(Regular readers of this blog will know I consider that a good thing.)

The fiscal multiplier is an important and hotly debated measure for macroeconomic policy. If the government spends an additional dollar, a dollar’s worth of output is produced, but in addition the dollar is added to disposable income of the recipients who then spend some fraction of it. More output is produced, etc.

It’s hard to measure the multiplier because observed increases in government spending are endogenous and correlated with changes in output for reasons that have nothing to do with fiscal stimulus.

Daniel Shoag develops an instrument which isolates a random component to state-level government spending changes.

Many US states manage pensions which are defined-benefit plans. Defined benefits means that retirees are guaranteed a certain benefit level. This means that the state government bears all of the risk from the investments of these pension funds. Excess returns from these funds are unexpected exogenous windfalls to state spending budgets.

With this instrument, Daniel estimates that an additional dollar of state government spending increases income in the state by $2.12. That is a large multiplier.

The result must be interpreted with some caveats in mind. First, state spending increases act differently than increases at the national level where general equilibrium effects on prices and interest rates would be larger. Second, these spending increases are funded by windfall returns. The effects are likely to be different than spending increases funded by borrowing which crowds out private investment.