The Keynesian Multiplier

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One of the tools Keynesians are most proud of is their so-called “multiplier,” which they seem to think is equivalent to magic. The idea is that new additional spending of money creates new incomes. Keynesians believe that the formation of any additional spending in the economy, that is in turn spent by its receivers and re-spent in successive rounds, will create additional incomes at a multiple of the original amount of spending. They consequently propose that government should engage in deficit spending during recessionary periods when businesses will supposedly not spend, so as to pump up the economy. They are so convinced of this magic multiplier that they even claim that if government invests in building such things as Egyptian pyramids, the spending on the pyramids would create subsequent additional incomes and create prosperity. Paul Samuelson, a leading Keynesian theorist, wrote in his textbooks that if the government printed money to pay for a million dollars worth of goods to be thrown in the ocean, the spending and re-spending of the million dollars which created those goods would create additional employment and production. Under that logic, if we threw everynew thing, or merely many things, we created into the ocean we would somehow become really wealthy.

 
Indeed, the mathematics of the multiplier theory is sound, but the assumptions are not.  Since it is only productive expenditure, not consumption expenditure, which pays wages, the multiplier could only result in additional profit income, not wage income (the Keynesians specifically state that the multiplier works if incomes are spent, not saved and invested). To understand this concept better, suppose you spent $100 at the book store. Then the bookstore owner, instead of re-investing in his business, spent the money at the grocery store. The grocery store owner then takes the $100 out of the cash register and spends it on a new appliance. The appliance store owner spends it on movies, carnival rides, or whatever. The spending goes on and on in this fashion. In this case, the money was never not spent. If it were not spent, it would instead be saved.

 
If people spent all their incomes, there would be no funds available with which to invest and to pay wages. It is saving, i.e., not spending, that pays for additional capital goods and labor. Had any of the above businesses saved the $100 and invested it in their business, they could buy new machines or hire more workers. Had they saved the $100 in a bank, other businessmen, in borrowing these funds, could have expanded their operations or started new ones.

 
If all monies were spent and not saved, we would soon consume all existing goods. Since we would not have produced any new goods to replace those consumed, we would soon have literally no goods of any kind, including food or housing (after our food was eaten and our houses deteriorated).
In sum, the only effect from any additional spending is to raise the rate of profit: Business costs remain the same, but the additional spending increases sales revenues. But nothing new is created, no investments are made, and no wages are paid.

 
Keynes stated that if people were careful not to save too much, there could be full employment with interest rates of zero. But this is illogical thinking. For if people saved nothing, there would be no productive expenditure, thus there would be no employment (only self-producing for profit). In this scenario of not saving at all, profits would be equal to the entire amount of sales revenues, and the rate of profit would thus be infinite.

 
But the Keynesian multiplier has even deeper problems than assumed thus far. Any additional spending cannot create real additional wage income even if the spending was in fact saved. This is because increased real incomes can only come about from new and additional production; workers can’t consume more goods if there have not been any additional goods created for them to consume.

 
The multiplier’s math (Figure 9.1) shows us that a single $5 million of “investment” expenditures by the government can create $20 million of new national income, if people spent 75% of their incomes and saved 25%. With a portion saved each round, the amount of money being spent eventually completely diminishes to zero. But, according to the Keynesian’s own model, if people spent everything they earned, saving nothing, the amount spent each round would never diminish. In this case, each time the $5 million is spent it would create another $5 million in national income. This means that as long as the same money is spent and re-spent it will perpetually create an infinite amount of national income, forever. Obviously, this cannot, and does not, happen.

 
Now, a less important fact is that companies and businesses only receive so much income each year, and can only spend it once. And we know from studying how many times the same dollar is spent in the economy each year (velocity) that the same dollar is spent only several times in an economy on average —people don’t just take the same dollar and pass it around faster and faster.

 
The more important insight to consider is that it is not just passing around dollar bills that create new wealth. If it did, why would we need to pass around bills in order to encourage us to begin making things? It is not for lack of thought or incentive that we don’t make more things; it’s for lack of savings and real capital goods. If you think back to the desert island example in chapter 1 where a barter economy existed, you will recall that money is a “receipt” or “claim” that represents ownership of real goods already produced. It’s the real goods that are being exchanged, and once they are consumed they’re gone. Adding more paper bills to the economy for people to pass around simply changes the money price of the goods, but does not create new goods. Can we imagine five people on a desert island creating goods faster by passing around paper bills than they would by not doing so? With or without the bills they need to find resources, to build things, and to have real, unconsumed and stored previously-created food and materials (i.e., savings) to sustain themselves while they produce more wealth. If we look at the Keynesian multiplier in the context of a barter economy the assumptions behind its mathematics break down and its façade disappears.

 
Lastly, if new spending comes from newly printed money, it does in fact result in increased monetary incomes, but as incomes are spent, consumer prices rise in proportion (or even in disproportion, as consumer goods are used up), and no new wealth is created. Printing money is therefore not a realistic way to increase real incomes. Also, spending taken on by government necessarily reduces the ability to spend by others, because it either depletes savings via taxes or reduces purchasing power via inflation.

 
Still, since most of the government’s economic advisors believe in the multiplier effect, the government continues to spend and spend, on any and everything, believing it will somehow bring prosperity. This is the basis behind our “stimulus” programs. Japan too has tried unsuccessfully to spend its way out of economic recession for the last 19 years; the Keynesian economist’s only explanation is that Japan did not spend enough. The only thing the spending in Japan has created is the greatest amount of debt a country has ever had in history. But politicians don’t have to worry about profits and losses, as it’s not their money.

Kel Kelly @ May 31, 2009