The Keynesian Multiplier

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One of the tools Keynesians (left-wing, pro-government economists) 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 everything we have in the ocean, we would somehow become really wealthy.

Indeed, the mathematics of the multiplier theory is sound, but the assumptions are not. (1)  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, and it cannot create additional profit income if it is spent (except to the extent velocity increases (2)). 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 simple act of spending money merely transfers the same money from one person’s hand to another. Indeed, the faster this is done, the more the volume of total spending (velocity) in the economy increases. But given a static supply of money, spending can only increase a very little—we all have a particular amount of income from which to spend and we can only spend it once. The multipliers’ proponents who argue that any given amount of spending could result in 2, 3, or 4 times as much in additional incomes are implicitly assuming that people will physically take dollars handed to them and in turn hand them to others at 2, 3, or 4 times the speed, in a repetitive fashion, than they did previously. At whatever the speed, Keynesians pretend that simply passing around a given quantity of money can magically create more of the same money. This is all unrealistic nonsense. It could be true that if the new spending comes from newly printed money, increased incomes will occur, but as they are spent, consumer prices rise in proportion, and no new wealth is created. Printing money is therefore not a realistic way to increase incomes.

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 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.

(1) This statement is true with regards to most economists’ mathematical models.

(2) Most of the changes in velocity are affected by speculation. Increased speculation, in turn arises from changes in expected changes in purchasing power. Changes in purchasing power can only come about from changes in the money supply. Velocity does not, as most people believe, have a life of its own unrelated to other factors.

Kel Kelly @ May 31, 2009