Malaysian Fiscal Multipliers

New on the World Bank Policy Research Working Paper Series (abstract; emphasis added):

Fiscal multipliers over the growth cycle : evidence from Malaysia
Rafiq, Sohrab; Zeufack, Albert

This paper explores the stabilisation properties of fiscal policy in Malaysia using a model incorporating nonlinearities into the dynamic relationship between fiscal policy and real economic activity over the growth cycle. The paper also investigates how output multipliers for government purchases may alter for different components of government spending. The authors find that fiscal policy in Malaysia has become increasingly pro-cyclical over the last 25 years and establish that the size of fiscal multipliers tend to change over the growth cycle. A 1 Malaysian Ringgit rise in government (investment) spending leads to a maximum output multiplier of around 2.7 during growth recessions, and around 2 in normal times. The returns to government spending in Malaysia are greater when the focus is on public investment, as opposed to consumption. Changes in tax policy are less effective in stimulating economic activity than direct government spending. These results provide empirical backing to conjectures in the recent literature implying that procyclicality in fiscal policy reduces the effectiveness of fiscal actions in emerging markets.

I had the pleasure of being part of a group meeting the authors yesterday (they’re with Khazanah Nasional, though both are scheduled to leave soon) and we had a fairly stimulating discussion that veered quite a bit from the issue of fiscal multipliers. But since I don’t have permission to disclose what was discussed, I’ll confine my remarks to the paper alone.

My very first reaction was – those multipliers sound too high. But reading through the paper, it’s obvious that we’re looking at a multiplier that dropped substantially after 1997-98 (they showed the evolution of the multiplier(s) across time in the presentation, though that particular chart is not in the paper).

The paper also confirms that multipliers for government consumption are much lower than investment – much, much lower. In fact consumption multipliers on GDP and private consumption turn negative within one-two quarters. For much of the past decade, the overall effective fiscal multiplier for GDP and private consumption was not much better than zero.

My thinking on that can be summarised in two points:

1. Barring the mini-recession of 2001 and the deeper recession of 2009, the economy has been at full employment, both in terms of capital use and labour use. Under those circumstances, additional government spending should in theory crowd out private consumption, and/or result in inflation and/or higher imports. In effect, at full employment, the multiplier should be zero. If you’ve read through my FAQ on government debt, that’s where I put the real limit to fiscal expansion and debt accumulation.
2. We had a distinct regime change in 2005, with the float of the Ringgit. In an open economy, floating rate regime with independent monetary policy, both theory and empirical evidence suggest smaller multipliers than under autarky, or an open economy under a fixed exchange rate regime.

Does this mean that everyone’s suspicions are right and that the government should have reined in spending over the past decade?

Well, yes and no.

Yes, in the sense that all thing being equal, that would have been the correct policy choice. No, in the sense that you don’t have to keep things equal, because there are other non-fiscal policy choices.

The obvious one is that if fiscal policy is expansionary at the full employment boundary, the other side of the coin should be contractionary. In other words, BNM should have tightened monetary policy more than they have done. Instead, monetary policy was straitjacketed by the necessity of keeping parity with the USD in the first part of the decade. As Greenspan kept US Fed Funds Rate low (we had a deflation scares in 2001 and 2004 IIRC), monetary policy settings in Malaysia were probably too loose. The shackles only came off in 2005, and in less than a year the policy rate was raised 75bp.

Given the current circumstances – the economy again at full employment and a government budget still in deficit, I think it’s only a matter of time before monetary policy will have to tighten again.

Technical Notes:

Rafiq, Sohrab; Zeufack, Albert, "Fiscal multipliers over the growth cycle : evidence from Malaysia", The World Bank, Policy Research Working Paper WPS5982, March 2012