Now that fiscal policy is back on center stage, its alter ego, the fiscal multiplier, is also reentering the scene. The concept is an elegant but simple one: an increase in government spending (for Keynesians), or a tax cut (for Supply-Side economists), can spur a manifold increase in economic activity – hereby its name – via the circulation of money in the economy.
However simple it may sound, the concept is one of the most disputed in Economics, establishing the front line of an ideological war. Depending on one’s affiliation, its effects can range from a virtuous multiplication of economic activity, to a futile waste of public money that only serves to crowd out private investment and increase public debt.
One has a sense of déjà vu when listening to the current debate. During the early days of the Obama administration, and shortly after Lehman’s collapse, the US enacted the American Recovery and Reinvestment Act (ARRA), a stimulus package representing almost 6% of GDP. Republicans ferociously opposed it, passing later the Budget Control Act as a backstop, and causing the two debt-ceiling crises that ensued. Tables have now turned. Republicans are converted Keynesians, and Larry Summers, the mastermind behind the ARRA (and a prominent neo-Keynesian), is decrying Trump’s economic policies as a “sugar high” for financial markets.
To shed some light, it helps to do some simple maths. Assuming a 33% flat tax rate and no financing costs, a 1% stimulus would require a multiplier of 3.0 in order to break-even, substantially higher that most empirical estimates (ranging from 0.5 to 2.0). If the additional taxes raised do not recover the investment, the fiscal deficit increases, and with it government debt. As an example, during the Reagan years, the fiscal deficit averaged roughly 4% of GDP, and Debt/GDP doubled from 30% to 60%. Arithmetically speaking, a tax cut takes longer to pay off as it lowers the revenue base for both existing and new activity in the following years. All else being equal, for a tax cut of 5% to pay off in 10 years, the growth rate needs to increase from 2% to 5%!
If growth could be so easily boosted, we could have discovered an economic “perpetuum mobile”. In reality, this miracle rarely happens. One instance is when a new public good emerges, heralding vast social returns; think of motorways, the electrical network or public schooling. Alternatively, from an opportunity cost perspective, avoiding a severe economic downturn that harms the future growth of the economy due to “hysteresis effects” can also call for a fiscal stimulus.
The current situation hardly resembles any of them, and it is doubtful whether investing in infrastructure (not to say the building of walls) or a new tax code will be able to lift the potential growth rate of the US economy to the 4% promised by Mr. Trump. The sobering truth of the multiplier is that it is rather used as an intellectual alibi to spend today at the expense of future generations. In this regard, the idea of issuing 100-year bonds floated by the new Treasury Secretary provides some clues on the intentions of the new administration.
Keynes famously claimed that it would pay off to bury money in bottles, so that the society benefits from the economic activity generated by digging them up*. He forgot to mention that you need an accomplice in the central bank, purchasing your notes or suppressing interest rates. This was common practice during his time, and as public debt keeps rising, it may once more come back into fashion.
Fernando de Frutos, MWM Chief Investment Officer
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* John Maynard Keynes, General Theory of Employment, Interest and Money, Chapter 10: The Marginal Propensity to Consume and the Multiplier: “If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again (the right to do so being obtained, of course, by tendering for leases of the note-bearing territory), there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is. It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing.”
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