When the economy is in bad shape, the effectiveness of increased government spending in boosting GDP depends on the depth of the recession. That is the central finding of new research by Giovanni Caggiano, Efrem Castelnuovo, Valentina Colombo and Gabriela Nodari. Their study, published in the May 2015 issue of the Economic Journal, finds that:
· An increase in government spending is more effective exactly when it is most needed – that is, when the economy is experiencing a deep recession.
· More precisely, the deeper the recession, the more output is generated by increasing government spending. According to the researchers'' estimates, one extra dollar spent by the US government during the recent Great Recession would have generated up to $2.50 in total national GDP in three years time.
· Increasing government spending when economic conditions are less harsh generates positive effects on economic activity at most in the very short run: one extra dollar of government spending in milder recessions, like the one that followed the dot-com crisis in the early 2000s, would have generated less than $2 of GDP over three years.
· Increasing government spending when the economy is in an expansionary period has mild positive effects at most for one year, but then would generate negative effects on output.
The effectiveness of government spending in stimulating economic activity is a much-debated issue in economic policy. Academic researchers have found it challenging to quantify the gains from fiscal policy: what is the return from spending $1 of taxpayers'' money or ''how much bang for a buck?''
The new findings are at odds with the majority of work that has quantified the impact of fiscal spending on economic activity. This is due to two reasons that are often neglected.
First, the researchers quantify the effects of government spending on output by taking account of the level of economic activity. While there are studies that distinguish between the effects of government spending in recessions and expansions, this research shows that what really matters is the depth of the recession: not all recessions are alike; and the effectiveness of fiscal spending increases when recessions are deep.
Second, the new study takes account of the fact that any fiscal policy move takes time to be implemented. When a government recognises that the economy is in a recession and decides to intervene by increasing spending, in any democratic country it must first get the approval of Parliament and, after that approval, it must actually implement the stimulus package.
This means that the increase in spending is observed in the official data several months after the public has come to know that spending is going to increase. But if today we anticipate that spending is going to increase, say, in one year, we are likely to take decisions immediately after the news, for example, by increasing investment and consumption, without waiting for the stimulus package to be actually implemented.
If so, output would go up soon after the announcement of the increase in spending. Not taking account of the existence of this ''decision and implementation lag'' of fiscal policy, the duration of which in the United States is estimated to be on average two quarters, would lead to a severe underestimation of the impact of government spending on economic activity.
The researchers conclude:
''While the policy implication of our research is clear – expansionary fiscal policy is highly effective when it is most needed – it comes with two ''buts''.''
''First, it is based on the assumption that the debt level of the economy is sustainable. Hence, our findings do not imply a one-size-fits-all recommendation: increasing government spending is not a solution for countries whose level of debt might be perceived as unsustainable.''
''Second, our results cannot be mirrored to cuts in fiscal spending: they do not imply that cutting fiscal spending is positive for output in expansions, nor negative when the economy is in recession.''
''Estimating Fiscal Multipliers: News from a Nonlinear World'' by Giovanni Caggiano, Efrem Castelnuovo, Valentina Colombo and Gabriela Nodari is published in the May 2015 issue of the Economic Journal. Efrem Castelnuovo is at the University of Melbourne. Giovanni Caggiano and Valentina Colombo are at the University of Padua. Gabriela Nodari is at the University of New South Wales.