Debating Government's bang for its buck
ECONOMISTS talk about the negative impact from the $85 billion of automatic spending cuts with such authority, you would think these forecasts were written in stone. Hardly. These are projections spit out by econometric models that are pre-programmed with a specific multiplier: a number that reflects the effect of a $1 change in government spending or taxes on gross domestic product.
For example, a $1 increase in the government's purchases of goods and services, one component of GDP, translates immediately to $1 of output. Then what? That spending becomes someone else's income. The hope is that entity will spend or invest a portion of it. The multiplier attempts to capture to what extent that initial dollar boosts private-sector growth. If the estimate of the multiplier is wrong, then the projection for the effect of any given policy is wrong. Long-dead economists are still debating the issue.
John Maynard Keynes said that in a depressed economy, the federal government could and should use deficit spending to boost aggregate demand in the short run. To achieve a benefit, the multiplier only had to be greater than zero. (In other words, government spending couldn't depress private spending and investment.) Milton Friedman believed monetary policy could do the job without creating market distortions. He said the negative effects of financing deficit spending outweighed the positives. Friedrich Hayek was a fan of neither form of intervention. Given the diametrically opposed views on the impact of government spending, what should we expect from the $42 billion in actual cash disbursements in fiscal 2013? (The nonpartisan Congressional Budget Office says only half of the $85 billion sequestration will be implemented between March and September.) The CBO estimates the cuts will reduce the growth of real GDP by 0.6 percentage point in this calendar year and depress full-time job creation by 750,000. The CBO's 1.4 percent real GDP forecast reflects a 1.5 percentage-point hit from the various changes in tax-and-spend policy that went into effect this year.
When the CBO examined the effects of various parts of the American Reinvestment and Recovery Act, the $830 billion fiscal stimulus enacted in 2009, it found the multiplier was about one: $1 of federal outlays bought $1 of GDP. Or, to put it in layman's terms, there was nothing beyond the first-round effect.
Which shouldn't be a big surprise. The nature of a balance- sheet recession and its residual of bad debt made deleveraging, not spending, a top priority for households and institutions. The multiplier can be affected by the level of interest rates, the kind of exchange-rate regime a country maintains, the degree of unutilized resources, and the amount of stimulus that was already put in place, according to economists Veronique de Rugy and Matthew Mitchell, senior research fellows at the Mercatus Center at George Mason University in Arlington, Virginia.
In a 2011 working paper, de Rugy and Mitchell surveyed the academic literature and found a wide range of estimates for the spending multiplier: from +3.7 to -2.9. They also found that high levels of debt depressed the multiplier in various countries. The CBO is the first to admit that predicting the effect of any given policy is an inexact science that "would require knowing what path the economy would have taken in the absence of a given policy action," analysts Felix Reichling and Charles Whalen wrote in a May 2012 working paper.