Do you believe in magic?
When it comes to "stimulating" the economy, politicians across the nation are shamelessly relying on a bit of magic. The magic of the government spending "multiplier," that is.
Ever wonder where President Obama got his figures from when he claimed that his stimulus package will "create or save 3 million jobs?" From the multiplier.
The multiplier theory, made famous by John Maynard Keynes in his 1936 book General Theory of Employment, Interest and Money, basically says that each dollar of government spending "injected" into the economy will create a larger increase in national output. This is achieved because a portion of the new money will be spent on goods and services, becoming income to the providers of said goods and services. These providers then spend a portion of their new income on other items, and the process repeats itself many times over. The net result, as the theory goes, will be new jobs and an overall increase in the nation's income.
Indeed, it seems like multiplier madness is sweeping the nation, with Keynesian economic theory dominating political and mainstream economic thought once again.
With so many experts placing so much at stake on the basis of this theory, the multiplier must be a sound foundation for public policy, right?
As economic journalist Henry Hazlitt stated in his 1959 book, The Failure of the 'New Economics', "There are, in fact, so many things wrong with the multiplier concept that it is hard to know where to begin in dealing with them."
For starters, the amount of government spending is not taken into consideration when calculating the multiplier. As Hazlitt noted, "the amount of investment, as such, appears to be irrelevant to the mathematics of the multiplier or the reasoning on which it rests."
Do you really think twenty dollars of government spending will have the same impact per dollar as $20 billion, or $20 trillion? Believers in multiplier magic do.
Furthermore, consider that statistical models designed to calculate such multiplier effects suffer from what Nobel Prize winning economist F.A. Hayek described as the "Pretence of Knowledge" in the title of his Nobel lecture. Hayek warned other economists against the use of mathematical techniques to determine "quantitative or numerical constants" regarding the "study of such complex phenomena as the market." Efforts to do so can be harmful because they "proceed on the fiction that the factors which they can measure are the only ones that are relevant." Hayek's warning can be applied to the multiplier in two specific ways.
First, the opportunity cost of government "stimulus" spending can not be captured by multiplier models. In other words, nobody can ever know what entrepreneurial endeavors would have been created if a portion of available resources wasn't already tied up in government-financed projects. There's no telling the income and job growth that would have been created if the private sector were utilizing those resources for wealth-generating opportunities. The productivity lost is noticeably absent from multiplier calculations. But just because it can't be measured makes the lost productivity no less real.
Secondly, calculations of the multiplier are filled with data based on past behavior. Human beings, however, are not robots. The future decisions of millions of individuals within the marketplace as a response to massive government spending can not be predicted with computer-like precision. Any attempt to place billions of taxpayer dollars at risk based on such flawed predictions is foolhardy and irresponsible.
And finally, what can the multiplier tell us about long-term effects of government "stimulus" spending?
Even multiplier advocates admit any potential job and income effects of government construction projects are a one-time, temporary change lasting only as long as the project itself. What the multiplier will not reveal is the reallocation of resources that will be necessary after the dust settles. Resources that were employed supporting the government projects, both directly and indirectly, will need to be redirected by the private sector.
Necessary during this reshuffling period will be a loss of jobs and a time of idle resources. It will take time for the construction workers, tractors, cranes and countless other resources to be put to use in new combinations and locations by various entrepreneurs attempting to respond to new and changing consumer needs. Likewise, the additional waiters, grocery clerks and other workers that were hired in response to the temporary influx of money into the local economies hosting the public projects will find themselves unemployed. The short-term activity created by government projects will thus be followed by a rise in unemployment and reduction in output.
It is disappointing that such a flawed concept as the multiplier has once again captured the imagination of policymakers nationwide. Unfortunately, just like when a carnival magician produces a quarter from behind a child's ear, the "magic" of the multiplier is mere illusion.
Brian Balfour is a policy analyst with the Civitas Institute in Raleigh, NC (www.nccivitas.org)