David R. Henderson  

The Microeconomics of "Stimulus" Policy

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But couldn't economic productivity be increased by targeting federal spending on hiring the unemployed either directly to work for government or by subsidizing private firms to hire them? Such an approach makes sense only if it produces more value than it costs, and there are several reasons for doubting that it does. First, with the federal government spending well over 20 percent of GDP, and most of this spending reducing economic productivity (spending additional dollars creates less value than it costs), it is unlikely that there are many government jobs left in which additional workers would add to the net productivity of the economy.

Second, assuming that there are government jobs in which the right people could create more value than their opportunity costs, without reliable market prices and wages guiding political decisions, it is very unlikely that political authorities would identify those jobs and match them with the right workers. This would be a problem even if the information were available to place government workers in jobs where they would be most productive. Political influence is far more important than economic productivity when officials decide what government jobs to create and on how much to pay those who are hired. This political influence is also dominant when private firms are subsidized to reduce unemployment by hiring more workers. Those subsidies are more likely to go to firms in politically favored industries that have been generous campaign contributors. Also, workers hired for federally funded or assisted construction projects are required by the 1931 Davis-Bacon Act to be paid the prevailing union wage, which is invariably higher than the market wage.

This is from this Dwight Lee, "Reducing Real Output by Increasing Federal Spending," this month's Featured Article on Econlib. The whole thing is worth reading.

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CATEGORIES: Fiscal Policy

COMMENTS (21 to date)
david writes:

Shouldn't an article on the microeconomics of government macroeconomic policy at least try to tackle the proposed microfoundations of the prevailing macroeconomic ideology? Where are the arguments against staggered price-setting, against rational expectations, against state credibility and policy precommitment?

The silent invocation of Ricardian equivalence midway through was particularly bizarre. Perhaps it is too obviously recognized as fringe crackpottery if it mentions the name of the concept.

Jeremy, Alabama writes:

"Political influence is far more important than economic productivity when officials decide what government jobs to create and on how much to pay those who are hired."

Absolutely, and having the government hire further millions either directly or indirectly creates a new Democrat party constituency who can vote themselves into pseudo-jobs.

Chris Koresko writes:

I've heard that a study of New Deal federal spending showed that it was concentrated in swing states... strongly Democratic and strongly Republican states got less. The natural suspicion is that the spending was being used to swing those areas toward the Democrats.

I wonder if anyone has done a similar study of the 2009 stimulus package?

David R. Henderson writes:

@Chris Koresko,
I thank Veronique de Rugy at Mercatus did.

Dwight R. Lee writes:

I think, but am not sure, that David is critizing my article for not arguing against rational expectations, [the lack of] state credibility and the difficulty the state has commiting to policies (time inconsistency). But those problems with government policies are in general agreement with my view that government action is unlikely to achieve their advertised results. So why should I argue against them. And one does not have to agree 100 percent with Barro's argument on deficit spending to recognize that that Ricardian equivalence is a powerful and useful concept (hardly crackpottery) and certainly a relevant consideration when assessing the effectiveness of deficit spending at stimulating the economy.

Rob writes:

What if the government subsidized all new employment and paid for it by creating new money. Would this not lead to an increase in the demand for labor and and therefore an increase in production (if not in productivity) ?

At full employment this would be inflationary and cause people to work longer than they would otherwise choose to, but in a recession caused by deficient AD would this not be a fast way of moving demand for all products rightwards ?

David R. Henderson writes:

No. Look at Dwight Lee’s reasoning. How would the government know which new jobs to fund? There’s no market test. You say “all” but it can’t be all. Think about why.
Also, look at the other part of his reasoning. Wouldn’t a lot of people who accept these new jobs be people who were previously employed. So we lose production elsewhere.

Rob writes:

Ok, assume that the government subsidizes all employment (new and old) and pays for it by money creation and lets the employer decide wage levels without interference.

Again in a situation where AD is low (relative to the price level) this should boost employment, increase the money supply and AD and bring things closer to equilibrium (defined as the price level matching the money supply).

Again this may be inflationary but if the government was using this a policy tool to increase and then stabilize AD I don;t see why it would not work.

I agree that in practice the government would
a) screw this up by incompetence
b) use it as a tool to favor its friends
c) use it to promote inflation and monetize the debt.

But leaving that aside in pure theory what is wrong with the logic in this proposal ?

David R. Henderson writes:

I don’t know what you mean by “pure theory.” Are you saying that in pure theory, the government knows where the jobs would produce the most value? But my theory--which is that only a market discovery process can tell you that--is a theory. So in pure theory, it can’t work.

Rob writes:

I suppose that in "pure theory" a market discovery process would allocate all resources to their optimal use and all government intervention would be bad.

However if one adds in price stickiness and the implication that the market discovery process may take some time to rediscover equilibrium after a sharp change in demand for money then one may need to include in "pure theory" some role for an agent that is able to adjust the money supply to the demand for money (even when the interest rate is zero and the loan-market is not clearing).

One policy option of such an agent would be to inject new money into the system via the proposed jobs subsidy. (of course there are many other ways the money supply could be increased other than this).

So by "pure theory" I mean a theoretical model where a non-market process (a central bank) may be added in to compensate for a perceived market inadequacy (the ability to adjust in an optimal manner to a change in demand for money).

Costard writes:

Rob - fiscal policy and monetary are two separate things. Placing them together does not in any way inform the argument. Inflation can be judged on its own merits, and so can make-work schemes.

Corruption and moral hazard are the logical outcomes of a political process. What you are suggesting is not theory, but fantasy.

David R. Henderson writes:

I understood what you meant by “pure theory.” And what I’m saying is that economic theory says without price signals, the government has no way to know which jobs to subsidize.

Rob writes:

In this thought experiment (its not something I'm actually advocating) since all jobs are subsidized equally the government would not need to think about price signals. And the market signals would be distorted in subtle ways that might be a price worth paying for the increase AD generated.

david writes:

Dwight R. Lee, New Keynesian theory is built on those concepts. I would recommend acquiring at least a passing familiarity with mainstream macro before embarking on a critique of it.

david writes:

Alright, to be less snide: NK macro relies on the private sector to suppress the allocative problems.

This isn't old Keynesian macro, where the private sector is assumed to be static and stupid in the short run; instead the private sector (and labour market!) is asserted to adjust almost instantly in an individually rational way. The NK argument revolves around coordination failures, sunspot equilibria, individually rational real or nominal rigidities (a la Mankiw), precommitment and expectations, etc.

There is no requirement that the state is capable of beating the Hayekian knowledge problem - save recognizing that the aggregates exist at an unfavorable level. Indeed it is the miracle of privately rational allocation that suppresses the aggregation problems. The theory is reactive, not predictive - all the knowledge stuff gets shoveled under the long run and NAIRU. Milton Friedman won his battle and two of the three fundamental propositions of monetarism are inherently integrated into NK macro.

Rick Hull writes:


What does it mean to subsidize "all" jobs "equally"? Have you thought this through?

How is the subsidy for an unemployed person equal to the subsidy for a Fortune 500 CEO? What about your garbageman or city council member? The high school kid across the street who mows your lawn?

Do you mail them each a $100 check? Is this a different set of people than "taxpayers"?

I am very curious to hear some concrete examples of your proposed policy.

David R. Henderson writes:

Thanks for catching your own snideness. I bet Dwight Lee and the other readers appreciate that and I know I do.
The next step, which would be more helpful, would be for you to say one of two things: (1) where Dwight Lee makes a wrong argument or (2) where taking account any of the factors you cite would undercut or weaken his argument.

Rob writes:

Well, its not really a serious suggestion more a way of trying to think about how government policy could be used to stabilize the economy in a way that minimizes distortions of market signals.

A simple implementation would be just to issue a check to each employer for a % of their total wage bill, the subsidy to be financed by printing money.

In equilibrium this would be inflationary and would distort the market towards hiring labor over capital goods. Both things would be bad. However when there is unemployment caused by deficient AD (assuming one accepts that such a thing is possible) then this policy would seem to have the advantage of increasing the money supply using a mechanism that is supply-side rather than demand-side. Combined with some sort of targeting regime where the subsidy is varied depending upon a GDP-related variable it could be used to stabilize AD.

I suspect (and indeed hope) that there are sound free-market reasons why this would not work but I don't think any of the replies on this thread have supplied them.

Rob writes:

I read Dwight's article again and I think it fails to acknowledge the monetary disequilibrium effects of a fall in AD.

His final sentence "Only by increasing productivity can effective aggregate demand be increased, and the unfortunate reality is that increasing federal spending is decreasing both." The first part of this is only true where the money supply is in equilibrium with the demand to hold money. Before prices fall following an increase in the demand for money then I think it can be convincingly demonstrated that an increase in the money supply will indeed cause a sustainable increase in output.

david writes:

@David R. Henderson - Dwight Lee is beating up a strawman. His argument is wrong because he is not attacking the New Keynesian consensus that dominates thinking in the Fed and Obama's circle of advisors.

David R. Henderson writes:

So I take it that you aren’t going to actually do what I asked you to do in my previous response.

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