There’s a growing amount of evidence that the spending multiplier is much smaller than stimulus advocates have argued. As a reminder, the multiplier effect or spending multiplier refers to the idea that a certain amount of government spending leads to a certain amount of change in the activity of the larger economy. In other words, a change in the total demand for goods and services (what economists term aggregate demand) causes a change in total output for the economy that is a multiple of the initial change. For example, if the government spends one dollar and, as a result of this spending, the economy (as expressed by the gross domestic product, or GDP) grows by $2, the spending multiplier is 2. If the economy grows by $1.50, the spending multiplier is 1.5. However, if the economy only grows by 50 cents (a loss from the original $1 spent), the spending multiplier is 0.5. And if the multiplier is negative, it means that $1 in government spending shrinks the economy.
In a new paper, “In Search of the Multiplier for Federal Spending in the States During the New Deal,” economists Price Fishback and Valentina Kachanovskaya look at the impact of federal stimulus programs during the Great Depression on a state-by-state basis. Matt Nesvisky, writing for the NBER Digest, summarizes their results:
They estimate that for personal income, which includes transfer payments, the multiplier ranges from 0.91 for a combination of government grants and loans to 1.39 when only grants are considered. The personal income multiplier for public works and relief was around 1.67. The multiplier for farm payments to take land out of production was -0.57, which implies that the program actually reduced personal income.
The multiplier for wages and salaries was substantially less than one, as was the multiplier for retail sales. Furthermore, the researchers find that the impact of the federal spending on employment was negligible and may have been negative. These results may help to explain why measures of income have recovered more rapidly than measures of employment in both the 1930s and in the current era.
How about the 2009 stimulus package? Fishback and Kachanovskaya conclude:
Given the differences in unemployment levels between the 1930s and today, we should anticipate that the spur to income and employment would be smaller in size relative to the stimulus in the 1930s. Our rough guess is that the current multiplier in the states would be around one or less for personal income, which includes transfer payments, and smaller for other measure of income. The absence of a private employment boost during the New Deal suggests that further stimulus packages would not likely translate into increases in private employment.
Basically, it is likely that, at best, for every dollar of government spending, we got a dollar or less in growth (when the economy didn’t shrink). Moreover, they suggest that more spending isn’t likely to change a thing.
This other paper, “How Big (Small?) Are Fiscal Multipliers?” by economists Ethan Ilzetzki, Enrique Mendoza, and Carlos Vegh, looks at how the impact of government fiscal stimulus depends on key country characteristics, including the level of development, the exchange-rate regime, openness to trade, and public indebtedness. NBER Digest explains:
After analyzing a quarterly data set on government expenditures for 44 countries (20 high-income and 24 developing) from 1960 to 2007, they conclude that the output effect of an increase in government consumption is larger in industrial than in developing countries. That response — which is called the fiscal multiplier — is relatively large in economies operating under a predetermined exchange rate, but it is zero in economies operating under flexible exchange rates. Finally, they conclude that fiscal multipliers are smaller in open economies than in closed economies, and are zero in high-debt countries.
The three authors conclude:
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. The medium- to long-run effects of increases in government consumption vary considerably. In particular, in economies closed to trade or operating under fixed exchange rates we fi nd a substantial long-run effect of government consumption on economic activity. In contrast, in economies open to trade or operating under flexible exchange rates, a fiscal expansion leads to no significant output gains. 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.
The United States has the features of a country where stimulus by spending does have an impact and, in fact, can have a negative impact on growth.
The good news is that if all this data bores you, you can just watch the new video by Russ Roberts and John Popola, “Fight of the Century: Hayek vs. Keynes Round Two,” here.
Thanks to Matt Mitchell at Mercatus and Bill Niskanen at Cato for the pointer.