Economics #6: Fiscal Policy

In 2009, as economies around the world faced the prospect of economic collapse, massive packages of tax cuts and spending were enacted to halt the decline. In the United States, President Barack Obama signed the American Recovery and Reinvestment Act, which over three years would spend about 6% of the countries GDP split between tax cuts and infrastructure projects.

The idea was simple, if there is slack in an economy (idle factories and workers), then the Government can borrow and spend to close that gap. Flash forward to 2011, at the height of the euro crisis, when a similar economic contagion was spreading throughout Europe. This time, the response was a package  of bail-outs contingent on imposing strict fiscal discipline in the troubled countries. The idea was also simple, recklessness had brought about the crisis, so discipline should help fix it.

If these responses seem contradictory, they should. In both cases, some economists argued for fiscal stimulus, some for fiscal austerity, and each side had their own evidence which ultimately boiled down to how they modeled something called a “fiscal multiplier”.

The Fiscal Multiplier

When it comes to fiscal policy, the fiscal multiplier is the foundation that everything else is built upon. Formalized by Richard Kahn, a student of John Maynard Keynes, the fiscal multiplier tells us how effective tax cuts or government spending will be in boosting output.

For example, if the government spends money on building a road, then the employees it hired to build that road will have money to spend elsewhere, for example buying new clothes, which will give that industry money to spend elsewhere, and so on. Consumer spending as a whole will be boosted in theory, but by how much?

Before we try to answer that, let’s take a step back and consider the alternative, where the economy is left to sort itself out. Classical theories claimed that government intervention would do more harm than good, choosing winners and losers, crowding out private investment, and causing inflation. All that needed to be done was to let wages naturally fall to a point that the unemployed were rehired and production could pick up profitably.

Keynes and his disciples pointed out that wage cuts rarely go over well, and companies have an incentive to just fire people instead. Fired people will have less money to spend, reducing demand for the products that businesses produce, causing businesses to fire more people, lowering demand more, and so on, in a vicious spiral. To stop the spiral, Keynesian’s suggested that the government should step in and put the unemployed back to work.

Back the the example of infrastructure spending. When the government pays those construction workers, the question becomes how much of those wages will go to consumption elsewhere in the economy vs how much will go to savings. The marginal propensity to consume (MPC) is the estimated percentage of a paychecks will be consumed. For example, if the  MPC is 80%, then the fiscal multiplier would be:

Fiscal Multiplier = 1 / (1 – MPC)
Fiscal Multiplier = 5

In other words, for every $1 the government spends, they will boost the economy by $5. The people put to work would spend $0.80 on another industry, which in turn would spend $0.64 on another industry, and so on. $5 of economic activity for every $1 spent sounds like a good return, so what’s the problem?


What if the economy was already operating at full capacity? Any spending by the government would just shift resources that where already employed somewhere else. There would be no new employment. The fiscal multiplier should be zero in this situation. What if the economy is operating well below capacity and the unemployed are desperate to make purchases that they have been holding off on. The fiscal multiplier should be high in this situation. It’s not that easy to tell which situation we are in.

Confidence in the government doing the spending also plays its role. If government spending bolsters confidence and stimulates the animal spirits of investors, the multiplier should go up. But if the government is already highly in debt, the increased spending could just increase interest rates and savings as people prepare for the burden of higher taxes down the road.

For these reasons and more, estimating economists rarely agree on estimates of the fiscal multiplier. For example, economist in Obama’s administration put the multiplier at 1.6 when arguing for their stimulus package. An alternative model, which put more weight on rising taxes and interest rates, put the multiplier closer to 1. In the case of Europe, the IMF admitted to dramatically underestimating the fiscal multiplier when imposing the austerity programs of 2011.


Today, economists like Larry Summers argue that insufficient fiscal stimulus was the key failure in the response to the great recession. Other economist, like John Cochrane, argue that the idea of a fiscal multiplier above 1 is a fairy tale that people go back to in times of stress.

One key point of Keynesian that often gets ignored, like the quote at the top says, is that there is a time for fiscal austerity, and it’s when the economy is going strong. Spend when in recession, save when in expansion. The problem is that fiscal contraction is rarely politically viable. No one wants to run for political office on a platform of raising taxes and reducing spending. Instead, like clockwork, when the times get better, politicians argue that it’s the perfect time to spend even more on the future while reducing taxes. One of the few thing that economists can agree on, is that this political thinking has it backwards.





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