Why I Think the Multiplier is Large
By Arnold Kling
A payroll tax holiday and a permanent payroll tax credit would be effective tax cuts, particularly if designed to help harder-pressed lower- and middle-income households and smaller businesses.
Tyler Cowen also favors payroll tax cuts. I like the idea because there is minimal time lag, it lowers the price of labor, and it keeps the government out of picking winners and losers in terms of industries.
I have zero faith in econometric estimates of the Keynesian multiplier. I think that today’s asset-deflation economy is too different from most of what we have observed over the past fifty years for econometrics to be of any help.
Logic suggests that the multiplier today is large. It more likely to be closer to 3 (or above) than to 1.1. Interest rates on Treasuries are so low that printing Treasuries is tantamount to printing money.
2. Unless the fiscal stimulus is really stupidly targeted, there should be few supply bottlenecks. The demand increase will go mostly to output and hardly at all to prices.
3. Investment is more likely to be “crowded in” by stronger demand than crowded out by higher interest rates.
4. We are likely to see a strong “Minsky effect.” That is, higher income should increase wealth and improve balance sheets. This will stimulate spending by both businesses and consumers.*
Having said all that, it is still a bit strange to think of a larger government deficit as a stimulus. If I wrote myself a check for $5000, obviously that would not be a stimulus. If I wrote my daughter a check for $5000 and said that it was coming out of her inheritance, we are saying that would be a stimulus. At a national level, what we are doing is writing checks to our children and taking it out of their inheritance. And, yes, I do think that under present circumstances that will be a net stimulus.
*It is the Minsky effect that is the real kicker here.
Let E be expenditure and let Y be income or GDP. Suppose that without the Minsky effect, we have:
E = $100 + 0.5Y
E = Y
The multiplier is 2, and Y = $100/(1-0.5) = $200.
Now, introduce a Minsky effect, where wealth is denoted by W.
E = Y
W = 5Y
E = $100 + 0.5Y + 0.08W
Now, E = $100 + 0.5Y + 0.08(5Y)
= $100 + 0.9Y
and the multiplier is 10, so that Y = $1000