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Missing from the debate on multipliers

Scott Sumner and Paul Krugman have been going back and forth about fiscal multipliers, in a debate with many other participants. (Here are the first post and the latest post by Sumner on the issue.) For those of you who have not followed the debate, the fiscal multiplier is the change in output resulting from an additional dollar of government spending. If the multiplier is greater than one, $1 of additional government spending results in more than $1 of output.

What has been missing from the debate is the concept of the structure of production. Resources, including human abilities, are not just a homogeneous lump. They have a structure: some are less scarce than others, some are easier to switch to new purposes than others, some require less know-how to work with than others. The idea of a fiscal multiplier from spending makes me uneasy because it is basically a supposed case of something for nothing: the government, which almost everywhere in the world cannot even deliver the mail at a profit, steps in to fix a situation that the private sector cannot. How does it happen? The answer has to be that somehow the government is able to put resources to a higher-valued use than the private sector can. Given the specificity of resources and the knowledge that must be applied to use them efficiently, it is hard to imagine how such a thing can happen unless resources are so abundant that is little risk from wasting them.

An early critic of John Maynard Keynes, W.H. (William Harold) Hutt wrote a book on precisely this point in 1939, called The Theory of Idle Resources. Hutt carefully explained how many resources that seem idle to the unpracticed eye are in some kind of use — perhaps not the most active use we can imagine for them, but one that has considerable economic value. Considers cars. Most car owners use their cars for just an hour or two per day. Are the cars idle the rest of the day? True, they are parked, but they not idle in the economic sense. They are held in inventory, set aside by their owners for whatever need may arise to use them. People who don’t wish to hold a car in inventory can ride the bus or hail a taxi to get them where they want to go. (George Selgin or Steve Horwitz, both of whom have used Hutt’s ideas to help develop their own conceptions of the relationship between money and business cycles, may want to chime in with their own posts to say more about Hutt.)

If some resources are so abundant that there is little risk from wasting them, something is restraining the private sector from using them. Either millions of experienced businessmen can find no opportunities for converting something abundant into something more valuable, or government is somehow preventing the private sector from taking the initiative.

I lean to the latter explanation. Why should government, which eats profits (through taxes) rather than generating them, know how to turn resources to more profitable use than the people in the private sector who spend their whole careers trying to do just that?

As Scott Sumner has discussed on his blog, when monetary policy has gone so wrong that it is impeding trades that people would otherwise make, to their mutual benefit, there is a case for certain kinds of fiscal policy as a clumsy work-around. The simpler course, though, is to change monetary policy. And so I wind back up at free banking. Because free banking applies principles of competition that we observe at work in other markets, and that historically have worked in the issuance of money and credit as well, free banking is less likely than central banking to result in economy-wide failures to use resources efficiently. I do not think free banking would eliminate credit booms and busts, but I think they would be less severe than they are under central banking because the scale for making mistakes in monetary policy would be smaller. Then there would be even less reason to debate fiscal multipliers.


  1. A good article.

    I particularly liked the mention of W.H. Hutt – an East End of London boy (like my own father) who was also the first writer of an economic attack on the racialist policies in South Africa ("The Economics of the Colour Bar" which was published by the Institute of Economic Affairs).

    Austrian School critics of Keynes (such as Henry Hazlitt and, of course, Ludwig Von Mises) are remembered and have many followers today. However, many economists whilst not strictly speaking (perhaps) Austrian School, also understood that Keynesianism was based upon fallacies – and tried to expose those fallacies.

    A work such as Hutt's "Keynesianism: Retrospective and Prospective" may not be the classic of the ages that Mises' "Human Action" is – and it may not be as easy to read as Hazlitt's "The Failure of the New Economics" and his collection of short pieces of writing (from many economists – such as Anderson) "The Critics of Keynes", but Hutt should have an honoured place in the history of economic thought – and this article gives him his due.

  2. Keynesian supporters love to refer to stimulus as "a jump start of the economy". That deficit government spending will jump start the private sector and hence bring an economy out of recession.

    The jump start theory always comes with the lovely diagram of the "bucket". The bucket represents demand. The bucket's content is household, business, and government demand for goods and services. A recession is a bucket that is not full to the brim. The bucket is no longer full as the demand components of households and businesses has shrunk and hence its (according to Keynesians) the government's responsibility to increase its expenditures (increase its component of the bucket) in order to bring the bucket back to full.

    Seems like common sense. However, the increased government deficit expenditure that attempts to fill the bucket is really draining the bucket simultaneously. Its counter intuitive. As the government increases deficit spending, private capital formation leaks out of the bucket. Hence you try and try to fill the bucket yet the bucket content level remains below the brim.

    Enter the White Queen before breakfast and the multiplier effect ["When I was younger, I always did it for half an hour a day. Why, sometimes I've believed as many as six impossible things before breakfast."]. Since the bucket will not fill to the brim……why not make up a reason why it “should” fill to the brim and we can all pretend the bucket is full i.e. “the multiplier effect”.

    Once you stop filling the bucket with government deficit spending, and end one’s belief in impossible things like the multiplier effect, one must pay for the deficit spending. Hence Keynesians raise taxes. The taxes then create another leak in the bucket as disposable income shrinks causing the demand for goods and services by consumers and businesses to shrink. Therefore the bucket goes right back to the level that you began with before you started this wasted exercise.

    Keynesians should wear the bucket over their heads to trap the multiplier effect between their ears.

  3. Team Obama estimates of jobs created is based on the mistaken idea that "money moving around" is what causes prosperity, instead of being a side effect of the distribution of goods in a period of prosperity. Worse, the government believes in the economics of Keynes that government spending is actually multiplied by 1.5 or more in its good effect.

    If the 1935 economist Keynes were correct, then all would be glorious. Unfortunately, he was a crackpot. The Keynsian multiplier is a mistake, counting transactions as if the entire value of each transaction creates wealth instead of merely valuing or identifying wealth.

    If there were a multiplier such as the 1.5 multiplier claimed by the Obama team, then we could Counterfeit Our Way to Wealth.

    Government spending doesn't multiply anything. Government takes resources from taxpayers and applies them to government projects. We get a bridge or some paperwork; that is it.

    The Myth of the Economic Multiplier

    The "multiplier" from government taxes and spending is less than 1. The government wastes resources collecting more tax, and the citizen wastes resources trying to minimize his tax. Then, the government spends the tax revenue wastefully, achieving less production of useful goods and services than the citizen would have created through careful purchases and investment.

    A "spending multiplier" is absurd. If government spending of $100 creates $150 in wealth, then why doesn't this apply to ALL spending? The $50 you spend for groceries should produce $75 in wealth. In fact, all money spent each day should produce wealth of 1.5 times the current day's spending, sometime in the near future. This would lead to a wealth explosion, as total wealth increased by 50% every few months. Heck, even if it increased by 5% every few months.

    There is no spending wealth multiplier greater than 1. If there were, we would all be living in Aruba by now, on the beach, sipping cool drinks.

    There can be an investment multiplier. Every profitable business produces more value in its outputs (its sales) than it uses as inputs (its costs). A new product or efficiency does multiply the value put in as an investment. For that result, you need investments (savings) and a businessman making it work.

  4. Good comments everyone. And good links from Andrew and Steve ( Dr Horwitz I have put a link to your article as a Facebook entry – if you object I will, of course, remove it).

  5. "The simpler course, though, is to change monetary policy. And so I wind back up at free banking. Because free banking applies principles of competition that we observe at work in other markets, and that historically have worked in the issuance of money and credit as well, free banking is less likely than central banking to result in economy-wide failures to use resources efficiently."

    I'm sure the following is easier said than done, but assuming a relatively smooth transition away from central banking is even possible, wouldn't the "simpler course" toward free banking (my version, anyway) be to nurture it from within existing U.S. banking corporations?

    First, have the Treasury Department inform both banks and depositors that depositors have a Constitutional right under McCulloch v. Maryland (1819) to demand Treasury-Direct coin and/or non-coin currencies at any U.S. incorporated bank, and that the obstruction of such rights will not be tolerated.

    Second, inform bank owners that Treasury-Direct funds held at their banks are subject to free, not central, banking principles (i.e., banks can issue their own notes and checks based on their Treasury-Direct deposits), but that bank owners and operators will be held personally liable in any subsequent bankruptcy proceedings.

    I'm on the fence about what to do with FDIC in the free banking context. It should not be necessary, but lots of depositors may be spooked without it. In other words, depositors may not believe that the Treasury Department can be sufficiency insulated from politics, and therefore depositors may doubt the Treasury's ability to enforce personal liability on bank owners for irresponsible lending of Treasury-Direct currencies.

  6. … many resources that seem idle to the unpracticed eye are in some kind of use …

    The most obvious use to which an unemployed worker puts his time is the business of finding useful employment, i.e. finding employment that produces goods chosen by free consumers. If the state pays the unemployed worker to build pyramids instead, it necessarily consumes productive means other than the worker's labor while producing nothing that consumers freely choose.

    If productive means satisfying free consumers are scarce (as they always are), then forcing these means into an organization with idle labor to produce goods not satisfying free consumers necessarily reduces opportunities to organize the means and the labor otherwise, i.e. it reduces employment opportunity in the economy organized by free consumers.

  7. "There can be an investment multiplier. Every profitable business produces more value in its outputs (its sales) than it uses as inputs (its costs). A new product or efficiency does multiply the value put in as an investment. For that result, you need investments (savings) and a businessman making it work."

    This is really a point that deserves revisiting. Keynesian economics is really a mystification of this point: Investments are capable of taking less valuable goods or services using them to somehow acquire more valuable goods or services through some kind of production process, and this drives economic growth as valuable output increases. Talk of 'Government stimulus' is really just the claim that the government can make a productive investment which will spur the economy along in exactly the same way private investment does.

    The validity of fiscal policy versus monetary policy ultimately comes down to whether you think the government or private industry is more capable of making productive investments. Keynes' argument was that, in times of great uncertainty, private industry can't be sure where it is going to find productive investment opportunities, so it holds back, which opens up a gap in which government can or must fill with productive investments of its own. So questions about the 'structure of production' don't really mean without bringing in questions about the knowledge problem which seem implied but need to be made explicit. Can the government find productive investments that private entrepreneurs cannot?

    What makes an investment productive or not is where the structure of production comes in. How can the existing capabilities of currently unemployed resources be reoriented to generate a profit? Answering this question for any specific situation requires a level of detail that is, to put it simply, insane. Right now there are millions of unemployed people with a ridiculously varied host of skills and capabilities. There are machines, buildings, and other capital goods out there in a million different locations with a million different capacities. Putting it all together productively as a government official is essentially to summon the old demon of The Use of Knowledge in Society.

    Occasionally, it seems, governments can find productive investments to make which can drive huge amounts of economic activity. I don't know if any real study has ever been done, but I can only imagine the Eisenhower Highway System was a productive investment on the part of the Eisenhower administration. I have no trouble believing it drove employment and output for decades afterwards. However, some other government investments end up being boon-doggles, or at least not profitable. Some, like the space race in the 1960's, were great investments in some ways (the technological improvements from figuring out how to put a man on the moon were marvelous), but it's hard to see how an ultimately 'pointless' venture like that would turn a profit. When you've built a highway system people will be using it to get around for decades to come. However, once you've put a man on the moon…now what? You can't really do much with that. It doesn't support economic activity, you can't sell it to anyone, it doesn't augment productivity in ANY way.

    More specific to today, I feel like the recent stimulus package was even more of a boon-doggle. Infrastructure spending isn't necessarily profitable (as any railroad magnate of the 19th century will tell you), so just looking at the amount of road-and-bridge repair spending in it won't tell you how much was profitable in the aggregate. Most of the other things in it were either neutral, lossy, or 'unknown' (the tax cuts, especially, just pass the buck back to private industry).

    What the recent package highlights, though, is that the problem with Keynesian policy is more a problem of political economy than of economics. Something more the realm of James Buchanan than Will Hutt. Stimulus packages represent a massive potential for rent-seeking profits, so it's really difficult to pass an efficacious one in a democratic government. Only a hypothetical technocratic dictator would be a really effective user of Keynesian fiscal stimulus over the long term. If the government really looked in an honest way it could find productive investments to make, but there are political challenges on top of the normal economic challenges of search and other transaction costs that make it very unlikely for such things to be effective. After all, if political problems didn't exist, central planning would be quite a bit more effective (if still sub-optimal — see: Hayek).

  8. As the classical economists (the Say family, Bastiat and on and on) pointed out ….

    Unemployment is NOT caused by "lack of demand" (a fallacy that goes back long before Keynes) – and creating extra money or credit is NOT the way to deal with unemployment.

    Unemployment is a sign of a obstructed labour market – so the proper response is to find the source of these obstructions (what is preventing wages adjusting so that there is full voluntary employment – so that no one who really wants a job need not have one) and remove them.

    In a country that has a fairly free labour market (such as the United States in 1921) even a massive credit money bust (the bust of the World War One credit money bubble) does NOT produce long term mass unemployment.

    The Harding Administration did not react to the bust by "busting demand" (actually it CUT government spending by 25% – and that was from a 1920 PEACETIME budget), and the Federal Reserve did NOT "expand demand" either in 1921.

    Yet the economy was in recovery (from a savage bust) within six months – something that should be impossible under the doctrines of J.M. Keynes and the other "monetary cranks" (that term originally meant people who think that boosting "demand" is the key to prosperity – modern leftists sometimes take the term and move it around 180 degrees to attack people who OPPOSE the original "demand" doctrines of monetary crankism).

    In 1929 the Hoover Administration (from Herbert "The Forgotten Progressive" Hoover on down) did everything it could to PREVENT wages adjusting to the crash (i.e. to the crash of the Ben Strong created credit money bubble of the late 1920s). Thus mass unemployment emerged and persisted.

    The expansion of demand in the 1930s (i.e. the wild spoending) did NOT get rid of this mass unemployment (it was about as bad in 1938 as it had been even in 1932). And it was not the "increase in demand" of World War II that broke the back of it – it was de facto WAGE CUTS, as real (black market) prices went up during World War II, whereas wages were held down.

    The Germans had done the same in 1933 – as Keynes (in a backhanded way) admitted in the introduction to the German edition of his "General Theory…" in 1936.

    Government wage controls are a TERRIBLE idea – but governments preventing the market adjusting (by backing labor unions and so on – or the various threats and so on that Hoover made to "keep up demand") are, perhaps, an even worse idea (at least in the short term – in the long term both forms of interventionism lead to destruction).

    MichealM's comment….

    Yes one would expect that if firms invest their profits and if individuals SAVE (i.e. lend out their income for INVESTMENT, rather than consume it all) then there will be positive economic effects in the longer term.

    And YES one would expect these benefits to be greater than the loss of spending power (the loss of effective living standards – people living harder lives so that there is investment for the future) in the short term.

    But I am not sure this should be called an "investment multiplyer" – even though successful investments can produce a return of many times the origical sacrifice.

    This is because each investment is really a MICRO economic thing – it is (perhaps) a mistake to think of it in "macro" terms.

    Each investment must be judged in detail – for example NOT " companies are doing well – so I will invest in this company" but, "this company is making good profits and this business plan is sound and will produce greater profits for the following reasons…..".

    People who "invest" without considering the specific details of the enterprise they are investing in, might as well use 100 Dollar bills to make a bonfire. And people who trust a bank (or whatever) to study these things for them – are placing trust in the JUDGEMENT and ETHICS of these third parties (sometimes justified – sometimes not).

    It is like people who "invest" in mortgage backed securities (not technically an "investment" at all of course – as there is no future production being generated). They did not even know which houses they had "invested" in, they could not point to the houses on a map (let alone find them on the ground) and they knew NOTHING about the financial circumstances of the people who had bought the houses (that is not investment – it is magic spells, and magic is not real even if gets a "Triple A").

    The "interstate road system" is a good example of something that violates the basic rules of investment (even though the people who "invested" in it could at least find the things they were investing in – which is a big plus).

    People were not investing THEIR OWN MONEY (a bit like bankers investing the money of other people in mortgage backed securities – please note that the top bankers were rarely so foolish with their own personal income, indeed the Goldman Sachs people and so on bet on the housing market crashing, even as their clients money was going into it).

    Perhaps a vast road system could outcompete the railroads (and the airlines).

    But it is impossible to tell – because there is NO REAL MARKET.

    The ICC turned the railroads into a cartel (whilst claiming to do the opposite) and the new Ike roads were "free".

    I.E. there were mostly no tolls.

    Where there are no tolls there can be no real "return on the investment in roads".

    Of course people used the roads – but they would have used railroads (for both passengers and cargo) if the roads had not been built.

    So "bottom line".

    The interstate road network can only be defended in ECONOMIC terms if……

    People were investing their own money – not tax money.


    A positive return could be shown – better than the OPPORTUNITY COST (i.e. better than investing the money in other things).

    For, of course, even private voluntary investors can make mistakes.

    The market is not perfect (can not be perfect) – as it is simply the voluntary choices of human beings.

    But it is vastly better than the government "investing" and then saying that the Moon program gave the world nonstick frying pans (or whatever).

    For how the government messed up the markets recently (especially the housing markets) see…

    Thomas Woods "Meltdown", and Thomas Sowell's "Housing: Boom and Bust".

  9. Rick on deposit "insurance".

    I agree with you that people get spooked without it.

    But it is Fool's Gold.

    One of the more depressing things I have seen recently is the spreading of this idea to the Isle of Man and the Channel Islands (G as well as J).

    In the past people were told "you can earn a higher rate of interest by putting money in banks here – but if they go bust you lose the money".

    That was honest (or at least as honest as modern banking gets).

    Now they are being told "have no fear…. DEPOSIT INSURANCE is here".

    Of course the whole idea is impossible (there is no way that these little island governments could possibly pay up).

    Indeed there is no way that even the British or American governments can pay up – without creating new money (from NOTHING) as they have.

    "Get the banks to pay for each other" – accept that the banks tend to act like a hurd. They respond to fashions (like lending money to Argentina – they all do that every 20 years or so, and few years late Argentina DEFAULTS, it has done so many times, but there is always a new generation of bankers to lend OTHER PEOPLE'S MONEY to Argentina and so on, so these national governments can default yet again – you see the bankers still get the commission on the deals….).

    The banks can not really "pay for each other" – unless the government is (in one way or another)standing behind them with a printing press (or, these days, with a computer con – type the figures on the screen and you have created new money).

    For those of us who do not believe in the "Philosopher's Stone" or a perpetual motion machine that speeds up – efforts to create new money lead to (inevitable) problems.

    "But why not private insurance".

    O.K. let us see how that would work.

    One can insure against a Safe Deposit place being robbed, or against a fire or a flood.

    I understand all that.

    But how does one insure against BAD BUSINESS JUDGEMENT?

    Some people have actually tried to do that.

    For example, the massive insurance company AIG (American Insurance Group).

    Was the biggest insurance company in the world – and it had lots of really "smart" people (from the best universities) on telephone number salaries.

    However, it did not turn out very well……

    But have no fear – AIG turned out to be de facto "insured" as well.

    Bailed out by the government (with money created from NOTHING) – so Goldman Sachs (I mean the economy – the fact that Goldman Sachs was owned vast sums by AIG and that the people in government were Goldman Sachs people is not relevant at all) was saved.

    In the end one can not insure against a bank failing any more than one should be able to insure against a steel company failing.


    If it is a honest business, then bankers lend out their own money (and that of people who entrust their money to them – rather than spend it on consumption). They do NOT lend out magic Pixie dust and Moonbeams (i.e. try and "expand credit" in order to "reduce interest rates").

    And if a bank goes bankrupt then it closes its doors – and the people who have trusted their money to the banker lose the money.

    That is why (in a real free market) people would be very careful who they trusted their money to. Come on now who would really (in a free market) trust the present bunch?

    Would anybody trust them?

    Of course not, so is it not a bit odd that they control hundreds of billions of Dollars (at least on paper on on computer screens)?

    We entrust our life savings to people who nobody would buy a used car from?

    Is there not something odd in that?

    And it would not matter if they were as pure as fresh snow – as the stuff they try and do is PHYSICALLY IMPOSSIBLE.

    So crooks or crazy people – Jamie Dimon and co are one or the other (or both), neither possiblity is a good one.

    Anyway back to insurance.

    If one wants insurance – then put the money in safe deposit establishment (and insure that).

    No interest of course (indeed one has to PAY the safe deposit place – and quite rightly so, they have to make a living).

    However, in a free market prices would gradually (not rapidlly – gradually) fall over time, as better ways of producing goods and services were developed.

    So at least one would not worry about money put in a safe deposit being eaten away over time.

    People would still invest their savings – but only with people (enterprises) they really trusted.

    And people would know if a deal is "too good to be true" IT IS NOT TRUE (it will not work – regardless of whether the people in charge of it THINK it will work).

    There is no Philosopher's Stone, and there is no perpetual motion machine (let alone one that speeds up – just as well, as such a machine would destroy the universe).

    Just hard work, thrift and self denial.

    No quick fixes and short cuts.

    Martin Van Buren and Senator Benton understood this.

    1. Paul, I generally agree with your comments about deposit insurance, but since this is blog about "banking" (a word that should mean "socially responsible lending," in addition to the safe keeping of money), I would not consider the insuring of safe deposit boxes to be an alternative to deposit insurance.

      But to do without deposit insurance in the true banking context, I think we need some very honest people in the Treasury Department at all times, and it's often difficult to get them some of the time.

      However, with modern electronics, if the will and resolve is there at the Treasury Department, it should be relatively easy to impose effective personal liability on bank owners, and therefore forego the need for deposit insurance. As soon as a bank was lending out more than the owners had available as (seizable) collateral, the Treasury would know about it, and nip it in the bud.

  10. Personal liability is a interesting one Rick.

    I really am a soft hearted (or soft headed) person on the subject – or perhaps I just know (in my bones) that the likes of Jamie Dimon would walk away scott free (or, rather, go away in a private jet) saying "I am just an employee, I do not own this bank", whilst a little old lady in Pasadena suddenly found she owned a million, zillion Dollars because her late husband once bought one share in 1962.

    Actually I (unlike a lot of people) am not opposed to the CONCEPT of a corporation (after clubs, societies and churches are corporations – small "c").

    But I am opposed to the distorted tax law and the vast web of regulations that have robbed control of corporations from real, flesh and blood, shareholders.

    If you ever hear (and I am being serious now – deadly serious) someone say it is a good thing that in "modern capitalism" "ownership and control have been divided" (i.e. it is a good thing that such things as inheritance tax have undermined individual share ownership – and that the vast web of regulations have castrated shareholders in favour of corporate managers) then WATCH OUT – because the person who says something like that is a very bad person indeed.

    As for investment – of course sticking the money in a safe deposit is not going to be a real investment.

    But be careful when in investing – or in giving the money for someone else to invest.

    One golden rule applies – if someone shows you good returns, yet can not clearly explain what he is doing ("leave it to me – you would not understand the math…").

    Then run for your life.

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