Art Laffer and the Effect of Government Stimulus on Jobs and Investment…

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This week, noted economist Arthur Laffer wrote an interesting piece in the Wall Street Journal entitled The Real “Stimulus” Record.  In this piece, Dr. Laffer argues that before policymakers in Washington again try yet another round of stimulus spending in an ostensible attempt to mitigate high unemployment and poor growth rates, they should remember that President Obama’s first stimulus package did not exactly meet with great success.  As support for his argument, Dr. Laffer cites the facts that while stimulus spending over the past five years totaled more than $4 trillion, increasing  U.S. Federal government spending from 21.4% to 27.3% of GDP over the 2007 and 2009 window, economic growth rates still sputtered.  While it is difficult to draw strong conclusions about the effect of stimulus from evidence reported in a newspaper article, Dr. Laffer’s argument than additional stimulus is “an expensive leap of faith with no evidence to confirm it” will not ring hollow for most Americans.

Indeed, a paper we published last year entitled Can Government Spending Get America Working Again? An Empirical Investigation and highlighted in a blog we posted in March, presents evidence consistent with Dr. Laffer’s general sentiment on the ineffectiveness of economic stimulus.  In that paper, we divided the past fifty years of U.S. economic history into low-growth and high-growth periods.  We then applied a non-linear, two-regime model to study whether the stimulus effects of government and private investment differ between recessionary and expansionary periods.  This paper was a significant departure from the traditional literature, which typically contemplates the average or typical effect of government spending on private-sector jobs.

And guess what?  During periods of economic sluggishness (such as the current situation), we found that government spending has zero effect on private-sector job creation.  This result is consistent with the apparent impotence of huge federal government spending increases aimed at reducing unemployment.  In contrast, when it comes to job growth, expansions in private investment are effective in both regimes, but its efficacy is greatest during economic stagnation.  By implication, policies that discourage private investment may have more severe job-killing effects during economic downturns, since it is during the low growth periods that private investment is most effective at creating jobs.

To illustrate this point, we calculated the employment effects of a hypothetical 5% increase in private investment (about $90 billion in 2005 dollars) and the equivalent dollar increase in government spending.  As set forth in Table 2 from our paper below, based on the computed multipliers, an additional 432,000 jobs would accompany this 5% increase in private investment during the low-growth period.  In contrast, an equivalent $90 billion increase in spending by the government would produce no net jobs in the low-growth period.  For the high-growth periods, however, the $90 billion in government spending or private investment both would generate over 200,000 jobs.  Be sure to note the significant increase in the potency of private investment in the low-growth regime (another 432,000 jobs) relative to the high-growth regime (just over 200,000 jobs).  This differential effect is informally consistent with the idea that periods of higher growth are coincident with higher levels of resource utilization, so increases in demands may involve displacement and price rises to a greater degree.  Other explanations are also possible.

As we pointed out, the results from our two-regime non-linear model are important for policymakers.  First, government spending does not appear to be an effective stimulant for private-sector job creation during periods of slow economic growth.  As such, the federal government simply can’t spend the U.S. out of high private-sector unemployment.  Second, private investment has a positive effect on job creation during low and high growth regimes, but the jobs effect is more potent effect during periods of low growth.  Based on the historical data, therefore, stimulating private investment, not more government “stimulus” spending, appears to be the key to labor market recovery in the current economic environment.

In sum, it is becoming increasingly difficult to justify massive government spending in the name of “economic stimulus.”  If we want to (and should) get America back on its feet, then the solution remains straightforward: we need policies that encourage efficient private-sector investment.  Otherwise, we are just talking about good old fashioned pork-barrel politics.