By popular thinking, the key driver of economic growth is increases in the total demand for goods and services. It is also held that the overall economy’s output increases by a multiple of the change in expenditure by government, consumers and businesses. The popularizer of this way of thinking John Maynard Keynes, wrote,
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.
An example will illustrate how an initial spending increase raises the overall output by a multiple of this increase. Let us assume that out of an additional dollar received individuals spend $0.9 and save $0.1. Also, let us assume that consumers have increased their expenditure by $100 million. Because of this, retailers' revenue rises by $100 million. Retailers in response to the increase in their income consume 90 percent of the $100 million, i.e., they raise expenditure on goods and services by $90 million. The recipients of these $90 million in turn 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 on. Note that the key in this way of thinking is that expenditure by one person becomes the income of another person.
At each stage in the spending chain, people spend 90 percent of the additional income they receive. This process eventually ends, so it is held, with total output higher by $1 billion (10*$100 million) than it was before consumers had increased their initial expenditure by $100 million.
Observe that the more that is being spent from each dollar, the greater the multiplier is and therefore the impact of the initial spending on overall output will be larger. For instance, if people change their habits and spend 95 percent from each dollar the multiplier will become 20. Conversely, if they decide to spend only 80 percent and save 20 percent then the multiplier will be 5. All this means that the less that is being saved the larger is the impact of an increase in overall demand on overall output. Note that on this way of thinking an increase in savings weakens the pace of economic activity. Following this way of thinking it is not surprising that most economists today are of the view that by means of fiscal and monetary stimulus it is possible to prevent the US economy falling into a recession.
Is the multiplier a real thing?
Are increases in savings bad for the economy, as the multiplier model indicates? Take for instance Bob the farmer who has produced twenty tomatoes and consumes five tomatoes. What is left at his disposal is fifteen saved tomatoes, which are his savings. With the help of the saved fifteen tomatoes, Bob can now secure various other goods. For instance, he secures one loaf of bread from John the baker by paying for the loaf of bread with five tomatoes. Bob also buys a pair of shoes from Paul the shoemaker by paying for the shoes with ten tomatoes. Note that savings at his disposal limit the amount of consumer goods that Bob can secure for himself. Bob’s purchasing power is constrained by the amount of savings i.e. tomatoes at his disposal, all other things being equal. Now, if John the baker produced ten loaves of bread and consumed two loaves his savings are eight loaves of bread. Equally, if out of the production of two pair of shoes Paul uses one pair for himself then his saving is one pair of shoes.
When Bob the farmer exercises his demand for one loaf of bread and one pair of shoes he is transferring five tomatoes to John the baker and ten tomatoes to Paul the shoemaker. Bob's saved tomatoes maintain and enhance the life and wellbeing of the baker and the shoemaker. Likewise, the saved loaf of bread and the saved pair of shoes maintain the life and wellbeing of Bob the farmer. Note that it is saved final consumer goods, which sustain the baker, the farmer and the shoemaker, that makes it possible to keep the flow of production going. Now, the owners of final consumer goods, rather than exchanging them for other consumer goods, could decide to use them 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.
Note that by exchanging a portion of their saved consumer goods for tools and machinery the owners of consumer goods are in fact transferring their savings to individuals that specialize in making these tools and machinery. Savings sustain these individuals whilst they are busy making these tools and machinery. Once these tools and machinery are built this permits an increase in the production of consumer goods. As the flow of production expands this permits more savings all other things being equal, which in turn permits a further increase in the production of tools and machinery. This in turn makes it possible to lift further the production of consumer goods. So contrary to popular thinking, more savings actually expands and not contracts the production flow of consumer goods.
Can an increase in the demand for consumer goods lead to an increase in the overall output by the multiple of the increase in demand? To be able to accommodate the increase in his demand for goods the baker must have means of payment i.e. bread to pay for goods and services that he desires. Note again that the baker secures five tomatoes by paying for them with a loaf of bread. Likewise, the shoemaker supports his demand for ten tomatoes with a pair of shoes. The tomato farmer supports his demand for bread and shoes with his saved fifteen tomatoes. The baker’s increase in the production of bread permits him to increase demand for other goods. In this sense, the increase in the production of goods gives rise to demand for goods. People are engaged in production in order to be able to exercise demand for goods to maintain their life and wellbeing.
Note that what enables the expansion in the supply of final consumer goods is the increase in capital goods or tools and machinery. Savings in turn enables the increase in tools and machinery. We can thus infer that the increase in consumption must be in line with the increase in production. From this, we can also deduce that consumption does not cause the production to increase by a multiple of the increase in consumption. The increase in production is in accordance with what the pool of savings permits and is not constrained by consumers’ demand as such. Production cannot expand without the support from the pool of savings i.e. something cannot emerge out of nothing.
Let us examine the effect of an increase in the government's demand on an economy's overall output. In an economy, which is comprised of a baker, a shoemaker and a tomato grower, another individual enters the scene. This individual is an enforcer who is exercising his demand for goods by means of force. Can such demand give rise to more output as the popular thinking has it? On the contrary, it will impoverish the producers. The baker, the shoemaker, and the farmer will be forced to part with their product in an exchange for nothing and this in turn will weaken the flow of production of final consumer goods. Not only does the increase in government outlays not raise overall output by a positive multiple, but on the contrary this leads to the weakening in the process of wealth generation in general. According to Mises,
[T]here 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 curtails the citizens' spending and investment to the full extent of its quantity.
Murray Rothbard in his Man, Economy, and State discussed the absurdity of the Keynesian multiplier.
The theory of the “investment multiplier” runs somewhat as follows:
Social Income = Consumption + Investment
Consumption is a stable function of income, as revealed by statistical correlation, etc. Let us say, for the sake of simplicity, that
Consumption will always be .80 (Income).
In that case, Income = .80 (Income) + Investment.
.20 (Income) = Investment;
or Income = 5 (Investment).
The “5” is the “investment multiplier.” It is then obvious that all we need to increase social money income by a desired amount is to increase investment by 1/5 of that amount; and the multiplier magic will do the rest….
The following is offered as a far more potent “multiplier,” on Keynesian grounds even more potent and effective than the investment multiplier, and on Keynesian grounds there can be no objection to it. It is a reductio ad absurdum, but it is not simply a parody, for it is in keeping with the Keynesian method.
Social Income = Income of (insert name of any person, say the reader) + Income of everyone else. Let us use symbols:
Social income = Y
Income of the Reader = R
Income of everyone else = V
Let us say the equation arrived at is: V = .99999 Y
Then, Y = .99999 Y + R
.00001 Y = R
Y = 100,000 R
This is the reader’s own personal multiplier, a far more powerful one than the investment multiplier. To increase social income and thereby cure depression and unemployment, it is only necessary for the government to print a certain number of dollars and give them to the reader of these lines. The reader’s spending will prime the pump of a 100,000-fold increase in the national income.
Does the introduction of money make the multiplier possible?
The introduction of money does not alter our conclusions. Money only helps to facilitate trade among producers— it does not generate any real stuff. Paraphrasing Jean Baptiste Say Mises wrote that,
Commodities, says Say, are ultimately paid for not by money, but by other commodities. Money is merely the commonly used medium of exchange; it plays only an intermediary role. What the seller wants ultimately to receive in exchange for the commodities sold is other commodities.
When an individual increases his spending by $100 all it means is that he has lowered his demand for money by $100. The seller of goods has now acquired $100, which he can employ when deemed necessary. We can also say that the seller's demand for money has increased by $100. Likewise, if the seller will now spend 90 percent of $100 all that we will have here is a situation wherein his demand for money has fallen by $90 whilst somebody else's demand for money has now risen by $90. In addition, all other things being equal, if individuals have increased their expenditure on some goods then they will be forced to spend less on other goods. This means that the overall spending in an economy remains unchanged. Only if the amount of money in the economy increases, all other things being equal, spending in money terms will follow suit. However, also in this case the increase is not because of some multiplier but because of the increase in money supply. The increase in monetary expenditure because of an increase in money supply cannot however produce the expansion in real output as the popular story has it.
All that it will generate is a reshuffling of the existent pool of savings. It will enrich the early receivers of the new money at the expense of last receivers or no receivers at all. Obviously then, a loose monetary policy which is aimed at boosting consumers' demand cannot boost real output by a multiple of the initial increase in consumer demand. Not only will loose money policy not lift production, but on the contrary it will impoverish wealth generators in exactly the same way as the enforcer in our previous example.
Summary and Conclusion
John Maynard Keynes's writings remain as influential today as they were eighty-five years ago. His ideas remain the driving force of economic policy makers at the Fed and Government institutions. These ideas permeate the thinking and writings of the most influential economists on Wall Street and in academia. The heart of the Keynesian philosophy is that what drives the economy is demand for goods. Economic recessions are predominantly the result of insufficient demand. In the Keynesian framework, an increase in demand not only lifts overall output but that output increases by a multiple of the initial increase in demand. Within this framework, something can be created out of nothing.