Wednesday, June 30, 2010

John Maynard Keynes' Multiplier Effect

Those who follow the Keynesian economic theory firmly believe in the "multiplier effect" as was originally espoused by Mr. Keynes. The multiplier effect is a demand-side economic theory that assumes that, for every dollar that is spent by any government, the economy will actually be stimulated by 1.5 times that amount as that dollar of spending ripples through the system. Simply said, a dollar spent returns $1.50 in economic activity.

But, for me, and many in the economic community, Keynes ignores the supply-side effect in promoting this demand-side economic philosophy. That's because government spending, through higher deficits, additional taxes, and inflation that is ultimately caused by the printing of more and more money, will have a more negative effect, in the long run, because too much disposable income (supply) is being removed from the economy in that government's quest to spend the country back into economic health.

Additionally, there is an immediate "carrying cost" associated with all government spending. By this, I mean, that, for every dollar spent by any government, more than one dollar had to have been collected in taxes and/or penalties. That's because any dollar of government spending is only a dollar after all the administrative costs and interest on that money has been paid. In our country, that carrying cost can be as much as 30% as any dollar of collected taxes tries to make its way through our massive bureaucracy for final distribution. Further, that distribution, especially in the case of the Stimulus Package, is typically to State governments who, in turn, deplete the value of that dollar with their own handling costs before any final distribution to the private sector.

Lastly, Keynes does not take into consideration what ultimately happens to every dollar of spending; once it makes it's way to the private sector. It's taxed! And, because a lot of stimulus money is given to small businesses and contractors for government-let projects, the tax rates are some of the highest in the country. Then, after the contractor pays his taxes on his/her portion of the stimulus money that remains as profits, any stimulus that was distributed to their employees in the form of pay is also taxed.

To me, there is no multiplier effect. If anything, a dollar of government spending was probably more than a buck and a half before the government got its hands on it, completely negating that supposed $1.50 multiplier effect. That's why the Stimulus Package hasn't worked and that is why Keynesian economics has never worked in the past. Further, as governments continue to grow in size, the false theory of the multiplier effect gets even weaker as more and more of any collected tax money yields less and less value after being digested by the government.

This is why lowering taxes is the best mechanism to stimulate the economy. Lower taxes means that any dollar of stimulative spending is a real dollar in spending; long before the government gets its value-shredding hands on it. Then and only then, is there any true multiplier effect!

Capiche, all you Keynesians out there!


Cheryl Pass said...

Great explanation! Go get 'em! Don't give up!!

Marshall said...

I am confused. Taxes were cut during President Bush's term, but the effects on the economy from that point on accumulated to end in the implosion we now are trying to find our way out of. With that as proof how can you champion for that as a final answer? It sounds like you are just giving me the same pablum you were fed and accepted. I don't want that stale food, just like I don't want bigger government. How about a real answer George, not what the rest of the herd thinks?
Chef Mars

Cranky George said...

The fact is that federal tax revenues grew by 37%, or from 1.7 trillion to $2.4 trillion from 2003 to 2006 (Google the Congressional Budget Office Report: Growth in Federal Tax Revenues From 2003 to 2006). This helped offset much of the spending that took place during this time. The Iraq and Afghanistan Wars had cost almost a trillion dollars through that same period, yet the total combined deficits by the Bush Administration from 2003 through 2007 was about $1.4 trillion; meaning that, if you exclude the cost of those two wars, the 5-year adjusted deficit spending was really only about $50 billion a year. Compare that to that to the declining revenues and fruitless economy under Obama and the Keynesian philosophy. Keynesian spending didn't work during the Great Depression (which only recovered following WWII) and it won't work now. I personally would like Obama to let the tax cuts for the wealthy expire so that, once and for all, we can see what the impact of higher taxation is? Only then will we know of higher taxes hurts the economy.

Cranky George said...

The recovery from the depression had nothing to do with the massive WWII spending. It had all to do with the euphoria of winning the war are the pent up consumer demand of 4 to 5 years of no consumer spending from everything from cars to homes to, even, silk stockings for the ladies. In essence, the economy was on hold for the war years. During that time, commercial production was converted to the war effort. When soldiers returned, the started families (the baby boom) and they needed tons of things they hadn't bought for years. Government spending and Keynesian economics had nothing to do with it. Just as, today, Keynesian economics and spending is a failure.