Note to Fiscal Policymakers: Multipliers are Definitely Still Large

In a post on Wonkblog from yesterday morning, Dylan Matthews has an excellent interview with Michael Linden, a budget expert at the Center for American Progress. It’s definitely worth reading—not least for Linden’s correct (and therefore deeply depressing) point that in terms of discretionary spending, “We’ve already essentially adopted the Ryan budget.”

But, the simplistic Keynesian in me demands I disagree with something Dylan says about the influence of fiscal policy in the current economy:

“In 2009 it was easy to see how the multiplier on government spending, the GDP bang for the buck, would be pretty high. There were a lot of unused resources in the economy that government spending could spring into action. But during good economic times, the multiplier should be around 0. Obviously, we’re somewhere in between now, but where on the spectrum do you think we are?”

This is actually all pretty correct until that last sentence, particularly the “somewhere in between now”. Linden makes a very good empirical rebuttal to this by noting that today’s output gap is much, much closer to where it was in 2009 than zero, and, even this current output gap may well understate how much slack actually exists, since CBO has been steadily marking down potential output for reasons that may reverse if the economy recovered (see figure below from the famous DeLong/Summers fiscal policy paper).

I suspect Dylan knew he was heaving a softball question here, because he certainly knows there’s a lot of slack remaining in the economy. But it is important to note that the larger economic logic in his question isn’t quite right. Values of the multiplier really aren’t linear like that. If the multiplier on UI benefits in an economy with an output gap (a measure of economic slack) of 7 percent is 1.5 and the multiplier on these benefits in an economy with an output gap of zero is zero, this does not imply that the multiplier on these when the output gap is 3.5 percent is 0.75. I wish it did work like this, as it would make macroeconomic projections much easier.

What makes today’s fiscal multipliers so high is the combination of a large output gap and the rock-solid expectation that there will be no countervailing pressure on fiscal stimulus (or contraction) coming from changed monetary policy. Right now the Fed has signaled clearly that it will not tighten in response to fiscal stimulus (indeed, Ben Bernanke is nearly begging fiscal policymakers to try to boost the economy), and  they are hugely constrained in how much it can make monetary  policy more expansionary in response to fiscal contraction. So, multipliers can actually be quite high in economies with output gaps well below (say) 5 percent so long as there is confidence that monetary policymakers will be purely accommodative. They can also be quite low with large output gaps if monetary policymakers instead are sure to react to fiscal stimulus by tightening. In today’s U.S. economy, the combination of still-huge output gaps with a Fed that has signaled clearly that monetary tightening will be conditions based and will not happen soon means that there’s very little reason to mark down multiplier estimates at all.

So, nitpicky point to make? Yeah, but we have had policymakers looking for excuses to not do the right thing on fiscal policy for years now, and we can’t give any false opening at all for any of them to claim that it would matter that much anyway.