Thursday, October 8, 2009

My thoughts on a second economic stimulus package

Some economists and politicians are advocating a second economic stimulus package. Here are my thoughts on a second stimulus.

State governments likely have better ideas than Congress regarding what are high value spending projects within each state. On the whole, pre-existing state spending was likely already going to the highest-value projects available. Since state governments are now being forced by circumstances to drastically cut back at a time when Congress's stimulus package is in effect, this suggests that Congress massively misallocated capital with the first stimulus.

If Congress creates a second economic stimulus package, it should only consist of more aid to the states and extended unemployment benefits. Congress should avoid a bunch of bells, whistles, and pet projects. Stuff like cash for clunkers and subsidies to transfer existing homes from one person to another are just real-life examples of the broken window fallacy.

Wasteful spending harms long-term economic growth just to avoid short-term pain. On the other hand, when states are forced to cut useful investment spending (e.g. education and infrastructure), then it harms the economy in both the short-term and the long-term.

Warren Buffett described the first stimulus package as a mix of Viagra and candy. Aid to the states and extended unemployment benefits would be pure Viagra. Most other spending options would be candy.


  1. The multiplier effect in macro economics recognizes that even if the government were to pay people to dig holes and fill them up, the economy is stimulated to produce more goods and services as a result of increased demand by the hole diggers.

    The actual digging of the holes isn't the point. Even when the GDP addition of the broken windows, empty holes, or 10 ton bombs is ignored, the GDP also will have increased due to the consumer spending of the hole diggers.

    Of course, if there are projects that invest in infrastructure, all the better.

    The real question doesn't rest in the short term but rather in the long term. The question is, when the stimulous is removed, will the economic engine continue to run at full speed or simply wind back down again.

  2. First, the multiplier is not very big. Economists debate whether it even exceeds 1.0. Barro says no. Krugman says he thinks it's about 1.5.

    Second, a stimulus moves future spending to the present. If the return on the spending is less than the cost of capital, then the long-run effect on the economy will be harmful. By breaking windows, you may force people to buy windows now instead of shoes later, but you will still have destroyed wealth and made the overall standard of living lower in the long run.