Wednesday, September 29, 2010

Fighting The Keynesian Multiplier

This may be a good time for me to elaborate on my little private fight against the Keynesian multiplier.

The Keynesian multiplier was a little trick which Keynes used to argue for fiscal stimulus for the purpose of generating jobs. His argument went something like this: "See, you can spend some public money and it will trigger private investments which will add up to a multiple of the original sum, if the trigger effects are allowed to work themselves out properly."

If the government spends RM100 on public works, and that amount is spent on fully on local materials and local workers, then the RM100 will go into the pockets of businessmen and workers. If they keep, out of that RM100, RM20 and spend RM80, that RM80 will generate additional income of RM80 in round two. The RM80 becomes the new income and if RM16 are saved and RM64 spent, then it creates an additional income of RM64 in round three. Etc, until infinity.

Mathematically, this is an infinite series. If the whole series is added up, it goes neatly into a formula 1/(1-c). In the economic system, that c is the propensity to consume C/Y and (1-c) is the rate of saving. If the rate of saving is 20% of income, as we assumed above, the multiplier is 5 (from 10/2).

Consultants working in Malaysia have been very happy to use a multiplier of 4 to expand the benefits of every little (or big) government spending programme.

I am only very concerned that the application of a multiplier of 3 or 4 or 5 may unduly exaggerate the benefits of budget spending.


If we extract 2009 figures from Bank Negara's Annual Report 2009, we get Y=661.8 and C=435.2 in current prices. This gives a consumption rate of 65.8% or a savings rate of 34.2% and a multiplier of 2.9 (1/0.342). We can say this is about the maximum average multiplier we can apply for Malaysia.

There are other complications.

1. The calculation assumes that all the increased incomes are spent on locally produced goods and services. But leakage in Malaysia is very high because of the inability to produce world-class products which are the targets of those spending. E.g. High-spend railway line. In the example above, of the RM100 spent, RM80 could go to imports (rail engine, steel, foreign consultants, foreign workers, corruption money) and only RM20 could be spent on local goods and services. So the multiplier will be only 20% of the 2.9 or 0.6 which is less than the original amount spent (i.e., RM60 out of RM100).

2. The trigger effects may not have the chance to go to infinity. The first round is RM100 spent, and RM80 goes to imports, and RM16 consumed on local stuff. We will be lucky if the RM16 gets recycled in the local economy. If it is spent on a foreign product, then the whole of the RM16 disappears. So, the multiplier in this instance is only RM16 out of RM100 or 0.16.

It is for problems like these that our stimulus packages do not get to stimulate the economy. The whole idea of simply throwing some cash into the system and hoping that things will reboot themselves is a fantasy of policy makers who do not have a clue as to what they are doing.

And I blame the Keynesian multiplier taught in Form 6 or First Year economics to be at fault.

It is because of the impotence of the multiplier that I have been trying to fight all this while for a clarity of the programme or the economic strategy that the government is pursuing. There is a need to get the whole economic system to move in tandem in order for the movement forward to be sustainable. The government (our money) simply does have the cash to keep propping up the economy. If the baton is now given to the government-linked companies, I have to be more fearful.

We now have a strategic economic misalignment - our system with the rest of the world - and our system needs to be re-aligned. (I am tempted to pursue the analogy of re-aligning the four wheels altogether.) We have to get the economy back to the path of indigenous excellence (and I use the word "indigenous" here broadly to include all citizens, all locals) so that we can generate a good multiplier internally - so that a little home-grown investment can go a long way (and bankers do not have to worry about borrowers absconding abroad). We just have to try to plug the holes in our system.


hishamh said...

etheorist, have a look at this paper. If a country has a flexible exchange rate, is highly open to trade, and/or has an independent central bank, the fiscal multiplier is effectively zero. That to me describes the current situation in Malaysia pretty well.

Note that the analysis is conducted using a structural VAR, so it should be atheoretic (not influenced by theoretical priors, whether classical or Keynesian). Malaysia is one of the countries included in the sample.

etheorist said...


Thanks. Very interesting. Statistical analysis matching intuition.

What I find illuminating in the paper is that government investments have better impact than government consumption. There may yet be some hope for stimulus - although I really would like to see purposeful and directed government strategy rather than throwing cash on the existing structure.

semuanya OK kot said...

I don't claim to understand this and neither am I particularly interested. Economics stated as the apologist for Big Money in Britain, and seems to have reached its limits. Today, capital itself (the need for it to kep growing) is the problem, but there are few alarm bells ringing, let alone any serious work on a way out.

hishamh said...

Ah, another hyperinflation crackpot. Roberts derides the economics profession for being clueless, then turns around and thinks money printing alone will create hyperinflation.

hishamh said...

Just in case, the crackpot remark was directed at the article writer, not at you semuanya.

etheorist said...

There is a lot of unhappiness about economists even among economists.

Even this blog has decried the lack of progress in economic thinking and theorising, which has resulted in very very stale economic policies.

To think that printing money is the solution to all problems in the economy is a big mistake in policy thinking - it just betrays the lack of understanding of the underlying developments in the technology and trade adjustments in the global economy.

China comes in a big structural change to the global economy. Economists do not see it. MNCs just see it as a way to cut costs.

hishamh said...

No, money printing is not a cure-all and never has been. But neither does it automatically imply inflation, much less hyperinflation.

That's as shallow an economic analysis as always assuming the Keynesian multiplier is always above one.

Call it my own personal bugbear.

Peter L. Griffiths said...

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 creating considerable intellectual confusion.