Multiplier Myths

This is the third in a series of three articles on the wrong way to reduce the growing federal debt. The first piece in this series is on the fallacy that low interest rates will allow the federal government to continue to safely accumulate high levels of debt. The second is on the fallacy that raising taxes will reduce the deficit.

As happens during every economic downturn, economists are reviving Keynesian fiscal multiplier arguments to justify enormous federal spending packages. However, these arguments ignore recent empirical evidence that the costs of increased government spending far outweigh the benefits to the economy.

In simple terms, the fiscal multiplier, popularized by the economist John Maynard Keynes, is a method of measuring the effect of government spending on the nation’s economic output, or gross domestic product (GDP). A multiplier of 1 means that for every additional $1 the government spends, GDP is boosted by an equal amount ($1). A multiplier of 1.5 means that for every additional $1 the government spends, GDP is boosted by a larger amount ($1.50). A multiplier greater than 1 is typically seen as an endorsement of interventionist government stimulus because the benefits to GDP are greater than the cost of the additional spending.

We saw this theory in action during the Great Recession when government economists claimed that stimulus spending would create a fiscal multiplier between 1.1 and 1.6. These large fiscal multipliers were used to estimate that the 2009 stimulus package would create 3 to 4 million jobs by the end of 2010. In reality, 2.3 million jobs were lost during this period. Using alternative models and assumptions, economists later asserted that the Keynesian models used to evaluate fiscal stimulus were not robust and that the fiscal multiplier was actually around one-sixth of what government economists were claiming.

Improved modeling on the effects of fiscal multipliers shows that firm and household decisions to spend, produce, and invest are largely influenced by their expectations of the future. If households anticipate that increased government spending and resulting deficits will be financed by higher future taxation, then they will consume less, not more. Reviewing a survey of this new literature, the Federal Reserve Bank of San Francisco found that "in contrast to theoretical predictions from the simple Keynesian framework, the analyses found that government spending had less bang for the buck than tax cuts. For instance, one year after the increase in spending, the impact on the level of real GDP is less than one-for-one, partly reflecting a decline in investment."

Much of the empirical literature on fiscal multipliers conducted since then has found economic multipliers resulting from additional government spending ranging from a lower estimate of around 0.2 to an upper estimate of around 0.9. Pulling the results from two dozen academic studies, we calculate an average multiplier at the low end of 0.31 and an average multiplier at the high end of 0.66.

Our estimates are largely in line with the findings of economists Valerie Ramey and Sarah Zubairy of the University of California at San Diego and Texas A&M respectively. In a 2018 study, they found the spending multiplier is between 0.3 and 0.77, depending on unemployment levels and interest rate policy. In a similar vein, International Monetary Fund economists reviewed 41 studies on first-year multipliers and found mean multipliers of 0.7–0.8 and median multipliers of 0.6–0.8—a higher range than that found by Ramey, but still notably lower than 1.

Economists largely recognize that low interest rates held at the zero lower bound (ZLB)—the theoretical value below which interest rates cannot fall, or else no one would borrow—for a prolonged period of time typically result in a larger spending multiplier. While Ramey finds no evidence that the multiplier is greater than 1 at the ZLB in her full sample, when she excludes World War II years from her sample, her preferred measure of shock (a change to the economy that has a substantial effect on economic performance) indicates a multiplier as high as 1.4 at the two-year horizon. Other studies at the ZLB find spending multipliers around 0.8 at the four-year and five-year horizons.

Newer studies, such as one recently published in the Journal of Monetary Economics by University of Texas at Austin economist, Christopher Boehm, acknowledge that ZLB monetary policy lowers the real interest rate and increases private-sector spending. Using a similar time horizon as Ramey, Boehm finds that the multiplier rises from a range of 0.3–0.7 to around 0.95 at the ZLB.

What’s more, several studies find that the fiscal multiplier turns negative in countries with high levels of debt. That’s because when debt levels are high, increases in government spending act as a signal that fiscal tightening will be required in the near future. Anticipation of such adjustments could have a contractionary impact that offsets the short-term expansionary impact of government consumption. Negative multipliers for countries with debt-to-GDP levels above 60 percent can be as large as −2.3 in the long run, while other studies find the multiplier to be around zero in highly indebted countries.

Largely ignoring a decade of empirical discovery, some economists and left-wing academics are once again making the case that pandemic-related stimulus spending will create a fiscal multiplier in the range of 1.5 to 2. This is false, even when unemployment is high.

Indeed, if we take the average upper estimate (0.66) from over two dozen academic studies and adjust the multiplier upward by 10 basis points for every 2 percentage points that the unemployment level is above the historical median (as one study suggests is the case), we would still observe a multiplier that is lower than 1. Recent studies have found similar results, observing how unemployment levels only have a significant upward effect on spending multipliers when the unemployment rate is at or above 12 percent, with multipliers rising from 0.61 to 0.94 after 4 years.

If a multiplier of greater than 1 is typically seen as a full-throated endorsement of interventionist government stimulus, a multiplier of less than 1 indicates that the government should decrease its spending. Policymakers should be wary of falling for the same old Keynesian models that led to misguided policy in 2009. Not only is more open-ended government spending a perfect recipe for debt-related economic and wage stagnation, but with a multiplier of less than 1, this new spending will crowd out private spending and investment, reducing our chances of a swift economic recovery. Policymakers should steer clear of flawed Keynesian models of yesteryear and instead look to removing barriers to economic growth and dynamism to unleash the productive potential of the private sector.

Photo credit: John Maynard Keynes in 1933/Wikimedia Commons