INSIGHTS: DEMYSTIFYING THE MAGICAL MULTIPLIER MYTH
GUEST COLUMNIST: VERONIQUE DE RUGY, Senior Research Fellow, Mercatus Center at George Mason University. Reprinted with permission.
The scale and scope of government spending expansion in the last year are unprecedented. Because Uncle Sam doesn’t have the money, lots of it went on the government’s credit card. The deficit and debt skyrocketed. But this is only the beginning. The Biden administration recently proposed a $6 trillion budget for fiscal 2022, two-thirds of which would be borrowed.
Obviously, the politicians pushing money out always make extravagant promises about the economic growth that will result from their generous use of other people’s money. A new study by George Mason University economist Garett Jones and myself dispels some of the magical thinking that goes on in this area.
In our paper published by the Mercatus Center at George Mason University, we review the most recent literature on the short-term effects of government spending, including recent findings on what economists call the “multiplier.”
The multiplier looks at the return we get in economic output when the government spends a dollar by directly hiring federal employees, paying contractors for public projects and so forth. If the multiplier is above one, it means that government spending draws in the private sector and generates more private consumer spending, private investment, and exports to foreign countries. If the multiplier is below one, the government spending crowds out the private sector, hence reducing it all.
Economic textbooks traditionally claim that the government multiplier is high. In other words, they say that spending not only pays for itself but generates large increases in economic output. In recent years, Keynesian-leaning economists have had more modest expectations and have theorized a multiplier around 1.5 or 2. However, reality is often different than theory.
The evidence presented in our paper suggests that government purchases probably reduce the size of the private sector as they increase the size of the government sector. On net, incomes grow, but privately produced incomes shrink.
According to the best available evidence, we find that “there are no realistic scenarios where the short-term benefit of stimulus is so large that the government spending pays for itself. In fact, even when government spending crowds in some private-sector activity, the positive impact is small, and much smaller than economic textbooks suggest.” If you understand how legislators make their decisions to spend money, based on politics rather than sound policy or economics, that finding shouldn’t surprise you.
We also find that the only case where the literature finds a multiplier above one requires some very specific conditions, such as a zero lower-bound interest rate. And even in that case, the multiplier is 1.4 at best. Arguably, we have those conditions today. That said, our colleague Scott Sumner offers a compelling argument that “this finding … is conditional on having an incompetent or passive monetary policy in place; that is, having a monetary policy not designed to hit a growth target in aggregate demand.”
A competent Federal Reserve would set its policy to achieve optimal growth of expected aggregate demand and attempt to neutralize the impact of fiscal stimulus through policies like quantitative easing. As for what it means today, if you think that the current monetary policy of the Federal Reserve is reasonably competent, then you actually shouldn’t expect the fiscal boost from all that spending to be large. In fact, it could be close to zero.
This is, of course, all before taking future taxes into account. When economists like Robert Barro and Charles Redlick have looked that the multiplier, they’ve found that once you account for the future taxes that will be required to pay for all that spending, the multiplier could be negative.
Finally, the COVID-19 recession was better described as a bad supply shock, where the pandemic unexpectedly affected the supply of goods and services, relative to demand. These poor conditions make a multiplier above one unlikely. Under circumstances where economies were closed by government officials and consumers were staying at home to mitigate the effects of COVID, government spending could not have stimulated the economy. As such, the hundreds of newspaper reports about COVID relief that called the spending “stimulus” were misleading.
On the flip side, reporters today should also be careful not to assume that government spending deserves all the credit for economic growth this year, since much of it will be the normal effect of the broad economy reopening. Many economists are worried that the extravagance of government spending may seriously backfire and lead to inflation.
ON THE ECONOMY: NOTHING IS WHAT IT SEEMS
John Dunham, Managing Partner, John Dunham & Associates
Well you know everything’s gonna be a breeze, at the end will no doubt justify the means
You can fix any problem with the slightest ease – Yes please. But you might find out it’ll go to your head, when you write a report, on a book you’ve never read. And with the snap of your fingers, you can make your bed – That’s what I said. Everything is not what it seems. When you can get all you wanted in your wildest dreams. You might run into trouble if you go to extremes, because everything is not what it seems. So sings Selena Gomez in the title song to the Disney Channel television series Wizards of Waverly Place, written by Bradley Hamilton, John Adair, Ryan Elder and Stephen Hampton.
When it comes to the current bout of inflation, everything is really not what it seems, or at least what the wizards at the Federal Reserve are suggesting. To understand what is happening with prices, one must first understand what inflation is.
First, inflation is not an increase in prices for one or two items. Prices are determined by the magic of the market and supply and demand conditions. If a specific product runs into a supply disruption, or if demand for a product rises dramatically, prices will go up. For example a drought in Brazil will impact the volume of coffee produced. This will reduce supply and the magic of the market will lead to a price increase to the point where supply and demand come into equilibrium.
Neither is inflation an increase in the Consumer Price Index (CPI), which reflects the average prices of an ever-changing market basket of goods and services generally purchased by consumers. The CPI can rise or fall for reasons totally unrelated to inflation – for example a large increase in fuel prices, which make up a large percentage of the index.
Inflation, on the other hand, is a general decline in the purchasing power of a currency over time. It is not reflective of the market for goods and services, but rather the market for money itself. Just like the price of coffee increases when the supply falls, so too does the price of money. In the case of the United States, if more dollars are available to purchase the same number of goods, the value of the dollar falls relative to other measures. Likewise, if fewer dollars are available, then the value of the dollar rises. As the Nobel Laureate economist Milton Friedman stated, Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.
The current run-up in prices is the result of both a temporary reduction in the supply of goods and services as a result of the government-imposed economic shutdown and other policies that have reduced production and increased demand. While the temporary imbalances are transitory (as are nearly all supply and demand dislocations), the actual inflation will be long lasting.
Going back to Dr. Friedman’s quote, inflation is a monetary phenomenon that is produced by a rapid increase in the quantity of money in excess of output. Let’s look at the statistics. As the graph shows, the money supply has increased by 1,284 percent since the end of the last recession. At the same time, economic output has risen by just 46 percent. In other words, 1,284 percent more money is chasing just 46 percent more stuff. Obviously, there is a disconnect.
General inflation has not occurred, because the bulk of the new money created by the Federal Reserve has not entered the economy, but rather has
remained inside of the banking system. In fact, beginning at the start of the 2008 recession, assets held by the Federal Reserve increased at a much faster rate than the overall money supply. In effect, the Fed printed cash, sent it to banks and drew it back out of circulation. The central bank also began to undertake huge purchases of other assets including debt instruments from the private market, in effect sucking money out of circulation. So even though output was not rising very quickly, neither was the actual money supply. So just as Dr. Friedman would suggest, inflation was held in check.
Things changed dramatically with the onset of the recession created by the government-induced shutdowns in response to COVID-19. While Federal Reserve asset purchases continued, they no longer kept pace with the money supply, which was now entering the economy through transfer payments to individuals and businesses. At the same time, production (output) fell. The result has been inflation, first at the producer level, and now at the consumer level. The disconnect between output and the money supply is without precedent. Even during the high inflation era of the 1970s the money supply never outstripped production to the levels that it is now.
Of course, it is always difficult to predict what will happen when the economic models break down, but it is hard to think that there cannot be an extended period of inflation – at least until the change in production balances with the change in the money supply. How long this will take is unknown, but one thing is for certain, the imbalance is huge, and the supply and demand machinery of the economy has not changed. Another thing to bet on is that everything’s not gonna be a breeze. This problem will not be fixed with the slightest ease. Because everything is not what it seems.