Paul Krugman describes and writes:
Here’s how I see it: the opponents of a strong stimulus plan don’t
really have an alternative to offer. They don’t even have a really
coherent critique; as Brad DeLong points out,
if you believe that a surge in private spending would raise employment
– and even the critics agree on that – it’s very hard to explain why a
surge of public spending wouldn’t have the same effect.
The critics are instead mainly engaged in a series of minor complaints, aka niggles; FDR didn’t do so well, the statistical evidence ain’t so great, you can’t trust government, etc., etc..
My view is the disaggregated one that sometimes private spending can stimulate employment and sometimes it cannot. Private spending has the greatest chance of stimulating employment when a) market psychology is on its side, and b) the financial system is relatively well-functioning. Neither is the case right now.
Note that under standard theory neither monetary nor fiscal policy will set right the basic problems from negative real shocks and indeed the U.S. economy is undergoing a series of massive sectoral shifts. That includes a move out of construction, a move out of finance, a move out of debt-financed consumption, a move out of luxury goods, the collapse of GM, and a move out of industries which cannot compete with the internet (newspapers, Borders, etc.)
I’ve never seen a stimulus proponent deny this point about real shocks but I don’t see them emphasizing it either. It should be the starting point for any analysis of fiscal policy but so far it is being swept under the proverbial rug.
Maybe a big enough push to aggregate demand could stimulate useful, productive employment (as opposed to merely boosting measured gdp) right now, but since the
U.S. savings rate must rise sooner or later, that would only mean a
steeper decline for aggregate demand some time in the future. My discount rate isn’t that high.
The alternative to a huge fiscal stimulus is simple: enough pro-active fiscal policy to ensure that cuts in state and local spending do not bring additional contractionary pressure to bear on the economy. Otherwise bear the costs of the ongoing sectoral shifts and allow consumption to decline as indeed it must sooner or later. Aggregate demand macroeconomics really does matter, but it is easier to do badly from negative shocks than it is to engineer good results from expansionary shocks.
Those looking for other policy alternatives might consider Robert Lucas’s recent suggestions for monetary policy or cuts in the payroll tax, although I am myself not quite (yet?) on either bandwagon (though I think they are better plans than massive fiscal stimulus).
By the way, FDR didn’t do so well, the statistical evidence ain’t so great, and you can’t trust government, etc. But those are only my minor complaints.
The bottom line remains this: we are being asked to spend ???? hundreds of billion dollars when a) the evidence for fiscal policy is inconclusive, and b) when you consider how real shocks fit into aggregate demand analysis, the theory isn’t there either.
Addendum: Here is a post by Krugman on the "hangover theory." The answer to Krugman’s #1 is a combination of (perceived) wealth effects, downward nominal and real rigidities, and, during the boom workers at least thought they knew what they should be doing but now they do not. The coordination problem on the upswing is not symmetric with the coordination problem on the downswing. In any case it is correct that real sectoral shift theories do not explain all facets of a recession or depression; it is incorrect to conclude that therefore, in light of sectoral shocks, fiscal policy will be effective.