Faith in multipliers

Economists could skip to the penultimate paragraph

The multiplier is the size of any decrease in output that results from a fiscal contraction (lower government spending or higher taxes), both measured in the same units. Why am I confident that multipliers that result from temporary decreases in government spending in current conditions will be somewhere around one rather than somewhere around zero? It is not because of empirical studies that try to directly estimate multiplier sizes.

Do not get me wrong. Such studies are very important, as are meta studies that try and pull together and synthesise the large number of individual studies. However I tend to use them to either confirm or question my priors. My priors come from thinking about models, or perhaps more accurately mechanisms, that have a solid empirical foundation. Let me explain.

Some of the terminology makes more sense if we talk about an increase in government spending (for example, a new school being built), so from now on I’ll consider that. A multiplier around one means that for every school built GDP increases by the cost of that school (a multiplier of exactly one) plus or minus some private sector expenditure (hence around one). If private sector expenditure falls we talk about it being crowded out, but if private sector spending increases we can talk about that expenditure being encouraged or crowded in by the additional public spending. The first point to note is that by thinking in this way I’m focusing on aggregate demand rather than aggregate supply, which I think is appropriate in the situation we have recently been in. If, in contrast, everyone was already working as much as they could, it might be more natural to start from a multiplier of zero, because the school will have been built with labour that otherwise will have built something else. A multiplier of zero is called complete crowding out.

Will we get crowding in or crowding out? Here my starting point is to note that because the increase in government spending is temporary, any impact on pre-tax income or taxes will be relatively small relative to a consumer’s lifetime income. As a result, aggregate consumption is likely to change either way by an amount that is a lot less than the cost of the school. For similar reasons firms think long term when planning investment, so they are not going to invest that much because of a temporary increase in government spending and GDP. There is a lot more we could say here, but I want to keep it simple.

We next need to think about whether this reasoning could be upset by some change in a price that results from the extra school being built. The two key prices here are the real exchange rate and the real interest rate. My basic model of exchange rates is that they are grounded in some medium term view concerning competitiveness, plus beliefs about what might happen to short term interest rates. If the spending is temporary medium term competitiveness is largely unaffected, so what happens to real interest rates is critical. If they rise as a result of the additional employment required to build the new school, then this might lead to a real exchange rate appreciation. This will reduce the demand for domestically produced goods, and higher real interest rates will also discourage private spending directly. So what happens to interest rates is critical.

This is the second point at which actual circumstances are important. Nominal interest rates have been stuck at their Zero Lower Bound, which suggests that they would be quite likely to remain there despite any increase in employment generated by our additional school. If the additional GDP adds a bit to inflation, real interest rates might actually fall, leading to crowding in. (The point is reinforced if we reverse the sign and think about fiscal austerity - central banks will be unable to cut rates to offset austerity’s impact.)

That is where my priors come from: thinking about the structure of the economy, and situation we are in and the nature of the experiment involved. The problem for empirical studies that directly relate changes to output to changes in government spending is that they face huge difficulties in relating the data to particular circumstances and the kind of experiment involved. For example, is any increase in government spending observed in the data expected to be temporary (with relatively minor consequences for tax) or permanent (with implications for tax that could lead to complete crowding out as a result of lower consumption)? Some studies try and take account of this by focusing on shocks to spending, but that is not quite the same thing. (A new school will tend to raise GDP whether it is expected or not.) Even if the change in government spending is expected to be temporary, if any additional borrowing is paid for by cutting future spending rather than increasing taxes this will in theory make some difference.

Up until recently studies have not really controlled for monetary policy, which as we saw was crucial. This recent study from the IMF is an exception, although if you read it you will see just how difficult trying to control for monetary policy actually is. They find that monetary policy does have a large influence, which fortunately agrees with the analysis above. What some earlier studies have shown (I’ve often referenced a study by Jorda and Taylor, but here is another, and a meta analysis is here) is that multipliers tend to be larger when economies are depressed. What has not been clear is whether this is picking up a monetary policy effect (if economies are depressed, monetary policy is unlikely to try and offset the impact of any fiscal expansion), or whether it is picking up something else (for example, multipliers could be larger in a recession because more consumers are credit constrained). This IMF study, which is just based on US data and which does allow for monetary policy, finds no additional depressed economy effect. It will be interesting to see if that result proves robust to alternative treatments of monetary policy and data for other countries.