the O-bel Prize

the many faces of Obama....

How is that stimulus working?

Since April 2009, the administration spent roughly $90 billion, or 18 percent of the total stimulus spending, on top of $62 billion in tax relief. During that time, the unemployment rate grew from 8.9 percent to 9.8 percent. And according to the Bureau of Labor Statistics, job losses accelerated in September. As we see here, the current unemployment rate is already far above the 8.8 percent the administration said the rate would top out at next year without a stimulus.

How can we explain this? For starters it seems the administration misjudged the severity of potential job losses.

When the government grows by $1, the private sector shrinks by 20 cents, according to one estimate.

With respect to the stimulus, there are two theories on why unemployment keeps rising despite stimulus dollars. Some economists, including Paul Krugman, have argued that the problem with President Obama’s plan is that it doesn't spend enough. Hence, they think that a second stimulus is needed. Yet it is hard to argue that we already need another stimulus when less than a quarter of the money has been spent.

Other economists are arguing that the money is not being spent fast enough. Indeed, at this rate, the economy is likely to have recovered before most of the stimulus money has been spent.

One potential problem with the slow rate of spending is highlighted by some new Keynesians who typically teach that government spending can only grow the economy in the short run. After that, government spending actually hurts the private sector. Under the current plan, only 25 percent of the total spending will take place in 2009 (within four years all the money will be spent). That is too slow, they claim, since by the time the economy starts recovering, most of the stimulus money will remain unspent and, by then, government spending will actually hurt the economy.

It is hard to argue that we already need another stimulus when less than a quarter of the money has been spent.

So, what do the data say? There are few studies on the issue, but two have found that government spending shrinks the private sector, at least a little. Looking at war spending, Harvard University’s economist Robert Barro estimates that the multiplier of government spending is 0.8: when the government grows by $1, the private sector shrinks by 20 cents. Also, using a variable that takes into account the fact that military spending is anticipated several quarters before it actually occurs, the University of San Diego’s Valerie Ramey has shown how U.S. military spending influences GDP and estimates that the multiplier of government spending is between 0.6 (when World War II data is excluded) and 1 (when it is included). Thus both papers support the “crowding out” hypothesis.

More interestingly, in a recent Wall Street Journal piece, Barro and Charles Redlick add that while government spending during a period of average unemployment crowds out private investment, an increase in unemployment makes government intervention slightly more efficient. They write, “Our research also shows that greater weakness in the economy raises the estimated multiplier: It increases by around 0.1 for each two percentage points by which the unemployment rate exceeds its long-run median of 5.6%. Thus the estimated multiplier reaches 1.0 when the unemployment rate gets to about 12%.” In other words, it takes a lot of job losses for government spending to stop shrinking the private sector.

Putting aside the question of whether the stimulus is too small or being spent too slowly, what too many stimulus advocates overlook is that to spend money, the government needs to either borrow, tax, or print it (or combine these). Money taxed or borrowed from the private sector is money that firms cannot spend on goods or employees. The government’s slice of the pie gets bigger by making the rest of the pie smaller. This may explain in part why the stimulus has not translated into declining unemployment. from Veronique de Rugy is senior research fellow at the Mercatus Center