Mr Rudd's Helicopter is No Magic Pudding

By Peter Swan  Friday, 6 February 2009  Features

Professor Peter Swan, from Banking and Fi​nance at the Australian School of Business, writes about the Federal Government's proposed stimulus package. An edited version of this opinion piece appeared in the Sydney Morning Herald on Friday 6 February 2009.

Now that the Opposition has, rightly in my view, refused to endorse Mr Rudd's helicopter dump of an additional $42 billion of cash on the Australian economy, it is time to ask what its likely consequences are. Almost certainly, its net stimulatory effect is likely to be either zero or negligible within the context of a global decline in the demand for our exports.

To understand this we need to revisit John Maynard Keynes General Theory that hit the Depression-devastated world like a bombshell in 1936. Keynes recognised that under such conditions with vast under-utilised labour and capital resources there may be scope for additional government expenditure to boost demand and put idle resources to use. This theory became known as the Keynesian income multiplier. If this multiplier is zero then a $1 additional "spend" "crowds out" an equal amount of private expenditure. Output remains unchanged but its new composition reflects the nature of the spend.

By contrast, new converts to Keynesianism such as Mr Rudd and Mr Obamba believe in a positive multiplier. Additional government outlays such as handouts to those most likely to spend it create new income that is additional to the governmental spend as the unemployed ​are put to work. This process is perfectly captured by Norman Lindsay's "magic pudding" that freely recreates itself the more that is eaten. This is a brilliant satire on the unmet promises of Australian politicians.

Where does this income come from? The innards of the magic pudding lie in the failure of the unaided private sector to make use of essentially "free" resources. Keynes pointed to downwardly "sticky" money wages. Workers would accept lower real wages if governments printed more money to depreciate the currency (shades of Mr Mugabe and Zimbabwe) but unemployed workers would not accept a job if lower money wages were on offer. If $1 of additional government demand stimulates $1 of new private demand as the unemployed are put to work digging useless holes in the ground, then society is better off. With this multiplier of one or more we can have our cake and eat it, too. Unlimited infrastructure could be built at essentially zero or negative cost.

Yes, Mr Rudd will spend $3.9 billion of newly borrowed funds employing people to provide free ceiling insulation to those who have chosen not to do so prior to now. But this handout, along with much of the remaining outlays of $38 billion, will most likely simply displace an equal amount of private sector consumption or investment leaving little or no net stimulus. Those who have already paid to insulate their own homes will be left fuming.

How can this be so when politicians are always telling us that the outlaid billions on the 2000 Sydney Olympic games, etc., have large Keynesian multiplier benefits? How do we know that what was taught in introductory macroeconomics courses is fantasy? New South Welshmen know that, far from taking off following the Olympics, the economy has been in the doldrums ever since. Robert Barro at Harvard (WSJ Jan. 22, 2009) has carried out a more authoritative study. He analysed what seems a good case for the Keynesian pudding. This was the 1943-44 U.S. war expenditure amounting to a massive 44% of GDP per year ($US 540 billion p.a. in 1996 dollars).

This raised GDP inclusive of war-related acquisitions by US$ 430 billion, so that GDP exclusive of war-acquisitions actually fell but not by as much as the rise in war expenditure. Barro observed a multiplier of 0.8. Due to the temporary nature of the wartime hardships, patriotism, conscription, the entry of women into the workforce, etc., motivating better outcomes, no comparable success could be obtained for peacetime purchases. In peacetime, his studies indicate a multiplier of approximately zero. But then we are yet to experience the devastation of the Great Depression.

Surely, the war-footing of the U.S. economy cannot be the only example where Keynesian deficits provided at least some net benefit? Did not Roosevelt's 1933 New Deal help bring the U.S. economy out of the mire of the Great Depression? Harold L. Cole and Lee E. Ohanian (WSJ Feb. 2, 2009) argue that it actually postponed recovery by deliberately creating monopoly to foster high wages for those in jobs. Similarly, it has been part of the Democratic Party policy to promote high wages for unionised auto workers, helping to bankrupt U.S. car manufactures, and also artificially promoting "affordable housing", the precursor of the subprime crisis.

In the Australian context one of the most prominent early advocates of Keynesian pump-priming was my father, Trevor W. Swan. He was an author of the 1945 White Paper on Full Employment. However, it was never necessary to implement such policies to achieve full employment due to the post-war boom. By 1956 he became disillusioned with simplistic Keynesian remedies to the extent that he invented a new economics-neoclassical growth theory-at the same time as, but independently of, Bob Solow at MIT.

If Wednesday's headline, "Average family richer by $3,800", is grossly misleading, what should be done? Given the poor state of infrastructure in Australia, projects with high ratios of benefits to costs should be adopted. This is true even if they cannot be commenced immediately. The quality of the spend is paramount. Taxes falling on private sector investment can be eased to encourage higher private uptake. Handouts, like the earlier $10 billion giveaway that created a temporary Christmas blip, are the centrepiece of the Rudd Plan. They should have no place in a sensible package based on neoclassical growth theory to build long-term sustainable wealth.