Economics focus: Much ado about multipliers | The Economist

What is the goal of fiscal stimulus during a recession? Is it simply to increase nation’s total income by a certain amount determined by how much a government increases its own spending by? If this were the case, then an $800 billion stimulus package, like the one begun this year in the US, would lead to a total increase in national income of, well, exactly $800 billion.

While such an outcome is possible, it is not the desired outcome of the Obama administration and the economists who have supported the use of expansionary fiscal policy during economic downturns (i.e. the Keynesian school of economists). Keynesians expect that an initial increase in government spending (or a decrease in taxes) will result in households and firms increasing their own consumption and investment, meaning successive increases in spending. The initial change in spending ultimately gets multiplied through further rounds of spending. The total change in national income resulting from an initial change in government spending or taxes depends on the size of the fiscal multiplier. Now, this is where things get tricky! From the Economist:

The size of the multiplier is bound to vary according to economic conditions. For an economy operating at full capacity, the fiscal multiplier should be zero. Since there are no spare resources, any increase in government demand would just replace spending elsewhere. But in a recession, when workers and factories lie idle, a fiscal boost can increase overall demand. And if the initial stimulus triggers a cascade of expenditure among consumers and businesses, the multiplier can be well above one.

The above scenario, where an economy is operating below full-employment and government spending puts the nation’s idle resources to work, creates new income and further increases private spending, is precisely what the Obama team and its economists hope will happen in the US economy soon. A multiplier of above one means the $800 billion will ultimately increase America’s national income by something greater than $800 billion!

The multiplier is also likely to vary according to the type of fiscal action. Government spending on building a bridge may have a bigger multiplier than a tax cut if consumers save a portion of their tax windfall. A tax cut targeted at poorer people may have a bigger impact on spending than one for the affluent, since poorer folk tend to spend a higher share of their income.

Crucially, the overall size of the fiscal multiplier also depends on how people react to higher government borrowing. If the government’s actions bolster confidence and revive animal spirits, the multiplier could rise as demand goes up and private investment is “crowded in”. But if interest rates climb in response to government borrowing then some private investment that would otherwise have occurred could get “crowded out”. And if consumers expect higher future taxes in order to finance new government borrowing, they could spend less today. All that would reduce the fiscal multiplier, potentially to below zero.

Herein lies the controversy about the effectiveness of deficit-financed fiscal stimulus. Several posts on this blog have focused on the neo-classical, supply-side economists’ fears that expansionary fiscal policy financed by government borrowing will drive up interest rates to private borrowers, thereby “crowding-out” private investment, off-setting any expansion in output achieved through government spending. In the Keynesian model, however, it is precisely because interest rates have bottomed out at the “zero bound” (according to Paul Krugman) that government borrowing and spending will not lead to crowding-out, rather could actually increase investors’ willingness to spend (their “animal spirits”) on new capital, actually “crowding-in” private investment.

Alas, the debate continues. The ironic thing is that even years from now, after all of Obama’s stimulus money has been spent, and the US economy is either fully recovered or it is not, we still won’t know how large the fiscal multiplier was, since tomorrow’s economists will find it nearly impossible to isolate the variable of the $800 billion of government spending and determine just how much of America’s growth in income can be attributed to government spending, and how much resulted from automatic stabilizers built-in to help the economy recover on its own during recessions.

Discussion Questions:

1. Why do tax cuts for the rich tend to have a smaller multiplier effect than tax cuts for lower income households?
2. How can government borrowing drive up interest rates, and why is this a concern to policy makers deciding on the size of a fiscal stimulus package?
3. What are the animal spirits the article mentions? Where have you heard this expression before?
4. Do you think borrowing trillions of dollars and spending it to put people back to work and try to dig the US economy out of recession is wise, or should the US government be practicing better fiscal responsibility?

Economic View – A Dose of Skepticism on Government Spending – NYTimes.com

We all understand that fiscal stimulus is one of the tools that governments can use to increase the level of economic activity during a recession. The fiscal medicine can be delivered in one of two ways. The government can tweak the tax systems to boost incentives to spend and work or it can increase government spending. One tool that we can use to evaluate the merits of these two policies is to compare the relative multipliers that relate to government spending and taxation.

The multiplier is the key component of Keynesian theory and shows the possibility of a given increase in injections, e.g. government spending, investment and exports, increasing aggregate demand by more than the initial value. This logic fits with our understanding of the circular flow where say increased government spending will lead to increased derived demand for other products, and increased demand for labour. Workers will spend additional wages on other products which leads to further increases in aggregate demand. This flow on effect can be diluted by withdrawals from the system such as taxation or savings.

Greg Mankiw wrote an excellent analysis of this issue in the New York Times in Janurary. “A dose of skepticism on government spending”

An essential skill for IB and AP Economics students is to be able to evaluate the effectiveness of Keynesian  demand-side policies as well as classical supply-side policies, both fiscal and monetary. An understanding of multipliers can improve a student’s ability to evaluate fiscal policy. Greg writes:

“Economics textbooks, including Mr. Samuelson’s and my own more recent contribution, teach that each dollar of government spending can increase the nation’s gross domestic product by more than a dollar. When higher government spending increases G.D.P., consumers respond to the extra income they earn by spending more themselves. Higher consumer spending expands aggregate demand further, raising the G.D.P. yet again. And so on. This positive feedback loop is called the multiplier effect.

In practice, however, the multiplier for government spending is not very large. The best evidence comes from a recent study by Valerie A. Ramey, an economist at the University of California, San Diego. Based on the United States’ historical record, Professor Ramey estimates that each dollar of government spending increases the G.D.P. by only 1.4 dollars. So, by doing the math, we find that when the G.D.P. expands, less than a third of the increase takes the form of private consumption and investment.”

This low multiplier effect implies that any government spending must be used in an effective manner where it will increase the long-term productivity of the country. During a “jobs think-tank” recently in New Zealand, a media release announced an idea of the government spending a vast sum of money to develop a walking track from one end of the country to the other. Would this lead to increased tourism? How much money would these hiking visitors spend? Would it create more jobs?

Should we therefore expect that tax cuts will lead to a greater increase in GDP through the feedback loop compared to government spending? Well, we have to remember that not all tax cuts will be spent immediately, according to the marginal propensity to consume. In a recession some workers will be pessimistic about the future and save the money. Will tax cuts compensate workers who are working shorter hours? Greg suggests that tax cuts might actually be more potent than government spending according to current research.

“Textbook Keynesian theory says that tax cuts are less potent than spending increases for stimulating an economy. When the government spends a dollar, the dollar is spent. When the government gives a household a dollar back in taxes, the dollar might be saved, which does not add to aggregate demand.

The evidence, however, is hard to square with the theory. A recent study by Christina D. Romer and David H. Romer, then economists at the University of California, Berkeley, finds that a dollar of tax cuts raises the G.D.P. by about $3. According to the Romers, the multiplier for tax cuts is more than twice what Professor Ramey finds for spending increases.

Why this is so remains a puzzle. One can easily conjecture about what the textbook theory leaves out, but it will take more research to sort things out. And whether these results based on historical data apply to our current extraordinary circumstances is open to debate.”

So the current research indicates that one-dollar of tax cuts can increase G.D.P by $3 compared to an additional dollar of government spending increasing GDP by $1.40. But why is there such a large difference? Is this related to the arguments about the efficiency of increased government spending? The verdict is still out and we may need to wait till the next global recession to find out.

Below is a picture of the aptly named Bridge to Nowhere located in the central North Island of New Zealand. It was built by the government in a spending splurge in the 1936 to open up land in the area. The land is now no longer fertile or accessible and all access to the area is cut off except for this concrete relic. The area is now popular with trampers.

Discussion Questions:

1. How do economists calculate the multiplier?
2. What are leakages from the circular flow that reduce the multiplier effect?
3. Explain the link between the accelerator model and the multiplier.
4. What would multipliers for other injections such as export receipts or investment look like? Would they be higher or lower than multipliers for taxation or government spending?
5. Evaluate the effectiveness of fiscal stimulus to increase the level of economic activity.

FT.com / China / Economy & Trade – Downturn drives expat exodus from Shanghai

Having recently moved from Shanghai to Zurich myself, I was interested to see this headline in today’s Financial Times.

Korean companies are shipping workers home, cutting off school fees and repatriating wives and children without their menfolk to cut costs. They are the first large wave of expatriates to have begun leaving China’s financial capital as a result of the global economic crisis but their departure raises the prospect of a broader exodus of foreigners who may take investment, skills and job creation opportunities with them.

The press officer of the Korean consulate in Shanghai could not answer questions about the exodus of her countrymen – because her post had just been abolished and she was being sent back to Korea…

Japanese relocation companies, meanwhile, say there has been a marked rise in Japanese families returning home from Shanghai compared with last year and they expect the pace to pick up further during the traditional peak relocation months of March and April.

As Korean and Japanese families pack up and leave Shanghai, the impact is likely to be felt at international schools catering to the expat community in Eastern China. Koreans made up around 15% of the students at Shanghai American School, while other schools in the city had even larger numbers of Japanese and Korean students. In Beijing the exodus is also underway:

The pain has not been limited to Shanghai. A parent with children enrolled in an expensive Beijing international school says most of her daughters’ Korean classmates have left the school almost overnight.

This story reminds me of my own experience as an international school student in the late 1990′s, when the Asian financial crisis plunged Korea’s economy into deep recession. At the time, 30% of my school in Malaysia were Korean students, and in one semester over half of them packed up and moved back to Korea. In one year enrollment at the International School of Kuala Lumpur’s high school fell from 600 students to 420!

One reason the Korean and Japanese economies are struggling is that they are heavily dependent on exports to the rest of the world. With incomes falling and unemployment rising among their trading partners, the effect is amplified in Japan and Korea by significant falls in aggregate demand and GDP due to lower net exports, investment and consumption in the Japanese economy.

According to this article in the FT, the current fall in exports in Japan is the worst in 50 years.

Japanese exports fell 45.7 per cent in January, eclipsing a 35 per cent drop in December and big declines last month for Taiwan and South Korea.

The slide in exports was the steepest since 1957 and highlighted the severe impact of the global slowdown on demand for Japanese products ranging from cars to heavy machinery and electronics. Exports to the US fell 52.9 per cent and those to China were down 45.1 per cent .

Falling demand has forced manufacturers such as Toyota and Sony to cut production and jobs. It has reinforced concerns the economy will suffer another quarter of falling output. Gross domestic product shrank 3.3 per cent in the last three months of 2008, the largest fall in 35 years.

The diagram below provides a graphical representation of the impact of falling exports on Japan’s economy.

Discussion questions:

1. Some economists believe that recessions are a crisis of confidence. What do they mean by that and how does the situation in Japan seen above reflect this theory?
2. What is the multiplier effect and how does the fall spending on Japanese exports by the rest of the world result in an even greater fall in Japan’s GDP?
3. If you were the manager of a Japanese firm facing falling demand from international customers and you had to cut costs, what costs would  you cut in the short-run to remain competitive? What about in the long-run, assuming demand for your products remained weak?

Below is the explanation of the “Multiplier effect” from our class wiki, as explained by my Econ students:

• The multiplier effect shows that an initial change in spending can cause a larger change in national income and output.
• The multiplier determines how much larger that change will be; it is the ratio of a change in GDP to the initial change in spending.
• It measures the effect that any change in expenditure (Investment, Government spending, Consumption, or Net exports) will have on GDP

Multiplier = 1/(1-MPC) = 1/MPS
Multiplier = change in real GDP/ initial change in spending
Change in GDP = mutlplier x the initial change in spending

Rationale: The multiplier is explained based on the following facts:

• The economy supports repetitive, continuous flows of expenditures and income
• Any change in income will vary both consumption and saving in the same direction as, and by a fraction of, the change in income
• Initial change in spending will set off a spending chain throughout the economy
• Chain of spending, although of diminishing importance at each successive step, will accumulate and result in a multiple change in GDP

Harvard Economist Gregory Mankiw has applied the concept of the spending multiplier to the proposal coming from Barack Obama’s economic transition team to inject as much as $700 billion of goverment spending into the economy to stimulate aggregate demand and help America escape its recession. Mankiw quotes today’s Washington Post:

Facing an increasingly ominous economic outlook, President-elect Barack Obama and other Democrats are rapidly ratcheting up plans for a massive fiscal stimulus program that could total as much as $700 billion over the next two years….Obama has set a goal of creating or preserving 2.5 million jobs by 2011.

Mankiw, the Econ teacher that he is, applies the basic formula for the Spending Multiplier to the numbers coming from the Obama camp, and finds the following:

Dividing one number by the other, that (the $700b of government spending) works out to $280,000 per job.

What is going on here? Logically, it must be one of three possibilities:

1. The fiscal stimulus is going to be much smaller than is being reported.
2. The new administration is setting a low bar for itself when it comes to job creation.
3. The Obama team believes in very small fiscal policy multipliers.

Let me amplify the last point. The average weekly earnings of production and nonsupervisory workers is about $600, or about $60,000 over a two-year period. Granted, labor income is only about two-thirds of national income, and we have to add a few supervisors into the mix.

So let’s say each job created means $100,000 of extra national income. If we are generating $100,000 of income with $280,000 of government spending, the multiplier is only 100/280, or 0.36. Traditional Keynesian models suggest a multiplier closer to 2.0.

What Mankiw has found, using simple economic analysis understood by anyone who has studied AP or IB Economics, is that if we believe in the numbers given by the Obama camp itself, then government spending package of $700 billion will result in roughly $250 billion of new income for the nation.

How did we find this? Simply by applying the forumula given on our wiki above: Multiplier = change in real GDP/ initial change in spending, and plugging in the numbers calculated by Mankiw:

• Multiplier = 0.36.
• Change in spending = $700b.
• Therefore, the change in national income (or GDP) equals $700b x 0.36 = $252 billion

Perhaps Mr. Obama needs to consider the basic economic principle of the Spending Multiplier before he goes around throwing out numbers about the jobs that will be created or preserved from a new fiscal stimulus package. Clearly, 2.5 million jobs grossing an average of $100,000 each over two years, while SOUNDING good, in reality represents a truly unbelievable squandering of wealth and income by the US government.

FT.com / Weekend columnists / Tim Harford – Why a tax cut just isn’t fair on teenagers

Tim Harford, aka The Undercover Economist, loves to expose the overlooked effects of governments’ economic policies. For example, both the United States and the UK have recently announced tax cut and rebate plans aimed at putting hundreds of dollars back into the hands of taxpayers, with the hope that households will spend their “free money” from the government, giving the national economies a much needed boost in a time of economic slowdown.

Expansionary fiscal policy, as such a tax cut is known, is a popular tool in times of macroeconomic slowdowns. The hope, of course, is that taxpayers who experience sudden fiscal relief will rejoice upon their newfound disposable income, spending it on goods and services, creating new income for various sectors of the economy, which in turn will be spent on more goods and services. In economics, we call this the “multiplier effect”, the idea being that a certain tax cut (say $150 billion), will ultimately create some multiple of that amount in new spending and income throughout the economy as a whole.

In reality, however, house holds do not spend 100% of a tax rebate or tax cut like those recently passed in the US and the UK. When disposable income increases, household will spend a certain proportion and save or pay off past debts with the rest. The proportion of new income spent is determined by an individual’s marginal propensity to consume, and the proportion saved is based on his or her marginal propensity to save. The greater proportion of additional income that is spent, the larger the multiplier effect in the economy as a whole, and the greater impact expansionary fiscal policy will have towards achieving growth in the economy.

Policy makers, therefore, prefer households spend, rather than save, new income from a tax cut or rebate. According to the Undercover Economist, however, saving a tax rebate is precisely what smart households will do. Why? Because of the basic economic truth learned in the first week of most principles of economics courses: There’s no such thing as a free lunch! Tim Harford explains:

…since neither the UK nor US governments plans to alter its spending plans, these tax holidays will be funded by government borrowing – borrowing that must eventually be repaid. That will require taxes to go up in the future, or not to fall when they otherwise might.

Who should celebrate? Not the typical taxpayer, that is for sure. The tax cut makes no difference to her. If she – assume she is British – had wanted an extra £120 right now, she could already have it in her pocket, either by withdrawing it from savings or by borrowing the money. If she did that, of course, she would later have to repay £120 plus interest. But that is exactly what Darling’s successor as chancellor will require of her. To look at it another way, the rational taxpayer should save the £120 windfall now, keeping it to pay the higher taxes that are surely on the horizon.

A tax rebate financed through government borrowing does not make American or British households any better off. Imagine a scenario where your buddy is experiencing some financial difficulties (maybe he’s lost his job, maybe he’s experienced an expensive injury and has no health insurance…), so you decide you’ll help him out by throwing some cash his way. The catch is, you’re already in debt and have spent more in the last couple of years than your actual income should have allowed. So, in order to help your buddy out, you actually need to borrow money from him. So you give him an IOU, he scrounges up the little cash he can find, gives it to you for the IOU, and you turn around and give it back to him to “help him out.” You can imagine, your buddy is not very thankful and certainly doesn’t feel any richer.

On the macro level, the cash mailed out to American households as part of the recent stimulus package came from new borrowing by the government from American households. All those IOUs issued to finance the stimulus must be paid back, and must be done so through future tax increases. The government has chosen to forgo future spending in order to stimulate current spending. Not everyone should dismay, however, as a certain lucky group will clearly benefit from today’s debt-financed fiscal stimulus packages:

…some people should count themselves wealthier after the tax cut. Anyone expecting to die without making a bequest should be pleased: if the Grim Reaper knocks on the door before the taxman does, he can spend the tax rebate now and leave the bill for some other sucker.

Who will be the fall guy? We don’t know for sure, because we can’t say who a future government will tax. But an obvious candidate would be today’s teenagers, very few of whom are paying income tax right now, but most of whom will pay it in the next few years. Their best hope is that their grandparents add the tax windfall to their bequests rather than blowing the money on a weekend in the sun.

A tax cut today almost certainly implies a tax increase tomorrow. Since teenagers enjoy almost none of the tax cuts today, but will bear the future increases required to pay back new debt, it is you, my students, who should be most opposed to the shortsighted policies being undertaken by US and UK policy-makers.