One of the surprising aspects of the GFC has been the rush to endorse expansionary fiscal programs. The motivation for such programs is that $1m spent by the government is sometimes claimed to lead to more than $1m extra spending in the economy so that such fiscal spending stimulates the economy. When I first went to university I was taught that this was so because the $1m spent would accrue as income to people who would spend a certain fraction of it, say c, and that $c would accrue to other people who would spend a fraction of it c*c which would accrue as income to others who would spend c*c*c and so. The original $1m in spending becomes:
$(1 + c + c2 + c3 +……… ) = $1/(1-c)
which is a number (called the multiplier) which is bigger than 1 if c is a fraction. For example if c=0.8 the initial $1m expansion generates $5m in total demand. Analogous results hold for tax cuts.
Modern economists have become sceptical about this analysis which is part of my surprise that is has been so widely endorsed in delaing with the GFC. Not that I am suggesting the analysis is false but just that recent endorsements are inconsistent with the recent history of the idea. The Economist sorts out this literature and conveniently provides background papers.
I summarise The Economist article:
Countries have countered the recession by cutting taxes and boosting government spending. The G20 economies have introduced stimulus packages worth 2% of GDP this year and 1.6% of GDP in 2010. How effective will these measures be – how large will the multiplier be?
1. It will vary with economic conditions. For an economy operating at full capacity, the multiplier should be zero since there are no spare resources - so any increase in government demand would just replace spending elsewhere. In a recession, a fiscal boost has more chance of increasing demand and the multiplier can be above one.
2. It will vary with type of fiscal action. Government spending on building a bridge may have a bigger multiplier than a tax cut if consumers save their tax windfall. A tax cut targeted at poorer people will have a bigger impact on spending than one for the affluent since the poor save less.
3. It will depend on how people react to higher government borrowing. If government actions bolster confidence and revive ‘animal spirits’, the multiplier could rise as demand goes up and private investment is ‘crowded in’. But if interest rates climb in response to government borrowing then some private investment that would otherwise have occurred could get ‘crowded out’. And if consumers expect higher future taxes to finance new government borrowing they could spend less today which might reduce the multiplier below zero.
Economists in the Obama administration, who assume interest rates will remain fixed for 4 years, expect a multiplier of 1.6 for government purchases and 1.0 for tax cuts from America’s fiscal stimulus. An alternative assessment in which interest rates and taxes rise more quickly in response to higher public borrowing suggests the US stimulus will boost GDP by only one-sixth as much as the Obama team expects.
It is tricky to isolate the impact of changes in fiscal policy. One approach is to use microeconomic case studies to examine consumer behaviour – an Australian study is here. US studies find that permanent cuts have a bigger impact on consumer spending than temporary ones and that consumers who find it hard to borrow, such as those close to their credit-card limit, spend more of their tax windfall. But case studies do not measure the overall impact of tax cuts or spending increases on output.
An alternative approach is to try to estimate the statistical impact of changes in government spending or tax cuts on GDP. The difficulty to isolate the effects of fiscal-stimulus measures from the rises in social-security spending and falls in tax revenues that naturally accompany recessions. This empirical approach has narrowed the range of estimates. It has also yielded interesting cross-country comparisons. Multipliers are bigger in closed economies than open ones (because less of the stimulus leaks abroad via imports). They have traditionally been bigger in rich countries than emerging ones (where investors take fright more quickly, pushing interest rates up). But overall economists find as big a range of multipliers from empirical estimates as they do from theoretical models.
To add to the confusion, the current situation is distinctive. Most of the evidence on multipliers for government spending is based on military outlays, but today’s stimulus packages are heavily focused on infrastructure. Interest rates in many rich countries are now close to zero, which may increase the potency of, as well as the need for, fiscal stimulus. Because of the financial crisis relatively more people face borrowing constraints, which would increase the effectiveness of a tax cut. At the same time, highly indebted consumers may now be keen to cut their borrowing, leading to a lower multiplier. And investors today have more reason to be worried about rich countries’ fiscal positions than those of emerging markets.
The main conclusions – temporary tax cuts pack less punch than permanent ones and fiscal multipliers will probably be lower in heavily indebted economies than in prudent ones. But policymakers looking for precise estimates are deluding themselves.
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