Econ 101 teaches that government spending comes with a multiplier effect, yet whenever anyone in an election wishes to raise the size of government by even 0.5%, the right starts screaming the world will end. Obviously for large changes to the size of government, the above equation likely breaks down (since market economics effectively gets eaten up by a government controlled allocation system), is this just wrong view?

(my example being Corbyn in the UK, asking for a 2% of GDP increase to the size of the state, yet being threatened with a 6% GDP contraction by some critics).. Are there studies as to how government spending correlates to GDP?

  • $\begingroup$ It's appropriate to ask here about the relation between government spending and GDP, but I suggest that you edit your wording to moderate its tone. $\endgroup$ – Adam Bailey Jun 2 '17 at 10:57

There are a few reasons why, at least in a broader theoretical context, substantial government influence in a market economy may have negative consequences. A few are:

Crowding Out Effect Increases in government spending can potentially lead to a decrease in investment from the private sector. This can be thought of in the more formal definition of the term (that an increase in government demands for loanable funds can lead to an increase in the interest rates faced by the private sector) or in the more informal one- that government involvement can change the profit motive faced by private entities in the field. If you assume that those private firms are, on balance, more efficient with resources than the governmental agency, it can lead to negative economic outcomes.

Market Distortions One potential problem of increased governmental activity in the economy comes from unforeseen distortions that can ripple through other sectors. For all their problems, one nice feature of market equilibria are their ability to reflect private information and demands, and aggregate the individual actions of hundreds of millions of people effectively. That is no small feat; it is hard for a centralized agency to mimic that effectiveness. One of the major problems with centralized economies in practice is their practical inability to allocate resources "efficiently."

Modeling government interaction in a repeated game-like context. Another (albeit more philosophical) problem some see is that, even if a larger government would be optimal for right now, it is often difficult to cut bureaucracy once it becomes entrenched. Therefore, we should consider that "future value" of inefficiently large government spending in the future (even if it is optimal to increase government's size today) into today's perceived "payoffs" of different actions.

Problems with the Multiplier Effect: The multiplier, as learned in econ101, is a bit oversimplified in its presentation. While there almost certainly is some multiplier in every case, it isn't really just a single number that turns on an economy wide "marginal propensity to consume." Instead, it's far more subtle, and often depends on who is receiving the benefit, what the context of the payment is, etc. Furthermore, some conservative economists argue it is often too small to justify the expense.

Now, note that I personally don't really believe much of what was said above. I'm not trying to suggest that Mr. Corbyn should or shouldn't increase the size of government expenditures (I haven't studied the issue enough to make an informed opinion). Furthermore, I think it should be noted (in the interest of fairness) that many times these theoretical concerns can be misapplied in practice: for example, The Laffer Curve may be the most poorly applied theoretical concept in political economy.

Let me know if that didn't answer your question, or if you'd like more detail!

  • $\begingroup$ NB- that was a bit more of a theoretical answer to the first part of your question. Regarding the end line, are there studies into the effects of government spending on economics- there are several subfields of economics devoted to examining that exact question. For that, I'd ask you be a bit more specific on which country, when, what spending, and what horizon you're considering. $\endgroup$ – AndrewC Jun 2 '17 at 11:54

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