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Does Fiscal Stimulus Work?

August 28, 2010

Paul Krugman has a great post on fiscal stimulus that throws light on two questions I’ve been scratching my head about. Firstly, there are those, like Kenneth Rogoff, who argue that fiscal stimulus is not borne out by the evidence to be an effective economic policy tool in situations such as the US and other economies recently found themselves.

Well, this data from Krugman, if not putting a nail in the coffin of that argument, at least offers some pretty impressive prima facie evidence for the effectiveness of fiscal stimulus. Here’s how one economist initially saw it affecting gdp growth rates evolving over the post-stimulus months:

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And here’s what happened:

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True, they are not an exact match – but the key thing to notice I think is the pattern exactly bears that same structure as stimulus theory and forecasts like the one above suggest. (Krugman puts the delay in the real data down to variations caused by changing inventory stocks, which effect the actual GDP as noise in the model that applies in real life.)

But secondly, the Krugman post explains why it is that two months ago, when earnings reporting season began in the financial markets, a bunch of companies showed surprisingly positive results, and from revenues too, not just cost cutting, despite the fact that the long term prospects were seen as decidedly gloomy. Because, the boost to GDP is temporary: After that, you need real private sector demand to come in and fill the gap, to keep GDP growing (as shown in the graphic below, from Deutche Bank via Krugman). Which also explains, why people fear a double dip once the stimulus is over.

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So when will demand come back online? When people get their jobs back, for one thing. (And, by all account, that will take years.) Further, when demand appears to be recovering strongly enough to justify new private sector investment. By the looks, it ain’t gonna come from the US housing market any time soon, that’s for sure. And tight credit markets – unwillingness by banks to lend – is not helping either.

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