Fiscal Policy and Economic Recovery
Romer, Christina D., Business Economics
The American Recovery and Reinvestment Act of 2009 is the biggest, boldest countercyclical fiscal stimulus in American history. What is its likely impact? Current econometric models indicate that a tax cut is likely to have a multiplier of about 1.0 and that spending has a multiplier of about 1.6 after about 18 months. Even the most sophisticated econometric analysis, however, suffers from "omitted variable" bias. In trying to take account of this, David Romer and I have found that the tax multiplier is more likely to be around two to three; and we suspect that the spending multiplier is correspondingly higher than the conventional estimates. Of course, every recession is different. The unique factors of this recession are analyzed to determine whether the multipliers are likely to deviate from historical averages.
Business Economics (2009) 44, 132-135.
Keywords: fiscal policy, economic recovery, multiplier, financial crisis, budget deficits
On February 17th. the President signed the American Recovery and Reinvestment Act of 2009. With the last-minute drama surrounding the bill's passage and all the other things going on in the realm of economic policy, I think it is easy to lose sight of what a major accomplishment this act represents. It is simply the biggest, boldest countercyclical fiscal stimulus in American history. One way to see this is to compare it with Franklin Roosevelt's New Deal. In the biggest year of the New Deal, 1934, the fiscal expansion was about 1 1/2 percent of GDP. And this expansion was followed the very next year by a cutback of almost the same size. In contrast, the act that was just passed provides fiscal stimulus of roughly 2 1/2 percent of GDP in each of 2009 and 2010.
Another fact that may have been lost in all the hoopla is that almost all of the spending in the bill is genuine stimulus. Yes. the patch to prevent the Alternative Minimum Tax from raising taxes on millions of families, while desirable, was largely anticipated, and so may not have a large extra stimulatory effect. And, a small amount of the government investment, about 4 percent of the overall package according to the Congressional Budget Office, won't happen until after fiscal 2011. But, even CBO says that about 75 percent of the $787 billion will spend out in just the next 18 months. And this is the stuff of conventional textbook stimulus--tax cuts for 95 percent of families; direct aid to people hurt by the recession, through increased spending on programs like unemployment insurance and Food Stamps; checks to state and local governments so they don't cut services and raise taxes; and direct government spending on infrastructure, education, energy efficiency, and other valuable programs.
A key question that I have tried to answer, and that I'm sure that any of you who do forecasting have faced, is what we can reasonably expect this massive infusion of fiscal stimulus to do. This is a question where my current life as a policymaker and my previous life as an academic intersect. I have spent much of my academic career trying to estimate the effects of both monetary and fiscal policy. I thought I would draw on that work today to talk about the role fiscal policy is likely to play in the much needed economic recovery. In particular, I want to talk about two issues. First, what do we know about the effects of fiscal policy in general? And second, are there special factors in the current situation that may make fiscal policy more or less effective than usual?
1. Fiscal Policy Multipliers in General
Let me start with the issue of the effects of fiscal policy in general. If we cut taxes by 1 percent of GDP or increase government spending by a similar amount, what will that typically do to real GDP or employment? That is, what are the fiscal policy multipliers? I will be the first to point out that estimating these multipliers is difficult and that there is surely substantial uncertainty around any estimate. …