Macroeconomic effects of government spending in China

Date01 August 2019
AuthorYi Wen,Xin Wang
Published date01 August 2019
DOIhttp://doi.org/10.1111/1468-0106.12242
ORIGINAL MANUSCRIPT
Macroeconomic effects of government spending
in China
Xin Wang
1
| Yi Wen
2
1
Chinese University of Hong Kong, Hong Kong,
China
2
Federal Reserve Bank of St. Louis, USA
Correspondence
Yi Wen, Research Department, Federal Reserve
Bank of St. Louis, P.O. Box 442, St. Louis,
MO 63166, USA.
Email: yi.wen@stls.frb.org
Abstract
Government spending plays an important role in deter-
mining economic performances in China. Its macroeco-
nomic effects are analysed in this paper. We show that
government spending in China Granger-causes output,
consumption and investment booms as well as inflation,
and has a multiplier larger than 1. The large multiplier
effects are found not only in aggregated time-series data
but also in panel data at the provincial level. We also pro-
vide a theoretical model and Monte Carlo analysis to
rationalize our empirical findings. Our theoretical and
Monte Carlo analyses support the large multiplier found
in China but also suggest that government spending is
not necessarily a free lunch in spite of the large multiplier
effects.
1|INTRODUCTION
The macroeconomic effects of government spending in China have been remarkable, both in terms
of fostering long-run economic growth and in driving short-run business cycles. Consider the fol-
lowing observations:
1. Chinas public capital formation in infrastructure (such as urban water supply, electricity, trans-
portation and telecommunications) has been growing at the fastest rate in the world.
1
Vast
improvements have been made over the past 30 years in irrigation systems, underground sewer-
age systems, streets and highway networks, air and rail transportation, electricity transmission
grids, gas and oil pipelines, schools and hospitals. As a result, China now enjoys an
1
From 1978 to 2008, Chinas infrastructure capital stock (in constant prices) grew by 12.3% per year while the real GDP grew by
9.5% per year.
Received: 28 March 2016 Revised: 11 August 2017 Accepted: 19 August 2017
DOI: 10.1111/1468-0106.12242
416 © 2017 John Wiley & Sons Australia, Ltd wileyonlinelibrary.com/journal/paer Pac Econ Rev. 2019;24:416446.
exceptionally high ranking in the World Bank Logistics Performance Index (LPI).
2
China
ranked 27th in 2016 among 160 countries, just above Israel. In fact, China is the only develop-
ing country that has achieved an LPI comparable to that of industrial high-income nations in
international shipments, infrastructure, custom services, logistics competence, tracking and trac-
ing, and timeliness. Such a remarkable catch-up in infrastructure has no doubt made a signifi-
cant contribution to Chinas rapid economic growth.
2. However, government spendingin China has also been viewed by many as reckless and highly inef-
ficient (such as building roadsleading to nowhere and ghost towns where nobody wants to live).As
a recent example, a significant fraction of the 4 trillion RMB government stimulus package,
designed to counter the adverse impact of the worldwidefinancial shocks on Chinas export sector,
went to the housing market and fuelled a new housingbubble (Deng, Morck, Wu, & Yeung, 2011).
3
It is, thus, not surprising to note that Chinas big government spending programmes have them-
selves often been a major source of aggravationfor Chinas inflation level and price instability.
4
Therefore, with governmentspending, there can be dramatic trade-offs. On the one hand,it may sig-
nificantly boost aggregate output through aggregate demand, especially in developing countries with
severely underutilized resources due to massive market failures and secular stagnations. On the other
hand, it may have severe adverse consequences, such as unintended inflationand price volatilities. Such
a trade-off is perhaps most clearly revealed in Chinas recurrentinflation cycles in the 1980s and 1990s,
driven mainly by large governmentspending (or de-spending) programmes (see Section 2).
This paper attempts to estimate the macroeconomic effects of government spending in China. In
particular, we use both nationwide and regional data from post-reform China to estimate the multi-
plier effects of government consumption. It is generally believed that the multiplier of government
spending is larger in less developed economies than in developed countries because they have more
underutilized resources and tend to suffer more from insufficient aggregate demand.
We have two interesting key findings. First, our estimates show that the multiplier in China is
significantly larger than 1 at both the national level and the regional level. This value is, indeed, sig-
nificantly greater than those found in developed countries such as the United States.
5
2
The Logistics Performance Index (LPI) is an interactive benchmarking tool created based on a worldwide survey of operators on the
ground (global freight forwarders and express carriers), providing feedback on the logistics friendlinessof the countries in which
they operate and those with which they trade. They combine in-depth knowledge of the countries in which they operate with informed
qualitative assessments of other countries where they trade and experience of the global logistics environment. Feedback from opera-
tors is supplemented with quantitative data on the performance of key components of the logistics chain in the country of work. LPI
2016 ranks 160 countries on six dimensions of trade (including customs performance, infrastructure quality and timeliness of ship-
ments) that have increasingly been recognized as important to development. The LPI uses standard statistical techniques to aggregate
the data into a single indicator that can be used for cross-country comparisons.
3
Wen and Wu (2013) argue that inefficient government expenditures in China can nonetheless serve as a coordination device to pre-
vent recessions.
4
Since the start of economic reform in 1978, Chinas central government has relied heavily on inflationary deficit financing to stimu-
late the economy. Big stimulus packages often generate short-run booms followed by high inflation. The high inflation, in turn, causes
widespread social and economic problems and then forces the central government to adopt severe measures to curtail spending pro-
grammes that are largely supported and sustained by self-interested local government agencies. The contraction of government spend-
ing, in turn, leads to recessions. See Section 2 below for more examples.
5
Empirical studies show that the estimated government spending multiplier for developed countries, such as the United States, is in
general smaller than 1 or in the range of 0.6 to 1.2 (Ramey, 2011a). Barro (2011) argues that the multiplier in the United States is
more likely to be close to zero. The reason for expecting a small multiplier is that capacity utilization in developed countries is suffi-
ciently high and markets are sufficiently efficient and complete. However, during severe recessions, especially in a situation with a
zero nominal interest rate, the multiplier in developed countries can be potentially greater than 1 (see e.g. Christiano, Eichenbaum, &
Rebelo, 2011). Ramey (2011a), however, finds no empirical evidence for the New Keynesian prediction that the multiplier is larger
than 1 when the interest rate is near zero. However, Shaog (2010) finds a multiplier of 2 using regional data by panel regressions. For
a comprehensive literature review on empirical and theoretical studies of the fiscal multiplier, see Ramey (2011b).
WANG AND WEN 417

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