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The Multiplier

December 1, 2011

Now trawling across the internet as I do, I’ve encountered a fair bit of criticism concerning the Multiplier and its role in fiscal policy: not just its effectiveness but even its validity. So, having the spare time that I do, I thought I’d take a little bit of time to explain the concept of the Multiplier, its theoretical context, and how it actually works in modern economies. I apologise in advance for the wonkiness of this article, but it forms the basis of my critique of Obama’ s stimulus bill, which I will write about next, and I don’t think the argument is that complex to begin with.

The Multiplier arose from a paper that Richard Kahn, a member of Keynes’ “circus”, wrote, based actually on a campaign pamphlet co-authored by Keynes for the Liberal (future Lib-Dem) Party, “Can Lloyd George Do It?”. Kahn was shocked to find that an empirical analysis of Keynes’ more than political claims, that spending £1m would not only create five thousand new jobs (about half through direct government employment and half through subsequent increased demand), but actually also recover roughly half of its revenue, through a corresponding increase in tax revenue and a  reduction in unemployment benefits and necessary social expenditure for the poor, proved itself to be highly accurate, and subsequently led to its incorporation into the General Theory.

The theory goes that as capitalist economies are exchange economies, production is based off the circulation of money: the more money that is exchanged leads to increased production. So if $100 goes from A to B to C to D and back to A again, sure A still has $100, but in the meantime all of A, B, C and D produced goods and services to the value of $100, so in fact everyone’s richer, to the tune of 4×100=$400. The implication of this of course, is that the less one spends, the less is exchanged and the less is produced. If A spent $100, but B only spent $90, and then C only spent $80 of that, with D spending $70, then the societal increase in wealth is only $340. Thus: the more that is saved, the less wealth is produced. This is the oft-touted “paradox of thrift”, in private thrift is not beneficial but in fact harmful for the economy. It’s one of those twists in the capitalist system.

Keynes’ innovation and Kahn’s confirmation was that the expenditure would not only be partly subsidised by a roundabout process of increasing tax returns, but that spending a few dollars would in effect increase production to a much larger degree. As long as the income generated is not completely saved, then an increase in government expenditure can in effect spark a much larger increase in private demand, assuming that the economy was not already at full employment (a point Keynes stressed).

Now, you may ask how have economists not come across this problem sooner? Well, Neoclassicals and Austrians get around this through their theory of the interest rate. As they argue that the interest rate equilibrates savings and investment, the more one saves, the more one reduces the interest rate, and thus the greater incentive is to invest and increase production. Given the tendency of Neoclassical economics to assume the economy tends towards operating at full employment (via Say’s Law: supply, through the production process itself, creates its own demand), any shortfall in consumption (ie: saving) is simply made up for by an increase in investment; thus resolving the paradox of thrift.

Thus, it is easy to see how in recognising the flaws in the Classical theory of interest, Keynes had found his theoretical point of entry for the substantiation of views he had held for a long time, namely that governments should assist in maintaining full employment. With the development of his theory of Liquidity Preference, which essentially posited that the interest rate equilibrates the demand and supply for money, not savings and investment, Keynes successfully collapsed the house of cards supporting the assumption of full employment. Full employment no longer having any theoretical certainty, the paradox of thrift is suddenly enabled, and thus the notion that an increase in consumption (or investment or government expenditure; the three components of aggregate demand) will directly create an increase in employment. As investment is no longer determined by the level of savings, an increase in the rate of savings simply reduces demand and thus employment.

Therefore, in arguing their case against the “Fiscal” Multiplier, that is against the notion that fiscal policy can effectively boost production and employment, either the Classical theory of interest, or a similar theory (like the Austrian theory of capital, albeit I myself do not quite understand the difference) must be re-established, or fiscal policy itself must be proven to have a Multiplier so close to zero that it only generates as much demand as the government spends (which given the usual ratio of federal budget to GDP could soon become very costly). The third criticism is that policy makers rely on the Multiplier far too heavily, and that their economic models and forecasts are consumed by hubris, in that they think they can they can shape the economy to the very percentage point. As no modern economist really likes to propose that Say’s law is still valid, at least by name (despite the fact that all Neoclassical, including Neo-Keynesian, Monetarist, New Keynesian and New Classical theory relies on it, with unemployment only as a result of inefficiencies in an otherwise perfect system), I will ignore that critique and move onto the second two.

a) People don’t spend money the government gives them, so the multiplier is always very low.

Now this has a bit of truth about it, at least in the general critique that peoples’ consumption patterns can very country to country and year to year, so it is not guaranteed that individuals themselves will consume, especially in times of recession in which the importance of thrift is emphasised. Milton Friedman argued this in his “permanent incomes hypothesis”, that individuals respond very little to artificial, one-time increases in their income.

The problem with this argument is that it is not particularly empirical (even if Friedman backed it up with figures, his figures have proven time and time again to be unique to him; other people struggle to come up with the same data), so it is difficult to say that fiscal expenditure is entirely negligible when you cannot say by how much. And of course, sometimes even a negligible effect is what is needed; sure the Multiplier might be lower, but just because it is less effective does not rate it entirely useless. Friedman’s PIH simply revolves around the notion that tax cuts are an inherently better form of fiscal stimulus than cash handouts, operating through the same Multiplier apparatus (which leads into very murky waters, as Friedman’s theories are ambiguous concerning the Liquidity Preference and the Classical Theory of Interest).

More importantly, Keynes himself always emphasised the importance of public works, in employing those who are unemployed, so that they may task themselves with something even slightly useful, and in the meantime consume with their income from the government, which increases effective demand, increasing production and thus employment, ending the recession and also increasing tax revenues. So his theory appears consistent with the PIH: he does not advocate one-off cash handouts, and indeed did advocate substantial tax cuts during the Great Depression. Even accepting Friedman’s argument, the multiplier stands.

[As a side note: most Keynesians have tended to promote public investment over tax cuts, which are seen as an ineffectual and slow method of increasing effective demand. It is likely that Keynes promoted a reduction in taxes given the severity and length of the Great Depression, compared to more shallow recessions, in which the very gradual process would do little to provide a rapid increase in consumption that is necessary.]

b) The Multiplier is ridiculous, how can policy makers claim to model that their policies will reduce unemployment by an exact amount?

Again, this has more than a ring of truth about it, but is rather irrelevant to the Multiplier itself, but rather pertains to the application of economic policy. Regardless of how properly it can be modelled, there is little doubt that increasing workers’ consumption will increase production and therefore employment. To me it appears more than ridiculous that so much economic data is compiled and such precise forecasts are made, but this does not diminish from the broad arguable case, which was very much Keynes’ focus in the General Theory, which after all, was the first text conceived in macroeconomic terms.

I believe it was Paul Davidson who defined the Post Keynesian modus operandi as “better to be roughly correct than precisely wrong”, and that is very much applicable here. Yes, it is ridiculous to claim that the US federal stimulus was going to contain unemployment to X.Y%, especially given how data belie the truth, such as an increase in underemployment and the precarious definition of unemployment itself. But this is an issue of execution (and a pedantic one at that), hardly concerned with the theory itself.

Ultimately, the Multiplier is a very clever and crucial concept. It clearly validates the use of fiscal policy, which not only subsidises its own cost, but provides an exponential increase in effective demand. It should be the weapon of every social democrat: through expansion of government services, not only is society more productive but also more equitable! Asides from the Austrian critique, which I’ll deal with in future posts, there is no valid economic argument against it. Unless of course, you wish to reinstate Say’s Law. Any takers?

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