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.

How?

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.