Talking Stimulus; Or Why Fiscal Deficits Might Fail To Boost Economies

This article on VoxEU caused a stir in the economics blogosphere went it first appeared. I’d originally intended to post on this much earlier, but for a number of reasons I’ve sat on it for a while. What’s interesting is that the underlying research attempts to measure the impact of government fiscal deficits on GDP – that amorphous quantity known as the fiscal multiplier.

There are two contending views on the fiscal multiplier – Keynesians of course contend that the multiplier is positive and above unity i.e. for every dollar spent by the government, GDP expands by more than a dollar. The opposite viewpoint, typically associated with monetarists and Neo-classicals, is that the multiplier is below unity, and at the extreme can actually be negative. Empirical investigations into the question have yielded a range of estimates from zero to well over 2, which means the question is far from settled.

The paper explains why there’s such a diversity of estimates – fiscal policy is equally diverse in its application, the structure of the economy matters, monetary policy reaction matters, as does the position of the economy relative to full employment output. The methodology at arriving at the estimates also matters enormously (check the paper’s critical appraisal of the Obama government’s estimates). So the real answer is: it depends.

Here are some of the key issues (not limited to the discussion in the paper):

1. The output gap – the greater the gap between the current level of output and full employment output, the greater the likely impact of fiscal spending. This is the prototypical Keynesian argument, and one Neo-classicals have a hard time with. Why? Because under the assumption of complete and fully clearing markets, by construction unemployment cannot exist. You then get howlers like, “people must be demanding more leisure time,” in an attempt to explain the drop in employment.

2. Crowding out – the effectiveness of fiscal spending depends on its use of available resources. The Keynesian argument is that since output is below capacity, idle resources can be used by the government to boost economic activity back to full employment level. However if resources (both real and financial) are not idle, then government spending partially or fully replaces private sector spending, and the multiplier must be less than one and at the limit, zero.

3. Central bank independence – the more optimistic estimates of fiscal multipliers generally have one thing in common, which is that they assume no change in monetary policy. But deficit spending requires raising government debt, which in turn pushes up interest rates. How a central bank would react to that depends on how independent it is and the outlook for inflation. If inflation is low or there is deflation, monetary expansion is called for which would tend to exaggerate the effect of fiscal expenditure. But over the medium term to long term, as output picks up, inflation should rise and monetary tightening will reduce the stimulus impact. Over time then, the multiplier should therefore be declining. Under full employment of course, independent central banks would act to offset the inflationary impact of increased government spending, and it’s more than possible that under such circumstances the fiscal multiplier can actually be negative.

4. Trade openness – another key assumption of the Keynesian argument is that government spending falls mainly on local production of goods and services. If it doesn’t, then the impact of government expenditure is actually lost to the economy, as it “leaks” to other countries. This was explicitly tested in the paper and found to be a significant factor – more “open” economies tended to have lower multipliers.

5. Structural fiscal spending – policy choices matter. Tax cuts and rebates will have different effects on the economy then construction projects, although as a rule, direct spending will have the higher multiplier.

In addition, the paper finds that multipliers in developing countries as well as highly indebted countries vare lower than in developed countries, but higher for countries with fixed exchange rates than for countries with flexible exchange rates.

Do these estimates apply to Malaysia? I’ve off and on been monitoring whether any research has been conducted on the fiscal multiplier(s) for Malaysia – believe it or not, I have yet to find any empirical research into this question. If anybody knows of any, please let me know.

The authors of the paper unfortunately don’t list the countries included in their sample, although it’s a mix of 45 developed and undeveloped economies (it’s an unbalanced panel VAR regression – I presume Malaysia is included). But even so you can’t directly take their estimates as applying to Malaysia, as panel studies lose country specific information. It’s quite possible (probable) that you get unbiased statistically significant aggregate estimates, yet have one or more countries in the sample with wildly different experiences.

But looking at the list of factors above (as well as the estimates from the paper), it’s hard to be confident that fiscal stimulus would have much impact on the Malaysian economy. While I accept the basic Keynesian premise that in the presence of an output gap and idle resources (little or no crowding out effect) expanded fiscal expenditure can be desirable, the mitigating factors mean that any impact will leak from the economy resulting in a low multiplier.

Here’s why I think so: first is the relative openness of the economy. The authors of the paper use a threshold of total trade exceeding 60% of GDP to define open and non-open economies; the ratio for Malaysia exceeds 200%. Also, the evidence on the Balassa-Samuelson effect on Malaysia is inconclusive, where studies usually take government consumption as a proxy for spending on non-tradables. What that means to me is that there’s a high import element in government spending.

Think about the structure of the March 2009 stimulus package for instance. Only about RM20b+ can properly be called stimulus spending, out of which most are construction projects. The reason for this policy choice is that construction typically (from previous studies in developed countries) has a high multiplier effect. But in Malaysia’s case, construction labour is mainly foreign and a lot of raw materials are sourced overseas. While we’d get a long term benefit from the infrastructure created, the short to medium term impact on GDP is already half-lost at the outset. Given the import content of some of our domestically produced and consumed goods as well, I’m not sure that tax cuts or rebates would be any better.

Second, Malaysia is definitely not a high income economy, so if we take the estimates from the paper, the impact is indistinguishable from zero. And third, the Ringgit is relatively flexible (well I think so anyway), which should also means a low multiplier.

So why bother with deficit spending? Under the current circumstances I can think of only one, albeit very good, reason. While taken individually, Malaysia and its trade partners would be “open” economies, in aggregate the world is a “closed” economy. That means aggregate excess fiscal spending will have an impact somewhere, even if the benefits do not fall wholly on the country spending the money. There’s no doubt that China’s massive stimulus spending over the past year helped pull East Asia very quickly out of recession. Malaysia’s fiscal spending therefore is in effect our contribution to reflating the global economy, not just Malaysia’s alone.

The risk here is we beget a “free rider” problem – if only one country is doing the spending, they bear the cost while gaining less of the benefit. Fiscal rectitude on the part of their trade partners under those circumstances would amount to being bad global citizens. Also pertinent is that the US stimulus spending could have the paradoxical effect of exacerbating global trade and capital imbalances that helped start this whole mess in the first place. Hence the calls for coordinated international action in stimulus spending earlier this year; and the talk about the need for coordination when withdrawing stimulus spending, which should presumably happen later next year. So under the circumstances, where we have had a synchronous global downturn, there are solid grounds for fiscal deficit spending.

Just let’s not get the politicians too comfortable spending taxpayers’ money when we get out of this.

Ethan Ilzetzki, Enrique G. Mendoza & Carlos A. Vegh, “How big are fiscal multipliers? New evidence from new data”. Link to full paper here.