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.