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Economists' Voice www.bepress.com/ev February, 2009 The Berkeley Electronic Press
Voodoo Multipliers
RoBERT J. BaRRo
B
ack in the 1980s, many
commentators ridiculed as "voodoo
economics" the extreme
supply-side view that across-theboard
cuts in income-tax rates
might raise overall tax revenues. Now we have
instead the extreme demand-side view that
the multiplier effect of government spending
on output is greater than one (Team Obama is
reportedly using a number around 1.5).
To think about this assumed multiplier,
suppose first that it took on the lower value
1.0. In this case, an increase by one unit in
government purchases and, thereby, in the
aggregate demand for goods would lead to
an increase by one unit in real gross domestic
product (GDP). Thus, the added public goods
are essentially free to society. If the government
buys another airplane or bridge, the economy's
total output expands by enough to create
the airplane or bridge without requiring a
cut in anyone's consumption or investment.
The explanation for this magic is that idle
resources--unemployed labor and capital--
are put to work to produce the added goods
and services. If there is a social cost, it is only
that people who used to be unemployed have
less leisure because they are working.
If the multiplier is greater than 1.0, as
apparently assumed by Team Obama, the
process is even more wonderful. In this case,
real GDP rises by more than the increase in
government purchases. Thus, in addition to
the free airplane or bridge, we also have more
goods and services left over to raise private
consumption or investment. In this scenario,
the government spending is a good idea even
if the bridge goes to nowhere or if government
employees are just uselessly filling holes. This
free lunch would make Charles Ponzi proud.
If the deal is genuine, why stop with only $1
trillion or so of added government purchases?
So, where is the flaw in the argument? The
theory (a simple Keynesian macroeconomic
model) implicitly assumes that the government
is better than the private market at marshaling
idle resources to produce useful stuff.
Unemployed labor and capital can be utilized
at essentially zero social cost, but the private
market is somehow unable to figure any of
Robert J. Barro is the Paul M. Warburg Professor of Economics
at Harvard University, a senior fellow of the Hoover Institution
of Stanford University, and a research associate of the National
Bureau of Economic Research.
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Economists' Voice www.bepress.com/ev February, 2009
this out. Implicitly, there is something wrong
with the price system. Keynes thought that
the problem lay with wages and prices that
were stuck at excessive levels. But this problem
could be readily solved by expansionary
monetary policy, enough of which will mean
that wages and prices do not have to fall. So,
something deeper must be involved--but
economists have not convincingly identified
market failures, such as incomplete information
or moral-hazard problems, that generate
multipliers above one.
A much more plausible starting point is a
multiplier of zero. In this case, the real GDP
is given, and a rise in government purchases
requires an equal fall in the total of other parts
of GDP--consumption, investment, and net
exports. In other words, the social cost of one
unit of additional government purchases is
one. This approach is the one usually applied
to cost-benefit analyses of public projects. In
particular, the value of the project (counting,
say, the whole flow of future benefits from a
bridge or a road) has to justify the cost of the
public outlay. I think this perspective, not the
supposed macroeconomic benefits from fiscal
stimulus, is the right one to apply to the many
new and expanded government programs that
we are likely to see this year and next.
Aside from theory, what is true about
multipliers in the data? Because it is not easy
to separate movements in government purchases
from overall business fluctuations,
the best evidence comes from large changes
in military purchases that are driven by shifts
in war and peace. A particularly good experiment
is the massive expansion of U.S. defense
expenditures during World War II. This case
works well because the United States from
1941 to 1945 did not suffer from the massive
destruction of property and life that led
to large declines in real GDP in many other
countries during WWII. In any event, the
usual Keynesian view is that the WWII fiscal
expansion provided the stimulus that finally
got the U.S. economy out of the Great Depression.
Thus, I think that most macroeconomists
would regard this case as a fair one for seeing
whether a large multiplier ever exists.
I have estimated (in my book Macroeconomics,
A Modern Approach) that World War
II raised U.S. real defense expenditures by
$540 billion (1996 dollars) per year at the
peak in 1943­44, amounting to 44% of trend
real GDP. I also estimated that the war raised
real GDP above trend by $430 billion per
year in 1943­44. Thus, the multiplier was 0.8
(430/540). The other way to put this is that the
war lowered components of GDP aside from
military purchases. The main declines were in
private investment, non-military parts of government
purchases, and net exports--personal
consumer expenditure changed little.
We can consider similarly three other
U.S. wartime experiences--World War I, the
Korean War, and the Vietnam War--although
the added defense expenditures were much
smaller in comparison to GDP than that for
WWII. When I combined the evidence for all
four wars, I got an overall estimate of the multiplier
of 0.8, the same value as before. (This
similarity is not so surprising because WWII
gets a lot of weight due to its particularly
large change in government purchases when
expressed as a ratio to GDP.) In an earlier
study in the Journal of Political Economy, I
got a similar regression-based estimate for
the multiplier effect on real GDP from temporary
defense purchases--for a sample from
1942 to 1978, the coefficient was 0.71, with a
standard error of 0.06.
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There are reasons to believe that
the war-based multiplier of around 0.8
substantially overstates the multiplier for
peacetime government purchases. For one
thing, the temporary nature of much of military
spending during wars means that consumer
demand would not fall a lot. In contrast,
an increase in non-war spending--which
historically has been mostly permanent--
would tend to reduce consumer demand
substantially through a negative income effect.
Second, the use of the military draft in
wartime has a direct, coercive effect on total
employment. Third, the U.S. economy was already
growing rapidly after 1933 (aside from
the 1938 recession), and it is probably unfair
to ascribe all of the rapid GDP growth from
1941 to 1945 to the added military outlays.
Another point is that the added labor during
the two world wars was very large, and much
of this expansion cannot be viewed as merely
putting idle labor to work. For example, the
dramatic rise in female labor during WWII
likely had a sizable social cost.
When I attempted to estimate directly
the multiplier associated with peacetime
government purchases, I got a number that
was statistically insignificantly different from
zero. In the regression-based results from my
1981 Journal of Political Economy paper,
for the sample from 1942 to 1978, the estimate
was 0.14 with a standard error of 0.51.
Thus, the regression did not pin down the
non-war multiplier very well.
As we all know, we are in the middle of what
will likely be the worst U.S. economic contraction
since the 1930s. In this context and from
the history of the Great Depression, I can understand
various attempts to prop up the financial
system. These efforts, akin to avoiding bank
runs in prior periods, recognize that the social
consequences of credit-market decisions extend
well beyond the individuals and businesses
making the decisions. That is, externalities are
likely to be important in the financial sector.
But, in terms of fiscal-stimulus proposals,
it would be sad if the best that Team Obama
can offer is an unvarnished version of Keynes's
General Theory, 1936. The financial crisis and
possible depression--which I take very seriously--do
not invalidate everything we have
learned about macroeconomics since 1936.
In designing effective policy responses,
much more focus should be on incentives for
people and businesses to invest, produce, and
work. On the tax side of fiscal stimulus, we
should avoid programs that throw money at
people and emphasize instead reductions in
marginal income-tax rates--especially where
these rates are already high and fall on capital
income. We should keep in mind the structure
of rate-cutting programs that worked:
Kennedy-Johnson 1963­64, Reagan 1981­83
and 1986, and Bush 2003. At the present
moment, the full elimination of the federal
corporate income tax would be brilliant. (In
the long run, the best way to raise more real
tax revenue--for example, to pay for healthcare
and public retirement programs--is likely
to involve a value-added tax. However, I hesitate
to recommend this efficient form of taxation
because its presence makes it too easy for
government to grow.)
Going back to the spending side, my main
point is that we should not use the cover of
fiscal stimulus to undertake massive publicworks
programs that do not pass muster from
the perspective of cost-benefit analysis. (And,
by the way, "shovel-ready project" is probably
the silliest term I have ever heard in a discussion
of macroeconomic policy.) Just as in the
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Economists' Voice www.bepress.com/ev February, 2009
1980s, when extreme supply-side views on tax
cuts were unjustified, it is wrong now to think
that added government spending is free.
Letters commenting on this piece or others may
be submitted at http://www.bepress.com/cgi/
submit.cgi?context=ev.
references and further reading
Barro, Robert (2008) Macroeconomics, A Modern
Approach, Cincinnati, South-Western College
Pub.
Barro, Robert (1981) "Output Effects of Government
Purchases," Journal of Political Economy,
89(6):1115.
acknowledgment
An earlier version of this article appeared in the
Wall Street Journal. Material republished with per-
mission.