The magic multiplier

I've written several times lately about what I call the magic multiplier, the oft-mentioned figure that will turn the government spending of the various stimulus packages into great positive effects on our GDP.  The more responsible economists point out that this measurement of the results of fiscal policy applies only when there is slack capacity in the economy, that is, when people and plants are idle.  They could all be working, except, for some reason, they are not, so government as the employer of last resort puts them to work.

I have been somewhat dismissive of this multiplier, which has been pegged at about 1.40.  In other words, every dollar of government spending will translate into an injection of $1.40 into our economy.  Having done some economic modeling myself, I'm pretty aware of its limitations; it's a field that's still in infancy, no matter how powerful the computers we throw at it.

Since studies of fiscal stimulus rely on previous conditions similar to the ones in which we find ourselves now, and our situation now is widely acknowledged to be one-of-a-kind, unprecedented as to its causes and effects, it's difficult to see how even the best model can be more than indicative.  The results aren't treated that way, of course, not when there's a political point to be made.  So it's now pretty much taken as common wisdom that the money we throw around the economy will be returned to us with a nice bonus thrown in.

There are many reasons, if we can pull our eyes away from the equations for a moment, to suspect that the multiplier may be overstated.  Even if the models were perfect in capturing what happened in the past (that is, they could predict the already-known "future of the past"), conditions are radically different than they have been before.  Do they take into account the possibility that, as an example, GM could invest some of their bailout money, $1,000,000,000, in Brazil?  [H/t to the Job Destruction Newsletter.]

Do people really believe that the new energy economy is going to be confined to this country?  Or all the new development in health care technology?  Or will we see leakage to the increasingly aggressive offshoring companies (see Carrie's Nation for some thoughts on this)?

All that said, I still guardedly believe we have to move ahead with our current path.  I just want us to temper our expectations, take 1.40 with a grain of salt, and remain vigilant as to what we're actually spending our money on.  We can all react with horror to the likes of "Buy American" provisions, but it really isn't all that surprising that people want some protection for their trillions of dollars.

I try not to get too technical in this blog; I have some training in economics, and could draw the occasional graph or put a few equations here.  But there are people who do that sort of thing better, the likes of Brad DeLong and Mark Thoma, so I leave the heavy lifting to them.

However, if you want to get a little heavier into the development of these multipliers, there's an excellent item by Mark Thoma from about a month ago ("The Great Multiplier Debate").  In it, he presents a lengthy excerpt from Menzie Chinn on the three basic models used to develop these multipliers.

Thoma then gives us five excellent paragraphs on why these models are flawed.  Essentially, current economic practice focuses on growth and monetary policy:

Nobody, or hardly anybody, was asking questions about the use of fiscal policy to stabilize the economy. Hence very few models were built to look at this issue.

No one has thought for some time that fiscal policy, that is, government spending, was ever going to be the tool by which we "fixed" the economy:

Thus, the need for stabilization policy, fiscal policy in particular, was believed to be greatly diminished. The fact that fiscal policy might be needed in a deep recession because monetary policy would be rendered ineffective was discounted and ignored because the the belief was that a deep recession couldn't occur, the economy was too robust and flexible for that.

Monetary policy could handle any problem that arose, so cutting edge economists simply didn't develop tools for discussing our current situation.  The only models we have to explore the now are fairly old-fashioned, and subject to the distortions of unrealistic assumptions:

The next approaches to macro modeling and estimation, the micro-founded models and the VAR models, came into being as the fiscal policy question was falling by the wayside (most VAR models do not even include government spending and taxes). Thus, as you may have noticed, there isn't much in the way of evidence from these models that we can rely upon (and that's not even considering the fact that we have very little data from recessionary episodes to inform us on these issues). The models will be built - I guarantee you they are being built presently - but for now we have what we have.

As is all so typical, the more you know about economics, the less you rely on it for simple answers.  There's a lot of insight in the field, but predicting, especially in a new kind of environment, just isn't there, and we need to understand that, and level our expectations accordingly.