Thursday, March 05, 2009

Are fiscal multipliers now big or small?

Small, says Richard Clarida:
Because of the financial crisis and the severe damage caused to the system of credit intermediation through banks and securitization, policy multipliers are likely to be disappointingly small compared with historical estimates of their importance. Many of you will remember from Econ 101 the idea of the Keynesian multiplier, which is that the impact of traditional macro policies is “multiplied” by boosting private consumption by households and capital investment by firms as they receive income from the initial round of stimulus. It is important to remember why and how policy multipliers actually work. Policy multipliers are greater than 1 to the extent the direct impact of a policy on GDP is multiplied as households and companies increase their spending due to the increased income flow they earn from the debt-financed purchase of goods and services sold to meet the demand generated by the initial round of stimulus. Historically, multipliers on government spending are estimated to be in the range of 1.5 to 2, while multipliers for tax cuts can be much smaller, say 0.5 to 1. But these estimates are from periods when households could – and did – use tax cuts as a down payment on a car or to cover the closing costs on a mortgage refinance. For example, in 2001 the economy was in recession, but households took advantage of zero rate financing promotions – as well as ready access to home equity withdrawals from mortgage refinancings – to lever up their tax cut checks to buy cars and boost overall consumption. With the credit markets impaired, tax cuts, as well as income earned from government spending on goods and services, will not be leveraged by the financial system to nearly the same extent, resulting in (much) smaller multipliers.
Big, says Christy Romer:

Critics have complained the Obama administration has been all doom and gloom about the economy, but in an apparent shift in rhetoric since the President's address to Congress last week, one of his top advisers today predicted the stimulus package will prove even more beneficial than expected in helping the nation out of its recession and ushering in a period of "very rapid growth".

“A common argument is that fiscal stimulus will have less effect because financial markets are operating poorly and lending is not flowing. I want to offer a different view,” said Christina Romer, chair of the Council of Economic Advisers. "I think it is possible that fiscal policy will have even more oomph in this situation. When households and businesses are liquidity-constrained by reduced lending, any money put in their pockets is more likely to be spent.

In a speech this morning at an economics conference in northern Virginia, just outside Washington DC, Romer, noting that "the deeper the recession, the more rapid the rebound," forecasted that when the country recovers from its current crisis, it will enjoy a period of “very rapid growth”.

“When the economy turns around and confidence returns, the resulting pent-up demands spur rapid growth," she said. "What this means for the current situation is that fiscal policy may have a very large effect at some point. Given how far the economy has fallen, it is clear that sooner or later, we are going to have a period of very rapid growth as things return to normal.”

In a previous post, I suggested that, in light of the substantial uncertainty we now face, the marginal propensity to consume is likely larger than normal. As a result, multipliers would be larger than normal as well, as Christy Romer suggests. But I will be the first to admit that all of these arguments--Clarida's, Romer's, and mine--are essentially theoretical. I don't know of much empirical work on state-dependent fiscal multipliers to establish convincingly which side of this debate is correct.