A body of empirical evidence shows that, in practice, government outlays designed to stimulate the economy may fall short of that goal. In response to the financial crisis and its impact on the economy, the federal government has increased government spending markedly in order to stimulate economic growth.
With billions of taxpayer dollars appropriated toward this effort, policy makers should examine whether federal spending actually promotes economic growth. Although the studies are not all consistent, historical evidence suggests an undesirable, long-run effect from government spending: it crowds out private-sector spending and uses money in unproductive ways. Policy makers should use the best literature available to analyze government spending designed to spur growth for the likelihood of achieving that effect.
Where the assumptions or data are uncertain, the analysis should fully explore the potential consequences of different assumptions or different potential values for the uncertain data. Proponents of government spending claim that it provides public goods that markets generally do not, such as military defense, enforcement of contracts, and police services.
John Maynard Keynes, one of the most significant economists of the 20th century, advocated government spending, even if government has to run a deficit to conduct such spending. Keynes's theory has been one of the implicit rationales for the current federal stimulus spending: it is needed to boost economic output and promote growth. These views of spending assume that government knows exactly which goods and services are underutilized, which public goods will be value added, and where to redirect resources.
However, there is no information source that allows the government to know where goods and services can be most productively employed. In addition to this information problem, the political process itself can stunt economic growth. For example, Professor Emeritus of Law at George Mason University Gordon Tullock suggests that politicians and bureaucrats try to gain control of as much of the economy as possible.
Rather than spend money where it is most needed, legislators instead allocate money to favored groups. The data support the theory.
A paper by Stanford's Gavin Wright found that political attempts to maximize votes explained between 59 and 80 percent of the difference in per capita federal spending to the states during the Great Depression. Wright's analysis indicates that instead of allocating spending based purely on economic need during a crisis, the party in power may distribute funding based on the prospect of political returns.
Proponents of government spending often point to the fiscal multiplier as a way that spending can fuel growth. The multiplier is a factor by which some measure of economy-wide output such as GDP increases in response to a given amount of government spending.
According to the multiplier theory, an initial burst of government spending trickles through the economy and is re-spent over and over again, thus growing the economy. A multiplier of 1. A multiplier larger than 1 implies more employment, and a number smaller than 1 implies a net job loss.
In its assessment of the job effects of the stimulus plan, the incoming Obama administration used a multiplier estimate of approximately 1. This would mean that for every dollar of government stimulus spending, GDP would increase by one and a half dollars. Non-defense spending may have an even smaller multiplier effect.
Another recent study corroborates this finding. A New Classical understanding of the multiplier starts with the idea that government spending has some social cost i. As such, the value of the public projects bridge construction or roads needs to justify that social cost. This view doesn't assume that an increase in consumption at any cost is a good thing: if the multiplier's value is less than 1, then government spending has crowded out the private investment and spending that would have otherwise happened.
Even government spending where the multiplier is higher than 1 could still be a poor use of taxpayer dollars. So what is the historical value of the multiplier in the United States?
Barro and Redlick examine this question in detail. They explain that in order to understand the effects of government spending on the economy, one must know how much of the economic change is due to government spending and how much is due to other factors. Unfortunately, it is impossible to figure this out with general government spending, since the level of government spending often expands and contracts along with the economy. This, in turn, leads to increased government spending see figure 1.
However, they argue that there is a useful, much more isolated proxy for overall government spending: defense spending. Using defense spending as a proxy has several advantages. Non-economic factors drive defense spending. Second, changes in defense spending are very large and include sharply positive and negative values see figure 2.
Finally, the historical data on defense spending covers periods of high unemployment. Thus this data set should reveal whether government spending creates increased economic growth in a slack economy. Moreover, studying the effects of defense spending on the economy gives the best-case scenario of the spending multiplier effect of government spending on the economy because defense spending leads to economic growth in ways that general government spending does not.
For example, in times of war, the government mandates the increased production of particular goods, and the scarcity of domestic labor due to military enlistment and resources also forces economic resources to go to innovative and productive uses that did not exist before the war. Barro and Redlick's research estimates that the multiplier for changes in defense spending that people think will be temporary—spending for the Iraq war for example—is between 0. If the change in defense spending becomes permanent, then these multipliers increase by 0.
Thus even in the government's best-case spending scenario, all of the estimated multipliers are significantly less than one. This means greater government spending crowds out other components of GDP, particularly investment. In addition, they calculate the impact on the economy if the government funds the spending with taxes.
They find that the tax multiplier—the effect on GDP of an increase in taxes—is When this tax multiplier is combined with the effects of the spending multiplier, the overall effect is negative. Barro and Redlick write that, "Since the tax multiplier is larger in magnitude than the spending multipliers, our estimates imply that GDP declines in response to higher defense spending and correspondingly higher tax revenue.
Other economist have also calculated defense spending multipliers of less than or equal to 1. Getting the multiplier wrong has big consequences when understanding the effects of fiscal stimulus on the economy. The government uses multipliers to estimate the widely cited projections of unemployment, job creation, and economic output.
These projections, however, have been largely wrong. For example, in their January report, 19 Romer and Bernstein used multipliers of between 1. Because employers are unable to reduce wages during an economic downturn, they lay off workers, which exacerbates the initial economic shock. This can generate a convex AS curve because it means that wages and prices do not decline or decline less when output is low.
This can be seen by the relative flatness of the AS curve at point C in Figure 2. As Figure 2 illustrates, an increase in government purchases shifts the AD curve outward up and to the right , which leads to a new equilibrium, going from point A to point B.
A decrease in government purchases shifts the AD curve inward down and to the left and the equilibrium would move from point A to point C. The size of the fiscal multiplier is given by the magnitude of the change in output going from the old equilibrium to the new equilibrium. As the figure shows, the convexity of the AS curve results in the output change being smaller when the AD curve shifts outward than when it shifts inward.
If the AS curve were a straight line, the output change would be the same in absolute value, regardless of which direction the AD curve shifts. This discussion demonstrates that a convex AS curve can lead to an asymmetric multiplier, in that an increase in public spending has a comparatively smaller effect on the economy than a decrease in public spending, as illustrated in Figure 2 and consistent with our empirical findings.
Taken at face value, our finding that the expansionary multiplier is small suggests that government spending can be a costly way to stimulate the economy. What does this imply for the efficacy of government stimulus in the current downturn?
One important feature of the current recession is that the main monetary policy tool, the federal funds rate, is constrained by the zero lower bound, leaving little room to lower interest rates to boost the economy. Because an increase in government spending raises inflation, in normal times monetary policymakers react by raising interest rates. This response tends to mute the boost in output.
However, in a deep downturn, monetary policymakers are unlikely to raise interest rates, so an increase in government spending is more likely to result in a larger multiplier. In addition, when monetary policy is unable to lower interest rates because of the zero lower bound, real interest rates end up being too high, thus restricting economic activity.
By boosting inflation and expected inflation, government spending can have the beneficial effect of lowering real interest rates and stimulating the economy further. We can use an expanded version of our model to study the impact of the zero lower bound on the expansionary multiplier.
We find that an economic downturn severe enough to push monetary policy to its zero lower bound results in a higher expansionary multiplier. If the zero lower bound binds for some time, the multiplier can reach and even surpass one. Thus, our results indicate that government purchases could be an effective way to stimulate an economy during a deep recession when monetary policy is constrained at the zero lower bound.
Unfortunately, there is not enough evidence to empirically estimate the magnitude of that effect in the United States, because times with a binding zero lower bound have been rare historically.
However, our conclusion is consistent with recent evidence that the spending multiplier can be above 1. Recent research has shown that the effectiveness of fiscal tools can depend on the underlying economic conditions, for example whether the economy is in a boom versus a slump. In this Letter , we show that the effectiveness of fiscal policy can also depend on the direction of the intervention—expansionary versus contractionary. In particular, we find that the expansionary multiplier is generally smaller than the contractionary multiplier.
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