Keynesians wrongly believe that government spending during recession (i.e. fiscal stimulus) will stimulate the economy to the extent that the money will put into motion the idle resources.
There are still phenomena of creative destruction at work, regardless of the business cycle. Some industries naturally disappear due to a shift in consumer preference. Clearly, these obsolete industries were destined to disappear due to technological advances, even in the absence of recession. Government cannot distinguish between the obsolete industries and the slack industries which result from the recession. He will inevitably inject funds into industries that do not need it.
According to the keynesian theory, fiscal stimulus encourages the subsidized industries to invest. There is no reason to assume that investment would necessarily increase. Subsidized firms could realize that the injected funds keep their activity afloat for a short period of time, until the economy recovers from recession. If so, these firms would know that the actual demand for their product is temporary. They will not increase investment.
One of the biggest flaws of keynesian economics is to assume that government spending during a recession would not cause a crowding out effect until the economy reached full employment. The assumption, therefore, states that the fiscal stimulus would only affect idle resources (including unemployed workers). But in reality, there is no guarantee that the money will be spent exclusively on unemployed workers. There is no way to avoid this dilemma. When slack industries will be finally able to hire some workers, skilled or non-skilled, thanks to the injected funds, part of them are likely to come from another job. See Garett Jones (2011) for empirical evidence of the crowding-out effect. Also, when subsidized firms get the money they will be able to compete, and out-compete, their competitors for resources such as nails, steel, or lumber. In subsidizing the less needed industries, the fiscal stimulus will make the economy less productive.
In addition, most projects are not “shovel ready” (Jones, 2011) which means that most of them will require engineers and other specific skills to do the planning. To make things even worse, if the projects require some qualified and specific skilled workers, the problem arises when the skills offered by the unemployed do not match the skills demanded by the firms, because the unemployed have not these qualifications or because there is a lack of unemployed with such qualifications, the subsidized projects will fail to obtain the kind of labor they need. This would unavoidably delay the stimulus projects.
If keynesian stimulus did work in stimulating private consumption of final consumer goods, the process could operate only at the expense of the stages of production furthest from consumption. Thus, the early stages of production will experience a massive contraction, leading to a contraction in the sectors and jobs located in early stages. And precisely because of that, the economy will tend to be less capital-intensive and, accordingly, to be poorer than before.
So, basically, when government stops spending money, the jobs which have been previously diverted from the stages further from consumption need to be recover and workers hired in temporary funded projects will lose their jobs once again. Because the government will increase taxes in order to pay the debt, whether stimulus package is financed by taxes or borrowing, unemployment is also expected to increase. Unless labour market flexibility is facilitated, private firms would find it more difficult to hire workers.
What the economy really needs during a recession is flexible labor markets so that resources (including workers) will be directed toward where they are actually needed. Keynesians may argue that nominal wages are rigid downward because workers are reluctant to wage cuts. But the newly unemployed could not resist a wage cut when the other option is to die from starvation. They will necessarily accept a cut in wages. It could be argued however that a further drop in wages will depress private consumption even more. But customers would necessarily notice the increased amounts of money in their wallet as a result of the price decline. Furthermore, customers will not refrain from purchasing to the point of dying of starvation. Also, a quick drop in wages until reaching the equilibrium level could not incur downward expectations as it would do if wages fall slowly for a long time before reaching the equilibrium level. Perpetuating the downward trend in prices will stimulate withholding of labor purchases, encouraging businessmen to wait for a further drop. As Rothbard explained, a quick fall in wages will “not lead businesses to wait further before investing in labor, it will stimulate businesses to hurry and invest before wage rates rise again” (Murray N. Rothbard, “America’s Great Depression”, 2000, pp. 47-48).
Resources will remain idle unless prices and wages are allowed to decline. And if some resources remain idle in spite of the decline in prices, this would mean that those idle resources are considered by their owners to be more useful. They would in fact expect a higher return in the near future. That is the very reason why these resources are still idle. Contrary to what Keynes posits, idle resources provide an important economic service, by ensuring that there will still be capital to invest after the collapse of the bubble, as long as entrepreneurs are willing to bet they will be more wanted later (William H. Hutt, “The Theory of Idle Resources”, 1939, pp. 25-26, 26-27). Goods in their continued idle existence simply reflect an expected revival of demand or an expected fall in costs (Hutt, pp. 15-16). Thus, the “availability” of a good, a resource, whatever it is, can itself represents a service as long as it is regarded as income for its owner. Fiscal stimulus will waste those resources in projects for which there is uncertainty about the existence of a private demand.
Another concern arises from the politicisation of stimulus spending. If such politicisation cannot be avoided because of government’s desire to “buy” votes, the money will go to some privileged groups. How could fiscal stimulus be even effective ?
To summarize, the problem with keynesian stimulus is that while its short-term effectiveness is unclear, its very high costs on the short and the long run are indisputable.
Further reading :
The “Multiplier” Concept Must Be Entirely Discarded