Reports from the Economic Front

by Martin Hart-Landsberg

The Role Of Government In The Economy

with one comment

A big debate is underway about fiscal multipliers.  Sounds esoteric but it is not—it reveals that economics is far from an exact science and the outcome appears to confirm what most working people thought, which is that government spending can help an economy grow.

A fiscal multiplier is an estimate of the economic impact of a change in government spending.  The debate was triggered, surprisingly enough, by a small box in the International Monetary Fund’s annual publication, World Economic Outlook.  There, the International Monetary Fund (IMF) admitted that its previous estimates of fiscal multipliers were too low.

Here is what the IMF chief economist Olivier Blanchard wrote:

The main finding, based on data for 28 economies, is that the multipliers used in generating growth forecasts have been systematically too low since the start of the Great Recession, by 0.4 to 1.2, depending on the forecast source and the specifics of the estimation approach. Informal evidence suggests that the multipliers implicitly used to generate these forecasts are about 0.5. So actual multipliers may be higher, in the range of 0.9 to 1.7.

As part of the attack on the role of government in the economy, many economists, prior to the Great Recession, argued that fiscal multipliers were roughly equal to 1.  That meant a 1% reduction in government spending would likely cause a 1% decline in GDP, and a 1% increase in government spending would likely generate a 1% increase in GDP.

As the Great Recession got under way, many economists, including those at the IMF, began arguing for substantially lower multipliers, on the order of 0.5%.  On the basis of this reduced value, many forecasters argued for the benefits of austerity.  Debt was seen as a major problem and if fiscal multipliers were only 0.5%, a $1 cut in government spending would reduce debt by $1 but GDP by only 50 cents.

Well, after watching how austerity policies collapsed many economies around the world, especially in Europe, the IMF acknowledged that it had badly misjudged the size of the fiscal multiplier.  As Cornel Ban explains:

In contrast [to its previous low estimates], the October 2012 WEO found that in fact [fiscal multipliers] ranged between .9 to 1.7 (the Eurozone periphery is closer to the higher end of the range), an error that explained the IMF’s extremely optimistic growth projections for countries who front-loaded fiscal consolidation.  Assuming the multiplier was 1.5, a fiscal adjustment of 3 percent of GDP-as much as Spain has to do next year- would lead to a GDP contraction of 4.5 percent. It was momentous finding and those who had been skeptical of the virtues of austerity felt vindicated.

Barry Eichengreen and Kevin H O’Rourke provide additional evidence for large fiscal multipliers, in fact for larger multipliers than those proposed by the IMF.  According to them:

The problem is that standard theory doesn’t tell us much about the precise magnitude of the multiplier under [current] conditions. The IMF’s analysis, moreover, relies on observations for only a handful of national experiences. It is limited to the post-2009 period. And it has been criticized for its sensitivity to the inclusion of influential outliers.

Fortunately, history provides more evidence on the relevant magnitudes. In a paper written together with Miguel Almunia, Agustin Bénétrix and Gisela Rua, we considered the experience of 27 countries in the 1930s, the last time when interest rates were at or near the zero lower bound, and when post-2009-like monetary conditions therefore applied (Almunia et al. 2010).

Our results depart from the earlier historical literature. Generalizing from the experience of the US it is frequently said, echoing E Cary Brown, that fiscal policy didn’t work in the 1930s because it wasn’t tried. In fact it was tried, in Japan, Italy, and Germany, for rearmament- and military-related reasons, and even in the US, where a Veterans’ Bonus amounting to 2% of GDP was paid out in 1936. Fiscal policy could have been used more actively, as Keynes was later to lament, but there was at least enough variation across countries and over time to permit systematic quantitative analysis of its effects.

We analyze the size of fiscal multipliers in several ways. First, we estimate panel vector regressions, relying on recursive ordering to identify shocks and using defense spending as our fiscal policy variable. The idea is that levels of defense spending are typically chosen for reasons unrelated to the current state of the economy, so defense spending can thus be placed before output in the recursive ordering. We also let interest rates and government revenues respond to output fluctuations. We find defense-spending multipliers in this 1930s setting as large as 2.5 on impact and 1.2 after the initial year.

Second, we estimate the response of output to government spending using a panel of annual data and defense spending as an instrument for the fiscal stance.

Here too we control for the level of interest rates, although these were low virtually everywhere, reflecting the prevalence of economic slack and ongoing deflation. Using this approach, our estimate of the multiplier is 1.6 when evaluated at the median values of the independent variables.

These estimates based on 1930s data are at the higher end of those in the literature, consistent with the idea that the multiplier will be greater when interest rates do not respond to the fiscal impulse, whether because they are at the lower bound or for other reasons. The 1930s experience thus suggests that the IMF’s new estimates are, if anything, on the conservative side.

 Some economists remain unconvinced—in fact, some actually argue that government spending is incapable of creating jobs.  The economist Robert J. Samuelson was so upset to read a New York Times editorial which claimed that government spending creates jobs that he had to respond:

In 35 years, I can’t recall ever writing a column refuting an editorial. But this one warrants special treatment because the Times’ argument is so simplistic, the subject is so important and the Times is such an influential institution.

Here is the nub of his argument:

it’s true that, legally, government does expand employment. But economically, it doesn’t — and that’s what people usually mean when they say “government doesn’t create jobs.”

What the Times omits is the money to support all these government jobs. It must come from somewhere — generally, taxes or loans (bonds, bills). But if the people whose money is taken via taxation or borrowing had kept the money, they would have spent most or all of it on something — and that spending would have boosted employment.

In other words, because the government relies on the private sector for the money it spends, the jobs created by its spending cannot be a net addition to the economy.  Said differently, jobs supported by public spending are not real jobs.  There is a lot that can be said, but here is Dean Baker’s response:

Samuelson tells us that if the government didn’t tax or borrow or the money to pay its workers (he makes a recession exception later in the piece) people “would have spent most or all of it on something — and that spending would have boosted employment.”

Again, this is true, but how does it differ from the private sector? If the new iPhone wasn’t released last month people would have spent most or all of that money on something — and that spending would have boosted employment. Does this mean that workers at Apple don’t have real jobs either?

The confusion gets even greater when we start to consider the range of services that can be provided by either the public or private sector. In Robert Samuelson’s world we know that public school teachers don’t have real jobs, but what about teachers at private schools? Presumably the jobs held by professors at major public universities, like Berkeley or the University of Michigan are not real, but the jobs held at for-profit universities, like Phoenix or the Washington Post’s own Kaplan Inc., are real.

How about health care? Currently the vast majority of workers in the health care industry are employed by the private sector. Presumably these are real jobs according to Samuelson. Suppose that we replace our private health care system with a national health care service like the one they have in the U.K. Would the jobs in the health care no longer be real? . . .

How about when the government finances an industry by granting it a state sanctioned monopoly as when it grants patent monopolies on prescription drugs. Do the researchers at Pfizer have real jobs even though their income is dependent on a government granted monopoly? Would they have real jobs if the government instead paid for research out of tax revenue and let drugs be sold in a free market, saving consumers $250 billion a year?

Robert Samuelson obviously thinks there is something very important about the difference between working for the government and working in the private sector. Unfortunately his column does not do a very good job of explaining why. It would probably be best if he waited another 35 years before again attacking a newspaper editorial.

If people are confused about how our economy works, or doesn’t work, it is no wonder.

One Response to 'The Role Of Government In The Economy'

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  1. I recall engaging in a discussion with Professor Dale O’Bannon on this subject as a student in 1973. From my perspective, it is promising that there is at least a public discussion going on. Regardless of the political implications, if one actually believes in economic efficiency we should continue to seek the best analysis of both the quality and quantity of multipliers. If the numbers don’t pan out, then we shouldn’t, as a matter of economic policy, embracing inefficient government spending. Until things are a bit more clear, I will remain skeptical that a dollar spent by government someone produces more economic effect than a dollar spent by anyone else.

    Mark Johnson '75

    31 Oct 12 at 5:11 pm

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