That’s no typo, today I’ll argue that the fiscal multiplier might be bigger than Paul Krugman suggests. Since I’m no Keynesian, this post is actually a sort of question for my Keynesian readers. Here’s Krugman discussing Robert Hall’s work:
The Hall approach is to compare changes in real defense spending as a percentage of the previous year’s GDP with the actual percentage growth in real GDP. Over the period 1930-1962 — no point going further, since there hasn’t been a good case since the Korean War — it looks like this:
Clearly, expansionary policy is expansionary, and contractionary policy is contractionary. The apparent multiplier is only about 0.5, but anyone who knows a bit about the history realizes that this is likely to be an underestimate for current conditions: during World War II private spending was constrained by rationing, and postwar effects of the military contraction were partially offset by the pent-up consumer demand; the Korean War was paid for with tax increases amounting to around 4 percent of GDP.
I’ve never liked studies that use RGDP when looking for multiplier effects; it seems to me that the issue should be separated into two distinction questions:
1. Does more G boost AD, and hence NGDP?
2. Does more NGDP boost RGDP?
Those are actually unrelated questions. The Keynesian model predicts that more G will boost NGDP, but also that the effect on RGDP depends on the slope of the SRAS curve. Keynes assumed a sort of backward L-shape, where it becomes almost vertical at “full employment.” Beyond that point more demand just leads to higher inflation, with no boost to output. That’s now realized as being a bit too simple; the economy can temporarily go beyond full employment, as for example when housewives were put in munitions factories during WWII.
As you know, my skepticism about the fiscal multiplier has to do with point one (at least under certain monetary regimes like inflation targeting), not point two.
Now let’s look at the graph provided by Krugman. I am no econometrician, but I recall being told that in this sort of graph the slope is mostly determined by the 4 points that are way off the Y-axis. I’d guess the three boom years were WWII, and the big drop was 1946. If I’m right, then Hall’s study might better be characterized as 1941-46, not 1930-62. But perhaps there are now more sophisticated econometric techniques, which give more weight to small changes.
In any case, it seems to me that during WWII we were at full employment, so I’d expect the effect of more NGDP on RGDP to be much less than usual. That’s a very different argument from Krugman’s “rationing” claim. In other words, if I were Krugman I’d make two separate claims:
1. The change in NGDP over the change in G is the fiscal multiplier.
2. The multiplier model will usefully predict changes in RGDP when output is well below capacity (like right now.)
In that case Krugman could argue that the effect of more G on RGDP today might actually be greater than in 1943 and 1944, when we were already at full employment.
There are actually two ways of justifying the Keynesian multiplier, a real mechanism and a nominal mechanism. The traditional Keynesian approach is basically nominal. More G gives you more NGDP, and because wages and prices are sticky in the short run, you get more RGDP as well. But there are also real models that don’t require any change in NGDP, especially those where the government output is quite different from private output. Thus if the government spent lots of money on the military, it would increase RGDP unless private spending fell by an equal amount. But a crowding out of private spending would make people “poorer” in terms of consumption, so they’d work harder to maintain their lifestyles. This harder work would prevent complete crowding out. (These real multiplier arguments don’t apply to lump sum tax cuts.)
I read Krugman as mostly relying on the traditional Keynesian nominal approach to the multiplier, augmented by an assumption that NGDP affects RGDP.
Since the evidence Krugman supplies is probably mostly based on WWII, here’s my take, FWIW:
1. After mid-1940 the escalating war in Europe led to sharply higher US military output, and also probably raised expectations for future growth. The monetary regime at the time was still linked to gold (as Christina Romer showed) and so it was very passive. The stimulus seems to have boosted NGDP for very Keynesian reasons, as will happen if monetary policy is passive.
2. Even if monetary policy had prevented any impact on NGDP (as under inflation targeting), I expect there still would have been some effect on RGDP for the “real multiplier” reasons I discussed above. However in that case it’s unlikely (not impossible however) that Americans would have been better off in terms of living standards.
3. Just to be clear, I do think Americans were made better off by the very fast 18 months of growth before Pearl Harbor, but that’s because NGDP did rise. So to some extent we were overcoming suboptimal output due to sticky wages and prices.
To summarize, I think there are two arguments for a fiscal multiplier, both of which are somewhat problematic:
1. The traditional Keynesian NGDP argument, which relies on incompetent central banks which fail to hit their nominal target (inflation or NGDP.)
2. Real arguments that work to some extent under any monetary regime, but are more likely to raise RGDP than living standards.
Take the current situation in the UK. If I’m not mistaken, the British political system is different from that in America. British governments are basically elected dictatorships, with no checks and balances. Even though the Bank of England is independent, the government can give it whatever mandate it likes. If I’m right then both fiscal and monetary policy are technically under the control of the Cameron government.
So I read the UK austerity critics as saying:
Because you guys are too stupid to raise your inflation target to 3%, or to switch over to NGDP targeting, fiscal austerity will fail. We believe the solution is not to be less stupid about monetary policy, but rather to run up every larger public debts.
Is that right? Is that what critics are doing?
Some will argue that my views are naive, that Cameron would be savagely attacked for a desperate attempt to print money as a way of overcoming the failures of his coalition government. Yes, but by whom? Would this criticism come from Ed Balls? Perhaps, but in that case he would essentially be saying:
“It’s outrageous that the Cameron government is trying to use monetary stimulus to raise inflation from 2% to 3%, whereas they should be using fiscal stimulus to raise inflation from 2% to 3%.”
I’m sorry to have to repeat this over and over again, but what 99% of pundits on both sides of the Atlantic are treating as a debate about “stimulus” and “austerity” is actually a debate about stupidity. I’m not saying the pundits are stupid (Krugman certainly understands what I’m saying) but rather they are addressing their audience as if the audience was stupid.
Don’t talk down to Cameron and Osborne! Don’t say “austerity will fail.” Say “austerity will work, but only if the BOE becomes much more aggressive, otherwise it will fail.” That sort of advice would be USEFUL. Instead we are getting a bunch of pundits getting ego boosts because they can say “I told you so.”
Why are we few market monetarists the only ones to point out that the emperor has no clothes?
Update: The excellent commenter Britmouse says my UK argument was actually much stronger than I thought:
I did a post which touched on that. UK fiscal budget changes are subject to parliamentary approval, so there are “checks and balances”, especially given that we have a coalition government with a thin majority.
The legal mandate for the Bank of England only requires them to maintain “price stability”, where HM Treasury is required to define “price stability”, and can change it at will.
So to do a fiscal spending boost, Cameron/Osborne would have to go through parliament. To get a 3% inflation target, they would need only to send a single letter to Threadneedle Street, and the Bank of England would jump to it.
The argument against British austerity just vanished into thin air. The Cameron government needs to ask for a higher nominal target over at the BOE. Period. End of story.