Fiscal Stimulus or Fiscal Depressant?

The “fiscal multiplier” is one of the basic building blocks of  Keynesian economics and the centerpiece of modern macroeconomic analysis of the effects of fiscal policy. Contrary to the impression given by Paul Krugman and other proponents of fiscal stimulus, however, there is no clear consensus among economists regarding the size of the multipliers that are used to estimate the amount of additional income created by an additional dollar of government spending (or tax cuts).

A remarkable example of the disagreement among economists regarding the size of the fiscal multiplier for government spending occurred in early 2009. In assessing the likely impact of President Obama’s $787 billion stimulus program on the U.S. economy, economist Robert Barro argued that the peacetime multiplier was essentially zero. That is, each additional dollar of government spending would displace or “crowd out” exactly one dollar’s worth of private consumption and investment, resulting in a negligible effect on employment.  In sharp contrast, Christina Romer, then Chair of President Obama’s Council of Economic Advisers, argued that a multiplier of 1.6 should be used in estimating the new jobs that would be created by the stimulus program. This sharp difference between Barro’s and Romer’s multiplier estimates translated into an enormous disparity of 3.7 million new jobs, the number which Romer notoriously claimed would be generated by the stimulus package by the end of 2010.

In an IMF Working Paper entitled How Big (Small?) Are Fiscal Multipliers? published in 2011, co-authors Ethan Ilzet, Enrique G. Mendoza and Carlos A. Vegh attempt to more precisely measure the size of fiscal multipliers. Ilzet et al. use a new and unique data set to statistically estimate government spending multipliers for countries sorted according to several “key characteristics” of the policy regime under which fiscal policy may be conducted. While most studies use annual data or quarterly data interpolated from annual data, Ilzet et al. use only data that have been originally collected on a quarterly basis. The study takes a sample of 44 countries comprising 20  high-income and 24 developing countries and covers a period from the first quarter of 1960  to the fourth quarter of 2007, although the extent of the coverage varies across countries.

The most significant findings of the study, especially as they relate to the key characteristics of the U.S. economy, are very interesting. The “impact”  multiplier for high-income countries is 0.37, which is to say that one added dollar of government spending is associated with only 37 cents of additional output in the quarter in which it is undertaken. But since fiscal stimulus packages are usually implemented over time, it is the “cumulative” or long-run multiplier that is more relevant because it accounts for the full effect of the fiscal expansion. For high income countries the cumulative multiplier is estimated at 0.80  over 20 quarters. Thus even in the long run, 20 cents of private output (consumption plus investment plus net exports) is crowded out by  each dollar of government spending that accrues to GDP.

When countries are sorted according to exchange rate regimes, the study finds that for countries with flexible exchange rates like the U.S., “the multiplier is negative and statistically significant on impact and statistically indistinguishable from zero in the long-run.” This essentially means that, in the long run, for every additional dollar of income created by government spending, one dollar of income created by private consumption, investment and net exports combined is destroyed. In contrast, for countries with fixed or “predetermined” exchange rates, the long-run multiplier is 1.5. The authors explain this difference by noting that monetary authorities operating under a fixed-exchange rate regime typically expand the money supply in order to prevent the appreciation of their currency that would result from the capital inflow induced by the higher interest rates associated with  the fiscal expansion (deficits). Under flexible exchange rates, the monetary authorities maintain the money supply unchanged and permit the exchange rate to appreciate which reduces net exports.  Thus the zero long-run multiplier estimated for this case reflects the fact that overall output does not change because the rise in government spending is exactly offset by the decline in net exports. The authors conclude that “differences in monetary accommodation are the main cause for differences in he magnitude of fiscal multipliers across exchange rate regimes.” In other words, absent inflationary monetary policy, fiscal stimulus is essentially ineffective.

Last and most important for the U.S. economy, the study sorts the sample into “country-episodes” where the total central government debt to GDP ratio has exceeded 60 percent for more than three consecutive years. This is the case for the U.S. from 2007 to the present. For the high-debt country-episodes the impact fiscal multiplier is close to zero and the long-run multiplier is -2.30. This means that $1.00 of additional government spending has no effect on impact but in the long run destroys $2.30 of total output in the economy.

The authors conclude, in part:

We have found that the effect of government consumption is very small on impact, with estimates clustered close to zero.  This supports the notion that fiscal policy (particularly on the expenditure side) may be rather slow in impacting economic activity, which raises questions as to the usefulness of discretionary fiscal policy for short-run stabilization purposes. . . . Further, fiscal stimulus may be counterproductive in highly-indebted countries; in countries with debt levels as low as 60 percent of GDP, government consumption shocks may have strong negative effects on output. . . . Moreover, fiscal stimuli are likely to become even weaker; and potentially yield even negative multipliers, in the near future, because of the high debt ratios observed in countries, particularly in the industrialized world.

Of course, the very concept of a fiscal multiplier is completely rejected by Austrian economists and it has been subject to detailed and devastating critiques in the works of  Henry Hazlitt, William Hutt, and Murray Rothbard. But the dawning realization among mainstream economists that government spending, at least in some circumstances, may actually destroy income and depress economic activity is a long overdue and highly welcome development.


  1. === ===
    Economic News of the Future:

    Keynesian economists I.M.Whacknut and M.T.Mindset have released a breakthrough paper. By simplifying their observational protocol, they have identified the direct operation of the Keynesian Multiplier. “We are surprised that this simple system shows such a clear signal”, reports Mindset.

    They set out to observe money in action “in the wild”, in a local administrative office. Whacknut: “We thought that there would be a better paper trail in an office”. They were rewarded almost immediately.

    The company president Toppman took $9 from corporate cash to buy 12 donuts (stimulus spending) for a morning meeting. He presented these to the staff. It took Whacknut and Mindset only a moment to realize what they had witnessed.

    12 donuts of value came into possession of Toppman, which then produced 12 donuts of value in the meeting system, where unfortunately they were consumed. The total of 12 + 12 = 24 donuts is a direct representation of the Keynesian multiplier of 2.0 in this case.

    Whacknut: “These types of transaction are usually fragmented, poorly documented, and devilishly hard to measure. The tiny scale of the donut transactions nevertheless reveals the essential nature of the Multiplier.”

    Whacknut and Mindset are working on a more sophisticated experiment, where Toppman gives the donuts to secretary Sally, who then presents the donuts to the staff. Whacknut: “We believe that we can achieve a Multiplier of 3 in this case, and even higher values in the future”.
    === ===

    An absurdity. If government spending of $100 creates $150 in wealth, then why doesn’t this apply to ALL spending? The $50 you spend for groceries should produce $75 in wealth. In fact, all money spent each day should produce 1.5 times in wealth of the current day’s spending, sometime in the near future. This would lead to a wealth explosion, as total wealth increased by 50% every few months. Heck, even if it increased by 5% every few months.

    There is no wealth multiplier greater than 1. If there were, we would all be living in Aruba by now as a result of huge government borrowing and spending.

    If there were a multiplier such as the 1.5 multiplier claimed by the Obama team, then we could Counterfeit Our Way to Wealth.

  2. In 1959, Hazlitt wrote: “I have said that a whole literature has developed around this concept of “the multiplier.” There are many different concepts, in fact: the “logical” theory of the multiplier, which assumes no time lag; the “period-analysis” concept, which assumes time lags; the “comparative-statics” analysis, and so on. Immense ingenuity has gone into the mathematical development of these theories. But if the reader wishes to economize his time before he plows through the monographs of the multiplier addicts he will ask a few simple questions: What reason is there to suppose that there is any such thing as “the multiplier”? Or that it is determined by the “propensity to consume”? Or that the whole concept is not just a worthless toy, the kind of thing made depressingly familiar by monetary cranks?”–THE FAILURE OF THE NEW ECONOMICS, P. 139

  3. Under the tutelage of J.M. Keynes, the entire, non-Austrian, economics profession has strayed so far from logical analysis and common sense that it is possible for said not-Austrians to have really, really serious discussions and conduct comprehensive studies in really, really deep depth of such topics as the multiplier effect and the best methods for turning stones into bread. Statolatry!

  4. The one thing I miss in these discussions of that magic multiplier is where the money comes from and how it is included in the formula.
    Let’s use a multiplier of 1.5

    If the dollar comes from the past as in saved taxes to be released at a time of need, we have a negative 1 carried to the present, plus 1.5 Multiplier equals .5 of economic activity.

    Every time I do this all I see is depressed economic activity ether past present or future. At best it is a redistribution of wealth from the past, present, or future. With a lesser economic impact.

    What am I missing or adding?

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