How to Spend Public Money in a Crisis?

In response to the coronavirus crisis, governments across the globe unveil significant fiscal and monetary stimulus to support economies. For example, the U.S. government is about to approve a $2 trillion (approximately 10% of GDP) fiscal package, its largest countercyclical response in the post-WWII history. This package has a variety of measures ranging from direct cash transfers to short-term loans to bailouts. This diversity underscores that what matters is not only the size of the stimulus but also how it is spent. Much of the design is informed by experience of the Great Recession in the U.S. but Ukraine can learn some lessons too. 

Lesson #1: A recent survey of the evidence demonstrates that estimated government spending multipliers are close to one. That is, if the Ukrainian government spends an extra hryvnia buying goods, it will increase Ukraine’s GDP by a hryvnia. This suggests that government spending can be an effective tool in compensating a fall in private demand. 

Lesson #2: Multipliers vary across countries. For example, open economies have smaller multipliers. Flexible exchange rate is associated with smaller multipliers. While I am not aware of estimated fiscal multipliers for Ukraine, available evidence predicts somewhat smaller multipliers for Ukraine but it does not mean fiscal policy is powerless. This also does not mean that Ukraine needs to switch to a fixed exchange rate (doing so would limit the ability of the economy to respond automatically to external economic shocks). 

Lesson #3: Multipliers tend to be larger in recessions than in expansions. Intuitively, government spending is less likely to crowd out private investment and consumption in a depressed economy because the economy has underutilized capital and labor. Because Ukraine is about to have a huge army of unemployed, fiscal stimulus will be the most effective: a lot of labor is underutilized and, as I discuss below, transfers to the unemployed is one of the most effective ways to stimulate the economy. 

Lesson #4: Multipliers for government spending are larger than multipliers for tax cuts. Normally, this pattern is due to the fact that a portion of tax cuts is saved by households and businesses. This lesson suggests that it is not enough to reduce taxes or transfer funds to households and firms. A successful package should have a significant portion allocated to direct government spending, i.e., the government should buy goods and services from domestic firms. 

Lesson #5: The largest multipliers appear to be for infrastructure projects. In short, spending on infrastructure not only creates income in the economy directly but also raises productivity of the economy in the longer run and thus benefits the economy above and beyond the immediate spending effect. Because construction declines dramatically in recessions, supporting this industry is good in the short run (reduce unemployment) and the long run (improve productivity). This means for Ukraine that cutting development projects (e.g., building roads) to pay for other expenses is counterproductive: it will increase unemployment. Instead, the government should continue building roads and other infrastructure. 

Lesson #6: Giving resources to high-income households is less effective than to low-income households. U.S. Congress Budget Office estimated that the multiplier for low-income households is three times larger than the multiplier for high-income households (Table 1). In a similar spirit, transfers to the unemployed have much higher multipliers. Giving money to pensioners is somewhat effective. This means that extra UAH 1 000 promised by the Ukrainian government to pensioners is the move in the right direction but one can use public money even more effectively. Transfers targeted to the poor and unemployed should be a priority. 

Lesson #7: Supporting local governments has high multipliers (Table 1). Why? Because local governments are often constrained in how much they can borrow in recessions and, as a result, are forced to cut spending (to balance budgets) thus exacerbating the negative economic effects of a recession. In addition, local governments tend to be much more informed about local needs and hence direct funds to most critical areas, which raises the multiplier. The Ukrainian government unfortunately decided to reduce the revenues of local governments by announcing holidays on a few local taxes. This policy should be reversed as soon as possible.

Ukraine’s government recently approved a fiscal stimulus but its size (less than 1% of GDP) is inadequate given the scale of the crisis. Hopefully, the Ukrainian government will not only follow the lead of other countries and beef up its fiscal stimulus but also use the lessons from the Great Recession and other crises to spend the public money most effectively. The design of the package can be literally a matter of life and death for many Ukrainians.