The global economy is in a deep, synchronized recession, and
governments around the world are moving mountains to stop job
losses and wealth destruction. Monetary authorities are pumping
massive liquidity into credit markets and working with finance
ministries to prop up, sustain, and nationalize major financial
institutions. Nearly every government in Asia, Europe, and North
America is pursuing some vigorous form of Keynesian fiscal stimulus
policy, defined generally as debt-financed consumer-oriented tax
cuts and substantial increases in government spending to push up
aggregate demand in the hope that economic output, jobs, and
incomes follow. President Bush signed a $152 billion stimulus bill
in 2008 and President Obama signed a $787 billion stimulus bill
early in 2009, and the ranks of unemployed continue to swell.
Despite the paucity of results, some policymakers are suggesting
the need for a third round of debt-financed spending.
The U.S. recession that began at the end of 2007 is different
from that in Japan, which differs from those in Russia and Germany.
This observation is important to understanding the recession
triggers. Perhaps without exception, every country in recession
today contributed to its own economic weakness in some material
way, either through the actions of its citizens, institutions, or
Weakness first appeared in the United States in the housing
sector, spread to the financial sector leading to a credit crunch
that sapped the rest of the economy. Export-dependent countries
like Germany and Japan suffered disproportionately from a collapse
in international trade. Europe eventually succumbed in 2008 to the
financial distress that swept the United States. From Iceland to
Italy, financial institutions engaged in irresponsible, high-risk,
highly leveraged lending similar to the lending in the U.S.
mortgage market. Nor are the shocks over--the United States is
facing new troubles from commercial real estate while Europe is
badly exposed to dubious lending to emerging markets, especially in
Ongoing research will eventually determine what went wrong in
the credit markets and in the regulatory architecture, and
policymakers will attempt to respond. The immediate task, however,
is to restore economic growth. In addition to very innovative,
aggressive monetary policy responses, policymakers have pursued
massive doses of Keynesian fiscal stimulus. The U.S. government
alone may borrow up to $2 trillion in 2009 to finance its fiscal
policy stimulus policy, equivalent to nearly 15 percent of gross
domestic product (GDP).
Fiscal policy as an umbrella term refers to policies involving
government revenue, spending, and debt issuance. In macroeconomics,
fiscal policy may simply refer to whether the budget is balanced,
in surplus, or in deficit. In public finance, the meaning of fiscal
policy is more textured, involving the composition of government
spending, distinguishing between direct consumption, research,
infrastructure investment, and so on, and the kinds of tax systems
imposed to collect revenues, such as property taxes, individual and
corporate income taxes, and value-added taxes.
A stimulative fiscal policy in the newly revived Keynesian
tradition increases the budget deficit from one year to the next to
raise aggregate demand through either increased government spending
or reductions in tax levels with the expectation that increases in
output and income will follow. The federal government has twice
applied Keynesian stimulus during the current recession with no
evidence of improvement. There is good reason to believe that this
brand of fiscal policy will not help the economy recover this time,
or in the future.
A History of Ineffectiveness
The theory behind Keynesian stimulus is simple enough. The
economy is underperforming; for whatever reason total demand from
the private sector--consumption, investment, and the international
sector--plus government demand is inadequate to allow the economy
to operate at full employment. The proposed solution is to increase
public-sector demand and let output rise to meet the higher level
of demand. Expressed in these terms, the efficacy of fiscal
stimulus would hardly seem debatable.
That something must be seriously amiss with Keynesian theory is
apparent in the simple observation that if fiscal policy were so
readily effective at raising output and lowering unemployment,
countries with persistently underperforming economies would have
been doing it for years. Some have tried, but their economies
continued to underperform stubbornly, nonetheless, while their
government debt burdens continued to rise.
The 1960s and 1970s were the golden age of Keynesianism.
Policymakers embraced persistent budget deficits combined with
accommodative monetary policy to fine-tune the economy and increase
employment. This approach failed. As Christina Romer, Chairman of
President Obama's Council of Economic Advisers, noted in a paper
published prior to her government service, "The economic ideas of
the 1960s and 1970s that led to expansionary policy also led to
inflation and real instability."
Europeans shared in the dream of fine-tuning the economy while
justifying additional spending, with similarly lackluster results.
As James Callahan, the former Labour Prime Minister in Great
Britain, said in 1967, "We used to think that you could spend your
way out of recession and increase employment by cutting taxes and
boosting government spending. I tell you in all candor that the
option no longer exists, and that insofar as it ever did exist it
only worked on each occasion since the war by injecting a bigger
dose of inflation into the economy followed by a higher level of
unemployment as the next step."
Japan of the 1990s is the modern poster child for Keynesian
stimulus, having embarked on massive government infrastructure
projects producing wonderful new roads, bridges, waterworks, and
government debt rose as a share of the economy from 15 percent in
1990 to 60 percent in 2000. Japan was left with beautiful
infrastructure, a mountain of debt, and the now-resumed lost
Recent experience in the United States with Keynesian policy is
no less discouraging. The United States ran a budget deficit in
2008 of $459 billion, or 3.2 percent of GDP, up from a deficit of
1.2 percent of GDP in 2007. This increase of 2 percent of GDP
represented a powerful dose of Keynesian stimulus and yet the
recession accelerated markedly. Again, an explicit policy of
Keynesian stimulus failed.
According to the Congressional Budget Office (CBO), the U.S.
government is expected to run a deficit of $1.8 trillion in 2009,
or 13 percent of GDP. This would amount to a stunning $1.4
trillion of Keynesian stimulus--nearly 10 percent of GDP. Despite
this massive jolt of deficit spending, the CBO and others project
the real economy to decline in 2009. The numbers tell the story in
black and white. Either these forecasters believe the economy would
have contracted by 11 percent or more in 2008 but for the stimulus,
or they believe massive Keynesian stimulus will be as ineffective
in 2009 as more modest stimulus was in 2008.
For 2010, the CBO projects a deficit of $1.4 trillion under
President Obama's budget, a decline of $393 billion, or 2.7 percent
of GDP. Under the Keynesian theory, the deficit needs to
rise slightly to have a neutral effect on the economy in the
short run. A drop in the deficit of 2.7 percent of GDP under this
theory is then massively contractionary. Keynesians should be in
panic about the economy's immediate future. Most forecasters,
including the CBO, appear calmly to ignore this phantom
contractionary pressure in their own economic forecast. Apparently,
forecasters outside the political realm do not believe in Keynesian
Why Keynesian Stimulus Fails--The
Second Half of the Story
Simple observation has its place, but how does the Keynesian
stimulus approach break down in theory? Keynesian stimulus theory
ignores the second half of the story: Deficit spending must still
be financed, and financing carries budgetary consequences and
economic costs. Proponents generally acknowledge the long-term
budgetary costs, but ignore the offsetting near-term consequences
that render Keynesian stimulus useless.
In a closed economy, government borrowing reduces the pool of
saving available for private spending, either investment or
consumption. Government lacks a wand to create real purchasing
power out of thin air (with the fleeting exception of monetary
expansions, discussed below). Government spending or
deficit-increasing tax cuts increase demand as advertised; and
government borrowing reduces demand by the same amount, for no net
The dynamics in an open economy are slightly more complicated,
but the final outcome for output is unchanged. An open economy
permits a government to finance its deficits by importing savings
from abroad as the United States has done for years, rather than by
tapping domestic sources. However, an increase in deficit spending
met by an increase in net imports of foreign savings must, in turn,
be matched by an increase in net imports of goods and services to
preserve the balance of payments. Thus, the increase in domestic
demand due to deficit spending is fully offset by a reduction in
demand arising from an increase in net exports. Once again,
Keynesian stimulus has no effect.
What if the extra government borrowing soaks up "idle savings"
in an underperforming economy, proponents may ask. In troubled
economic times those who can save more often do so, directing their
savings toward safe investments like Treasury Bonds and bank
deposits. However, these cautious savers almost never withdraw
their savings from the financial system entirely by stuffing cash
into mattresses. Aside from the occasional mattress stuffer, even
savings held in the safest of instruments are not idle but remain
part of the financial system, working to find their most productive
uses through the available channels. Borrowing to finance Keynesian
stimulus, then, remains a subtraction from the funds available to
the private sector.
Suppose widespread fear spurred savers to engage in rampant
mattress stuffing, withdrawing purchasing power from the economy
and creating large amounts of truly idle savings. This has happened
before, and could be happening now to some extent. Surely,
Keynesian stimulus works in such cases. Highly unlikely. Nothing
about a flood of government bonds engulfing capital markets to
finance a surge in wasteful government spending is likely to
convince nervous mattress stuffers that their concerns are
misplaced. Idle savings, then, remain idle, making deficit spending
a competitor for an even smaller pool of available private savings.
Worse, mattress stuffers are likely to increase their
mattress-based, economically idle saving in the face of a surge of
profligate, irresponsible government spending. Keynesian "stimulus"
would then be an economic depressant.
Printing Money to Make Fiscal Stimulus
In the last theoretical refuge for Keynesian stimulus, suppose
the monetary authority broke its commitment to independence and
opted explicitly to buy up the Treasury's debt issuance under a
Keynesian fiscal policy. Government cannot create real purchasing
power by whim, diktat, or debt, but the monetary authority can
create the illusion of purchasing power through a policy of
monetizing debt and increasing cash liquidity in the economy.
Combining an obliging monetary policy with increased deficit
spending may create the illusion that fiscal policy is effective,
but as Prime Minister Callaghan commented, it is temporary and only
In most countries the monetary authority's independence is a
foundational policy principle. The monetary authority may buy
significant amounts of Treasury notes and bills in pursuit of its
own expansionary monetary policy as the Federal Reserve has done
for many months in extraordinary quantities. But these actions
would be driven by monetary policy considerations of maintaining
strong long-run growth consistent with low and stable inflation.
The monetary authority would take these actions whether or not the
fiscal authorities embarked on a stimulative policy. The central
bank's policy goal is the same as the Treasury's in this
instance--to resuscitate the economy--but the central bank is
ultimately pursuing its policies independent of Treasury
However, the monetary authority may opt to subordinate its
policy rules and objectives to fiscal policy, repeating the 1970s
experiments in the United States. The previous outcome of loose
monetary policy was economic stagnation coupled with high and
rising inflation, what came to be known as "stagflation." The
policy failed to produce sustained economic growth because market
participants learn quickly. Businesses, investors, workers, and
savers recognized the shift toward an inflationary monetary policy,
interpreted it correctly, and reflected higher inflation in their
pricing and expectations. In so doing, they nullified the potential
stimulative effects of the policy and the Federal Reserve was
forced to adopt a contractionary counter-inflationary policy
resulting in the deep recession of 1981- 1982. Even a compliant
central bank cannot make Keynesian policy effective unless the
central bank can consistently and persistently fool the
Casual empiricism suggests that Keynesian stimulus policy does
not work, and the theory behind the policy fails on inspection.
What does empirical research indicate?
Empirical Insights on Keynesian
One approach to testing the efficacy of debt-based fiscal
stimulus is to turn to the data and learn what stories it tells.
Unfortunately, few have attempted this task in recent years. This
may be due to a focus on the emergence, development, and
parameterization of a new consensus model in macroeconomics, the
so-called New Keynesian model. Also, until recently most of the developed
world (other than Japan) had been relatively immune to significant
business cycle swings, thus dampening the demand for research on
countercyclical fiscal policies in industrial nations. Part of the
reason may also be the strong consensus, before recent events, that
Keynesian stimulus was ineffective and that studies reporting
statistically insignificant results confirming the consensus view
are rarely published.
Perhaps Robert J. Barro's analysis of fiscal stimulus efficacy
is the most well known and controversial. Barro argues the clearest
evidence of fiscal policy effects is likely to be found when
spending ramps up rapidly during wars. Examining U.S. fiscal policy
in the periods surrounding World War II, the Korean War, and the
Vietnam War, Barro's analysis suggests a fiscal multiplier of 0.8,
meaning even at its most effective, the increase in output was a
fraction of the increase in government spending.
Barro further theorizes the wartime multiplier is likely to be
much greater than the peacetime multiplier, with a peacetime
multiplier likely near zero so every extra dollar of government
spending actually replaces a dollar of private spending leaving
output unaffected. Paul Krugman among others have criticized
Barro's results, noting that the wars themselves and the often
attendant wage and price controls would have diminished the
effectiveness of fiscal policy. However, none of his critics has as of yet
provided an empirical analysis challenging Barro's results.
Using a purely statistical approach, Andrew Mountford and Harald
Uhlig find an unexpected increase in government spending, beyond
what would occur through automatic stabilizers, "weakly stimulates
the economy": a 1 percent increase in spending increases output by
about 1.3 percent after one year. Proponents of extra increased spending as
Keynesian stimulus may take comfort in this result, but then they
must also acknowledge that the authors find "a deficit-financed tax
cut is the best fiscal policy to stimulate the economy."
An alternative approach to ferreting out fiscal multipliers is
to use macroeconomic models to simulate policy effects. Modern
macroeconomic models are abstract, mathematical representations of
essential elements of the economy as described by theory. They may
be simple or complex, derived from underlying principles or
constructed from suggested broad relationships. Their great
advantages are that they force a degree of specificity on the part
of the model builder and offer as a reward the ability to examine
economic interactions consistently and in great detail.
The downside to all economic models is that they often provide
uncertain illumination for policymakers because the models
ultimately only report what their builders have designed into them.
Economic models are inherently abstract representations of an
economic phenomenon, dependent on the state of economic theory and
the quality and availability of data. Given these limitations it
can be difficult to discern whether an interesting result reflects
the model or the economy the model is intended to represent.
Christina Romer and Jared Bernstein, Chief Economist of the
Office of the Vice President, provide a recent example of the model
simulation approach. They averaged the output from policy
simulations using two quantitative macroeconomic models--one in use
at the Federal Reserve Board, and one from an unnamed private
forecasting firm. Romer and Bernstein found that an increase in
government spending of 1 percent of GDP increases output by 1.6
In contrast, John Cogan and his colleagues used a state-of-the-art
macroeconomic model constructed by Frank Smets and Rafael
The Smets-Wouters model embodies the "new Keynesian" approach to
macroeconomic analysis. Among the differences from older models,
such as those used by Romer and Bernstein, Smets-Wouters includes
forward-looking, or rational, expectations. Cogan found the impact
in the first year of a Keynesian stimulus to be "very small" and
that the multipliers are less than one as consumption and
investment are crowded out.
As the above discussion on monetary policy suggests, the policy
of the central bank can have a powerful influence on the economy
and thus on the apparent effectiveness of fiscal policy. Eggertsson
used a model similar to Smets-Wouters to examine these questions. Her
analysis explored the consequences of increased government spending
in the two cases in which monetary policy is and is not explicitly
coordinated with fiscal policy. Uncoordinated policies need not
mean that monetary and fiscal policies have divergent goals. For
example, both monetary policy and fiscal policy may react to
economic weakness, a threat of deflation, or off-target inflation.
As defined by Eggertsson, the lack of coordination in policies
means that in reacting to macroeconomic conditions the monetary
authority's actions may be coincidental to fiscal policy, but not
specifically intended to support fiscal policy. On the other hand,
if the monetary authority sets aside its usual guidelines to
subordinate monetary policy to fiscal policy goals, it is
considered to be coordinated with fiscal policy.
Eggertsson found fiscal policy very effective if monetary policy
is explicitly supportive, producing a fiscal policy multiplier of
3.76. However, if monetary policy remains independent, as
economists and financial markets generally assume, the multiplier
becomes exactly zero and fiscal policy is completely ineffective.
This latter result is fully consistent with the theoretical
discussion above and is generally consistent with Cogan et
al., who also explicitly assumed that the monetary authority
remains fully independent of fiscal policy.
Stepping back, Eggertsson's monetary policy focus, while
understandable coming from a member of the New York Federal Reserve
staff, is perhaps not on point as a test of Keynesian stimulus.
Eggertsson's results derive from a stylized model intended to
explore a specific question of economic policy and thus depend
critically on the effects of fiscal policy on inflationary
expectations. These are important issues but do not address the
underlying rationale for Keynesian fiscal stimulus of increasing
aggregate demand. The real message of Eggertsson for current policy
is to underscore the point made above that despite their
sophistication modeling exercises sometimes address the modeler's
interests more than they do the economic processes relevant to
policymakers. This is not a criticism of Eggertsson or any user of
such economic models, but rather a caution to those who might
interpret and apply their results.
Keynesian Stimulus Theory Comes
Recent experience with Keynesian, deficit-based fiscal policy to
provide short-term stimulus to the economy very much agrees with
the theory described above and essentially agrees with the corpus
of modern empirical research: Keynesian stimulus does not work. As
the economy was experiencing a mild recession in 2008, the budget
deficit jumped by 2 percent of GDP, partly as a result of the $152
billion stimulus signed into law by President Bush. The economy was
presented a sizable dose of Keynesian stimulus and remained in the
doldrums with employment dropping by 590,000 workers from the third
quarter of 2007 to the third quarter of 2008. Then the recession
Consequently, President Obama inherited a budget deficit of
almost $1.7 trillion, representing a massive dose of Keynesian
stimulus equal to 8.7 percent of GDP, almost three times larger
than the largest such peacetime increase. He then advocated even
more, and signed a $787 billion package of spending hikes and
ineffective tax reductions, pushing the projected 2009 deficit to
above $1.8 trillion. Despite the massive initial and the additional
deficit spending, the unemployment rate rose by almost two full
percentage points in the first half of 2009, and Administration
officials are cautioning that unemployment will rise above 10
The Keynesian stimulus theory fails for the simple reason that
it is only half a theory. It correctly describes how deficit
spending can raise the level of demand in part of the economy, and
ignores how government borrowing to finance deficit spending
automatically reduces demand elsewhere. Exculpatory allusions to
idle saving simply do not wash in a modern economy supported by a
modern financial system. Deficit spending does not create real
purchasing power and so it cannot increase total demand in the
economy. Deficit spending can only shift the pattern of demand
toward government-centric preferences.
Empirical research rarely provides a simple, single answer to a
policy question, and examinations of Keynesian stimulus are no
exception. Yet the available results consistently indicate that,
using a modern macroeconomic model and treating monetary policy
carefully, Keynesian stimulus's short-term effects lie somewhere in
the narrow range between slim and none. Keynesian stimulus produces
debt, not jobs.
Bad policy ideas rarely go away forever. Circumstances change,
memories fade, political fashions come and go. The current global
experiments with Keynesian fiscal stimulus will fail as they have
failed before. Unfortunately, the price of learning this lesson yet
again is an unnecessarily prolonged recession, a weaker recovery,
and millions more lost jobs--and, of course, the massive increases
in public debt.
J. D. Foster, Ph.D., is Norman B. Ture Senior
Fellow in the Economics of Fiscal Policy in the Thomas A. Roe
Institute for Economic Policy Studies at The Heritage
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Consequences of a Mistaken Revolution," presented at the Economic
History Association Annual Meeting, September 2007.
BBC TV, 1967, "Jim Callaghan: A Life in Quotes," March 26, 2005, at
(July 19, 2005).
Eggertsson and Jonathan D. Ostry, "Does Excess Liquidity Pose a
Threat in Japan?" IMF Policy Discussion Paper No. 05/5,
2005, at http://www
.imf.org/external/pubs/ft/pdp/2005/pdp05.pdf (July 19,
Economic Outlook Database, at http://www.imf.org/external/
pubs/ft/weo/2008/02/weodata/index.aspx (July 22, 2009).
The figures for Japanese government gross debt were 69 percent and
142 percent for 1990 and 2000, respectively.
Budget Office, "An Analysis of the President's Budgetary Proposals
for Fiscal Year 2010," June 2009, at http://www.cbo.gov/doc.cfm?index=10296
(July 10, 2009).
Blanchard, "The State of Macro," NBER Working Paper No.
14259, August 2008, and Michael Woodford, "Convergence in
Macroeconomics: Elements in the New Synthesis," American
Economic Journal: Macroeconomics, January 2009.
Barro, Macroeconomics: A Modern Approach, South-Western
College Publishers, 2007.
"War and Non-Remembrance," The New York Times, January 22,
2009, at http://krugman.blogs.nytimes.com/2009/01/22/
war-and-non-remembrance (July 20, 2009).
Mountford and Harald Uhlig, "What are the Effects of Fiscal Policy
Shocks?" NBER Working Paper No. 14551, December 2008, at
.org/papers/w14551 (July 20, 2009).
Romer and Jared Bernstein, "The Job Impact of the American Recovery
and Reinvestment Plan," The Council of Economic Advisers, The White
House, January 9, 2009, at http://otrans.3cdn.net/ee40602f9a7d8172b8
_ozm6bt5oi.pdf (July 20, 2009).
Cogan, Tobias Cwik, John B. Taylor, and Volker Wieland, "New
Keynesian versus Old Keynesian Government Spending Multipliers,"
self-published by authors, February 2009, at http://www.volkerwieland.com/
docs/CCTW%20Mar%202.pdf (July 20, 2009).
Smets and Rafael Wouters, "Shocks and Frictions in U.S. Business
Cycles: A Bayesian DSGE Approach," American Economic Review
Vol. 97 (2007), at http://www.cepr.org/pubs/dps/DP6112.asp
(July 22, 2009).
Eggertsson, "Fiscal Multipliers and Policy Coordination," Federal
Reserve Bank of New York Staff Report No. 241, March 2006,
at /static/reportimages/00BFBC2F811C012A249CFC2BC2E7852B.pdf (July