One of the economic myths that has infected economic doctrine is the spending multiplier. The story starts with an increase in spending. Suppose a tourist from abroad spends $100 in a shop. The store owner now has an extra $100, and he spends it in a restaurant. The restaurant owner now has an additional $100, and he buys shoes. The shoe seller now has $100, and he buys a printer. That initial $100 of extra spending gets multiplied, as each time it is spent, the $100 becomes income for the next person, so the initial $100 injection into the economy has gotten multiplied into $400, and it keeps on multiplying until some rich person saves the $100 rather than spending it. Now, because of that wicked savings, the multiplier stops.

The multiplier myth appeals to government officials who think that if they inject $100 of extra government spending, it gets multiplied into $1000 of higher output, reducing unemployment. That is how many politicians believe that we can spend ourselves into prosperity.

The multiplier myth has a superficial appeal, and it has even fooled many economists who evidently have not thought it through. The myth appeals to government officials who think that if they inject $100 of extra government spending, it gets multiplied into $1000 of higher output, reducing unemployment. That is how many politicians believe that we can spend ourselves into prosperity.

The superficial appeal of the multiplier myth lies in thinking in terms of money rather than physical output.

The superficial appeal of the multiplier myth lies in thinking in terms of money rather than physical output. Suppose there is a farmer who grows wheat that sells for $5 per bushel. The quantity of wheat he produces is based on the farmer’s calculation of the extra costs versus extra revenue from greater output. Now suppose that the government borrows $50,000 from abroad and buys 10,000 bushels of wheat from the farmer. The farmer sells the wheat to the government instead of to a granary. If the farmer was already producing the optimal amount of wheat, maximizing his profit based on the costs of inputs and the price of wheat, that purchase will not make the farmer increase his output. The same logic applies to other firms. If they are already profit-maximizing, or fully employed, they will not expand production.

As evidence, the government of Greece borrowed funds for years to provide greater welfare programs, yet the economy of Greece did not respond with greater growth. Likewise Japan spent a fortune on infrastructure and welfare after its real estate bubble of the 1980s, with no multiplier response in the economy. By the doctrines of the followers of the economist John Maynard Keynes, government spending is supposed to get multiplied into high growth, yet economies world-wide—all having Keynesian demand-side stimulus—have had sluggish growth.

As evidence, the government of Greece borrowed funds for years to provide greater welfare programs, yet the economy of Greece did not respond with greater growth. Likewise Japan spent a fortune on infrastructure and welfare after its real estate bubble of the 1980s, with no multiplier response in the economy. And the USA has had large government deficits, hence greater spending, but since the recession of 2008-9, growth has been sluggish.

Demand-side policy is the hope of an increase in output caused by greater government spending. By the doctrines of the followers of the economist John Maynard Keynes, government spending is supposed to get multiplied into high growth, yet economies world-wide—all having Keynesian demand-side stimulus—have had sluggish growth.

Higher prices for shares of stock and land value do not generate growth.

In a normal economy, savings is not a leakage from output. Savings get loaned out for borrowers to spend. However, the economies of today are not normal. Super-low interest rates and government borrowing have not gotten multiplied into much more output. Like in the years after 2001, funds from savings and money creation have been misallocated into the purchase of assets - stocks and real estate. Instead of expanding output, firms are buying back their shares of stock. But higher prices for shares of stock and land value do not generate growth.

The deadweight loss of ever greater restrictions and imposed costs have stifled economic growth. Small companies might be able to survive when they are exempt from some of these costs, but they must remain forever small, for when they have more than 50 workers, bang! imposed costs kick in. Instead of investing more, companies are leaving high-tax states such as California, and are moving their business and capital out of the United States.

The economic problem is not a lack of demand, but a lack of supply. Although interest rates and commodity prices are low, banking regulations—implemented in reaction to the Depression of 2008—create credit constraints that prevent loans for investment. Also, firms will not invest in capital goods and human capital if the total costs are too high—costs that come from taxes, restrictions, and mandates. The deadweight loss of ever greater restrictions and imposed costs have stifled economic growth. Small companies might be able to survive when they are exempt from some of these costs, but they must remain forever small, for when they have more than 50 workers, bang! imposed costs kick in. Instead of investing more, companies are leaving high-tax states such as California, and are moving their business and capital out of the United States.

Imposed costs can generate perverse incentives, such as investing in machines that replace labor when higher minimum wages plus labor taxes make labor too expensive.

Imposed costs can generate perverse incentives, such as investing in machines that replace labor when higher minimum wages plus labor taxes make labor too expensive. Technological progress, such as 3D printing, software for legal and accounting services, robots, and medical advances should be generating investment, but that gets stifled if restrictions and taxes interfere.

Rather than rely on the economic magic of a spending multiplier, governments should switch to a real-world supply-side policy of inducing greater production by removing the costs and restrictions that government imposed in the first place. Instead of taxing production and consumption, government could shift to taxing the productive capacity of land.

Rather than rely on the economic magic of a spending multiplier, governments should switch to a real-world supply-side policy of inducing greater production by removing the costs and restrictions that government imposed in the first place. Instead of taxing production and consumption, government could shift to taxing the productive capacity of land. With no tax on their output or income, but a tax based on what the land could optimally produce, whether the land actually does or not, production would be stimulated rather than stifled.

In an unhampered economy, the economic law discovered by the French economist Jean-Baptiste Say would prevail: production pays the input providers, and so enables them to have an effective demand for the goods produced. Real demand comes from real supply rather than the hope that spending magically multiplies.

© Text Copyright Fred Foldvary, Ph.D. rights reserved.
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