Wednesday, August 11, 2010

Fiscal Stimulus Slows Growth By Channeling Demand To Wrong Sectors

From "To spend or not to spend: Is that the main question?" by Guillermo Calvo, Professor of Economics, International and Public Affairs at Columbia University, August 4, 2010 on VOX blog:
The argument [for fiscal stimulus] assumes that the government channels additional spending towards the very same goods that B [borrower] cannot afford. This is not true in general. In the US, for instance, small firms lost access to working capital that the government spends on solar energy. Hence, sectoral “lack of demand” is unlikely to vanish. The sun will set on B goods and shine on government goods.

Fiscal expansion could thus have little impact on unemployment, because the unemployed in the sector that caters to B's [borrower's] tastes are unlikely to find new jobs in those sectors that benefit from the government's largesse. One important reason for sluggish employment creation is that stimulus packages are transitory and hiring-and-firing is costly. Sectors producing government goods will go on overdrive, but will be reluctant to hire new workers. Equally important, labour reallocation is costly and cannot take place in the spur of the moment: a bricklayer does not become a computer technician overnight. This helps to explain why US unemployment is still high even though output is heading to recovery (see Calvo and Loo-Kung 2010). Moreover, if trust in financial intermediaries does not recover, even this type of inefficient and employment-less recovery may lose steam if fiscal stimulus is discontinued.
[W]e have reached a major fork in the road:
  1. Maintaining or increasing fiscal stimulus will probably prevent a major slump of economic activity and a sharp rise in unemployment (the feared double-dip recession), but at the cost of slowing down growth and technical progress;

  2. On the other hand, phasing out fiscal stimulus risks generating double-dip recession but, if unnecessary pain is avoided, it may result in a more vibrant economy in the medium run.
The choice is difficult and I am afraid that it will be guided by political expediency, and the outcome will depend, in no small measure, on implementation.
Read Professor Calvo's complete post here.

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