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've heard the number a hundred times: every dollar the government spends generates more than a dollar of economic activity. That's the multiplier. It's the bedrock argument for stimulus. But here's the thing — the actual research is a lot messier than the talking points suggest. Luna: Messier how? I mean, the basic idea seems intuitive: government hires someone, that person spends their paycheck, businesses hire more, and so on. Lucas: Right, that's the textbook version. But there's a counterforce that often gets left out of the political debate. When the government borrows to spend, it pushes up interest rates. Higher rates make it more expensive for private companies to borrow for investment. So for every dollar the government spends, you might lose some amount of private spending. That's crowding out. Luna: And that lowers the multiplier. But by how much? It seems like the answer would depend on the economy's state. Lucas: Exactly. That's why the Congressional Budget Office — the CBO — doesn't give you one number. They give you a range. For the 2009 Recovery Act, they estimated multipliers between 0.5 and 2.5. That's a five-to-one spread. So whether stimulus is a home run or a dud depends on when and how you spend. Luna: Let's get specific. What determines where you fall in that range? Lucas: The biggest factor is whether the central bank pushes back. If the Fed sees the economy overheating and raises rates, crowding out is stronger — multiplier sinks toward the low end. But if the Fed holds rates steady — say, near zero — then there's less crowding out, and the multiplier can be above one. Luna: So the multiplier isn't a fixed number. It depends on monetary policy. That seems obvious once you say it, but I feel like most stimulus debates ignore it. Lucas: They do. And there's a second layer: what kind of spending? A paper by economist Valerie Ramey looked at defense spending, which is a big chunk of discretionary federal spending. She found multipliers consistently below one. In some cases, around 0.6 to 0.8. Luna: Defense spending is often ramped up quickly, not targeted at slack in the economy. And it doesn't have a strong automatic stabilizer component. Lucas: Right. Compare that to unemployment insurance or food assistance — those tend to have higher multipliers because the recipients are likely to spend the money quickly. The CBO estimates unemployment insurance multipliers around 1.5 to 2.0. Luna: Okay, so the composition matters a lot. But there's a more fundamental critique too, isn't there? The idea that the multiplier itself is a slippery concept to measure. Lucas: Absolutely. John Cochrane, an economist at the University of Chicago, has argued that the whole multiplier framework is fragile. His point is simple: if the government spends a dollar, that dollar has to come from somewhere — taxes today, taxes tomorrow, or borrowing. Rational households and firms anticipate that. So they might save more today to pay for future taxes, which cancels out the stimulative effect. Luna: That's the Ricardian equivalence idea. But does it hold in practice? People don't really behave like hyper-rational forward-looking agents. Lucas: That's the critique of the critique. In the real world, people have liquidity constraints. If you're unemployed and get a benefit check, you're not saving it for future taxes — you're spending it on rent. So there's a strong argument that multipliers are positive during deep recessions, especially when the Fed can't cut rates further because they're already at zero. Luna: So the consensus seems to be: multipliers are higher when there's slack, lower when the economy is near capacity, and highly dependent on what you spend on and how it's financed. Lucas: That's a fair summary. And I think that's actually useful for listeners to know, because so much of the fiscal policy debate is painted in black and white. On one side you hear 'stimulus always works' and on the other 'stimulus never works.' The truth is, it depends. Luna: If today was actually useful to you — like, if walking through the economics of the multiplier made something click — that's exactly the kind of conversation we try to have here. And the way these stay ad-free is listener support. You can find us at buy me a coffee dot com slash fexingo. Lucas: Yeah, it's a small gesture that keeps us independent. No ads, no sponsors. Just a direct line between us and the people who find this valuable. Luna: So let's get back to that range. One thing that's often overlooked is how the multiplier changes over time. A dollar spent today might not have the same effect as a dollar spent next year. Lucas: Right. There's a concept called the 'intertemporal multiplier.' If the government announces a big infrastructure project that will take five years, households might adjust their behavior now. They anticipate future income and future taxes. So the immediate boost could be smaller than if the spending were a surprise. Luna: That's a good point. And it ties into the credibility of the government. If people believe the spending will be paid for with future spending cuts, they might not expect higher taxes — but they might expect lower future government services. That also affects their spending today. Lucas: Exactly. Fiscal policy is as much about expectations as it is about actual cash flows. That's why some economists prefer to focus on 'fiscal space' — the room a government has to borrow without spooking markets. Luna: Let's bring this back to a concrete example. The 2009 Recovery Act — what do we actually know about its multiplier? Lucas: There's been a lot of research. One influential study by the Council of Economic Advisers estimated that the Recovery Act raised GDP by between 1.5 and 3 percent relative to baseline, and saved or created about 2.5 million jobs. That implies a multiplier around 1.5 to 2.0, depending on the assumptions. Luna: But critics like John Taylor at Stanford argued that the multiplier was much lower, maybe even less than one. They point to the slow recovery after 2009 as evidence the stimulus didn't work as advertised. Lucas: Right. And here's where the state-level evidence is illuminating. Researchers like Emi Nakamura and Jón Steinsson compared different US states that received different amounts of federal spending. They found multipliers around 1.5 to 2.0 for states in recession. But those numbers are for a given state — they don't account for the fact that the Fed might have offset the national effect. Luna: So state-level studies give you the 'partial equilibrium' effect — what happens if one state gets money while the Fed doesn't change policy. National-level studies give you the 'general equilibrium' effect, which includes monetary offset. Lucas: Exactly. And that's why the multiplier range is so wide. It's not that economists disagree about the mechanism; they disagree about which assumptions hold in a given moment. Is the Fed at the zero lower bound? Are households credit-constrained? Is the spending temporary or permanent? Luna: So when you hear a politician say 'this stimulus will create X jobs per million spent,' they are implicitly picking a multiplier from somewhere in that wide range. Lucas: They are. And they usually pick the number that supports their argument. That's why I find it useful to look at the range and think about the conditions that push it one way or the other. Luna: What about automatic stabilizers — things like unemployment insurance and progressive income taxes? Do those have a different multiplier profile? Lucas: Yes. Automatic stabilizers kick in without legislative delay. They tend to have higher multipliers because they target people who are likely to spend the money quickly. And they are temporary by design — they fade as the economy recovers. So they cause less crowding out over the long term. Luna: So if we want high-multiplier fiscal policy, we should lean on automatic stabilizers and targeted transfers, not broad tax cuts or slow-moving infrastructure. Lucas: That's the argument. But politically, infrastructure is popular. It's visible. You can cut a ribbon. Writing a check to the unemployed doesn't get you the same photo op. Luna: True. And there's another angle: the multiplier for tax cuts. The evidence suggests that tax cuts for high-income households have a low multiplier — maybe around 0.3 to 0.5 — because those households are more likely to save the extra income. Tax cuts for low-income households have a higher multiplier, maybe 1.0 to 1.5. Lucas: That's consistent with the marginal propensity to consume. People with less income spend a larger share of any extra dollar they get. So the distribution of the stimulus matters as much as the size. Luna: So if we were to design a stimulus from scratch based on the best evidence, what would it look like? Lucas: I think you'd want it to be timely, targeted, and temporary. Timely so it arrives when the economy needs it. Targeted toward households and businesses most likely to spend. And temporary so it doesn't create expectations of permanent higher spending that could cause crowding out or raise long-term interest rates. Luna: That sounds a lot like the automatic stabilizers we already have — plus maybe some extra transfers during deep recessions. Lucas: Yes. The 2020 pandemic response actually had some elements of that — the stimulus checks were timely and targeted, though some went to households that didn't need them. But overall, the multiplier from those checks was probably around 1.0 to 1.5. Luna: I think we've given listeners a pretty good framework for evaluating the next stimulus debate they hear. It's not about whether multipliers exist — it's about which one applies, and why. Lucas: Exactly. And the honest answer is: it depends. But now you know what it depends on. That's a lot more than most pundits will tell you.