Intro: When fiscal stimulus ‘works’ it tends to be because it prevents the emergence of idle resources resulting from the unwinding of economic imbalances. However, in doing so it tends to create additional distortions undermining future growth. The weaker the economy’s initial health, the less likely that any fiscal stimulus measures will be growth supportive, even in the short term.
Fiscal stimulus measures are loved by politicians as the benefits are highly visible while the costs are much less so. While stimulus spending can have a short term positive impact on real GDP growth this inevitably comes at the cost of long-term economic growth. In theory fiscal stimulus measures could benefit long term growth should the spending help to increase the efficiency of private investment through improved physical and human capital. However, generally speaking stimulus spending tends to ultimately be wealth destructive.
As explained in ‘Why Lower Government Spending is Good for the Economy‘, the reason policicians, and indeed economists, like fiscal stimulus measures is because the benefits are very easy to point to in terms of the positive impact on growth, but their drawbacks are far less easy to see. However, they only tend to actully boost growth overall if they actually prevent economic distortions from correcting.
When Fiscal Policy ‘Works’
There are times when fiscal spending surges or tax cuts can support economic growth in the short term. These tend to be when they help to reverse or prevent the emergence of ‘idle resources’ resulting from the unwinding of economic imbalances. For example, if a economy is suffering the effects of an economic bust and unemployment is high, an infrastructure stimulus or tax cut can be a quick way of putting these idle resources back to work. After the Global Financial Crisis, US growth would have been supported by a stimulus programme or tax cuts that benefited real estate construction. Those people left unemployed by the housing bust would have been re-employed and this would have lead to an increase in growth. That said, this increase in growth would have come at the expense of weaker growth in the future as economic distortions build creating a greater correction down the road.
Much Depends on the Economy’s Initial Health
The weaker the economy’s initial health, the less likely that any fiscal stimulus measures will be growth supportive, even in the short term. This is clearly seen in the behaviour of emerging market financial assets when their leaders announce profligate fiscal policies. Investors tend to fear that loose fiscal policy will lead to a rise in inflation, weaken growth, and raise default risk, and so tend to sell local bonds and the currency. This often results in shocks that undermine the economy and offset any positive direct impact from the fiscal stimulus.