Robert Barro On The Economic Stimulus And Other Topics

On January 22, 2009, the Wall Street Journal published "Government Spending Is No Free Lunch: Now the Democrats are Peddling Voodoo Economics," by Robert Barro. The article touched off a small maelstrom between economists who support the stimulus and those who do not.

Barro's disagreement is with multipliers estimated using a Keynesian model and used by Team Obama to justify the $800 billion stimulus package winding its way through Congress. The administration claims that every dollar of stimulus spending will have a multiplied effect, increasing GDP by 1.5 dollars. Barro begins by examining multipliers from the wartime fiscal expansion and explains why.

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.

He estimates the WWII multiplier at .8; a dollar spent on wartime activities produces only an 80 cent increase in overall economic activity. The resources used by the government must come from somewhere, and that is from other productive uses. Barro then describes what he believes is a flaw in the model used to support the administration's stimulus plan.

The theory (a simple Keynesian macroeconomic model) implicitly assumes that the government is better than the private market at marshaling idle resources to produce useful stuff. Unemployed labor and capital can be utilized at essentially zero social cost, but the private market is somehow unable to figure any of this out. In other words, there is something wrong with the price system.

Barro ends with several suggestions for a stimulus plan.

Much more focus should be on incentives for people and businesses to invest, produce and work...Eliminating the federal corporate income tax would be brilliant. On the spending side, the main point is that we should not be considering massive public-works programs that do not pass muster from the perspective of cost-benefit analysis.

His critics believe that WWII was not a good choice for estimating multipliers. Matthew Yglesias gives a clever and oft cited criticism on his Think Progress post, "Multipliers and Diminishing Returns".

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...The 0.8 multiplier is probably the result of diminishing returns.

Conor Clarke of the Atlantic, in "A Brave New Deal" conducts an interview with Barro, providing a forum to defend his research against blog attacks.

Most economists haven't really been thinking about this issue, they haven't really focused on it. It's not their specialty. Most economists today, they haven't really been thinking about this kind of multiplier issue. Which goes back to that first question you asked about how come now we're so worried about this. I don't think most economists are focused on this, or that they're familiar with the empirical evidence. I don't think they've really worked on the theory. So I don't know, maybe they have some opinion that they got from graduate school or something.

I think my sense is that the sentiment has been moving against this kind of approach both within the economics profession and more broadly. I think the initial view was that "yeah, this is a terrible situation" -- which I agree with -- "and we've got to do something about this, and maybe this will work." I think there was support in that sense.

I would fall into the group of economists who are trying to dredge up old memories from graduate school. Being a micro guy, there isn't too much to dredge. He also states that more can be done with monetary policy.

There are things that they can still do...The Federal Reserve is buying up all kinds of other assets, like long-term government bonds. But they are also buying a lot of private stuff, and that will presumably have a substantial impact. I mean there's a downside to doing all this, but it should certainly have effects. So in that sense they haven't run out of ammunition.

He expresses the view that the recession will not end until credit markets are fixed and praises the appointment of Jeremy Stein.

Larry Summers did bring in Jeremy Stein, who is probably one of the best people in the area. I think he's going to have a lot of impact on that design. I hope so. That's another person they hired recently. Summers brought him in to advise particularly on the financial and housing issues, the design of the new regulations structure. That was an excellent appointment. That's the stuff that's really going to count.

Because I am not a macroeconomist, I will keep my observations brief. I think Yglesias' comments are valuable, but for Barro's critics, it is a Goldilocks argument. Peace time deficit spending during the Great Depression was too small to be effective, and the effective war time expenditure was too big to have a big multiplier. If this argument is correct, the peace time multiplier must be large. The problem is one of measurement. The multiplier impact of expenditures could easily be overwhelmed by other economic events.

I am concerned about the quality of WWII data. But if Robert Higgs is correct, and real GDP was overestimated during the war period [1], possible multipliers would be overestimated as well. The mismeasurement of GDP might also have inflated the value of war production and deflated he valued of consumer production. In this case, the crowding out impact of war expenditures would be smaller than Barro estimated.

[1] Higgs, Robert. "Wartime Prosperity? A Reassessment of the U.S. Economy in the 1940s," The Journal of Economic History, 1992.