April 2015 #7 The keynesian multiplier in recession: why fiscal stimulus is now even more neces- Page 1 sary in the eurozone? SÉBASTIEN CHARLES, THOMAS DALLERY & JONATHAN MARIE Sébastien Charles, Université Paris 8, LED - The keynesian multiplier Thomas Dallery, Université du Littoral, Clersé in recession: why fiscal sti- Jonathan Marie, Université Paris 13, CEPN mulus is now even more necessary in the eurozone? Abstract: Page 3 The Great Recession has revived economic policy debates from the 1930s between the advocates of a - Seminars & Conferences Page 4 balanced budget under all circumstances and the supporters of counter-cyclical fiscal policies. Since - Books 2012, a consensus has emerged that fiscal policy is more effective in recessions that during periods of growth. Now, new studies have explained why fiscal multipliers are usually higher in times of recession. These results confirm the pressing need for fiscal stimulus in Europe. Fund had underestimated the value of fiscal mul- Following the outbreak of the international finan- tipliers. This error had in turn led to an underesti- cial crisis in 2007, its contamination of the real mation of the negative effect on economic activity economy has provoked the “Great Recession”. Af- of fiscal consolidation policies, pursued in applica- ter the initial consensus in favour of measures to 1 tion of R&R’s results on the optimum ratios of Reinhart, C. et Rogoff, K. support the economy in 2008-2009, several fierce (2010),“Growth in a Time of public debt. controversies have developed since 2010 over eco- Debt”, American Economic Re- view, vol. 100(2), p. 573-8. nomic policy recommendations. What is the fiscal multiplier? The fiscal multiplier expresses the relation be- The most highly-mediatised of these disputes con- tween variations in public spending or tax revenue 2 cf. Herndon, T., Ash, M., Pol- cerns the possible existence of a maximum debt-to- and the level of national production. lin, R. (2014), “Does High Public GDP ratio that countries should not exceed. In a fa- Debt Consistently Stifle Econo- Since 1936, this macroeconomic mechanism has mic Growth? A Critique of Rein- mous article published in 2010, C. Reinhart and K. hart and Rogoff”, Cambridge 1 been associated with J.M. Keynes and The General Rogoff (R&R) concluded that a public debt-to-GDP 3 Journal of Economics, vol. 38, ratio of more than 90% causes negative growth. Theory of Employment, Interest, and Money. The n°2, pp. 257-279, higher the value of the multiplier, the greater the doi:10.1093/cje/bet075 This conclusion had extremely important practical consequences: it was considered essential to re- impact of government intervention on economic duce public debt if it rose above this threshold. activity. This mechanism is caused by the fact that 3 additional spending in the economy generates in- Keynes, J.M. (1936), “The Ge- neral Theory of Employment, In- come which in turn provokes further spending. terest and Money”, Cambridge Among other examples, the European Commis- However, this virtuous circle is limited by three University Press sioner for Economic and Monetary Affairs O. Rehn factors (which prevent the income generated and the British Chancellor of the Exchequer G. Os- from being entirely spent on domestically-pro- borne had no hesitation in using the results of R&R duced goods and services): savings, imports and to justify the fiscal consolidation they considered to taxes. be necessary in Europe. Since then, however, the conclusions of R&R have been largely refuted.2 The practical interpretation of this mechanism, according to which an increase in public spending A second controversy has also burst into the lime- should be considered as an effective instrument light. In January 2013, Blanchard and Leigh to avoid recessions, was soon called into question. acknowledged that the International Monetary Firstly by the “neoclassical synthesis” movement, and then by the “new classicals”. During the Directeur de la publication : David Flacher, Directeur du CEPN Rédacteur en chef : Nathalie Coutinet |Maquette : Philippe Abecassis www.univ-paris13/CEPN 2 1990s, a new generation of research developed sion, which tends to raise the value of the multi- 4 the idea that cutting public spending (fiscal con- plier. But these well-known mechanisms are insuf- Blanchard, O., Leigh, D. ficient to account fully for the variations in the (2013), “Growth Forecast Errors solidation) is a means to sustain economic growth. and Fiscal Multipliers”, Ameri- This was a complete turnaround: the multiplier is multiplier. can Economic Review, vol. 103, now negative! pp. 117-120 Using a methodology first developed by Palley 5 (2009)8 and then applied by Pusch (2012),9 the au- Auerbach, A.J., Gorodni- These theoretical developments have had undeni- chenko, Y. (2012), “Measuring able consequences on the economic policy rec- thors seek to bring to light the influence on the the Output Responses to Fiscal ommendations made by international financial in- multiplier of variations in imports over the eco- Policy”, American Economic nomic cycle. To this end, they ascribe a different Journal: Economic Policy, vol. 4, stitutions since the 1980s. The multiplier has been pp. 1-27. considered negligible or illusory. Only supply-side propensity to import to each component of de- mand. policies are effective, and over the short-term, 6 Riera-Crichton, D., Vegh, C.A., only monetary policy should be used. Aggregate demand can then be written in the fol- Vuletin, G. (2014), “Procyclical and Countercyclical Fiscal Multi- lowing form: pliers: Evidence From OECD Rediscovery of the multiplier and observation of its 푌 = (1 − 훼)퐶 + (1 − 훽)퐼 + (1 − 훾)퐺 + (1 − 훿)푋 Countries”, NBER Working Pa- variation over the economic cycle Where Y is the GDP, C is consumption, I is invest- per, n°20533, September. In a now-famous article published in 2013, ment, G is government spending and X is exports, 7 Blanchard and Leigh4 indicated that they had un- and α, β, γ and δ are respectively the share of im- Charles, S., Dallery, T., Marie, ports in consumption, investment, government J. (2014a), “Why are Keynesian derestimated the value of fiscal multipliers. Auer- Multipliers bigger in Hard bach and Gorodnichenko (2012)5 had already spending and exports. The multiplier k can then be Times?”, 4th Conference of the published results showing that multipliers were written as follows: French Association of Political 휕푌 1 Economy, 2-4 July, Paris, higher than had generally been assumed. In a very 푘 = = http://afep2014.sciences- 퐶 퐼 퐺 푋 recent article, Riera-Crichton et al. (2014)6 휕퐺 1 − 푐휑 + (훼 + 훽 + 훾 + 훿 ) conf.org/33825/document 푌 푌 푌 푌 showed that multiplier effects are all the stronger where 휑 is disposable income as a share of GDP. Charles, S., Dallery, T., Marie, when the economic slowdown is more pro- 9 J. (2014b), “Keynesian Multi- nounced and when public spending is used coun- Whereas Pusch (2012) postulated that consump- pliers During the Great Reces- ter-cyclically. In other words, the multiplier effect tion, investment and public spending all contain a sion: Assessing the Changes similar share of imports, Charles, Dallery and Ma- since 2007 to Advocate an Ef- is at its strongest in the configuration where pub- 7 fective Fiscal Policy in the Euro- rie used the results obtained by Bussière et al. zone”, 18th Conference of the lic spending is increased significantly during the 10 worst recessions, reaching as much as 3.20 for in- (2013) , who estimated the share of imports in Research Network Macroecono- the components of demand of the OECD coun- mics and Macroeconomic Poli- creased public spending in OECD countries during cies (FMM), 30 October - 1 No- tries in 1995, 2000 and 2005. The results are clear: the deepest recessions. In this case, the value of vember, Berlin, http://www.boeck- ler.de/pdf/v_2014_10_30_marie.pdf the multiplier is far from negligible. the propensity to import is strongest in the case of investment, followed by exports, then con- sumption and lastly public spending. To put it an- Why is the multiplier higher during recession? other way: β>δ>α>γ. These elements are decisive. 8 Palley, T.I. (2009), “Imports This phenomenon has not yet received a fully sat- and the Income-Expenditure Model: Implications for Fiscal isfactory explanation. With their simple method- Recalling the principle of the investment acceler- Policy and Recession Fighting”, ology, Charles et al. (2014a, 2014b)7 recall that the Journal of Post-Keynesian ator proposed by Aftalion at the beginning of the value of the multiplier is positively dependent on Economics, vol. 32, pp. 311- 20th century (variations in investment amplify the 322. the propensity to consume (the share of income variations in economic activity) and observing that devoted to consumption) and the disposable in- in recession, public spending tends to rise while 9 come of households, and negatively dependent Pusch, T. (2012), "Fiscal spen- exports fall, the authors explain why the multiplier ding multiplier calculations ba- on the propensity to import. moves countercyclically. To summarise, their sed on input-output tables – an It is known that the propensity to consume varies work shows that during a recession, investment application to EU member with the economic cycle: as incomes increase, the states", European Journal of shrinks more than the other components of ag- Economics and Economic Poli- savings rate also rises, which reduces the propen- gregate demand. Since investment is the compo- cies, n°1, vol. 9, pp. 129-144. sity to consume and thus the multiplier. Growth nent which contains the highest share of imports, therefore tends to reduce the value of the multi- it follows that the share of imports in GDP falls and 10 plier. Moreover, because of the existence of auto- Bussière, M., Callegari, G., the multiplier rises.