The $819 billion fiscal stimulus package proposed by the Obama administration was passed by the House of Representatives last week and is now under consideration by the US Senate. There is intense debate going on, both inside and outside the US, on whether the package is adequately sized and effectively targeted.
Even as divergent opinions are being voiced on these two issues, a third dimension of the package is stirring up a different kind of controversy. This relates to a 'buy American' clause in the proposed legislation, which requires the purchase of locally produced iron and steel products for any construction activity financed by the package. Only if this requirement causes the budget for the project to increase by more than 25 per cent can it be waived.
The analytical underpinning for this clause comes from a particular interpretation of the well-known Keynesian 'multiplier,' which is the force by which increased spending translates into faster growth.
Proponents of the clause argue that the multiplier effect is enhanced if more money is spent on goods and services produced domestically. Conversely, the impact is diluted when the spending is on imports. While there is probably some merit to this in a simplified textbook framework, opponents of the clause argue that the real world is too complicated to be viewed in these terms. The opposition comes from economists as well as politicians in other countries.
On the political side, Peter Mandelson, UK cabinet minister and former EU trade commissioner, has criticised the clause. He has suggested that the natural response of all other countries would be to look for ways to retaliate against the US.
The UK is the current chairman of the G-20, whose resolution last November explicitly stated that no recourse to protectionism would be made while solutions to the global crisis are being worked out. In fact, UK Prime Minister Gordon Brown raised concerns about the tendency towards protectionism in financial services during his speech at Davos last week, arguing that it would severely hamper a global recovery.
Even though George W Bush hosted the November G-20 meeting and signed on to its resolution, it does represent an international commitment by the US which the 'buy American' requirement clearly goes against.
From an analytical perspective, at the very least, by increasing the cost of projects, the requirement would constrain spending on other activities. However, beyond this, the categorical conclusion about the magnitude of the domestic spending multiplier breaks down in a multi-country context. For example, even if, say, Chinese steel were used on the grounds that it was cheaper than American steel, Chinese companies may use part of the earnings to buy American equipment or software or financial services.
Greater global integration itself generates positive multiplier effects. This was a bitter lesson learnt during the Great Depression, during which protectionist responses by all the major economies served only to intensify and prolong the crisis.
President Obama is clearly playing to some rather vociferous domestic interests, something that any politician is always prone to do. But then, he has taken pains to project himself as an extraordinary politician. Besides which, his honeymoon period is far from over, giving him ample ability to resist the potentially destructive agenda of these interests. Even as the rest of the world looks up to the US to lead the economic turnaround, with this requirement it demonstrates an unfortunate reluctance to play that role.
This is of a piece with the bail-out of the three big American car companies, after they have been unable to compete effectively against cars made by other firms both in and outside the US. Japan, South Korea and others can legitimately argue that the bailout package is trade-distorting and therefore a form of protection. If the world's largest economy responds to the economic crisis in this fashion, then there is trouble ahead.
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