The Keynesian Multiplier Is an Illusion
For most economists and financial commentators the heart of economic growth is the increase in the demand for goods and services. It is held that increases or decreases in demand are behind rises and declines in the economy’s production of 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 or businesses.
An example will illustrate how an initial spending raises the overall output by the multiple of this spending. 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% 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% of the $90 million, i.e., $81 million. Then the recipients of the $81 million spend 90% 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% 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 is being spent from additional income the greater the multiplier is and therefore the impact of the initial spending on overall output is larger. For instance, if people change their habits and spend 95% from each dollar the multiplier will become 20. Conversely, if they decide to spend only 80% and save 20% then the multiplier will be 5. All this means that the less is being saved the larger is the impact of an increase in overall demand on overall output.
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.
The popularizer of the magical power of the multiplier, 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.1
Is the multiplier a real thing?
Is more 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’s left at his disposal is fifteen saved tomatoes (real 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 real 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 real savings i.e. tomatoes at his disposal, all other things being equal.
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 well-being 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 real savings to individuals that specialise in making these tools and machinery. In short, real 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 the 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 the means of paymen, i.e., bread to pay for goods and services that he desires. We have seen 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.
Once the supply of final goods increases this permits an increase in demand for goods. 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.
We have seen that what enables the expansion in the supply of final consumer goods is the increase in capital goods or tools and machinery — what in turn permits the increase in tools and machinery is real savings. 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 the multiple of the increase in consumption. The increase in production is in accordance with what a given infrastructure permits and is not constrained by consumers’ demand as such.
Increase in government demand and economic growth
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. As one can see, 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,
…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 curtails the citizens' spending and investment to the full extent of its quantity.2
Summary and conclusion
John Maynard Keynes's writings remain as influential today as they were eighty years ago. His ideas remain the driving force of economic policymakers 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.
In the real world, an artificial boost in demand that is not supported by production leads to the dilution of the pool of real savings and, contrary to the Keynesian view, to a shrinking in the flow of real wealth, i.e., results in economic impoverishment.