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Tuesday, June 9, 2009

Keynes’s Ghost

Underlying the belief that increased government spending can stimulate the economy is the “expenditure multiplier” theory formalized by Richard Kahn in 1931 and later enshrined in modern macroeconomic analysis through John Maynard Keynes’s 1936 book, The General Theory of Employment, Interest and Money.

That the Obama administration based its policy on the assumption that every dollar of government expenditure has $1.50 worth of impact is a remarkable testimony to Keynes’s observation in that book: “The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.”

So it is that Keynes’s false expenditure-multiplier argument, severely criticized by his contemporaries, can now be invoked in support of massive spending.

The argument is founded on two key assumptions that turn out to be false. First is the notion that savings are not spent but rather are withdrawn from the expenditure stream. That assumption prompts stimulus proponents to believe that taxation or government borrowing expands total spending, while leaving the money in the private sector retards it. The flaw is the equation of saving with hoarding. People save their unconsumed income in bank deposits and mutual funds, purchase bonds (private or government) and stocks, or some combination of all of these. Thus savings are the sources of funds spent by borrowers. And as the classical economist most admired by Keynes declared: “No political economist of the present can by saving mean mere hoarding.”

That was Malthus, who was reaffirming Adam Smith’s explanation in The Wealth of Nations that “What is annually saved is as regularly consumed as what is annually spent, and nearly in the same time too; but it is consumed by a different set of people.” Note that “to consume” does not only mean “to eat.” It also means to “use up.” Thus John Stuart Mill elaborates Smith’s explanation: “The word saving does not imply that what is saved is not consumed, nor even necessarily that its consumption is deferred; but only that, if consumed immediately, it is not consumed by the person who saves it. If merely laid by for future use, it is said to be hoarded; and while hoarded, is not consumed at all.” And when savings are borrowed by businesspeople, they are “all consumed; though not by the capitalist. Part is exchanged for tools or machinery, which are worn out by use; part for seed or materials, which are destroyed as such by being sown or wrought up, and destroyed altogether by the consumption of the ultimate product. The remainder is paid in wages to productive laborers, who consume it for their daily wants; or if they in their turn save any part, this also is not, generally speaking, hoarded, but (through savings banks, benefit clubs, or some channel) re-employed as capital, and consumed.”

Keynes’s lack of formal training in economics, besides his eight weeks of tutorials from Alfred Marshall, may explain his failure to interpret correctly Marshall’s own restatement of the meaning of saving, which Keynes himself quoted: A man “is said to spend when he seeks to obtain present enjoyment from the services and commodities which he purchases. He is said to save when he causes the labor and the commodities which he purchases to be devoted to the production of wealth from which he expects to derive the means of enjoyment in the future.”

The Government Spending Shuffle

The multiplier’s second incorrect premise is that government expenditures are “autonomous”; that is, government spending does not depend on current income. It may be true that politicians pay hardly any attention to the level of income in the economy when they choose how much government should spend. That it planned to spend $787 billion when the economy was in a recession is ample testimony to such an inclination. But the amount the government spends comes primarily from taxes paid out of the public’s current income. Furthermore, government expenditures above tax receipts have to be paid for through the sale of bonds, purchased out of the public’s savings. Thus increased government spending simply shuffles around currently earned incomes and savings without adding anything to total spending. And when government shifts more of current income toward its favored expenditures, the economy’s future functioning is impaired because such spending yields less than would have resulted had the income earners spent the money themselves.

Borrowing from the rest of the world may add to total spending in the United States at the expense of spending in some other countries. But it is hard to conceive of foreign savers eager to send their unspent incomes to the United States when their own economies are experiencing recessions. Besides, the Keynesian multiplier idea is supposed to hold in every country. Thus it is unrealistic to expect that all governments would be able to increase their borrowing from “the rest of the world” in order to increase total world spending.

Borrowing from a central bank (inflation) may increase total spending beyond currently generated incomes. However, the stimulative effect can only be temporary, until nominal wages adjust to the resulting rise of prices and participants in the capital markets have taken measures to hedge against future capital losses. This is the classical forced-saving doctrine that Keynes read but failed to interpret correctly, thinking it applies only to an economy operating at full employment.

Indeed, David Ricardo described as an “absurdity” the belief in the ability of a central bank to promote lasting economic prosperity by issuing paper money. The belief, he said, attributes “a power to the circulating medium which it can never possess.” Keynes encountered a similar warning about the futility of a central bank’s money creation to promote prosperity in Ricardo’s Principles but unwisely dismissed it as having relied on the assumption of full employment. The Federal Reserve evidently has been attempting to prove Ricardo wrong with its reckless money creation, especially since the third quarter of 2008. It has lost so far.

Production Drives Economies

A fundamental flaw of the Keynesian multiplier argument, besides the two faulty premises, is its failure to recognize that consumption spending follows production and the earning of income. It is incorrect to think of spending as one consumer handing over a fraction of her income to another to spend. Rather, individuals engage in production from which they earn incomes by selling what they do not consume. From the incomes thus earned, individuals purchase goods and services they themselves do not produce. The remaining income may be held in cash (hoarding) or turned over to others through purchasing interest- or dividend-earning assets (saving). That is why the classical economists emphasized that production, rather than consumption, drives an economy, another explanation Keynes encountered from Mill but could not interpret correctly:

What constitutes the means of payment for commodities is simply commodities. Each person’s means of paying for the productions of other people consist of those which he himself possesses. All sellers are inevitably, and by the meaning of the word, buyers. Could we suddenly double the productive powers of the country, we should double the supply of commodities in every market; but we should, by the same stroke, double the purchasing power. Everybody would bring a double demand as well as supply; everybody would be able to buy twice as much, because everybody would have twice as much to offer in exchange.

Before Keynes borrowed Richard Kahn’s formulation of the expenditure multiplier, founded on consumption expenditures, other analysts had argued the “multiplying effect” of production, as Mill explains above. The argument is that increased productivity or a surge in production within one sector of an economy stimulates increased production in others as a result of the additional demand or income generated by that sector. Thus the discovery of high-yielding varieties in agriculture or the introduction of more advanced information-processing technologies into computers may have multiplying effects on production in other sectors of an economy. That explanation is a far cry from the Keynesian belief that by taking some of the public’s income to subsidize the arts, pay the unemployed over an extended period, or cover children’s health care, government will stimulate increased production in the rest of the economy. Even necessary expenditures on infrastructure entail forgone production. For a correct analysis, one always has to keep in mind the displacement effect of government spending.

Among Keynes’s contemporaries who criticized his multiplier argument most consistently was R. G. Hawtrey, who declared it variously as “practically untenable, . . . nonsense, . . . [and] fallacious,” and said that it does not represent “a correct account of the sequence of events.” (See more of such criticisms in my “On the Mythology of the Keynesian Multiplier,” American Journal of Economics and Sociology, October 2001.) Evidently, those who recommend massive government spending have paid little heed to previous criticisms of the multiplier argument. They presumably were impressed by its expression in algebra and geometry in modern macroeconomics textbooks. They also have not learned from the failure of former President Bush’s tax cuts of 2008, which were meant to stimulate consumer spending and spare the economy from a downturn. Cutting taxes, only to borrow from the public to fund the increased deficit, could not have increased production. Perhaps the failure of the so-called stimulus to bring economic recovery will finally teach the right lesson on the impotence of increased government spending.

Economic recessions typically are the result of a mismatching of production with consumer demand. Given the incentives of producers to correct their own mistakes to recover profitability, economies sooner or later recover from recessions on their own. But recovery can be forestalled when governments undertake expenditure or regulatory measures that frustrate the corrective actions of private producers and consumers. Massive, diversionary spending by government does not help the recovery process.

  • James Ahiakpor is a Professor of Economics at California State University, East Bay. He received his Ph.D. in economics from the University of Toronto and he has taught at Saint Mary's University and the University of Ghana.

    He is a member of the FEE Faculty Network