The Reality of the Fiscal Stimulus

di Giacomo Saibene

The debate between the so-called Keynesian and anti-Keynesians is still looking for a definitive resolution. On the one hand, Keynesians such as Krugman [1] and Stiglitz [2] argue for further fiscal stimulus. On the other, anti-Keynesians such as Taylor [3] and Greenspan [4] argue for a reduction in governments’ spending and a rebalancing of their fiscal position. Institutions are also involved in the debate: some, such as the International Monetary Fund [5] [6]and the Federal  Reserve [7], argue that this is not the right time to cut governments’ deficits, since recovery is still far from being strong, and that fiscal consolidation should be pursued only later in the future; others, such as the Bank for International Settlement [8] and partly the European Central Bank [9] and [10], appear to be more worried about governments’ deficits and thus call for immediate fiscal tightening.

In my view, the economic model behind this debate is the standard IS-LM, which was firstly translated into equations by economist John Hicks  [11],  in an effort to depict mathematically the insights of Keynes’s General Theory of Employment, Interest, and Money. Basically, the model tries to describe how the economy works, describing the mechanism through which the two main markets of the economy interact each other and push towards equilibrium: the equilibrium in the goods and services market is represented by the IS curve (Investment-Saving), while the equilibrium in the money market by the LM curve (Liquidity-Money); thus, the intersection of the two curves gives the domestic general equilibrium. The fundamental belief behind this model is in the causal relationship – not a simple identity – going from demand to income:

Y = C + I + G +NX

In words, income or GDP (Y) is stimulated by demand: private consumption (C), investment (I), government expenditure (G), and net exports (NX). Indeed, whenever I buy a good or service, I generate at the same time additional income for the person or firm from whom I buy it. Therefore, the more we demand and consume goods and services, and the more our incomes increase.

The Great Recession of 2007-2009 (and further) saw a dramatic decrease in demand: business investments plunged and consumers’ demand for goods and services decreased too, principally because of a decrease in disposable income (due to falling stocks prices, houses’ values, and credit availability). In turn, lower demand created a decrease in revenues and incomes – the Recession. The first instrument available to policy makers in responding to an economic crisis is monetary policy: the central bank can cut the interest rates (which is basically printing money) in order to stimulate investment. Krugman brilliantly explained the functioning of monetary policy (and more) in a short article titled Baby-Sitting the Economy [12], which I strongly suggest to read.

However, it could happen that monetary policy is not enough. In fact, once the economy falls in the Liquidity Trap, central banks cannot cut interest rates further, and their grip on the economy vanishes. Broadly, Keynesians believe that the answer to such crises lies in government intervention: authorities should intervene by expanding demand (increasing government spending) so as to restore GDP at least to its previous (higher) level. One of the major proponents of the idea that fiscal policy should act in a counter-cyclical way is certainly Minsky [13], who also discussed about the hypothesis [14] that financial markets are intrinsically unstable. Nonetheless, the idea of counter-cyclical fiscal policy is evidently fading away, as governments around the world are amending their constitutions in order to add balanced-budget provisions [15].

Almost three years after the first fiscal policy reaction by the Obama administration in February 2009 [16] and two years after the beginning of the Greek and the Eurozone crisis in October 2009 [17], a resolution of the debate between Keynesians and anti-Keynesians is still far from being reached, especially regarding the effectiveness of the fiscal stimulus. Yet, three main facts can be outlined, especially in relation to the U.S. economy.

1) First, the real effectiveness of fiscal stimuli. In theory, fiscal policy can raise aggregate demand through two main channels. First, government can increase demand directly by increasing government spending and keeping taxes constant. Second, government can increase demand indirectly by cutting taxes, making households’ disposable income rise and in turn increase final consumption. In practice, the effectiveness of government’s spending in stimulating demand is associated to the long-debated empirical question about the ‘true’ value of the fiscal multiplier, i.e. the ratio of a change in national income to the change in government spending that causes it. Some argue that it is lower than 1 (i.e. fiscal policy is ineffective), while other argue that it is higher than 2 (i.e. fiscal policy is strongly effective). However, in the case of the stimulus plan engaged by the U.S. administration, there seems to be a certain consensus about its ineffectiveness: it was badly designed [3] [18]. In fact, the fiscal packages approved by the US Congress were mainly about tax cuts, which were of little worth in a situation of excess savings and debt deleveraging [19], and they actually translated into higher savings rather than increased consumption.

2) Second, the dimension of the fiscal stimulus. Some argued that it was too big and it was a waste of money since it failed to restore employment. Others, and I among them, argue instead that the fiscal stimulus actually barely occurred.

In fact, the same definition of fiscal stimulus may be misleading. Broadly, governments have two policy tools: taxation (T) and expenditure (G). Fiscal policy is said to be expansionary (i.e. a fiscal stimulus) when the difference between government’s spending and revenues increases [20], namely when one of the following occurs: a rise in G, a reduction in T, or any combination of the two – everything else being equal. The problem is that, sometimes, other things are not equal. The Great Recession of 2007-09 made income and revenues from taxation fall sharply, mainly independently from governments’ decisions; as a consequence, government expenditure turned out to be greater than revenues (G>T), and fiscal policy began to be erroneously[a] recognized as “expansionary”.

Of course, part of the deficit was really a consequence of ‘real’ expansionary fiscal policy: both because of the presence of automatic stabilizers, such as the unemployment insurance, and discretionary fiscal policies, such as the tax cuts of the fiscal packages. Yet, this is not the bigger part, as the IMF already outlined it (figure 1). Fiscal stimulus and automatic stabilizers play only a minor role in the percentage increase of the government’s deficits: what truly caused the surge in deficits are the consequences of the slump, i.e. falling revenues.

Figure 1. Decomposition of Government Debt Increase, 2007-14 (total debt increase: 35.5 percent of GDP)


Source: WEO April 2010, Figure 1.7, General Government Fiscal Balances and Public Debt

The bigger insight, however, comes from the data about real total government expenditure: the alleged huge size of the U.S. fiscal stimulus is actually a myth. In fact, as recently pointed out by Krugman [21] and others [22], the increase in federal spending (fiscal stimulus + automatic stabilizers) was largely offset by a decrease in spending by states. As depicted in figures below, there has been barely a change in total expenditure by the U.S. government, which corresponds to the Keynesian G – what really matters in times of depression. The quarterly change in G exhibits almost no modifications after the occurrence of the recession, while GDP suffered a large drop (figure 3): the quarterly variations in G are impressively similar, regardless the period. Furthermore, beginning in July 2010, fiscal policy is actual becoming restrictive – the opposite of what the world economy needs! Government expenditure already decreased in real terms by about $ 60 billion compared with the peak of July 2010 (figure 2). Hence, arguing that Keynesians policies revealed to be a failure is just misunderstanding reality. We cannot affirm that such policies either do or do not work, since they had not been even really tried!

Figure 2. U.S GDP and total Government Expenditures (total level of US chained 2005 dollars, rescaled axes).


Figure 3. U.S GDP and total Government Expenditures (quarterly change, US chained 2005 dollars).


3) The third and final point is about the politicians’ approach to fiscal policy. Many governments worldwide are either supporting packages too focused on tax cuts (which might have a low efficacy, as argued earlier) or engaging in deficit-reduction plans that are not focused on anything. In fact, one may consider government spending much as a standard investment decision: there are always some alternatives from which to decide, each of them granting an estimated rate of return. First of all, borrowing had never been that cheaper for many governments worldwide (with the exception of the so-called peripheral members of the Eurozone): real interest rates are very low, either near to zero or lower. For instance, at the moment the U.S. Government faces negative yields:

Table 1. U.S. Treasury Real Yield Curve Rates.


Source: U.S. Department of the Treasury (

As argued by Martin Wolf [23], the chief economics commentator at the Financial Times, markets are actually telling governments to borrow and spend:

“What is to be done? To find an answer, listen to the markets. They are saying: borrow and spend, please. Yet those who profess faith in the magic of the markets are most determined to ignore the cry. The fiscal skies are falling, they insist.

HSBC forecasts that the economies of high-income countries will now grow by 1.3 per cent this year and 1.6 per cent in 2012. Bond markets are at least as pessimistic: US 10-year Treasuries yielded 1.98 per cent on Monday, their lowest for 60 years; German Bunds yielded 1.85 per cent; even the UK could borrow at 2.5 per cent. These yields are falling fast towards Japanese levels. Incredibly yields on index-linked bonds were close to zero in the US, 0.12 per cent in Germany and 0.27 per cent in the UK.”

To me, it seems unreasonable to believe that government expenditures yield the same rate of return regardless of their purpose. Spending on education or infrastructure provides certain yields, while spending on subsidies or military activities provides others. Therefore, when choosing what to cut or what to support, one must necessarily differentiate among the multiple alternatives that governments have to choose from; in my view, politicians have still a lot to do on this issue.



[1] Krugman, Paul. Optimal Fiscal Policy in a Liquidity Trap. The New York Times, 2011.

[2] Stiglitz, Joseph. To Cure the Economy. Project Syndicate, 2011.

[3] Taylor, John. An Assessment of the President’s Proposal to Stimulate the Economy and Create Jobs. Testimony, 2011.

[4] Greenspan, Alan. Fiscal Stimulus Worked Far Less Than Expected. The Wall Street Journal, 2010.

[5] Freedman, Kumhof, and Laxton, Lee. The Case for Global Fiscal Stimulus. IMF Staff Position Note, 2009.

[6]IMF. G-20 The Path From Crisis to Recovery. IMF Note on Global Economic Prospects and Policy Challenges, 2011.

[7] Bernanke, Ben. The U.S. Economic Outlook. Speech, 2011.

[8] Bank for International Settlements. 81st Annual Report. 2011

[9] Rother, Schuknecht, and Stark.The Benefits Of Fiscal Consolidation In Uncharted Waters. ECB, Occasional Paper Series, No 121. 2010.

[10] European Central Bank. Annual Report. 2010.

[11] Krugman, Paul. There’s Something About Macro.

[12] Krugman, Paul. Baby-Sitting the Economy. Slate, 1998.

[13] Minsky, Hyman. Stabilizing an Unstable Economy. McGraw-Hill, 2008.

[14] Cassidy, John. The Minsky Moment. Comment, The New Yorker, 2008.

[15] Balance-budget amendment. Wikipedia, 2011.

[16] U.S. Government. The Recovery Act.

[17] The Associated Press. A timeline of Europe’s debt crisis. Businessweek, 2011.

[18] Feldstein, M. Why Has America’s Economic Recovery Stalled? Project Syndicate, 2010.

[19] Krugman, Paul.Debt, deleveraging, and the liquidity trap. VoxEu, 2010.

[20] Weil, David. Fiscal Policy. Library of Economics and Liberty.

[21] Krugman, Paul. The Truth About Federal Spending. The New York Times, 2011.

[22] Aizenman, Joshua, and Pasricha, Gurnain Kaur. The net fiscal expenditure stimulus in the US 2008-2009: Less than what you might think. VoxEu, 2010.

[23] Wolf, Martin. We must listen to what bond markets tell us. Financial Times, 2011.


[a] Paradoxically, by associating the stance of fiscal policy to the figure “government’s deficit as a percentage of GDP”, even a contractionary fiscal policy may be viewed – erroneously – as an expansionary fiscal policy: when a drop in GDP causes deficit (%GDP) to rise. The following fiscal policy, however, would be contractionary if remained unchanged. Indeed, assuming G and T to remain unchanged, the only different thing is the greater tax burden, now spread over a lower GDP than before the slump and thus affecting negatively disposable income. After a recession, deficits (%GDP) must increase by definition assuming fiscal policy to remain unchanged.

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