I’ve been puzzling over the stimulus-advocate’s argument that government spending does not crowd out private spending, but in fact has a higher multiplier effect. I’m basically struggling against Krugman and DeLong, who know a tad more macro econ than I do, and not getting as much help as I needed from my regular econ blog reads because those guys (bless their souls) aren’t macro folks. But fitful and sporadic perseverance led me to this article by Robert Barro, who is a macro guy, and a quite eminent one at that. Here’s what he has to say.
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.
His “plausible starting point” of a multiplier of zero is an assumption of perfect crowding out–each dollar of government expenditure crowds out a dollar of private spending. But he doesn’t stop with that starting point, and goes on to discuss empirical findings.
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.
He finds evidence from each of these wars for a multiplier of 0.8. He thinks that is actually overstated, but his reasons are somewhat ad hoc, so let’s just go with 0.8. That means every dollar of government spending boosts the economy by less than a dollar. That means crowding out is going on.
But the Obama administration assumed a multiplier of 1.5 (as did Bernstein and Romer). Where did that number come from? According to Chicago’s John Cochrane it came from the standard Keynesian model, where it was an assumption, not a finding.
So even if there are answers to my questions, I’m in good company asking them.
Just a few weeks ago Krugman responded, not directly to either of these posts that I dredged up, but but to effectively the same argument, calling the argument about government doing a better job of spending “a crude fallacy.”
[T]hese … crude fallacies are being enunciated, with confidence, by famous and influential economists. Here’s Eugene Fama, arguably our most famous and influential finance economist:
Again, here is my [Barro’s] argument in three sentences.
1. Bailouts and stimulus plans must be financed.
2. If the financing takes the form of additional government debt, the added debt displaces other uses of the same funds.
3. Thus, stimulus plans only enhance incomes when they move resources from less productive to more productive uses.
Are any of these statements incorrect? [Hooray, Fama agrees with me, too!–JH]
In his attack on me Krugman implicitly assumes that sentence 3 above is true; that is, the stimulus plan will on balance move resources from less productive to more productive uses…
… It’s completely wrong; the whole point is that stimulus is supposed to put resources that would otherwise be unemployed to work. But at this point, a large part of the economics profession no longer understands that. …
OK, I’m very glad to have this so explicitly from Krugman. He doesn’t think government has a higher multiplier than private sources. But he does accept the 1.5 number for government spending, contra Barro, but I have no idea what data he bases the assumption on. Based on Barro’s empirical analysis Krugman appears to be wrong about that.
But let’s set that aside for the moment and focus on what he says is the issue, “resources that would otherwise be unemployed.” I have two major problems with this this. One, as I have been saying all along, is the question of “where are all these unemployed resources?” The money must be sitting somewhere not doing anything, so where is it and how much is there? Second, Krugman argued that we needed a much larger stimulus package, and his argument about that was based on declines in GDP, with a particular claim that the stimulus wasn’t large enough to offset a decline in state and local government spending. But that’s not the same as basing it on the amount of unemployed resources. Krugman called for a stimulus of around $1.8 trillion. Does he believe that there was $1.8 trillion of cash sitting around doing nothing? Is that at all possible? Or am I missing something here?
* By which I include not just the stimulus, but the Iraq war and the massive discretionary spending under Bush (although I will give Afghan War spending a pass).