Monday, July 7, 2008

The Multiplier Effect

I have had a couple of responses to my post 'Government Waste an example...' by two anonymous posters (hereafter 'anonymous1' and 'anonymous2').

The first post I will respond to is provided by Anonymous1, who discusses the multiplier effect, citing Wikipedia (i). The principle of the multiplier effect is explained in Wikipedia as a company building a factory, and how the money then circulates through the economy through, for example, the employment of builders. It is pointed out (correctly) that this will raise output overall in the economy.

Anonymous1 links this idea of the multiplier effect to my article about government waste, asking the following question:

'Can there ever be value in economic activity for its own sake?'

Anonymous1 also (again correctly) links this to the economics of Keynes, who believed that government ameliorate the effects of recession/depression through increased government spending (relying in part on the multiplier effect).

I have talked about the multiplier effect in my essay 'A Funny View of Wealth' (See my posts June 2008, though I do not use the term itself), and point to this effect in the creation of the recent boom. In this case the stimulus was a massive inflow of money in various forms of consumer debt and government debt.

Now to return to the question asked by Anonymous. Can there be value in the kind of economic activity for its own sake (i.e. of the kind that I detailed in my post on government waste). The first point is that, even if we accept the idea of using government spending to ameliorate the effects of recession/depression is a good thing, this kind of spending could not be justified, as it was undertaken during a period of economic boom. It would therefore be an additional stimulus to an already highly stimulated economy (in this case stimulated by growth in consumer/government debt). As such, this kind of spending, regardless of questions of economic philosophy, was just plain wasteful. All of the members of the team on the project almost certainly could have found more productive employment in other sectors of the economy. As such non-productive activity was displacing potential productive activity. Furthermore, the source of finance was from, at least in part, genuinely productive sectors of the economy. For example, it is possible to make a relatively crude argument that some of the finance used to fund the activity might otherwise been used to expand a productive business. Instead it was taken as taxation.

Another point made by Anonymous was as follows:

'And when you consider that the 'real' economy apparently thrives on jobs like mobile phone ringtone development and crystal healing he might have a point. Presumably the jobs people do in the 'real' economy are justified because others are prepared to pay for them, but by any definition, many of them are pointless and wasteful.'

I would not actually say that these jobs are wasteful, as the people who buy such services value them. Whilst they are (by my view) odd ways for people to spend money, they have as much value as a bottle of whisky, or going to see an opera. How people spend their disposable income is not an issue in the overall picture of economic health, excepting the issue of whether the spending retains wealth in the country (whether the purchase is for imported goods or services). What is an issue is whether there is a sustainable source of productive activity that creates sufficient output to allow such discretionary expenditure to take place. There are many ways that such output can be created, and I consider these in some depth in 'A Funny view of Wealth'. However, the idea that such wealth can be sustained through the expansion of borrowing is not included, and my argument is that borrowing has been the source of the UK's apparent (illusory) wealth.

What I am saying is that we can say that crystal healing, however odd it may be, is productive output as long as someone values this service. If the service is provided to the wife of a Russian oligarch, then this odd activity even provides a net contribution to the UK economy as a whole. If it is paid for by a factory worker out of his/her wages, it represents a distribution of the wealth created by the worker's productive activity. If it paid for out of debt accumulation, it becomes a net loss of future wealth for an individual. In all cases the service remains a productive activity in its own right. The real problem lies in the origin of the wealth that is redistributed through the purchase of the service. If we return to the multiplier effect, the question is as to where the wealth is coming from - its real origin. Is it from the loss of future wealth represented from debt, or is it from productive activity? In each individual case, it is nearly impossible to separate out the origin of the wealth that is redistributed. This is why we can have an illusion of economic growth, when the reality is that the economy is becoming poorer - through the loss of future wealth represented by debt accumulation.

The real problem arises when a stimulus is created through debt accumulation, and individuals and government believe this is real wealth creation, rather than loss of future wealth.

I hope the above answers the question posed. Next, a slightly more difficult post provided by Anonymous2.

Anonymous2 points to the difficulty in seeing the reality of the waste for anyone outside of the system, and says:

'Your post suggests that an awful lot of public sector employment is wasteful. I have heard people use the term 'rentier economy' to describe the UK. One characteristic of such a state is a high level of unproductive public sector employment designed to keep much of the population content.

The thing I don't understand is what the resource is that we would be 'renting out' externally.'

I will do my best to answer some of your comments, though I am not sure I fully understand your intent.

What we are doing in the UK, in many cases, is selling assets such as utilities to non-UK owners, which offers a short term boost of cash in the economy.This is at the cost of these assets becoming a source of 'rent' for the new owners of the assets. As such, whilst such sales of these assets present a short term cash boost for the economy, over the long term they represent a net loss of wealth. After all, if a person buys an asset, their intention is to extract more wealth from the asset than they have invested into the asset. This process comes under the term inward investment, and inward investment is widely seen as a 'good thing'. However, (sorry to mention it again) as is discussed in my essay 'A funny View of Wealth', it is not easy thing to determine which kind of inward investment represents an overall gain for the economy, and which represents a loss. I mention the case of the utilities as an example, because this is an example where it is hard to find any sensible reason for why there might be a gain for the economy. For other inward investments, such as establishing a manufacturing facility, the relative benefits are harder to measure (sorry, but for this discussion to make sense you really need to see 'A funny view of wealth', where I discuss the potential pros and cons in depth). However, it is certain that certain kinds of inward investment will over the long term see a net loss for the UK economy. Some of these investments might plausibly support elements of what Anonymous1 is suggesting (if I have correctly understood the meaning of the comment).

This government, and previous governments, have enjoyed the short term benefits of such (ongoing) sales of assets which helped provide an illusion of a healthy economy. How this works is a complex subject, and is difficult to summarise. A simplistic analogy is to think of a company that has owns a piece of productive machinery. It then sells the machine to a finance company that subsequently leases it back to the company. This gives a short term benefit to the balance sheet of the company, but has the long term negative effect of having to pay back more than the initial short term cash from the sale. It looks good on paper initially but, in the end, the company will have spent money with no productive gain (unless the money from the sale is invested in something else that generates more cash than the cost of servicing the lease).

As for the suggestion that the government is using spending to maintain a content (docile?) population, this is a very cynical view, but does have some merit. The more people that are dependent on government income, the more likely they are to vote for a government, and support a government that promises to continue with the spending. This is all very well, but creates a long term structural problem in the economy due to government spending removing people from productive activity. The government pays for this unproductive activity through taxation of productive activity. In doing so, the government sets in train a process of long term economic decline. The really tragic part is that this creates potential for a vicious circle, where a government will need to create ever more 'make work' jobs in order to retain votes and power. As the productive economy suffers under the burden of wealth extraction, it starts to contract, and the government responds by making further extractions to maintain the economy to a degree where the voters will still continue to vote for the government and, in doing so, makes more people dependent on the government, and so on.

I am simplifying, but I hope that you take the point. This government has seen a marked increases in the numbers of civil servants, as can be seen in the following article:

This is a very old article, so the figures are now very much out of date (sorry, I am a bit pushed for time, but it serves to illustrate the point).

In addition, there are many other areas of government spending where there are jobs reliant on government spending and in reality the workers are state employees, but which are not directly recorded as such (e.g. the project that I worked on). Every one of these jobs creates a dependency on continued government spending at a cost to the productive parts of the economy.

The implication in the comment by Anonymous2 is that this dependency is planned. In this respect, I disagree with Anonymous2. I think that there are people out there who genuinely believe that the kind of wastefulness, as I detailed in my original post, is actually of value to the economy, and genuinely believe that an ever expanding state can be maintained alongside a healthy economy. As such, where I would agree that such expansion creates docility in a large part of the electorate, I do not believe that this is part of grand plan. I would accept that there is tactical usage of such government expenditure, but do not (perhaps wrongly) believe that there is any strategic plan. Perhaps I am naive but I think that, even allowing for the petty ambition that drives politics at the micro level, the majority of politicians (and the government) are unaware that the cumulative negative effect that such micro-level activity can create. Each little piece of expansion has its own justification and appears, on the face of it, to be merited.

Note for Anonymous2: I am not sure that I have answered your point fully. If you read my this post and feel that I have not addressed your points, then please feel free to post a follow on, and I will do my best to respond.

(i) There are some people who very critical of Wikipedia, pointing out inaccuracies in various entries. However, an independent study comparing Wikipedia with Encyclopaedia Britannica found that there were less errors on average in Wikipedia. I compared the Wikipedia definition with one in an economics textbook, and concluded that the Wikipedia definition was more intelligible. My experience with Wikipedia is almost all positive. The link given for the citation was:


  1. I would like to see a tax system where the individual could opt out of some public services in exchange for tax breaks.

    Certain sectors require us all to contribute, as it is impossible not to have them involved in our lives.

    The best example of this is the Police.

    But I would like to have an option to opt out of all NHS services and resources, other than the ability to call for an ambulance to take me to a private hospital. Shouldn't that be 10% off my tax bill?

    To opt out of all state education for any children I had. Should they go to University, they would be 18 years old and responsible for themselves. Another 10% reduction?

    I might well feel that I will never claim benefit, so I should opt out of that. Of course that is not feasible. The worst case scenario must be assumed - that I will find myself broke and unemployed at some point in my life and therefore have nobody left to rely on, except the state.

    Of course, many will argue that this will lead to a widening chasm between the rich and poor. The state is increasingly paid for by the less well off. Having said that, more people are encouraged to relieve the pressure on the education and health services. They are also creating new jobs as customer-driven private hospitals and schools should be created to meet demand.

    The key to this working would, presumably, be the tax-relief being less than the average cost to the state of what I would be expected to cost the state if I didn't opt out.

    The figure of 10% was just plucked out of the air. I have no idea how much it would cost the state.

    CynicusEconomicus, what are your thoughts on this? I am sure this idea would horrify most people, who would find it easy to pick holes in. I still feel that essentially that this is the only way forward.


  2. Certain sectors require us all to contribute, as it is impossible not to have them involved in our lives.

  3. Keynes's multiplier is a mathematical identity whereby the consumption function series equals the reciprocal of the savings function, and is utterly useless in spite of sounding very learned. My name is Peter L. Griffiths.


You are more than welcome to comment on the posts, but please try to stay on topic....I will publish all comments, excepting spam and bad language, and my moderation of the comments is just to exclude these.

Please allow up to two days for the comment to appear.

I have had a request for an email address for the site and have created the following:


I have ommitted the @ symbol to avoid spam....

For general purposes I would suggest using the comment form, but will occasionally look at this email account. Please be clear what is for publication and what is not, though I will also not guarantee publishing of email comments, unlike the comments through the form! Thanks.