According to John Maynard Keynes,
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.
This means that government spending on digging up the buried notes will generate an increase in the real income in the economy by a multiple of the increase in government spending. The rationale behind this is Keynes’s view that spending by one person becomes the income of another.
Let us say that, out of an additional dollar received, individuals spend $0.90 and save $0.10. Now, let us also assume that consumers have increased their expenditure by $100 million. As a result of this increase, retailers’ revenue increased by $100 million. Retailers, in response to the increase in their income, also consume 90 percent of the $100 million (i.e., they increase expenditure on goods by $90 million). The recipients of the $90 million spend 90 percent of the $90 million (i.e., $81 million). Then the recipients of the $81 million spend 90 percent of this sum, which is $72.9 million, and so it continues.
At each stage in the spending chain, individuals spend 90 percent of the additional income they receive. This process eventually ends, with total income increasing by $1 billion (10 x $100 million), that is, by a multiple of 10. The more that is spent out of additional income, the larger the multiplier, and therefore, the impact of the initial spending on the overall output is larger. For instance, if individuals change their habits and spend 95 percent out of each dollar, the multiplier will become 20. If they decide to spend only 80 percent and save 20 percent, then the multiplier will be 5. This means that the less saved the larger the impact on overall output per increase in overall demand.
Following this logic, it is not surprising that some economists are of the view that, by means of fiscal and monetary stimulus, it is possible to prevent the economy falling into a recession. On this, former Federal Reserve Chairman Ben Bernanke suggested that there is good evidence that cash that goes to low- and moderate-income individuals is more likely to be spent in the near term, hence, it will be more beneficial for economic growth. In this framework, given that the government is an important part of the economy’s total demand, it means that the government can always revive the economy.
Does the Multiplier Model Match Reality?
Can an increase in individuals’ spending increase the overall output by the multiple of spending? Let us say that Bob spends $10 to purchase the 10 pounds of potatoes from John. Jim spends $10 to purchase tomatoes from Mike.
Because of the spending by Bob and Jim, the overall income of John and Mike increased by $20. Note, however, that spending doesn’t have any effect on the quantities of potatoes and tomatoes. There will not be any effect on the quantities of potatoes and tomatoes if John and Mike will spend 90 percent of their income. Also note that, for a given amount of money, all other things being equal, if individuals increase their expenditure on some goods, then they will be forced to spend less on some other goods.
If the amount of money in the economy expands because of expansionary policy of the central bank, all other things being equal, consumers’ expenditure will follow suit. The increase in spending because of an increase in money supply cannot, however, cause the expansion in output; it cannot raise the production of tomatoes and potatoes. It will only cause a reshuffling of the existing potatoes and tomatoes. It will enrich the early receivers of the new money at the expense of the later receivers or non-receivers.
Expansionary monetary policy sets the exchange of nothing for something. This, however, undermines the wealth-generation process. Obviously, then, an expansionary monetary policy which is aimed at increasing the economy’s demand cannot increase overall output by a multiple of the initial increase in the demand.
Is more saving detrimental for economic growth, as the multiplier model indicates? For instance, the producers of consumer goods, after allowing for their consumption of the portion of the goods, could decide to use the saved goods to secure better tools and machinery. With better tools and machinery, a greater output and a better quality of consumer goods can be produced some time in the future. By deferring consumption and pursuing the production of tools and machinery, producers are transferring their savings to capital goods. Savings sustain these individuals involved in various stages of production.
Once capital goods have been produced, this permits an increase in the overall production of consumer goods. As the flow of production expands all, other things being equal, this makes it possible for more saving, which enables a further increase in capital investment. So, contrary to the multiplier model, savings expands, rather than contracts, the production of consumer goods.
Hence, an increase in production is dependent on the enhancement and the expansion of the infrastructure (i.e., capital goods). Increases in private savings enables the expansion and the enhancement of the structure of production or capital goods. Consequently, without saving, an increase in output can’t take place, all other things being equal.
Can Government Spending Increase Economic Growth?
According to the multiplier model, an increase in government spending (i.e., government demand) can increase the total output by the multiple of the increase in government demand. The increase in demand cannot cause an increase in output without the preceding increase in the production of wealth. Given that the government is not a wealth producer, it would have to take the wealth from the wealth-generators to support the increase in its demand.
In order to satisfy demand for goods from others, one has to produce or exchange. In order to exchange, an individual must produce something useful for other individuals. Therefore, production has to precede consumption. Given that the government is not a wealth producer, it therefore sets in motion the exchange of nothing for something.
In the framework of nothing-for-something, wealth-producers must relinquish a part of their wealth from production in an exchange for non-wealth, such as digging out notes in the example of Keynes. This weakens the productive wealth-formation process. Hence, not only does an increase in government spending not raise overall output by a positive multiple, but, on the contrary, it leads to the weakening in the process of wealth generation.
According to Mises,
. . .there is need to emphasize the truism that a government can spend or invest only what it takes away from its citizens and that its additional spending and investment curtail the citizens’ spending and investment to the full extent of its quantity.
Conclusion
John Maynard Keynes’s ideas remain the driving force of economic policy makers at the Federal Reserve and government institutions. The heart of the Keynesian philosophy is that what drives the economy is the demand for goods and services. Economic recessions are predominantly the result of insufficient demand. In the Keynesian framework, an increase in the total demand raises the output by a multiple of the initial increase in the demand.
In the real world, an artificial boost in the total demand that is not preceded by production leads to the depletion of savings and, contrary to the popular view, to a shrinking in wealth (i.e., it results in economic impoverishment). It is not possible to generate something out of nothing.
According to Mises,
An essential point in the social philosophy of interventionism is the existence of an inexhaustible fund, which can be squeezed forever. The whole system of interventionism collapses when this fountain is drained off: The Santa Claus principle liquidates itself.
