Friday, October 2, 2009

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."

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