists think that multiplier effect is so relevant to address the current worldwide economic meltdown?
The term 'animal spirits,' popularized by John Maynard Keynes in his book "The General Theory of Employment, Interest and Money," is related to consumer or business confidence. When animal spirits evaporate, consumers do not want to spend and businesses do not want to make capital expenditures or hire new employees. When interest rates are close to zero, and thus, conventional monetary policy is ineffective, Keynesian theory would argue that the government should have a fiscal target. If spending would otherwise be less than full employment GDP, the government should put more green bills into people's pockets. China has already announced to do so.
What's wrong with the Keynesian macroeconomic model? Keynes assumed that unemployed labour and capital can be utilized at essentially zero social cost, but the private market is somehow unable to do so. In other words, there is something wrong with the price system. John Maynard Keynes thought that the problem lay with wages and prices that were trapped at excessive levels. But this problem could be readily fixed by expansionary monetary policy so that wages and prices do not have to fall. However, real-life complex economy does not comply with simple Keynesian model. In addition, a simple Keynesian macroeconomic model implicitly assumes that the government is better than the private sector at marshalling unoccupied resources!
In addition, another substantial downside with the Keynes's model is that the money for government spending boom has to come from somewhere, which means it is removed from the private sector as higher taxes or debt. For every $1.0 the government 'injects,' it must take $1.0 away from someone else - either in the form of taxes or by issuing T-bills. In either case this leaves $1.0 less available for investment by the private sector or consumption. Moreover, the 'leaky bucket principle,' originally coined by Arthur Okun, is another reason which states that when government transfers income or wealth from rich to poor a lot leaks out and is wasted because of corruption, lack of monitoring, and planning.
For instance, a 2002 study of U.S. data by Roberto Perotti found that the effect of debt-financed spending increases was somewhat positive, but the multiplier effect was much less than one. A 2004 IMF study on recessions in advanced economies also found that "multipliers are unlikely to exceed unity." A 2006 study of U.S. data by IMF economist Magda Kandil found that the effect of fiscal expansion is insignificant on aggregate demand and economic activity. In December 2008, the National Bureau of Economic Research (NBER) published "What are the Effects of Fiscal Policy Shocks?" by Andrew Mountford and Harald Uhlig, and says, "The best fiscal policy to stimulate the economy is a deficit-financed tax cut," and "the long term costs of fiscal expansion through government spending are probably greater than the short term gains."
Thus, contrary to Keynesian followers, some economists suggest eliminating the federal corporate income tax rather than throwing money to the people. To be really stimulating, tax cuts need to be immediate, permanent and must be on the margin, and this was the principle behind the Kennedy tax cuts of 1964, as well as the Reagan tax cuts of 1981. The revenue cost of eliminating the corporate tax wouldn't be any more than their proposed $355 billion in new spending, but its 'multiplier' effects on growth would be far greater. Research by Mr. Obama's own White House chief economist, Christina Romer, has already shown that every $1.0 in tax cuts can increase output by as much as $3.0.
The "New Deal" is widely recognized as to have ended the Great Depression, and this has led many policy makers to support a 'new' New Deal to address the current crisis. For our new readers, the New Deal is the name that United States President Franklin D. Roosevelt gave to a sequence of central economic planning programmes with the goal of ensuring employment, reform of business and financial practices to ensure recovery of the economy during The Great Depression in 1930s. And, the lesson we have already learned from the New Deal is that government intervention can - and does - prolong a recession and might lead to severe depression. This was true in the 1930s, when artificially high wages and prices kept the U.S. economy depressed for more than a decade, it was true in the 1970s when price controls were used to combat inflation but just produced shortages. It is true also today, when poorly designed regulation produced a financial system that bears too much risk. If the multiplier effect were true, the government should spend $10 trillion and we'd all live in paradise.
However, Noble Lauret Paul Krugman (2008) has asserted that the Great Depression in 1930s lasted 10 years because the New Deal didn't spend enough. But if we take a close look at an other attempt by Japan, we will observe that it tried to spend its way out of its post-bubble economic disorder in the 1990s but ended up with a pile of debt and a 'lost decade' of no economic growth.
So, to address the current economic meltdown, government must ensure incentives for people and businesses to invest, produce and work. But the government spending will be a net stimulus only if its $1.0 goes to more productive purposes than those to which private investors would have put that same $1.0. So, if the government does not want to prolong the current recession, it should stimulate business activities through providing different incentives to businesses, e.g., tax-cut on corporate income and eliminating trade barriers, rather than following Keynes's vague multiplier in this multifaceted world.
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