Stimulating the Economy: The Great Debate

The debate on the fiscal stimulus plan is all the rage these days. Prominent economists are killing each other over this topic. The arguments from the pro-stimulus camp can be found from Krugman (1), Krugman (2), Stiglitz, Mankiw, Summers, Feldstein. The anti-stimulus camp include the usual Chicago-school suspects such as Fama (1), Fama (2), Barro, Cochrane, Murphy, and Chinn (Chinn is not Chicago). You can click on the names to view their arguments.

Where do the disagreements come from? The whole thing centers around three key issues:

Is government intervention worth the costs?

Keynesians believe that an economy can become stuck in a recession when its natural recovery forces operate far too slowly, creating prolonged periods of high unemployment. They further believe that the government is able to move the economy out of a recession through fiscal policy and it should.

Chicago-school economists believe that the government has no business interfering in the economy, and that government intervention, however well-intentioned, too often makes things worse, not better.

What extent of the role should government play?

People on the left of the political spectrum – liberals, socialists, and Democrats – believe that more control by the government over resource allocation in the economy is a good thing. Those on the right – conservatives and Republicans – believe the government is an inefficient allocator of resources, and that individuals, through spending financed by tax cuts, can cause the market to produce and distribute more desirable outputs in a more efficient fashion.

How should the government finance an increase in spending?

An increase in government spending can be financed in three ways:

1. Raising taxes
2. Selling bonds to the public
3. Printing money (selling bonds to the central bank)

Chicago-school economists, such as Fama, essentially ignore printing money as a method of financing. As a result, stimulus plans can never work because raising taxes or selling bonds to the public lead to a phenomenon called “crowding out”, that is, financing offset the impact a stimulus plan is supposed to have on aggregate demand.

In contrast, financing by selling bonds to the central bank increases the money supply. When buying a government bond, the central bank writes a check against itself and thereby creates money out of thin air (printing money). In this case, there are no crowding-out effects. This is where Krugman thinks Fama made his mistake.

Recently, China proposed to increase government spending by a massive 4 trillion Yuan, or about 16% of GDP. This dwarfs the proposed stimulus package in the United States, a mere 5% of GDP. However, the U.S. has expanded its monetary base by 100% from last year. Clearly China favours the use of fiscal policy while the U.S. favours monetary policy. Why is it so? I will blog about this interesting phenomenon in the near future.

The above materials are based on Peter Kennedy’s Macroeconomic Essentials, a wonderful book written by my favourite university professor.