We’ve been hearing a lot lately about how government spending is supposedly going to get us out of a recession. I’ll leave the value judgments for the end and start with the reasoning. The reason that spending is attractive is because there is a theoretical multiplier effect on Gross Domestic Product (you can just think of this as a country’s output). The multiplier works as follows:
- The government spends $1 on some sort of project. This $1 goes to some combination of individual workers, companies doing the work, etc.
- The workers and companies take this $1 and turn around and spend some of it, let’s say 50 cents. The 50 cents spent then goes to the providers of the goods and services that it was spent on.
- These providers of goods and services spend some of the 50 cents that they got, let’s say 25 cents.
- And so on…
In the above example, the government spent $1, but total output (or income) went up by $1.75. It seems like there is some leverage to be had with government spending. (The same theory applies to a decrease in taxes as well, since a tax cut puts money into the hands of consumers who then spend at least some of it, thus starting a similar cycle.)
Apparently the characters on Frasier (my repertoire of bad/old TV watching is clearly expanding) understand this concept:
Niles: “By hiring a plumber that plumber can now afford, say, a Dolly Parton album. Ms. Parton can then finance a national tour, which will of course come to Seattle, allowing some local promoter to make enough money to send his cross-dressing teenage son to us for $150 an hour therapy.”
Frasier: “To the circle of life.”
I would say “to the theoretical stimulating of aggregate demand,” but whatever.
In order to present you with full information, I acknowledge that the jury is still out on how effective the multiplier concept is in practice. Greg Mankiw presents a view that government spending is too easy an answer, and Robert Barro says that government spending is no free lunch, though it does come with a nice side of voodoo economics (which is apparently just a disparaging term for supply-side economics). The second article is a bit, er, dense, but Mankiw’s article is a pretty easy read. The main points:
- The multiplier on spending is likely smaller than people would like to think it is. Barro even argues that the multiplier could be less than 1- i.e. that a goverment spend of an extra $1 could crowd out some other consumption and investment and therefore not add a full $1 to GDP.
- GDP increases aren’t necessarily beneficial if the increased output is on projects that are not socially valuable. (I particularly like the “You can pay someone $100 to dig a hole and then pay someone else $100 to fill it up” example. The point is that you’ve increased GDP by $200, but have you really created any value? As much as I like watching dirt being moved around, and paint dry for that that matter, I would argue that the answer is no.)
- The government should think harder about how it’s going to pay for all this spending, since it’s going to have to do so eventually. (econgirl’s note: In this case, it’s worth considering that the multiplier effect could work in reverse too. Thought exercise- what might happen to GDP as a result of a $1 decrease in government spending?)
- There might be a larger multiplier on tax cuts than previously thought. (econgirl’s note: tax cuts also don’t result in the government having to know or decide what projects are socially beneficial, since the market takes care of this, at least to a degree.)
All I will say for now is that at least the current stimulus plan will give economists some new data to play with.