What’s the alternative to Keynesian stimulus?

I read an article recently in Forbes about why the financial press buys into a non-existent Keynesian consensus, which prompted a conversation with a liberal friend about what the alternative to Keynesian stimulus is.

It’s telling that my friend didn’t know what the alternative to Keynesian economics was, though I think that’s typical of low- to medium-information Democratic voters.

Here’s my answer about the alternative:

Stimulus spending DOES stimulate the economy (Write this down; Bob’s actually saying this), which is why the Democrats are constantly trumpeting it.  Here’s the problem, though; it’s very hard to say that government stimulus actually stimulates the economy MORE than the alternative.  Economics is all about allocation of scarce resources.  When the government takes scarce resources and uses it for “stimulus,” it’s taking those resources away from other uses.  If the government didn’t use that money, then it would be used by other entities for other purposes.

It’s all about the multiplier effect.  Government spending, according to some, as a multiplier effect of 0.4-0.9 (which means that for every $1 of government spending, GDP growth is between $0.40 and $0.90), which means that it’s not effective.  Robert Barro of Harvard University has estimated from past stimulus packages (not the most recent one) that the government stimulus multiplier is 0.4 following the first year, and 0.6 in the second year and following.  Democrats would argue with that, saying that the multiplier effect of government stimulus is 1.1-1.2 (creating a positive GDP growth).  So, it’s debatable whether stimulus is effective or not.

What’s not debatable is that, relative to government spending, tax cuts are actually MORE effective as a way to increase GDP growth.  Tax cuts have a higher multiplier effect than stimulus does, which is why Republicans advocate for them.  Greg Mankiw, the chair of the economics department at Harvard, says that while government stimulus has a multiplier of about 1, tax cuts/adjustments have a multiplier of about 3 (which means that for every $1 of tax cuts, the economy grows by $3).  However, with tax cuts, you can only cut so much before you start cutting into essential government functions.  It’s kind of like the Federal Reserve rates in that respect; you can only cut them so much.

Why do tax cuts have a greater multiplier effect than government stimulus?  Because, fundamentally, the private sector is more efficient than government is.  If you give people a tax cut, that money is used more efficiently; those scarce resources are used more economically, thus creating greater growth.

When the government does a stimulus, the government officials are choosing what’s most important: roads, teachers, unions, construction, etc.  But, typically, they choose only those sectors from which their supporters come.  This is likely not the sectors where the resources are ACTUALLY needed, so the effect is a lower GDP growth.

I don’t think anyone can argue that stimulus “works,” because you’re pumping billions of dollars into the economy.  However, what you CAN argue about is whether it’s MORE effective than the alternative.  Democrats say you can’t do any better than a 0.9 multiplier; Republicans think you can.

The data on the 2009 stimulus package has been in for a long time; it wasn’t effective in raising GDP, and it caused a debt-drag on our economy that may cause a downgrade on our debt and a continually slow economy.