"OK, Stimulus Isn't Always a Good Idea, but It's Necessary When a Country Has a Large Output Gap."
False. Fiscal stimulus is rarely beneficial. Before the global financial crisis, there was broad macroeconomic consensus that fiscal policy was not an appropriate tool for moderating the business cycle. It's slow, imprecise, and difficult to reverse. Monetary policy, by contrast, can be decided, implemented, and withdrawn instantly and is thus a far superior vehicle for countercyclical policy.
But in the midst of the financial crisis, desperate G-20 leaders threw these well-established insights overboard and embraced old-style Keynesianism once again. At the November 2008 G-20 summit in Washington, leaders declared their intention to "use fiscal measures to stimulate domestic demand to rapid effect, as appropriate, while maintaining a policy framework conducive to fiscal sustainability." It would have been better if they had stuck to monetary measures.
Fiscal stimulus requires parliamentary authorization, which takes time and usually involves complex compromises. Typical projects, such as infrastructure investments, take years to implement, easily turning procyclical. In this way, temporary fiscal stimulus tends to become permanent, leading to chronic budget deficits. Cyprus and Slovenia offer excellent illustrations. In 2008, both countries had relatively small public debt loads (22 and 49 percent of GDP, respectively). In 2009, however, both expanded their budget deficits to 6 percent of GDP, where they got stuck, eventually ending up in financial crisis.
In theory, an output gap represents free capacity, but in periods of severe overheating, like in 2007, economies are operating far beyond their capacities. According to the European Commission, for example, Latvian GDP in 2007 was as much as 14 percent above actual capacity. In such cases, what looks like an output gap is actually nothing but the usage of borrowed resources. It is also difficult to assess whether free capacity is of real economic value until years later. Often, an apparent cyclical problem turns out to be structural. In the 1970s, for example, Western Europe considered its steelworks and shipyards in cyclical crises until it became apparent that they were chronically underperforming and had to be closed down. "Output gaps" that have lasted for five or more years are probably chimeras.
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