Sunday, 12 February 2012

The Fiscal Multiplier Effect: Another useless economic theory

Continuing my occasional series, another one which bugs me is the Multiplier Effect aka The Fiscal Multiplier or The Keynesian Multiplier. As the Wiki article says,:

In general, the only thing that can be said with certainty is that "economists are in fact deeply divided about how well, or indeed whether, such stimulus works." [3]

Broadly speaking, the lefties think that there is a general multiplier, that nearly all government spending increases GDP by >£1 for every £1 spent, so the multiplier is positive, and the right-wingers are equally adamant that the net effect of nearly all government spending is negative. As ever, both sides are missing the point, you have to look at each single item of government spending on a case by case basis:

1. A good example of something with a hugely positive multiplier was The National Grid. All the different power stations were supplying electricity with different voltages and frequency to very small areas, so you had to buy different electrical appliances depending on which town you lived in, and there was little or no mains electricity in the countryside. There was no possibility of spreading the load, so if your local power station went down, that was it, they couldn't just crank up generation elsewhere and redirect the electricity.

So, following the example of Germany and others, the UK government just got on with it in the 1930s, built all the pylons to link up power stations and consumers across the whole country (only the government could have forced this through, as they are the only party who could override the landowners and NIMBYs), standardised the voltage and frequency. Hey presto, electrical goods could be standardised, so became cheaper; so sales and profits of electrical goods manufacturers went up; electricity became much cheaper for consumers; so demand went up, so more electricity was generated, so profits of the power stations went up as well; better electricity supplies had a very positive impact on the industrialisation of the UK, so win-win-win all round (unless you're a die hard Greenie or NIMBY).

I think that the government pre-financed this, but then covered its costs by simply charging the power stations for the amount of electricity they sent down the wires, so ultimately, it didn't cost 'the taxpayer' a penny.

2. I'm sure you can all think of lots of examples of things with a negative multiplier, where GDP grows by <£1 for every £1 spent, like foreign aid (some of which is export subsidies), and there are even things were GDP shrinks as a result of government spending/action, for example traffic lights or EU membership.

3. I'm not sure which side of the line transfer payments like taxpayer funded old age pensions are. We could in theory scrap old age pensions and cut taxes by £100 billion or something; there would be a boost to the economy of £10's of billions because the dead weight cost of taxation has been reduced (positive), but assuming that there is no propensity to save among pensioners, i.e. that they spend every penny they receive on goods and services, if they have £100 billion less to spend, the total output of goods and services would also fall by £100 billion (negative).

Further, we don't know how pensioners and their children would respond. Some pensioners might go back to work or realise assets (positive), less callous children would give some of their extra income to their parents to tide them over (neutral) or try and earn more to be able to do so (positive), and resources would be freed up from keeping pensioners alive to producing other stuff (positive).

Because there would be so many positive and negative effects of scrapping old age pensions, all of which are very difficult to quantify, it's therefore difficult to say whether spending on old age pensions is negative or positive overall. Morality aside, I suspect it is slightly positive, so on balance we ought to keep going.

4. And so on and so forth, you just can't generalise, not even within narrow categories, like "education". For example, does the economic benefit of teaching children the Three R's up to age 12 outweigh the costs? Definitely. What about educating them up to age 15 or 16? Almost certainly. Do we know what educational standards would be in the absence of universal taxpayer funded provision (such as vouchers), or what the resulting impact on the economy would be? Nope - as harsh as it sounds, it might be sufficient for the parents of a quarter of children to pay for them to be educated to A-level or University standard and for the unlucky three-quarters to leave school at the age of 12 and become drones. There again it might not, it might be an absolute disaster, and that's before we consider the breakdown in social cohesion, we just don't know.

5. Here endeth.


Anonymous said...

Yes, it all depends what is done with the money. Paying cronies at inflated rate most probably delivers negative multiple. Some universities project probably delivery positive multiple and on a whole, I am not sure if government spending results in +ve multiple due to the nature of carelessness when one spends other people money.

I wonder though - if there wasn't a national grid, would UK have a Standard Oil sort of company who would have bought up all these small stations and created Standard Electric PLC.

Richard Allan said...

You seem to be making the confusion between Real GDP and Nominal GDP. The Keynesian Multiplier only refers to Nominal GDP. To be fair, I didn't figure this out until years after I'd completed my Economics degree, when I started reading Scott Sumner's blog. The Keynesian wants to boost nominal GDP because of either sticky wages/prices or because of "debt deflation". The effect on real GDP/employment is therefore only indirect.

Also in a modern monetary economy the distinction between monetary and fiscal policy is obscured.

Mark Wadsworth said...

Anon, The National Grid would never have spontaneously come into existence. Even if all the power stations had agreed to finance it, they would still have needed to be able to override the landowners and NIMBYs. See also Britain's canals, Victorian railways or modern motorways.

Whether these things are publicly or privately financed is a secondary issue, the point is that the whole concept of private landownership overrides the 'invisible hand'. Sometimes we need a very visible central power to allow the 'invisible hand' to do its work!

RA, let's ignore subtle distinctions like that, that's getting into left-right politics. Whichever measure you use, there is clearly some stuff which is positive and some which is negative.

Ian R Thorpe said...

I always though talk of GDP was eyewash, it only measures the churn in the economy. So theoretically government could tax us at 100% of earnimgs, give us 50%back and boost GDP hugely.

But the economy would not have grown at all.

Mark Wadsworth said...

IRT, a lot of the constituent bits of the official GDP may be wild estimates, but by and large it does mean something.

"theoretically government could tax us at 100% of earnimgs, give us 50% back and boost GDP hugely."

Well no, because at a 100% income tax rate, GDP would be nil. You can rework the example with a 60% tax rate and everything being dished out as a Citizen's income and you'll find that the dead weight costs of the tax (a quarter of potential GDP?) outweigh any boost from the Citizen's income.

There may some least-bad position, like with old age pensions, where the income tax is an acceptable burden, but you're assuming that income tax is the least bad tax, which it clearly isn't.

chefdave said...

Nice one, some more suggestions:

Paradox thrift
Labour theory of value
Keynesian demand manipulation
The fallacy of the export driven recovery
Austrian savings theory
Any arguments in favour of subsidies and/or tariffs and barriers
Anything to do with job creation, as if the act of work is mnore important and unrelated to the consumption of said work.

The list of idiotic economic theories is endless, you've tapped into a rich vein here.

Mark Wadsworth said...

CD, that's a good list of crap, thanks.

Although I think that there is something in the 'paradox of thrift' and I'm not sure if there is such a thing as 'Austrian savings theory', can you provide a link? Suffice to say, most concepts starting with the word 'Austrian' are crap, but you never know, nobody is wrong all the time about everything.

Anonymous said...


Sometimes short term subsidies /barriers work - look at the Japanese and Korean. Without these state support, there would be no Samsung, Daewoo, NEC. Long term subsidies (like the EU Agriculture policy), obviously lead to corruption.

Export driven recovery is pretty valid though provided your trade partners let you pursue the mercantilist policies.


Lola said...

@Anon - Japan, Korean, Germany and the US, that's mercantilism - different thing.

The Nationalised Grid may or may not have come into existence from the power of the 'invisible hand', but the trouble is Big Government - generally but not always lefties - use 'successes' like this to justify nationalising everything else.

Nationalising as in creating vertically integrated services where everything is top down managed and funded, then grow to exhibit the classic failures of central planning - massive waste, endemic producer capture, exploited workers, overcharged customers etc.

Reverting to the Nationalised Grid for the nonce if you read the wikipedia entry (of course, always reliable) there is some hint that private concerns and existing local grids were as up for the creation of the national (as opposed to nationalised) grid as anyone else. They could see the advantages. All this happened in the 1920's to 1930's when nationalisation was not on the agenda in the same way as it was post war. So the point I am trying, badly, to make is that full nationalisation is not necessary to create somehting of national advantage. Of course I do agree that it needs a 'state' to deal successfully with myriads of landowners, but as can be seen from the various 19th century railway acts, it can be done for private businesses creating infrastructure.

Overall, I like to challenge very hard, every single state proposal to spend my money on something they think is A Good Thing, 'cos mostly they aren't. HS2 for example.

chefdave said...

lol, thanks. There's another theory about "excess capital" knocking around that needs a good drubbing too. These guys would like to destroy factories so that output is restricted, profits increase and then we'd all be incentivised to..erm.. merrily rebuild those factories again. Genius! Add Ludditism to the wankfest too.

Austrian savings theory is based on the notion that we need a pool of savings from which to draw in order to lend. When the potential pool is small excess demand drives interest rates up which in turn increases the incentive to save and reduces the propensity to borrow, IRs act as the arbiter between saver and borrower. In other word they've got the relationship between saver and borrower the wrong ay around, in our money system savers depend on borrowers to give them something to save, not vice versa.

I dislike paradox thrift (brought to you from the guy that popularised the 'digging holes' theory of economic management) because it assumes that savings are detrimental to economy growth: if we're saving we're not consuming and therefore output drops which pardoxically hinders out ability to save. The Keynesian economy prefers a nation of shopaholics all living on the edge! I disagree for two reasons:

1) If we're saving we're still producing and therefore economic activity would actually be enhanced, if we've all saved 50 tonnes of wood and barn full of tinned meat it's a sign of a lot of previous productivity
2) If you save and withdraw from the economy your inactivity has no bearing on the remaining participants, it's as if you're not even there. So their ability to save remains unaltered.

Mark Wadsworth said...

EBM, yes sometimes they do, the problem is identifying that one example out of twenty; knowing when to turn off the taps etc.

L, the government did not 'nationalise' The National Grid, they built it from scratch, in the same way as our motorways were not nationalised, the government built them from scratch. That's quite different to e.g. coal mines.

"I do agree that it needs a 'state' to deal successfully with myriads of landowners, but as can be seen from the various 19th century railway acts, it can be done for private businesses creating infrastructure."

As I said above at 18.36:

"Whether these things are publicly or privately financed is a secondary issue, the point is that the whole concept of private landownership overrides the 'invisible hand'. Sometimes we need a very visible central power to allow the 'invisible hand' to do its work!"

The Victorian railways would not have come into existence without the relevant Acts of Parliament overruling the landowners and NIMBYs.
The Channel Tunnel is a recent good example, that was entirely privately funded, but still needed the government to push the project through.

Lola said...

Oh, and something else. I am a big fan of edukayshun. No-one should be prevented from going as far as they want for lack of wealth.

From memory (I did some work on the history of UK education years ago) prior to the 1944 education action there is good evidence that schooling was improving and that many working people could afford the then relatively small cost of sending their children to school to achieve proficiency in the three R's. Teachers weren't necessarily well paid. But there again neither were doctors. Furthermore as you travel around you will see various buidling erected as working men's educational establishments / libraries and also big employers paid for their people to be trained.

Thing is it's the 'nationalisation' thing again. What it seems to have achieved in education is some of the thing I cautioned about above re the nationalised grid. Endemic producer capture, exploitation of employees, short changing of customers...

Mark Wadsworth said...

CD, I see what you mean.

If I understand correctly, the 'Austrian savings theory' and the 'paradox of thrift' entirely cancel each other other out. In other words, both can't be true at the same time therefore neither is.

Mark Wadsworth said...

L: " there is good evidence that schooling was improving [pre 1944] and that many working people could afford the then relatively small cost of sending their children to school to achieve proficiency in the three R's. "

Oh yes of course, the post WW2 state education and NHS were not huge step changes, they hardly made much difference on Day One. The problem is measuring the value of incremental improvements against incremental extra costs.

Suffice to say, we'd be better off with education or health vouchers like in so many civilised countries, to get 'the state' as provider out of the picture - but that doesn't get us round the questions of what is the optimum value of education vouchers in £-s-d, and up to what age should a child get them?

Lola said...

MW re National Grid. Forgive me, I know that the state got the national grid going from scratch.

What seems to have happened though was that the voltage and cycle standards set by the State (and I think agreed with the major local grids) were then adopted by many local grids which were all then nationalised in 1947(?).

The point I was making was that the consensus among the existing producers and the state, was for the creation of a 'national grid'. Latterly all the local grids were nationalised. This is not the same thing as creating a 'nationalised grid'. I admit the differences are nuanced, but they are important. And yes, of course, you need the state to umpire between landowners and infrastructure developers and when necessary apply compulsion. But nationalised infrastructure need not be created from scratch by the state, not the least because the state means politicians which means cronyism which means HS2, which is where we came in.

On this latter point of compulsion, and you know that I am anti-h-o-ism, is that in latter times the state has deployed these powers in ways that leave whole collections of local 'landowners' feeling powerless. Often adjusting criteria for cronyistic reasons. The trick is therefore to be 'reasonable' in these compulsions, not something that the quango state can be arsed with.

Lola said...

MW @ 21:45 - or one's wrong and one's right?

They're probably both 'right'. It's the way round that they are argued for and against, especially in absolute terms and the policies thence made that are 'wrong'. In other words left to itself the 'market' would work this out.

Personally I favour the Austian savings argument, not in the least because the 'paradox of thrift' is used by cronyistic politicians as an excuse for taxing and spending, which never really works out entirely for the best. In other words I like to use it as a discipline on politicians, cnetral banks, Treasuries, quangos, the EU, Barak O'Bama etc etc.

chefdave said...

M, yes I suppose so. Never thought about it like that.

Austrian savings theory = savings are an essential prerequisite for capital formation

Paradix thrift = savings reduce consumption and undermine our productive capacity. If we're saving we're not consuming.

I pinched the Austrian savings theory from Peter Schiff's picture book: how an economy grows and why it crashes. An enjoyable read even if skips over the Georgist fundamentals.

Lola said...

MW, Yeah, what top age do we pay edikayshun vouchers to? Personally, I reckon at least 60 (guess what my last birthay age was). Seriously anyone with any sense, and that's most of us - mankind being curious - keep studying one way or another all of our lives. Perhaps there needs to be an overall 'account' that funds health, education and retirement from which you can draw as you think fit over your lifetime. You culd argue that spending loads on education early on would pay for itself in higher earnings later (which is what I think you said you did). At the same time this approach might encourage you to take out commercial health insurance at a oyung age which would bring the costs to all of us crashing down especially as it would be combined with de-nationalisation of the health system.

Just a thought.

Lola said...

o/t. Your new header strap line. It's 42.

Mark Wadsworth said...

CD, ta.

L, re National Grid, education, HS2, you're getting off the main topic, which is that there is no general multiplier. The govt does things (spends money, passes laws) and sometimes this helps the economy and sometimes it harms it.

On your substantive point, HS2 is probably a waste of money, I have taken the train from London to Birmingham and back, it's a good a regular service, gets there quite quickly, it's not even overly expensive. This scarcely needs improving. I only support HS2 because it pisses off NIMBYs.

On the other hand, most roads, most local transport is a great investment, even if the government pays it.

Dinero said...

GDP includes government spending so exactly how to quantify the stimulus effect of government spending on GDP seems a bit tricky. Any way on a qualative note,how can gvmt paying a an extra lot of dosh to its beurocrats be treated as a positive thing in the sense "GDP is up hooray".

Mark Wadsworth said...

Din: "how can gvmt paying a an extra lot of dosh to its beurocrats be treated as a positive thing in the sense "GDP is up hooray"?"

That has always puzzled me. I think what they do is simply assume that if they spend £50,000 on a bureaucrat, that he adds £50,000 of value, which is a bit of a cheek.

This is probably one of the myriad examples of govt spending with a very negative multiplier, but that wasn't the point of the post.

Old BE said...

Great post.

The point surely is that if there was a clear answer on any of these things we wouldn't need the discussion. The German government noticed the importance of the railways immediately and nationalised the fledgeling companies and then the state built the entire national network. Contrast Britain where the state just enabled private firms to build some of what they wanted. Who has the more efficient system in 2012?

Britain and Japan make for a good comparison. Eastern and Western Japan have incompatible mains grid voltages! Tokyo's tube system is run by three different companies.

It's arguable that the state is best placed to build infrastructure because it can negotiate with NIMBYs but also because it has the best access to capital. Perhaps if the economy was *more* corporate (see Japan, Korea et al.) the state wouldn't need to be so important because the big companies would be able to fund a new tube line, or whatever.

Old BE said...

Returning to the original point, central government is quite adept at estimating the "multiplier" of major projects. For example, roads projects are only approved if the multiplier is greater than X. (HS2's most flattering guesstimated multiplier is X/2...).

With things like education and health it's a lot more complicated, obviously. It's said that the NHS provides a reasonable level of service much cheaper than different systems in other wealthy countries. But does that mean we have more to spend on other stuff or would the economy be boosted if more of our hard-earned stayed in the UK employing matrons rather than buying imported TVs?

Fraggle said...

The reason the Paradox of Thrift exists is because:

a) people think money is a store of value, and so monetary policy is often discussed with this objective.
b) debts are denoted nominally. Regardless of price levels, debt remains the same.

CD's saving would after a time cause a reduction in prices (as there's less money available, prices must go down somewhere). If debt wasn't an issue, then price drops wouldn't be an issue; things would just work themselves out. The problem is that debt contracts were entered into based on price levels being what they were. Lower general prices means reduced ability to service *nominal* debts. Either:

i) the contracts are renegotiated (but lenders never like admitting that their debt assets aren't worth their face value)
ii) someone takes out more debt to temporarily boost money supply (kick another can)

History seems to me to say we choose ii) until forced to do i).

LVT helps here by reducing long-term private debt, but that shifts the problem onto ground rent pricing levels. Ground rent becomes the new debt.

Mark Wadsworth said...

BE, ta.

"central government is quite adept at estimating the "multiplier" of major projects. For example, roads projects are only approved if the multiplier is greater than X."

For a land value taxer, doing these break even calculations is much easier of course, and all projects which meet the hurdle would be approved and would be self-funding from Day One.

UK's roads were a fantastic investment and highly profitable because the govt only spends £10 billion a year building/maintaining them but collects £40 billion a year in duty+VAT on petrol, which is like "rent for roads" or a "road user charge". And that's even ignoring the boost to GDP, our economy would simply not exist without roads.

F, I'm going to have to think about this. Other myths which we can chuck into the same pot is that "the government should incentivise people to save" and the whole concept of "the savings ratio" in the first place.

neil craig said...

If there is a multiplier effect then, by definition, if government spending is paid for by the taxpayer there must be a similar multiplier effect downwards on money taken in taxes. In the long term paying for it by printing money is even more damaging & anyway unsustainable.

In practice, since it is generally agreed that people spending other people's money, mostly on yet other other people (ie government) do so far less efficiently than those spending their own money on themselves (ie us) the multiplier effect downward of raising taxes must be many times greater than any upward effect through spending.

If government spending were really to stimulate growth they would instead put the money into cutting taxes. I doubt if any of the government employees advocating more spending are honestly unaware of this.

Mark Wadsworth said...

NC, you appear to be taking the "right wing" view that all govt spending is bad for the economy and that tax cuts are always better. It's more nuanced than that.

I think you miss the point. If the govt decided to save £20 billion a year by turning off foreign aid and EU payments, then clearly we'd be £20 billion ahead of the game, yippee, count me in!

Conversely, if the govt decided to save £20 billion a year by shutting down most of the police force and no longer paying for road building/maintenance, we'd be in a right old mess.

neil craig said...

OPf course i make an exception for muy own hobby horse X-prizes.

I believe this can be justified even more easily than things like the grid since it only costs anything if the prize is won, in which case it has succeeded. It can also be justified by the market failure of patents to enable inventors to fully protect their inventions. Of course payment to anybody capable of achieving results, even if they have no friends in government, rather than the conventional funding of grants to the usual suspects is anathema to government parasites.

Mark Wadsworth said...

NC: "X-prizes... only costs anything if the prize is won, in which case it has succeeded"

That's not true.

Imagine the government decided to offer an X-prize of £100 million for the first person to invent a remote controlled electric razor. Half the R&D people in the coutnry would drop their more important things and waste a year perfecting it.

That's wasted a huge amount of R&D expertise and what do we end up with? Some gimmicky tat with no particular market value.

neil craig said...

No Mark. I was saying that the overall effect is that government spending is less efficient than private spending. I do not say that it is always thus - your examples of police and national grid & mine of X-prizes being counter examples. However the normal curve of state spending is well into the inefficient zone and indeed there are many examples of instances where state spending has heavily negative effects on the economy which more than balance the good bits - eg H&S, nuclear regulations, housing "planning" restrictions.

Mark Wadsworth said...

NC: "the normal curve of state spending is well into the inefficient zone"

Oh yes agreed, nobody's disputing that.

"H&S, nuclear regulations, housing "planning" restrictions."

That's not spending as such, that's regulation, all of which is hugely damaging in net terms.

H&S is actually good stuff up to a certain point, but I think we are way beyond it (the pub smoking ban being one extreme example).

Dinero said...

Keynsian economics tries to keep everyone in a constant state of activity. There is no objective reason to say why that is a good thing.

neil craig said...

But all these regulators require paying (offices, cars, pensions, bosses, support staff etc) Mark, so that is spending - I believe about £100k per civil servant. Once they have been paid they have to go out and find something to regulate just to show (even to themselves) they are earning it.

My understanding is that the rule of thumb is that the regulated are cost 20 times more than the cost the state pays for such regulators. Thus 200,000 elfin regulators destroy the product of 4 million workers.

Adam Collyer said...

Generally I agree with your original post, MW. The rest of the picture of course is that whether the government spending is financed by taxes, borrowing or printing, the money is removed from other uses in the economy.

Keynes seems to have had this idea that there were pots of money just sitting around not being used, and by bringing them into use you could somehow magically produce growth. It really is such utter nonsense. Keynes ought to be seen for the charlatan and quack that he was.