Debating the Keynesian Multiplier

The old joke about economists is that if you laid them all together from head to toe they still wouldn't reach a conclusion. While there are many areas where economists broadly agree, the virtues of economic stimulus is not one.

The latest salvo in this rather un-gentlemanly (and gentlewomanly) debate comes via Harvard's Robert Barro, writing in the Wall Street Journal:

"The bottom line is this: The available empirical evidence does not support the idea that spending multipliers typically exceed one, and thus spending stimulus programs will likely raise GDP by less than the increase in government spending. Defense-spending multipliers exceeding one likely apply only at very high unemployment rates, and nondefense multipliers are probably smaller. However, there is empirical support for the proposition that tax rate reductions will increase real GDP."

Barro is summarizing his research into the size and impact of multipliers, in which he analyzed US GDP and changes in government spending data over time. Increases in government spending, according to Barro, haven't led to proportionally larger increases in GDP, as Keynesian analysis might suggest.

Mark Thoma chastens Barro for essentially re-cycling an op-ed (compare his new piece to this article from January) and, in response, re-posts some of the criticisms made at the time by people like Paul Krugman, Brad DeLong and Christina Romer.

For as important an issue as fiscal stimulus is, there is surprisingly scant research into its effectiveness. The best work is by David and Christina Romer, but they look at tax cuts as opposed to government spending.

Fortunately, Ethan Ilzetzki, Enrique G. Mendoza and Carlos A.Vegh have just published some new research, which looks at the impact government spending on GDP for a panel of 45 countries (20 developed, 25 developing). Their conclusions include:

1. In developing countries, the response of output to increases in government spending is smaller on impact and considerably less persistent than in high income countries.
2. The degree of exchange rate flexibility is a critical determinant of the size of fiscal multipliers. Economies operating under predetermined exchange rate regimes have long-run multipliers of around 1.5, but economies with flexible exchange rate regimes have essentially zero multipliers.
3. The degree of openness to trade (measured as exports plus imports as a proportion of GDP) is another critical determinant. Relatively closed economies have long-run multipliers of around 1.6, but relatively open economies have very small or zero multipliers.
4. In highly-indebted countries, the output response to increases in government spending is short-lived and much less persistent than in countries with a low debt to GDP ratio.
5. The multipliers for the US in the post-1980 period are rather small (in the range 0.3-0.4) both in the short and long-run. On the other hand, multipliers for government investment are large (around 2).

While far from the last word on the issue, the Ilzetzki, Mendoza and Vegh (IMV) work provides us with a much more subtle analysis of the nature of the Keynesian multiplier. It suggests that developed countries can use fiscal stimulus to boost employment in recessions, particularly if the spending takes the form of government investment. Interestingly, IMV's conclusions support Keynes' original claims. I'm currently reading Keynes' "The General Theory" and stumbled upon these passages:

Fiscal stimulus in rich vs. poor countries:

"Thus whilst the multiplier is larger in a poor community, the effect on employment will be much greater in a wealthy community, assuming that in the latter current investment represents a larger proportion of current output." (p126)

Trade openess and fiscal stimulus:

"In an open system with foreign trade relations, some part of the multiplier of the increased investment will accrue to the benefit of employment in foreign countries... so that if we consider only the effect on domestic employment as distinct from world employment, we must diminish the full figure of the multiplier." (p120)

It seems that Keynes, writing in 1935, predicted findings (1) and (3) in IMV.

Finally, as one might expect, Paul Krugman weights in, yet again:

"On a happier note, this piece by Ilzetzki et al is interesting, and offers a wide range of multipliers depending on a country's situation. The question for the United States is which estimate is most relevant.

I'd say it's the fixed exchange rate estimate. Yes, I know, we have a floating rate. But they explain the relatively high fixed-rate number by pointing to Mundell-Fleming, which says that fiscal policy is effective under fixed rates because it doesn't drive up interest rates (capital flows in). We're in a similar position for a different reason: fiscal expansion doesn't drive up rates because we're at the zero bound.

Oh, we're also relatively closed.

The thing is that both the fixed rate and closed multipliers are around 1.5 — which so happens to be just about the number assumed by Christina Romer in her analysis for the Obama administration. Just saying."

Ha Joon Chang on Culture and Economic Development

Ha-Joon Chang, Cambridge University Professor of Economics makes an eloquent argument for why differences in culture don't explain differences in income:

"...in the early days of capitalism when most economically successful countries happened to be Protestant Christian, many people argued that Protestantism was uniquely suited to economic development. When Catholic France, Italy, Austria, and Southern Germany developed rapidly, particularly after the Second World War, Christianity, rather than Protestantism, became the magic culture. Until Japan became rich, many people thought East Asia had not develop because of Confucianism. But when Japan succeeded, this thesis was revised to say that Japan was developing so fast because its unique form of Confucianism emphasised cooperation over individual edification, which the Chinese and Korean versions allegedly valued more highly. And then Hong Kong, Singapore, Taiwan, and Korea also started doing well, so this judgment about the different varieties of Confucianism was forgotten. Indeed Confucianism as a whole suddenly became the best culture for development because it emphasised hard work, saving, education, and submission to authority. Today, when we now see Muslim Malaysia and Indonesia, Buddhist Thailand, and even Hindu India doing economically well, we can soon expect to encounter new theories that will trumpet how uniquely all these cultures are suited for economic development (and how their authors have known about it all along)."

Culture has a certain appeal on both the left and the right as a determinant of a country's politics and economics. But cultural arguments are often subject to a winner's bias: since rich countries will typically have high levels of education and entrepreneurial spirit, we can look for teachings within a given culture that promote those values. But we're looking the wrong way. As Chang argues:

Culture is the result, as well as the cause, of economic development. It would be far more accurate to say that countries become “hardworking” and “disciplined” (and acquire other “good” cultural traits) because of economic development, rather than the other way around.

This is from a chapter in Chang's book "Bad Samaritans", a critical look at global trade. It's definitely worth a look.

The trouble with tariffs

The stated logic behind tariffs is that they protect domestic jobs against international competition. That's the justification behind the recent tariffs on Chinese tire imports imposed by the Obama administration. Many people think this is a laudable goal; but is it worth the cost? As Brad DeLong explains, probably not:

"Let's see... 250 million cars in America... need 4 tires per car... need new tires every 2.5 years. 400 million tires a year... $1.4 billion dollars a year... 10,000 worker jobs saved... $140,000 dollars per worker-job per year.

Looks like we could (a) let the Chinese sell us tires, (b) tax each tire by $2.50, (c) pay each tire worker who loses his or her job $100K a year, and we come out ahead: American households have more money to spend on other things, China has more jobs to help what is still a very poor country grow, and tire workers have higher incomes and more leisure as well.

But, you say, it would be stupid to impose a $2 a tire tax and use the money to pay each laid-off tire worker $100K a year.

That's the point: when the policy you are adopting is worse for everybody than a policy you agree is stupid, the policy you are adopting is best characterized as really stupid."

We should not ignore or diminish all concerns about free trade. But the trouble with tariffs is that they usually cost more than they're worth in terms of protecting domestic jobs*.

Some have suggested that this tariff is designed to boost support for healthcare reform among labor groups. In that case, the cost/benefit calculation changes depending on the desirability of the proposed legislation. However, the point is that tariffs are rarely justified by their overall economic impact.

*Not everyone would agree that protecting domestic jobs is a worthwhile public policy goal. Assuming that it is, however, we need to consider whether it's a cost-effective policy.

Why care about inequality?

This is a follow-up post to a previous discussion about economic inequality.

Emmanuel Saez, the UC Berkeley economist, recently produced a fascinating chart on income distribution in the US, depicting the share of national income held by the top 10% of Americans over time:


As you can see, the top 10% of families accounted for roughly 50% of national income in 2007, a level not seen since the time of Jay Gatsby. Though this is only one of numerous measures of income inequality, it clearly shows that the distribution of income in America is more skewed now than at any point since before the Great Depression.

Why should we care about this? There are good economic reasons for discounting measures of inequality. First, economics is not, in general, a zero-sum game. We can all do better even if some gain more than others. And conversely, while some poor societies are highly equal, equal poverty is no great virtue.

Second, there are good reasons why some people make more than others. People who make great innovations (eg the founders of Google) or who have specialized skills (eg neurosurgeons) have every right to be compensated for what they do, since they provide value for society. Bill Gates is enormously wealthy, but he didn't get that way by stealing from others; he became wealthy by providing valuable products to society, making everyone better off (Vista notwithstanding). The carrot of great individual wealth has done much to improve human welfare.

However, there are equally good economic reasons to care about inequality. First, sometimes inequality does result from zero-sum interactions. As Harvard labor economist Larry Katz notes,

"Much of the growth of high-end incomes stemmed from market forces, like technological innovation... But a significant amount also stemmed from the wealthy’s newfound ability to win favorable government contracts, low tax rates and weak financial regulation".

If government is captured by narrow interests, then we are likely to see the growth of policies that privilege one group and do nothing to help (or sometimes even hurt) other groups. A less regressive tax code, for example, helps the wealthy but can hurt the poor.

We should also care about changes in inequality because it can indicate how well the economy is functioning for different groups in society. For this reason it is important to understand what is driving inequality. For example, Katz and co-author Claudia Goldin have argued that inequality has increased because of a decline in the relative supply of highly skilled workers. This suggests that increasing college enrollment (and completion rates) for lower-income groups would stem the growth in inequality and increase incomes for poorer Americans.

On the other hand, Arnold Kling and others have argued that inequality has been driven by changes in technology and the growth of "winner take all" markets, as well as changes in family structure. People today are more likely to marry someone of a similar economic and educational background than they were 50 years ago. This re-enforces inequality among now and in the future, as successful, highly educated parents are likely to have successful, highly educated children. If these are the causes, Kling argues, then there is little government policy to can do to stop them, since we are obviously not going to put restrictions on technological progress or prevent wealthy people from marrying each other.

Inequality is not something that the government can directly set, like interest rates or the budget deficit. It is the product, of complex economic, political and social forces. It is important to recognize that inequality has many causes and that by understanding those causes, we can understand fundamental structures in the economy. We should care about inequality because we should care about an economy that satisfies the needs of everyone in society. By understanding what causes inequality, we can better understand how to get there.

On the other hand...

Maybe President Obama doesn't have plans to euthanize the elderly and disabled.

Last week Iowa Senator Chuck Grassely seemed to agree with Sarah Palin's "death panel" accusation, saying:

"There is some fear because in the House bill, there is counseling for end-of-life... And from that standpoint, you have every right to fear. You shouldn't have counseling at the end of life. You ought to have counseling 20 years before you're going to die. You ought to plan these things out. And I don't have any problem with things like living wills. But they ought to be done within the family. We should not have a government program that determines if you're going to pull the plug on grandma"

Due to the outrage caused by Palin's asinine comment, Congress is no longer considering end-of-life counseling as part of the health care bill. But now that the faux controversy is over, Grassely can re-acquaint himself with reality:

"Grassley says he opposes that counseling as written in the House version of the bill, but a spokesman said the senator does not think the House provision would in fact give the government such authority in deciding when and how people die. The House bill allows patients to decide for themselves if they would like such counseling."

If someone proposed an bill covering end-of-life counseling in a different context (were we not debating health care reform), it would be overwhelmingly popular. Too bad.

Usually when people make comments as dumb as Grassely's, I'm left asking myself whether they are stupid, crazy or disingenuous. Fortunately, Grassely answered the question for us.