One of the basic debates between “conservative” and “liberal” (i.e. Keynesian) economists concerns the extent to which government spending stimulates the economy.  Keynesians argue that government spending stimulates money through a multiplier effect, wherein the initial government expenditure leads to further private sector spending (leading to a total economic addition greater than the economic loss caused by taxes).  Conservatives contend that the government spending actually crowds out private consumption and investment.  (Learn more about crowding out here or see one form of crowding out at right.)  A new NBER paper [subscription required] by Harvard economist Robert Barro is sure to only add fuel to the fire.  First, Barro finds that government spending (in this case, defense spending) has a multiplier coeffecient of only 0.6 to 0.7.  In other words, every government dollar spent actually removed 30 to 40 cents from GDP.  Second, Barro finds that (perhaps unsurprsingly) increases in taxes have significant negative effects on GDP. 

I’m intrigued by this research, but I have to wonder if these conclusions hold up in a credit crunch like we’re in now.  When banks and other financial intermediaries are unwilling to lend (and consumers are unwilling to spend), the money they’re hoarding produces no multiplier effects.  Even if government spending is less than optimal, it would still have to produce better results in those circumstances than letting that money sit.  Of course, in normal economic times Barro’s conclusions would seem to make perfect sense to a neoliberal like me: individuals would be more informed about what investments produce the best economic results than a government-centered approach.

Macroeconomic Effects from Government Purchases and Taxes
Robert J. Barro and Charles J. Redlick
NBER Working Paper No. 15369 (September 2009)

Abstract: For U.S. annual data that include WWII, the estimated multiplier for defense spending is 0.6-0.7 at the median unemployment rate. There is some evidence that this multiplier rises with the extent of economic slack and reaches 1.0 when the unemployment rate is around 12%. Multipliers for non-defense purchases cannot be reliably estimated because of the lack of good instruments. For samples that begin in 1950, increases in average marginal income-tax rates (measured by a newly constructed time series) have a significantly negative effect on real GDP. Increases in taxes seem to reduce real GDP with mainly a one-year lag due to income effects and mostly a two-year lag due to substitution (tax-rate) effects. Since the defense-spending multiplier is typically less than one, greater spending tends to crowd out other components of GDP. The largest effects are on private investment, but non-defense purchases and net exports tend also to fall. The response of private consumer expenditure differs insignificantly from zero.

-Michael