What's Wrong With Fiscal Stimulus?

"Fiscal stimulus" is all the rage in the United States, as the possibility of a recession in a presidential election year looms. But it's a bad idea.

A deficit will boost aggreggate demand and a surplus reduce it, all other things being equal. But all other things aren't equal. The Federal Reserve has the ablity to raise or lower interest rates, and if it is following its own policies concerning an acceptable rate of inflation, a higher deficit will just induce it to raise interest rates. This will mean a fall in private investment without any corresponding stimulus.

Since it takes longer for fiscal policy makers to react to changes in the cycle than monetary policy makers, the general view of macro types is that counter-cyclical policy (reducing inflation in times of boom, boosting output in downturns) should be left to central banks, and not governments.

Moreover, over the longer haul, McCain, for all his acknowledged ignorance of economics, is right that getting spending under control is the most important thing. To spend a dollar, we need to take more than a dollar in private wealth, whether the spending is paid for by taxes or borrowing. So higher spending means lower growth. Obviously, that doesn't mean the government should spend nothing at all, but it does imply that keeping the government as small as possible is good for the economy.

Update: Greg Mankiw, not surprisingly, makes the point more cogently here. So did Paul Krugman, back in the day.