Economic Fallacy VI: The Divisive Multiplier

There is a widespread believe that if governments inject a certain amount of money into “an” or “their” economy, it will miraculously multiply and bear fruit beyond what was invested. This is one of the mainstays of Keynesian economics in that it justifies state subsidies, public works, in short just any intervention by a state in the realm of private enterprise on the expenditure side.

(Statistical resources in our References section!)

Of course, it being the mainstay of this “General Theory” it has consequently been one of the, if not the, most attacked theoretical pillars of Keynesian economic policy.

The problem with proving or refuting this (and any other) economic hypothesis generally lies in today’s fashion of statistical research where coincidence is taken to prove causation. Since each time is different nothing of that sort can prove a theoretical postulate, at best it could refute it if in each and every case the effect predicted does not appear in the right sequence or magnitude. However, even any statistical refutation in the last analysis rests not only on the selective bias of data researched by the statistician, often coloured by the theoretical camp he or she is in, but also in the interpretation of any such effect. Or how could two equally “qualified” economists, one from the trade unions, the other form a confederation of industry, come to opposite conclusions when looking at the same data sets?

So in this post we will not try to argue via observable effects but just look at the theoretical basis of any such multiplicative effect of any public investment in the domain of private enterprise.

Before we do this, just one other puzzle CrisisMaven yet has to get a straight answer to: if it were true that any well-planned state injection of monetary stimulus would have a multiplicative effect, thus “boot-strapping” the economy and allegedly paying “for itself by itself” in higher growth from which the initial investment could surely be recouped, why not always run the economy in this fashion? Why not constantly place seed money in areas of an economy perceived to be most promising (or most lacking), either in terms of creation of jobs or for strengthening international competitiveness?

CrisisMaven generally applies two criteria to each proposed theoretical concept in economics. One could be called a copy of the Kantian imperative whereby if an action is productive or allegedly yields positive results in a microcosm or in a singular case why shouldn’t it yield even better or greater results if applied across the board and as a grand scheme? And the other criterion is that if a certain postulate is wrong then the exact opposite should be right. So if you can’t prove or refute one postulate, try to do so with its opposite and in the majority of cases you can demonstrate if a certain hypothesis has scientific merits.

So we just asked why the multiplier were not always employed across the board and why we are not all rich beyond our wildest dreams because governments at least since the late 1940s could have used this effect to boost their economies and our welfare beyond comprehension. This not having happened at least should make us suspicious of the remedy, if it may not be the cause of what it is meant to be the cure for.

But there is a much easier and generally overlooked way to prove that the multiplier does not exist, at least not in its positive form. Certainly no one would deny that there can always be a negative multiplier effect in that a state or any entity for that matter can squander money somewhere sometime on something and be left with less return than they invested. So we can observe multiplicative effects where the multiplier is one at best and smaller than one without effort on the side of whoever plays the role of “investor”.

However, to achieve a multiplier greater than one, indeed, even of at least one, more factors need to come into play:

  1. The yield of the investment must be positive.
  2. And mostly forgotten: the yield of that alternative investment must be greater than the potential return of any investment foregone by redirecting the invested funds away from their original intended usage to the new, allegedly positive application.
  3. And totally overlooked: the new, publicly directed, investment must have a higher return than the original investment that was stopped short by taking away the money to finance the stimulus by any amount that is lost in transmission.

While in the abstract all has already been said to refute the multiplier concept let us elaborate on each to make it crystal clear:

A positive yield of return

Looking at such “investments” as the London Millenium Dome or hundreds of thousands of public expenditures great and small around the world it is probably safe to say that even if bureaucrats in public administrations sometimes manage to find an investment with a positive return the overall historic average is probably weighed down by the negative examples as to safely sum up that the total public expenditure in the industrial domain has been a disaster. But surely this is going to be contested by not only those responsible for each of these failed projects but also by those who say, like Keynes who advocated burying money to lift the economy by the work “created” in digging it up, that even if the investment “as such” was misdirected, it still created “lots of jobs” elsewhere and that that had a positive effect on the economy as a whole and at large:

“If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coal mines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again (the right to do so being obtained, of course, by tendering for leases of the note-bearing territory), there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is. It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing.” (John Maynard Keynes: The General Theory of Employment, Interest, and Money, Chapter 10: The Marginal Propensity to Consume and the Multiplier)

Applying CrisisMaven’s imperative as above, we need to ask why then not just randomly wasting money would be the way to go; at least it would do away with the pretense of prudent stewardship and all ensuing discussion if the investment was a wise decision if one pronounced it a foolish decision always from the outset, were it not for the long-range effect of the multiplier. (Again we might ask what we need the state for – we all can invest money foolishly ourselves and many of us have and … there’s a reason why we desisted eventually.)

A positive differential yield of return

Now, let’s for argument’s sake assume that indeed in one, several or even the majority of cases the government managed to invest the money so “wisely” as to generate a positive return. Still we must ask: if the money had to be first raised from within the economy, what rate of return was foregone in investments forborne? Let us assume that indeed the government managed to diagnose a spot in the economy where the rate of return was dismal enough so that it can clearly determine it would be wiser to take the funds away from there and invest them elsewhere at a higher return.

This line of argument though has a whole slew of implications:

  1. Naturally, if one line of industry had an under-average return (the “marginal producer” probably), then the funds would seek higher rates of return elsewhere all by themselves, without an intermediary necessary to put them into temporary storage before investing/spending them elsewhere. Any entrepreneur actually spends every second of his/her life just thinking about exactly that.
  2. The second and similar question is why only a civil servant was able to discover that new investment opportunity and why millions of private enterprises and their consultants failed to do so. This at least seems counter-intuitive and in fact leads to the imperative demand to either let those brilliant civil servants take over the whole economy or at least get all these dim-witted entrepreneurs retrained in public administration. Again we wonder why this hasn’t happened at least since the late forties?

A positive differential yield of return even after losses in transmission

Now, when the state raises monies from private enterprise (if it is income taxes from workers or salaried employees these equally come from the coffers of a private enterprise which generates them, with the help of those employees, in the first place) it is money that goes missing there. And of course in some countries there still are even taxes on substance, be they on landed property or based on the sum of capital, or capital gains taxes on unrealised “profits” (which goes counter the principle of marking at the lower of cost or market) or taxes on the sum of salaries or machinery employed, estate or inheritance taxes etc.

Whether the state raises money through taxes or through bonds, in each case he needs to maintain an organisation that controls the process. This administration costs money without adding to the return on investment envisaged (yes, we know, private enterprises have some loss of transmission too, like in a hedge fund that employs analysts – however, there is a fundamental difference: if they don’t make the right decisions they will eventually be weeded out; that mechanism does not apply to the state’s collecting agencies!). Plus it keeps people out of the productive processes of the economy, as civil servants consume, they do not increase the total wealth of any economy. In some cases civil servants are costs that avert greater costs, such as police hindering crime to make an even bigger dent in the economy than what the police force costs (though all around the world they fail dismally when it comes to organised crime which probably has the highest return of all criminal as well as legal “economic” activities).

So, to avoid all the difficulties in measuring the elusive multiplier we decided to grant it exists, with the only irrefutable qualification that if it exists when the sovereign spends the money it must equally exist if a private entity spends the exact same amount. Were it not so, i.e. would the state’s expenditure always yield better results than private investment, then immediately we need to ask that all private investment be stopped in favour of public expenditure.

Now is there any reason to believe that any public agency can better assess the vagaries of investment than any private agent? I think the answers are clear:

  • Either it can, then we need to mandate that private investment be forbidden on the grounds of being socially detrimental so that everyone should be better off than in a private market economy (and if, as argued in the “Third Way” both types of activity have their merits then still one needs to establish how to distinguish when to apply which behaviour and this leads to the same epistemological circular reasoning – it’s always “one or the other”).
  • Or we must admit that, while the multiplier may exist, it can work even better if the money thus invested were not first diverted through a state agency which, though it may have exactly the same (but no greater) business acumen will not have the same (but always a little less) money at hand to invest but a smaller sum, by whichever minute amount, than if the private entities had re-invested without a lossy diversion.

Should anyone suggest that instead of taxing or raising the money in the capital markets the state, and only he, could create the money and therefore public expenditure were of a different, lossless (to industry) kind and came thus “on top of” private investment, this argument is just as easily refuted: such measures can only be had at the price of inflating the money supply. With the value of such money falling reciprocally (though not uniformly) one could create an illusion of positive returns in nominal terms, but the real amount of wealth would not grow. Since all the other objections as to transmission losses etc. still apply, even the nominal growth falls further behind real growth than if government had left the economy to its own devices. And thus we might then with greater justification and again greater net nominal return grant private business the right to create money directly.

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  1. Callum Kemp
    2011-01-02 at 02:33

    The multiplier simply does not exist. It can’t exist because it is being taken away from certain groups who would spend it how they want and is being spent by the government. The power of the money is diminished by the fact there is a cost of administration this reallocation of funds. The government in no way shape or form can choose better than an individual of where to spend money. Public spending kills growth in the private sector to expand the public sector. The shame of it all is, Colleges in the UK are only teaching Keynesian economics for the simple fact of it is easier to let the government decide on how to spend your money.

  2. 2010-04-01 at 13:17

    “Why not constantly place seed money in areas of an economy perceived to be most promising (or most lacking), either in terms of creation of jobs or for strengthening international competitiveness?” Answer: who’s going to do the “placing”? If it’s government, the latter has proved not very good at identifying industries likely to expand or create jobs.

    • 2010-04-01 at 14:06

      That’s what I argue – what Keynes advised is that the government must make up for the “slack” – if that is so in an abstract way, it doesn’t tell us where, how and when how much money should be spent. The moment we look into that we are faced with one of two “alternatives”:
      a) as in his “bury bottles with banknotes” example, which he meant seriously, then it doesn’t matter at all on what item and for what purpose a government spends money – then this begs the question I raised: “Why don’t we do that always and prosper beyond our (current) dreams?” (And why does it matter if government spends, why cannot I and you spend beyond our means with equally positive effect?)
      b) If it is not that easy, if governments have hard times figuring out 1) where to spend and 2) where to get the money in the first place without doing more harm than they try to later compensate we are in another fix: why not let government run the economy “all year ’round”?
      If either alternative leads to insoluble conflicts and logical contradictions then Keynes was obviously wrong not only about the never-proven multiplier but even more so about advising the government to intervene at all.

  3. 2010-03-31 at 23:34

    “If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coal mines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again [...] the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is.” –Wasting resources increases real income. Abwrackprämie?
    I didn’t know that Keynes really was so stupid.

    • 2010-04-01 at 00:18

      Oh no, he wasn’t stupid, he was clever – he knew that where Mises and Say had failed to convince people he would succeed by stating “it doesn’t matter what you produce, even waste is richdom” – and you can get Nobel Memorial Prizes with such rubbish. Oh how Hilde & Walter (Benjamin) would have loved it … Auferstanden aus Urinen … cash for clunkers was a good Keyresian policy – destroy cars, don’t give them to poor people who might now be able to drive to work with them where before they couldn’t. But no, Keynes’ principle requires that all they’d have to do is pull the crushed cars back from the junk yard, straighten all the creases, replace the smashed wind screens (probably from glass bottles?) and set these cars back in motion – how much more wealth then can be created than if these cars had remained intact? We see the light, at last …

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