In economic theory, the spending multiplier is the amount of output generated by spending. If you spend $100 for shoes, the seller orders $100 of new shoes, and that generates $100 of shoe product. In that case, the multiplier is one.
Common sense would tell us that the spending multiplier is normally one. If a foreigner visits the USA bringing in foreign money, each dollar he spends should induce a dollar of output. But it is possible for the multiplier to be greater than one. Suppose the economy is depressed, and there are idle resources. Then a purchase of $100 of corn not only stimulates $100 of new cultivation, but the seller will spend that $100 for tools which otherwise would have been unsold, and the tool seller will spend those funds for shoes, and so on, so that as the money circulates, it multiplies the original $100 into much more output.
When an economy is depressed, there are credit constraints that prevent people from exchanging services. The carpenter can’t sell chairs because buyers have no money and no credit, and the dentist is sitting idle in his office because the patients have no money and no credit. The dentist would like to buy a chair, and the carpenter needs dental services, but with no money, they can’t trade. An infusion of cash breaks the credit constraints, and now people can trade and therefore produce.
The demand-side doctrine in economics that originated with the thought of John Maynard Keynes states that there is a general spending multiplier that government can exploit by spending. This doctrine says that savings is not necessarily borrowed and spent, so more savings results in less spending and less output. So when government takes up the slack and spends, we not only get that spending, but several times more as output gets multiplied.
An application of this doctrine is the essay, “Social Security’s Impact on the National Economy” by Gary Koenig and Al Myles, published for discussion by the AARP Public Policy Institute. In 2012, US Social Security paid $775 billion to recipients. There would seem to be a multiplier from this income, as the receivers buy goods, and then the sellers pay for labor and supplies, and so on. The input-output economic model used by the authors, IMPLAN, claims that the Social Security income “supports 9 million jobs” and adds $1.4 trillion in output. The authors conclude that every dollar of Social Security income generates $2 of additional output.
However, one cannot conclude from this analysis that without Social Security, output would be lower. First of all, the same or greater spending would be accomplished in the private sector if the funds put into payroll taxes were instead invested in the financial markets, such as with indexed mutual funds, and then converted into annuities that provide a lifetime income. The spending would be even higher, since for most workers today, Social Security pays back about what is put in, whereas investments would grow with compound interest, paying much more than what was invested. Also, the investments would generate more growth and so more income.
Secondly, in a normal economy (not depressed), savings does not just sit idle, but is loaned out for borrowers to spend. The Keynesian spending multiplier depends on investment being a fixed amount regardless of savings, but since investment comes from savings, more savings implies more spending for investment in capital goods and education. When all income is spent, there is no gain from governmental spending, since it replaces private spending. The money spent by Social Security recipients is taken from payroll taxes which otherwise would have been spent privately.
When it is recognized that savings are spent for investment, the model’s spending multiplier disappears. The spending multiplier model depends on a fixed amount of investment, so that more spending from private consumption or from government generates more output, because the “marginal propensity to consume” (the extra spending from extra income) is less than one. But as savings is spent by borrowers, the total marginal propensity to consume is one, and when government spends funds, the money is taken from the private sector as taxes or bonds, and reduces private spending.
While the superficial appearance is that the farmer who receives $100 and spends the funds for tools generates $100 of more tool production in addition to his $100 worth of more crops, the reality is that when the farmer repeatedly trades with the tool maker, there is no multiplier. Only if a foreigner injects $100 into the economy does spending rise, but if the farmer is already fully employed growing corn, the extra spending just raises the price of corn.
“There is no gain to the economy from Social Security.”
There is therefore no gain to the economy from Social Security. In a normal economy, the spending multiplier is a myth, and without Social Security, private spending would more than replace the spending from Social Security. By reducing savings and growth, Social Security is a loss, not a gain, to the economy.
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FRED E. FOLDVARY, Ph.D., is an economist and has been writing weekly editorials for Progress.org since 1997. Foldvary's commentaries are well respected for their currency, sound logic, wit, and consistent devotion to human freedom. He received his B.A. in economics from the University of California at Berkeley, and his M.A. and Ph.D. in economics from George Mason University. He has taught economics at Virginia Tech, John F. Kennedy University, Santa Clara University, and currently teaches at San Jose State University.
Foldvary is the author of The Soul of Liberty, Public Goods and Private Communities, and Dictionary of Free Market Economics. He edited and contributed to Beyond Neoclassical Economics and, with Dan Klein, The Half-Life of Policy Rationales. Foldvary's areas of research include public finance, governance, ethical philosophy, and land economics.
Foldvary is notably known for going on record in the American Journal of Economics and Sociology in 1997 to predict the exact timing of the 2008 economic depression—eleven years before the event occurred. He was able to do so due to his extensive knowledge of the real-estate cycle.