Thursday, January 22, 2009

Barro on the Fiscal Policy Multiplier: Does He Understand the Full Employment Constraint?

Robert Barro writes an op-ed critiquing the Obama fiscal policy proposal that is far below his intellectual standards. He starts off well:

Team Obama is reportedly using a number around 1.5. To think about what this means, first assume that the multiplier was 1.0. In this case, an increase by one unit in government purchases and, thereby, in the aggregate demand for goods would lead to an increase by one unit in real gross domestic product (GDP). Thus, the added public goods are essentially free to society. If the government buys another airplane or bridge, the economy's total output expands by enough to create the airplane or bridge without requiring a cut in anyone's consumption or investment. The explanation for this magic is that idle resources -- unemployed labor and capital -- are put to work to produce the added goods and services. If the multiplier is greater than 1.0, as is apparently assumed by Team Obama, the process is even more wonderful. In this case, real GDP rises by more than the increase in government purchases. Thus, in addition to the free airplane or bridge, we also have more goods and services left over to raise private consumption or investment.

In other words, Barro understands that the Keynesian multiplier theory rests on the proposition that the economy is below full employment – which seems like a plausible characterization of today’s economy. But then Barro pulls some empirical research from a period where we were likely near full employment:

A much more plausible starting point is a multiplier of zero. In this case, the GDP is given, and a rise in government purchases requires an equal fall in the total of other parts of GDP -- consumption, investment and net exports. In other words, the social cost of one unit of additional government purchases is one … What do the data show about multipliers? Because it is not easy to separate movements in government purchases from overall business fluctuations, the best evidence comes from large changes in military purchases that are driven by shifts in war and peace. A particularly good experiment is the massive expansion of U.S. defense expenditures during World War II … I have estimated that World War II raised U.S. defense expenditures by $540 billion (1996 dollars) per year at the peak in 1943-44, amounting to 44% of real GDP. I also estimated that the war raised real GDP by $430 billion per year in 1943-44. Thus, the multiplier was 0.8 (430/540). The other way to put this is that the war lowered components of GDP aside from military purchases. The main declines were in private investment, nonmilitary parts of government purchases, and net exports -- personal consumer expenditure changed little. Wartime production siphoned off resources from other economic uses -- there was a dampener, rather than a multiplier.

After saying “good grief”, I turn the microphone over to Paul Krugman:

Consumer goods were rationed; people were urged to restrain their spending to make resources available for the war effort. Oh, and the economy was at full employment — and then some. Rosie the Riveter, anyone? I can’t quite imagine the mindset that leads someone to forget all this, and think that you can use World War II to estimate the multiplier that might prevail in an underemployed, rationing-free economy.


kevin quinn said...

"Good Grief" is right. Then mind, it boggles!

Anonymous said...

That is selective editing of Barro's paper. In the full article, he goes on to state that during times of peace, it is actually zero.