Thursday, June 30, 2011

The stimulus: A microeconomic analysis

While I understand the title of this post probably scared away 90 % of all readers, let me assure the remaining 10 % that this post won't be nearly as complicated as it sounds.

First, for those of you who haven't studied economics, let me just introduce you to the terms macro and micro: Macroeconomics is all economics that concerns inflation, unemployment, growth etc. The "big" view so to speak. Microeconomics on the other hand, is about trade, competition (how a monopolist sets prices compared to a company with a lot of competitors), and most of all about incentives: Motivations for doing stuff, that is.

The above is a bit of a general, non-academic way of defining the areas, but basically that's what the different terms are all about.

The stimulus is often analysed and discussed from a macroeconomic perspective: How much growth has it created or not created, how much unemployment was caused or prevented, when will the government get the money back if at all etc.

This perspective is very important, of course. But if you're a conservative (and I know the very majority of our visitors, and all of our writers, are conservative) then you already agree that the stimulus was a failure.

The question is; why did it fail? Conservative pundits and activists may dumb it down to "Because Obama is a socialist".

Maybe he is, maybe he is not - let's not have that debate here, please - but the problem is deeper than that.

Keynesians (economists who support government intervention and steering of the economy) tend to ignore the most basic microeconomic question: Where are the incentives? Who has an incentive to improve the economy?

Keynesians make the mistake of looking at the country as an entity; they think "It would be best for the country to have an efficient stimulus package, so the country will get one".

What these economists forget is that ultimately, it is not the "country" which decides where stimulus money will be spent: It is the politicians who are governing the country. This makes a big difference: Instead of looking at what would be best for the country, we need to look at what would be best for the politicians (or, in economics language, what they have an incentive to do). Keynesian simply assume that politicians want the best for the country and nothing else. That's a glamorised, simplified view. It says that the utility (happiness, satisfaction) of a politician is a function of (depends on) the nation's economic health, and nothing else.

So in other words, if growth is 4 %, every member of the government will be happy, if it's 1 %, they'll start feeling a little down, and if it's -4 % we have to put the government on suicide watch.

Sounds a bit unrealistic, doesn't it? Just like with regular people, politicians "utility function" is complex. A politician may for example be perfectly fine with a growth rate of 2.5 % instead of 3 %, if that means 2 million more in campaign cash. We then say that this politician is indifferent between +2 million campaign, 2.5 % growth and no additional campaign money, and 3 % growth (meaning he thinks they are just as good).

Too complicated? Let's get to the point. A guy like Obama may know that it would be better to spend stimulus money in California, but he also knows that California will vote for him no matter what he does. He may also know that Utah could use some money, but they won't vote for him no matter what. So the money will be distributed in a way that is economically less than optimal, but it will maximize Obama's personal utility (which, as previously mentioned, is just another word for happiness or satisfaction).

Here is the key to the problem: The stimulus is certain to maximize the personal utility of the politicians involved in creating it, but far from certain to maximize the country's wealth and its citizens utility.

Still though, politicians care about being re-elected, don't they? And their re-election prospects are tied to the health of the economy, right? To a certain point, that is correct. Still, what's important is the headlines, not the actual health: If politicians can convince media that the economy is turning around, they will face positive headlines going into re-election and they will then still have a good shot (that was exactly what Obama tried to do with his "recovery summer"). Also, if they can concentrate unemployment to certain areas (in non-swing states), that will be good enough for a presidential election. People don't look at numbers and graphs when they decide how to vote, they look at their own situation and their family, friends and neighbours situations: If no-one in your family, friend of neighbourhood is unemployed, you are no less likely to vote for the sitting president, even though you know unemployment is at 9 % nationally. It's sad, but people really are that egoistic.

We must also remember that presidential elections only happen once every 4 years (although, if you're hanging on RS, you'll think they happened every month). As long as the recession is over and unemployment is down before that time, the sitting president need not worry. That's probably what Obama was thinking; that the crisis would be long over before 2012, even if some of the stimulus money was spent inefficiently.

Can you put together an efficient stimulus package? That will be the subject of my next post, but for now, let's just summarize: The reason why stimulus packages are so inefficient is because no-one who has any power over how they are shaped, have any incentive to create an efficient package, the incentive to spend stimulus money on special interests and swing states is greater than the incentive to actually help the economy as a whole. To do so, would be to let a good crisis go to waste.

Thanks for reading,

John Gustavsson


Pablo said...


It would be good to see some data regarding where the stimulus money has gone, what states needed it the most, and how those decisions were made. While I agree with you in theory, I would like to see some evidence that an insufficient stimulus is what actually occurred.

Pablo said...


I am finding that Rhode Island received the most stimulus cash. Hardly a "swing state." Here is a breakdown by state.

What is interesting is that Rhode Island had a 10% unemployment rate at the time of the stimulus. By June 2011, its unemployment rate was 10.9%. I haven't seen more recent statistics, but I am assuming that that number has not decreased.

This means that the stimulus package (1) quite literally did not work or (2) prevented a worse unemployment rate from happening. I am leaning toward number one, since I don't yet see how the stimulus has created jobs. Regardless, your theory that government inefficiently spends money on a stimulus needs to be tested by what has happened in 2009.

Anonymous said...

I was a T.A. in Managerial Economics (Money and Banking) my senior year at University, so I do understand something of these matters. Another point never to be forgotten about Keynesian economics is that government, once creating a spending program, rarely, if ever, ends that program. We still have many programs left over from the New Deal Era, as well as the War on Poverty, that are basically irrelevant at this time, but still exist--and receive funding. House cleaning of these programs really, really should take place.

Another problem with the most recent stimulus is that the "shovel-ready jobs" had a lot of strings attached. For example, they had to go to Unionized workers, so right-to-work states such as AZ had a much more difficult time qualifying for funds than some other states.


Pablo said...

This guy argues that there is a strong correlation between stimulus spending and states that voted against Obama. If there were political reasons behind the stimulus package, it seems that it was directed into trying to entice non-Obama states to turning blue.

John said...

Pablo, I'm sorry I wasn't more clear about my point: Stimulus money obviously won't just be spent inefficiently in swing states, but also in pet projects (like John Murtha's airport if you've heard of tha tone) and special interests (like giving more money to an industry because they donated loads of money during the last campaign).

Politicians don't always want what is good for the country, they ultimately want what is good for themselves - like we all do. Now, a patriotic politician would want what is good for his or her country, because doing what's best for the country will be what is best for this individual too (their "utility" is tied to the country's health).

In my next post, set to be finished in a few hours, I'll talk about whether you can have an efficient stimulus at all.