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. @TerjeP

    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.

    Gosh you talk some tosh. Of all the lessons they could draw from a savage loss, “fiscal responsibility in government {being} a core value of the Australian electorate” would be much the most outlandish. Their slightly more rightwing populist rivals have figuratively dropped their trousers and opened their bladders all over that one — while for three years claiming they were all for fiscal restraint. Last I heard they were handing out money for wealthy women to have children, playing Willy Wonka with state funds in some chocolate factory in Tasmania and promising to corner the fishing boat market in Indonesia. To date they have yet to even release properly audited balance sheets on their programs — setting as their benchmark the actions of the party you say has been fiscally irresponsible, who, ironically, have released costings.

    The lesson they might draw is that perceptions of competence are made and broken in the Murdoch press and that well chosen porkbarrelling is really handy but that competent or responsible or not — it’s all moot if the old media is on the other party’s side. Oh, and that dumping a leader before an election turns out to be a bad idea. Apparently, they are slow learners as they chose to do it twice.

    A less probable but more helpful lesson is that they need to stand up for equitable policy and explain why the privileged are not going to like that, and to prepare to fight for that policy tooth and nail against the boss class press and its yappy puppies. Oh … and not pander to your hardened enemies. That’s not likely, but at least it fits the history.

    As to you, Mr Fiscal Responsibility and all things Free Trade — how’s the thinking on One Nation’s prospects in this election? I hear Antony Green isn’t best pleased that Arthur Sinodinos might just be supplanted by Pauline Hanson. Well done you … another blow for the cause.

  2. TerjeP :
    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.

    Here is the complete list of evidence to back up TerjeP’s assertion of horrible (nominal) left-wing fiscal management:

  3. Now that every policy must be costed and every major party promises a return to surplus in a few years, the Ricardian theory of budget deficits is an optimistic view of the power of fiscal policy.

    When Barro wrote in the 1980s, he pointed out that there is no reason to assume that forecasting errors about future taxes are always biased in the direction of under-estimating future taxes. People might over-estimate future taxes.

    It is certainly the case that most think they have to provide for their own retirement and that government will not tax enough to support them.

    People have relatively sophisticated views of both long-run spending and taxing in an ageing society and that deficits must be paid for. The voter is a fiscal conservative.

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