Beware the Multiplier Effect

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THEORIES ARE DEBATABLE. REALITY? NOT SO MUCH.

When a public official wants to sell a big spending increase, he’ll almost inevitably justify it by claiming that it won’t just create the benefit for which it’s intended; it will also have a “ripple effect” that will accelerate economic growth even more. This is the case not just for programs whose stated purpose is to stimulate the economy – think of the 2009 “stimulus” bill – but also, perhaps especially, for programs and projects that would seem to have little to do with economic growth – the Affordable Care Act (ACA or Obamacare), for instance. In fact, proponents of Medicaid expansion in South Carolina made just this argument, claiming that the economic growth resulting from Medicaid expansion in South Carolina would create “44,000 new jobs.” More recently supporters of a planned development off Bull Street in in Columbia have pitched the project by casting it as a job creator.

On what basis are public officials making these assertions? When supporters of a government project reference growth that will be generated from spending, their claims are premised on something called the “multiplier effect.” The multiplier effect, a product of the Keynesian school of economics, claims that spending (most often government spending) can increase the size of the broader economy beyond the actual amount expended. According to the theory, the initial spending will lead to an increase in consumption spending that will in turn increase output and incomes, thereby growing the size of the overall economy.

The theory sounds nice and is attractive for public officials for evident reasons, and many media reports repeat the stimulative effects of government projects as fact. Yet the size of the fiscal multiplier of government spending is a hotly disputed topic in the field of economics. A multiplier of 1.5 would mean that for every dollar of government spending the economy grows by $1.50, whereas a multiplier of .5 would imply that for every dollar of government spending the economy grows by 50 cents – that is, a loss of 50 cents; a multiplier of 1.0 would imply no change to the overall economy. Proponents of government stimulus and economic development have published studies that claim the fiscal multiplier of government is somewhere between 1.0 and 2.0 and occasionally even greater. Naturally, economists skeptical of the claims of a large multiplier have published studies claiming that the fiscal multiplier for government spending falls somewhere under 1.0 and is therefore detrimental to economic growth.

The economists who argue for a multiplier of less than one stress an effect of government spending commonly called the “crowding out effect.” Since all funds government spends must be extracted from the private sector, private sector enterprises are left with less money to spend and invest. It’s also argued that the investments that would have come from the private sector would have generated more growth than increased government spending, since private entities face more incentives to make sure they’re investing in profitable ventures. The threat of profit losses effectively discipline private enterprises in ways not experienced by government. The latter can always extract more from the private sector to keep bad investments alive.

In light of competing research on the fiscal multiplier, the impartial observer is left to judge the multiplier through historical or anecdotal evidence and other economic theories.

Unfortunately for proponents of a large multiplier, the evidence and theories tend to point in the opposite direction. Ignoring for a moment the larger demand-driven vs. supply-driven economic debates that color economists’ view of the multiplier, all economists agree that people respond to incentives. Indeed, the concept of incentives underlies the field of economics itself. Here’s the point: private sector actors have much stronger incentives when compared to public sector actors to ensure that their investments perform well. The reality of incentives doesn’t mean every private sector venture will succeed or that every public sector venture will fail; it simply means that the private sector will as a whole generate more economic growth with their own dollars than the government will by spending the same dollars.

Casting further doubt on the assumption of a large multiplier is the fact that government funds are rarely expended in the efficient way that pro-multiplier studies assume. Instead government funds are usually distributed slowly and inefficiently, and the decision of what to spend simulative funds on is frequently animated by political motivations.

Simply put: when the government steps in to help provide what would normally be a private service, the results are rarely profitable. Take the U.S. Post Office and Amtrak. These entities, flush with government money, have been losing hundreds of millions if not billions every year in recent memory. Recall, too, the bankruptcy of Solyndra, a firm supported with huge loans from the federal government. The Solyndra deal is estimated to cost taxpayers up to $849 million, and the Treasury last estimated that the bailout of General Motors would cost taxpayers some $25 billion once the government finalized selling off its shares in the company.

These are not the most striking recent examples, however. That distinction probably belongs to the larger federal stimulus. The government expenditure of nearly $800 billion was supposed to generate significant economic growth that would quickly “multiply” and lower the unemployment. In reality, much to the embarrassment of the Obama administration, unemployment has remained worse than the administration’s projections of what would have occurred if Congress did not pass the stimulus bill. In other words, the economy with the stimulus is performing worse than what the administration predicated would have occurred without the stimulus. These results led the administration to fall back on claims that the stimulus had “saved” jobs instead of creating them – a point that’s conveniently impossible to prove one way or the other.

The debate and effects of the 2009 stimulus is a kind of microcosm of the debate over the multiplier effect. Scholars may debate the size of the multiplier and the simulative effects of government projects, but when the rubber meets the road on these projects, the real world results almost always prove disappointing to those promoting a large multiplier.

The real world lesson? The next time politicians promise large economic growth for minimal public investment, be wary. And grab your wallet.

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