Thursday, August 25, 2011

Would stimulus work?

Since the publication of the General Theory by John Maynard Keynes, modern macroeconomics has long been criticized for a lack of strong micro-foundations. Chicago and Austrian school economists, for instance, claimed that there is too much aggregation in the Keynesian perspective which unfortunately ignores the basic drivers behind all economic activities, i.e., human incentives. Without a clear understanding of incentives behind human action and how these incentives interact and properly "aggregate", economic facts could be misinterpreted and wrongly theorized, and policy based on its prescription could be dangerous and disastrous.

In his WSJ op-ed today, Harvard economist Robert Barro revisits this decades-old topic. He firmly supports the view of what he calls "regular economics", where incentives play a central role in shaping overall economic activities.

Professor Barro, once a follower of Keynes, argues in this short essay that Keynesian stimulus transfer programs, such as food stamps, will not lead to an expansion of the overall economy - that one could get back more than one puts in - as Keynesian economists have long believed. The reason why stimulus transfer won't work is two folds. One, these transfers to the people with earnings below designated levels would motivate less work effort by reducing their reward from working; and two, more taxes are needed to finance these transfers. And these added tax burdens may not only reduce the work effort of taxpayers, but also lower overall investment levels since returns after taxes could be diminished. The consequence? The overall GDP pie would be reduced, rather than enlarged.

Although little empirical evidence exists in favor of either school, some scattered evidence could well support the view of "regular economics": an increase in unemployment insurance eligibility to 99 weeks in 2009 would have an adverse effects on unemployment - the fraction of the long-term unemployed (more than 26 weeks) has jumped since 2009 - to over 44% today, whereas the previous peak had been only 26% during the 1982-83 recession. However, as Barro suggests, more empirical evidence of this type is needed to get more reliable conclusions.

Debate could heat up, again (see here).

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