Money Multipliers, Macroeconomics, Government Spending and Obama's SOTU proposals

• Posted by Jeff Carter
• on January 24th, 2011

Here are some objective statements one can make about economic growth:

1. Every one percentage of tax cut will lead to a three percentage growth in economic output.

2.  Virtually all new job creation since 1980 has come from companies less than 5 years old.

Let’s try to translate this so laymen can understand.  Much of it is based on economic multipliers.  In the world of economics, what you see on the surface is not always what it seems to be.  Government spending is like that.  Most people intuitively think that because a government spends money, there is economic gain.

Money multipliers are like that.  What the heck is a multiplier anyway?  It’s the mathematical relationship between the monetary base, and the money supply of the economy.  Oh, “What’s that?”, you ask.  The monetary base is the value of all the currency in circulation held by the public in their accounts, and the amount of money held in reserve requirements by a central bank.  In the US, it’s also called “M1″.  You might ask, “Doesn’t that sound like money supply?”.  It does, it’s related, but it isn’t.  The money supply is the spending power of the monetary base.  There are other measures of the supply of money, from M0 all the way to M5 depending on the central bank that is measuring it.

Aha!  So, the multiplier refers to the creation of money when a bank makes a loan to a person or business.  The bank is essentially “creating” money, because it uses leverage with the Federal Reserve to lend money out. The Fed charges and interest rate to the private bank-and in turn, that bank earns a profit by charging an interest rate on money it lends out. Capice?

In Japan today, they reported that “Base money grew by almost 5 per cent last year, but it did not multiply: the money stock increased by just 2.8 per cent.”  Japan has been in economic doldrums since the real estate crash of 1992.  Many try to equate the economic situation in the US to what is happening in Japan.   But, in fact, because the underlying macro economies are so different, the outcomes will be far different-yet Keynesian stimulus in each have had the same result.

Japan’s central bankers and government have aggressively pursued Keynesian economic stimulus for the better part of two decades now. Nothing has happened, except the government has built up a crushing amount of debt.  Japan’s central bank has continuously purchased it’s own debt, “quantitative ease”, over all this time, to no avail.  Why hasn’t it worked?

Japan’s economy is relatively closed.  They don’t allow a lot of imports of goods. Their workforce is aging, and it also doesn’t allow for a lot of immigration.  The lion’s share of the Japanese GDP relies on exports. Domestic consumption has improved in the past few years, but their indigenous population can’t possibly consume, and demand enough to cause consistent increases in GDP.  Booth Chicago economist Raghu Rajan eloquently points this out in his book, Fault Lines.  Economies need both domestic growth, and growth in exports to remain healthy over long periods of time.

The Japanese bank is “pushing on a string”.  Until they change the underpinnings of their economy, they won’t climb out of their economic stagnation.  There is no demand for loans in Japan to create economic activity.  The Keynesian model of economic stimulus that they have used has yielded the multiplier effect that it is supposed to yield, 1:1.  For every dollar they borrow, they get no economic oomph from it.

Japan’s economy is vastly different than the US economy, but Keynesian stimulus has produced the same results.

In the US, we spend boatloads of money in the Democratically passed porkulus of March 2009.  Our Federal Reserve is actively trying to create money using quantitative ease.  Currently, they have embarked on the second one, QE2.  The US is still treading water.  For every dollar we are borrowing, we get a 1:1 macroeconomic effect in the economy.  Ironically, spending increases in World War 2, and the Korean War got us the same multiple! Government spending has little effect on the overall economy.  It’s merely a transfer of wealth.

In 2007, former Obama economic advisor Christine Romer found that if you cut taxes, the multiplier effect is 1:3.  For every one percentage point in tax cuts, there is a corresponding three percentage point move upward in economic output. However, it is important to note that “targeted” tax cuts don’t work.  The government cannot predefine where the economic growth will happen.  So, they are better off passing a blanket tax cut and letting the private market figure it out for itself.  In more pedestrian terms, you might call this picking winners and losers versus just standing back and seeing what happens.

Ironically, this point on multipliers was made December 11, 2008 in Harvard Professor Greg Mankiw’s blog.  Economist Kevin Murphy of the University of Chicago produced a powerpoint that shows the stimulus effect of government spending is 0, null, nada.  I hate to say they “told you so”, but they did tell you so.  The facts were out there, but they were ignored.

This brings us to today.  We are still in this mess, and have a new cadre of congressman, and some new cabinet personnel.  Will they change?

One sign that the ship steadied was the re-enactment of current tax policy.  But, they can go much further than that.  If Obama and Congress are really serious about growth, they will cut taxes, and at the same time, cut government spending.   If Obama is truly a pragmatist and data matters-that’s what he should propose in his State of the Union address.  The economic facts are clear both in theory and practice.

Most entrepreneurial companies pay taxes at either the highest personal rate, or corporate rate.  To create economic growth, drastically cut those rates.  At the same time so they have room to borrow, government spending has to be decreased.  This frees up risk capital for banks to lend to emerging companies-causing growth to occur.  When banks lend back to the government in the form of QE2, no growth occurs.

This stuff isn’t rocket science.  It’s actually pretty simple.

tip of the hat to Professor Pinch at Minyanville

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