The fiscal multiplier varies over the business cycle

Alan Auerbach and Yurij Gorodnichenko have a nice piece over at Vox which reports empirical evidence that the size of the fiscal multiplier in the US is not constant over time, but varies over the business cycle. During good times, it is small — between 0 and 0.5 — while during recessions it is high — between 1 and 1.5. (During depressions it is even higher.) This is of course exactly what we teach our undergrads in standard macro courses (at least, I think of them as standard macro courses, but I guess not everyone agrees nowadays): here is more evidence consistent with those models.

Recessions are not a good time to have to cut government expenditure. They’re an even worse time to cut expenditure if you don’t have to.

11 replies on “The fiscal multiplier varies over the business cycle”

How does this sit with Mr. Lane’s work:
“the main message of the Benetrix-Lane empirical analysis is that the …fiscal multiplier varies across expenditure categories, with public investment boosting the level of output whereas an expansion in the public sector payroll is associated with output contraction.”

“public investment boosts productivity and thereby drives down the relative price level, whereas government consumption squeezes the export sector by reducing the availability of labour to the private sector.”

The concentration on defense spending is a little troublesome too – part of the reason the US has so little fiscal room for investment is the cost of the two wars it is fighting – is there a difference between peacetime spending (which may constitute investment from a GDP perspective) and wartime (which is an export of capital)?

I presume there are also differences based on tax cuts – tax rebate cheques for lower income workers being stimulative while those for higher earners having a low multiplier? (Unless you subscribe to the notion that the senior stock markets are a worthy destination for tax cuts!).

The work seems to be based entirely on the USA, and has a “high” multiplier as 1.5 or perhaps somewhat more. So, if we consider Ireland to be a much more open economy and even debate the Irish debt position as better or worse, the implications of the Ilzetzki, Mendoza and Vegh paper seems to be similar to that of other papers, i.e. that the multiplier in Ireland’s current position may well be close to zero or even negative.

Given that the spending is also largely being borrowed, with only a little more than a half of spending actually being raised from taxes, how much more might this impact the long run multiplier on the downside in Ireland’s case?

A quote from the Lane paper seems relevant to this question. “if an increase in spending today signals a long-term increase in the tax burden, its positive
demand effects will be negated”

I guess that describes Ireland pretty well. If we keep spending like this then long term taxes will be, ehm, significant.

The credit bubble (do we all agree that it existed?) means that malinvestment occurred. That will be much of the contraction. The absence of the bubble. It is now gone. But not forgotten!

So the real econopmy one without excessive lending, will reassert itself, after the loans have been paid off, if you like that sort of thing.

Bankruptcy is recognized to be a safety net for those who cannot afford to repay. It has existed for so long and has religious backing, that it is a highly moral position.

So the bubble can be paid off as the economy declines. It has to overshoot. It has to becausse we have all that private and public debt to pay off. The overshoot is the cost of NAMA and ANGLO and the interest on the borrowings. This will only correct when NAMA is liquidated and the borrowings repayments are in equilibrium. Then we see the “normal” economy.

Until then, Hell to pay!

Now let’s just have a supply curve of sovereign credit, and let’s, er, make it slope away from the borrower. Even, like, sharply away from the borrower. Then the multiplier is……

It is frustrating we don’t have a better grasp on the multiplier for Ireland.

While the openness of the economy and the endogeneity of the risk premium (as Colm suggests) are reasons to believe in a small multiplier, it is well to note factors that tend to raise the multiplier for Ireland as well: the large negative output gap, the severe credit constraints faced by households and firms, and the almost 100 percent accommodative monetary policy as a small economy in a large monetary union.

By the way, I think Colm’s kinked credit supply curve is essentially the same idea as the fiscal limit idea in the IMF’s fiscal space framework (see previous thread). I am a bit more optimistic about where that kink might be — or at least where it would be with a more future-focused fiscal policy framework.

The openness of the Irish economy is a factor which ought to make the multiplier larger, not smaller.

This is because, from Adam Smith onward, participation in the division of labour (in Ireland’s case this means the international division of Labour) increases productivity and the productivity of all factors, including investment.

Theory suggests that the high degree of Ireland’s participation in the global economy increases the productive effects of investment, or, the investment multiplier.

Happily, that is also th experience as monitored in Lane/Benetrix over the medium-term

In that research the multiplier from a one-off increase (immediately reversed the following year) in government investment over 6 years was 4.01, while a one-off permanent increase in governemtn investment has a mutiplier of 4.44 in the first 4 years (and becomes negative thereafter).

Of course, this is an average experience, and the multiplier tends to increase when the output gap is wider, or interest rates are low or credit access is constrained. All of which apply currently.

@ KO’R,

Here is a question which might have some relevance. Take on the one hand, the theory that Ireland had lagged behind much of the developed world for a long time post WWII. It needed to do some ‘catch up’. But the problem is Ireland was forced to do its ‘catch-ing up’, whilst also joining a single European currency – in which the ECB set rates around levels appropriate to the Franco-German core states – and not appropriate to that in peripheral areas such as Ireland, Spain, Portugal, Italy, Greece and so on.

The point is worth bearing in mind, that when Spain and Portugal joined the European Union, there was a conscious understanding on the part of most people, those were ‘poor states’. I remember for instance, Malta was debating joining the European Union ten years ago, and it had buses running, which had been there since WWII. There is that problem for all peripheral nations in Europe, that when they join the EU, and play catch-up, there is a period of immense growth and also, no control over monetary policy. It makes things exceedingly difficult in terms of management of the cycle. I.e. Too much going on at once.

I am not saying there weren’t many mistakes made by those in positions of responsibility in Ireland during the naughties. But it seems to me, that we had quite a lot of stuff happening at once – indeed, too much – and no one analysed that properly, and drew sufficient attention to the fact. Markets do work, economies do work, but they need time in order to adjust and respond. It seems to me, the Irish economy (and those of many other peripheral European states) were trying to change and respond to altered circumstances at the same time – and that was managed very poorly indeed. At least with policies at the moment, the government and financial houses seem to be leaving some space between effects on their timeline, in order to guide events rather than react only, as it happens. BOH.

@ All,

At this stage in September 2010, there are too often used cliches, I think have become over-used. One is the ‘small business’ handle used to describe entreprises with a smaller number of people. When you break down even a very large entreprise, it always breaks down into smaller units anyhow. I.e. Groups that can be fed with one large piazza. In terms of entreprise, I don’t understand this constant hang up with speakers, on the issue of small-ness, or medium-ness of entreprise. I wish more people would go off and attempt to understand entreprise in general better, and read Ronald Coase. End of rant on that.

The other cliche I have heard quite enough of in September 2010, is open-ness in regards to the Irish economy. We always seem to describe ourselves in those terms – open, small, medium – as if that made us different in some way. Maybe these terms have got lodged into the vocabulary at this stage and are stuck there now. But as a student of texts which really try to deal with the subject of entreprise, I find the shallow-ness of debate in Ireland at this moment, quite appalling. Hence the need for my post above. Rather than describe ourselves in terms such as ‘open’, or ‘small’, I would rather look at an unfortunate (and perhaps un-controllable) combination of two important variables.

That being, the idea of Ireland’s economy ‘catch-ing up’ with the developed world. And that at the same time, the Irish economy being controlled by centralised European monetary policy. Even one of those events at any time, would impose considerable strains on any economy, but together at the same time, was very poor management. It was the combination of those two major variables which over-stretched the Irish economy’s speed and ability of adaption. It was less to do with ‘small-ness’ or ‘open-ness’. And I wish Farmleigh conference members could have left more of that sound bytes vocabulary in their day-job brief cases in 2009. We are stuck with the same vocabulary today, for use in debates, for better or for worse. BOH.

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