I’ve been thinking a bit about stimulus spending recently. In part this is because Emi Nakamura and Jon Steinsson just recently published a paper on the multiplier in the American Economic Review but it also came up as I was skimming through Paul Krugman’s lecture slides for his Great Recession class.

The logic behind economic stimulus spending is pretty straightforward. If you are in a recession caused by low demand, the government can step in as a surrogate spender to restore demand and hopefully get the economy out of trouble. Here is Rachel Maddow describing how she understands stimulus spending during the crisis. Her description is actually pretty good. The only thing she leaves out is much mention of the multiplier: the ratio between the final change in overall spending to the initial change in government spending. If the government spends money, the workers it employs spend some of their new income on other businesses, and so on … In theory, this chain of spending can imply a multiplier greater than 1. If stimulus is to be effective, it helps to have a multiplier as big as possible.

There is actually a fairly clear picture of how big multipliers are. The Nakamura and Steinsson paper is part of a family of papers that look use cross-sectional variation to quantify the effect of stimulus. They compare regions that get additional government spending to regions that don’t and ask whether the spending encourages economic activity. (Other papers that focus on cross-sectional variation include Shoag (2011), Wilson (2012) and Hausmann 2013). In the cross-sectional studies, the estimated multipliers seem to be quite large (roughly between 1.5 and 2.5).

A different set of studies focuses on aggregate variation in government spending. The aggregate studies have a much more sobering message. For the most part, the aggregate studies suggest that the government spending multiplier is less than 1 (typical estimates are between 0.5 and 0.8). With a multiplier less than 1, private spending contracts in response to increased government spending. (See Ramey and Zubairy 2013, Ramey, Owyang and Zubairy 2013, Hall 2009, Ramey and Shapiro 1998, and Barro and Redlick 2011). It’s perhaps not surprising that the aggregate studies find smaller multipliers. Large aggregate changes in spending entail some crowding out which the idiosyncratic spending in the cross-sectional studies won’t. The aggregate changes also come with price tags – if the Federal Government is going to spend more then U.S. tax payers are eventually on the hook for the cash. This isn’t true for a cross-sectional experiment. If Pensacola gets a new Naval contract then the money is coming from the rest of the country (and only partially from the people who live in Florida). If we reserve stimulus spending for periods of economic slack (or liquidity traps / ZLB events), then, in theory, the multipliers will be somewhat bigger. The IS/LM model predicts that fiscal policy will have its greatest effects if the economy is in a liquidity trap. This intuition carries over to fully articulated DSGE models (see Christiano, Eichenbaum and Rebello 2011). The empirical evidence is not as clear on this point. There is a study by Auerbach and Gorodnichenko (2012) which seems to find evidence in support of this idea.

Even if the multiplier is substantially above 1, it is not obvious that stimulus spending is a good idea. The reason is that we are not trying to maximize output and employment – we are trying to maximize overall social well-being. At a basic level, the idea behind stimulus spending is that the government will spend money on stuff that it wouldn’t have purchased if we weren’t in a recession. The classic caricature of stimulus spending is the idea of paying a worker to dig a hole and then paying another worker to fill the hole in. This type of stimulus spending will increase employment and GDP but it won’t really enhance social welfare. True, we might get the beneficial effects of the stimulus but we could achieve that by simply giving the workers the money without requiring that they dig the holes. If we simply give out the money, GDP increases by less but social well-being goes up by more since the work effort and time wasn’t required.

Even though the Keynesian hole-digging example is silly, the same argument can be applied to any type of government spending. If a project doesn’t meet the basic cost / benefit test, then it shouldn’t be funded, regardless of the need for stimulus. Of course, one form of fiscal stimulus used in the ARRA was providing funds to state governments so they could maintain services that they would normally provide. This is perfectly sound policy because it is allowing the government to continue to fund projects that (presumably) do pass the cost / benefit calculation. If the social value of a government project exceeds its social cost then we should continue to fund the project whether we are in a recession or not. If the social value falls short of the social cost then, even if the economy is in “dire need” of stimulus we should not fund it. If we really need stimulus but there are no socially viable projects in the queue then the government should use tax cuts. Tax cuts can be adopted quickly and aggressively and, unlike spending initiatives, apply to virtually all Americans.

There are other “legitimate” reasons for the government to expand spending during a recession. The most obvious is that many things are relatively cheap in recessions. Reductions in manufacturing and construction employment may lower the cost for government projects. But again, this decision can be made on a simple cost / benefit basis. If prices fall because of a recession and this makes some projects socially viable as a result, then it’s perfectly correct for the government to fund those projects.

If it makes people feel better we could re-label tax cuts as spending. I could pay people $200 to look around for better paying jobs. This would be counted as $200 of job searching services purchased by the government but in reality, the money would be essentially the same as a tax cut. In the clip above, Rachel Maddow jokingly says that it might be better to simply put money in envelopes and hand them out to low-income families. If the choice is to either hand out money in envelopes or give out the same amount of money to have people perform work that doesn’t meet the cost benefit calculation, then Rachel is right. The envelopes would be better.

UPDATE: Rudi Bachmann points me to a paper by Eric Sims and Jonathan Wolff. An excerpt :

(M)ovements in the welfare multiplier are quantitatively much larger than for the output multiplier. The output multiplier is high in bad states of the world resulting from negative \supply” shocks and low when bad states result from \demand” shocks. The welfare multiplier displays the opposite pattern { it tends to be high in demand-driven recessions and low in supply-driven downturns. In an historical simulation based on estimation of the model parameters, the output multiplier is found to be countercyclical and strongly negatively correlated with the welfare multiplier.

UPDATE No. 2: In the comments JADHazell points me to this “sketch” by Paul Krugman. This also seems related. My initial reaction is that Krugman is saying that the marginal social cost of government spending drops sharply if the economy enters the liquidity trap (i.e., the ZLB). This means that the cost/benefit calculation points to an opportunity for the government to load up on goods and services during such periods. It does not say that further expansion is justified in the name of fiscal stimulus. That is, I suspect that a version of Krugman’s model in which the marginal benefit of government spending to consumers were zero (say due to satiation) would justify stimulus spending even if the economy were below full employment.

UPDATE No. 3: In the comments thread at MarginalRevolution, Tom West says that “(i)It sounds like the author is advocating that certain benefits be excluded from (the cost/benefit) analysis.” This is exactly what I am saying. If the direct social benefit of a bridge is $100, then all the government needs to consider is whether the cost of building the bridge is greater or less than $100. If you then tell me that, because we are in a recession, there are additional stimulus benefits from the project (e.g., the workers who build the bridge take their new wage income and buy goods and services from other businesses further stimulating demand, increasing employment, and so on.), the government should exclude these additional benefits from its calculation.