Backgrounder: The Keynesian Multiplier

December 15, 2016

by T. Norman Van Cott

The notion that additional government expenditures magically increase national output is ingrained in the national psyche. Keynesian economics professors can certainly take credit for this mindset; it is they who have schooled multiple generations of college students in Keynesian multiplier analysis. The professors’ counter-intuitive tease in this effort has always been what is called the “balanced budget multiplier” (BBM). That is, even with equal increases in government spending and taxes increase output, output should supposedly rise by the same amount that spending and taxes rise.

The BBM is what Keynesians call a hybrid multiplier, meaning it combines the putative positive effects of increased government spending and the putative negative effects of higher taxes. Multiplier champions and skeptics spar with statistical evidence supporting their respective positions. While the BBM traces to the early 1940’s, it is not a long-discarded Keynesian relic. Indeed, it still appears in the current textbook literature.

The BBM is so at odds with simple economic logic that it should be an embarrassment for the economics profession. Strong words? Yes. But how else to describe economic nonsense? (I should note that I made this point in an abbreviated Wall Street Journal letter-to-the-editor some years ago. The letter was in response to an op-ed by Allan Meltzer outlining the failings of Keynesian policy making).

Let’s begin by taking claims of the balanced budget multiplier at face value. That is, suppose a balanced budget increase in government spending really does increase national income by the same amount. To my knowledge, no one has ever noted the lack of incentive to produce the additional output. Think about it for a moment: If output and taxes rise by the same amount, as asserted by BBM expositors, this means producers’ after-tax income is unaltered by the fiscal action. That should lead to an obvious question: Why will additional output be produced when its producers receive no additional income for doing so? However obvious, the question has never been asked let alone answered in the macroeconomics literature. Decades of balanced budget multiplier expositors, Nobel-laden and otherwise, would have us believe the impossible — output is produced even though its alleged producers receive no net-of-tax claim on output for doing so.

What explains such inattention to economic basics? I don’t know. Maybe it’s the diagrammatics and mathematics. The procedure lends a scientific aura — although I would argue fog — to the discussion. Notwithstanding this flaw, Paul Samuelson, the first American to win a Nobel Prize in economics, once labeled the balanced budget multiplier as “classical.”

The closest anyone has come to recognizing this flaw is a New York Times op-ed, by Yale University’s Robert Shiller, who noted that following a balanced budget increase in government expenditures, “. . . people have the same disposable income before and after. So there is no reason for people as a whole, taken as a group, to change their economic behavior. But the national income has increased by the amount of government expenditures, and job opportunities have increased in proportion” (emphasis added). In other words, Shiller would have us believe that additional output gets produced even though incentives are lacking.

All government expenditures are financed by taxes, so it follows that all multiplier theorizing should be suspect.

The fact that such nonsense follows upon hybridizing the expenditure and tax multipliers should give multiplier expositors pause about the hybrid’s components, especially since all government expenditures in the final analysis are financed by taxes, assuming we think like economists instead of accountants. That is, if new money finances the additional government expenditures, the tax is a tax on money, called “seigniorage.” Borrowing to finance the additional expenditures hinges on the government’s ability to repay via future taxation. Borrowing is delayed taxation.

It follows that all multiplier theorizing should be suspect. If one wants to speak about the effect of government’s fiscal expansions on national output, one must explain that the particular fiscal expansion (say, refining the definition of property rights) is superior to the necessary contraction in the private sector due to the additional taxes. Sorry, but additional government expenditures to enforce a higher minimum wage won’t do it.

T. Norman Van Cott, an adjunct scholar of the Indiana Policy Review Foundation, is a professor of economics at Ball State University. A version of this essay was published by the Foundation for Economic Education.


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