Is there a balanced budget multiplier?

Tim Worstall is bemused by Robert Shiller’s endorsement of the balanced budget multiplier. His bemusement is partly wrong, and partly right.
It’s wrong on the grounds that Tim presents. He says it‘s absurd that:

People spending peoples’ money in Friedman’s fourth manner (other peoples’ money on other people) will increase general wealth than people spending money in Friedman’s first manner (their own money on themselves).

This begs the question, in the proper sense of the phrase. Tim is assuming that the fourth manner and first manner are substitutes for each other. But to Keynesians, they are not. The precise point of the balanced budget multiplier is that it creates spending that wouldn’t otherwise occur. For them, Friedman’s fourth manner doesn’t come at the expense of his first manner at all. It is a free gift.
To see why, remember the basic textbooks.
Assume - and this is crucial - that we have unemployed resources. The government then raises both income tax and public spending. Consumer spending would not fall one-for-one as the tax rises, simply because the tax will also reduce our savings; a £10 tax rise might reduce our spending by only £8, with the other £2 being saving that doesn‘t now occur. This means that if the government spends all of the tax revenues, public spending will rise by more than personal spending falls. Aggregate demand will thus rise, putting some of those unemployed resources to work.
This is true as long as our propensity to save is positive.
So goes the basic textbook story. What could go wrong?
And here is where Tim might have a point - plenty.
- It could be that we don’t have truly unemployed resources at all. If the government can only hire men to dig holes and fill them in again by poaching workers away from the private sector, then we have crowding out, not a multiplier.
 - Maybe  the increased initial demand will lead to higher interest rates or a stronger exchange rate, either of which would tend to reduce subsequent aggregate demand.
Perhaps - and Tim would emphasize this more than me - higher taxes reduce labour supply and thus output.
- Higher taxes might cause people to increase their savings. They might think “if the government can try the balanced budget multiplier once, they‘ll try again, I‘ll save up in anticipation of  higher future taxes.” This is analogous to, but analytically separate from, Ricardian equivalence.
For these reasons, it’s quite sensible to be sceptical about the efficacy of a balanced budget rise in government spending. And in truth, governments very rarely use it as a tool of stabilization policy. Automatic stabilizers, unbalanced budget fiscal expansions, and monetary policy are all far more common than balanced budget stabilization.
For practical purposes, then, Tim might be right - albeit for the wrong reasons. But this is a merely empirical matter. It cannot be settled by snarking or by mere ideological statements.

Comments

[chris strange]

Tax cuts can also provide a stimulus effect, therefore logically if you increase spending it should be the equivalent effect of removing stimulus from the economy. If this is true then the anti-stimulus effect of tax rises to balance the budget could be greater than the stimulus effect of the increased government spending, and the net result will be to depress the economy. I have read elsewhere that there is research (this PDF was pointed to http://www.economics.harvard.edu/faculty/alesina/files/Large%2Bchanges%2Bin%2Bfiscal%2Bpolicy_October_2009.pdf) which shows says that the tax cutting has a greater effect than spending rising so it could be true that balancing the budget by spending more and taxing more could be bad for economic growth.

[anon]

> Assume - and this is crucial - that we have unemployed resources. The government then raises both income tax and public spending. Consumer spending would not fall one-for-one as the tax rises, simply because the tax will also reduce our savings; a £10 tax rise might reduce our spending by only £8, with the other £2 being saving that doesn‘t now occur.

This seems wrong to me. Generally speaking, savings are invested, thus they do contribute to aggregate expenditure. It is only when savings are held as currency or bank reserves that spending decreases, because the increased demand for money combined with price level stickiness leads to monetary disequilibrium. But raising taxes won't much alter the demand for money balances; it's better to subsidize investment, expand the money supply directly, or run a budget deficit.

[Grace]

Really interesting.

[Jon]

What about the lost savings? As long as savings were being invested by banks then you're losing out on investment, which is just as important as consumer spending to growth. Though of course there's probably more of a bottleneck in getting the banks to lend in the first place.

[chris]

@ Jon - on this, Keynes was right. A decision to save does NOT imply a decision to invest. Foregone savings do not therefore mean foregone investment.
I suppose less saving might put up interest rates. But rates are determined by the stock of savings, compared to which the flow is small, so any impact on investment via higher rates is likely to be small.