Fiscal multipliers and employment (wonkish)

With two weeks to go in the election campaign, we still haven’t seen anything resembling a budget proposal from Tony Abbott and the LNP. Various people have made estimates of the cost of his promises and the cuts likely to be needed to fund those promises and return to surplus. My main concern is that Abbott has locked himself so thoroughly into the rhetoric of surplus that, in the event of a downturn or recession, he will feel compelled to adopt the kinds of austerity measures that have had a disastrous impact in Europe and prevented any real recovery in the US. To make this point properly, we need some numbers. One way to get such numbers is with a macroeconomic model. That gives you some better precision, but often hides the key assumptions. Instead, I will give a very simple Keynesian analysis, yielding back-of-the-envelope estimates.

For illustration, I’ll assume a public expenditure cut of $10 billion a year – the calculation is linear so it can be scaled up or down as needed. In a recession, the fiscal multiplier is likely to be around 1.5 (that’s the value used by Christina Romer when she pushed for a larger fiscal stimulus in 2009, and consistent with recent estimates by the IMF). So, the impact of the cut, when multipliers are taken into account is $15 billion or around 1 per cent of national income (or GDP if you prefer that measure).

Now we can use Okun’s Law to estimate that the cut will raise the unemployment rate by around 0.5 percentage points. Taking participation rates into account, employment will also fall by around 0.5 per cent (about 50 000 jobs).

A bunch of qualifications and observations over the fold

This assumes monetary policy is unchanged. In practice, presumably there would be some relaxation of monetary policy. But in a recession and with interest rates already low, expansionary monetary policy is unlikely to have much effect. As my old teachers used to say, it’s ike “pushing on a string”.

This calculation assumes that the cuts aren’t offset by additional spending or tax cuts elsewhere. It deals with the idea of attempting to restore budget balance during a recession. When you are looking at a mixture of cuts and increases, what matters is composition effects. Changes in public sector employment are likely to have a bigger short-term impact than changes in taxes,particularly changes in corporate taxes.

Allowing for the scale of the economy, Newman’s cuts in Queensland are comparable to those used in the calculation above, and the increase in unemployment since then is consistent with the estimates. Of course there are lots of other things going on, but I conclude that Newman’s policies have increased unemployment both directly and indirectly through multiplier effects.

Finally, I haven’t had time to calibrate this for the 2008 & 2009 stimulus packages, but my preliminary guess is that they imply that GDP would have been 2-4 per cent lower and unemployment 1-2 percentage points higher in 2009 if not for the stimulus

53 thoughts on “Fiscal multipliers and employment (wonkish)

  1. The fiscal multiplier is just an estimate of central bank incompetence (that’s Keyensian Brad Delong’s quote). The RBA will offset anything shock to inflation, including fiscal stimulus/austerity.

    You are wrong about monetary policy being out of ammo when interest rates are zero. At the end of last year people were saying that the tax hikes and spending cuts in the US would plunge the country into recession. But since then job growth has continued to grow strongly because of the offsetting forces of QE3. Talk of a taper has also strongly impacted the markets in recent months, hardly what you would expect if mobetary policy at the zero bound has been like “pushing on a string”.

    The UK hasn’t had a recession since the tories came to power (the growth figures have just been revised to show there was no double dip). Stimulus in Japan has caused the yen to fall, the stock market to rally and inflation expectations to pick up after 20 years of Keyensian economists saying Japan was stuck in a liquidity trap.

    Since the ECB has cut interest rates the Eurozone has started growing again. It had been shrinking since the ECB raised interest rates in 2011 out of fear of inflation. It was mobetary, not fiscal austerity that plunged the Eurozone back into six straight quarters of negative growth.

    The fed, BoE, ECB and BoJ could all do more, growth is still too slow in those countries. But even their sub optimal policy is enough to offset fiscal austerity.

    The RBA still has room to move to cut interest rates, so we won’t even face the zero bound issue that incompetent central bznks around the world have faced. Unless the RBA really screws up, the multiplier effect of the Coalition’s cuts will be exactly zero.

  2. Add in the $30 billion Malcolm Turnbull proposes to pile up in an infinite number of nodes and burn and it looks like austerity will follow for everyone. Yay! 😦

  3. “Britons’ real disposable income fell by 1.7 percent in the first three months of 2013, the biggest quarterly drop since 1987, driven down by an outright fall in wages and rising prices, causing households to reduce their savings to the lowest share of income since early 2009.

    Britain’s current account deficit with the rest of the world unexpectedly widened to 3.6 percent of gross domestic product and business investment slumped by 16.5 percent on the year, casting doubt on government hopes for an economic recovery driven by exports and capital spending… Britain’s slowest economic recovery on record since then means that output is still 3.9 percent below its pre-recession peak – compared with an earlier estimate of 2.6 percent below.”

    But TECHNICALLY, it’s not a double-dip recession. So that’s all right then.

  4. @John Quiggin

    Employment in Great Britain is higher than before the crisis. I never said Britain was in a great position, I said the BoE should do more to support growth, but fiscal austerity has had no effect on British NGDP.
    The market monetarists have been proven right time and time again and the Keyensians have been wrong. Monetary, not fiscal policy, sets the path of Nominal GDP.

    You should know better than to claim the fiscal multiplier will be anything other than zero when interest rates are positive. Even Keyensians like Krugman, Delong and Romer will tell you that. Michael Woodford, the world’s foremost monetary economist and a Keyensian, doesn’t believe in the liquidity trap. Maybe you’re a bit behind on recent events, or maybe you’re just being intellectually dishonest.

  5. Gosh, a look in the crystal ball tells me another country where the people don’t read newspapers or the wrong ones, is about to undergo the same processas occurred under Cameron.
    Some of the comments above demonstrate a targic misunderstand the true function of government in the twenty first century.

  6. @Grim23

    If you can slip from
    “The UK hasn’t had a recession since the tories came to power”

    “I never said Britain was in a great position”

    in the space of two comments

    I don’t think we are likely to have a productive exchange of views

  7. @John Quiggin

    Wow you really do think in black and white. I didn’t think I’d have to hammer such a simple point across like this.

    It’s true. The UK hasn’t had a recession. That doesn’t mean it’s in a great position. But it’s not as bad as the austerity critics claim. Nominal GDP is growing (despite austerity) but the bank of england needs to be more aggressive to get it back to the trend it was on pre-2008.

    Maybe you can explain how austerity is depressing aggregate demand even though inflation has been consistantly above the BoE’s target.

    And if the UK was doing as poorly as the critics claim, why is employment rising?

    Saying that monetary policy is doing enough to offset fiscal austerity and keep the economy just out of recession is not the same as saying that economy is doing just fine or that monetary policy is doing enough. Do you understand that?

  8. Paul Krugman:
    “This is a curious thing for him to say, because it’s an outright lie; as anyone who has been reading me, Martin Wolf, Brad DeLong, Simon Wren-Lewis, etc. knows, our case has always been that fiscal stimulus is justified only when you’re up against the zero lower bound on interest rates.”

    Still banging on about how fiscal stimulus “saved” the Australian economy with rates still way above zero?

  9. Looks like Abbott is (suddenly) less hawkish on a surplus than the government:

    Yes Tom, but they are in the enviable position of being able to say “Look what a mess the last lot left us with”. True or not, they will most likely get away with it as well.

  10. @Grim23

    I am an ardent critic of macro-economic models (not of Keynes’ original writing viewed in historical context), your story included.

    You write: “Still banging on about how fiscal stimulus “saved” the Australian economy with rates still way above zero?”

    Zero interest rates (RBA cash rate) are of no use to businesses and private individuals who are locked into financial contracts. In case you have forgotten, the GFC is what the acronym says: a global financial crisis. A crisis is a systems failure. It is the financial system which failed. Pushing more money (fiat money numbers) into ‘the economy’ saved the bankers’s bacon while increasing public debt (in the US and the UK, Spain, Ireland and a few other places).

    In Australia, the initial government policy reaction (guaranteeing deposits up to a limit, which was extended as the extent of the GFC became clearer, and a cash payment to all people whose income as per last tax return did not exceed a specified limit) was a hell of a lot smarter than subsidising those who don’t seem to know the difference between debt and equity but are smart enough to not allow their balance sheets to be dirtied by a lot of junk by hiring rating agencies to fool the savers all over the world.

    Obviously, the set of policy options as well as their effect depend on initial conditions as well as risk preferences of people. Australians responded to the GFC by increasing their savings. Its neither all government nor all private. Its neither only monetary policy or only fiscal.

    There I was, trustig that the IS/LM framework (including the monetarist version) has been declared dead. I am disappointed again.

    Grimm as you may find it, details about ‘the economy’ matter, particularly people.

  11. To translate Ernestine Gross in non professional wording so that Grim can understand the full scope of it:
    Fiscal stimulation (or austerity) to the economy can come from 3 sources; Government, private sector increasing spending or trade sector balance improvement. This comes from equasion on sector balances ; G+P+T=0
    Grim23, you need to look at changes in sectors, not at static numbers to know the purpose of the model. Monetary policy is ineffective but trough private Expectations. Expectations which change spending pattern, save more or spend more.
    Spending = income. Whatever you spend is someone else’s income. Spend less (save) will reduce total income in an economy.

    Australian stimulus had no effect in aditional spending but to prevent increase in private savings (“risk preferences of the people” as EG wrote in proffessional wording) which would reduce employment. Increased saving would reduce incomes which could triger private deleveraging of the debt and that is the crisis. In AUS case that would be taking less credit then before and paying old credits off.
    EG’s analysis is better then JQ’s in that includes private sector spending effects

    In US as you pointed out, all those talks about austerity did not produce more unemployment but the reasons are that private sector reduced savings (increased spending) provided stimulus which replaced reduced government spending. At the same time, trade balance was improved a tad bit, but not enough to have visible influence. SO it was private spending that did provide counterbalance to US switch to austerity.
    Increased spending by private sector will drive again to the limit of leverage and panic in financial sector again as it happened in 2008 because it is not driven by increase in wages which are supposed to pay off such debts. Australia had increase in wages following increase in debt on much better rate then US.

  12. On a side note, i got this next insight by observation altough i know it is not a way to be considered, but…
    Central bank’s interest rates are effective down to 2%, not bellow it, so effects of Zero Lower Bound is at CB interest rates of 2%. The reason is that private interest rate (not between banks) does not go bellow 4% where it matters. Since the mechanism of monetary policy is through housing sector, not trough credit cards and cars since the cars and shoping is a smaller portion of total private loans. Loans for consumption can have 0% interest but as we saw it in US it went up as soon as banks got scared, their expectations plumeted when crisis hit.
    Zero lower bound in effect is at 2% CB’s interest rate not at 0% because mortgage loans do not go bellow 4%.

    All the effect comes from the fact that issuing credit is money creation/ more liquidity/ increased quantity of money in economy and paying off debts is money destruction/ less liquidity/ reduced quantitiy of money.
    So, from formula MV=PQ where increased credit creation produces increase in V,P and Q, paying off credits at higher rates then before will reduce V and Q. Prices do not fall, not for years except in one sector where credits did drive increase in price. In Housing.

  13. Not quite, Jordon. I did not wish to give the impression that the initial Australian government ‘stimulus’ (as described) had no effect on the economy. On the contrary, I am saying by giving the cash to individuals early (before bankruptcies grew in various places) the ‘stimulus’ had an effect on the economy. Furthermore, what was possible in Australia was not possible in Iceland (initial conditions). Not even the threat of sending warships to Iceland would have produced more than payment in fish.

    IMHO, one of the important lessons from Keynes is the distinction between a Walrasian demand and an effective demand. The Australian government’s ‘stimulus’ impacted on effective demand, ie individuals’ cash balances. This was crucial at the time because the financial system was essentially broken, hence private spending couldn’t come from more borrowing. The increase in savings by the public (financial risk preferences) happened later.

    (Incidentally, the distribution of wealth matters also in Walrasian general equilibrium models; regrettably this is typically not taught in undergraduate subjects where Economics is split into micro and macro – leaving the difficult part to students to work out, namely what happens in aggregate and under which conditions.)

    I shouldn’t have commented at all because I know from reading this blog JQ is following a systematic critique of neo-liberalism.

  14. I did not say that stimulus had no effect on economy, but..”no effect in aditional spending but to prevent increase in private savings” In other words, it replaced decrease in private spending and affected expectations.

  15. @Jim Rose
    The IMF estimates are for economies more open than ours

    He’s not quite lying, just being tricky. Because the population has risen, you can get marginally higher emp with a lower E/P ratio. And of course rising employment+falling GDP =falling productivity

  16. @Jim Rose
    You probably meant to ask if there is a demand leakage of demand acros the borders, or if there is stimulus stimulating other countries instead of domestically due to trade. This demand leakage is supposed to reduce fiscal multiplyer.

    The answer is in change of spending which matters, not to look at static numbers.
    Of course that demand leakage would be effective if you take 0 trade and then apply it at the present, but if you take present trade balance and compare it to balance with stimulus then that would be much smaller effect.
    The reason is that advanced economies have available capacities to quickly cover for increased demand instead of getting products from outside.
    And there is no trade in housing as you know so if you apply stimulus to housing, there can not be demand leakage but in imported materials which is a small percentage in housing.

    After a longer periods in recessions, such available capacities can be gone for good, because workers are taken other jobs and manufactoring plants have bankrupted. That is why leaving recession on its own for longer periods is wasting available resources and letting them sit idle, not to mention suffering of people.

    I would say that fiscal multiplyers are even higher then 1.5. I would say that it is around 2.5 in the beggining of a recession and as time goes by it falls even bellow 1 within 5 years.

    The things are a bit different in fixed exchange rate economies (which is probably what Jim meant by “open economy” and which i also tought it meant untill a year ago).
    Demand leakage is bigger in fixed exchange economies then in floating exchange rates economies, especially after the devastation of available capacities.
    Falling exchange rate will reduce demand leakage in “closed” economies.

    After a prolonged recession the nature of fiscal stimulus have to change, it can not work through private demand anymore, state has to direct it and organize spending into infrastructure or organize companies that will produce what a domestic economy needs. Companies in state ownership.

    Fixed ERE have to direct stimulus much earlier then in flexible ERE and employ available capacities / workers. I would preffer that fixed ERE do not even try stimulus trough the private sector since longer exposure to the fixed ER destroys a lot of available capacity trough negative trade balance.

  17. Fixed exchange rate has the same effect as Gold Standard.
    Having a currency pegged effectively means that you are using someone else’s currency, not your own = no sovereignety.

  18. @John Quiggin
    Okay, my mistake. I assumed that “employment” was referring to an E/P ratio. However I have a new complaint. Isn’t it almost always more meaningful to normalise thing’s like employment to the population?

  19. @Nathan
    It would be much easier to look at total employed and change in number of jobs then changing number of kids and retired in E/P ratio.

  20. I should shut up on any ‘macro-debate’.

    For the record, here are the latest GDP rates of change for individual European countries as well as for sub-groups. (Just as the Brisbane floods caused a dent in the QL numbers, so did the floods in Germany during Q1 2013. Q2 2013 looks very different from Q4 2012 but Q2 2013 is spring time and early summer while Q4 is very cold and miserable.)

    Click to access 2-14082013-AP-EN.PDF

    Is there anybody who shares my opinion that the only country to which Australia can be meaningfully compared is Canada? While being located on opposite ‘ends’ of the world, both are large in geographical dimensions, rich in natural resources, similar size populations and multicultural. They have a history which sufficiently overlaps, and have extreme weather conditions, albeit on the opposite of the scale. Both cultures seem to have a well developed dislike for extreme politics. Not sure which population produces the better sense of humour.

  21. @Jordan
    I should have said that in the numbers I’m quoting the population being normalised to is only those aged 16-64. I think that roughly solves the children/retired problem.

  22. @John Quiggin

    My data from germany came from the world bank. In 2010 and 2011 germany grew faster than Australia, according to this link

    Still can’t answer my basic point though, can you? If interest rates are above zero then according to Keyensian theory the fiscal multiplier is zero. Not very controvertial. Every Keyensian would agree.

    But at the zero bound monetary policy is still powerful. I don’t care what Woodford called his paper, if you think that monetary policy can work at the zero bound you don’t believe in a liquidity trap, because where is the “trap”?

    If you are right and I am wrong, and monetary policy is impotent at the zero bound then answer this:

    1. Why is the US recovery continuing at the same pace as before the “sequester”?

    2. Why is talk of a taper to QE3 sending markets into a spin?

    3. Why has UK inflation consistently been above the BoE’s target during so-called “austerity”?

    I could think of more, but you’ve had trouble answering those basic points already.

  23. @Nathan

    I agree. Considering the confidence expressed in the perfect effectiveness of monetary policy, the reliance on incredibly selective use of statistics is revealing.

  24. @Grim23 This is the Gish Gallop at work. Spray so many absurd claims that your antagonist can’t possibly meet them all, then claim victory.

    But, as you say, the important one is the suggestion that

    If interest rates are above zero then according to Keyensian theory the fiscal multiplier is zero. Not very controvertial. Every Keyensian would agree


    This is total nonsense. And I don’t even need to quote Keynesians to prove it. Here’s Scott Sumner, of whom you presumably approve

    Keynesian economists have never been able to accept my assertion that the fiscal multiplier is roughly zero because the Fed steers the (nominal) economy.

    (emphasis added).

  25. Also, minor point, but it’s “Keynesian”, not “Keyensian”. Named for John Maynard Keynes, the well-known English economist

  26. @Ernestine Gross
    I share your opinion on Canada and Australia but mostly because of dislike of extreme politics which is usually a result of economic desperation which produces the rise in extreme politics. But mostly on dislike of extreme economic theories and changes within theories are going paralell way.

    Both have world record in housing leverage. I am not sure about bank reserve requirement in Canada, so Aus does not have such policy space to reduce it if needed when compared to Canadian policy space.

    But only qualitative difference for comparison is whether economy operates on fixed exchange rate and debt only in domestic currency. So UK, Canada, US, Japan and Australia are comparative while everyone else operates under what is effectively a Gold Standard

  27. Maybe you should try reading the rest of that article
    “Smith doesn’t seem to realize that he’s not just arguing against my “batty” views, but also against mainstream new Keynesian economics. That’s why the new Keynesians moved from fiscal stabilization to inflation targeting in the late 1980s; they came to realize the futility of using fiscal policy when monetary policy is already steering the economy.”

  28. @Grim23
    Although there’s not been much point in providing you with evidence so far…

    1. It isn’t, at least not according to the US Federal Reserve and the Federal Open Markets Committee [1].

    2. This was explained in detail in Krugman’s piece linked above.

    3. According to the Office for National statistics, growth in university tuition fees, regulated energy tariffs and higher gas prices leading to rapidly increasing manufacturing and hence retail prices



  29. @Grim23
    Just in case anyone is playing along at home I’ll point out that need for the distinction “new Keynesian” shows your “every Keynesian” claim was hyperbolic overreach.

  30. JQ Says:

    @Grim23 This is the Gish Gallop at work.

    That’s sort of right, but the Gish Gallop really only works in a public forum where you don’t get a chance to respond properly.

    There’s another term, fractal wrongness that might be closer to the mark.

    It’s the climate change denialists’ style of argument.

    Not saying that Grim23 is a climate change denialist, he comes across more as an unemployed libertarian teenager.

  31. Responding to Sumner’s version of the claim, it’s a zombie version of the Great Moderation idea that monetary policy alone is sufficient to stabilize both inflation and the real economy. If that’s true then monetary policy will be adjusted to cancel out the effects of fiscal policy. But the Great Moderation ended in the crisis, and monetary policy has proved to be of limited use since then.

  32. My main concern is that Abbott has locked himself so thoroughly into the rhetoric of surplus that,

    Abbott successfully got the ALP to lock themselves into that rhetoric but over the last six months l don’t think there has been much rhetoric from the Liberals along those lines. What they talk about is “repairing the budget” and getting the “budget back on track” not delivering immediate surpluses. In fact it is the ALP that has been talking up the prospect of the Liberals rapidly returning to surplus with their mantra of “what are you going to cut”.

    The Liberals have promised several forms of stimulus. Including axing the mining tax, axing the carbon tax and trimming the company tax rate.

    Unfortunately the Liberals have also committed to a pile of new spending. Some of it is one off pork like the pile of promises to local sporting facilities or to road projects but there are some recurring liabilities like the parental leave scheme and direct action which impact the budget into the future. Not to mention several labour promises that the Liberals have also signed up for.

    What the Liberals actually do is a lottery. I suspect they will be Labor lite. In spite of recent promises about shrinking the size of government I don’t expect them to genuinely throw much real red meat to classical liberals such as myself. I expect that if the Liberals win their first full year budget will be in deficit. And probably their second one also.

  33. Describing Keynes as a ¨well-known English economist¨¨ is a bit like describing Isaac Newton as a competent physicist.

  34. apologies for the twaddle JQ.
    i caught the grimy vibe.
    i still think there is a tag team of obfuscators—belittle,misinform,split hairs etc.

    anything to keep a factual discussion off beam.

  35. SJ, your reference to ‘fractal wrongness’ is very useful. I have a data set stretching over 8 years. I know already the process is chaotic. Thank you.

    Apologies to JQ for being off topic..

  36. See for the views of Delong and Summers on fiscal policy where they say that:

    It surely cannot be the case that at most places and times expansionary policy is desirable, nor that at all times when economies are severely depressed fiscal policy should be pursued without limit.

    This is why we stressed that, outside of extraordinary downturns where the zero lower bound constrains interest rates, we believe that the right assumption is that the fiscal multiplier is effectively zero. Increases in demand will run up against supply constraints.

    And to the extent they do not, increases in demand will be offset by monetary policy. With a zero policy-relevant multiplier, judgments about fiscal policies should be on allocative rather than stabilization-policy grounds.”

    I ask whether Australia is or is likely to face a zero-bound?

  37. As I said above, all of these estimates depend on institutional assumptions about fiscal and monetary policy. In the US context, fiscal policy is just about impossible to adjust, so it’s reasonable to assume it’s fully offset by monetary policy, even when you are not facing supply constraints.

    But that’s not true more generally. The IMF now estimates a multiplier of 0.5 for the period of the Great Moderation.

  38. @TerjeP That has been the ALP’s biggest mistake, responding to LNP. Somehow they lack the weight to punch through the Libs nonsense.

  39. Considering the New Keynesians are basically neoclassicals with sticky prices tacked on and have no idea of how the monetary system actually works I wouldn’t be holding them up as great authorities on monetary matters.

  40. @rog

    Rog – Labor didn’t “somehow” lack weight. The Labor party, based on it’s fiscal track record, and it’s track record of crazy spending initiatives, had a shot reputation. It is because of this shot reputation that they felt a strong need to puff themselves up with grand promises. The Liberals simply exploited this weak form of false pride. Revealing for all to see that not only is the Labor party fiscally reckless they are also politically weak.

    I must say that one of the things I really love about this debate is that for a change we are having a vigorous debate about the cost of government.

    The other thing I’m loving is that Labor looks like losing, and if they have any brains the lesson they will draw is that fiscal responsibility in government is a core value of the Australian electorate. Hopefully a defeat under such circumstances will make them a smarter party and one more averse to the vision of big government.

  41. Hopefully a defeat under such circumstances will make them a smarter party and one more averse to the vision of big government.

    Won’t make the coalition any smaller

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