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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