Written by Dan Lieberman, Alternativeinsight
British economist John Maynard Keynes transferred Richard Kahn’s employment multiplier into the concept of an investment multiplier. Others used the same formula to arrive at a Gross Domestic Product (GDP) multiplier. Portrayed by Keynesian followers as an advantage for government deficit spending and featured as a significant advance in economic thought for determining public policy, the ‘multiplier” could be misunderstood and not deliver the benefits it promises.
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Both Mr. Kahn and Lord Keynes might have used a hypothetical capitalist system to describe their theories and achieve spurious results. Using a real world system, does the “multiplier’ become a “divider,” and does the theory do nothing more than describe the normal functioning of the capitalist economic system.
Other commentators ― analytically, empirically, and logically ― attempted to discredit the investment multiplier, but it remains as a vital consideration in economic thought. This article takes a new approach, one, which, hopefully, will definitely clarify the multiplier’s benefits and characteristics.
Investopedia explains the multiplier:
The Keynesian multiplier was introduced by Richard Kahn in the 1930s. It showed that any government spending brought about cycles of spending that increased employment and prosperity regardless of the form of the spending. For example, a $100 million government project, whether to build a dam or dig and refill a giant hole, might pay $50 million in pure labor costs. The workers then take that $50 million and, minus the average saving rate, spend it at various businesses. These businesses now have more money to hire more people to make more products, leading to another round of spending.
Keynes represented these rounds of spending as a geometric series: 1 + k + k2 + k3 + … to infinity, where k=propensity to spend. Mathematically, the geometric series obeys the formula:
If part of the available spending is saved, say 20%, and only 80% is spent, then k=0.8. Substituting 0.8 in the multiplier formula indicates that the original spending, represented by the total rounds of spending will be multiplied by 5, which occurs after an infinite number of investment transactions and infinite time. Note that if all of the available spending is actually spent, k=1, and the total investment becomes infinite; the age of abundance has been achieved.
The questions for the multiplier theory are:
- Can employment multiply without multiplied additions to the money supply? Where is the multiplied money to pay employees and purchase the products?
- Has Keynes used a specious capitalist system in his theory?
- Has Keynes only formulated the operation of the capitalist system; after products are sold and the market is cleared, a new round of investment occurs?
- Did Keynes neglect an important factor – time? Is it possible in the goods economy, where tooling takes much time, that there can be a rapid purchasing of new goods?
Uncovering the fallacies in the operation of the investment multiplier.
For this analysis, we must assume that in the economic production system (apart from the services sector), the total price of all goods consists of cost plus expected profit. Rarely, if ever, is sufficient purchasing power within the system available to entirely clear the market and enable the expected profit and so demand falls short of supply. Keynes attempted to overcome this difficulty, refuted an assumption, attributed to John Say, that “supply creates its own demand”, argued that inadequate overall demand leads to periods of high unemployment, and government spending can play the role for increasing demand.
Not all government spending does the task. This lack of clarity has led many economists, including Joseph Stiglitz to use the term government spending too broadly. Stiglitz wrote:
… [W]hen the government spends more and invests in the economy, that money circulates, and recirculates again and again. So not only does it create jobs once: the investment creates jobs multiple times.
The result of that is that the economy grows by a multiple of the initial spending, and public finances turn out to be stronger: as the economy grows, fiscal revenues increase, and demands for the government to pay unemployment benefits, or fund social programmes to help the poor and needy, go down. As tax revenues go up as a result of growth, and as these expenditures decrease, the government’s fiscal position strengthens.
Government revenue, from taxes and sales of non-monetized securities (not purchased by the Federal Reserve) only transfers already available purchasing power to the government. When the government uses this revenue to purchase goods by contracts, such as aircraft, the manufacturer and its suppliers employ a labor force that transfers the revenue from the government expenditure as wages to the workers. Employment is increased and the airplane manufacture adds to the GDP, but that is all. The airplane workers and workers of the suppliers to the aircraft industry use the transferred purchasing power to purchase the products that the taxed and purchasers of government securities had the opportunity to buy. No other added production occurs from the sale of the previously unsold goods and no additional employment happens.
Government spending from taxes and non-monetized debt has benefits in adding to GDP and decreasing unemployment, but there is no investment multiplier. A fixed amount of employment occurs, and GDP is enhanced, but the basic economy, outside of the government transactions, does not receive an added stimulus.
The writer described this aspect of government spending in a previous article, The Tax Deception Exposed.
The Money Supply
The role of the money supply in long-term advances of the economy is hotly debated. Businesses raise capital from selling securities or acquiring debt and establish new production facilities, but these are long-term considerations that have no relevance to current spending and are not part of an investment multiplier. To enable near-term reinvestment, profit must be made. How is additional profit made? In the short term, increases in the money supply definitely have the essential role. The following two graphs, which cover different amount of years, and have slightly different scales show the close relation between money supply and GDP in the last decade.
GROSS DOMESTIC PRODUCT
For the money supply to increase, exogenous spending, which is spending that arises from an outside source, must occur. Exogenous spending comes from a positive current account balance (has not happened), monetization of government debt (printed money), and bank loans (banks originate money).
Former Federal Reserve Chairperson, Ben Bernanke, in an Oct. 1, 2012, speech to the Economic Club of Indiana claimed that the Federal Reserve Open Market Operations have only decreased interest rates and not monetized the debt.
By buying securities, are you “monetizing the debt”–printing money for the government to use–and will that inevitably lead to higher inflation? No, that’s not what is happening, and that will not happen. Monetizing the debt means using money creation as a permanent source of financing for government spending. In contrast, we are acquiring Treasury securities on the open market and only on a temporary basis, with the goal of supporting the economic recovery through lower interest rates. At the appropriate time, the Federal Reserve will gradually sell these securities or let them mature, as needed, to return its balance sheet to a more normal size.
Carefully note the words and his argument may be true, only maybe, in the long-term, but not true in the short term.
Sales of manufactured goods consist of costs plus profit. If the manufacturer retrieves costs and makes a profit from the exogenous spending, the profit may be either re-invested in new production, distributed as dividends, pay off loans, given as bonuses, or banked as retained earnings. Clearly, the profit and thus the re-investment can never exceed and is usually much less than the exogenous spending. If the entrepreneur uses profit to establish new manufacturing facilities, the cost of those goods absorbs the profit. The entrepreneurs’ vision is that the new production, which increases employment, will generate additional profit. As before, gaining this additional profit will require new additions to the money supply. No investment multiplier occurs; for each investment cycle to expand, demand must increase and the money supply must expand from one or more of the factors mentioned above, which includes government debt monetization. Increased production follows increases in the money supply.
Followers of the investment multiplier seem to indicate that if someone goes to purchase an automobile for $20,000, the seller takes the $20,000 and immediately spends it elsewhere on quickly produced goods, and that seller does the same and so forth. Not in the real economic system. Businesses receive income and then purchase other already manufactured goods from inventory in the present investment cycle. After the manufacturer’s marketing department realizes the company will have profit, it decides how the profit is distributed and if additional investment in new manufacture is beneficial.
Economists have unknowingly justified the investment multiplier by referring to investment in the service sector. Multiplication of employment, investment, and GDP is not unique in this sector and does not need new government or other new spending to create a multiplier.
As an example, suppose a wage earner does not purchase a consumer good or commodity from his/her wages but purchases a service, such as medical response. The doctor is employed, and the service is registered in the GDP statistics. The doctor goes to a lawyer for advice. The lawyer is now employed, and the service is registered in the GDP statistics. The lawyer goes to a cabinetmaker to purchase custom furniture, the cabinetmaker is now employed, and the service is registered in the GDP statistics. The cabinetmaker finally purchases the unsold goods in the domestic economy. Plenty of apparent multiplication of investment and employment without government spending and creation of new money.
This is how the service industry normally functions and how its efforts are recorded in the employment and GDP statistics, which is why some economist sense that including them in the GDP can over-inflate the appearance of the economy. A rapid exchange of money can occur in the service sector and give the appearance of an investment multiplier without government spending or increases in the money supply. The same process cannot occur in the manufacturing industry, where Keynes intended to apply his investment multiplier.
In his theoretical analysis, Keynes shaped the industrial economy to fit his analysis and did not include the time element required to establish a new manufacturing process of goods. “Leakage” has meaning but Keynes might have ascribed “leakage” to the wrong element – because
- some wages are saved,
- not all the current balance deficit is retrieved, and
- much money churns in the speculative markets, not all income is available for purchase of goods.
Monetary expansion comes to the rescue, purchasing the unsold product and allowing profits. Borrowing money has a purpose, which is to finance the purchase of goods and the borrower is not going to permit his borrowings to “leak.” “Leakage” occurs at the production end, where industrialists do not use the entire profit for re-investment.
Keynes’ multiplier formula actually says that if purchasing power decreases, then consumers will not purchase all goods in subsequent investment cycles, profits will decrease, and, eventually, no more profit will be made on the original investment. Manufacturing of those goods will cease. The “investment multiplier” of the geometric series is actually a divider.
Let k=0.8 in the investment series described above, and, with each investment cycle, the investment is reduced by 20% until it becomes nil and the company stops producing from the original investment. Instead of investment being multiplied by 0.8, investment is reduced by 0.2. If k=1, then injections of new money into the system stays constant, purchasing power remains constant, and investment is entirely repeated in each investment cycle. After an infinite number of cycles, total investment reaches infinity. The formula becomes logical and has no indeterminate value. The total profits accumulated may be used for various purposes, but if there is a constant or declining demand due to a either a constant or declining money supply, investment of profits will not generate additional profits, and the profits will not be used to increase production.
The capitalist production system has a built-in lack of demand that cannot satisfy supply. Demand created from wages does not complement available supply ‒ the surplus generated by the workers, which is the profit, and unwanted goods generate supply without immediate demand. Credit and Federal Reserve quantitative easing furnish the money supply with additional funds to soak up the excess supply and equalize the system. These funds barely accomplish that task without enabling any additional multiplication of investment. Additional investment comes from the additional profit made from the monetary expansion.
Keynes “investment multiplier” only describes the way the system works ‒ sell the goods in one investment cycle, and, if there is profit due to the added money supply, start a new investment cycle that is slightly greater than the previous. The renowned economist iterated in mathematical terms what all adequate company managers knew ‒ if you turn over inventory quickly and replace it with new inventory, the enterprise can earn a lot of bucks.
The operation of the United States economy in the last decade demonstrates the lack of an investment multiplier. The table below uses statistics from the St. Louis Federal Reserve Bank (referenced from previous charts above and subsequent chart below) to demonstrate the conclusion.
INCREASES IN MONEY SUPPLY AND GDP
From the end of year 2008 to the end of year 2016, government debt monetization, not all of which circulated in the money supply, increased by $4.4 trillion, and the money supply increased by $5 trillion, but the GDP increased by only $3.8 trillion.
Where are the multipliers?
Evidently, government revenue, which transferred income, plus some re-investment supported a portion of the added employment, while part of the Fed quantitative easing lay dormant or supported a speculative stock market.
Debt monetization played a crucial role in financing profits immediately after the 2008 recession, when, at the same time, household debt was going negative. During the last years, household debt is more positive in its contribution to the money supply and debt monetization has lessened.
Former Federal Reserve Chairperson, Ben Bernanke, in his Oct. 1, 2012 speech to the Economic Club of Indiana indicated the limits of debt monetization in directly increasing the money supply. The Fed’s intent was to lower interest rates and indirectly stimulate credit expansion.
Moreover, the way the Fed finances its securities purchases is by creating reserves in the banking system. Increased bank reserves held at the Fed don’t necessarily translate into more money or cash in circulation, and, indeed, broad measures of the supply of money have not grown especially quickly, on balance, over the past few years.
This questioning of a significant and well accepted-theory in economics, which has determined public policy and highlighted famous economic textbooks, cannot be lightly dismissed. It is possible the arguments are not entirely correct and a “tripwire” exists. A careful and complete examination of Keynes’ multiplier and the contradictions concerning it are in order. If analysts cannot refute the presented arguments the multiplier’s” significance may have to be re-evaluated.