Economic Myths: The Fiscal Multiplier

From City AM Forum:

In early 2013, Blanchard and his colleague Daniel Leigh published an IMF working paper on the size of the fiscal multiplier. The multiplier, a theoretical concept invented by John Maynard Keynes in the 1930s, is the most fundamental concept in the whole of macroeconomics.

It measures the eventual impact on the economy as a whole, GDP, of a sustained increase or decrease in public spending. An increase in such expenditure brings more people into work, they in turn will have more to spend, the companies whose products they buy will have more revenue, and will employ even more people. The initial impact is multiplied through the economy.

Sounds simple. But there are many potentially offsetting factors to take into account. Some extra spending will be on imports, for example, which does not boost domestic output at all. The bigger public deficit which the extra spending creates may lead to higher interest rates.

Economists have struggled for decades to arrive at a consensus on how big the multiplier really is. While still being far from agreement, there is a general view that it is low. Indeed, a fiscal expansion, once all the other feedbacks are taken into account, may even lead to GDP rising by less than the size of the stimulus.

In contrast, Blanchard and Leigh argued that, in the current circumstances, it is large and positive. So a fiscal contraction, the basis of the chancellor’s policies, will lead to the opposite, to a sharp reduction in GDP. Events have shown this to be wrong.

They are truly mental.

This is just political bullshit. The lefties always say that the fiscal multiplier is greater than unity (which can't possibly be true in all cases) and the right wingers always say that the fiscal multiplier is less than unity (which can't possibly be true in all cases either).

Allow me to explain...

There are lots of ways a government can finance spending - by increasing any one of dozens of taxes or by running a deficit, which could be financed long term, short term, by 'printing money' etc.

There are also nigh infinite ways a government can spend money [long, long list] and one of the ways in which it can 'spend' money is by just giving people money back, whether as subsidies, tax cuts or higher welfare payments - and the categories all overlap. For example, are Working Tax Credits a subsidy to low paying employers; a tax cut for low paid workers; or a welfare payment?

So there are in turn more or less infinite comparisons you can make by choosing one source of finance and matching it with one type of spending. Some of these combinations will be hugely positive and some will be hugely negative.

For example: increasing taxes on output employment and spending it on Working Tax Credits is nigh self-defeating and a huge negative. Conversely, increasing taxes on land values and spending it by cutting taxes on output and employment is a large positive.

And raising a modest amount in any taxes, i.e. up to 5% or 10% of GDP (however damaging the taxes might be in isolation) and spending it on the core functions of the state: law and order, defence, roads, public health and immigration control is always a massive, huge great positive (notwithstanding that the gains might not be shared equally or even fairly).

It would be impossible to chuck all these infinite possible combinations into a pot and average them out to anything within a margin of error of thousands of per cent.

So it makes much more sense to imagine a Laffer Curve for the spending side. The government just pays for the core functions first (massive, huge net gain), then spends on stuff with smaller and smaller net gains until it reaches the top of the spending curve where the 'multiplier' is unity, and then it stops.

Similarly, there is a Laffer Curve for different types of taxes, there are good taxes and bad taxes. Once a government has collected as much as it can from good taxes it stops. There is no point imposing bad taxes.

With a bit of luck and a tail wind, total revenues at the top of this curve will be exactly enough to finance the spending at the top of the spending curve. Remember that both curves are pretty flat at the top, it is not going to be too difficult to find a level at which they intersect.
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UPDATE: As PaulC points out in the comments, the whole premise of the current political debate in the UK is wrong. If we take government's word for it that the economy is growing, then the Labour/high spending protagonists have won the argument hands down!

Remeber that despite the Indian Bicycle Marketing narrative, the Lib-Cons did not and have not implemented any sort of 'austerity' programme (except for people they don't like, like unemployed people under 25 etc). Spending was going up even under Plan A and is shooting up under Plan B. Quite what they are spending it on is an absolute mystery to me, probably a load of crap like corporate subsidies.

Which either means that the lefties are right and I am wrong, or possibly that the government is lying and the so-called recovery is built on sand.