The Government Spending Multiplier and Other Keynesian Paradoxes

The Great Recession of 2008-9 has brought forth some intriguing claims about public policy and the nature of factor supply. Using “New Keynesian” models to guide the discussion, a number of economists suggest that government purchases might stimulate private spending, rather than crowd it out, thereby increasing total spending more than dollar-for-dollar (Christiano, Eichenbaum, and Rebelo, 2009; Eggertsson, 2009; Woodford, 2010). At the same time, few have evaluated current macroeconomic policies on the basis of the incentives they provide to supply labor and other factors of production. Is it possible that factor supply does not matter during a recession? Or even worse, that our economy suffers from a “paradox of toil:” expansions in factor supply actually reduce aggregate output (Eggertsson, 2010)?

Economic theory suggests that the government spending multiplier and the paradox of toil are related, because both involve the (general equilibrium) relationship between factor supply conditions and private sector factor demand. Models with crowding out predict that a reduction in the supply of factors to the private sector – either because the government is using some of those factors or because a distortion causes some of the supply to be withheld – ultimately reduces private sector output and factor usage. One mechanism achieving this result is that private sector employers pass on their higher factor costs into output prices, which causes their customers to demand less. In “Keynesian” models, this pass through doesn’t happen and perhaps even the high factor rental rates feed back to increased demand for private sector goods.

One approach to these questions would be to use historical data to measure the government spending multiplier (Barro, 1981; Alesina and Ardagna, 2009; Barro and Redlick, 2009; Mountford and Uhlig, 2009; Ramey, 2009) or to measure output effects of factor supply growth. But it has been claimed that historical output responses to government spending impulses ought to be atypical of those that occur today, because today we are in a deep recession, and monetary policy is fundamentally different than it was in the past (Christiano, Eichenbaum, and Rebelo, 2009; Eggertsson, 2009; Woodford, 2010).

Even without the added burden of estimating a separate multiplier for deep recessions, clear and significant shifts in government demand that are economically similar to the kinds of spending proposed in government “stimulus” laws are difficult to find, and thereby difficult to translate into an accurate estimate of the government spending multiplier. The purpose of this paper is to exploit the close relation between the government spending multiplier and the paradox of toil, and the ready availability of obvious factor supply shifts during this recession, to test the paradox of toil hypothesis. The empirical analysis can be interpreted as a test (of whether government spending stimulates private spending) that is admittedly indirect, but not reliant on the historical data.

Section V of this paper examines three events that happened during this recession, for the purpose of determining whether the outcomes confirm the paradoxes rather than showing significant resource reallocation among competing uses of the economy’s output. Those events are: the labor supply shifts associated with the annual seasons, the minimum wage hike of July 24, 2009, and the collapse of residential construction spending.

The academic year concluded twice during this recession, and both times over a million teens entered the labor market. Well over a million of them found employment, and as a result total employment for the economy was significantly higher in July than it was in April. This pattern reversed itself the two times that the academic year resumed during this recession. The real federal minimum wage was hiked at the end of July 2009 from an already high level relative to the CPI. Employers of part-time workers appeared to respond by significantly cutting part-time employment after July 2009, despite the fact that part-time employment had trended strongly up prior to the hike. Finally, the collapse of housing construction served to shift resources into non-residential building.

Despite the presence of perhaps the deepest recession of our lifetime, and nominal interest rates on government securities that were essentially zero, these three episodes show how factor markets seemed to behave as if output prices were flexible at the margin. In particular, markets absorb an increased supply of factors of production – even during a recession like this one – and do so by increasing output. It would seem, then, that government spending crowds out private spending: the government spending multiplier is less than one.

Nothing about my results implies that this recession was efficient, or that government spending necessarily reduces efficiency. Indeed, my “flexible price model” includes a distortion in the output market and a distortion in the labor market. As noted by Woodford (2010), the presence of distortions by itself does not tell us whether government spending stimulates private spending, or how output responds at the margin to factor supply shifts.

This is not to say that output prices were actually flexible during the recession, because producer entry and exit and a variety of other market mechanisms could have many of the qualitative effects of flexible prices. Moreover, even if it were shown that output prices actually were flexible during this recession, that does not preclude the possibility that those prices would be inflexible in response to smaller shocks. But, for the purposes of this recession, models that feature fixed output prices have been a poor description of actual events in the real economy.