Government spending actually crowds out private economic activity and therefore doesn’t stimulate the economy
The Fraser Institute
As the federal and provincial governments shift their focus to economic recovery, there will be heightened calls for fiscal stimulus in an attempt to kick-start the economy. However, a new study by the Fraser Institute demonstrates that, based on past experience, stimulus measures will almost certainly be ineffective.
Fiscal stimulus refers to additional government spending and/or tax relief used in an effort to mitigate the impact of a recession and speed up economic recovery. The theory assumes that stimulus measures can influence people to spend more and create a positive ripple effect in the economy.
Let’s see how this theory holds up.
During the 2008-09 recession, the federal government enacted a two-year $47 billion stimulus package focused mainly on spending measures, such as public infrastructure and subsidies to business, with the hopes of improving economic growth.
Although the economy did recover, a 2010 study found that government spending on infrastructure had little to no effect on Canada’s economic growth during the recovery. Instead, the data demonstrated that private-sector investment and increased net exports were the drivers of economic recovery.
Stimulus efforts in the United States provided similar results. Stanford University professor John Taylor analyzed the impact of providing temporary tax rebates to American households to stimulate consumer spending and thereby grow the economy during the last recession. His research showed that the stimulus measures were ineffective at increasing spending because households largely chose to use the rebates for savings or paying down personal debt.
Tthe U.S. stimulus package during the 2008-09 recession had little to no effect on economic growth and only resulted in additional government debt.
In both the U.S. and Canada in 2008-09, infrastructure spending was used in an effort to kick-start the economy. The problem with this approach is that infrastructure projects that are deemed to be “shovel ready” actually take significant time to plan and implement.
In fact, experience shows that the economic recovery had already begun before the shovels hits the ground. By the time government infrastructure spending occurred, it was competing with the private sector for resources, resulting in increased costs and fewer private-sector projects.
Evidence from University of California San Diego professor Valerie Ramey and Harvard University professor Robert Barro emphasizes the issue with stimulus spending, using a concept called the “fiscal multiplier,” which shows the impact that each additional dollar of government spending has on the economy.
In theory, a multiplier greater than 1.0 indicates that stimulus works because a $1 increase in government spending will increase overall economic output by a value greater than $1.
Their research, however, demonstrates that the multiplier for stimulus spending is likely below 1.0, indicating that stimulus spending actually crowds out private economic activity that would otherwise have occurred and therefore doesn’t stimulate the economy.
Further, research from late Harvard University professor Alberto Alesina found that increased government spending is associated with lower economic growth. His research showed that a 1.0 percentage point increase in government spending relative to the size of the economy is associated with a 0.75 percentage point reduction in economic growth.
So increased government spending and stimulus measures could actually be a hindrance rather than a help to Canada’s economy.
Before implementing any fiscal stimulus, Canadian policy-makers must consider the empirical evidence, which raises significant doubts about whether fiscal stimulus can achieve its objective to kick-start the economy.
Past experience suggests stimulus won’t improve the Canadian economy and may even be a detriment to it.
Jake Fuss, Tegan Hill and Alex Whalen are analysts at the Fraser Institute.
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