Fiscal multipliers are unhelpful

John Quiggin has re-opened the fiscal multiplier debate to advocate for fiscal stimulus. Quiggin, along with others such as Krugman, Summers and DeLong, and Blanchard claim that the effect of government spending on production will be greater than the government’s initial injection. The empirical evidence they use tends to rely on cross-country regressions, although some calibrated modelling has been done by NIESR.

An important caveat on these studies is that they rely on the unusual macroeconomic circumstances of the current recession. In ‘normal’ times one would expect that a central bank would lean against fiscal policy, resulting in very small multiplier effects. Scott Sumner has discussed this point extensively. To summarise, he claims that:

It sort of implies ‘the’ multiplier is some sort of stable parameter out there, waited to be discovered. Like the cosmological constant. In fact, it is nothing more than an estimate of central bank incompetence, which will vary from one case to the next.

Obviously the illustrious authors of the multiplier studies aren’t unaware of this problem. The general theme of their arguments is that we are currently in a liquidity trap and monetary policy has little traction in these circumstances. Central banks are thus unable to counteract the effects of fiscal policy, which is only doing what the central bank would do itself if it could: boosting demand. Sumner rejects the idea of a liquidity trap, hence the disagreement.

Obviously, these estimates of fiscal multipliers are entirely contingent on the response of the monetary authority. As discussed on Vox, the characteristics of an economy and monetary policy regime can cause the multiplier to vary between zero and 2, which is basically the difference between being in favour of fiscal stimulus and considering it a complete waste of money. Without estimates for each country individually that means the average multiplier is likely to be a poor guide to the multiplier in an individual country. That doesn’t make the estimates ‘wrong’ but it does mean that cross-country estimates are unreliable as a guide to national, fiscal policy. From a policy perspective then, it’s unclear that these estimates provide much guidance on the extent of fiscal stimulus or austerity; at least not without a lot of investigation of country-specific factors.

Update: FT said much the same thing. Simon Wren-Lewis suggests that the theory on this is obvious and people just got too caught up in the empirics.