Commentary
Columbia Management Perspectives: Searching for Big Foot
By Anwiti Bahuguna
Senior Portfolio Manager, Asset Allocation
Columbia Management
Recent events in Europe have reignited the debate over the effectiveness of government policy interventions and on the question of what stimulates growth. Unfortunately, we can’t look to academia to provide convincing answers. Fierce debates on this topic have raged ever since the 1930’s when John Maynard Keynes theorized that during times of economic slack (recession), government spending could stimulate economic activity and lead to growth. According to the multiplier effect, increased government spending can increase employment and incomes, thereby boosting private consumption and sentiment which in turn increases total spending. The attractiveness of the multiplier comes from the idea that $1 of spending could in theory lead to more than $1 of economic growth. Similarly, reducing government spending at times of slow growth could have the reverse effect of contracting growth and resulting in a recession. When President Obama introduced his fiscal stimulus program, his economic advisors expected the multiplier to be somewhere between 1.6-2.0 times. In other words, if the government spent $800 billion in stimulus, gross domestic product (GDP) was expected to increase by twice that amount. In a 2009 op-ed, Economist Robert Barro argued that in peacetime, multipliers were essentially zero because increases in government spending crowded out private investment.
Keynesian theories have been questioned by those who are suspicious of government interventions and who have faith in the market’s ability to self-correct. In 1976, Nobel Prize winner Robert Lucas argued that it is naïve to predict the effects of policy changes based on historically observed relationships because the introduction of policies could lead to a breakdown of those relationships.
While several studies have attempted to measure the government spending multiplier, the results are inconclusive. It is difficult to isolate the effect of one policy measure in the real world where behavior of consumers and businesses is determined by multiple factors. In 2009, an International Monetary Fund (IMF) paper summarized the results of multiple academic studies on this topic and concluded that the size of the multiplier (from negative to 2.0) varies depending upon the type of government program, country, time and circumstances. In times of extreme uncertainty when consumers and businesses question the permanence and/or sustainability of policy changes, or expect taxes to go up in the future to fund the spending, the multiplier can be small. In such cases, marginal increases in income are not spent, but instead saved. On the other hand, when there’s slack in the economy, government capital spending programs are found to have a high multiplier (1.6).
Economists may quibble about the type of policies, but ultimately they believe in a role for some sort of public policy intervention. The most thought provoking criticism of the effectiveness of fiscal and monetary policy efforts has actually come from studies of behavioral finance. Incorporating ideas from psychology, behavioral economists have questioned the fundamental economic assumption that people behave rationally at all times. Instead, people are generally imperfect processors of information and are frequently subject to biases and errors of judgment and often driven by emotions rather than objective, rational, hard analysis. If indeed people are more emotional than rational, then it throws into question the efficacy of all macroeconomic models and their predictions.
Meanwhile, European investors are in a conundrum. For the past few years, the sovereign bond markets have pushed peripheral European countries to reduce public debt. This has meant adopting austerity measures whereby government budgets are slashed and taxes are raised. Such measures meet investors’ approval. However, the immediate impact of such efforts is less economic growth which is intolerable to the people in Europe. They have been voting out incumbent governments, resulting in increased instability which is also something the markets dislike. The path to sustainable growth is complicated and requires long-term investments. We believe despite decades of research on the topic, academic efforts have not found a clear answer. Perhaps finding Big Foot will be easier.
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The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Columbia Management Investment Advisers, LLC (CMIA) associates or affiliates. Actual investments or investment decisions made by CMIA and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that the forecasts are accurate.
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