April 2, 2010

MULTIPLICATION CROCK:

Robert Barro on The Lessons of the Great Depression: Robert Barro is a professor of economics at Harvard, and a commentator for The Wall Street Journal and Business Week. His critique of the Obama stimulus package provoked a sharp attack from Paul Krugman in The New York Times, which brought a spirited response from Barro. Basing his arguments on his empirical work, Barro takes issue with some common assumptions about the Great Depression, and how America got out of it. (5 Books)

So you’re not saying the New Deal was a mistake, you’re saying basically we don’t know.

One of the things I’ve been trying to do in my research is to calculate the effect, particularly on Gross Domestic Product, of government expenditure programs. And I’ve been focusing on the US experience, because that’s where I have the information, although it would be good to go beyond that. But the thing you can clearly isolate is the effect of wartime expenditure – particularly World War Two – it is so big that in a statistical sense it gives you a lot of power to figure out what is going on.

There’s both the build-up, starting in 1941, and then there’s expenditures coming down after the war, in 1945-6. There’s a lot of evidence there. Sometimes the spending in a year is 20 per cent of GDP, which is absolutely astounding. In comparison, the New Deal programs, particularly in 1934 and 1936, are only two to three per cent of GDP of extra spending.

In terms of the stuff that’s not wartime spending – which we’re probably most interested in in the current climate –it’s just hard to know from the history of the data and the time series. The New Deal is part of my research, and it’s bigger than the other non-defence expenditure in terms of stimulus, but it’s not enough to really sort it out.

So I don’t think you can reliably say what the effect is. But conceptually you’d expect the wartime spending to have a bigger effect for various reasons on the GDP than the equivalent amount of expenditure in a non-war situation. And the wartime effect you can estimate pretty precisely, and the multiplier is clearly less than one, even in World War Two – it’s in the order of 0.6, 0.7, something like that.

So your point is that even in the context of massive expenditures in a wartime situation, the multiplier effect of government spending on the economy is less than one – ie, it is not a multiplier at all. In other words, fiscal stimulus does not work. I read your WSJ editorial on this. Is that a good way for the layman to understand your arguments? Also this, on the “Voodoo Multipliers" and your September 2009 NBER working paper (most recent version available on the left)?

Yes, those articles refer to this kind of evidence, and I’ve been working more on it, trying to make it more precise. Some economists have argued that in a time of slack the multiple should be bigger, because there’s more capacity to respond to the extra demand. There’s a little bit of evidence that that’s right. A lot of that comes from the build-up in World War Two, because in 1941 the unemployment rate is still around nine per cent, so you can see what is the effect in that environment, in a high unemployment situation, of having a big expenditure increase. (Later in the war, the unemployment rate is close to nothing, so you don’t have that setting.) There’s a little bit of evidence from that that the multiplier is bigger when there’s more slack. But it doesn’t look like the multiplier gets up to one, even when the unemployment rate is nine per cent. It’s getting closer to that, but even then it is not one.

And yet neo-Keynesians – which include White House economics adviser Christina Romer – often cite the number as being 1.5, and you say in your article that the Obama administration is using 1.5 as a basis for its fiscal stimulus policies. How do they come up with that then?

Oh they pulled that out of the air. I have the advantage of having at least a little bit of empirical evidence....


Danged empiricism....


MORE:
Government Spending Is No Free Lunch: Now the Democrats are peddling voodoo economics. (ROBERT J. BARRO, 1/22/09, WSJ)

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.

John Maynard Keynes thought that the problem lay with wages and prices that were stuck at excessive levels. But this problem could be readily fixed by expansionary monetary policy, enough of which will mean that wages and prices do not have to fall. So, something deeper must be involved -- but economists have not come up with explanations, such as incomplete information, for multipliers above one.

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.

This approach is the one usually applied to cost-benefit analyses of public projects. In particular, the value of the project (counting, say, the whole flow of future benefits from a bridge or a road) has to justify the social cost. I think this perspective, not the supposed macroeconomic benefits from fiscal stimulus, is the right one to apply to the many new and expanded government programs that we are likely to see this year and next.

What do the data show about multipliers? Because it is not easy to separate movements in government purchases from overall business fluctuations, the best evidence comes from large changes in military purchases that are driven by shifts in war and peace. A particularly good experiment is the massive expansion of U.S. defense expenditures during World War II. The usual Keynesian view is that the World War II fiscal expansion provided the stimulus that finally got us out of the Great Depression. Thus, I think that most macroeconomists would regard this case as a fair one for seeing whether a large multiplier ever exists.

I have estimated that World War II raised U.S. defense expenditures by $540 billion (1996 dollars) per year at the peak in 1943-44, amounting to 44% of real GDP. I also estimated that the war raised real GDP by $430 billion per year in 1943-44. Thus, the multiplier was 0.8 (430/540). The other way to put this is that the war lowered components of GDP aside from military purchases. The main declines were in private investment, nonmilitary parts of government purchases, and net exports -- personal consumer expenditure changed little. Wartime production siphoned off resources from other economic uses -- there was a dampener, rather than a multiplier.


Posted by Orrin Judd at April 2, 2010 10:55 AM
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