Fiscal stimulus and leakage

On this fine Waitangi day, Marginal Revolution mentions that Ireland is actually cutting spending in the face of a deteriorating economic climate.

Tyler Cowen gives a few reasons why this may be the way to go for Ireland:

A few things are worth noting.  First, a small open economy has a harder time making fiscal stimulus work.  Second, a small open economy often has to worry more about its credit rating.  Third, a small open economy offers a tougher testing ground for macroeconomic “field experiments” because there are more confounding external factors

Looking solely at the first point, it is “harder to get the stimulus to work” because of “leakage”. Fundamentally, some of the stimulus will lead to an increase in production overseas (through rising imports) rather than greater production at home.

This matters because the purpose of the stimulus is to increase “domestic production” to increase employment to its natural rate.  If all the stimulus does is increase imports then it doesn’t do this.  (Although I would note that if it did solely increase imports, the exchange rate would depreciate, which should lead to some substitution from imports to domestic production)

For small open economies the idea of a fiscal stimulus may become a “prisoner’s dilemma” where all the countries are best off if everyone stimulates but there is the potential for an individual country to “free-ride” by taking the stimulus from overseas and not stimulating themselves.  In this case, each country will individually choose not to stimulate – and they will all end up in a situation where output is stuck below potential (this has been mentioned before by Paul Krugman etc – does anyone have the links, I can’t find them 🙁 )