The US federal government responded to the financial crisis and recession that began in 2007–08 with unprecedented fiscal stimulus. Passed in February of 2009, the American Recovery and Reinvestment Act (ARRA) came with a price tag of
The US federal government responded to the financial crisis and recession that began in 2007–08 with unprecedented fiscal stimulus. Passed in February of 2009, the American Recovery and Reinvestment Act (ARRA) came with a price tag of $831 billion. Yet the economy has not returned to a path of robust economic growth and unemployment has stubbornly remained high; only in September of 2012 did it dip (barely) below 8 percent. This has not stopped the Obama administration from pushing for further fiscal stimulus.
Whether or not fiscal spending stimulus is effective hinges critically on the size of the spending multiplier, which is dependent on several factors. In particular, if individuals anticipate the future tax liabilities associated with deficit spending and/or are "crowded out" by the deficit spending, then the multiplier is likely to be less than one; that is, each dollar of stimulus increases total spending in the economy by less than one dollar. Ultimately, whether the government spending multiplier is less than or greater than one is an empirical question.
While no one seriously debates the long-run costs associated with exploding public debt, the evidence suggesting significant short-run benefits of stimulus spending is weak. Studies suggesting that stimulus spending is effective assume that current economic activity does not affect fiscal policy. This assumption is questionable and, most important, the studies' results are very sensitive to it.
Alternatively, studies using a narrative approach based on historical and contemporary accounts of US military buildups to identify government spending shocks find that the short-run effects of stimulus spending are small. These latter studies are grounded in historical reality and are thus more compelling.
In 1965 Milton Friedman was famously (or infamously, depending on your point of view) quoted as saying "We are all Keynesians
now." Though he later remarked that he had been taken out of context, Friedman accurately expressed a consensus among economists and policymakers at the time: countercyclical fiscal policy is an appropriate and effective means toward combating the
business cycle. Specifically, in response to a recession, the federal government should increase its expenditures and/or provide tax relief to make up for the shortfall in the private
sector's aggregate demand for goods and services. Nearly three decades after his publication of The General Theory of Employment, Interest, and Money, the policy prescriptions of Lord Keynes were dogma.
However, by the beginning of the new millennium all that had changed. Countercyclical fiscal policy had fallen into disrepute. A new consensus held that fiscal stimulus in the wake of a recession was politically infeasible and, even if it could be enacted in a timely fashion, stabilization pol