Table Of ContentCrowding Out
Fiscal Stimulus
Testing the Effectiveness
of US Government Stimulus Programs
John J. Heim
Crowding Out Fiscal Stimulus
JohnJ.Heim
Crowding Out Fiscal
Stimulus
Testing the Effectiveness of US Government
Stimulus Programs
JohnJ.Heim
UniversityatAlbany-SUNY
Albany,NewYork
USA
ISBN978-3-319-45966-0 ISBN978-3-319-45967-7 (eBook)
DOI10.1007/978-3-319-45967-7
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E S
XECUTIVE UMMARY
Dodeficit-financedgovernmentfiscalstimulusprogramsactuallystimulate
the economy? This study exhaustively tests a wide variety of different
stimulusmodels,testingthemindifferenttimeperiods,andusingdifferent
regressiontechniquesinanattempttoanswerthisquestion.Fiscalstimulus
programs examined include both those that cut taxes and those that
increasegovernmentspending.
Mostmodelsthatpredictgovernmentdeficitswillstimulatetheeconomy
are Keynesian. A principal characteristic is that they are demand-driven.
Eachoftheirkeystructuralequationsindicateincreasesindemandwilllead
to increased supply (and employment), at least up to full employment of
resources.Henceadeficit,whichincreasesgovernmentdemandbyincreas-
ing government spending, or increases private demand by cutting taxes,
stimulatestheeconomy,accordingtostimulustheory.
Intestingwhether these stimulus programsactually work, we tookcare
to test equations taken from the Keynesian model. This gives the stimulus
effects of deficits, should they exist, the best possible chance of being
verified empirically. 1960–2010 data on the US economy were used. A
total of 228 models of the determinants of consumption, investment and
theGDPweretested.Thesemodelsdifferinthevariablesincluded,thetime
period tested, the regression techniques used, the level of the economy
whentestingandthespecifictypeoftaxcutorspendingstimulusused.Each
model is reported in detail, with differences in each subsequent model
compared to the last tested. Differences in results are compared as well.
The work is lengthy, but necessarily so. Our goal was to test every
vii
viii EXECUTIVESUMMARY
conceivable model readers might feel stood a chance of showing positive
stimuluseffects.Thatway,whateverourresultsturnedouttobe,itwould
bedifficulttoarguewedidnotexamineawideenoughbreathofstimulus
programstogivethemafairchancetoshowwhattheycando.
In theory, the effectiveness of stimulus programs can be curtailed by
“crowd out”. Crowd out theory suggests that whatever their stimulus
effects, government deficits have the undesirable result of simultaneously
reducingprivatespending,becausefundsnormallyborrowedbyconsumers
andbusinessesmustbeusedtofundthedeficit.Reducedprivateborrowing
inturncausesareductioninconsumerandbusinessspending,offsettingthe
deficit’sstimuluseffects.
In testing to show crowd out effects, a deficit variable is added to each
Keynesian consumption, investment or GDP model. This allows simulta-
neoustestingofbothKeynesianstimulusandcrowdouteffects.Eachmodel
shows stimulus and crowd out effects separately, and allows readers to
directly calculate net effects of stimulus programs, for example, the effects
of reductions in federal taxes on consumption spending, controlling for
many other factors that affect consumer spending. Everybody acknowl-
edges the possibility that crowd out, “if it occurs”, can adversely affect
stimulus programs. Rarely do people actually test to see if it does occur.
Thisbook’suniquecontributionistoexhaustivelytesttodetermineifitdoes
occur,andifso,howseriousaproblemitis.
As alternatives to Keynesian models, we could have tested dynamic
stochastic general equilibrium (DSGE) models, but these are models that
typically contain assumptions about human behavior like perfect foresight
andintertemporalutilitymaximization,thataredesignedtoinferfromthese
assumedbehavioralcharacteristicsthatstimulusprogramsdon’tworkinthe
longrun.Similarly,wecouldhavepickeddifferentcombinationsoffiveor
sixvariablesthoughtappropriateandtestedVARmodels.Theproblemhere
isthatsinceVARstypicallyarenotrecognizabletheoreticalconstructs,itis
hard to know what your results mean. By comparison, we know what a
Keynesiantheoreticalconstructmeans,andifweslipadeficitvariableintoit
and then test, the test will either show the variable statistically significant
(crowd out matters) or not (crowd out doesn’t matter), controlling for all
theotherKeynesianinfluences.Inshort,wewillhaveausefulresult,froma
fairtest,scientificallyarrivedat.
When examining how consumption or investment spending varies as
deficits rise or fall, we control for the effect of business cycle variation on
both government deficits and on private spending. This was necessary to
EXECUTIVESUMMARY ix
unambiguouslyidentifycrowdout’seffects.Adecliningeconomyalonecan
causeagrowingdeficitandsimultaneouslydecliningconsumerandbusiness
spending,butthatisabusinesscycleeffect,notacrowdouteffectinwhich
the deficit causes the decline in private spending. Some argue it is only
businesscycleeffects,notcrowdout,whichcausethenegativerelationship
betweendeficitsandprivatespending.Theyarguethatwithoutthestimulus
programs, the observed decline in private spending associated with the
deficit would have just been worse. The difference between this and the
crowd out explanation has enormous political and economic implications
forgovernment’sroleintheeconomy.
Methodologically, extensive tests for endogeneity, stationarity and
heteroskedasticity were undertaken. Testing was done in first differences,
eliminating most non-stationarity and reducing multicollinearity problems
byabouthalf.Modelsexplained90–95%oftheyearlychangesofconsump-
tion and investment during the 50-year period tested. Four different,
though overlapping, time periods were tested. Findings were essentially
the same for the 1950s and 1960s as for the 2001–10 decade, and for
decadesinbetween.Deficitresultswerealsorobustformoderatechangesin
the structure of the models tested. They were also generally robust to
different regression techniques (OLS, strong and weak instrument 2SLS),
and use of different strong 2SLS instruments. Hence, we feel our findings
will be difficult to refute in reasonably well-constructed future models of
howtheKeynesiansystemworks.
Ourfindingsoverwhelminglyindicatethatasgovernmentdeficitsgrow,
creating observable stimulus effects, consumer and business spending
declines due to crowd out, fully cancelling the stimulus effects (or worse).
Theoffsettingdeclineinprivatespendingappearsdueto“crowdout”,that
is,tryingtofinancebothincreaseddeficitsandtraditionalprivateborrowing
levelsfromarelativelyunchangingsizedpoolofloanablefunds.
This finding that stimulus programs do not work held in virtually all
circumstances tested. The specific type of tax cut or government spending
deficitdidnotmatter,nordiditmatterifwetestedinrecessionsornormal
economic times. Nor did it matter what particular decades since 1960 we
tested,and,generally,itdidnotmatterifweusedoneregressiontechnique
(OLS)versusanother(2SLS)todoouranalysis(thoughasamatterofgood
practice, where 2SLS is needed, it should be used). With rare exceptions,
usually due to statistical problems like multicollinearity, none of these
variations in the models we tested resulted in a net positive effect for tax
x EXECUTIVESUMMARY
cut or spending increase stimulus programs. In virtually all cases, results
indicatedcrowdoutfully,ormorethanfully,offsetstimuluseffects.
Examination of the 1981–83 recession period indicates the pool of
loanable funds drops even faster in recessions than business and consumer
loandemand.Hence,newdeficitfinancingdemandsonthepoolofloanable
fundsinrecessions,ifanything,causeevenbiggercrowdoutproblemsthan
innormaltimes.Thedataexaminedsupportthisconclusion.
Themodelsfromwhichweobtainedtheseresultsalsoexplainextremely
well the behavior of consumption and investment during the 2007–09
economic crisis. Our econometric findings suggest that deficit-financed
stimulus programs such as the 2009 Obama stimulus program have a
substantial negative effect on the GDP, raising unemployment 2.26–
2.94% during the period they are in force. Deficits have this undesirable
result because to fund them, funds normally borrowed by consumers and
businesses are used. Reduced borrowing by consumers and businesses in
turn causes a reduction in their spending, offsetting the deficit’s stimulus
effects.
Worse, “lumpiness” in borrowing tends to result in private spending
reductionsevengreaterthanthestimulus’positiveeffects,leadingstimulus
programstohaveanetnegativeimpactontheeconomy.Bylumpinesswe
meanthefollowing:consumerswhoneedtoborrow$10,000tobuyanew
car, but find that their bank can only lend them $9000 (because they lent
theother$1000tothegovernmenttofinancea$1000stimulusprogram),
willnotbuythecaratall.Thiscausesprivatespendingtofall$10,000from
expectedlevels,afargreaterdropthanthestimuluscanoffset.
Chapter 16 provides a more detailed summary of findings and
conclusions.
P
REFACE
Ileftacademiclifein1972,nottoreturnuntilaquartercenturylater.When
I returned, one of the most hotly contested issues of my youth, “Do
Keynesian-type stimulus programs work?” was still unresolved. I was sur-
prisedbecausewhenIleftacademia,workineconomicsseemedmoreand
more dominated by the new, econometrically based scientific method,
rather than the older philosophical approach, i.e., mainly theoretical
deductions derived from “self evident” truths about human and business
behavior.Ifeltitwouldonlybeamatteroftimebeforescienceprovidedan
answertothestimulusquestion.Thatdidnotoccur.
Myresearchinterestsinlarge-scaleeconometricmodelingledmetotry
to develop and test a Keynesian-type model of the macroeconomy. For
aboutsixmonths,IkepttryingtobuildandtestsimpleKeynesianCrossand
IS-LM models,and then extend the worktomorecomplexmodelsofthe
sametype,butwithnosuccess.Inempiricaltestaftertest,Ikeptcomingup
withthewrongsignonthegovernmentrevenuesvariable:Iwasconsistently
getting positive signs, when Keynesian stimulus theory said I should be
gettingnegativesigns.Worse,Iwashavingnearlyasbadaproblemwithmy
governmentspendingresults.Inmoresophisticatedmodels,testresultsfor
governmentspendingwerealsogivingmethewrongsign:negativeinstead
ofthepositivesignKeynesiantheoryleadsustoexpect.
What to do? One thought was just scrap my Keynesian model testing
programandmoveontotestingsomeothertheory.Thisisclearlywhatmany
ofmycolleagues had doneduring the 1980sand 1990s whenI wasout of
macroeconomics.Whatlarge-scalemodelsremainedwerenowDSGE-based.
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