Unemployment in the US continues to be high despite the stimulus program enacted by the federal government in March of 2009. Some argue that this proves that the stimulus was too small; more is needed. Others question the validity of a key implication of Keynesian economics, that when demand is low, government spending can bridge the gap and have a multiplier effect on demand. The multiplier is defined as change in real GDP divided by change in government spending, so a multiplier greater than unity is essentially a ‘free lunch’: GDP goes up by more than the amount of government spending. A multiplier smaller than unity indicates that government spending is crowding out some private spending. A multiplier of zero means that all government spending crowds out private spending, and has no stimulus effect at all.
Sceptics of high Keynesian multipliers frequently cite the work of Harvard’s Robert Barro, a New Classical economist who has estimated government spending multipliers for the United States that are smaller than unity during periods of war, and close to zero in peacetime.
I have estimated … that World War II raised U.S. real defense expenditures by $540 billion (1996 dollars) per year at the peak in 1943–44, amounting to 44% of trend real GDP. I also estimated that the war raised real GDP above trend by $430 billion per year in 1943–44. Thus, the multiplier was 0.8 (430/540). ….
We can consider similarly three other U.S. wartime experiences—World War I, the Korean War, and the Vietnam War—although the added defense expenditures were much smaller in comparison to GDP than that for WWII. When I combined the evidence for all four wars, I got an overall estimate of the multiplier of 0.8, the same value as before. ….
When I attempted to estimate directly the multiplier associated with peacetime government purchases [from 1942 to 1978], I got a number that was statistically insignificantly different from zero.
Robert J. Barro, “Voodoo Multipliers“, Economists’ Voice (February, 2009).
High multipliers are only plausible when demand is low and there are no constraints on supply. During wartime supply constraints are the norm, and are often so severe that governments ration consumer goods. Nor would Keynesian multipliers be high during all periods of peacetime – rather, only when demand is low. Keynesian multipliers are relevant at the present time only if the US economy is in a severe recession and is not supply-constrained.
A new paper from the prestigious NBER (National Bureau of Economic Research) examines the period 1939-1941, the recessionary period just before World War II, to shed light on this debate. The authors show that the US fiscal multiplier was 1.9 through mid-1941, but falls to 0.9 if data are included from the second half of 1941, when capacity constraints began to appear.
Co-authors Robert Gordon and Robert Krenn conclude that nearly 90 percent of the economic recovery that took place between the first quarter of 1939 and the last quarter of 1941 can be attributed to fiscal policy innovations. ….
This paper highlights a paradox in the study of fiscal multipliers: even though proponents of fiscal policy stimulus to cure a weak economy operate in an environment of low capacity utilization, most of the actual episodes of rapid fiscal expansion have taken place either prior to or during wartime episodes in which capacity constraints were operative (including World War II, the Korean war, and the Vietnam war). An ideal test case for measuring the fiscal multiplier occurred in the six quarters between mid-1940 and late-1941, prior to the Pearl Harbor attack. Previous analysts assumed that this period represented a fair test of the multiplier effect, because the unemployment rate was 9.9 percent on average during 1941. However, this paper shows that capacity constraints did exist in 1941, particularly in the second half of the year. The fiscal stimulus in 1940-41 was partly crowded out not by any increase in interest rates, but rather by capacity constraints in critical area s of manufacturing that became increasingly binding in the second half of 1941. Therefore, estimates of fiscal multipliers for 1940-41 are only relevant to low-utilization situations like 2008-10 if they are based on the evolution of the U. S. economy through mid-1941 and exclude the effect of the capacity-constrained last half of 1941.
After reviewing evidence from the 1940-41 editions of Business Week, Fortune, and The New York Times, Gordon and Krenn document that the American economy went to war starting in June 1940, fully 18 months before Pearl Harbor. In February 1941 fully one percent of the American labor force was at work building army training camps for 1.4 million new draftees. Employment in ship-building to expand the U. S. Navy and to supply Lend-Lease aid to Britain accounted for another one percent of the labor force in 1941. As early as June 1941, capacity utilization had reached 100 percent in the production of iron and steel and durable goods of all types.
… Gordon and Krenn … show that private consumption and investment actually declined in the last half of 1941, as shortages of steel prevented auto companies from satisfying demand, and shortages of aluminum needed for aircraft production suppressed civilian production of everyday pots and pans. As a result, the government spending multiplier is 1.9 when estimated through mid-1941 but only 0.9 when measured through the end of 1941.
Robert J. Gordon and Robert Krenn “The End of the Great Depression“, NBER Working Paper No. 16380 (September 2010).
The summary above was compiled by Matt Nesvisky for The NBER Digest, February 2011.
Robert J. Gordon teaches economics at Northwestern University and is author of the popular text Macroeconomics, now in its 10th edition. His co-author Robert Krenn is employed by a proprietary trading firm in Chicago’s financial district. Their paper should satisfy Keynesian sceptics, but probably won’t, because empirical evidence seldom has any effect on economics as faith.
