The problem with stimulus (in local government spending)

There is a paper by Ishii and Wada from the Peterson Institute for International Economics, that focuses on Japan's fiscal packages and why they haven't worked in the period from 1992 to 1996 - in times of their immediate response to the aggregate demand shock (which was really a structural shock to their booming economy). 

Here is what they say:
"Our main finding is that, from 1992 to 1996, real discretionary fiscal spending was merely 21 trillion yen in public works. This is about two-thirds of the officially announced public works spending during the period. Meanwhile, tax revenues declined by about 33 trillion, which is approximately equivalent the total officially announced tax cuts. A closer look reveals that the local governments, not the central government, failed to spend announced discretionary fiscal spending. In addition, there is evidence that much of the public work was geared toward projects of dubious significance. However, the key to solving the mystery of Japanese fiscal packages is the awkward and fettering fiscal relationship between the central and local governments."
Their argument is supposed to be something like: don't blame the central government - they tried everything they could, blame the local government for the stimulus not working. 

But that's actually the point when you think about it. All the money gets distributed to local firms and local projects. In that process the inefficiency of local agents (politicians and bureaucrats) will disturb the effect of central government policies. This is true not just for the stimulus but for a number of laws and rules that get passed. Basically, the more detached a country's local government from its central government, the less likely a stimulus would work. 

Their findings on low quality public spending and the fact that public investments didn't lead to growth can tell us a lot on the effectiveness of the stimulus in the real world, outside the Keynesian fiscal multiplier model. It tells us (1) that bureaucrats cannot provide a a better evaluation of who should get government funding than market actors themselves. They don’t have any responsibility on distributing the funds and they don’t have any obligation (or knowledge for that matter) to make an effective decision over who gets the funds.

Furthermore, (2) on a local level corruption and cronyism get into the picture where local politicians hand-pick the projects they would like to see go through. This is far from a market allocation mechanism. And this is the elementary reason why a fiscal stimulus will be ineffective. It will mostly give money to favourable enterprises who enjoy political support, thus furthering their inefficiency and lack of adaptiveness.

This was one of my biggest questions for the proponents of fiscal stimuli: Why would they expect that the model version would work in a world with imperfect agents? Particularly if these imperfect agents lack real accountability? 

Moving away from the pre-crisis instabilities 

Raghuram Rajan has an interesting article on Project Syndicate on that issue from another interesting angle:
"The neo-Keynesian economist wants to boost demand generally. But if we believe that debt-driven demand is different, demand stimulus will at best be a palliative. Writing down former borrowers’ debt may be slightly more effective in producing the old pattern of demand, but it will probably not restore it to the pre-crisis level. In any case, do we really want the former borrowers to borrow themselves into trouble again? 

The only sustainable solution is to allow the supply side to adjust to more normal and sustainable sources of demand – to ease the way for construction workers and autoworkers to retrain for faster-growing industries. The worst thing that governments can do is to stand in the way by propping up unviable firms or by sustaining demand in unviable industries through easy credit."
This is the exact position this blog has been advocating from the start - move away from the pre-crisis unsustainable growth model and think of the enduring crisis as a structural shock, not an aggregate demand one. This will imply a long recovery, but at least it will enable the markets to adjust and restructure. 

Rajan accounts for this and doesn't forget Japan: 
"Supply-side adjustments take time, and, after five years of recession, economies have made some headway. But continued misdiagnosis will have lasting effects. The advanced countries will spend decades working off high public-debt loads, while their central banks will have to unwind bloated balance sheets and back off from promises of support that markets have come to rely on. 

Frighteningly, the new Japanese government is still trying to deal with the aftermath of the country’s two-decade-old property bust. One can only hope that it will not indulge in more of the kind of spending that already has proven so ineffective – and that has left Japan with the highest debt burden (around 230% of GDP) in the OECD. Unfortunately, history provides little cause for optimism."
No, not even in the zero lower bound 

Some time ago Tyler Cowen wrote a great post on the fiscal multipliers and the ZLB trap in an open economy, to which Scott Sumner reacted in claiming that the New Keynesian theory cannot explain neither Japan or the UK. They both dismantle the idea that expansionary fiscal policy can be effective because of the zero lower bound. 

This, I feel, is the basic point I was trying to make in my previous texts on fiscal multipliers and fiscal stimuli as a way to boost the economy (see here, here, and here). It is summed up by paper from Fujiwara and Ueda:
"Incomplete stabilization of marginal costs due to the existence of the zero lower bound is a crucial factor in understanding the effects of fiscal policy in open economies. Thanks to this, government spending in the home country raises the marginal costs of home-produced goods, which increases expected inflation rates and decreases real interest rates. Intertemporal optimization causes consumption to increase, so that the fiscal multiplier exceeds one. While government spending continues, the price of home-produced goods increases more than that of foreign-produced goods. Expecting that two countries are at symmetric equilibrium when government spending ends, the home currency depreciates and the home terms of trade worsen on impact when government spending begins. That shifts demand for goods from foreign-produced goods to home-produced ones. The fiscal spillover thus may become negative depending on the intertemporal elasticity of substitution in consumption."


  1. "This was one of my biggest questions for the proponents of fiscal stimuli: Why would they expect that the model version would work in a world with imperfect agents? Particularly if these imperfect agents lack real accountability? "
    Love to hear the answer to this one :D

    Love the concept in Fujiwara and Ueda , Im definitely going to try to find time to read the paper (among other things Im trying to find time for :D).

    Here's Allan Meltzer on the issue of fiscal stimulus in Japan, from an older paper I read a few weeks ago :
    "As public debt mounted, the risk increased that the government would have to renege partially on its pension and healthcare promises. The public responded by increasing saving relative to GDP, offsetting part of the effect of fiscal stimulus. Believing their pensions were threatened, households tried to restore personal wealth. The more they responded this way, the smaller the effect of fiscal expansion on GDP. The government's response was to further increase the fiscal deficit absolutely and as a percentage of GDP.
    Further, much of the fiscal stimulus took the form of public works with low contribution to productivity and high maintenance cost. A rational person could not believe that today's government spending would yield higher future incomes that would pay the unfunded liabilities for pensions and health care or service the debt. Perhaps tax cuts that helped the public to restore its desired wealth position would have helped the public to achieve its goal and, thus, slow the increase in the saving rate. Deregulation that increased efficiency and productivity would have had a positive effect also. "

    I normally dont view savings as something bad, but I think in Japan additional savings basically helped fuel more government consumption reinforcing the vicious circle described above, while delaying the restructuring of broken banking system clogged channels for private (more efficient) allocation.

    I guess you wouldnt agree with Sumner on the need for monetary policy rule which would imply more easing at this point lol, but more on that on market monetarism post ;) (I havent forgot)

    1. Those are some very good points. Meltzer is a great economist, I recommend his newest excellent book "Why Capitalism"

      I'm glad you haven't :)

  2. I'm glad to have read these texts on the faulty of fiscal stimulus and deficit spending approaches (both this one and the one before that). The "textbook solution" to crises is proving to be more and more wrong and what bemuses me is the increasing number of people subscribing to this failed approach..

  3. So I want to understand this. If Britain (for instance) wanted to do a Keynesian fiscal stimulus, then the price of domestic goods and services would rise contra imports? I am not sure what effect, if any that would have on economic growth. However, Meltzer's description of Japan's woes is easy to understand. In addition you have the evidence that nation's with a high debt simply do not have much growth.

    1. It would have a negative effect on net exports and hence a negative effect on GDP growth. But yes, Meltzer makes it more straightforward


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