Home > Articles > Business & Management > Finance & Investing

  • Print
  • + Share This
This chapter is from the book

Government Spending Must Be Redirected as Well as Cut

The term “fiscal multiplier” is the same conceptually as “bang for the buck.” Government spending that boosts a nation’s income by more than the amount it spends results in a fiscal multiplier of greater than 1.0. Here I highlight how at the Keynesian Endpoint, traditional concepts on the fiscal multiplier must be re-examined and reworked if government spending is to be a net positive for a nation’s economy.

To begin our discussion, there is no better place to start then to turn to the shepherd of the fiscal multiplier, John Maynard Keynes. He discussed the fiscal multiplier at length in his book, The General Theory of Employment, and it is at the center of Keynesian economics. In his book, Keynes refers to the works of Richard Kahn, who, Keynes says, was the first to introduce the concept of the multiplier in 1931 in his article on “The Relation of Home Investment to Unemployment” (Economic Journal, June 1931). Keynes interpreted Kahn’s theory as follows:

  • His argument in this article depended on the fundamental notion that, if the propensity to consume in various hypothetical circumstances is (together with certain other conditions) taken as a given and we conceive the monetary or other public authority to take steps to stimulate or to retard investment, the change in the amount of employment will be a function of the net change in the amount of the investment; and it aimed at laying down general principles by which to estimate the actual quantitative relationship between an increment of net investment and the increment of aggregate employment which will be associated with it.6

Keynes goes on to introduce the concept of the marginal propensity to consume (MPC), which measures the proportion of disposable income that is spent. The difference between disposable income and the marginal propensity to consume is the marginal propensity to save. Keynes believes that as long as the MPC is high, increases in government spending result in a fiscal multiplier:

  • If the marginal propensity to consume is not far short of unity, small fluctuations in investment will lead to wide fluctuations in employment.7

Keynes allowed for leakages, pointing to important factors “not to overlook” when calculating the multiplier, including the source of funds used for government spending and the impact that the use of these funds might have on interest rates and inflation; the “confused psychology which often prevails” from government spending and its effect on confidence and therefore liquidity preferences; and the likelihood that “in an open system with foreign-trade relations, some part of the increased investment will accrue to the benefit of employment in foreign countries.” In other words, some of the spending will be on imported products, not domestically produced ones.

These leakages are major elements of the Keynesian Endpoint because the leakages reduce the effectiveness of continued fiscal profligacy and of traditional Keynesian-style efforts to stimulate economic activity through deficit spending.

Consider, for example, the impact of large budget deficits on liquidity preferences. Alan Greenspan (2011)8 argues that the size of government affects investments in long-term assets, finding that as a share of corporate liquid cash flow, long-term fixed corporate investment “is now at levels, relative to cash flow, that we have not experienced since 1940.” He explains it this way:

  • I infer that a minimum of half and possibly as much as three-fourths of the effect can be explained by the shock of vastly greater uncertainties embedded in the competitive, regulatory and financial environments faced by businesses since the collapse of Lehman Brothers, deriving from the surge in government activism. This explanation is buttressed by comparison with similar conundrums experienced during the 1930s. I conclude that the current government activism is hampering what should be a broad-based economic recovery.9


  • U.S. fixed private investment has fallen far short of the level that history suggests should have occurred given the recent dramatic surge in corporate profitability.10

Greenspan makes a vitally important point about how uncertainty affects human behavior, and he draws a link between the recent spreading of government activism and current uncertainties:

  • The inbred reaction of businessmen and householders to uncertainty of any type is to disengage from those activities that require confident predictions of how the future will unfold... While most in the business community attribute the massive rise in their fear and uncertainty to the collapse of economic activity, they judge its continuance since the recovery took hold in early 2009 to the widespread activism of government, in its all-embracing attempt to accelerate the path of economic recovery.11

If a nation is to be effective in optimizing the use of its taxpayer dollars, it must stop the leakages to which Keynes referred and get out of the way, so to speak. People will continue to fear confiscation of their income and cuts in benefits and services as long as their country is filled to the gills with debt and overly active. When these leakages are controlled or reduced, nations should focus on redirecting taxpayer money toward areas likely to provide lasting benefits, including infrastructure (why not retrofit buildings to make them more energy efficient?), research and development (spend to create new products that provide new sources of income), and education (or else the jobs will go elsewhere and the newly unemployed will have difficultly regaining employment).

It can be helpful for nations that have reached their borrowing limits to implement budget rules that investors will find credible. This is especially true for serial defaulters, who need to gain the credibility of investors. If they don’t, the nominal interest rates on their debts will exceed the nominal growth rates of their economies. In this case, the debt-to-GDP ratio will rise in perpetuity unless the nation runs a budget surplus large enough to offset the interest payments. In other words, achieving a zero primary balance (discussed earlier) won’t necessarily be enough to stave off continued deterioration in a nation’s fiscal situation if investors lack confidence that the zero primary balance will be sustained. A recent study by the IMF (“Fiscal Rules Can Help Improve Fiscal Performance,” December 2009)12 supports this idea.

Nations at the Keynesian Endpoint are starved for sources of economic growth. One that has been dependable is the implementation of free trade agreements (FTAs). To illustrate, consider data from the United States. In 2001, the U.S. had forged three FTAs. By 2006, it had signed 14 of them. Data from the Census Bureau in 2006 show that the 14 FTAs accounted for over 42 percent of U.S. exports even though these countries accounted for only 6 percent of the world economy. Data from the White House show that after 5 years of signing FTAs, the average increase in trade between bilateral trading partners was 32 percent; after ten years it bolted to 73 percent; after 15 years the increase surged to 114 percent. These data and numerous other data clearly show the benefits of free trade in boosting economic activity, presenting an enormous source of growth for countries willing to put down their protectionist arms.

Suppose a nation’s economy is growing at a 5% annualized pace overall and 2% minus inflation. Suppose also that the nation’s budget deficit is 4% of GDP. The nation decides that in order to reduce its debt-to-GDP ratio it will inflate its way out. In doing so, it boosts its money supply growth to say 8%, thereby spurring an 8% overall increase in the economy, but at the expense of more inflation, which increases to a 5% annual pace. In five years, this nation will have seen its economy grow by 40% in nominal terms, and its debts will have increased by 20%, lowering the GDP ratio by 4% per year. This seems desirable, but it isn’t; the nation’s purchasing power declined as a result of the increase in the inflation rate. This lowers the nation’s standard of living. The lesson is that nations must be careful about using this tempting math to lower its debt load because although it might solve the debt problem, it will create many unintended consequences.

Despite the risks, nations for centuries have turned to coinage and the printing of money as a means of shedding debt, in many cases with disastrous consequences. The many lessons learned from the debasement of currencies nevertheless are lost upon Keynesians, as they seeing through rose-colored glasses debt spending as the cure for all that ails a nation.

  • + Share This
  • 🔖 Save To Your Account