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How Big Is My Multiplier?

Posted by on September 10, 2012 in Economic Theory | 0 comments

The debate rages about whether the Chancellor should implement a Plan B, or C or D or even Z.  There seems to be a plethora of alternatives.  But many of them share a key common theme.  Namely, that an increase in public spending will boost output in the economy overall.

This was one of the revolutionary new ideas developed by Keynes, which he called the ‘multiplier’.  An increase in public spending means that more people are employed, in the public sector itself of in building infrastructure. These in turn spend more money and the effect ripples across the economy. The final impact is a multiple – hence the word ‘multiplier’ – of the initial increase in spending.

This seems to be commonsense.  But commonsense can often lead us astray.  It seems to be common sense that the Sun goes round the Earth, it goes round the sky after all.  What does modern economics have to say about the size of the multiplier?

Keynes himself thought it was between 2 and 3.  So an increase of £1 billion in public spending would eventually increase GDP by between £2 and £ 3 billion.

Great news if this is true.  The tax take from an increase in spending is around 40 per cent, and 40 per cent of £2 or 3 billion is around £1 billion.  So public spending creates jobs, boosts output and pays for itself.

Here is the bad news.  Modern estimates of the multiplier put it much lower than that.  In the late 1970s, I was involved in the first systematic comparison of the multiplier in the 3 leading macroeconomic models of the UK economy, including that of the Treasury.  We estimated then it was between 0.5 and 1.2.

The Journal of Economic Literature, one of the world’s top academic journals, published a symposium in September last year on the size of the multiplier.  Even the Keynesian-based models of the US economy only put the multiplier at between 0.8 and 1.5.  And this will be lower for much more open economies such as the UK, because a bigger proportion of any increase in spending simply leaks out of the economy in imports.  Nobel Prize winner Robert Barro argues that spending targeted to have very low import content has a multiplier of around 0.6.

Poor old multiplier, just look how small it is!   Even at the optimistic end, modern economics suggests that the eventual increase in national output will hardly be any bigger than the increase in public spending.  Many estimates have the eventual rise as being considerably less.  There are all sorts of reasons for the tiny multiplier.  Some spending disappears into imports. If interest rates rise, the value of government bonds falls and there is less wealth.  Economics itself suggests that more public spending is not the panacea it is purported to be.

As published in CityAM on Wednesday 5th September

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