Friday, 23 January 2009

Government spending is no free lunch

Over at the Wall Street Journal Robert J. Barro makes the obvious point that Government Spending Is No Free Lunch. Barro writes about the so-called "multiplier" effect of government spending:
To think about what this means, first assume that the multiplier was 1.0. In this case, an increase by one unit in government purchases and, thereby, in the aggregate demand for goods would lead to an increase by one unit in real gross domestic product (GDP). Thus, the added public goods are essentially free to society. If the government buys another airplane or bridge, the economy's total output expands by enough to create the airplane or bridge without requiring a cut in anyone's consumption or investment.

The explanation for this magic is that idle resources -- unemployed labor and capital -- are put to work to produce the added goods and services.

If the multiplier is greater than 1.0, as is apparently assumed by Team Obama, the process is even more wonderful. In this case, real GDP rises by more than the increase in government purchases. Thus, in addition to the free airplane or bridge, we also have more goods and services left over to raise private consumption or investment. In this scenario, the added government spending is a good idea even if the bridge goes to nowhere, or if public employees are just filling useless holes. Of course, if this mechanism is genuine, one might ask why the government should stop with only $1 trillion of added purchases.

What's the flaw? The theory (a simple Keynesian macroeconomic model) implicitly assumes that the government is better than the private market at marshaling idle resources to produce useful stuff. Unemployed labor and capital can be utilized at essentially zero social cost, but the private market is somehow unable to figure any of this out. In other words, there is something wrong with the price system.
Now there may be something wrong with the price system, but there is a lot more wrong with the government system.

But back to the multiplier. Team Obama is reportedly using a multiplier of around 1.5. Barro's response:
A much more plausible starting point is a multiplier of zero. In this case, the GDP is given, and a rise in government purchases requires an equal fall in the total of other parts of GDP -- consumption, investment and net exports. In other words, the social cost of one unit of additional government purchases is one.
He notes that even looking at the massive expansion of U.S. defence expenditures during World War II you only get a multiplier of 0.8. What this means is that the war lowered components of GDP aside from military purchases. Declines occurred, in the main, in areas such as private investment, nonmilitary parts of government purchases, and net exports -- personal consumer expenditure changed little. Wartime production siphoned off resources from other economic uses so there was a dampener, rather than a multiplier. But as Barro points out:
There are reasons to believe that the war-based multiplier of 0.8 substantially overstates the multiplier that applies to peacetime government purchases. For one thing, people would expect the added wartime outlays to be partly temporary (so that consumer demand would not fall a lot). Second, the use of the military draft in wartime has a direct, coercive effect on total employment. Finally, the U.S. economy was already growing rapidly after 1933 (aside from the 1938 recession), and it is probably unfair to ascribe all of the rapid GDP growth from 1941 to 1945 to the added military outlays. In any event, when I attempted to estimate directly the multiplier associated with peacetime government purchases, I got a number insignificantly different from zero.
A multiplier of zero doesn't make government stimulus packages look at all good. Over at the Organizations and Markets blog, they make the point:
Of course, if GDP is adjusted for quality, the multipler is most likely negative, as resource allocation is directed by government officials, not consumer demands.
And that makes stimulus packages look even worse!

It should also be noted that Barro's estimate of the wartime multiplier could be an overestimate, if Robert Higgs is right, see here, and here.


Matt Nolan said...

"Now there may be something wrong with the price system, but there is a lot more wrong with the government system"

That's really your key value judgment isn't it. I'm not sure I agree. I am not a fan of "multipliers" - but in the face of a large, sustained, market failure I find it hard to conclude that there is no role for government.

Also note that WWII is hardly a comparable data point to what we face today. Fiscal stimulus in the face of full employment and rationing is likely to have a lower "multiplier" than in the case of insufficient effective demand.

I'm not supporting the extreme stimulus being pushed by Krugman and co - I'm just saying that there is a middle ground between mass interventionism and allowing complete market autonomy.

Anonymous said...


What is the market failure you refer to specifically?