Tuesday, March 28, 2017

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Does stimulus displace private economic activity?

According to Keynesian economic theory, many recessions have little or nothing to do with underlying (structural) economic problems. Instead, recessions are the result of a crisis in confidence. People are simply freaked out and therefore not spending. And when they are not spending, others are not earning income and so the economy suffers.

Keynesians argue that the government can cure this crisis in confidence by borrowing (deficit spending) to fund an increase in government purchases. If people are too freaked out to spend, the logic goes, the government can spend for them. And this spending has a multiplier effect, rippling throughout the economy.

You might be wondering how the government is able to get something for nothing. Government has to borrow the resources from the private economy, doesn’t that mean that the government is competing with private borrowers who have their own plans to invest in the economy? Doesn’t that mean that government investment displaces or crowds-out private investment? The Keynesians, being clever economists, have an answer for this. Their answer is that during a recession there are “idle resources.” That is, individuals and businesses are too freaked out to undertake any major investments and so there is money just lying around. The government can borrow it without displacing any private activity.

Most Keynesians (and by this I mean the economists, not most politicians and pundits who subscribe to Keynesian theory) recognize that this is only a short term phenomenon. Obviously, there comes a time when government borrowing will, indeed, displace private economic activity. That’s why Keynesians believe that the multiplier is larger during a recession and its why they counsel that stimulus should be “timely, targeted, and temporary,” as Lawrence Summers famously put it in December 2007.

Leaving aside the question of whether government can effectively spend the money, is it true that the government purchases multiplier is larger during recessions? A new paper by Michael Owyang (St. Louis Fed), Sarah Zubairy (Bank of Canada) and Valerie Ramey (UCSD) examines this question:

A key question that has arisen during recent debates is whether government spending multipliers are larger during times when resources are idle. This paper seeks to shed light on this question by analyzing new quarterly historical data covering multiple large wars and depressions in the U.S. and Canada. Using an extension of Ramey’s (2011) military news series and Jordà’s (2005) method for estimating impulse responses, we find no evidence that multipliers are greater during periods of high unemployment in the U.S. In every case, the estimated multipliers are below unity. We do find some evidence of higher multipliers during periods of slack in Canada, with some multipliers above unity.

Remember, the way the government calculates GDP, $1.00 in government purchases, automatically increases measured GDP. So a multiplier “below unity” (<1) implies that government purchases displace private economic activity, that stimulus shrinks the private economy.

The paper can be found here.