A few weeks ago, the International Monetary Fund published a paper looking at the impact of government spending on economic growth. Economist John Taylor explains:
The paper is quite technical, but the bottom line summary is that a one percent increase in government purchases (as a share of GDP) increases GDP by a maximum of 0.7 percent and then fades out rapidly. This means that government spending crowds out other components of GDP (investment, consumption, net exports) immediately and by a large amount.
The IMF estimate is much less than the multiplier reported in a paper released last year by Christina Romer of the President’s Council of Economic Advisers and Jared Bernstein of the Vice President’s Office. The attached graph shows how huge the difference is. It shows the impact on GDP of a one percentage point permanent increase in government purchases as a share of GDP reported in the IMF paper (labeled GIMF) and in the Administration paper (labeled Romer-Bernstein).
Getting the multiplier wrong has big consequences for understanding the effects of fiscal stimulus on the economy. The government uses the multiplier to estimate the widely cited projections of unemployment, job creation, and economic output. In the time leading up to the passage of the American Recovery and Reinvestment Act, Council of Economic Advisers (CEA) economists Christina Romer and Jared Bernstein used spending multipliers greater than 1 to promote the economic effects of the stimulus. In the months following the implementation of this package, the Congressional Budget Office (CBO) has used estimates of a spending multiplier between 1.0 and 2.5 — relying on macroeconomic models that ignore the possibility that the growth of the economy may be affecting the level of government spending, and not the reverse. By extrapolating from these multipliers, CBO and CEA have made important projections about the effects of fiscal stimulus on the economy. These projections have been largely wrong.
For example, in their January 2009 report, Romer and Bernstein used multipliers of between 1.0 and 1.55 to determine the effect that the proposed stimulus spending (then $775 billion) would have on GDP and, by extension, on job creation. They assumed that each 1 percent increase in real GDP would create an additional 1 million jobs. Based on that assumption and their estimated spending multiplier, they estimated that the fiscal stimulus would create 3.5 million jobs by the end of 2010. While we cannot be certain how many jobs would have been lost or created without a stimulus package, we do know that since January 2009 3.8 million jobs have been lost.
The IMF paper notes: “Using the same method our estimate is closer to ½ million additional jobs.”
Taylor has a great chart to illustrate the multiplier difference: