Government Spending and Private Activity
by Valerie A. Ramey  -  #17787 (EFG ME)

Abstract:

This paper asks whether increases in government spending stimulate
private activity.  The first part of the paper studies private
spending.  Using a variety of identification methods and samples, I
find that in most cases private spending falls significantly in
response to an increase in government spending.  These results imply
that the average GDP multiplier lies below unity.  In order to
determine whether concurrent increases in tax rates dampen the
spending multiplier, I use two different methods to adjust for tax
effects.  Neither method suggests significant effects of current tax
rate changes on the spending multiplier. In the second part of the
paper, I explore the effects of government spending on labor markets.
I find that increases in government spending lower unemployment.
Most specifications and samples imply, however, that virtually all of
the effect is through an increase in government employment, not
private employment.  I thus conclude that on balance government
spending does not appear to stimulate private activity.

Note that this does still allow for some multipliers to exceed one. And note that this is not a study of what monetary stimulus might do.

I don’t want to summarize the arguments here, you can click through the links, starting with the Krugman one above, then Steve’s and then following the Boudreaux one, to get the economic intuition behind the arguments. I am strongly in the corner of my colleague’s model of whether debt is ipso facto an issue.  It’s not, as I think his parable here makes clear. His entirely correct point is that government spending indeed imposes a burden on someone. But from the fact that it is financed with debt says nothing about whether that burden necessarily is imposed on future generations. Current generations have complete control over who the burden of their spending falls upon. What remains unsaid in the debate, but implied, is that the spending  indeed can cause harm, and irrespective of whether it is tax financed or debt financed it can cause harm to future generations.

I guess my only quibble with my colleague’s point above is what the term “complete control” means and it is here that I will add my one cent. Assume for simplicity’s sake that all tax collections today and in the future are non-distortionary. It is possible to structure taxes this way, though we are unlikely to see it in practice. What is the problem with transferring resources from some citizens to others? If we ignore prices perhaps nothing. But don’t be a priceless economist. When resources are transferred from Peter to Paul, this will distort the relative prices in an economy from where they would be if Peter had command over the resources himself. And these relative price distortions have ramifications not just for current production and consumption (by others) but also out into the future.

So, if there is a reason to be apoplectic about the level of the public debt, it should be retrospective. It seems to me an indicator that market prices were likely to have been heavily distorted in the past and that the adjustment process in the future of prices getting “more right” is going to be painful. I would note, however, that this position does not follow ipso facto from the fact that governments spend, I suppose one could write down a model where such government spending is price neutral, but again I find that to be an implausible assumption to make.

By the way we measure economic activity in this country, my watching of the kids is a bad thing! Since no exchange takes place, then the value of the “child care” that I deliver on this Friday never can be calculated and added into GDP statistics. There is no reason an effort to do so could not, in principle, be attempted. The point of measuring GDP is to add up the total value of all goods and services produced within the borders of the United States, regardless of who does the producing. When I deliver child care services, or attend to a skinned-knee, or brew my own coffee, or clean my own gutters (not fun when you are scared of heights), and mow my own lawn, each and every one of these actions constitutes valuable goods and services produced. But those values (and indeed the quality of the output from those vis-a-vis trading for it) are not included.

But by the way we measure GDP, none of those actions constitutes economic activity. I actually like the distinction, but I wanted readers to understand this distinction nonetheless. Economic activity occurs the second we take a risk as individuals and determine that rather than doing something for ourselves, we seek to have others do things for us (how’s that for greed!). The way we do this is not by asking others to do stuff for us, but by assuming that they are each making the same determination as we are. Great, so we all agree to start having others do things for us. How do we get the things we need from them? As Smith said, we do not make appeals to them about ourselves, rather we think hard about what we can do to provide them things they may be interested in (again, how about that greed and self interest?). But this is inherently risky. We may have  a hard time figuring out what people want. We may have a hard time delivering those things to others. The preferences and needs of others may change, and quite rapidly. The resources and technologies available to us to produce things for others may change and quite rapidly. The number of people who are making these same decisions can change and quite rapidly. It could very well be the case that when you stop trying to cook for yourself  and sit for your own kids, you end up getting neither service since there are barriers to providing your talents to others. But the risk is worth the reward, at least most of the time. Why?

Because when others do stuff for us, it dramatically expands the division of labor. And this expansion does a whole host of wonderful things: it lowers the cost of making any one particular good (no different than if we invented a new machine), it reduces the costs to us of learning and constantly switching tasks all day long, it allows each of us to take advantage of “economies of scale” in the things we are producing, and it enables and encourages learning about the particular things we specialize in, and encourages the accumulation of capital to further increase our ability to produce things for each other.

Which takes us back to measuring GDP.

I might argue that we should measure the value of wintercow’s watching his kids and include that in our measure of GDP. Indeed, I think there is a case for at least estimating it. But when wintercow spends his entire day cooking and cleaning for example, he is in his own way being self-sufficient, he is pulling himself out of the extended order of human cooperation, he is not relying on others to do stuff for him – in other words, he is truly making the world poorer – at least in a very real material sense. Thinking in those terms indicates that we perhaps are OK to not include these in GDP.

But by not including those activities in our GDP measurements, we are presenting an extremely misleading picture about how much activity, valuable activity, is taking place in our societies. If, for example, GDP is $15 trillion this year, that means that if you multiply the price of every good/service sold times how much is sold, that is the expenditures on those goods/services. Clearly much more valuable activity happens. How much more? I have not seen good estimates, but my brain tells me that if we were able to truly measure it, the real number would be closer to $30 trillion.

One implication of this is that when we enter a downturn, the decrease in measured GDP will overstate how much of a decline in value-producing activities are going on in the economy. Instead of my wife and I eating out and spending $60 to do it, we may produce a meal at home. There is not $60 less value in the economy, but rather there is a fraction less. The benefit of including the “whole shebang” in GDP statistics would be for us to get a better sense for how serious “real” shocks to the economy are. In a world where we experience a real negative shock to the economy, it means that it becomes much harder to produce the valuable goods and services we want. When we measure GDP the way we do, we are only capturing how difficult it becomes to exchange them with one another.

This is not meant at all to diminish the importance of the current measure – indeed decreases in measured GDP do correlate extraordinarily well with changes in well being. But let’s not be misled into thinking that it tells us too much about what is actually happening in the economy. Finally, I’d offer up (the obvious?) observation that even if we measured all of this stuff into GDP, it is not clear that declines in measured GDP would indicate regress. Why? Consider what would happen if every American decided they wanted to spend an extra month each year camping and backpacking and not at work. Measured GDP would drop substantially. Would well-being?