Friday, 13 June 2014

Economic Myths: The Fiscal Multiplier

From City AM Forum:

In early 2013, Blanchard and his colleague Daniel Leigh published an IMF working paper on the size of the fiscal multiplier. The multiplier, a theoretical concept invented by John Maynard Keynes in the 1930s, is the most fundamental concept in the whole of macroeconomics.

It measures the eventual impact on the economy as a whole, GDP, of a sustained increase or decrease in public spending. An increase in such expenditure brings more people into work, they in turn will have more to spend, the companies whose products they buy will have more revenue, and will employ even more people. The initial impact is multiplied through the economy.

Sounds simple. But there are many potentially offsetting factors to take into account. Some extra spending will be on imports, for example, which does not boost domestic output at all. The bigger public deficit which the extra spending creates may lead to higher interest rates.

Economists have struggled for decades to arrive at a consensus on how big the multiplier really is. While still being far from agreement, there is a general view that it is low. Indeed, a fiscal expansion, once all the other feedbacks are taken into account, may even lead to GDP rising by less than the size of the stimulus.

In contrast, Blanchard and Leigh argued that, in the current circumstances, it is large and positive. So a fiscal contraction, the basis of the chancellor’s policies, will lead to the opposite, to a sharp reduction in GDP. Events have shown this to be wrong.


They are truly mental.

This is just political bullshit. The lefties always say that the fiscal multiplier is greater than unity (which can't possibly be true in all cases) and the right wingers always say that the fiscal multiplier is less than unity (which can't possibly be true in all cases either).

Allow me to explain...

There are lots of ways a government can finance spending - by increasing any one of dozens of taxes or by running a deficit, which could be financed long term, short term, by 'printing money' etc.

There are also nigh infinite ways a government can spend money [long, long list] and one of the ways in which it can 'spend' money is by just giving people money back, whether as subsidies, tax cuts or higher welfare payments - and the categories all overlap. For example, are Working Tax Credits a subsidy to low paying employers; a tax cut for low paid workers; or a welfare payment?

So there are in turn more or less infinite comparisons you can make by choosing one source of finance and matching it with one type of spending. Some of these combinations will be hugely positive and some will be hugely negative.

For example: increasing taxes on output employment and spending it on Working Tax Credits is nigh self-defeating and a huge negative. Conversely, increasing taxes on land values and spending it by cutting taxes on output and employment is a large positive.

And raising a modest amount in any taxes, i.e. up to 5% or 10% of GDP (however damaging the taxes might be in isolation) and spending it on the core functions of the state: law and order, defence, roads, public health and immigration control is always a massive, huge great positive (notwithstanding that the gains might not be shared equally or even fairly).

It would be impossible to chuck all these infinite possible combinations into a pot and average them out to anything within a margin of error of thousands of per cent.

So it makes much more sense to imagine a Laffer Curve for the spending side. The government just pays for the core functions first (massive, huge net gain), then spends on stuff with smaller and smaller net gains until it reaches the top of the spending curve where the 'multiplier' is unity, and then it stops.

Similarly, there is a Laffer Curve for different types of taxes, there are good taxes and bad taxes. Once a government has collected as much as it can from good taxes it stops. There is no point imposing bad taxes.

With a bit of luck and a tail wind, total revenues at the top of this curve will be exactly enough to finance the spending at the top of the spending curve. Remember that both curves are pretty flat at the top, it is not going to be too difficult to find a level at which they intersect.
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UPDATE: As PaulC points out in the comments, the whole premise of the current political debate in the UK is wrong. If we take government's word for it that the economy is growing, then the Labour/high spending protagonists have won the argument hands down!

Remeber that despite the Indian Bicycle Marketing narrative, the Lib-Cons did not and have not implemented any sort of 'austerity' programme (except for people they don't like, like unemployed people under 25 etc). Spending was going up even under Plan A and is shooting up under Plan B. Quite what they are spending it on is an absolute mystery to me, probably a load of crap like corporate subsidies.

Which either means that the lefties are right and I am wrong, or possibly that the government is lying and the so-called recovery is built on sand.

26 comments:

paulc156 said...

When he says "events have shown this to be wrong" he doesn't explain where or when. Since he's talking about the UK he's presumably talking about the 'austerity' and the resultant 'growth' of the economy.
Problem is, it appears that the 'austerity'[plan A-2010/11 and 2011/12] such as it was was relaxed quite markedly [plan B] in 2012/13, after which we started to see increased growth. So, 'if anything' the opposite of what he claims seems more accurate. That under the circumstances in 2012/13 of spare capacity, near zero interest rates and low levels of private investment that 'some fiscal easing' would have the desired effect of boosting GDP.

Kj said...

Yet, "Macroeconomics" are taught With the fiscal multiplier as a given, With the only country-specific variable AFAIR being the savings rate, even if country A can raise 10% of GDP from VAT, zero from land, and vice versa in country B. It's dismal indeed...

DBC Reed said...

The fiscal multiplier will only work surely with LVT back-up.Otherwise all the stimulus money will put up land prices ,increase rents ,decrease demand among the punters and, under the usual bozo regime, actually contract the economy.
Much as I admire Keynes,he had no idea about Land Values, although his idol Silvio Gesell was a land nationaliser.

Bayard said...

"what they are spending it on is an absolute mystery to me"

Well, practically every time I listen to Radio 4, there is someone whining either for compensation or a place at the public udder, and many a mickle makes a muckle.

Mark Wadsworth said...

DBC, firstly there is no single, identifiable "fiscal multiplier", that's the whole point, and secondly, everything works better with LVT.

B, at least under New Labour you had a vague idea of what they were spending/wasting it on, under the Lib-Cons it is a mystery.

Lola said...

There is no 'recovery'. It's just GDP bullshit. GDP being capable of being manipulated.

DBC Reed said...

Most definitions talk about the fiscal multiplier in the singular e.g. "The ratio in which the change in a nation's income level is affected by government spending ".Since government spending is an aggregate, I cannot see the point of disaggregating it.
Agreed LVT helps cure most known ills but it is a specific
for problems with Keynesian stimulus so if you want such stimuli to work you have to have LVT back-up.Of course if you are a pre Joe Chamberlain-ite laissez faire revivalist you may feel the economy is a self-righting mechanism (provided the government arranges for huge sums of newly created money to be poured in the top) but then you would be entirely wrong .

Mark Wadsworth said...

DBC, "Since government spending is an aggregate, I cannot see the point of disaggregating it."

Ok, forget clever economics, what is wrong with the good old fashioned notion of "value for money"?

Police and roads pay for themselves many times over.

Straight cash redistribution via welfare is a positive up to a certain level and negative above that;

Some things are just negative (long list includes PFI, war in Iraq, political correctness, quangos, overseas aid etc).

Ralph Musgrave said...

If there is no multiplier at all, it matters not one iota. E.g. if in printing and spending £X, GDP rises by £X, what’s the problem? Assuming the economy has spare capacity, that money printing will not be inflationary.

Mark Wadsworth said...

RM, who says?

If the government "prints" £30 billion and "spends" it on aid payments and EU contributions, by how much does GDP rise?

Ralph Musgrave said...

Mark, EU contributions come back to the UK in the form of grants for rich farmers and other “worthy” causes which we could perfectly well have supported ourselves without bothering with EU bureaucrats. Likewise, aid payments have lots of strings attached: specifically that the money is spent on stuff made in the UK.

So the above two items DO BOOST British GDP. As to how much they boost GDP by, I was just taking the worst possible scenario from the “multiplier” point of view, namely that the multiplier is zero, and showing that that zero multiplier really doesn’t matter. I.e. if the multiplier is precisely and exactly zero, then printing and spending £30bn raises GDP by £30bn. Indeed if printing and spending £30bn raised GDP by only £15bn, there still isn't a problem. Printing money costs nothing in real terms.

Mark Wadsworth said...

RM, so you've no truck with old fashioned concepts like "value for money"?

(And no, subsidies for landowners do not boost GDP, they reduce it. If you pay people to do nothing, they will do nothing instead of doing something).

So if you were in charge, how would you set the upper limit for government spending, and how high would the deficit be after five years of Ralphonomics?

DBC Reed said...

You can only inject newly created money into the economy up to the point where you utilise all the spare capacity.Which Hitler thought meant getting the unemployment figures right down.When all the capital equipment is running flat out churning out goods and distributing wages ( some kind of unearned income for all might be needed to equalise demand with supply totally)then you reach a point where inflation might set in.
All this talk of deficits is the big bogeyman of Political Economy.
The financial system and the banks do have loads of money they lend to cash strapped governments: they make it up which governments could do for themselves .Professor Victoria Chick "Banks do not lend money.They do not have pots of money which they are passing on."

DBC Reed said...

NB Should be "banks do not have loads of money"above.My apologies

neil craig said...

I think it probable that some industries have a multiplier because they increase the efficiency of other industries (road building would be an example, X-Prizes another) while some have no effect (Bingo Halls) and some even a negative effect (importers).

So if government taxes importers and bingo and puts the money into roadbuilding and X-prizes it should & I think would have a net beneficial effect.

Assuming we don't count governments admin costs and assuming they build roads at competitive rates (they don't they average 8 times more than the rest of the world) and assuming the X-prizes are set sensibly (they aren't - government puts it all in to grants instead which are provably 33-100 less effective).

Mark Wadsworth said...

DBC, broadly agreed. But in a simplistic way, the point of collecting taxes is to prevent inflation and cancel out money printing. And the other justification is to redistribute income. But we know taxing economic activity is bad.

Therefore whichever the best thing to tax is something which is not 'economic activity' i.e. land ownership. Sorted.

NC, I did specifically mention roads (and railways) as something which usually pay for themselves.

But once you've built 'enough' roads, then you stop building them as the return is negative (famously, the Humber Bridge).

DBC Reed said...

Too much double-entry book keeping in all this.
The Government's task is to make sure there is enough money in the hands of the punters to buy all the goods and services. So demand=supply
The problem comes when money ends up in the hands of people who don't work very much and are deemed undeserving. This becomes acute with something-for-nothing schemes like Douglas's Social Credit ( work out/guess how much spare capacity there is and dish out enough spending power to match increased supply) and Citizen's Income schemes.
Strangely enough Homeownerists love something-for-nothing schemes when they consist of handing out huge capital gains to homeowners which they can use as income. Hoemownerism is basically Douglas Social Credit but for old homeowners.Ridiculous.

Tugwit said...

It's easy to prove that the fiscal "multiplier" is mathematical nonsense.

Keynes' original equation:

ΔY = ΔC + ΔI
ΔY = bΔY + (1-b)ΔY

Keynes called his investment "multiplier" k, and said:
k = ΔY/ΔI = ΔY/(1-b)ΔY = 1/(1-b)

b = marginal propensity to consume

Here's baseline income with some numbers:

Y = C + I
100 = 90 + 10

Add $1 of investment.
Both sides must give the same result:

Y +1 = C + I +1
100 +1 = 90 + 10 +1
101 = 101

So:
ΔY = ΔI = 1
k = ΔY/ΔI = ΔY/(1-b)ΔY = 1/(1-b) = 1/1 = 1
The "multiplier" is 1
and b MUST = 0
Investment has zero propensity to consume.

Actually b has simultaneously 3 different values.

Keynes' mistake was to use math.
You can prove stuff with math.
You can prove that the fiscal "multiplier" is nonsense.

I've debunked the whole scam at
Tugwit.blogspot.com

Tugwit

Mark Wadsworth said...

T, thanks. And here's the corresponding Downfall spoof.

Tugwit said...

I made that Downfall video to go with my Fiscal Multiplier Debunked cartoon bear videos. But now YouTube threatens me if I make Downfall videos, so I made my own cartoon Hitler. Here's one if you're interested:

Hitler Debunks Fiscal, Tax Cut, and Balanced Budget Multipliers

http://youtu.be/DqwedjQyYuQ

So when talking about the supposed benefits of tax, you have to consider:
1) There are no multipliers.
2) Keynesians have used even more fraudulent math: disguising the "saved" fraction of disposable income: (1-b)Yd, as (a+I+NX+G), to falsely promote tax and government spending.

With taxes, you're dealing with:
-1 +1 = 0
The fraudulent Keynesian math makes it turn out:
-1 +1 = 1

The fiscal "multiplier" uses a series of math frauds, and plausible-sounding bogus cover stories.

What's really interesting, is that Keynesians would rather let economies crash from government waste, debt, and money-printing to pretend to pay the debt, than admit that they've been running a scam.

But word will get around, and there'll eventually be serious ass-kicking.

Mark Wadsworth said...

T, ah, that was you, well done.

But you are also missing the point, government spending can be good, neutral or bad. Taxes can be good, neutral or bad.

So common sense says, raise the good taxes first and spend it on good stuff, and keep going until you are raising neutral taxes and spending it on neutral stuff. Then you stop, that is the upper limit of tax and spend.

Raising bad taxes and spending on bad stuff are both equally bad. Which is what most Western governments do, on both sides.

Tugwit said...

I do get your point.

But there's no reason for the government morons to use common sense and eliminate wasteful spending, when they've got Keynesian economists (using illegal and fraudulent math) to tell them:
1) Government can't overspend.
2) Government spending is better than private sector spending, better than tax cuts.
3) $1 of tax, and $1 of government spending, will get you a free $1 increase in national income.
4) Waste doesn't matter.

In fact, Keynesians say that wasteful spending is the best spending. They give the highest "multiplier" values (1.64 to 1.73), for paying people to do nothing.

And the government morons always tell us about the great things they will do with our $1 (then they do something else with it) and ignore what we would have done with it.

Keynesians have used illegal and fraudulent math to get around Bastiat's "broken window".

There's no "stimulus" from waste and Three Stooges Math.

Mark Wadsworth said...

TW, agreed.

Problem is, the supposed right wingers have hijacked even something as flawed as the leftie Keynesian doctrine (which in turn is a crass misrepresentation of what he actually said).

So they think it's justifiable for the government to subsidise banks and land owners and other monopolists. Which is even worse than paying people to dig holes and then fill them in again.

Tugwit said...

What Keynes actually said, was that he had discovered a new "economic law": the fiscal "multiplier".

It can be used against us by any government morons, regardless of ideology.

But it's based on illegal, fallacious, asinine, and fraudulent math. And because it's math, you can prove that.

So when word gets out, Keynesian economists will have to admit to being one of the following:
1) Frauds.
2) Morons.
3) Lunatics.

There are no other choices.

And I'm going to be LMFAO :D

Mark Wadsworth said...

TW, the Wiki entry says:

"The existence of a multiplier effect was initially proposed by Keynes student Richard Kahn in 1930 and published in 1931"

So I'm not convinced you can pin this particular bit of nonsense on Keynes himself.

Not that it really matters either way.

Tugwit said...

In the multiplier chapter of "The General Theory of Employment, Interest, and Money" (1936), Keynes gives credit to Kahn, whose "multiplier" he said was "a little different".

But it was Keynes:

1)Who claimed to have established the "multiplier" law in economics.

2)Who devised the roundabout way to put addition first in the math order of operations, without appearing to have done so.

So unless Keynes was not responsible for his own actions, then Keynes gets the credit for them.