Estimating fiscal multiplier in China – More than 2…

Xin Wang and Yi Wen of St. Louis Fed look at fiscal multiplier in China post the crisis. The paper is fairly technical though..

They say the multiplier is more than 1:

Most empirical studies based on U.S. data suggest that the fiscal multiplier is less than 1 (e.g., Barro and Redlick, 2011). However, Keynes argued that the multiplier would be the largest when markets have failed to the greatest extent in coordinating economic activities (such as during the Great Depression with rampant unemployment and low capacity utilization).

As a large developing country with high household saving rates, a large pool of rural labor force, and a wide range of market failures, China offers a unique opportunity to test the Keynesian notion that government expenditures (even as a pure waste of aggregate resources) can have a fiscal multiplier larger than 1 on aggregate income. Perhaps even more exceptional is China’s extensive use of government spending as a major policy tool to stimulate the economy over the past three decades. Based on both aggregate time-series data and panel data from 29 Chinese provinces, we find that the fiscal multiplier in China is larger than 2.

We provide a theoretical model with market failures and Monte Carlo analysis to rationalize our empirical findings. Specifically, we build a model that can generate the same multiplier and business cycles observed in China and use the model as a data-generating process to gauge whether structural vector autoregressions can yield consistent estimates of the theoretical multiplier in short samples. Our analysis supports the large multiplier found in China but also suggests that government spending may not necessarily be a free lunch despite the large multiplier.

 However, it is not a free lunch. The boom was soon followed by a bust:

However, such a large multiplier is not necessarily a free lunch, as government spending itself may also be an aggravating source of the boom-bust cycle in China. Consequently, the bene…t of the multiplier may be largely o¤set by the cost of the subsequent boom- bust cycles, especially when government purchases are …financed by credit expansion and money creation.

Understanding the effects of government spending in China can provide guidance or lessons to other developing countries in addressing their macroeconomic problems and development issues. Poverty traps in current developing countries may not be fundamentally different from those experienced by developed countries during the Great Depression of the 1930s. It may be market failures, rather than backward technologies per se, that have prevented poor countries from taking off on the road toward economic prosperity. Technology adoption and business investment are endogenous decisions made by fi…rms based not only on …financial conditions but also on expected demand, all of which can be in‡fluenced by the government. On the other hand, careless design of government spending programs, especially government spending through defi…cits and infl‡ationary …finance, can also be quite costly. Such programs cause unwanted in‡flation and economic instability, thus aggravating structural problems in developing countries and hindering economic growth. Therefore, a large multiplier does not imply that any form of public spending is bene…cial: Building roads that lead to nowhere or ghost towns where nobody wants to live can have severe detrimental consequences on economic development.

Just post-crisis, China’s fiscal stimulus was deemed as success story. Now there is criticism. Likewise, fiscal austerity in Europe was implemented in Europe and now there is criticism and clamors for reversal.

State of macro is perplexing…

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