Public expenditure multiplier

Understanding the budget multiplier

The fiscal multiplier is the ratio between changes in national income and changes in public spending.

The aim is to determine whether one euro of additional public spending will generate an increase in economic activity equal to, greater than or less than the amount of public spending carried out, and over what timeframe. It is then possible to assess the impact of an increase in public spending on the trajectory of public deficit and debt (more activity bringing in more revenue via compulsory levies, and less social spending on unemployment, for example).

The multiplier mechanism is relatively intuitive. Let’s imagine that the government invests 10 billion euros in energy-efficient building renovation. This public expenditure generates income for the renovation companies, which use it to pay their employees and suppliers. These in turn will spend the extra income (on consumer goods, for example), creating new demand for other companies. And so on, in successive waves.

However, this mechanism is not infinite, as several effects limit the amount of income distributed at each wave.

• Part of the income can be spent abroad (imports), creating an increase in activity outside the country. ¹ .
• Part of the income can be saved, blocking the circulation of money until it is reinvested.

The fact remains, however, that the $10 billion public investment has, in successive waves, potentially resulted in a distribution of income greater than the initial amount.

It should be noted that the budget multiplier is supposed to work in both directions: an increase in public spending leads to an increase in economic activity, and conversely, a drop in public investment leads to a recessionary effect.

The main criticisms

Public investment crowds out private investment

A first criticism was formulated in the context of the debates between Keynes and certain economists in favor of budgetary rigor in England in the 1920s and 1930s. Winston Churchill, then Chancellor of the Exchequer, put it this way: ” When the government borrows on the money market, it enters into competition with industry, attracts to itself resources which would otherwise have been used by the private sector and, in so doing, raises the cost of money to all who need it “. ² . This criticism was taken up by Milton Friedman (1912-2006) in the 1960s.

Keynes responds to this assertion with two major arguments:

• investment depends not only on the cost of money but also, and above all, on entrepreneurs’ anticipation of the evolution of their order books;
• in a situation of economic depression, with abundant savings and manpower, public investment does not crowd out private investment, but mobilizes unused, idle resources.

Yet Keynes recommends an expansive fiscal policy precisely in times of economic slowdown or even depression. The effectiveness of the multiplier mechanism clearly depends on the level of utilization of productive resources (utilization rate of productive equipment and employment rate).

Ricardian equivalence between public debt and taxes

Another challenge to the principle of the budget multiplier has been put forward by economist Robert J. Barro, via the notion of ” Ricardian equivalence “. He develops ³ the idea that public debt and taxes are equivalent. Schematically, financing a public expenditure today by borrowing would have the same effect on households as an additional tax, since, anticipating the future tax, they would save today the sums needed to pay the tax tomorrow. Borrowing, like taxation, would therefore have a crowding-out effect on private investment.

The intuition for this theory is attributed to the 19th-century English economist David Ricardo (1772-1823), hence the term ” Ricardian equivalence “. If this equivalence were true in practice, there would be no effect on economic activity from an increase in the public deficit. But it is based on completely unrealistic assumptions ⁴ – including the idea that citizens are “rational” economic agents, endowed with a capacity for calculation and anticipation that can only be described as “supernatural” – and is not convincingly validated by empirical studies.

What do you think?

As is often the case in economics, the budget multiplier is not a directly observable datum.

We can try to approach it through theoretical calculations, as Keynesian economists have done, for example, to represent the “circuit” mathematically in an attempt to quantify the multiplier effect. ⁵ . It is also possible to develop empirical analyses to see the results of public investment plans on economic growth, it being understood that other factors may come into play.

The debate surrounding the fiscal multiplier is central because it serves as the basis for major economic policy decisions.

It was in the wake of the 1929 crisis and in the post-war years that the budgetary tool was widely mobilized by governments to revive the economy. Until then, the prevailing economic thinking had been “laissez-faire, laissez-passer”, in application of Say’s Law. From the 1970s onwards, the tendency was to criticize public spending. Then, in the wake of the 2007-2008 crisis, many governments launched massive plans to rescue the financial sector and stimulate the economy. However, this revival of stimulus policies, after decades of neglect, was short-lived in Europe. From 2010 onwards, faced with rising public debt, European countries embarked on fiscal tightening policies (known as “austerity”), while at the same time the United States let its deficit soar. ⁶ .

The virulent rhetoric against what is described as “fiscal laxity” is underpinned by two econometric arguments

• High levels of public debt would have a recessionary effect.

The “proof” of this assertion was provided by an article by Carmen Reinhart and Kenneth Rogoff (2010). ⁷ . Recurrently used in speeches on the need for fiscal austerity, this article concluded that public debt in excess of 90% of GDP translates into a 2:1 reduction in growth.

However, as early as 2013, other economists examining the work of Reinhart and Rogoff showed that their conclusions stemmed from errors in the processing of statistics!

Austerity policies: because of an excel error!(Channel Sciences étonnantes)

• The fiscal multiplier would be well below 1, so lower public spending would have no recessionary effect.

An IMF study of some forty countries between 1970 and 2007 concluded, for example, that the impact of fiscal stimulus measures on output growth would, on average, be close to zero. ⁸ .

The appearance of recessionary effects following the 2010 fiscal tightening decisions in European countries prompted the IMF to make a mea culpa of sorts.

The main finding, based on data for 28 countries, is that the multipliers used to generate growth forecasts have been systematically too low since the start of the Great Recession, with errors ranging from 0.4 to 1.2, depending on the source of the forecasts and the specifics of the estimation technique. Informal indications suggest that the multipliers implicitly used to generate these forecasts are of the order of 0.5. Actual multipliers could therefore be higher, ranging from 0.9 to 1.7.

IMF – World Economic Outlook, 2012, box 1.1 p41-43

Numerous research studies have since shown that the multiplier effect clearly depends on the overall economic situation: it is much stronger in periods of recession (see reference in box).

This is one of the conclusions of an OFCE study on the links between public investment and growth: ” In times of crisis and, in particular, when monetary policy reaches the zero bound on interest rates, the multiplier increases and reaches higher values of between 1.3 and 2.5 “. ¹⁰