Why Stimulus II can’t work
Obama has proposed a $447 billion stimulus package called a “jobs plan.” I note a question the press never asks Obama: “Why do you believe the Keynesian multiplier is greater than one?” This is crucial. If the multiplier is greater than one (the usual assumption), then mere spending, even wasteful spending, will give a net boost to the economy. I will explain the multiplier, and then discuss the consequences when the multiplier is less than one.
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The logic behind the Keynesian multiplier is similar to the logic behind the money multiplier in fractional reserve banking. If a bank gets a one-dollar deposit, that dollar appears as both an asset and a liability on the banks balance sheet. By law, the bank must keep some fraction of that dollar asset in its vault as cash, and is free to lend out the rest. Let’s say for simplicity, the reserve requirement is 10 percent. That means the bank must keep 10 cents in the vault and can lend out 90 cents. That 90 cents will circulate in the economy, and eventually ends up somewhere in the banking system as a 90 cent deposit. The bank with the 90-cent deposit must put 9 cents into the vault and can lend out the remaining 81 cents. And so on. For simplicity assume an infinite number of circulations. We can write total of assets for the whole banking system as an infinite sum where each new term in the series is 90 percent of the prior term: $1.00 + $0.90 + $0.81 + $0.729 + $0.656 + $0.591 + $0.5314 + … = $10.00. Thus the money multiplier is 10. The original dollar deposit creates 10 dollars of assets for the whole banking system. It also creates 10 dollars in liabilities, as it must. This is a very good deal for the banks, because they lend money at a higher rate of interest than they pay depositors. They thus make more money on their assets than they lose paying interest on their liabilities.
The Keynesian multiplier works in a similar fashion. The federal government borrows money and injects it into the economy. The people and companies that receive the injected money spend it. This spending corresponds to banks lending out their deposits. The people and companies that receive the first round of spending, spend that money, and so on. Thus the original money injection gets amplified—the Keynesian multiplier. [LA asks: but does it get amplified? That’s the question.] The government can hire people to dig holes in the ground and then fill them back up. In other words, the initial round of spending can be wasteful because the multiplier effect bails out the wasteful spending. This is the theory. It did not seem to work with Stimulus I. Something went wrong.
Suppose the Keynesian multiplier is not greater than one. Does this mean the stimulus package won’t work? Not necessarily. In theory there is little difference between a company borrowing money for a project and the government borrowing money. Both sell bonds and invest the capital. But companies are usually careful to invest in projects they think will have a positive net present value (NPV). Thus if the government sells bonds to raise money to build a high speed rail the present value of the income stream from the future fares must exceed the amount of borrowing. Otherwise the government is digging the country ever deeper into a debt hole. The safest thing to do is to spend the stimulus money carefully, and then we will improve the economy even if the Keynesian multiplier is less than one.
Let us look at how Obama plans to spend that $447 billion, while assuming that the multiplier is less than one. We find that little of it could possibly have a positive net present value. For example $35 billion will go to state and local governments to avoid teacher lay-offs. That’s nice for the teachers, but it comes at the expense of the taxpayers, because they have to pay the interest on that $35 billion in borrowed money. (I assume the principal will get rolled over ad infinitum.) Why can’t the teachers take a pay cut? We also see that $105 billion goes for “infrastructure spending.” Why so little? We keep hearing that America needs trillions in infrastructure spending. We know the answer. That spending won’t help his reelection because it takes too long to take effect. He’s taking a big risk if the multiplier is less than one. This is why I think someone needs to ask him about it.
Obama and his economic advisers think that the Keynesian multiplier is 1.5. That’s what Larry Summers believes. That’s why they went for the 2009 stimulus package, which was about $800 billion. I suspect Summers got that number from some regression analysis, which probably does not apply to the current economy. Or he just assumed it. Some economists including Paul Krugman think that Obama needs to spend trillions more because Stimulus I was too small, and that’s why it failed. The current Democratic talking points say that it took WWII level spending to get us out of the Great Depression. If that’s the case, then why the niggardly $447 billion? Why not a $5 trillion stimulus? As it stands Obama’s proposal fails under any theory.
Alexis Zarkov writes:
Mr. Auster asks, ” … but does it [the spending] get amplified? That’s the question.” According to Harvard professor of economics Robert Barro, the answer is a qualified “no.” He’s done the work and published it as a technical article. Based on the spending during WWI, WWII, and the Korean War, he concludes that defense spending has a multiplier of 0.6 to 0.7 at the median rate of unemployment. The defense spending multiplier might rise to one when unemployment gets to 12 percent. He says that the multipliers for non-defense spending cannot be reliably estimated because of insufficiency in the data. He’s also thinks it’s likely that the non-defense multiplier is less than the defense multiplier.
Other economists assert the multiplier is greater than one, but they base that on contentious theoretical notions, not empirical analysis. At best the efficacy of Obama’s stimulus proposal is highly uncertain. A big gamble with the public’s money. And as we know, Stimulus I failed.
Should we take Barro seriously? I think we should. He ranks fourth in the world in terms of the number and influence of his economic publications, as we can see from the database of rankings here. His main field of expertise is macro economics, and stimulus spending lies exactly in that subject area.
Robert B. writes:
I am surprised that no one has noted that the multiplier effect is quite passé in our modern economy. When Keynes came up with it, the industrialized nations consumed their own products—they were not importing them from China. The case for M.E. no longer being valid became clear in the late ’70s as Carter’s attempts to stimulate the economy largely failed in the face of rising Japanese imports and massive amounts of money being transferred to the Arab oil producers—all we got was rising inflation and a weak housing market. We did, however, stimulate Japan’s economy and the bank accounts of Arab sheiks. Then, as now, all government stimulus packages will do is stimulate demand for foreign made products, cause the price of oil to rise and further crush the housing industry. Personally, it is my belief that the housing industry is never coming back in our lifetimes. The downturn was due to happen anyway as baby boomers aged and no longer needed their homes. The pathetic idea that hordes of uneducated Third World immigrants would fill the void was, at best, laughable. Just how in the world do dishwashers and roofers afford $250,000 homes let alone $500,000 homes? Oh, yes, “no doc” loans.
Posted by Lawrence Auster at September 10, 2011 12:08 PM | Send
Reagan turned the economy around by putting restrictions on imports, allowing oil companies to drill (thereby flooding the market and forcing prices down), fostering tax incentives for American companies to invest in America, and encouraging Americans to believe in America—i.e. “buy American.” Once Americans buy American, the M.E. will have an impact and the economy will turn around—for some, but not all. Blue collar whites will continue to suffer until the tide of immigration and Affirmative Action is turned back.