Stimulating debate

30th October, 2010

Should the government hire people to bury banknotes down disused mine shafts, thus stimulating the private sector to dig them up again? Keynes argued that there were circumstances in which even government spending as wasteful as this could be economically worthwhile, and ever since he did, people have been tying themselves in knots about how fiscal stimulus actually works.

The subject is laden with snares for the unwary, and yet is clearly one of the critical economic issues of the day. Take the infuriating proposition that private-sector workers create wealth, while public-sector workers are simply a cost centre. I’m sympathetic to the idea that competition works better than government targets, and that large-scale nationalisation is a bad idea. But as a matter of logic, the idea that the private sector pays for the public sector makes no sense.

Refuse collection, for instance, is usually done by private-sector companies, but it’s paid for by the taxpayer. Meanwhile the employees of Royal Bank of Scotland are creating wealth (it makes a nice change) yet they are public-sector workers. In the US, hospitals are private businesses paid for by health insurance. In the UK, they are government-run organisations paid for by taxes. Reasonable people could argue about which system is more sensible, but under either system, citizens have to pay, and in return they receive medical care. It is baffling to suggest that in the US system, doctors are wealth-creators while in the UK they are wealth-destroyers.

As for the stimulus itself, common sense is just as treacherous a guide. The naive pro-stimulus view is that if the government keeps half-a-million extra bureaucrats on the payroll, the bureaucrats will spend their salaries in the high street and create other jobs.

The truth is trickier. By hiring the bureaucrats, the government puts upward pressure on real wages. Private-sector firms might have to go without, unable to offer the same perks. Meanwhile, the bureaucrats’ wages must be paid, and since the government does not wish to raise taxes, it must borrow money. This, in turn, may make it harder for private businesses to borrow by nudging up interest rates. Worse, ordinary citizens may stay away from the high street because they are saving up to pay the inevitable higher taxes that lie ahead. In the jargon, government spending may “crowd out” the private sector instead of stimulating it.

Before deficit hawks start quoting this column, just as many questions remain over the opposing view. With unemployment high, is it really plausible to suggest that the private sector is hobbled because the government has snaffled all the best people? With UK and US government bond rates low, has the borrowing spree really squashed private borrowing? If the private sector always rushes in when there are workers standing idle, what happened to Detroit and Liverpool?

The only certainty is that nobody knows for sure how much the stimulus is needed. Historical statistics can only ever be an imperfect guide to macroeconomic policy.

My own belief, for what it is worth, is that there are circumstances when Keynes was right: the fiscal multiplier is sometimes greater than one, meaning that even the mine shaft stimulus programme is worthwhile. The recent recession was one of those times and large deficit spending was appropriate. I am less convinced that the multiplier is still greater than one, although I could very easily be wrong.

A multiplier of less than one simply means this: that government spending is not a free lunch, even though it may be a cheap one. Even as we argue about the size of the state, we should make sure that it does something more useful than burying banknotes.

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