Wednesday, January 21, 2009

Stimulation isn't Everything

President Barack Obama expressed a vision for federal spending: that 2009 presents an opportunity for the federal government to invest in infrastructure, health care, and education sooner rather than later. Investments like these have intrinsic value — they are appealing because they are believed to serve the greater good — but not much stimulation potential.

When the government hires employees or makes purchases, their ultimate economic effect depends on what private sector activity is displaced.

In one scenario – called “crowding out” in economic jargon – some (but not necessarily all) of the new government employees are people who quit their private sector jobs in order to accept better positions offered by the public sector, and many (but not necessarily all) the new government purchases just take items that would have been purchased by a household or private business.

For example, an improvement of public schools may cause some students to withdraw from private schools and enroll in public ones and cause some school employees to relocate from private to public. The stimulus potential is minimal in this scenario, because much activity is shifting from private to public rather than being recreated anew. Gross domestic product may increase, but less than the public spending does – because public spending “crowds out,” or displaces, private spending.

Many people believe that moving students from private to public schools has intrinsic value. Or that building a public highway has intrinsic value even if it reduces private construction. Or that modernizing health care data has intrinsic value even if it reduces some other activity in technology industry. Thus, government purchases might be desirable even if they are not stimulating.

The second scenario is called the “multiplier.” In this view, government hiring and purchases largely acquire employees and resources that would have otherwise been idle. If this were correct, than the government’s spending in one area would not reduce spending in another. Instead, it would employ otherwise unemployed people, and get them spending again, thereby creating private spending on top of the government spending – hence the term “multiplier”. In the multiplier view, G.D.P. increases more than public spending.

Despite the recent increase in unemployment rates, I see little reason why the multiplier scenario is realistic. For example, President Obama’s economists have explained how about half of the jobs they plan to create (both directly and indirectly) are jobs for women. But the large majority of this recession’s employment reduction has been among men. Thus, the Obama spending plan is not designed to primarily draw on the pool of persons unemployed in this recession.

President Obama has a vision to spend more on health care, largely for its intrinsic value. Its stimulation value is minimal because unemployment is low in that sector; health sector employment has actually increased every single month during this recession.

Even the construction industry shows crowding out. The chart below shows two types of construction spending over time: residential and non-residential. The housing boom prior to 2006 clearly crowded out non-residential construction.

Perhaps there was not enough unemployment during the housing boom to realize the multiplier effect. But in the two-year period since the end of 2006 – the last twelve months of which have been an official recession – shows a similar pattern: Reduced spending in one area allows for more spending in another.

Significant publicity has been given to residential construction workers and equipment that became unemployed since 2006, but less recognized is the absorption of many (but by no means not all) of those resources by non-residential construction projects. Public spending on construction that might come from the President’s spending plan will re-employ so of those unemployed, but it will also draw others out of their current work activity. The latter is why crowding out will occur even in construction.

Government spending will reduce private spending virtually anywhere it may be targeted. The case for government spending should be made on its intrinsic, not stimulation, value.

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