We have been told that "you don't need a PhD in economics" to understand why fiscal stimulus packages increase economic activity.
Senior government ministers, the Treasury, a host of business economists, and a legion of journalists -- amongst others -- seem to treat it as so obvious that it does not even require an explanation. Where an explanation is offered, it tends to be simplistic in nature. Here is one explanation ("everything you wanted to know") from the Sunday Age earlier this year:
Economic growth is normally driven by a combination of consumption spending, investment, exports and government spending. But ... three of the four fuel pipes feeding the growth engine are blocked. This leaves the ... [government] with the herculean task of keeping the economic engine whirring. That's exactly what the ... [government] has been doing, with a net $71 billion worth of new spending ...
While Australians don't need a PhD to understand, American supporters of fiscal stimulus appeal to the authority of economists, with the now Vice President of the United States stating:
Every economist ... from conservative to liberal, acknowledges that direct government spending on a direct program now is the best way to infuse economic growth and create jobs.
The belief that expansionary fiscal policy can increase economic activity and employment is (usually implicitly) based on the work of John Maynard Keynes (1883-1946) author of The General Theory of Employment, Interest and Money (1936). It certainly doesn't come from mainstream macroeconomics as currently taught in major universities around the world.
Keynes was a serious economist of great intellect, and his approach was the dominant paradigm in macroeconomics in nearly all major universities for about thirty years. Two prominent Keynesians, Lawrence Klein (1980) and James Tobin (1981), were the second and third of the eight economists to win the Nobel Prize in Economics explicitly for their work in macroeconomics. However, by the time of these awards, Keynesian economics was already passé.
While Keynes and his followers were far more rigorous than any of the expositions seen recently, at its heart was a simplistic concept: the belief that increased government spending and/or reduced taxation increases economic activity, not only dollar-for-dollar, but also with an amplified "multiplier" effect. While the Keynesian paradigm quickly displaced the classical paradigm (economic fluctuations are self-correcting as long as input and output prices are flexible), it began to be questioned almost immediately, and the interrogation intensified over time until it eventually gave way to a new paradigm. As this new approach is so complex and broad, it does not have a generally agreed name. Perhaps "rational expectations" is the best descriptor, but "supply-side economics", "monetarism", "fiscal irrelevance" and "Mundell-Fleming" are all associated with it. The new paradigm has yielded all five of the eight Nobel Prizes awarded after 1981 explicitly for macroeconomics.
An early question about Keynesianism came with John Hicks's 1938 article, "Mr Keynes and the Classics", that introduced the IS-LM framework, and showed how monetary resistance could dampen or even neutralise fiscal stimulus -- it only worked unimpeded in a depression and could be completely neutralised in other circumstances. However, Hicks remained a believer in fiscal policy in underemployment circumstances. He later won the Nobel Prize in Economics (1972), although not for his work in macroeconomics.
In the 1950s and 1960s, Milton Friedman provided a devastating critique of Keynesianism, including in a very accessible chapter in his masterly polemic, Capitalism and Freedom (1962). He found and published so many faults with the Keynesian approach that it is amazing it survived the 1960s. Two of the most important ideas arising from Friedman's research are the permanent income hypothesis and the natural rate of unemployment.
The permanent income hypothesis (incorporating what we now know as "rational expectations") is that any fiscal stimulus (increased government or consumption expenditure) is counteracted by reductions in consumption (increases in savings) from those anticipating increased future tax burdens. Individuals base their consumption on a concept of permanent income (closely related to "wealth") incorporating their expectations of the future. For example, expected increased future tax burdens reduce permanent income (and therefore reduce current consumption) and a "windfall" income supplement would be treated as temporary, with individuals only responding to the increase or decrease in permanent income flowing from it. This particularly powerful theory has gained strong empirical support and underlies much of the macroeconomics developed since the 1960s.
The natural rate of unemployment displaced the Keynesian-inspired "Phillips curve" (the inverse relationship between inflation and unemployment) and underpinned the supply-side economics developed by Friedman and ensuing macroeconomists. Amongst other things, the Phillips curve needed to be augmented by inflation expectations. Moreover, the demolition of the Phillips curve was associated with the beginnings of a sophisticated supply-side analysis, an area of enquiry that had been substantially left alone by Keynesians. The new macroeconomics demonstrated that supply-side impacts would slow down the impact on economic activity of any net increase in aggregate demand. These ideas were contemporaneously developed by Edmund Phelps, who won the Nobel Prize in 2006 for his seminal work in macroeconomics over forty years.
These developments had effectively demolished the belief in fiscal potency by 1968, but the Keynesian redundancy only became more generally obvious through the advent of "stagflation" (coexistence of high inflation and high unemployment) in major western economies in the 1970s. Fiscal policy was demonstrated empirically to be useless in increasing economic activity. This confounded Keynesians, but inspired other economists on the task of refining the new and more credible macroeconomics. In 1980, Robert Lucas (Nobel Laureate, 1995) declared in his article titled "The Death of Keynesian Economics" that
[o]ne cannot find good, under-forty economists who identify themselves or their work as Keynesian ... At research seminars, people don't take Keynesian theorizing seriously anymore: the audience starts to ... giggle
Building on the work of Friedman and Phelps, later economists established the new paradigm. So successful were these economists, that five of them were awarded the Nobel Prize, and that these five awards were the only awards made for macroeconomics after Tobin and Klein. In addition to Phelps and Lucas, these later Nobel Prize winners are Finn Kydland and Edward Prescott (2004) and Robert Mundell (1999).
Mundell won for his analysis of monetary and fiscal policy. The "Mundell-Fleming model" concentrates on the international repercussions of fiscal policy, where a fiscal stimulus will be counteracted by the effects in capital markets (increased interest rates leading to increased capital inflow); foreign-exchange markets (appreciation of the currency from increased capital inflow) and in "real" markets (appreciation leading to lower exports and higher imports). The common textbook version of the model -- standard fare in intermediate-level macroeconomics courses -- has fiscal policy being completely neutralised by an equal reduction in net exports. Robert Lucas won in 1995 for his work in macroeconomics; particularly the application of the ideas of "rational expectations" and the permanent income hypothesis in more sophisticated models than those developed by Friedman. Again, this is now standard fare in major universities.
Every economist who has won the Nobel Prize in Economics for his work in macroeconomics after 1981 has either dismissed or deeply questioned the crude Keynesian prescription of fiscal expansion to sustain or increase economic activity and employment. In contrast, they have argued that fiscal policy is either useless or weak because forces are set in motion that counteract any direct stimulatory effect. Their work built on that of Milton Friedman, who many years earlier had won the Prize for his macroeconomic analysis. It is astounding that this paradigm has been overlooked by governments and advisers in many (but not all) countries, as they reach back in time to a crude fiscal approach that has been regarded as passé by the vast majority of professional economists for at least thirty years.
While there are a few PhDs in economics around with a touching faith in the effectiveness of increased government spending in "stimulating" economic activity, there are many more who don't, including the 2004 Nobel Prize winner, Edward Prescott, and the 99 other American economists who publicly and unambiguously rejected the US President's package. Well-trained economists realise that the four "pipelines" are not independent of one another, and interact in various ways, all of which reduce the flow elsewhere. For example, consumers now (principally non-recipients of cash handouts) are saving more now in anticipation of the future tax slug they know they will bear. Competent economists also realise that the supply-side matters crucially, something -- to their peril -- the Keynesians never came to grips with.
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