The 2009 Budget - Can Stimulus Packages Stimulate?

While woe betides any politician who dares speak out against this new orthodoxy (witness the political chaos generated late last year when the Conservatives did not get on track quickly enough), a number of journalists and economists are questioning the stimulus package idea. In a recent National Post article, Terence Corcoran cites results from a number of studies by eminent economists that call into question the efficacy of stimulus packages. In what could be called the accepted wisdom before the events of the last six months, the studies cited were in agreement that government spending has little impact on economic performance and may even drive out private spending in many instances.

At the same time, economists like Paul Krugman, the most recent winner of the Nobel prize in economics, are saying that without a major stimulus package the economy will slide into a major depression (click here and here). Which economists should be believed?

One key to sorting out these very different conclusions is to look at how the arguments are being framed. Personally, I think Andy Harless' line of reasoning has merit. He argues that stimulus packages will work today because we are in a situation never seen since the 1930s. Put another way, the studies that Corcoran cites are correct under specific circumstances, since they were done for periods when the economy was more or less working correctly. Under these conditions, the previously accepted wisdom, I think, is accurate - government spending has little impact and may even drive out private spending in many instances.

But the conditions today are not normal, and this is where I think Krugman and others are coming from when they argue that a massive stimulus package is required. Without a stimulus package, Krugman believes the outcome will not be a minor downturn or relatively small increases in unemployment. Rather, the outcome could be a full-blown depression, perhaps with price deflation.

Personally, I think the world economy is in a great deal of danger. The reason is expectations. If everyone expects the economy to go to hell in a hand basket, then it will. While this kind of pessimism may seem foreign to residents of Saskatchewan (where Help Wanted signs still grace the door of most businesses), in the rest of North America and much of the world the very worst is being expected. And the cost of these expectations being fulfilled will be enormous. One outcome that Krugman is worried about is deflation - if people ever begin thinking that prices will fall, then consumer demand will essentially dry up and investments will be put on hold indefinitely. The result will be large-scale unemployment and further major losses in stock market value.