What Covid-19 teaches us about fiscal multipliers

Alan Auerbach, Yuriy Gorodnichenko, Peter B. McCrory, Daniel Murphy 23 December 2021

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The Covid-19 recession prompted an unprecedented fiscal stimulus that dwarfed the stimulus response to the Great Recession of 2008. And while much has been learned about the effects of stimulus in the post-2008 recovery, little is known about the effects of stimulus in response to the Covid-19 recession, which featured fundamentally different circumstances than those that prevailed during the Great Recession.

During the Great Recession, households substantially cut back their spending due to high debt and falling incomes, and this consumer deleveraging exacerbated the decline in incomes and the increase in unemployment (e.g. Mian and Sufi 2010). Government spending in this environment was especially effective (Demyanyk et al. 2019), since it put idle resources to work (the slack channel) and increased consumption, especially for households with limited borrowing capacity and hence high marginal propensities to consume (MPCs) out of income (the high-MPC channel). 

Unlike the Great Recession, the Covid-19 recession featured lockdown policies that effectively restricted subsets of spending and employment. Consumer spending on local services dropped not due to deleveraging motives but rather due to lockdown restrictions and health precautions. According to recent theoretical work, such restrictions can dampen the effects of fiscal stimuli. In the case of direct government spending, contractors may be restricted from directly hiring employees, or – in the more general case of increases in households’ net income – consumers may save new income for future spending, when a greater range of goods and services will be available (e.g. Auerbach et al. 2021b, Guerrieri et al. 2021). More generally, supply constraints, a prominent feature of the Covid-19 crisis, can limit the power of fiscal policy to stimulate the depressed economy (e.g. Ghassibe and Zanetti 2020, Jo and Zubairy 2021).

To what extent are the slack and high marginal propensity to consume channels operative during a pandemic recession, and how are they influenced by lockdown policies? In a recent paper (Auerbach et al. 2021a), we empirically address these questions by exploiting high-frequency data on government Department of Defence (DOD) spending, stay-at-home orders, consumption, mobility, and employment during the onset of the Covid-19 pandemic recession. As documented by Baek et al. (2021), severe stay-at-home orders (lockdowns) led to large declines in employment, worker mobility, and retail mobility, thus contributing to local economic slack but also imposing supply-side restrictions that might limit the effectiveness of demand-side stimulus.

We find that DOD spending increased employment during the onset of the pandemic recession, but only for cities that were not subject to meaningful stay-at-home orders. In particular, we estimate that it takes $4,000 of spending in a month to create a job in that month in unrestricted cities. This estimate is toward the upper-bound of estimates in the literature on the employment effect of government spending. One possible reason for a large effect of stimulus in our setting is that the sharp recession pushed many firms to the brink of exit. As discussed in Auerbach et al. (2021b), in the pandemic environment relatively small changes in marginal firms’ revenues can have large effects on their entry/exit decision and therefore large employment effects. A similar mechanism may operate through workers rather than firms. If the recession pushed many contractor workers’ earnings up against their fixed costs of remaining in the workforce, then small changes in revenues can have large effects on employment.  

There is no detectable employment response to DOD spending in cities under meaningful stay-at-home orders. This could reflect the possibility that lockdowns prevented matching between workers and employers. Alternatively, they may have prevented DOD spending from stimulating consumption, as consumers could not travel to retail or service establishments. To help disentangle these possibilities, we first examine whether DOD spending affected local consumption, as measured by Chetty et al. (2020). We find no evidence of a relationship between DOD spending and consumption, even in unrestricted locations. The fact that DOD spending increases employment but not consumption even in unrestricted locations is at first glance puzzling given that recessions are often associated with tight credit conditions, high average MPCs, and large consumption effects of fiscal stimulus (e.g. Eggertsson and Krugman 2012). The lack of a consumption response implies that the larger (across-location average) fiscal multipliers on employment during the pandemic recession are driven by the slack channel rather than the high-MPC channel. While potentially surprising, the lack of a consumption response is consistent with recent evidence that households predominantly saved their 2020 stimulus checks (Coibion et al. 2020). In addition, the composition of consumer spending did shift dramatically toward durable goods throughout the pandemic which can make consumer spending more similar across cities (Auerbach et al. 2020, McCrory 2020).  

Overall, our evidence implies that fiscal stimulus is indeed more effective in recessions, but not if there are restrictions on spending or other forms of economic activity. Lockdowns effectively restrict the ability of the economy to absorb slack, and there are no detectable consumption responses that would contribute to stronger general equilibrium effects of government spending.

Our evidence is consistent with recent theories that have broader implications for the current economic environment. The theory in Auerbach et al. (2021b) predicts that fiscal stimulus during the pandemic has weaker economic effects on impact, as households are unable or reluctant to spend on services that could pose a health risk. But as restrictions are lifted and consumers become more comfortable navigating health risks, there is a surge in spending and a corresponding surge in inflation. The spending and inflation surge is stronger the larger is the initial fiscal stimulus. 

These predictions have manifested in today’s economy, with inflation reaching levels not experienced since the early 1980s. And while concerns over high inflation did not manifest in the post-2008 recovery, there are clear reasons to believe that the current recovery is fundamentally different from a decade prior. Consumers have strong balance sheets and for many the main obstacle to spending has been health concerns and stay-at-home restrictions. Fiscal stimulus further strengthened households’ balance sheets and fuelled a predictable increase in spending as the pandemic subsided. Supply constraints that remain as a consequence of the pandemic contribute further to the existing pressure from the demand side.

This body of evidence suggests that, looking forward, well-targeted fiscal measures will be crucial in the event of another recessionary Covid-19 outbreak. Broad-based government spending can help prevent inefficient recessionary forces and provide disaster relief, but certain measures are more effective in the short-term and less inflationary during the recovery than others. In particular, the most effective measure according to Auerbach et al. (2021b) is transfers to multiproduct firms on the brink of exit. This permits consumers to maintain spending on a broad range of goods and services for which health risks are less of a concern while mitigating the inflationary spending surge in the future.

Authors’ Note: This column is not a product of the Research Department of J.P. Morgan Chase. The views expressed here reflect those of the authors only and may not be representative of others at J.P. Morgan. For disclosures related to J.P. Morgan, please see here.

References

Auerbach, A J, Y Gorodnichenko and D Murphy (2020), “Local Fiscal Multipliers and Fiscal Spillovers in the United States”, IMF Economic Review 68: 195-229.

Auerbach, A J, Y Gorodnichenko, P McCrory and D Murphy (2021a), “Fiscal Multipliers in the COVID19 Recession”, CEPR Discussion Paper 16754.

Auerbach, A J, Y Gorodnichenko and D Murphy (2021b), “Inequality, Fiscal Policy, and COVID19 Restrictions in a Demand-Determined Economy”, European Economic Review 137: 103810.

Baek, C, P B McCrory, T Messer and P Mui (2021), “Unemployment Effects of Stay-at-Home Orders: Evidence from High Frequency Claims Data”, Review of Economics and Statistics 103(5): 979-993.

Chetty, R, J N Friedman, N Hendren and M Stepner (2020), “How Did COVID-19 and Stabilization Policies Affect Spending and Employment? A New Real-Time Economic Tracker Based on Private Sector Data”, NBER Working Paper No. 27431.

Coibion, O, Y Gorodnichenko and M Weber (2020), “How did U.S. Consumers Use Their Stimulus Payments”, NBER Working Paper 27693.

Demyanyk, Y, E Loutskina and D Murphy (2019), “Fiscal Stimulus and Consumer Debt”, Review of Economics and Statistics 101(4): 728-741.

Eggertsson, G and P Krugman (2012), “Debt, Deleveraging, and the Liquidity Trap: A Fisher-Minsky-Koo Approach”, Quarterly Journal of Economics 127(3): 1469–11513. 

Ghassibe, M and F Zanetti (2020), “State Dependence of Fiscal Multipliers: the Source of Fluctuations Matters”, manuscript.

Guerrieri, V, G Lorenzoni, L Straub and I Werning (2021), “Macroeconomic Implications of COVID19: Can Negative Supply Shocks Cause Demand Shortages?”, American Economic Review, forthcoming.

Jo, Y J and S Zubairy (2021), “State Dependent Government Spending Multipliers: Downward Nominal Wage Rigidity and Sources of Business Cycle Fluctuations”, manuscript.

McCrory, P (2020), “Tradable Spillovers of Fiscal Policy: Evidence from the 2009 Recovery Act”, Mimeo.

Mian, A and A Sufi (2010), “Household Debt and Macroeconomic Fluctuations”, VoxEU.org, 29 April.

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Topics:  Covid-19 Macroeconomic policy

Tags:  COVID-19, coronavirus, fiscal stimulus, fiscal multiplier, lockdown, consumption, employment

Robert D. Burch Professor of Economics and Law, University of California, Berkeley

Quantedge Presidential Professor, Department of Economics, University of California – Berkeley

Economist at JP Morgan Chase

Assistant Professor, University of Virginia Darden School Of Business

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