This Might Be the Worst Ever Argument Against Government Stimulus
A silver bullet into the heart of Keynesianism, this is not.
I am going to blow your mind. Are you ready? Yes? Okay, here goes. Fiscal stimulus fails when it isn't tried. (I'll give you a minute to pick yourself up).
That might sound tautological to you -- but you aren't economist Art Laffer. He thinks it's the Rosetta stone to ... everything! More specifically, in his latest op-ed in the Wall Street Journal, Laffer claims that a bad economy without stimulus proves that stimulus leads to a bad economy. Laffer shows that countries where public spending as a percent of GDP increased the most between 2007 and 2009 also saw their growth slow down the most. He says this shows that "increased government spending acted more like a depressant than a stimulant." But this observation proves nothing. It is trivially true that when GDP goes down, government spending as a share of GDP will go up. That's how fractions work.
Think about your own life. You pay a mortgage and you earn a salary. Let's say your mortgage to monthly salary ratio is 33 percent. But then your company cuts your pay by half. Your mortgage won't change. But it will double as a share of your salary. Laffer would tell you that this proves that owning an expensive home has hurt your pay. But that's not what happened at all! You got a pay cut, and that made your mortgage seem higher.
But Laffer is worse than tautological. He is peddling tautology in order to make a separate, and even worse, point. He wants to show that the most devastated countries were also the most profligate, but instead he's simply showing that the most devastated countries were also the most devastated. That's not to say that spending doesn't rise when the economy declines. It certainly does due to automatic safety net programs like unemployment insurance. But again, Laffer has the causation backwards. This isn't even good propaganda. It's too transparently mendacious.
Let's do better. Start with the data set. Laffer looks at figures from 2007 to 2009, but the IMF has numbers through 2011. Let's use them. Then let's add Latvia and Lithuania to our country sample. The trio of Baltic nations have been at the epicenter of the debate over whether austerity works -- it doesn't make sense to include Estonia, as Laffer does, and exclude the other two. Next, let's look at the percent change in public spending itself, rather than the change in public spending as a percent of GDP. That way we won't mistake a collapse in GDP for a surge in stimulus. And finally, let's consider average annual per capita growth rates adjusted for wealth, rather than changes in growth rates. In plain English, this will control somewhat for countries growing faster because they are poorer or have more people.
The chart below shows our more accurate picture. The three countries that spent the least -- Ireland, Greece, and Latvia -- did the worst. A silver bullet into the heart of Keynesianism, this is not.
(Note: The X-axis shows the percent increase in government spending from 2007 to 2011; the Y-axis shows average annual GDP per capita growth rates in purchasing power parity terms, adjusted for convergence. Read here for more on the convergence calculations).
The dots colored yellow are countries Laffer singles out as the cautionary tales of self-defeating stimulus. But as Lars Christensen points out, Estonia is the poster child of anti-Keynesianism! It cut government spending between 2008 and 2010 amidst a depression-level slump. It has overall public debt -- not deficits, but debt! -- of 6 percent of GDP, which is miniscule. And then there was that time its president tried to pick a fight with Paul Krugman after he criticized their economic performance. The rest of Laffer's unusual suspects are equally absurd avatars of government spending run amok. Ireland cut its budget between 2008 and 2011. Finland and the Slovak Republic did spend more, but not that much more -- and their growth was average to above average anyway. In other words, Laffer's examples of stimulus failing are really examples of austerity failing -- or of stimulus working. Chutzpah doesn't begin to describe this.
That leaves one final question: Why did some countries -- like Latvia -- collapse when spending slowed, while some other countries -- like Switzerland -- did not? Here's the two word answer: the euro. The countries that have had negative growth and little spending growth are almost all either members of, or pegged to, the common currency. They don't have the usual escape valves of devaluation or interest rate cuts when crisis hits. Hard money and balanced budgets are toxic whether it's the 1930s or the 2010s. Contrast that with Switzerland, which has carried out open-ended quantitative easing to keep its currency from appreciating -- it's married fiscal prudence with relatively enviable growth. Of course, Laffer has been calling for tighter money since 2009, so it's not as if he's endorsing this.
Laffer's War-Is-Peace, Ignorance-Is-Strength, Freedom-Is-Slavery school of economics is what has made the dismal science so dismal over the years. But rather than embrace the troves of new data available to economists, Laffer is content to contort old data to validate old slogans. He really is the anti-Keynes. When the facts change, Laffer changes the facts back, so he won't have to change his mind.