Multipliers and Diminishing Returns
Via Tyler Cowen, Robert Barro tries to calculate fiscal multipliers involve in the second world war:
What do the data show about multipliers? Because it is not easy to separate movements in government purchases from overall business fluctuations, the best evidence comes from large changes in military purchases that are driven by shifts in war and peace. A particularly good experiment is the massive expansion of U.S. defense expenditures during World War II. The usual Keynesian view is that the World War II fiscal expansion provided the stimulus that finally got us out of the Great Depression. Thus, I think that most macroeconomists would regard this case as a fair one for seeing whether a large multiplier ever exists.
I have estimated that World War II raised U.S. defense expenditures by $540 billion (1996 dollars) per year at the peak in 1943-44, amounting to 44% of real GDP. I also estimated that the war raised real GDP by $430 billion per year in 1943-44. Thus, the multiplier was 0.8 (430/540). The other way to put this is that the war lowered components of GDP aside from military purchases. The main declines were in private investment, nonmilitary parts of government purchases, and net exports — personal consumer expenditure changed little. Wartime production siphoned off resources from other economic uses — there was a dampener, rather than a multiplier.
I think this is running together two separate issues. One is “whether a large multiplier ever exists” and one is whether such multipliers suffer from diminishing returns. World War II spending was enormous relative to GDP. Wartime spending on that kind of scale goes way beyond the conversations we’re having right now about fiscal stimulus—the equivalent today would be something like a $5.2 trillion package rather than the $800 billion or so we’re talking about. And to get spending up to that level the government had to resort to quasi-forced savings (”war bonds”), rationing, etc.—deliberate efforts to direct production away from where demand was highest and toward the national objective of military production. The 0.8 multiplier is probably the result of diminishing returns. The question is whether you got a decent multiplier out of the first 5-10 percent of GDP you spend on stimulus. It shouldn’t surprise us if it turns out that defense spending eventually got somewhat higher than would be economically optimal in the middle of the largest war in history.
31 Responses to “Multipliers and Diminishing Returns”
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January 22nd, 2009 at 11:32 am
Krugman posted on this earlier today:
http://krugman.blogs.nytimes.com/2009/01/22/war-and-non-remembrance/
January 22nd, 2009 at 11:33 am
There’s also the question of whether the estimates of a Hoover Institution fellow should be taken with a grain of salt on whether Keynesian multipliers exist.
January 22nd, 2009 at 11:35 am
Barro is completely disingenuous. One can’t use the example of huge defense spending DESIGNED to crowd out domestic spending in wartime in a fully employed economy to estimate the likely multiplier of the stimulus package today.
January 22nd, 2009 at 11:53 am
I’m not so sure the WWI era would provide an accurate measure of the multiplier effect from government (defense) spending because consumers (i.e., loyal Americans) were encouraged to save (buy bonds) not spend.
January 22nd, 2009 at 12:05 pm
Between his blindness of the economic meltdown to his continued promotion of intellectually dishonest economists, people need to stop giving Tyler Cowen traffic.
January 22nd, 2009 at 12:06 pm
OK I’ll look at the Krugman post after I comment, but seems like he commented on this sort of argument just a few weeks ago i.e. the stimulus came after WWII rationing ended…and it was a very powerful stimulus indeed. Now let’s see if that’s what Krugman said today.
January 22nd, 2009 at 12:19 pm
The other point is that imports were necessarily curtailed given hat most of the countries that the US used to import from were either enemies, conquered or blockaded. So the stimulus wasnot really leaking out of the country.
January 22nd, 2009 at 12:32 pm
Seems that when Tyler Cowen isn’t teh stupid, he’s linking to teh stupid.
So, a major war that kills hundreds of thousands and sends millions of tons of shipping to the bottom of the sea isn’t the most efficient way to stimulate the peacetime economy- who woulda thunkit.
And it seems like only yesterday that rightwingers were saying it wasn’t Roosevelt who ended the Depression, it was WW II. But it’s hardly man-bites-dog to notice that rightwingers toggle back and forth faster than the current in your lightbulb.
Barro is both dishonest and stupid. Dishonest for not noting that consumer spending didn’t rise because rationing constrained it, and stupid for not realizing that the pent-up consumer demand, postwar, bought all the cars the former tank and airplane factories could make, and filled every passenger train for the next five years.
Better idiots, please.
January 22nd, 2009 at 12:46 pm
Tyler can be very spotty on issues, especially when the best solution runs against libertarian dogma.
We are seeing the right side of the economics world run around in panic, because they know that if we are not in a recession in 2 years, they will look very, very bad. The deficits, the multipliers, all of the jargon is cover for their fear of being proven irrevocably wrong.
This crisis and near depression provides a almost near perfect situation to test economic theory. If we do this correctly, the stimulus will be a test of Keynes’s theory vs. classical theory. Classical theory says that government spending will not help that much if at all. Keynes says government spending will work.
We need to spend enough to be sure Keynes is incorrect. If we spend enough and it stimulates the economy out of recession, classical/libertarian economic philosophy takes a huge hit.
This is why Alex T, Tyler, Greg Mankiw, and the rest of them are pulling out every stop in attempting to cast doubt on the viablility of the stimulus. They are attempting to make the stimulus small enough so it does not work, thus preserving their world view.
January 22nd, 2009 at 1:28 pm
Matt please link to Krugman in an update. The crux of Krugman’s retort:
Actually, I’ve already taken that one on. But just to say it again: there was a war on. Consumer goods were rationed; people were urged to restrain their spending to make resources available for the war effort.
January 22nd, 2009 at 1:32 pm
Matt actually doesn’t comment on the intellectual dishonesty here. Barro argues, in the WSJ, that the stimulus effect doesn’t happen in a peacetime economy, and offers, as an example, what happened in a wartime economy.
This would be a good “careful reading ” test for a fifth grade class- with any student who didn’t spot the old switcheroo being sent back to relearn the basic concepts.
January 22nd, 2009 at 1:36 pm
Paul Krugman and people on the Left, though, routinely assert that the reason New Deal spending did not get us out of the Depression is that there was not enough of it. Is the suggestion that the optimal level of deficit spending was somewhere between Depression and WWII levels?
January 22nd, 2009 at 1:41 pm
Also Matt, you should be aware that you are using the economic concept of diminishing returns in a weird way. I don’t really think it makes sense to talk about dimishing returns when discussing the multiplier of various elements of the stimulus program. Different elements will have different multipliers. But if I build a thousand widget factories instead of hundred, I am still creating demand in the economy for cement, steel, labor etc, regardless, and that has nothing to do with the usefulness of said factories. But the concept of diminishing returns is discussing efficiency. Now if you want to discuss the relative worth of various stimulus projects in terms besides the multiplier such as how they will add to productivity one can do that, but I think you are mixing things up. Krugman explained it much better, and therefore I think you should link to him in an update.
Matt, you should seriously consider reading some economic textbooks to improve your economic posting. Krugman’s International Economics is a good place to start. Or even Mankiw’s Macroeconomics…
January 22nd, 2009 at 1:42 pm
Lest we forget, the spending stimulus that WWII provided in the US was matched by a cataclysmic reduction of production capacity in the rest of the world. It’s real easy to make smart investments when your competition is being reduced to smoking ruins. Given the current absence of global mass slaughter, I think that it may be harder for stimulus to work as effectively as it did in WWII and that it is more important to pick our spots wisely. Other than that though, no problem! Here’s hoping that our problems today aren’t as deep as they were in the 30’s.
Also, I’m really not trying to give the neocons another excuse to go to war with China, but, if you’re a greedy bloodthirsty idiot, the logic is compelling (economic lebensraum, anyone?).
January 22nd, 2009 at 3:11 pm
Aaron,
Yes, that’s what the claim is. You may not realize by how much the WWII deficit spending exceeded the New Deal in GDP terms. Check out the graph here and notice that the federal deficit (orange line minus blue line) was about 2.5% of GDP during the New Deal, peaking at around 4% right before the austerity measures in 1937 balanced the budget but derailed growth again. During WWII, the deficit looks like it was about 15% of GDP. There’s a lot of space between the New Deal deficits and the WWII deficits.
January 22nd, 2009 at 3:42 pm
“Lest we forget, the spending stimulus that WWII provided in the US was matched by a cataclysmic reduction of production capacity in the rest of the world.”
That factor is over-emphasized as a cause of the WWII and post-WWII stimulus. Germany’s industrial output was reduced by half during the war (but recovered extremely rapidly after 1948), but most of the industrial infrastructure outside Germany proper in Western Europe was not cataclysmically damaged (and avoiding destroying French, Belgian, Dutch, etc infrastructure was a central commitment . And the Commonwealth (UK, Australia, Canada, India, etc.) actually expanded their industrial base during the war. What industrial capacity was in Eastern Europe was largely destroyed, but the Eastern European industrial base was tiny anyway.
January 22nd, 2009 at 10:46 pm
It is my contention that what got us out of the Depression was the massive savings and investment in productve capacity (e.g. factories) during World War II that was financed by the rationing and savings (e.g. liberty bonds) during the war period.
Ir was not the spending on military material that got us out of the Depression.
January 23rd, 2009 at 12:31 pm
The simple fact is that government spending creates little, if any, real wealth. The wealth that it does create comes at the expense of private wealth creation. Wealth is what people want, and the government can’t even hold a candle to the power of the market for creating and providing what people want. That’s how businesses make money, that’s how wealth is created, by working to provide people with what the want, so that those people are willing to give them money. What the government creates isn’t want people want, it’s what people are forced to buy, through taxation and government spending. Get the government out of business, let the people keep and spend their money on what they want, and you’ll see real fiscal stimulus.
January 23rd, 2009 at 11:21 pm
The starting point of the “Keynesian revolution” — and the whole “multiplier” fantasy — is the claim that forced savings is IMPOSSIBLE.
How can you “analyze” the Keynesian multiplier, if you begin by assuming the falsity of it’s first premise?
Answer — you can’t.
I’m assuming here that you know Keynes — likely a false assumption.
January 24th, 2009 at 12:07 pm
So on the one hand, we’re being told that we need more stimulus because, according to the likes of Krugman and some other Keynesians, what we spent during the depression was “not enough.” Some Keynesians argue that it takes spending on levels closer to what we did in WWII to recover the economy. Now Matt says that, whoa, that was “too much” spending.
What exactly is enough? We’re at 8%+ of GDP in deficit spending, and the markets aren’t budging. This is the highest we’ve been since WWII and there’s nothing. So we need to be spending something more than this but less than that, is that what you’re implying?
And diminishing returns? Are you suggesting there is an “S” shape to stimulus spending (little return if there’s “too little”, then increasing returns in the “just right” amount, followed by diminishing returns when you reach “too much”)? If so, this ranks up there with the Laffer curve in terms of voodoo economics. Maybe if you draw it on a napkin you’ll be a policy maven for the next 8 years.
Anyway, Barro’s point was that there is little if any evidence that stimulus spending is an effective way to end a recession. The best way to counter this is to demonstrate otherwise, through a controlled economic analysis as he was attempting to do. Please, instead of just criticizing his example, try to find counter evidence.
January 24th, 2009 at 3:32 pm
So, Greg Craddock, you don’t think roads and schools and public transportation networks are wealth? People don’t want these things? Go to a less developed country and you will soon see how wealthy we are in the US and other developed countries simply by living where we do. You seem to be defining wealth simply as “private wealth”. You sound like another not particularly thoughtful reader of supply-side/monetarist dogma. I’m guessing you feel comfortable posting such a patently false comment because you’ve heard so many pundits and (dogmatic) economic theorists spouting this rubbish. Well, the time is coming when that Greek chorus will no longer reinforce these inanities at the volume you are use to.
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