Government Waste is Overrated? Who Knew?

"Is Government Spending Too Easy An Answer?" (Greg Mankiw, 1/10/2009)

Economics textbooks, including Mr. Samuelson’s and my own more recent contribution, teach that each dollar of government spending can increase the nation’s gross domestic product by more than a dollar. When higher government spending increases G.D.P., consumers respond to the extra income they earn by spending more themselves. Higher consumer spending expands aggregate demand further, raising the G.D.P. yet again. And so on. This positive feedback loop is called the multiplier effect.

In practice, however, the multiplier for government spending is not very large. The best evidence comes from a recent study by Valerie A. Ramey, an economist at the University of California, San Diego. Based on the United States’ historical record, Professor Ramey estimates that each dollar of government spending increases the G.D.P. by only 1.4 dollars. So, by doing the math, we find that when the G.D.P. expands, less than a third of the increase takes the form of private consumption and investment...

Textbook Keynesian theory says that tax cuts are less potent than spending increases for stimulating an economy. When the government spends a dollar, the dollar is spent. When the government gives a household a dollar back in taxes, the dollar might be saved, which does not add to aggregate demand.

The evidence, however, is hard to square with the theory. A recent study by Christina D. Romer and David H. Romer, then economists at the University of California, Berkeley, finds that a dollar of tax cuts raises the G.D.P. by about $3. According to the Romers, the multiplier for tax cuts is more than twice what Professor Ramey finds for spending increases.

Why this is so remains a puzzle. One can easily conjecture about what the textbook theory leaves out, but it will take more research to sort things out. And whether these results based on historical data apply to our current extraordinary circumstances is open to debate.

Seems like the reason is probably that government spending is wasteful.  Consumers and entrepreneurs have far better information about what allocation of new resources contributes the most value than does the government.  Any stimulating effect of new government spending is offset by the wealth-destroying effect of giving resources to bureaucracies rife with agency problems and micro-managed by lobbyist-ridden and less-than-brilliant legislators.

That's not to say we shouldn't have a public sector.  Bureaucracies are inefficient, but there are cases of market failure where tasks must be entrusted to bureaucracies if they are to get done at all, and the value of doing them might be worth the cost even if they're done inefficiently.  But if we just want to inject money into the economy, give it to the people.

Comments

[nato]

"Consumers and entrepreneurs have far better information about what allocation of new resources contributes the most value than does the government."

Though one could quibble with who really has better information, it's certainly true that consumers, entrepreneurs and other independent agents have much more effective utility-maximizing mechanisms. I actually think we have an astonishingly effective and wise government, given the dislocation between incentives and performance. I think it's just that so many public servants really do love their country and try to do the best they can, despite there being no real incentive to do so.

[Tom]

Good points, Nathain (using the dual-plural in Arabic).

[nato]

I wish there was some way to close the loop. If a corporation was in charge of setting the various parameters of the economy over the long term and investors were paid in long-term residuals or something, I bet they would do a great job. It's unworkable, I think, but maybe someday someone will come up with a way to close some of the incentive loops in maximizing aggregate output over the long term.