Friday, October 2, 2009

Fiscal multipliers under different conditions

I have blogged here, here, here, and here about the debate on the impact of fiscal stimuluses, more specifically the fiscal multipliers associated with different types of stimulus spending. While conservatives have argued that multipliers are essentially zero and therefore find no merit in fiscal spending, supporters point to substantial multipliers in government spending, especially in deep recessions when demand is weak and business investments have dried up.

A Vox post by Ethan Ilzetzki, Enrique G. Mendoza, and Carlos A. Vegh (full paper here) adds a new dimension to the debate by claiming that "fiscal multipliers are much weaker in countries that have high debt, lower income, flexible exchange rates, and greater international openness". They also find that preduicting fiscal multilpiers with any degree of certainty is even more difficult for developing economies. Their findings are

1. The response of output to increases in government spending is smaller on impact and considerably less persistent in developing countries than in high-income countries.
2. Fiscal multipliers are much larger in economies operating under predetermined exchange rate regimes than under flexible exchange rates.
3. Relatively closed economies have much larger multipliers than relatively open economies.
4. The output response to increases in government spending is short-lived and much less persistent in highly indebted countries than in countries with a low debt to GDP ratio.
5. The multipliers for the US in the post-1980 period are small both in the short and long-run. On the other hand, multipliers for government investment are large.

These findings carry important policy implications. They lend weight to the need for globally co-ordinated stimulus spending policies, among atleast the major economies, in an increasingly inter-connected global economy, failing which protectionist backlash is inveitable and some degree of protectionism is even desirable. With fiscal expansions having considerable positive externalities, a substantial fraction of the stimulus spending leaks out to the rest of the world through higher imports etc.

It also supports the important but always-forgotten holy grail in fiscal policy making - follow a counter-cyclical fiscal policy and build up surpluses during good times and unwind them and run up deficits during downturns. Governments, especially in the developing world, who have tended to follow either the populist "spend more when the going is good" or the a-cyclical business cycle neutral tax and spending policies, are left with limited fiscal space when the bad times arrive. India is a case in point.

The authors find evidence of "crowding out" effect in developing countries, where an additional dollar of government consumption crowds out some other component of GDP - investment, consumption, or net exports - in the long run. However, this finding may actually turn out to be the opposite in deep recessions, when household demand and private investments become frozen, and government spending can play the important role of "crowding in" aggregate demand. During the current recession, most of the emerging economies did not experience the same extent of output contraction as the developed economies, and therefore fiscal expansions in these countries may not have supplied the same boost to aggregate demand as in the latter.

Mostly Economics points to the US CEA's latest impact assessment of the $787 bn ARRA stimulus spending plan. It finds that the stimulus spending changed the trajectory of the economy toward moderating output decline and job loss; it added roughly 2.3 percentage points to real GDP growth in the second quarter and is likely to add even more to growth in the third quarter; caused employment in August to be slightly more than 1 million jobs higher than it otherwise would have been; and it added between 2 and 3 percentage points to baseline real GDP growth in the second quarter of 2009 and around 3 percentage points in the third quarter. It estimates a very high fiscal multiplier of 2.3 in Q2 2009 and 2.7 in Q3 2009. It also finds that assistance to states played a critical role in helping states facing large budget shortfalls because of the recession by increasing employment relative to what would have happened without stimulus.

Mark Thoma, as always, captures the debate on stimulus multipliers here. Paul Krugman has this response to Robert Barro's assertion of a multplier less than one. The Economist has a nice summary of the multiplier debate and explains why it is so difficult to make any predictions about them given the wide variations in economic conditions.

A recent NBER working paper by Lawrence Christiano, Martin Eichenbaum, and Sergio Rebelo argues that "the government-spending multiplier can be much larger than one when the nominal interest rate does not respond to an increase in government spending". They claim that if the nominal interest rate is governed by a Taylor rule, it rises in response to an expansionary fiscal policy shock that puts upward pressure on output and inflation, and thereby renders the multiplier small. However, when nominal interest rates does not respond to an increase in government spending (when the zero lower bound on the nominal interest rate binds), their model finds that the multiplier is very large. Taking this model and its line of explanation, the effectiveness of fiscal spending is likely to be limited for many developing countries, including India, where the nominal rates are high and where inflationary pressures makes interest rates more sensitive to revisions.

And their conclusion has great relevance for the major developed economies which have nominal interest rates kissing the zero-bound, "In such economies it can be socially optimal to substantially raise government spending in response to shocks that make the zero lower bound on the nominal interest rate binding... for government spending to be a powerful weapon in combating output losses associated with the zero bound state, it is critical that the bulk of the spending come on line when the lower bound is actually binding."

They argue that when the economy is touching the zero-bound and the output falls, a deflationary spiral is unleashed that drives up the real interest rates, which in turn leads to an increase in the level of desired savings. Since investment is zero during such recessions, the aggregate saving must be zero in equilibrium, and the total fall in output required to reduce desired saving to zero is very large. And about how fiscal spending works in a recession when this zero bound is binding, they write,

"This (spending) increase leads to a rise in output, marginal cost and expected inflation. With the nominal interest rate stuck at zero, the rise in expected inflation drives down the real interest rate which drives up private spending. This rise in spending leads to a further rise in output, marginal cost, and expected inflation and a further decline in the real interest rate. The net result is a large rise in inflation and output. In effect, the increase in government consumption unleashes an inflationary spiral that counteracts the deflationary spiral associated with the zero bound state."

Update 1 (28/8/2010)
Mark Zandi (via Ezra Klein) has this graphic which examines the bang for the buck for various types of stimulus spending in the US.

No comments: