Our Bad. The IMF Dumps The Chicago Story and You Can Too!

Via Krugman and (much more in depth, Antonio Fatas), we get the biggest economic news of the week: turns out when governments spend money, it's not immediately offset by something else, and economies tend to grow. Those of you who may have missed the last 10 20 years might have trouble understanding what all  the commotion is about here, since this used to be the consensus on this topic, and quite frankly it seems logical to anyone who hasn't been forced to sit through advanced macroeconomic seminars or a tea party rally. Which of these two stories seems to make the most sense?

1. The government contracts to build a road, and spends money to do so. It pays workers, aggregates companies for the asphalt, etc. So wages to construction workers and profits to companies that make road materials go up, and thereby total income in the US goes up by at least as much as the wages and profits in total. Hey, if the workers ever go out for a drink, or some dinner, or use the money to buy a car, it might even go up a bit more, as other folks' incomes rise too (the waitress, the auto salesman, etc.)
2. The government contracts to build a road, and spends money to do so. It pays everyone like before, and the road gets built. But somewhere, someplace else in the US, another company (or person) thinks, "Wait! The government borrowed that money, and sooner or later it's gonna ask me for more money. Therefore, instead of building that factory (or buying a new washing machine, or going out to dinner) I'm going to be super smart and postpone all of that purchasing, save the money in a rainy day escrow fund to protect against that inevitable government tax increase."  All that postponing offsets the initial road building income, and total production/income in the US stays the same.

I know, #2 sounds a bit far fetched, but maybe you ARE already an economist and you still buy into these "magically offsetting" hyperrational permanent income ideas. Now, let's assume that interest rates are roughly zero, so that by saving I mean basically stuffing all of your money into a mattress. Still believe that folks don't want to invest or buy washing machines because they'd rather save in their mattress for the inevitable doomsday tax increase someday?  Keep in mind that the government borrowed at 0%, so even if you want to "save" for a rainy day and offset the initial purchase you'd have to have NO investments that yield any positive return (or zero convenience yield for any purchases), because in that world you'd still build the factory and use its profits to pay off the future tax increase. Still buy story #2? Congratulations, welcome to your career in macroeconomics at the University of Chicago.  Outside in the real world where actual people live, we're going with story #1.

Oh yeah. You know which other crazy radicals believe story #1? The IMF. Here's the statistical box...see all of those -1's in the left column? 

Let me interpret. They're the error in the multiplier used to estimate the impact of government spending on growth. Multiplier? Huh? Remember story #1? If the government spending led to an increase in income of exactly the same amount, we say the spending had a multiplier of 1 (or that no one "offset" any of it). If story #2 was correct, we'd see a multiplier much less than 1 (say 0 if you want to make Eugene Fama happy!). But what the IMF is saying here is that they messed up. They used a .5 number as a multiplier and it really was about 1.5. Oh, and sorry about the austerity and all that suffering and unemployment the past two years. Our bad. We'll buy you a cognac and some foie gras to apologize. Oh, but you don't have anything to wear to our club? And you want a job? Tsk Tsk. Why don't you just be glad we admitted we were wrong.

The punchline? Multipliers are bigger than 1, unless interest rates are already high or we're at full employment. And if you tell me that .25% is high or that we're always at full employment (or there now) let me wait while I go find a wall to punch and a bottle of whiskey to drink.