On August 6, Christina Romer, the chairman of the President's Council of Economic Advisers, gave a talk entitled "So, Is It Working? An Assessment of the American Recovery and Reinvestment Act at the Five-Month Mark." The reference of course is to the $787 billion stimulus that Congress, at the urging of the Administration, enacted last February.
Romer answers the question in her title: "Absolutely." And despite the reference to "five months" in the subtitle, her focus is on the second quarter of 2009 (April, May, and June) and her claim is that the stimulus had a dramatic effect on output and employment during that quarter. I do not think her analysis is responsible, and I am concerned with the fact that academic economists, when they become either public officials or public intellectuals (like Paul Krugman), leave behind their academic scruples. (This is one of the themes of my book Public Intellectuals: A Study of Decline )--and Krugman was one of my examples of the phenomenon.)
Let me make clear at the outset that I support the stimulus, though I wish it had been better designed. I support it for two reasons. The first is that, given the state of panic of the economy last winter, and the limited efficacy of the measures already taken to arrest the economic plunge--the expansion of the money supply and the bailouts of the banks and the two failing automobile manufacturers (Chrysler and GM)--the government had to make a dramatic commitment to try all means of arresting the plunge. It could not just say, "We've tried everything we think might work; it's not working; so we'll just have to tough it out." That would have been destructive of business and consumer confidence, and would have accelerated the downward spiral that many thought could have brought the economy to the depths it reached in the 1930s depression.
Second, there is a pretty good theoretical case, and some empirical backing, for deficit spending on public works as a means of combating a depression. Output (GDP) is the sum of personal consumption expenditures, investment (including savings), and government expenditures. When personal consumption expenditures and investment decline, so that (if government expenditures are constant or falling) total output declines, which in turn results in layoffs, which further reduce income and therefore output, thus triggering a downward spiral, an increase in government expenditures can arrest or at least slow the downward spiral by replacing some of the decline in private consumption and investment.
Of course it's necessary to consider the impact of those increased expenditures, and the debt burden they impose on the government, on private consumption and investment. The impact on consumption is likely to be positive: if government "buys" new highways and thus employment in construction rises, the resulting increase in total wages will translate into an increase in consumption expenditures, though some of the wages will be saved rather than spent. The impact of the public-works program on investment is more complicated. But suppose, plausibly in a serious economic downturn such as the one that we're in at present (and that was even more serious back when the stimulus bill was enacted), that a great deal of investment is in the form of passive savings, such as demand deposits and Treasury securities, because people and companies are anxious about their economic prospects, and they want safe savings, rather than savings that would be at risk because invested in entrepreneurial projects. (In other words, "liquidity preference" has risen.) These passive savings are economically inert--even bank deposits, when banks are reluctant to lend, as they are, and demand for loans is down, as it is, so that, for both reasons, increased deposits do not translate into significantly increased lending to businessmen. By selling Treasury securities to finance a stimulus program, the government transforms inert private savings into expenditures on projects that result in more jobs and so higher incomes and consumption. It can borrow the passive savings of fearful hoarders because there is no risk of the government's defaulting.
Now unfortunately the stimulus was poorly designed and has been (so far as an outside can judge) lazily implemented. Only about a third of the stimulus funds is for public works. Two-thirds are for tax credits and other benefits (including the popular "cash for clunkers" program) and for state governments. The problem with the two-thirds is that there is no guaranty that transfer payments will be put to productive use; they may be saved, directly or indirectly. Suppose a state uses the money for tax relief; then it is in effect putting money in people's pockets, and the recipients may decide to save, rather than spend, the bulk of what they receive. The personal savings rate has been rising, and additional cash received from the stimulus program may go largely to increase personal savings beyond what they would otherwise be. Or, in the case of the "cash for clunkers" program, the major effect may be that people buy cars a little sooner than they otherwise would, in which event auto sales may be depressed a few months from now; or they buy cars in lieu of other products, and the increase in auto sales is offset by a decrease in other sales.
In contrast, when the government pays a road contractor to build or repair a road, we know that the money is going to be spent to hire workers and buy materials, and so employment will rise.