How does government spending affect the private economy?

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The Great Recession revived economists’ interest in fiscal policy, i.e. the use of government spending and tax policy to affect the economy (especially in the short run.) This isn’t surprising given the large increases in spending and transfer payments along with significant tax cuts enacted by the Bush administration in 2008 and the Obama administration in 2009.  These two programs together pumped about $2 trillion into the US economy from 2008 to 2011.

This marked a sharp turn from the sermons preached by macroeconomists since the 1980s.  The conventional wisdom since Paul Volcker became Fed chair in 1979 has been that monetary policy (i.e. changes in interest rates initiated by the Federal Reserve) is the preferred lever for governments trying to counter the effects of a recession. Monetary policy is less political due to the Fed’s independence and the Fed can act more quickly to change interest rates than Congress and the President can to alter spending or taxes.  Thus fiscal policy was relegated to history, something we did in the 1950s and 1960s but that we learned was too crude relative to monetary policy.

With the federal funds rate at zero from 2008 to 2016, however, fiscal policy came back as an important tool in the public policy toolbox. Two recent papers examine how federal government spending affects the private economy.

First, in “Can Government Demand Stimulate Private Investment? Evidence from U.S. Federal Procurement,” economists Shafik Hebous and Tom Zimmermann answer that yes, increases in government spending can stimulate private investment.  In general, “the estimates suggest that 1 dollar of federal spending increases capital investment by about 7 cents (p. 5).”  Further, in the case of large federal contracts, “the effect on investment increases to about 12 cents (p. 5).”

Federal contracts help firms, according to Hebous and Zimmerman, by “easing firms’ access to external borrowing (p. 2).”  That is, a firm awarded a federal contract can go to the financial markets and obtain more resources at a given interest rate and/or borrow the same amount as they previously needed at a lower interest rate.  In particular, “the evidence indicates that firms that face financing constraints display the highest increase in investment following a new government award (p. 5).”

Hebous and Zimmerman also check to make sure that the increased investment by individual companies isn’t coming at the expense of others and find that industry-wide investment rises.

The second paper looks at the specifics of government spending and asks, “Does the Technological Content of Government Demand Matter for Private R&D?”  The first two sentences of the abstract are particularly good: “Governments purchase everything from airplanes to zucchini. This paper investigates the role of the technological content of government procurement in innovation (p. 45).”

To carry out their analysis, Viktor Slavtchev and Simon Wiederhold “create a unique panel dataset that relates private R&D expenditures in US states to the technological content of federal procurement in these states (p. 47).”  They then study the movement of federal dollars from relatively low-tech industries to higher-tech industries to see if the funding shift affects private sector research spending.

Slavtchev and Wiederhold find that “In monetary terms, each procurement dollar that the government shifts from non-high-tech (“low-tech”) industries to high-tech industries induces additional $0.21 of private R&D (p. 47).”

So, how does government spending affect the private economy? First, increased government spending doesn’t simply replace private spending but stimulates additional private investment.  Second, the composition of federal spending matters, with spending on high-tech contracts encouraging additional private spending on research and development.

Policymakers need to remember both of these lessons for the next, inevitable, recession.