So You’ve Decided to Spend Money for Fiscal Stimulus…How It Should Be Done

November 24, 2008

So it appears as if Pres.-Elect Obama and Democrats in Congress have decided that a huge spending spree by government is necessary to help the short-run macroeconomy. It's classic Keynesian economics, which says that in the short-run, government should deficit-spend in order to spur aggregate demand and to therefore get the macroeconomy out of the current downturn.

But there is no free lunch. All of this spending must be paid for down the road. Now Keynesian models would argue that some of the spending is offset by the fact that revenue will increase in the short-run above what it otherwise would have been due to the fact that the short-run downturn "market failure" is corrected.

But what is the best way for government to boost aggregate demand if we are going to do it? I mean we could pay people to dig ditches and then pay others to fill them up, but that doesn't do much in terms of creating long-term wealth (besides the possible public good of "getting the economy moving" that some would argue). A benevolent government that is truly looking out for the interest of its citizens should increase short-run spending on projects that are already slated to happen in the medium-term. In other words, when possible, governments should push forward projects that are slated to occur a few years down the road anyway. In this way, a significant financing mechanism is already built-in for the short-run stimulus: it is financed by future decreases in government spending. (Similar to accelerating depreciation, the net cost to government is only the difference in the time value of money for a few years.)

Some Democrats in Congress may not like this suggestion because it would involve spending actually falling at some point. One of the scary possibilities that comes out of Keynesian policies (despite the question of their effectiveness which has been debated in the economic literature for decades) is a possible endowment effect (also status quo bias) whereby once government spends money on X, it can be difficult to lower it even if you only meant initially to have the increase be temporary. (The same is true for many special tax provisions.)

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