Which Part of the Stimulus Worked the Best?

by Veronique de Rugy

This is the question that Dartmouth economists James Feyrer and Bruce Sacerdote ask in a new paper published by the National Bureau of Economic Research called “Did the Stimulus Stimulate?

Whatever the problem with the article maybe, they authors start with an interesting point: the models used by pro- and anti-stimulus economists to evaluate the impact of the stimulus are relatively useless because no one knows what would have happened without the spending bill.

The fundamental problem is the lack of a counterfactual. We do not know what the path of the economy would have been in the absence of the stimulus. Without a counterfactual, the best we can do is fall back on our models. Unsurprisingly, the models tell the same story today that they did when arguments for and against the stimulus were being made.

For instance, talking about Zandi and Binder — who wrote that the “effects of the stimulus appear very substantial, raising 2010 real GDP by about 3.4%, holding the unemployment rate about 1½ percentage points lower, and adding almost 2.7 million jobs to U.S. payrolls” — they write:

This conclusion, however, could have been written before the ARRA was implemented, knowing only the intended policy path. Their methodology does not take any account of the actual path of employment after the passage of the bill.

That’s stunning, but Zandi and Binder’s models aren’t the only ones suffering from this flaw. That’s why Feyrer and Sacerdote use a different approach — they compare states and counties that got heavy doses of stimulus spending with those that didn’t, and look at the trends in growth and unemployment in these regions. One of potential problems with this technique is that regional differences in stimulus spending can be the expression of how bad the economic situation was there before the stimulus; they attempt to address is by falling back on the political economic literature that has established that states whose representatives have higher seniority in Congress tend to receive the most money per capita. (This finding is one that I highlighted in my paper “Stimulus Facts” back in April last year. Looking at the reported data on Recovery.org, I found that how long the district’s representative has been in office seems to have a small but significant impact on how stimulus money was spent.)

They also break down the spending by federal agency:

In examining the spending patterns we found that the agencies fell naturally into three groups. The first group includes agencies providing block grants to fund local government employment. A large proportion of spending by the Departments of Education and Justice were used to fund teachers and police at the local level. The second group consists of support to low income families. Spending by the Departments of Agriculture, Health Education and Welfare, and Housing and Urban Development had a large component of support to low income individuals (food stamps,Medicaid, and rental assistance). The spending of the third group largely consisted of paying for new infrastructure projects. This group includes the Departments of Transportation and Energy which funded building projects.

What they find is that in the short run, the stimulus did boost the economy, even though not to the extent promised by the administration. Why? Because the the stimulus was designed so that large amounts of money went to the states, which used the money to pay for education and law enforcement, which is not stimulative. Their model finds that programs to support low-income households and infrastructure projects are.

This all suggests that a stimulus package that did not include state level grants for local services would have been more effective per dollar than the actual stimulus package.

This could be important at a time when the states are in crisis (as outlined in this great post by Andrew Stiles this morning) and it won’t be long before they ask for a bailout. Bailing them out would likely take the form of transfers from the federal government to the states to pay for their teachers and other public employees. But it doesn’t work. It can’t work. States must address the underlying problems that are the source of the crisis: pensions and education spending, among other things.

So what now? Over at Economics One, economist John Taylor has a series of charts showing a correlation between increases in private investment (not government-purchase-labeled investment) and reduction in unemployment. Here is one:

Taylor writes:

The time series in the third chart [included above] show the relationship from another perspective. Either way you look at it, the relationship between unemployment and the investment share is remarkably close. It holds for both non-residential and residential investment, and is a subject of my current research. Of the four shares of GDP (the other two of course being consumption and net exports), the investment share shows by far the largest negative association with unemployment.

Encouraging the creation and expansion of businesses should be the focus on government efforts to reduce unemployment. The recent compromise agreement to prevent the increase in tax rates on small businesses and the move to lighten up on the anti-business sentiment coming out of Washington are two steps in the right direction.

Update: Over at Money Illusion, Scott Sumner criticizes the attempts to answer macro questions which micro economic tools as in the Dartmouth study.