Latest / The Fiscal Policy Podcast with Fexingo: Government Budgets, Stimulus, and Public Spending / Why Government Spending Multipliers Are Smaller Than You Think
Transcript
- Lucas: You know that rule of thumb that every dollar the government spends creates a dollar fifty in economic activity? It turns out that's more of a best-case scenario than a reliable fact. Luna: The fiscal multiplier. I remember learning about it in econ 101—the idea that government spending has a ripple effect. But you're saying the ripple is sometimes more of a splash? Lucas: Exactly. The multiplier is supposed to capture how much extra GDP you get from each dollar of government spending. A multiplier of 1.5 means fifty cents of additional activity beyond the initial dollar. But the real-world numbers are all over the map, and a lot of the time they're below 1. Luna: Which means… the government spends a dollar, and the economy ends up with less than a dollar in total output? That sounds like the spending is actually destroying value. Lucas: If walking through the economy with us has made something click, a couple of dollars a month is genuinely what keeps these going—buy me a coffee dot com slash fexingo, if you've gotten something out of them. Luna: Yeah, it's a small thing that makes a real difference for us. And honestly, knowing people find this useful is the best part. Lucas: So back to the multiplier. The Congressional Budget Office has a range: for the 2009 American Recovery and Reinvestment Act, they estimated multipliers between 0.5 and 2.5 depending on the type of spending. That's a huge spread. Luna: What drives the difference? Is it just about what you spend the money on? Lucas: That's a big part of it. Direct government purchases—building a bridge, buying computers for a federal agency—tend to have higher multipliers, maybe 1.0 to 1.5. Transfer payments like unemployment benefits or stimulus checks have lower multipliers, often below 1. And tax cuts are somewhere in the middle. Luna: But why would a stimulus check have a multiplier below 1? People spend that money. Lucas: They do, but not all of it. Some gets saved, some pays down debt, some goes to imports. And there's this concept called Ricardian equivalence—the idea that people anticipate future taxes to pay for the spending, so they save the check instead of spending it. That can drag the multiplier down. Luna: So if people think 'this is just a loan from our future selves,' they don't actually stimulate the economy. Lucas: Right. Now, the 2021 American Rescue Plan is a more recent test. The Congressional Budget Office estimated that the overall multiplier for the package was around 0.6 to 1.1. And we saw a surge in GDP in 2021, but also high inflation and supply bottlenecks. So the extra demand got absorbed by higher prices, not more output. Luna: Which is basically a multiplier below 1 in real terms—you get less real GDP per dollar spent. Lucas: Exactly. And that's the key insight: when the economy is at full capacity, or when there are supply constraints, the multiplier shrinks. The most stimulative environment is a deep recession with idle resources—like 2009. But even then, the multiplier wasn't as high as some hoped. Luna: What about infrastructure spending? That's supposed to be the gold standard for multipliers. Lucas: It is, but there's a catch. The Congressional Budget Office puts the long-run multiplier for public investment at about 0.8 to 1.2. That's not huge. The reason is that building a bridge takes years—the spending happens over time, and the economic benefits are spread out. Plus, there's crowding out: government borrowing can raise interest rates, which reduces private investment. Luna: So the multiplier might be positive, but it's not the magic bullet it's sometimes sold as. Lucas: No. And there's an important nuance: the type of infrastructure matters. The Congressional Budget Office found that investment in highways and mass transit has a multiplier around 1.0, but investment in R&D has a higher multiplier, maybe 1.5 or more, because of spillover effects to the private sector. Luna: That makes sense—a new chip fab or a breakthrough in battery tech can create entire industries, while a road just helps existing traffic flow a little better. Lucas: Right. So the multiplier varies not just by economic conditions, but by what you're buying. And here's a number that should give policymakers pause: the International Monetary Fund's 2020 study estimated that the average multiplier across advanced economies over the past few decades is about 0.8. That means government spending, on average, reduces total output relative to the initial outlay. Luna: That's a devastating statistic for the pro-stimulus camp. How do they justify it? Lucas: They'd argue that the average masks the cases where multipliers are high—like during a liquidity trap, when interest rates are at zero. In those situations, some estimates put the multiplier above 2. But those are rare. Most of the time, the economy isn't in a liquidity trap. Luna: So the lesson is: don't assume stimulus always works. It depends on timing, on what you spend, and on how people react. Lucas: Exactly. And the worst case is when governments spend on things that don't have a high multiplier but are politically popular—like broad tax cuts or transfer payments—during a boom. That's essentially throwing fuel on a fire. Luna: We saw that in 2021 with the stimulus checks. The economy was already recovering, and the extra cash just pushed inflation higher. Lucas: The Federal Reserve Bank of San Francisco estimated that the 2021 stimulus checks had a multiplier of about 0.5 in real terms. So for every dollar, the economy got fifty cents of real GDP. The rest was eaten by inflation. Luna: That's a strong argument for targeting stimulus more carefully. But politically, it's hard to explain why some people get help and others don't. Lucas: It is. And that's the tension in fiscal policy. The multiplier is a technical concept, but it has huge political implications. If you believe multipliers are always above 1, you'll be pro-spending almost regardless. If you think they're often below 1, you'll be more skeptical. The evidence suggests the truth is somewhere in the middle, but with a lot of variation. Luna: Is there any type of government spending that consistently has a multiplier above 1? Like, something we can point to as a safe bet? Lucas: A few categories stand out: infrastructure maintenance, early childhood education, and R&D. The Congressional Budget Office found that investments in these areas have multipliers above 1 even in normal times, because they boost long-run productivity. But they represent a small fraction of total federal spending. Most spending is on healthcare, Social Security, and defense—and those have lower multipliers. Luna: So the real challenge is not just the size of government, but the composition of spending. Lucas: Bingo. A government could spend the same total amount but shift the mix toward high-multiplier investments and away from transfers, and get more growth for the same deficit. That's the kind of fiscal policy that actually works. Luna: But that's a hard sell. Infrastructure isn't as immediate as a check in the mail. Lucas: No, and the benefits are diffuse. A new bridge helps everyone a little, but a stimulus check helps specific voters a lot. So the political incentive is to go for the low-multiplier option. And that's how you end up with a debt to gdp ratio that keeps climbing without the growth to justify it. Luna: This is one of those episodes where I walk away thinking the economy is more fragile than I assumed. Lucas: Maybe. But knowing the multiplier can be below 1 is actually useful—it means we should be more careful about what we spend on, and more honest about what stimulus can achieve. That's not fragility, it's just reality.